The traditional estate planning approach, aimed at reducing estate tax values, is less relevant for the vast majority of individuals today than it was in the past. The American Taxpayer Relief Act of 2012 (ATRA) provides relatively generous estate tax rates, limits and rules for estates.
Specifically, the ATRA reduced the top marginal estate tax rate from 55 percent to 40 percent, increased the federal estate tax exemption from $1 million to $5 million (adjusted annually for inflation) and made portability of the estate tax exemption permanent. The federal estate tax exemption is $5.43 million for 2015 — and it will go even higher in future years because it’s indexed to inflation.
Thanks to these changes, a Congressional Research Service report concluded that less than 0.2 percent of all estates will owe any federal estate tax. In contrast, almost everyone in the middle class (or higher) owes federal income tax each year. The current maximum 39.6 percent federal income tax rate plus the 3.8 percent Medicare surtax on net investment income can result in a combined federal tax rate of up to 43.4 percent. (Depending on where you live, you may owe state income tax, too.)
The result is a paradigm shift for estate planners. In most cases, estate planning now focuses on:
• Increasing the tax basis of transferred assets;
• Reducing capital gains on asset sales;
• Taking advantage of capital losses while you’re still alive; and
• Staying up-to-date on beneficiary designations.
Here are more details on these modern estate planning strategies.
Hang Onto Appreciated Capital Assets
If you continue to own appreciated capital assets (such as stocks, mutual fund shares, real estate and collectibles) until you or your spouse dies, the result could be a greatly reduced — or maybe even completely eliminated — federal income tax bill when the assets are eventually sold. This taxpayer-friendly outcome is courtesy of Section 1014(a) of the Internal Revenue Code which generally allows an unlimited federal income tax basis step-up for appreciated capital assets owned by a person who passes away.
Under this rule, the income tax basis of appreciated capital assets, including personal residences, are stepped up to fair market value (FMV) as of the date of death (or the alternate valuation date six months later, if applicable). When the value of an asset eligible for this favorable rule stays about the same between the date of death and the date of sale by the decedent’s heirs, there will be little or no taxable gain to report to the IRS. That’s because the sales proceeds will be fully offset (or nearly so) by the stepped-up basis.
How the Basis Step-Up Rule Works for a Personal Residence
If you are married and your spouse predeceases you, the basis of the portion of the home owned by your departed partner — typically 50 percent — gets stepped up to FMV. This usually removes half of the appreciation that has occurred over the years from the federal income tax return. If you then continue to own the home until you pass away, the basis in the part you own at that point, which will usually be 100 percent, gets stepped up to FMV as of the date of your death (or six months later, if applicable). So your heirs can subsequently sell the property and owe little or no federal tax on the sale.
Of course, if you’re unmarried and own the home by yourself, the tax results are easier to understand. The basis of the entire property gets stepped up to FMV when you pass on, and your heirs can then sell the residence and owe little or nothing to Uncle Sam. This is true even if the property has appreciated by millions during your ownership.
Special Basis Step-Up Rule in Community Property States
If you and your spouse own your home as community property, the tax basis of the entire residence is generally stepped up to FMV when the first spouse dies (not just the 50 percent portion that was owned by the now-deceased spouse). This weird-but-true rule means the surviving spouse can subsequently sell the property and owe little or nothing to the government. In other words, if you turn out to be the surviving spouse, you don’t need to hang onto the property until death to reap the full tax-saving advantage of the basis step-up rule. But if you want to hang on, there’s no tax disadvantage to doing so.
Sell Depreciated Capital Assets
While hanging onto appreciated capital assets can be a tax-smart strategy, the opposite is true for depreciated capital assets (those with current FMV below cost). If these assets are sold, capital losses are triggered. They can be used to shelter capital gains from selling appreciated assets.
However, if a depreciated capital asset is held until death, the tax basis will be reduced to the lower current FMV. So if the asset is then sold by the estate or an heir, there won’t be any tax-saving capital loss.
Giving away a depreciated capital asset is generally a bad idea, because the gift recipient’s tax basis for tax loss purposes will be the lower current FMV of the asset. Therefore, selling the asset will not result in a tax-saving capital loss.
Make Charitable Gifts of Appreciated Capital Assets
Individuals should also consider giving appreciated capital assets (such as stock and mutual fund shares) to IRS-approved charities. The tax-saving advantage is that you can generally claim an itemized charitable donation deduction equal to the current FMV of the appreciated asset while also avoiding any capital gains tax on the appreciation.
Check Beneficiary Designations
One important estate planning move has nothing to do with taxes: Check the beneficiary designations for your life insurance policies, bank accounts, brokerage firm accounts and retirement accounts. If you haven’t yet turned in the proper forms to designate beneficiaries, do it now. If your forms are out of date, update them immediately. The consequences of failing to take these simple steps can be dire. If you don’t believe it, consider the following real-life horror story.
