The death of the unified credit makes things tricky.

No, we're not talking about post-World War II Germany, or a married couple in the midst of divorce proceedings. Instead, we're talking about something far more esoteric, but still important for our clients-the disunification of the credits against gift and estate tax.

For those of you who don't realize it, the term "unified credit" is now a thing of the past. When passed in 2001, the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) increased for 2002 both the gift and estate tax credits to $345,800, enough to offset the taxes due on a $1 million gift or bequest. However, while EGTRRA scheduled the estate tax credit to continue to increase over the subsequent years, it did NOT do so for the gift tax credit. Consequently, the estate tax credit increased to $555,800 (an amount adequate to offset a $1.5 million bequest) on January 1, but the gift tax credit amount remains adequate for only a $1 million gift. Disunification has begun!

So what does that mean to us as practitioners? Well, first of all, it's time to change the language of financial planning-what was once the "unified credit" must now be referred to in its component parts: the estate tax credit and the gift tax credit. Although technically the credits are still "unified" in a sense (an inter vivos gift still reduces both the gift tax credit and its linked estate tax credit), the differing maximum credit amounts must force a rethinking of these constructs. Second, we must begin to adjust our thinking about how we advise clients, particularly in terms of lifetime gifting.

Aside from their now-unlike lifetime maximum credit amounts, the estate and gift tax systems have another significant difference: The estate tax is tax inclusive, while the gift tax is tax exclusive. For example, an individual with $2 million can utilize this money by gifting $1.7 million to a child and paying $300,000 in taxes (the applicable taxes on $1.7 million after subtracting the gift tax credit of $345,800). If the same individual chooses to bequeath $2 million, the tax base is the full $2 million, resulting in a tax bill of $435,000 (after application of the estate tax credit), with a net of $1,565,000 to the child-a $135,000 decrease in the net to the heirs.

Because of this important difference in tax exclusivity of the gift and estate tax systems, it has sometimes been beneficial for individuals with large estates to choose to utilize their unified credit and make additional gifts beyond it. Although incurring gift taxes, this allows clients to take advantage of the tax-exclusive nature of the gift tax system. As long as the individual outlived the gift by at least three years, the gift taxes were forever removed from the estate. If the individual died within three years, the gift taxes were still drawn back into the estate under IRC Section 2035. However, this really left the individual in no worse a position than he or she would have otherwise been in (aside from an adjustment for the time value of money by having paid gift taxes a year or two before death instead of at death).

Thanks to disunification, though, this strategy will fall on hard times. With an estate tax credit amount of $1.5 million, but a gift tax credit of only $1 million, a gift of $1.25 million might partially take advantage of the tax-exclusive nature of the gift tax system-but this amount would be ENTIRELY exempt if simply held until death. The individual never comes out ahead under the tax law of the next few years. This is exacerbated further by the fact that, although the gift tax credit will remain level indefinitely under the current tax law, the estate tax credit amount will continue to rise: $2 million in 2006, $3.5 million in 2009 and disappearing completely in 2010. (After 2010, under the current system, both credits will be "reunified" at $1 million in 2011 if there are no other future changes in the law.) As a result of this increasing laxity in the estate tax laws with no concurrent adjustment for the gift tax credit, individuals are now discouraged from making lifetime gifts in excess of the gift tax credit amount.

This is somewhat ironic in light of a nationwide trend of longer life expectancies. The natural result of this increased tax incentive to hold assets until death will be that children will receive inheritances later in life. Wealth from parents who die in their eighties and nineties will be transferred to children in their sixties and seventies-an aid to their children's retirement perhaps, but an inheritance that many would argue is coming far later than it should to be of optimal benefit to children. Parents are outright dissuaded from making substantial gifts during life to aid their children in lieu of securing their retirement in the distant future. Promises of this nature from parents to children can in turn have extremely deleterious effects-in effect, the lesson is "don't worry about your financial future." Although this thought may be relieving for some, it also tends to teach irresponsibility. It fails to teach children stewardship of money and instead encourages them to "do as they like" with their earnings throughout their working years, with the expectation that money, although unavailable in early years, will ultimately come to children in the later years as a most tax-efficient bequest.

Unfortunately, there is not a lot that we can do to change our tax system as it exists (short of writing our Congressional representatives), but we can do things to help our clients. We can encourage them to teach and model skills to their children that allow them to learn how to be responsible with money. This is a vast topic whose scope reaches far beyond a single article, but books such as Charles Collier's "Wealth in Families" can provide an excellent starting point. In addition, we can teach our clients the opportunities that are available as the tax law stands now. Finally, we can continue to show our clients (for those that can afford to do so) the intangible human benefits, such as an improved quality of life and added responsibility, that can come from gifting at least as much as the newly limited gift tax credit amount to children. If children of wealthy families don't learn how to handle "large" sums of money like the gift tax credit equivalent amount (i.e., $1 million), they almost certainly will be incapable of properly handling an even larger amount in the future. Thus, although we cannot avoid the disunification of the estate and gift tax credits, perhaps we can help avoid disunification of our clients' heirs and their money.

Michael Kitces, MSFS, CFP, CLU, ChFC, is director of financial planning with Pinnacle Advisory Group in Columbia, Md.