Federal Estate Tax Is No Longer The Biggest Concern

Focus of Estate Planning Shifts

As many of you have heard, recent tax law changes are turning traditional estate planning on its head – causing a shift in attention from an estate tax focus to an income tax focus.   Planning techniques long considered wise – e.g., shifting wealth to younger generations while senior family members are still alive or automatically leaving assets to a bypass “credit shelter” trust – may no longer be necessary to save estate tax and could now leave many families paying income tax they would not otherwise owe.  Chances are, if you have accumulated modest wealth, your existing estate planning documents drafted prior to 2013 contains planning techniques that are out of date.

The New Law Changing Estate Tax

The legislative deal Congress passed in January 2013 set the top estate and gift tax rate at 40% and raised the exemption to $5 million per person, adjusted for inflation. It now stands at $5.43 million and will rise to $5.45 million in 2016. That means an individual can leave $5.45 million to heirs and pay no federal estate or gift tax. Not only will this exemption rise with inflation, but spouses can now share–and effectively inherit through a portability election–each other’s exclusions.  In other words, a married couple will be able to shield $10.9 million from federal estate and gift taxes before the 40% rate will kick in.

As a result, the federal estate tax is no longer the biggest concern for most Americans who want to avoid taxes on wealth they leave to heirs.  In fact, according to the Tax Policy Center, only about 4,000 estates, or approximately .14% of the total, are expected to owe federal estate tax this year.  To provide perspective, 2.3% of estates were subject to tax in 1999 and 7.65% in 1976, according to the Tax Policy Center.

Income Tax Focused Planning

Although the legislative deal Congress passed in January of 2013 provided a generous estate and gift tax exemption, it also raised the top income tax rate on long-term capital gains to 20% – its highest level since 1997.  With the new 3.8% net investment income tax that took effect as a part of the Affordable Care Act, the top rate on long-term capital gains from investments is now 23.8%, up from 15% in 2012.  As a result, a main focus of current estate planning is what some practitioners refer to as “freebasing” – or utilizing planning techniques so that it frees survivors to get the most income tax savings from the step-up in basis of the decedent’s property.   In other words, while historical planning techniques oftentimes arranged for assets to be excluded from a loved one’s estate, under the new law, the greatest tax savings is now most often achieved through planning for estate inclusion, and minimizing capital gains.

For example, when you sell an asset such as stock, you owe capital gains tax on the difference between what you paid for it (its basis) and the sales price.  If you inherit certain assets you can “step up” the decedent’s tax basis to whatever the asset is worth at death.  Thus, highly appreciated inherited property can be sold immediately with no capital gains (or later, with all the gains before you inherited it disregarded).  On the other hand, if you receive property from a living donor, or receive a remainder interest from a standard “credit-shelter” trust, you do not get the stepped up basis and can result in significant capital gains tax.

Bottom Line

Do not fall victim to the trap that estate planning is just about reducing estate taxes.  Just because you do not have a taxable estate, does not mean that your existing estate documents still suit you.  While the true meaning of estate planning is more about people and relationships than about cold, hard numbers, if you are not diligent with your estate planning, you could be losing a stepped up basis in appreciated assets.  These new rules are complex, but they present tax-saving opportunities that many people planning estates remain unaware of.

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