The New Focus of Estate Planning
Estate planning’s been in turmoil for more than a decade, but the tax law is settled and the new rules and strategies are clearer. The turmoil began with the 2001 tax law that made multiple changes over 10 years and then scheduled a reversion to the 2000 law. Then, a 2010 deal temporarily eliminated the estate tax for most of us for two years. That change, with some modifications, became permanent in 2013.
Less than one half of one percent of estates of adults who pass away in 2014 will incur the federal estate tax, estimates the Tax Policy Center. That’s because each person has a $5.34 million lifetime estate and gift tax exemption that will increase with inflation each year. In addition, the portability rules allow married couples a true doubling of the individual exclusion.
Don’t conclude, as many have, that you don’t have to worry about taxes in estate planning because of the estate tax break. Taxes should figure in your estate plan as much as ever but in a different way. Your plan should focus on two areas other than federal estate taxes.
The first area is the non-tax features of the plan. You need a financial power of attorney, advance medical directive, trusts to protect assets from waste or creditors, and other protections for your wealth. I’ve had detailed discussions of these and other non-tax factors in the past.
The second area, which we’ll delve into in this visit, is a fresh and different focus on tax planning.
Instead of being focused on the federal estate tax, most of us now should focus on reducing capital gains and income taxes over the long term. We also need to plan for state taxes on income, capital gains, estates, and inheritances.
Here’s the key tax issue now. When property is included in your estate, most of the time the tax basis of the property is increased to its current fair market value. For example, let’s say you purchased mutual fund shares for $10,000 years ago and they now are worth $20,000. If you sell today, you’ll pay capital gains taxes on that $10,000 gain. If you give the property to your children to remove it from your estate, which used to be the recommended strategy, they’ll take the same $10,000 tax basis you had and eventually have to pay capital gains taxes on that gain when they sell.
Continue to hold the fund shares, however, and they’ll be included in your estate. The tax basis will increase to their fair market value at that time. The estate or your heirs who inherit can sell them immediately and owe no capital gains taxes. They receive the full value of the shares, not an after-tax value. Or they can continue to hold the shares. Eventually when they sell, they’ll owe taxes only on the appreciation that occurred while they owned the shares.
Bottom line: The longtime rule to remove assets from the estate through direct gifts or transfers to trusts might not be the best advice today. It might be better to hold appreciated assets. You’ll avoid federal estate taxes unless your estate is very valuable, and you’ll avoid capital gains taxes on the appreciation.
Your estate’s tax planning strategy should consider all the taxes that might be imposed on an asset. There is the federal capital gains tax, plus any similar tax your state imposes. There also are the stealth and add-on taxes that increase as income rises, including the 3.8% net investment income tax and Medicare premium surtax, taxation of Social Security benefits, reductions in itemized deductions and personal exemptions, and the alternative minimum tax. All of these might be avoided by your family when you hold appreciated assets and have them included in your estate, so the family can increase the basis and avoid capital gains taxes.
Even wealthy people who might have part of their estates subject to the federal estate tax should reconsider the extent to which they want to remove assets from their estates. These other taxes cumulatively could total more than the maximum 40% federal estate tax, especially if your state doesn’t have its own version of the estate tax.
Holding assets in the estate isn’t the ideal strategy in every case. If your state is one of the 19 plus the District of Columbia that has some form of estate or inheritance tax, you need to compare the state tax from holding the asset in your estate to the income tax that would be owed if you transferred the asset now to a loved one.
Remember to consider the income tax rate your beneficiary would pay, not that you would pay. For example, if you live in a state with an estate or inheritance tax but your children live in a state without an income or capital gains tax, you might save money by giving appreciated property to them now instead of holding it in your estate.
The tax planning is more complicated now. You need to evaluate each of the potential taxes that would fall on each asset before deciding whether or not to give property now.
Prime candidates to be held in your estate are appreciated investments and your personal residence. Depreciated investment and business real estate also would avoid income and capital gains taxes by remaining in your estate. Appreciated art, gold, and collectibles are likely to be worth holding in the estate because they are subject to a 28% maximum capital gains tax. Any patents, trademarks, and copyrights created by you also are good to hold in the estate, because your tax basis is likely to be zero but a beneficiary of the estate might be able to increase the basis.
On the other hand, there’s no tax reason to hold cash. Also, variable annuities and qualified retirement plans (including IRAs and 401(k)s) don’t receive an increased basis after the owner’s death. All the distributions will be treated as ordinary income whether taken by you or your beneficiary. You might save money by taking distributions and paying those taxes now instead of later.
The new law also created some unexpected costs for people who executed estate plans under the old law.
Suppose you planned under the previous law by transferring assets to an irrevocable trust to remove them from your estate. The trust and beneficiaries have the same tax basis in the assets that you had. That was fine under the old law, because the potential estate taxes were higher than capital gains taxes. But now the trust can be viewed as an unnecessary expense. It doesn’t save estate taxes and doesn’t allow your heirs to increase the tax basis of the assets.
You might be able to take actions to reduce taxes in these cases, if the trust terms allow it.
One strategy is to exchange assets with the trust. Take highly appreciated assets out of the trust and replace them with other assets of equal value that don’t have as much built-in gains. Estate planners call this decanting.
It also might be possible to change the trust terms so that you are considered the owner and the assets are included in your estate for tax purposes only. New trusts can be written to ensure the assets are included in your taxable estate. The most common way to do this is to retain a general power of appointment over the assets so that you can change the beneficiary at any time.
Today’s estate tax law requires a different approach to planning. Strategies that once were cutting edge now might be unnecessary or costly. Review your existing plan and meet with your planner to adjust it for the latest law.