In recent years, uncertainty around taxes and fiscal policy set the tone for estate planning: “Hurry up and wait” was the order of the day, followed by a year-end scramble to minimize damage from anticipated changes. This year brought a reprieve of sorts, with much to do, but a well-marked landscape in which to do it.
From 2001 to 2012, the federal estate tax exemption was more volatile than the stock market—ranging from $1 million in 2001 to unlimited in 2010 to $5.12 million in 2012. The federal gift tax exemption also changed dramatically.
Fortunately, the new estate tax law provides a firm foundation for planning. First, it keeps the amount exempt from federal transfer taxes high. In 2013, each person has a $5.25 million exemption that he or she can apply to lifetime gifts. Any exemption that is not used for gifts can be applied at the person’s death.
There is also a $5.25 million exemption from generation-skipping transfer taxes that applies to transfers to grandchildren. Second, the new law provides for automatic increases each year to reflect federal cost-of-living adjustments. Those adjustments are significant—they resulted in an increase of $130,000 last year. Third, the tax rate for estate, gift and generation-skipping transfers over the exemption is a flat 40%. Fourth, a surviving spouse can now elect to use a deceased spouse’s unused federal estate tax exemption.
Given the dramatic increases in the transfer tax exemptions over the past decade, it is important to do a checkup on existing wills and trusts. Estate planning documents often include formulas that allocate assets to trusts for spouses and descendants based on the desired tax results. That can result in too much being set aside for grandchildren, for example, and not enough for children or the surviving spouse.
Also, under the old estate tax laws, it was usually better for a married couple to shelter the maximum amount from estate tax at the first death. Now that the unused estate tax exemption can be transferred to the surviving spouse, it may be better to include more in the surviving spouse’s estate to get a higher income tax basis in family assets when the spouse dies.
The increased estate and gift exemptions mean that the 40% tax on gifts and estate transfers is a concern primarily reserved for the most affluent of U.S. citizens. It “leaves very few people who will be subject to the tax,” Reuters noted in a 2013 wrap-up of the changes. “For married couples, the estate tax is usually deferred, even for large estates, because of the unlimited marital deduction. Just 3,800 estates are expected to owe any federal estate tax in 2013, according to estimates from the Tax Policy Center.”
Wealthy taxpayers who are willing to plan ahead, fund trusts early on, and leverage the gift tax exemption have opportunities to significantly reduce their estate tax down the line. While some strategies are part of the program every year, here are several of the most appealing ways to ease the tax burden for 2013:
Be Strategic About Giving
Charitable giving serves the dual purpose of advancing philanthropic goals and reducing the taxable estate. For charitable gifts made in cash by year-end, up to 50% of a taxpayer’s “contribution base” (similar to adjusted gross income) can be deducted—a tremendous benefit, especially for families experiencing a major income event.
Donors can also be creative about how they give. Deductible charitable gifts can be made by transferring value by any method and in any form to a charity. This includes gifts of cash or property.
Given the increase in the capital gains rate from 15% to 20% for the highest tax bracket, 2013 is an ideal year to donate appreciated stock. Taxpayers get a charitable deduction for the full fair-market value deduction of the stock given, including the untaxed appreciation. Typically, the charity then sells the stock free of taxes. Donors should plan for a full month to complete the transaction, especially at the end of the year, when brokers are inundated with similar requests.
Finally, unless the law is extended, 2013 is the final year in which donors over 70½ can donate up to $100,000 directly from an IRA to a charity. The donation counts toward the donor’s required minimum distribution, but unlike normal IRA distributions, the amount passing directly to charity is not included in the donor’s taxable income. This giving strategy is especially helpful in states that do not provide a charitable deduction (Massachusetts, for example).
Use The Right Vehicles
While families try to plan as far ahead as possible and stay true to a strategy, sometimes year-end comes faster than expected. When time is an issue or donors are uncertain about their philanthropic strategy, they can transfer assets to a family foundation. If they do not have a family foundation, they can establish a donor-advised fund.
The charitable lead trust is another option, especially for the wealthy donor who wishes to fund a certain level of charitable giving each year and also leverage the amount left to children. With a charitable lead annuity trust, for example, the donor agrees to pay a certain percentage of the trust’s initial assets to one or more charities each year for a term of years. At the end of the term, any assets remaining in the trust will pass to the donor’s children. The value of the gift to the children at the time that the trust is established is based on the IRS interest rate in effect at the time of the gift. The IRS rates are currently very low (2.4% for October) and if the trust appreciates in excess of 2.4% per year, that excess growth passes to the donor’s children free of gift tax.
Be Careful Gifting Low-Basis Assets
In addition to charitable donations, gifts to children and other relatives move money out of the taxable estate. With the gift tax exclusion now set in stone, families can make significant annual gifts that reduce tax exposure. In fact, a cost-of-living adjustment provides for an additional amount each year that can be gifted tax-free; even those who gave gifts to the maximum lifetime allotment of $5.12 million by the end of 2012 can give another $130,000 in 2013. The annual gift tax exclusion—the amount up to which taxpayers can give to any individual each year without reporting it—has also increased to $14,000, the first such jump since 2009. In addition, there is an unlimited annual exclusion for the direct payment of tuition and medical expenses.
A major advantage of gift-giving strategies is that they not only allow for the straightforward, tax-free transfer of an asset, they also protect all future appreciation and income earned by the assets after the gift. If individuals do not need certain assets to support their current or future needs, their family can enjoy the significant financial benefits of their gifts well into the future.
A word of caution, though: With the federal exemption so high, the temptation to make sizable gifts can lead to higher capital gains taxes when the family later sells an asset that has been given to them. Years ago, with estate tax exemptions low and rates high, it was almost always better to make lifetime gifts than to pay estate tax, even if it meant higher capital gains tax when an asset was sold. That is no longer the case for families with assets below the federal estate tax threshold. If the federal estate tax does not apply, then the only estate tax may be at the state level. State estate tax rates tend to be significantly lower than the current federal capital gains tax rate of 20%. Also, for sales of tangible objects such as art or fine furnishings, the federal capital gains tax rate is 28%.
One of the best ways to shift assets to the next generation is to fund a generation-skipping trust that is a grantor trust for income tax purposes. That way, the donor will pay the tax bill on the trust during the donor’s lifetime and the trust assets can grow free of the annual income tax hit. A generation-skipping trust shelters assets from estate tax for as long as the assets remain in trust. The generation-skipping trust can be established in states such as New Hampshire that allow the trusts to go on indefinitely. Generation-skipping trusts also offer important benefits in terms of creditor protection for beneficiaries, which protects the assets in the event of a beneficiary’s divorce.
Grantor-retained annuity trusts or “GRATs” continue to be a great way to transfer assets to children without using up the gift exemption. With a GRAT, the donor transfers assets to a trust and receives an annual annuity that is designed to zero-out the value of the gift passing to children based on the IRS valuation rules. The federal interest rate used to value a GRAT is very low right now—it was 2.4% in October—so GRATs provide an ideal way to transfer appreciation in excess of the assumed federal rate to the children free of gift tax.
Whichever strategy is employed to move assets out of the estate, thoughtful planning allows individuals to make the most out of their current environment. With a more certain tax landscape in 2013, there are opportunities to make informed decisions that will benefit families for the next several years and for generations to come.
