Today, you generally do not need to be concerned about federal estate taxes unless your net worth approaches $5 million (about $10 million if you are married). For 2016, the federal estate tax exemption is $5.45million per taxpayer and the exemption is scheduled to be annually adjusted for inflation. The exemption is the amount, reduced by any taxable gifts you made during life, which can pass tax-free to your heirs upon your death.
As the higher, inflation-indexed estate tax exemption was permanently signed into law, the top ordinary income and long-term capital gains rates increased approximately five percentage points each, to 39.6% and 20%, respectively. In 2013, the 3.8% net investment income tax went into effect for higher-income taxpayers and at thresholds lower than those triggering the top income tax rates.
So, for higher-income taxpayers and people with higher-income heirs, income taxes are important to plan for. However, even middle-bracket taxpayers should factor income taxes into their estate planning to minimize tax liability for themselves and their heirs. After all, why pay, say, even a 15% federal tax on a capital gain if, with careful planning, your family could avoid incurring any federal taxes on that gain?
Two Valuable Income Tax Strategies
Several income-tax-saving strategies can be incorporated into an estate plan. However, the following are two of the most valuable that most taxpayers can take advantage of:
- Hold on to appreciated assets — unless you have loved ones eligible for the 0% rate. Inherited assets receive a step-up in basis to their fair market value on the owner’s date of death. The recipient can then sell the appreciated assets shortly after receiving them and owe little, if any, income tax on the sale. So, if estate taxes are not a concern, holding on to both assets that have already appreciated and assets that you expect to appreciate significantly in the future can be beneficial. However, if you would like to dispose of an appreciated asset and you have loved ones in the 10% or 15% bracket for ordinary-income taxes who thus are eligible for the 0% rate on long-term capital gains, consider gifting it to the loved one to sell. This might require a gift tax return to be filed.
- Make charitable donations during life. If you are charitably inclined, consider maximizing your lifetime donations rather than waiting to make large charitable bequests at your death. Properly substantiated lifetime gifts to qualified charities generally provide an income tax deduction (and reduce the value of your estate), while charitable bequests provide only an estate tax deduction, which you will not need if your estate is below the exemption amount.
Before making significant charitable gifts, be sure to consider your cash flow needs and the legacy you want to leave. Also, keep in mind that your annual income tax deduction for charitable donations is limited to a percentage of your adjusted gross income (AGI) — 50%, 30% or 20%, depending on the type of gift and charity. Contributions exceeding the applicable AGI limit can be carried forward for up to five years.
As you consider — and perhaps implement — these income-tax-savings strategies for your estate plan, you also need to keep an eye on two things: 1) Your net worth, and 2) Congress. If you have a financial windfall or simply enjoy a steady increase in compensation or investment performance, your estate could be boosted to a size where federal estate taxes become a concern. And, while the high, inflation-adjusted estate tax exemption has no expiration date, Congress could pass legislation to reduce it at any time.
Medicaid Planning Issues
Obviously, the above items do not work in the context of Medicaid Planning. Gifting of assets, holding onto appreciated assets work for estate planning strategies and tax strategies – but not for Medicaid Planning strategies. While an Irrevocable Income Only Grantor trust does allow for tax basis planning opportunities, charitable gifting during lifetime and within 5 years of applying for Medicaid will be a disqualifying transfer of assets.
Whatever happens, be ready to revisit your estate plan and, if necessary, alter your strategies based on changing circumstances. Be sure to consult with appropriate financial, tax and legal professionals. Want to discuss your plans? Contact us to schedule an appointment.