With Democrats in control of the Senate and House the likelihood of passing legislation in line with President-elect Biden’s agenda for estate plans has increased. While there are a number of proposed changes, there are two that are most significant. First, the amount of assets an individual can pass estate tax free to heirs may be substantially reduced. Second, capital gains taxes may be imposed on all estates with appreciated assets. This means that even individuals who are “not rich” will suffer some tax consequences at death.
What is the Current Law and what are the Proposed Changes?
Federal Estate Tax Exemption
The Federal Estate Tax (FET) exemption is the amount of assets an individual can pass to heirs free of Federal Estate taxes. This applies to both lifetime gifts and transfers at death—as long as the combined total does not exceed the FET exemption. (Note: there may be state taxes imposed which are beyond the scope of this article).
Current Law: For 2021 the FET exemption is $11,700,000 per individual or $23,400,000 for a married couple. The current law is scheduled to sunset at the end of 2025 and for 2026 and beyond the FET exemption would revert back to the 2017 amount of $5,490,000 plus a cumulative inflation adjustment for 2018-2025. An estimate of the 2026 FET exemption could be $6,500,000 per person or $13,000,000 per married couple.
Proposed Law: The Biden Plan (October 2020) reverts the FET exemption back to 2009. Under the 2009 law, there would be a $1,000,000 gift tax exemption and a $3,500,000 estate tax exemption per person. For a married couple that means $2,000,000 of gift tax exemption and $7,000,000 of estate tax exemption. There is some speculation that a new plan might just accelerate the already in-place sunset provision noted above for 2026 to an earlier date.
Capital Gains Tax
An asset that has appreciated in value since purchase is subject to capital gains tax upon sale.
Current Law: An asset passing through an estate receives a so-called “step-up” in cost basis at death. This means that the cost basis of an asset owned by a decedent is “stepped up” to fair market value upon death. The heir(s) would receive the asset with zero unrealized capital gain. If they immediately sold the asset, they would pay no capital gains tax.
Proposed Law: The Biden Plan (October 2020) proposes to tax appreciated property at death. The “step-up” to fair market value would be eliminated. It is unclear if this tax would integrate in some fashion with the estate tax—as a credit or deduction against the estate tax, for example. There also seems to be some discussion about having the unrealized capital gain carry over to the heirs. They would then incur the capital gain tax upon sale. This tax would apply to every estate—including those of the Not-So-Rich.
What is the Likelihood of Passing this Legislation and When Will Changes Begin?
The likelihood of passing some form of this proposed agenda is fairly strong. These changes have been part of the President-elect’s agenda for some time. From a legislative perspective, a simple majority of Senate members is needed to pass tax legislation. There are some challenges, however, in that it would only take one Democratic senator to force a material change or block the legislation. While having any legislation become effective with a retroactive start date of January 1, 2021 is possible, it seems unlikely given that other priorities may need to be addressed first. A more likely scenario is a start date in 2022.
What Should You Do Now?
While the loss of the step-up in cost basis for assets is uncertain, it seems highly likely that some loss of the Federal Estate Tax exemption will happen. To that end, a number of action steps are worth looking into now:
- Make sure your estate documents are up-to-date and allow for maximum usage of the Federal Estate Tax exemption.
- If the new law becomes effective 2022 or later there will be time to make large gifts this year.
- Make sure your balance sheet, asset titling, and beneficiary designations are all coordinated for maximum estate tax efficiency. Your balance sheet (net worth) is an indicator of the size of your estate. In this particular review, you should also add in the death benefit of any life insurance owned personally by you—it is an estate asset. (You can remove life insurance from your estate by transferring it to an Irrevocable Life Insurance Trust; certain rules must be followed.) How assets pass through your estate—by title (e.g., joint with right of survivorship where your half of an asset transfers to your spouse) and beneficiary designations (e.g., your IRA payable to your spouse) may help or impede proper tax planning. A determination of the optimal estate plan will guide how you should title assets and what your beneficiary designations should be.
- Consider the use of life insurance to offset the impact of higher estate taxes. In a typical planning scenario for a married couple, estate taxes are deferred until the death of the second spouse There are special types of insurance policies that insure both lives and pay the death benefit at the death of the second person when taxes are due. The cost of this type of insurance is typically lower than the cost of insuring one person. This insurance should be owned by an Irrevocable Life Insurance Trust to assure that the death benefit falls outside of your taxable estate and is fully available to your heirs.
- Consider the use of advanced planning techniques that can mitigate the impact of a more costly estate tax environment. These could include valuation discounts, Grantor Retained Annuity Trusts (GRATs), Spousal Lifetime Access Trusts (SLATs) and other estate reduction/freeze techniques that are beyond the scope of this article.
Estate taxes are about to become higher for many of taxpayers. A careful review of estate documents, assets and planning options resulting in a recommended estate plan can help assure that your estate goals are met and taxes are minimized. Your Round Table Financial Advisor can help.