The New Estate Tax Laws

How things have changed in the last few years.

With 2013 approaching, many families and their financial, tax and legal consultants are weighing major estate planning decisions. A short-term window of opportunity may be closing. The relatively low estate tax rates we have now may soon disappear, along with one of the largest federal tax breaks available in decades.

Estate taxes are at 80-year lows.
At the end of 2010, Congress reset the estate, gift and generation-skipping tax (GST) rates at 35% and raised the lifetime federal gift, estate and GST tax exemptions to $5,120,000 until January 1, 2013. Some Capitol Hill legislators want to see these rates retained, even made permanent. Two other scenarios may be more likely.

In the first scenario, which we consider unlikely, is that the Bush-era tax cuts expire at the end of 2012 and it becomes 2001 all over again: the lifetime estate and gift tax exemptions fall to $1 million and estate taxes are reset to 55% (60% for some households).

In the second scenario, which is likely, Congress makes good on President Obama’s request to turn the clock back to 2009: estate taxes reset to a top rate of 45% with a $3.5 million personal exemption. (The lifetime gift tax exemption would still fall to $1 million.) Part of the reason why we think that this is the more likely scenario is that the projected costs by most analysts of raising the limit above $3.5 to $5 million is quite high.

The current $5.12 million personal exemption is portable between spouses.
This represents a major tax break for wealthy families – an opportunity to transfer significantly greater amounts of wealth without triggering transfer taxes.

Currently, executors have an option to transfer an unused portion of a deceased spouse’s $5.12 million lifetime unified gift/estate/GST exemption to a surviving spouse. So with this new portability, a married couple can potentially transfer up to $10.24 million of assets without incurring any federal estate tax. In 2013, this portability is scheduled to disappear.

Portability is not automatic. When the first spouse passes away, the executor of his or her estate must file a federal estate tax return even if no estate tax is owed. That move formally notifies the IRS that you are transferring the unused or partially used personal exemption to the surviving spouse. This estate tax return is due nine months after the death of the first spouse, with a six-month extension permissible.

If some planning needs to be done to bring the value of your taxable estate under $5.12 million (or $10.24 million), your executor could make donations to qualified charities or non-profits on your behalf to lower the taxable value of your estate, although your heirs would consequently be left with less.

You can shrink your taxable estate without reducing the lifetime exemption. In 2012, the annual federal gift tax exclusion is set at $13,000. So you (and your spouse) may gift up to $13,000 each to an unlimited number of individuals in 2012 without reducing your lifetime $5.12 million gift/estate tax exemption. Those gifts can even be made as payments for school expenses (except housing costs) or medical bills.

Keep the $13,000 annual exclusion limit in mind: in 2012, gifts in excess of $13,000 per individual do cut into the $5.12 million lifetime exemption dollar-for-dollar.

Even so, you still might want to make large gifts of appreciating assets this year. Why? Here’s an illustration: if you gift shares valued at $52,000 to a relative, you will draw down your $5.12 million lifetime gift/estate tax exemption by $39,000 ($52,000-$13,000). Yet the future appreciation of these shares will not be included within your taxable estate. This year, you and your spouse can each give away up to $5.12 million worth of appreciating assets without incurring federal gift taxes.

An ILIT may be worth a look. Death benefits from life insurance policies are rarely subject to federal tax. However, if you have any “incidents of ownership” (i.e., have or have had the ability to make beneficiary, payment, loan or cancellation decisions), the policy proceeds may end up in your taxable estate.

This problem tends to affect unmarried taxpayers most, though married couples may also face it. One response is to create an irrevocable life insurance trust (ILIT) – a trust that owns an individual or couple’s life insurance policy/policies. Upon the death of the insured, the policy proceeds go into the trust rather than the insured’s taxable estate. The proceeds can subsequently be directed to the named beneficiaries of the ILIT. Two asterisks here: you have to stay alive for at least three years after moving any existing life insurance policies into the ILIT to keep the insurance proceeds out of your estate, and you don’t want to name the trust as the policy beneficiary as that negates the whole purpose of the ILIT.

It is time to carefully review your estate planning strategy in light of the potential changes ahead and the window of opportunity that may soon close.

About Michael Bradley, CFA

I am an independent financial advisor in San Francisco. My wealth management practice is primarily composed of affluent individuals with a scientific or technical background.
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