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Estate Planning Tax Law Changes Investors Must Understand

Last update on: Aug 14 2020
estate planning

A revolution is underway in Estate Planning. You know about the 2012 changes to the law (see our February 2013 issue).  They require fresh approaches and strategies.

Many believe the new law means estate planning is unimportant. That’s a mistake.

A result of the 2012 law is that for most people income taxes are a higher burden than estate taxes, and as income rises the income tax burden is higher. The top tax rate was increased to 39.6%. Long-term capital gains and qualified dividends had their rates increased to 20%. The phase outs of itemized deductions and personal exemptions were restored. In addition a new 3.8% Medicare tax on investment income was imposed by Obamacare.

These changes mean there should be new emphasis and focus in your planning, and you should reconsider your view of some strategies.

The new regime means estate planning is a much more important part of income tax planning. Coordinating income and estate tax strategies is more important, and estate planning strategies can be a key way to reduce income taxes for you and your heirs. Here are areas to review.

Life insurance. Traditionally the main reason to buy permanent life insurance was to help pay for estate taxes. The number of people with that need is reduced, but other ways of using life insurance can be more profitable, and some strategies that weren’t wise under the old law now make more sense.

Permanent life insurance has an investment component. Earnings of the policy’s cash value compound tax deferred as long as they remain in the policy. In addition, after the earnings compound for years, loans can be taken from the cash value. The loans are tax free and don’t need to be repaid during life as long as the cash value is sufficient to help pay premiums or you’re willing to make additional premium payments. The loans eventually are subtracted from the death benefits, reducing the amount available to heirs.

Higher income tax rates make life insurance as an investment vehicle more attractive. They’re even more attractive because of the higher estate tax exemption. Under the pre-2010 law, many people avoided owning policies, because the benefits would be included in their estates and potentially subject to estate taxes. The higher estate tax exemption means fewer people have to worry about the estate tax reducing the insurance benefits. Now, for most people heirs receive the full benefits, minus any loans, free of estate and income taxes.

Borrowing from insurance cash value isn’t risk free. Many people in recent years found that because of low interest rates their policy cash values didn’t generate enough income to keep the policies in force without significant new premium payments. If you plan to use life insurance as an investment vehicle, you need to work with a knowledgeable broker or agent and manage the policy.

The new law also makes life insurance more attractive in employer retirement plans. (They aren’t allowed in IRAs and some other retirement plans.) Buying the insurance through a pension plan means tax deductible dollars are used to make the purchase, and the insurance benefits should be far more than the premiums paid.

Estate planners often advised against the strategy because the life insurance would be included in the estate. With the higher estate tax exemption, however, fewer people need to worry about the estate taxes and can focus on the benefits of owning life insurance through a retirement plan.

Another change: It used to be routine that substantial life insurance policies would be held in trusts to ensure the benefits weren’t included in the taxable estate. With the high estate tax exemption, there is less need for incurring the expense and inconvenience of a trust. Many people now can own the policies themselves and still be confident the full policy value will be available to pay estate taxes or debts or enhance the inheritances of their loved ones.

Trust taxes. Trusts are in many estate plans these days, because they provide substantial benefits other than estate tax reduction. (See our April 2012 visit.) The estate planning benefits, however, can be offset by higher income taxes. Under the new law, even moderately well-off people need to consider the effect on trust income taxes.

A trust reaches the top income tax bracket and also faces the new 3.8% Medicare tax on investment income in 2013 when its undistributed income is only $11,950. Keeping income in a trust can provide creditor protection and other benefits, but perhaps at the cost of substantially higher income taxes.

The income taxes can be managed. The trustee can invest with taxes in mind by focusing on long-term capital gains, qualified dividends, and tax-exempt bonds. Assets with paper losses can be sold so the losses are available to offset gains and other income. Ideally, the trustee has the discretion to distribute income to beneficiaries and will consider income taxes as one of the factors in making those decisions. Trustees with that discretion should consult with beneficiaries to determine their income tax situations before making distributions.

Many people should reconsider their decisions to create trusts in their plans. As I said, there are many potential benefits of trusts. These benefits need to be compared to the potential higher income taxes of a trust.

This new outlook applies whether trusts are created during your lifetime or in your will. Last month we discussed reasons you still might want to include a bypass trust in your will. If you believe the potentially higher income taxes and the cost of setting up the trust offset its benefits, update your will to delete the bypass trust.

Charitable gifts. Planning for charitable gifts is affected in several ways. Higher income tax rates mean some people will reap more savings from making the gifts now, but at higher incomes the phase out of itemized expenses could offset some of the benefits. Also, the higher estate tax exemption removes some of the benefits of making charitable gifts in your will. Taken together, these two changes mean that for some people the tax benefits of charitable gifts are reduced.

That’s not the full story. Taxpayers who aren’t affected by the phase out of itemized expenses receive the same income tax benefits from their donations as before 2013. Because of that and the higher estate tax exemption, there’s more of an incentive to make donations during life instead of through the estate. You receive the income tax benefits now and also see how your gifts are used. But if you make the gifts through your estate there might be no tax savings, plus you won’t see the results of your gifts.

Charitable remainder trusts still are valuable. They shelter appreciated assets from capital gains taxes, provide immediate income tax deductions, and generate a lifetime stream of income for you and your spouse. (See our May 2008 visit for details on CRTs.) Gift annuities also retain their benefits for most people. You make a gift to charity, take a partial tax deduction, and receive a lifetime stream of income. (See our July 2007 visit for details.)

Lifetime gifts. Many people need to reconsider their lifetime giving strategies. With the higher exemption, fewer people need to remove substantial assets from their estates. Instead, your main concerns should be providing loved ones with wealth that will benefit them and do so in a tax wise way.

Income taxes should take a bigger role in selecting gifts. When someone receives a gift of property, they take the same tax basis the giver had. If the property has appreciated, when the recipient sells the property he’ll owe taxes on all the appreciation. That’s why you should try to give property that hasn’t yet appreciated much but that you expect will appreciate after the gift. An alternative is to consider giving appreciated property to someone who will be in the 0% long-term capital gains tax bracket when he or she sells.

State taxes. Many states don’t have estate or inheritance taxes. About 20 states, however, impose one or both of them and often at lower exemption levels than the federal law. Planning to avoid these taxes is more important for residents of those states than planning for federal taxes.

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