The New Math of Estate Planning

Estate tax planning looks much different than it did in the past. In prior years, estate planning often focused on minimizing taxpayer’s estates as exemptions were low and federal estate tax rates were as high as 77%. Today, the top marginal federal estate rate is 40%. The American Taxpayer Relief Act of 2012 (ATRA) made permanent the generous $5,000,000 federal transfer tax exemption, which is indexed yearly for inflation. This means an individual can die with $5,430,000 in assets and owe no federal estate tax. ATRA also made “portability” permanent. Portability permits a married couple to fully utilize both a taxpayer and a spouse’s combined exemption ($10,860,000 in 2015) by letting the surviving spouse claim any unused portion of the deceased spouse’s exemption as long as an estate tax return is filed. With these permanent changes, the Tax Policy Center projects that only .14% of adult deaths will result in federal estate tax.

At the same time, federal income tax rates are at higher levels – top rates are 39.6% for ordinary income items, 20% for capital gain items, plus the potential of an additional net investment income tax of 3.8%. Given the changing tax environment, one must now carefully consider the estate and income tax rate differentials when putting together an estate plan.

An important concept to understand when discussing estate and income tax planning is the “step-up” in basis. When a person dies their heirs receive a step-up in the tax basis of most inherited assets. The new tax basis is equal to the fair market value of the assets held by the decedent at the date of death. For example, if the decedent owned 1,000 shares of stock that they purchased for $10,000 in 1983 but was worth $100,000 when they died in 2015, the basis to the heirs is stepped up to $100,000. (Note that the decedent would also be subject to estate tax on the $100,000, if applicable). When the heirs sell the stock a few months later they will likely recognize little gain or loss, as compared to the $90,000 gain the decedent would have realized if they sold the stock right before they died. If the decedent were to have given the stock to the heir before he died, the heir would have to take on the basis of the donor, resulting in a $90,000 gain to the heir.

Planning for achieving the maximum step-up in basis of family assets at death has become more important than ever especially considering that most estates will not be subject to estate tax. It would make sense to hold onto highly appreciated assets, such as stock and fully depreciated real estate investments in order to obtain the basis step-up. An important item to note – step-up does NOT apply to many retirement accounts, such as IRA’s and 401(k)’s.

State estate tax considerations are just as important. For example, Illinois has an income tax rate of 3.75%. The estate tax rate is 8-16%; however, there is a lower estate tax exemption than the federal exemption – $4,000,000. Therefore, individuals with assets more than $4,000,000 and less than $5,430,000 will be subject to Illinois estate tax yet not to federal estate tax. As the estate tax rate will be less than the combined federal and state income tax rate in such a case, it would make sense for Illinois decedents in this asset range to maximize the value of their estates and minimize their income tax.

For married couples who will be comfortably below the $10,860,000 combined estate exemption amount, it would be wise to revisit existing trust agreements. Assets in a typical bypass trust (a staple in estate planning pre-ATRA) will not get a step-up in basis at the death of the second spouse. However, if you live in Illinois a bypass trust may make sense since Illinois does not honor portability. In addition, unless trust income is always distributed, the tax on the trust can be dramatic, as trusts reach the highest tax rate at $12,300 of income. While trusts may offer creditor protection and can offer protection in the event of a divorce of an heir, these benefits should be weighed with the potential tax consequences.

With the large federal estate tax exemption, the permanence of portability and the increase in income tax rates all brought about by ATRA, it is important to revisit your estate plan in light of income tax considerations. If you would like to discuss your estate plan, or have any questions on the information presented, please contact our office.