Potential Acceleration of Federal Estate Tax Exemption Decrease and Increase of Income Tax Rates
Now that the votes have been counted and our government has transitioned to a new administration, significant tax changes may be on the horizon. During the 2020 Presidential campaign, President Biden announced a tax plan that would decrease the federal estate tax exemption from the current amount of $11.7 million to $3.5 million. In addition, Biden’s tax plan, if implemented, would raise the individual income, capital gains, and payroll taxes for individuals with high levels of income. The changes to the capital gains tax would appear to be the most significant.
In light of these significant potential changes we recommend that you contact us to revisit your estate planning documents and asset allocations to determine whether changes are advisable.
Possible Changes Explained
In 2018, the Tax Cuts and Jobs Act (TCJA) doubled the estate, gift and generation skipping transfer tax exemptions to $10 million for each individual, but only for 2018 through 2025. The exemption level is indexed for inflation, and is $11.7 million in 2021. Transfers in excess of the exemption amounts are subject to gift or estate tax at a flat rate of 40 percent. Additionally, the TCJA retained federal estate tax exemption “portability,” meaning a surviving spouse can inherit a deceased spouse’s unused federal exemption provided the appropriate election is made on the deceased spouse’s estate tax return.
Under the TCJA these exemptions will be reduced to $5 million, indexed for inflation, effective January 1, 2026. With the change in administration, it is possible this reduction will be made effective sooner. In light of the current economic situation, it is also possible that under the new administration the tax exemptions could return to the 2009-level of $3.5 million, the tax rate for transfers in excess of the exemption amounts could be increased to 45 percent, and that “portability” could be repealed.
We are closely monitoring these matters and will post an alert if and when any changes are passed. In the meantime, if you have any questions about how these possible changes may affect you and your estate plan, we recommend that you contact us to re-visit your estate plan.
Impact of a Decreasing Exemption on Your Estate Planning Documents
Gifts Linked to the Amount of the Exemption
If you have an estate plan designed so that your bequests are linked to the estate tax exemption amount in effect at the time of your death, you should re-visit your estate planning documents as the documents may result in unintended distributions should the exemption amounts change.
Use of Exemption Before it is Reduced
In order to capture the benefit of the current large federal exemption, there may be a planning opportunity for some individuals to use the exemption in an amount that exceeds the amount of the lower exemption of the future. Of course, we do not know what the new exemption amount will be, but if we assume the exemption will be reduced to $5 million, an individual with an estate significantly in excess of that amount may wish to consider using more than $5 million of the exemption before the reduction takes effect. For example, if the exemption is reduced to $5 million on January 1, 2022, and you use only $5 million of the exemption prior to January 1, 2022, no portion of the current excess exemption over $5 million or “bonus” exemption was used, and you have no exemption remaining after December 31, 2021. Again assuming the exemption is reduced to $5 million on January 1, 2022, if you use $6 million of the exemption prior to January 1, 2022, while you will have no exemption remaining, you will have captured $1 million of the bonus exemption.
If you are a resident of Vermont, all gifts made more than two years prior to your death pass free of Vermont estate taxation without using any of the Vermont’s current $5 million state estate tax exemption. As a reminder if you are a New Hampshire resident, New Hampshire does not have an estate tax.
Another benefit of lifetime gifting is that the post-gift appreciation of any amount gifted is transferred free of gift and estate tax.
If a married couple is concerned that they cannot make a gift at such a high level without compromising their continued financial security, one possible solution may be for one or both of the spouses to create an exemption trust before the exemption is reduced for the benefit of the other spouse. The exemption trust for the benefit of a spouse can provide a safety valve, or at least a “delayed” gift to the next generation. This technique enables you to potentially continue to benefit from the gifted assets indirectly, through your spouse. This strategy works well as long as you remain happily married and live a long life. The indirect benefit of the gifted assets expires when the donee spouse dies.
The techniques discussed above, as well as others that may be available, have specific advantages and disadvantages that need to be discussed with an attorney before being implemented. Accordingly, please contact us to review your estate plan to determine whether revisions are appropriate.
Potential Income Tax and Capital Gains Tax Changes
For high-earning individuals, the Biden plan would increase taxes by, among other things, imposing a 12.4% payroll tax on earned income over $400,000 and increasing the maximum tax bracket income-tax rate to 39.6% from 37%. In addition, certain income tax deductions would be limited for individuals with income above $400,000.
The most significant changes in Biden’s plan, however, could be with respect to capital gains. Not only could long-term capital gains be subject to a tax of 39.6 percent on income above $1 million but also the so-called “step-up” in cost-basis at death could be eliminated. Currently, capital gains are subject to a 20 percent tax, and when an individual dies the cost or tax basis of the property the decedent owned individually or through a revocable trust is “stepped-up” (or down) to its fair market value at the time of death. Because capital gains are calculated by subtracting tax basis from fair market value, this “step-up” in basis effectively eliminates built-in capital gains on property passing to heirs.
These potential changes could warrant swift action, especially for those with built-in capital gains. While most individuals with high incomes will not be able to reduce their salaries to avoid paying higher rates, retired individuals may have control over the rate at which they choose to recognize income from retirement accounts and could therefore adjust income to keep rates low. But it is opportunities surrounding capital gains that will have the biggest payoff should these changes be implemented. For example, assets with large built-in capital gains could be sold to realize the tax on the built-in gain at the current 20 percent rate. For assets likely to be passed on to heirs through an individual’s estate, realizing tax now at lower rates could provide a secondary benefit: passing on a higher tax-basis asset to heirs.
Summary and Next Steps
We encourage you to review your personal financial situation along with your estate planning documents, and to contact us to discuss potential adjustments to your current plan and capital gain tax planning opportunities. We cannot predict if and when any of these changes may take place, and it is possible, although unlikely, that tax laws changes could be made effective retroactively. Accordingly, if you are concerned about these possible changes, it is advisable to contact us soon.
We welcome the opportunity to talk with you about the implications of these potential tax changes and any other estate and tax planning considerations such as:
- Planning for the disposition of your assets at your death;
- Asset protection planning;
- Planning for disability and incompetency;
- Business succession planning;
- Charitable giving;
- Retirement planning;
- Planning for children with disabilities;
- Planning for spendthrift children;
- Planning for real estate in other states, including ownership, state income taxation, spousal rights, and probate issues (in addition to state estate tax);
- Planning for clients who are U.S. citizens or residents who own property in other countries or who may receive inheritances or gifts from family members who are not citizens or residents of the U.S.;
- Planning to pay education expenses, including contributing to I.R.C. §529 plans; and
- Identifying potential guardians for minor children.
We wish you a healthy year ahead.