It’s Dangerous Not to Review Your Estate Plan after Tax Reform

In the Tax Cuts and Jobs Act, the only direct change in estate and gift taxes was the doubling of the lifetime exemption amount. Though the IRS has yet to issue the official inflation-indexed levels for 2018, the individual lifetime exemption could be as high as $11.2 million, and married couples could exempt as much as $22.4 between them. Those amounts will be indexed for inflation each year.

The rest of the estate and gift tax is unchanged. The tax is calculated the same way, and the top rate is 40%. The annual gift tax exclusion is $15,000 per person for 2018. There’s still an unlimited marital deduction for gifts and bequests between spouses. The lifetime exemption remains portable between spouses. The charitable contribution deduction isn’t altered, and the tax basis of inherited property can be increased to current fair market value.

All the strategies that reduced estate and gift taxes before tax reform still are effective.

So, why do most people need to review their estate plans?

First, a few notes for those few people who are wealthy enough they might be subject to estate and gift taxes under either the 2017 or 2018 laws.

The exemption amount is scheduled to revert to the 2017 law after 2025 if Congress doesn’t make a change in the meantime. That means in a few years you might not be able to transfer as much wealth tax free as you can today.

Consider how much wealth you want to remove tax free from your estate while you can. You might want to make direct gifts and put assets in vehicles such as irrevocable trusts, perhaps creating dynasty trusts that can benefit several generations. Or you can shift assets to family limited partnerships and limited liability companies, among other strategies. It is a tough decision, because you must anticipate the future actions of Congress. Will it keep the current exemption amount, decrease it, or even eliminate the estate tax?

Remember, for gifts, the exemption amount that counts is the one in effect the year the gift is made. For estates, it’s the exemption amount in the year the person dies. Under current law, people who die in 2026 will have half the exemption amount they would have had the previous year. At 1.5% annual inflation, the 2026 exemption amount is estimated to be $6.3 million per person if we revert back to the 2017 law.

Some people worry Congress will enact a “claw back” if we switch to a lower exemption amount in the future. Under a claw back, gifts that were tax free in the past become taxable if there’s a lower lifetime exemption in effect the year the person dies than there was in the years of the gifts. But Congress has never done that kind of claw back before, and there’s a good argument to be made that it would be unconstitutional as a retroactive tax.

Another wildcard is that a change in control of Congress could trigger a move to reduce the exemption amount before 2025.

The bottom line is that people with estates that potentially are taxable under either current law or the 2017 law should review the situation with their planners and consider making substantial gifts while the high exemption amount is in effect.

While everyone else is exempt from federal estate and gift taxes, don’t consider yourself exempt from Estate Planning. Your estate plan also needs a review and possibly some rewriting.

Beware of old wills. Standard wills that were written under old estate tax laws often disinherit the surviving spouse or have other unintended consequences.

In a typical estate plan, a portion of the estate of the first spouse to die is transferred to a trust, called a bypass trust, credit shelter trust, A/B trust and other names. The trust supports the surviving spouse during his or her lifetime and leaves the remainder to the children of the marriage. The rest of the estate goes primarily to the surviving spouse.

The trick is that the will usually says the amount that goes to the trust is the lifetime federal exemption amount. That made sense when the exemption was $600,000 or less. But at today’s exemption amount (and even 2017’s), in most families the surviving spouse receives nothing outright and is dependent on distributions from the trust.

That’s one of many reasons why most wills need to be rewritten or at least amended. Not only might the plan be obsolete and out of date, but the interplay of the new law and old tax laws could have unintended consequences that are very negative for your loved ones.

Focus more on income tax planning. Income and capital gains taxes are more important to most people than estate and gift taxes, and the estate plan can play a key role in reducing income and capital gains taxes for both you and your family.

The tax basis of assets is a key consideration. When an asset is inherited, the beneficiary increases its basis to the fair market value on the date of the previous owner’s death. The asset can be sold immediately tax-free. None of the appreciation that occurred during the previous owner’s holding period is taxed.

But when an asset is received as a gift, either directly or through an irrevocable trust, the basis is the same as the previous owner’s basis. When the beneficiary or trust sells it, all the
appreciation is taxed.

