The federal estate tax is no longer the biggest concern for
most affluent people who want to avoid taxes on wealth they leave to heirs. In
2004, the estates of people who died owning assets worth more than $1.5 million
were subject to federal tax at top rates approaching 50%, and married couples
had to set up trusts to benefit from their full $3 million estate exemption.
Finally, last year, Congress 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 $5.34 million and is expected to rise to $5.43
million next year. Lawmakers also changed the rules so that couples don’t need
trusts to get their full break from Uncle Sam.
These changes have freed hundreds of thousands of affluent
Americans from worrying about federal estate tax, and they may never have to.
The new rules present tax-saving opportunities that many
people planning estates remain unaware of—and that could contradict past advice.
Many people who won’t owe estate tax can reap substantial tax savings on
capital gains by choosing carefully which assets to hold until death. This
strategy is especially useful now that the top federal rate on long-term gains
is nearly 24%, two-thirds higher than in 2012.
The upshot: People covered by the federal estate-tax
exemption should review the plans they have in place to look for more tax
savings. Here are important factors to consider.
Reset Capital Gains
The federal code has long had a provision, known as the
“step-up,” that cancels the long-term capital-gains tax on assets that a
taxpayer holds until death. The step-up automatically raises the owner’s cost
basis for such assets—the starting point for measuring a taxable gain—to its
full market value as of the date of death.
If the investor holds the same asset until death, however,
the capital-gains tax vanishes. The asset will be included in the owner’s
estate at full market value, where the exemption of more than $5 million per
person could shelter it from federal estate tax as well.
Experts recommend scrutinizing which assets to hold until
death to maximize the step-up. This move is especially important in high-tax
states such as California, where the top combined federal and state
capital-gains rate exceeds 35%.
Tap the Right Assets
To meet cash needs, some advisers say, it may even make
sense to take out a loan rather than selling appreciated investments in taxable
accounts, especially with interest rates low.
Another strategy: making withdrawals from traditional
individual retirement accounts or other retirement plans. Because such assets
are in tax-deferred accounts, they don’t get a step-up in basis. Many planners
are advising couples to review their assets with the step-up in mind.
Rethink Your Trusts
The growing prominence of the step-up also affects
tax-saving trusts. Until the advent of a provision known as “portability” in
2011, spouses often needed trusts to provide their estates with the full value
of two federal estate-tax exemptions.
Now, however, a surviving spouse can claim the unused
portion of a partner’s exemption. Experts say many couples still have
tax-saving trusts set up years ago that could actually raise taxes for heirs.
People with more sophisticated tax-saving strategies, such
as a grantor-retained annuity trust, or GRAT, also should re-examine them with
the step-up in mind. GRATs are used to transfer the appreciation in an asset
that is expected to surge in value—but the asset often has a low cost-basis.
Some advisers are also turning to a long-dormant arrangement
often called an “estate trust.” It uses complex moves to provide a double
step-up on a highly appreciated asset to a married couple after the first
spouse dies. In effect, this trust aims to give couples who don’t live in
community-property states the same advantage as those who do.
Advisers are urging clients to take a hard look at the gifts
they make to other people as part of their estate planning.
When a person gives a noncash asset to someone else, the
original owner’s cost basis carries over to the recipient. So if an aunt gives
her nephew stock shares worth $10,000 that she acquired for $500 many years
ago, then the nephew’s cost basis will be $500 when he sells the stock. By
contrast, if the aunt leaves the shares to the nephew at her death and they are
worth $10,000, that becomes his cost basis—and there isn’t tax on the gain
between $500 and $10,000.
Beware of State Taxes
Nineteen states and the District of Columbia—home to about
one-third of the U.S. population—levy an estate tax on the assets of people who
die or an inheritance tax on those receiving the assets, or both.
There also are quirks in some state levies. New York, for
example, will soon have an exemption of more than $3 million per person—but
people whose assets are greater than 105% of the break get no exemption at all.
This provision is often called “the cliff.” For taxpayers living in states with
death taxes, the good news is that there is a trend toward larger exemptions.
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