The American Taxpayer Relief Act of 2012 (ATRA) eliminated much of the uncertainty that plagued estate planning for years by making two key provisions “permanent”: the $5 million gift and estate tax exemption (adjusted annually for inflation) and exemption portability between spouses. Currently, the inflation-adjusted exemption is $5.25 million.
ATRA relieves some of the pressure on people to transfer wealth during their lives. But lifetime gifting still provides some significant advantages.
Tax savings for the affluent
If your net worth is large enough for estate taxes to be a concern, you’ll still benefit from lifetime giving strategies designed to remove assets from your estate in a tax-efficient manner. And even if your estate is within the exemption amount, it’s possible that it’ll grow beyond that amount in the future. Gifting assets now — either outright or in trust — can “freeze” their value and remove future appreciation from your estate.
In addition, all things being equal, paying gift tax is “cheaper” than paying estate tax. Why? Because gift taxes are computed on a “tax-exclusive” basis while estate taxes are computed on a “tax-inclusive” basis. Here’s an example:
Mary is in the top gift and estate tax bracket (currently 40%) and has already used her $5.25 million exemption. She’d like to make a $1 million after-tax gift to her daughter, Jane. If she makes the gift this year, it will cost $1.4 million — $1 million for the gift and $400,000 in gift tax.
If, instead, Mary decides to leave Jane a $1 million after-tax bequest, it’ll cost $1.67 million (assuming the tax rate is still 40% when she dies) — $1 million for Jane and nearly $670,000 in estate taxes. The difference is that, with a bequest, estate tax applies to the amount used to pay the tax on the gift, as well as the amount of the gift itself.
Keep in mind that gifting is advantageous only if you survive for at least three years after you make a gift. Otherwise, the gift will be subject to the “three-year rule,” which pulls assets back into your estate if they’re transferred within three years before death.
Insurance against future tax changes
When it comes to taxes, “permanent” is a relative term. ATRA’s estate tax law changes are permanent in that they aren’t scheduled to expire after a certain period of time. But there are no guarantees Congress won’t reduce the exemption — or increase rates — in the future in an effort to boost tax revenues.
An effective strategy for insuring yourself against future tax hikes is to take advantage of lifetime gifting to remove wealth from your estate under current, favorable conditions. Nontaxable gifts are particularly valuable because they aren’t subject to the three-year rule. They include annual exclusion gifts — up to $14,000 per recipient this year ($28,000 for gifts by married couples) — as well as direct payments of tuition or medical expenses on behalf of your children or other beneficiaries.
Taxable gifts — including gifts within the $5.25 million exemption — are also effective. But there’s a potential risk of estate tax exposure if you die within three years and the exemption is reduced.
A holistic approach
Don’t make estate planning decisions based on tax savings alone. If lifetime gifting strategies are consistent with your overall estate planning objectives, they’ll continue to offer significant tax benefits. Talk to your estate planning advisor to learn more about the estate tax implications involved with making gifts.