Rules recently changed for estate planning, especially planning for large estates. If you drafted your estate plan before the new rules kicked in, examining your plan again might save you thousands of dollars.
The amount you can pass on free of estate tax is $5.43 million for 2015; the estate tax rate now maxes out at 40%. But recent changes in other tax rates now complicate estate planning: The top capital gains tax rate of 23.8 %, when including the new 3.8% Net Investment Income (NII) levy, remains less than both the estate tax rate and the top ordinary income tax rate of 39.6%. Yet some people’s income tax liability can be higher than the federal estate tax rate their estate will pay.
Besides these changes, the biggest development is a relatively new rule known as the portability election. Portability, available if an estate tax return is filed in a timely fashion for the first spouse who dies, allows the unused portion of the deceased spouse’s $5.43 million personal exemption to carry over to the survivor.
A married couple now effectively has a joint exemption worth twice the individual exemption. For federal taxes, if a couple expects the first spouse to die with less than $5.43 million of assets, portability might help minimize taxes and maximize wealth that passes to heirs. State taxes can of course still complicate planning for smaller estates.
So how do you and your family optimize taxes if your estate is big enough to still incur tax?
Flexibility. The executor or a trustee of your estate needs a framework in which to make his or her decisions but also leeway to alter planning strategies.
Planning documents need to acknowledge that the rules or the estate holder’s situation may change between when documents are signed and the death or other event that brings those documents into effect. Giving executors and trustees authority to make tax elections and the right to disclaim assets, which may allow the fiduciaries to settle the estate more tax-efficiently, provides needed flexibility.
Appreciated value of your assets. The way in which you leave assets can greatly affect your heirs’ wallets, especially regarding capital gains.
With gifts of appreciated assets, for instance, your heirs incur tax on the difference between your cost basis (typically what you paid for the assets) and the price for which they sell the assets.
When choosing assets to transfer, try to pinpoint those with very low appreciation while you’re alive and pass on the highly appreciated assets after you die, since assets transferred at death have their cost basis adjusted to the fair market value when you die or, in a few cases, six months later.
For example, if your beneficiary inherits an asset that had $100,000 of appreciation at the time of your death, the basis adjustment can save $23,800 in federal income taxes, compared with the taxes if your beneficiary receives the same property during your lifetime.
Unfortunately, the basis adjustment upon death works both ways. If your bequeathed asset lost $100,000 in value between when you purchased it and when you die, the recipient’s cost basis drops to the current fair market value of the property.
Holding appreciated assets until death, while appealing for tax purposes, might be a bad move if the asset is a concentrated position (meaning a big portion of your portfolio) or no longer fits your investment objectives. For these assets, see whether the capital gains cost is worth incurring right away or if you ought to pursue a new strategy, such as hedging with an added investment likely to change value in an opposite way, donating the asset to charity or contributing the property to an exchange fund.
Choosing not to fund a credit shelter trust upon the first spouse’s death is a perfect example of maximizing the value of a basis adjustment in light of new rules. These trusts, typically funded at the death of the first spouse, ensured that none of the deceased’s exemption went to waste and allowed the surviving spouse use of the trust’s assets and income.
Since portability rules now allow a surviving spouse to use the deceased’s untapped exemption, funding a credit shelter trust becomes less important. Instead, allowing all assets to pass to the surviving spouse directly allows capture of one step-up in basis (assets resetting to current market value) when the first spouse dies, and then another after that at the death of the second spouse. Depending on the amount of appreciation and the time between the spouses’ deaths, tax savings can be substantial.
(Our next article looks at more ways to improve your tax situation under new estate planning rules, including annual gifting, lifetime charitable giving and trusts.)
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Benjamin C. Sullivan, CFP, EA, is a client service manager at Palisades Hudson Financial Group LLC in Scarsdale, N.Y.
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