As published in
MD News May 2016
Beginning in 2006, but accelerating in 2013, the focus of estate planning shifted away from tax planning and toward income and capital gain planning. This shift is a direct result of substantial increases in the estate tax exemption from $2 million in 2006 to $5.43 million in 2016.
The new rules mean that it is now possible for married couples to shelter nearly $11 million from federal estate taxes. With the rise in the exemption, we’ve also seen a decrease in the maximum federal estate tax rate from 46 percent in 2006 to 40 percent in 2016.
Far Fewer Families Are Subject to Federal Estate Taxes
While estate tax planning is still important, especially for state inheritance taxes, far fewer families are subject to federal estate taxes, given the increased ceiling of $11 million. Estates valued over this threshold typically have exposure to family business ownership, highly appreciated real estate, or highly appreciated stock portfolios. Frequently, there are also estate liquidity concerns. For most families, however, extensive estate tax planning is no longer a major concern.
Income Tax and Capital Gain Ramifications on Estate Planning
Of primary concern for physicians, who tend to be higher-income earners, is the rapid rise in income tax rates. The maximum marginal income tax rate is currently 39.6 percent. When combined with deduction phase-outs, the new Net Investment Income Tax, and additional add-ons like the new Medicare surcharge, as well as state income taxes, higher earners are finding themselves at a nearly 50 percent tax rate. In addition to higher tax rates, higher income earners are also now subject to a 20 percent capital gain rate, instead of the 15 percent rate, or zero percent rate, for lower wage earners. As a result, the higher-income earner must be more vigilant with regular income tax planning and must pay closer attention to the income and capital gain ramifications of his or her estate plan. Estate documents drafted a decade ago may have been based on old estate tax reduction strategies and may need to be revised to reflect current law. For most families, estate planning focus should shift to flexibility, income tax planning and capital gain planning on assets that will eventually pass to heirs.
Under current law, when someone dies, inherited assets generally receive a step-up in basis. This means that when your heirs sell inherited assets, they are not required to pay capital gain taxes. Many estate planning strategies were designed for estate tax reduction and often included the use of inflexible “irrevocable trusts” which often did not provide for a step-up in basis of appreciated assets. They also often included gifting strategies, particularly of appreciated assets, designed to reduce the value of the taxable estate. The use of irrevocable trusts and gifting were both very effective at reducing estate taxes but often subjected heirs to significant capital gain taxes when the appreciated assets were eventually sold. At the time, this was an effective strategy because it made more sense for heirs to pay the 15 percent capital gain tax than to pay the much higher estate tax.
New Laws Require a Change in Estate Planning Focus
As the estate tax exemption and income tax rates have continued to increase, new laws require wealth managers to change focus. For example, in many cases, it may not be worth sacrificing the step-up in basis heirs would receive for the sake of lower estate taxes. Leaving appreciated assets in the estate to be “inherited” rather than “gifted” or placed into an inflexible irrevocable trust allows later generations to take advantage of capital gain treatment. Often, a long-term, multi-generational estate planning focus offers potentially huge tax savings for the extended family — more so than strictly focusing on estate tax planning.
It’s About Yours and Theirs
The planning strategies that are useful today are not new. They are very similar to the kind of income tax planning that we have recommended for many years. The difference today is that these same techniques should be applied at the estate planning level and not just in the development of long-term personal tax planning. They involve closely monitoring and effectively managing tax brackets and realized and unrealized capital gain levels to control their impact on wealth accumulation for current and future generations. It is now more important than ever to have a grasp not only on your tax bracket, but also on that of your heirs.
Due in part to the new laws and shift in focus, we are now seeing heirs participating in the estate planning process more than ever before. Heirs need to be aware of the tax impact of assets they may inherit and how to handle a potentially substantial inheritance when the time comes. Along with the shift in focus comes the need for a shift in how we define “long term.” Planning several decades or even multiple generations ahead is key to protecting and passing along the wealth you have worked a lifetime to create.