Estate planning attorneys have always focused on federal estate taxes, but the game has changed dramatically. With the new, larger ($5,340,000) federal estate tax exemption now portable, a decedent’s exclusion is now available to the surviving spouse. As a result, few people now have to worry about the federal “death” tax. The new focus is on income taxes and the how state taxes need to be planned for.
Traditionally, the federal exemption of the first spouse to die had to be used through complicated trusts, which kept the assets beyond the survivor’s complete grasp. With the higher exemption, a return to more simple documents – “all to the surviving spouse” - could be an option for some, but not for all. Two important considerations now dominate the thinking of estate planners.
First, estate planners now focus on achieving better income tax results on investments. With the new 3.8% surtax on investment income, the attention is now on reducing capital gain income. How can that be done? Well, one strategy is to cause investments to receive brand new “basis” at both spouses’ deaths, since basis helps measure the amount of taxable gain. With less worry about federal estate taxes, wills and trusts can now be drafted to leave everything outright to the surviving spouse (basis step-up number one) and when the survivor passes, everything goes to the children (basis step-up number two!). If the survivor’s estate is large enough to trigger federal estate tax, portability allows the survivor to use the first spouse’s unused exemption.
Second, for those living in states with low state estate tax exemptions such as New Jersey, Maryland, Minnesota, Oregon, Massachusetts, New York, Rhode Island and the District of Columbia estate planning, estate planning documents may have to be drafted in the traditional manner. That is so, because state exemptions are generally not portable and must be used when the first spouse passes or will be lost forever. So, income tax basis step-up may have to take a back seat to estate tax planning in some cases.
The estate planner must now balance income tax planning with state estate tax planning for those living in the twenty jurisdictions that levy state death taxes. More creative planning opportunities exist for those with large estates that include hefty retirement plan balances. Instead of using the first decedent’s federal exemption amount at death, passing it on to the surviving spouse via portability may make sense. Required minimum distributions taken by the survivor will diminish the value of the retirement account and less of the first spouse’s portable exemption will be used to shield the retirement assets when the survivor passes.
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Planning has become more complicated than ever with the competing considerations presented by the various federal and state tax considerations. One thing is for sure – the landscape has changed and each situation is different depending on the person’s state tax system and opportunity for federal income tax basis step-up. Call the above techniques loopholes or whatever you want, but remember the famous words of Senator Russell B. Long, “A tax loophole is "something that benefits the other guy. If it benefits you, it is tax reform.''
Michael Foltz is a Principal of Balasa Dinverno Foltz LLC, a fee-only, independent wealth management Firm in Itasca, Illinois that currently manages over $2 billion of assets. He is an attorney, CPA and Certified Financial Planner™ with over 25 years of wealth management experience. Michael has been quoted in national publications, including the Wall Street Journal, Financial Advisor and BusinessWeek.