Use it or lose it. That’s what many Estate Planning specialists are saying in the wake of the new estate and gift tax law enacted last December. You should act now, they say, to make large gifts and put other estate planning strategies in place. Give as much away as fast as you can.
It’s easy to see their point. The new estate and gift tax allows each individual to transfer free of estate and gift taxes up to $5 million during his lifetime through gifts or through his estate. Married couples can give up to $10 million, and it’s easier to take advantage of the $10 million exemption because of portability. (See our April 2011 visit for details about portability.) There’s also a $5 million exemption per person for the generation-skipping transfer tax, which is the extra tax on gifts directly to grandchildren and later generations.
These exemptions are in place only for 2011 and 2012. Your gifts qualify only when made by the end of 2012, and your estate qualifies only if you pass away by the end of 2012. These exempt amounts are due to expire at the end of 2012, and then the law reverts to the 2001 version, with a lifetime exemption of only $1 million.
Low interest rates are another reason we have unique estate planning opportunities today. You can leverage the $5 million exemption by using strategies that reduce the value of property for gift tax purposes and remove future appreciation from your estate. Low interest rates make many of these estate planning strategies more effective and let you give more property tax free. Wait until rates rise, and less property will qualify for the exemption.
You also should be aware that some key estate planning strategies are on the short list of tax planning devices shelters some in Washington want to end or limit. Estate and gift taxes could face back door increases if that happens.
Put all these factors together and you can see a potentially brief window to transfer to loved ones significant wealth free of taxes.
First, let’s take a breath and review who should seize the opportunity.
Of course, anyone with an estate worth $5 million or more should visit an estate planner and map out a plan. Even those with smaller estates need to consider taking action now, because your asset growth means your estate could be worth more than $5 million when the tax bill is determined. The $5 million gift tax exemption is an opportunity to remove both the current value and the future appreciation.
Another reason those below the $5 million benchmark should consider taking action is the exempt amount could revert to something lower after 2012. It could settle in at the previous $3.5 million level or drop to the old $1 million amount.
State transfer taxes also are a factor. The states that have estate or inheritance taxes tend to impose them at much lower levels than the federal tax. Avoiding state taxes could be the key issue for you, and the $5 million gift tax exemption makes that easier. (Only three states or territories have gift taxes to worry about.)
The high gift tax level also makes it easier to set up an asset protection plan without using elaborate or offshore structures. When you want to protect assets from creditors, lawsuits, divorce, or other events, you now have a low-cost opportunity to simply transfer up to $5 million to other family members or trusts for family members.
There are some offsetting factors to consider before you start transferring wealth. You don’t want to give away wealth simply to take advantage of today’s exemption. You need to retain enough money to maintain your standard of living. That includes a cushion for expenses such as long-term care and surprise expenses. When your main asset is a business, you need to look at non-tax factors such as deciding when to give up control and to whom the control should be transferred.
Before using your lifetime exemption, remember you have the annual gift tax exclusion, which this year is $13,000 per donee ($26,000 when a married couple give jointly). In addition, you can make unlimited lifetime gifts for qualified education and medical expenses, when the payments are made directly to the provider. Only after those gifts are made do you start to draw on the $5 million lifetime exemption.
When making large lifetime gifts is an appropriate estate planning strategy for you, consider estate planning strategies from this list to leverage and maximize your gifts. We’ve discussed most of them in more detail in past visits. These articles are in the Archive on the members’ web site.
Roth IRAs. Help your children convert their traditional IRAs to Roth IRAs by giving them enough money to pay the taxes. By doing this you create a stream of tax-free income for life for your children. You also can convert your own traditional IRA to a Roth IRA. The amount used to pay the taxes is out of your estate, and you pay the taxes instead of leaving them for your loved ones to pay. The conversion creates a tax-free stream of income for you and your beneficiaries. The IRA avoids estate taxes when the value of your estate is less than $5 million ($10 million when your spouse inherits first).
Personal residence trust. Now is a prime time to transfer your home or second home through a qualified personal residence trust (QPRT). Low interest rates combined with beaten-down home values let you transfer more home free of gift taxes than you could in the past, and appreciation from today’s base would be out of your estate.
In a QPRT, you transfer the house to a trust. You retain the right to live in the house for a period of years that is less than your life expectancy. At the end of that period, the house belongs to your children or whomever you named as trust beneficiaries. Most people write a lease when they set up the trust that gives them the right to continue living in the home in return for a market level rent after the trust term expires.
Grantor retained annuity trusts. Restricting GRATs long has been in the sights of those looking to increase estate taxes. Act soon if they appeal to you. You also should act interest rates are low. GRATs are ideal for assets that you expect to increase in value at a rate faster than current interest rates. You essentially are giving away the future appreciation free of gift taxes.
In a GRAT, you put assets in a trust with a limited term. Over the trust term you receive payments equal to the original value plus interest at a rate determined by the IRS each month. Currently, a trust with a two- to five-year term would pay interest at around 2%. The trust beneficiaries get whatever’s left in the trust. In other words, they keep the appreciation above the fixed interest rate.
Many estate planners find a series of two-year trusts works best. You put in assets that are likely to be worth more at the end of the trust term. They could be interests in your small business, beaten-down investments, or investments you believe are purchased at less than their likely value in a couple of years. When things go as expected, you’ve transferred the appreciation tax free. When the appreciation doesn’t happen, all you’ve lost is the fees for creating the trust.
Business strategies. Strategies to transfer shares of your business at discounted values include family limited partnerships and intentionally defective grantor trusts. Discuss these and other options with your estate planner.
Other strategies. This is a great time to consider other estate planning strategies we’ve discussed in the past, such as family loans, charitable lead trusts, and dynasty trusts.
When choosing which assets to give, consider the tax basis. Donees of a gift will take the same basis in the asset you had, so they’ll eventually pay capital gains taxes on the appreciation that occurred during your ownership. When assets are inherited, on the other hand, the basis is increased to its current fair market value under current law. You should try to give assets that haven’t appreciated much or that you expect to increase more significantly in the future.
You shouldn’t wait to discuss these issues with an estate planner. It takes time to decide which actions, if any, to take and more time to implement them. Wait until the last part of 2012 and you might find you waited too long.
RW May 2011.
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