Recent tax law changes demand new approaches to estate planning. For many taxpayers, traditional strategies, which focus on minimizing estate taxes, may no longer be relevant. In fact, they may result in unnecessary income taxes.
A new environment
As recently as 13 years ago, the federal gift and estate tax exemption was only $675,000 and the top gift and estate tax rate was a whopping 55%. Given the unpleasant prospect of forfeiting more than half of one’s wealth to Uncle Sam, it’s no surprise that affluent families devoted considerable time and resources to minimizing those taxes. Many of the strategies for doing so triggered additional income taxes, but in most cases the estate tax savings outweighed the income tax cost.
Fast-forward to 2014. The exemption amount has soared to an inflation-adjusted $5.34 million, the top tax rate has fallen to 40%, and exemption "portability" between spouses is now permanent. According to the Congressional Research Service, in the current environment less than 0.2% of all estates are subject to federal estate tax. Meanwhile, taxes on income are higher than they’ve been in many years. (See the sidebar "The high cost of taxes on income.")
In light of these changes, most taxpayers should concentrate their estate planning efforts on reducing taxes on income.
Stepping up your game
Traditional estate planning techniques focus on removing assets from your taxable estate as early as possible to shield future appreciation from estate taxes. Typically, these techniques involve shifting wealth to children or other heirs, either outright or in trust. Many vehicles, such as family limited partnerships (FLPs) and certain types of trusts, enable you to transfer assets at a discounted value for gift tax purposes.
If your wealth is unlikely to grow beyond the exemption amount, however, there’s no federal tax advantage to removing assets from your estate during your life. But there may be a significant tax incentive to keep assets in your estate.
When you transfer an asset during your life, the recipient inherits your tax basis, which can generate significant capital gains taxes if the asset is sold. Assets transferred at death, on the other hand, enjoy a "stepped-up" basis. That means the basis is increased to the asset’s date-of-death fair market value, and the recipient can sell the asset without incurring any capital gains tax liability (provided he or she sells it before it appreciates further).
Consider this example: Tony has a net worth of approximately $3 million, including $2 million in real estate with a $400,000 tax basis. He gives the property to his daughter, Annie, who holds the property for 10 years and then sells it for $3.5 million. Annie is in the top income tax bracket, so she’s subject to a 23.8% tax (see the sidebar for details on this rate) on the gain: 23.8% × ($3.5 million - $400,000) = $737,800.
Now suppose, instead, that Tony holds on to the property and dies 10 years later, leaving it to Annie in his will or living trust. Tony’s estate is within the exemption amount, so there’s no estate tax. But Annie’s basis is stepped up to the property’s date-of-death fair market value, $3.5 million, which means that, if she sells the property immediately, she can pocket the proceeds tax-free.
As you can see, with estate taxes out of the picture, there’s a big advantage to retaining assets in your estate and then transferring them at death.
A trust with a twist
There are also some disadvantages to holding onto your assets, however. For one thing, you’ll continue to be liable for income taxes on their earnings. Also, you may prefer to share some of your wealth with loved ones while you’re alive.
One option that can provide the best of both worlds is an estate defective trust (EDT). An EDT is carefully drafted to ensure that all of the trust’s income is taxed to your beneficiaries without removing the assets from your estate.
It enables you to provide financial benefits to your children or other family members while reducing your family’s overall income tax burden (assuming beneficiaries are in a lower tax bracket). At the same time, the trust assets are treated as part of your estate when you die, so you retain the tax advantages of a stepped-up basis.
Look at the big picture
Focusing on income taxes offers significant benefits, but it’s not without risk. If your estate unexpectedly grows beyond the exemption amount, for example, or if Congress reduces the exemption down the road, you could be stuck with a hefty estate tax bill.
Also, before you rule out traditional estate planning vehicles, consider the impact of state estate taxes as well as the potential nontax benefits of certain trusts, such as creditor protection. As you can see, it’s critical to enlist the help of a trusted tax advisor.
The high cost of taxes on income
For high earners, taxes on income are at their highest level in years. Recent tax increases include:
A top income tax rate of 39.6% (up from 35%) for taxpayers with income over $406,750 for singles, $432,200 for heads of households and $457,600 for joint filers (for 2014 — these amounts are annually adjusted for inflation),
Two new taxes under the Affordable Care Act: 1) an additional 0.9% Medicare tax on wages and self-employment income in excess of $200,000 for single and head-of-household filers and $250,000 for joint filers, and 2) a 3.8% net investment income tax on some or all net investment income of taxpayers with modified adjusted gross income over those same amounts (these amounts are not annually adjusted for inflation), and
A top capital gains rate of 20% (up from 15%) for taxpayers in the top income bracket.
In addition, reductions in personal exemptions and itemized deductions increase the effective tax rate for high-income taxpayers.
If you have any questions regarding this article, please contact Friedman LLP at firstname.lastname@example.org or 877-538-1670.