That’s why it makes sense to hold for life assets that have appreciated a lot. They aren’t likely to be subject to the federal estate tax. You avoid capital gains taxes by letting your heirs inherit them through the estate. During your lifetime, it’s best to make gifts of assets that haven’t appreciated much but that you anticipate will appreciate. Incorporating this kind of income tax planning in your estate plan can increase your family’s after-tax wealth.

Should you make gifts? Using the annual gift tax exclusion, you can make up to $15,000 of gifts in 2018 to a person without reducing your lifetime exemption. You can make these tax-free gifts to as many people as you want each year.

When the lifetime exemption was less than $1 million, even many middle-class families were advised to make annual gifts to remove assets tax-free from their estates. Now, unless your estate might exceed the lifetime exemption, estate taxes aren’t the motivation to make gifts.

Instead, consider the non-tax reasons for making gifts. Of course, first determine how much you can consider giving during your lifetime without putting your financial independence
at risk. Then, decide if you’d rather see loved ones benefit from those gifts now instead of after you’re gone and, if so, how you’d like them to benefit. Some people think heirs should wait to receive an inheritance, no matter how long that takes. Others would rather see how their gifts are used and give when their loved ones need the money.

The point is now your preferences and financial situation, not the tax law, should determine your giving strategy.

Rework old strategies. Many existing estate plans have strategies that were motivated primarily by tax reduction. These include irrevocable trusts, life insurance trusts, family limited partnerships and more. Take a fresh look at these strategies with your estate planner. In some cases, you’ll want to dismantle or modify the strategies, if you can. In other cases, you’ll find there are good non-tax reasons to continue them, such as creditor protection and more efficient management.

For example, suppose you transferred assets to an irrevocable trust years ago to remove their value and future appreciation from your estate. Now, the higher lifetime exemption
makes it unlikely they’d be subject to the estate tax in your estate. But they’ve appreciated a lot, so the trust or your heirs will face capital gains taxes on the appreciation when the assets are sold. It might be better to have those assets back in your estate so heirs can increase the basis to fair market value after you pass away.

Many trusts allow you to swap assets of equal value for the trust assets. You can transfer cash or property that hasn’t appreciated much to the trust and take back the appreciated assets. Hold them in your estate for life, so your heirs can increase the tax basis when they inherit. If the trust doesn’t allow a swap, it might allow a “decanting” that involves merging
it with a new trust you created. All trusts you create in the future should allow swaps and decanting.

Explore these and other ways of changing the current strategies in your plan.

Consider residence changes. Trusts pay taxes on income and capital gains they don’t distribute. You might be able to relocate a trust to a low-tax or notax state without disrupting your estate plan. Discuss it with your planner as a potential way to reduce taxes for years at little cost.

While you’re at it, consider your own residence. About 20 states retain an estate or inheritance tax or both. If you live in one of those states, you might discuss with your estate planner whether it is worthwhile to change your legal residence to a state with no estate or inheritance tax.

Review charitable giving. The Tax Cuts and Jobs Act means fewer people will receive tax benefits from charitable gifts made either during their lifetimes or through their estates.

That’s why you should consider making your charitable gifts through IRAs (see this month’s IRA Watch). You also should consider bunching contributions to make large gifts, such as by using a donor-advised fund (see this month’s Tax Watch). Also, review the charitable strategies discussed in the December 2016 issue that provide multiple benefits, such as avoiding capital gains taxes and generating lifetime income.

Emphasize the non-tax factors. The old tax laws distorted estate planning to make it mostly about tax planning in many people’s eyes. In fact, there are more important estate planning goals than tax reduction and always have been.

An estate plan is to ensure that you are taken care of the rest of your life and that your wealth is transferred to the people you want to have it. A good estate plan ensures these goals are accomplished with as much efficiency and as little cost as possible. A good estate plan also can smooth family relationships, while a bad plan makes bad family relationships
worse and even turns good relationships into bad ones.

I’ve discussed many of the non-tax issues of estate planning in our monthly issues that are in the Archive on the members’ website and in my book, “The New Rules of Retirement-Revised Edition.” Now that the estate tax law is settled for a while, it’s time to stop procrastinating, consider these factors and put a plan in place that will enhance your legacy and meet your non-tax goals.