Not too long ago, estate planning strategy, largely determined by high transfer taxes, typically included the use of lifetime gifts to shift appreciating assets to younger generations. Now that has all changed.
Today, the dynamics of estate planning have become much more complex due to the following factors:
- Reduction in transfer tax rates
- Higher income tax rates
- Higher capital gains rates
- Relatively new federal net investment income tax (NIIT)
Combined, these four factors make the decision of whether to use estate tax exclusions or lifetime gifts much more complex. The taxes also place a greater emphasis on asset basis, the original value of appreciated (or depreciated) assets like real property, collectibles and stocks and bonds.
When transfer taxes were so high in the past, traditional estate planning largely overlooked income tax issues related to the value of these assets. Now, lower transfer rates and higher income tax rates create a much larger role for basis management and life insurance as a potential tool to use in the estate planning process.
It’s All About the Basis
As advisors, we help clients make the determination between making lifetime gifts and retaining assets for a basis step-up at death by weighing the following tax factors:
- Asset basis
- Current appreciation
- Growth potential
- Taxes assessed by the state in which the client resides or in which an asset is located
The federal government and most state governments impose a tax on the sale of an asset if it has increased in value from its “basis” amount, that is, the amount that was originally paid. Basis is the figure that is used to determine whether the sale results in a short- or long-term gain or loss. Tax rates are based on the period of time the asset is held and the individual’s tax bracket at the time the asset is sold.
The changing value of these assets and the tax implications guide estate planning strategy.
When an asset is held for more than one year before it is sold, the gain or loss on disposition is considered long-term. Long-term capital gains (LTCG) are generally taxed at a 15% rate for taxpayers in ordinary income tax brackets of 25% – 35%. However, when the taxable income exceeds the threshold set for the 39.6% income tax bracket ($413,200 for single taxpayers; $464,850 for married taxpayers filing jointly or $12,300 for estates and trusts), the LTCG tax rate is 20%. All this figures into estate planning decision-making. Because there are many exceptions to this general structure, the rules can become complex.
When an asset is sold for less than its basis determination, the taxpayer will have either a short-or long-term capital loss when it is sold. Again, the length of time the taxpayer held the asset is a key factor.
Net Investment Income Tax
Since 2013, capital gains are also subject the federal NIIT of 3.8% if the taxpayer’s income exceeds the NIIT threshold amounts (in 2015, $250,000 for married taxpayers filing jointly; $200,000 for single taxpayers; $12,300 of undistributed income for estates and trusts.) When factoring NIIT into the equation, the effective federal LTCG tax rate can reach $23.8% for high-income taxpayers.
State Capital Gains Taxes
State capital gains taxes are another important factor; these taxes vary by state and range from no taxes in states like Florida, Texas and Nevada to 13.3% in California. Rates depend on the taxpayer’s residence and/or the state where the asset is located.
When federal capital gains tax rates and NIIT are combined with state rates, the effective LTCG tax rates can reach $37.1% or more and the effective STCP tax rates can reach 56.7%. Because these tax rates can exceed the 40% federal estate tax rate, they have great influence on the estate planning strategy and making the choice between estate tax inclusion and lifetime gifts. Therefore, the key to analyzing the impact of capital gains taxes on estate planning lies in determining the cost basis assets and understanding the complex rules that govern lifetime gifts versus including assets in a decedent’s estate at death.
Life insurance presents a significant opportunity in the new estate planning arena. Properly structured, an irrevocable life insurance trust (ILIT) can fund payment of estate taxes, which can then allow highly appreciated assets to be included in the client’s estate to obtain a basis step-up on the client’s death. Other benefits of the ILIT include:
- Supplements lifetime estate planning techniques, such as installment sales to grantor trusts, where proceeds can be used to offset funds that could otherwise be consumed by capital gains taxes, income taxes, and NIIT upon the grantor’s death
- Funds charitable remainder trusts, where the proceeds can provide an alternate source of funds for the client’s family as the charitable trust remainder passes to the charity
- Can be structured to give a third party (independent trustee or trust protector) power to confer a general power of appointment on the beneficiary in the case of long-term trusts where a substantial unrealized capital gain accumulates over time
Looking ahead, the shifting tax environment will continue to be a significant factor in determining estate planning strategy. Marsh & McLennan Agency formerly Benefits Resource Group can review your estate planning needs and weigh the implications of lifetime gifts and estate inclusion. By sorting through some of the complex factors that determine the best avenue for you and your family, we can help preserve your wealth.
Marsh & McLennan Agency formerly Benefits Resource Group also offers a free audit of your life insurance policy. We encourage you to contact Charles J. Farro to ensure your policy is updated the way it should be and that the intentions are clearly stated regarding your wishes. Chuck is the cofounder of Marsh & McLennan Agency formerly Benefits Resource Group. You may contact him by phone at 216-393-1818 or email firstname.lastname@example.org.