The fiscal cliff deal and you: Understanding gift and estate taxes

A number of taxpayers following the debate over provisions to address the fiscal cliff were concerned about changes to the estate tax; without any change to the law, the federal “death taxes” were slated to apply to estates as low as $1 million. However, the American Taxpayer Relief Act permanently sets the exemption amount at $5 million, indexed for inflation. For 2013, the indexed exemption is $5.25 million. Estates over this amount will be taxed at a top rate of 40%, up from 35% previously.

The same exemption threshold and tax rate apply to gifts made over the course of your lifetime, as well as to “generation-skipping transfer” (GST) planning (i.e., gifts in trust designed to last for multiple generations or for non-related beneficiaries significantly younger than you).

Article Highlights

  • The American Taxpayer Relief Act permanently sets the exemption amount for estate and gift taxes at $5 million per person, indexed for inflation.
  • The Act also permanently implements “portability,” which allows people to take advantage of their spouse’s unused exemptions after their death.
  • These two measures greatly simplify estate planning for many people.
  • However, taxpayers must still consider applicable state laws as well as personal circumstances.

Another feature of the Act that will make planning easier is the permanent implementation of “portability,” which was first introduced in the 2010 Tax Act. Portability allows a widow or widower to apply the deceased spouse’s unused exemption amount—either during his or her lifetime for taxable gifts or at death for estate tax purposes. For instance, assume that husband and wife George and Mary each have $5 million estates, and neither has used any of their exemption to shelter lifetime taxable gifts. If George leaves his entire estate to Mary at his death (subject to the unlimited estate tax marital deduction), he will have used none of his estate tax exemption. However, “portability” provides that George’s unused exemption will roll over to Mary. In this example, Mary will have George’s unused exemption in addition to her own to distribute tax-free as gifts during her lifetime or in her own estate at her death.

Having a permanent resolution on these issues will greatly simplify estate tax planning for the many people whose estates are under the $5.25 million for singles or $10.5 million for married couples.

Things to consider about portability

Before the 2010 Tax Act allowed for portability, you were required to use or lose your exemption: If the first spouse to die did not “shelter” his or her available exemption amount from federal estate tax via a family trust or unified credit trust, for example, then that amount would not be available to the surviving spouse. Portability can allow married couples to implement a much simpler plan than they would have required previously, with less need for federal estate tax planning at the first spouse’s death.

In some cases, however, you may still want to consider sheltering your exemption for your surviving spouse, even when portability would eliminate all federal estate tax at the survivor’s death:

  • About half of the states now impose a state-level estate tax, and the state exemption amounts for that state-level tax varies widely. If you live in one of these states, you may want to consider your options for sheltering your exemption amount.
  • If you and your spouse each have a taxable estate near the $5.25 million limit, you may still want to consider a credit shelter trust. This can shelter the growth on those assets after one spouse’s death from further taxation, since the surviving spouse may live long enough for those assets to appreciate above the exemption amount.
  • Portability does not apply to the GST tax exemption. Therefore, married couples with more than $5.25 million in 2013 may still wish to use tax planning at the first spouse’s death to fully take advantage of the deceased spouse’s GST exemption.

What should you do now?

If you are single, the portability issue has little impact, but the permanent setting of the exemption amount offers a number of opportunities for simplifying your estate planning. The same holds true for same-sex couples whose partnerships are not recognized by federal law and who are dealing with a hodge-podge of state laws. Your estate-planning attorney can help you determine — based on the size of your estate, your age, your planning needs and your state’s laws — what approach makes the most sense for you.

If you are married, with an estate well under $10 million, and you do not live in a state that imposes a separate state-level estate tax, there may now be ways to simplify your estate planning:

  • The permanent existence of portability may now allow you and your spouse to leave everything to your surviving spouse, rather than using trusts to shelter assets. Discuss with your attorney whether this approach makes sense for you.
  • There may be less of a need to balance asset ownership between spouses. If the majority of assets are currently in one spouse’s name, there is less risk to leaving these assets as they are.
  • You have greater options for flexibility with money in retirement plans, even if it is a substantial amount. Previously, it often made more sense for married couples to shelter these funds in a trust to avoid estate taxes, even though this could potentially have negative consequences on income tax planning. Now, however, you may be able to simply leave these funds to the surviving spouse.

If you are married, with an estate that is currently above $10 million or that you expect to appreciate up to or beyond that amount, you may have more complex tax planning needs. Contact your advisor to discuss a personalized strategy depending on your age and amount of wealth.

For more information on the provisions of the American Taxpayer Relief Act, please see “The fiscal cliff deal and you: Will your taxes increase?” and “The fiscal cliff deal and you: January 31 deadline for IRA charitable gifts.

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