As you progress into different stages of your life, estate planning is something that should be made a priority. Making sure there is a proper plan in place for your assets can set your dependents up for financial success. But how should that plan look now that tax reform has changed the way inheritances are taxed?
Even though taxes might not be going away, there are major changes going into effect to how your inheritance is, or is not, taxed when the assets transfer hands. The estate tax, or commonly called the death tax, has seen some of the biggest changes that will ultimately help preserve wealth for some families.
Estate and Gift Tax Exemption
Throughout US history there has been some type of estate tax imposed on those who amassed fortunes during their lifetimes. It capped out at 77 percent in the 1940’s and 1950’s (with a $10 million exemption) and has gone up and down often since then. The idea is simple, by imposing a tax it lowers the risk of creating dynastic money; that is, families with so much money they basically control the country.
Recently, at least until the latest tax reform, the estate and gift tax was 40 percent of the excess amount over $5,490,000. So you could leave roughly five and a half million without any tax worries, the amount above that was subject to taxes. This exemption amount has been increasing with inflation for the past eight years.
The new tax laws left the tax rate the same, but instead of going up to $5.6 million in exemptions, it doubled that number bumping it to $11.2 million. You can double that again for married couples, creating a possible exemption of $22.4 million. However, a bypass trust is needed in the event that both spouses don’t die at the same time.
What about after 2025?
Here’s the issue with this new law: it’s only good for eight years. At the end of 2025, the estate tax laws reset. Since it’s fairly impossible to understand exactly when you will die, how can you plan to maximize the amount passed to heirs when the laws are in your favor?
The answer is through the use of permanent life insurance and trusts. These can be created and funded before the end of the expanded exemption.
It’s always a good idea to speak with a tax attorney about your specific situation, but here are the basics. Let’s suppose you and your spouse have an estate worth $20 million. Under the Tax Cuts and Jobs Act, you would get an exclusion for the first $11.2 million. However, the next $8.8 would be taxed at 40%; creating a tax bill of $3.52 million. Most would have to sell properties in order to generate that much money.
Instead, during the exemption period, you can create a trust that would own life insurance for the couple. The trust can be funded with the gift tax exclusion before the end of 2025, allowing substantially more to be transferred into it. An insurance policy can be purchased that will offset most, if not all, of the taxes that will result in a death after the new reform laws go away.
Here’s the issue with the sunset clauses on these types of laws: they almost never sunset. That clause is built in so that more politicians will vote to make it go through. Then when the period is almost over, another quick vote extends it indefinitely. That may not be the case this time around, but historically that is what has happened.
How Tax Reform Will Impact Your Inheritance
If your inheritance is less than the exclusion amount, there really is no change that you will see. In fact, out of 2.6 million deaths in the US, only 4,700 were subject to the estate tax (that’s only 0.18 percent). For those who aren’t expecting large legacies coming their way, there’s one item to remember. The cost basis step-up has remained unchanged.
The step up in basis is a great way to avoid capital gains taxes on inherited equities. Let’s suppose your father buys 1,000 shares in XYZ Company for $1 each. They grow to be worth $1,000 each. Their sale would result in $150,000 in taxes (at 15% capital gains tax rate). But at his death, those can pass to you, and the cost basis goes from $1 each to the value at the time of death.
Taxes are complicated. As your family’s net worth rises there are even more complicated issues to deal with. As that exclusion mark is approached, start making plans to ensure that as much money stays in the family as possible. That usually means enlisting the help of a tax attorney. Set up regular reviews to ensure that everything is still on track to help you keep your inheritance.
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