Federal estate taxes changed under the new tax law, resulting in substantially less taxes for individuals with estates greater than $5.49 million and couples with estates greater than $10.98 million. The Tax Cuts and Jobs Act more than doubles the estate tax exemption—but only for years 2018-2025. For the next eight years, the estate tax exemption (the amount of your estate that you don’t have to pay any taxes on) is now $11.2 million per individual and $22.4 million for married couples who elect portability. This significant and temporary change may mean you need to update your current estate plan. And with the top estate tax rate at 40%, this also creates impactful estate planning opportunities for certain high net worth individuals.
How is the Estate Tax Calculated?
The estate tax is calculated at the estate tax rate multiplied by the value of an individual’s estate, less taxes calculated on the exemption amount. That’s why the exemption amount is so important. Let’s look at an example.
Say you passed away in 2017 and your estate is worth $10 million. For simplicity, we’ll say your tax bill is roughly 40% x $10m = $4m. But, because of the exemption, the taxes calculated on the first $5.49 million (40% x $5.49m = $2.196m) are subtracted from your total taxes owed ($4m – $2.196m = $1.804m). You’re left with $8,196,000 after federal estate tax ($10m – $1.804m) to transfer to your beneficiaries under the previous law.
But what if you passed away in 2018? Your estate would pay $0 in taxes, and the full $10 million would transfer to your beneficiaries. That’s because the exemption in 2018 is now $11.2 million per individual and your $10 million estate is less than the federal estate tax exemption amount. A savings of $1.804m!
Step-up in Cost Basis at Death
Also keep in mind that your assets get what’s called a “step-up in cost basis” when you pass away. This is a good thing and helps reduce your estate’s tax bill. In general, cost basis is equal to the amount you originally paid for an asset, plus any additions. This could apply to tangible investments, like real estate, or stocks or mutual funds held in a brokerage account, as well as intangible assets. When you pass away, your cost basis gets “stepped-up” to the market value of the asset as of your date of death and the untaxed unrealized appreciation goes away.
For example, let’s assume you bought shares of a stock for $1,000 and you hold those shares for your entire life. When you pass away, the value has increased to $5,000. If you had sold the stock before your passing, you would have paid capital gains tax on that $4,000. However, since the stock is left unsold when you pass away, it (along with all of your other taxable assets) gets the step-up in cost basis to fair market value. When your beneficiaries inherit the stock, their cost basis is $5,000 and they can now sell the holdings immediately without owing capital gains tax.
This is not changing under the new law. Assets still receive a step-up in cost basis at the death of the owner. This is important to consider when managing a portfolio with highly appreciated securities and determining lifetime gifting strategies. The idea is to hold on to low basis assets, to the extent possible, so that the assets get the step-up before transferring to your beneficiaries.
Estate Planning Strategies under the New Law
We can see why doubling the exemption is a positive for those with estates over $5.49 million. But it only lasts eight years. So… What if you died after 2025?
Even if you don’t plan to die between 2018 and 2025, you may still be able to capitalize on the temporary law change. One way to reduce your estate’s future tax bill is to utilize the higher exemption by gifting during your lifetime over the next 8 years.
For example, you could make a gift to an irrevocable trust in the amount of the higher federal exemption during these 8 years. This should “lock in” the higher exemption even if the law returns it to its lower levels in 2026 (assuming no claw-back). It also removes all future investment appreciation on these assets from your estate which could result in substantial tax savings depending on the assets transferred.
Additionally, asset titling is an important consideration with the law change. Although the law allows for “portability” (the ability to transfer unused exemption to your spouse upon your death) it is good practice and often beneficial to title assets so that each spouse can use their maximum estate tax exemption amount as individuals. This allows for more flexibility within your estate plan, which is particularly important in light of the changing tax law.
Review Your Current Estate Plan
The law change should encourage you to review your current estate plan with your financial advisor, and your estate planning attorney. Certain language or strategies may result in different outcomes than originally intended if you or your spouse were to pass away while the new estate tax law is in effect. (For example, if you have a credit-shelter trust that you direct to be funded with the federal exemption amount, that amount is now more than double what it was when you drafted the trust. Although a sophisticated strategy, the surviving spouse may be left with fewer assets in their control—not what you may have planned!) When redrafting your estate plan, you should make it as flexible as possible so that even with the law changing, your assets transfer as intended.
With estate plans, it is important to ensure your bases are covered under as many scenarios as possible, even the unlikely ones. Make sure your will and trust documents are updated to reflect these law changes and clearly delineate your intentions. This is also a good time to ensure your other important estate planning documents are in place, including powers of attorney and medical directives.
Estate planning is a complex and very important piece of your family’s financial plan. But keep in mind that while maximizing wealth transfer is important, it’s primarily imperative to ensure your own financial stability during your lifetime. Work with your wealth advisor to determine your capacity to gift, meeting philanthropic objectives, and designing the optimal estate planning strategy for your family. Your estate plan should work together with your portfolio and overall financial plan to protect your financial well-being and maximize your legacy.