Special Advice if You’re Married
If you have accounts set up with you and your spouse named as joint owners with right of survivorship, the surviving spouse will automatically take over sole ownership when the first spouse dies. But you may want to name some secondary beneficiaries to cover the possibility that your spouse dies before you do. Note that in the nine community property states — Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin — you’ll usually need your spouse’s consent to make beneficiary changes, because assets accumulated during your marriage are generally considered to be owned 50/50.
Turning in Beneficiary Forms Can Also Avoid Probate
Beyond just ensuring that your money goes where you want it to go, another advantage of designating individual beneficiaries is that it can avoid probate — because the money goes directly to the named beneficiaries by “operation of law.” In contrast, if you name your estate as your beneficiary and then depend on your will to parcel out assets to intended heirs, your estate must go through the potentially time-consuming and expensive process of court-supervised probate.
Don’t Let Your Estate Plans Gather Dust
Estate planning is a continuous process that should be reviewed on a regular basis to ensure you’re atop the latest trends. This article just touches on some basic considerations. For more information on modern estate planning rules and strategies, contact your tax and legal advisers.
How to Designate or Change Beneficiaries
Don’t depend on your will or living trust document to override outdated beneficiary designations. As a general rule, whoever is named on the most recent beneficiary form will get the money automatically if you die — regardless of what your will or living trust papers might say.
Naming a primary beneficiary may not necessarily suffice. You should also name one or more secondary (contingent) beneficiaries to inherit your money in case the primary beneficiary dies before you do.
Here’s how to designate beneficiaries or change them:
For life insurance policies, annuities, IRAs and other tax-favored retirement accounts, and employer-sponsored benefit plans: Fill out and turn in beneficiary designation forms to establish or change beneficiaries.
For bank and brokerage firm accounts: Fill out and turn in transfer on death (TOD) or payable on death (POD) forms to establish or change beneficiaries.
For 529 college saving accounts: Fill out and turn in beneficiary change forms if you want to change the account beneficiary.
Possible Estate Tax Changes in Washington
Even though you may have heard that the current federal estate tax rules are “permanent,” they could become a bargaining chip in tax overhaul negotiations between President Obama and Congress in 2015. Dwindling estate tax revenue could prompt Congress to makes changes to the estate tax.
During his State of the Union address, the President proposed eliminating the step-up in basis that occurs at the time of death (or the alternate valuation date six months later, if applicable). This basis step-up rule allows decedents to pass appreciated assets on to their heirs while minimizing or eliminating capital gains tax when those assets are sold.
Stay tuned for any developments in federal estate tax legislation.
“Stepchildren Not Considered Children”
A 2012 Fifth Circuit Court of Appeals decision concluded that a pension plan administrator didn’t abuse her discretion in determining that a deceased plan participant’s stepsons weren’t considered his “children” under the terms of the plan. Therefore, the deceased participant’s siblings, rather than the stepsons, were entitled to inherit the plan benefits. (Herring v. Campbell,5th Circuit 2012)
Case Facts. John Wayne Hunter died in 2005. He retired from Marathon Oil Company, where he was a participant in the company pension plan. The plan allowed Hunter to designate a primary and secondary beneficiary. Hunter designated his wife as the primary beneficiary but failed to designate a secondary (contingent) beneficiary. After his wife died, he didn’t designate a new primary beneficiary. Under the plan’s terms, when a participant died without designating a beneficiary, the deceased participant’s benefits were distributed in the following order:
- Surviving spouse,
- Surviving children,
- Surviving parents,
- Surviving brothers and sisters (siblings), and
- The participant’s estate.
After Hunter died, the plan administrator considered, and rejected, the possibility that his two stepsons might qualify as “children” entitled to Hunter’s benefits. Instead, the administrator distributed the benefits — more than $300,000 — to Hunter’s six siblings. The stepsons sued, claiming they should have inherited the benefits. Evidence showed that the stepsons had a close relationship with Hunter. His estate was left to them, and Hunter referred to them as his “beloved sons” in his will. The stepsons claimed they were Hunter’s children because, by his actions, he “equitably adopted” them. The evidence seemed to indicate that Hunter probably did intend to leave his benefits to the stepsons.
Court Finding. The Fifth Circuit found no error in the administrator’s interpretation that the term “children” for purposes of the plan meant biological or legally adopted children and didn’t include unadopted stepchildren. As to the stepsons’ claim that they had been equitably adopted, the Fifth Circuit found that nothing required the plan administrator to incorporate the theory of equitable adoption into the plan’s definition of “children.” Therefore, Hunter’s pension benefits went to his six siblings.
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