How the Tax Changes Affect Estate Planning

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. The recently enacted tax legislation didn't kill the estate tax, but it did limit its impact for all but the very wealthy. Joining me to discuss the latest news on the estate tax is Deborah Jacobs. She is an attorney and a personal finance expert.

Deborah, thank you so much for being here.

Deborah Jacobs: Thanks for having me.

Benz: There had been rumors that the tax package would do away with the estate tax. That didn't happen. But the exclusion amounts did increase quite a bit. Let's talk about that and the implications for people who are planning their estates. What things should they be thinking about?

Jacobs: As you say, Christine, the big news here is that the amount that you can transfer tax-free, either during life or at death has doubled from $5 million to $10 million per person indexed for inflation after 2011. Depending on how inflation is calculated, that means that the exemption for 2018 could be as much as $11.2 million per person, which means $22.4 million for married couples.

The thing is that the other pillars of the federal estate tax system remain the same. That is to say, if you exceed the limit, you or your heirs will owe tax of 40%. There is also an unlimited deduction from estate and gift tax that postpones the tax on assets that spouses inherit from each other until the second spouse dies. This is called the marital deduction, and it only applies if the inheriting spouse is a U.S. citizen.

In addition to all of that, widows and widowers can carry over any unused exemption amount of the spouse who died most recently and add it to their own. This is called portability, and it's started for death in 2011. It's a relatively new concept. With the new exemption amount, this allows married couples, whether the spouses are same sex or heterosexual, to transfer as much as $22.4 million together tax-free.

Benz: Let's discuss the implications for gifting.

Jacobs: On top of this, and completely independent of this system, anyone can give another person $15,000 per year, and you could do this for as many people as you want, without it counting against the lifetime exemption that we just mentioned. This is called the annual exclusion amount and it's adjusted for inflation. It went up in 2018, also, nothing to do with the new tax law, which was scheduled to go up from $14,000 where it had been for the previous five years to $15,000. Spouses can combine this annual exclusion to double the size of the gift. There are many opportunities now to give away assets during your life in different ways if you want to.

Now, whether people will do that or not will depend to some extent on how generous they are, how much money they need for themselves, and how compelling tax planning will be. For many people it's going to be a lot less compelling because of the extreme increase in the exemption amount. Very, very few of us now will need to worry about federal estate tax. In fact, the joint committee on taxation estimates that in 2018 it's going to affect only 1,800 estates. That's a minute number.

A much more pressing concern is people who now have plans in place that have been in place for a while, that are more complicated than what they are likely to need. If you previously set up trusts or family entities like family limited partnerships or limited liability companies, primarily for the purpose of minimizing estate taxes, I think this group of people needs to discuss with their financial advisors at the earliest convenience whether they should modify or dismantle those arrangements. I see much more rush for these people to take action than for the super wealthy to take action right now.

Benz: Deborah, there is a lot going on there. I want to talk about specifically that. If you have been a person who has been advised to set up these trusts, for example, to try to shield your estate from the estate tax, it sounds like you think that maybe you should revisit that with an attorney. An open question is that this is all set to sunset or go away at the end of 2025, correct?

Jacobs: Yes.

Benz: What about looking forward? Say, you are a younger individual, you think you have a long time horizon before any of this matters, should you rush to dismantle perhaps the trust that you've set up to shield yourself against perhaps a less friendly estate tax regime?

Jacobs: First of all, when it comes to estate planning, I believe in reading the tax code not the tea leaves.

Eight years is a very, very long horizon. Although the argument is, sure, that if once you have gotten assets out of your estate and all the appreciation is also out of your estate and you don't have to think about it and the trusts are funded--I don't think necessarily that's all such a good thing.

In addition, income tax planning has become even more important now than saving estate tax. If you have assets in a trust and those assets are sold down the line, you lose what's called the step-up in basis that you get when assets are passed outside of a trust through the estate plan, which is to say, if my house has appreciated greatly in value and a family member inherits it, the value of the house on my date of death is adjusted to the value on the date of death. Then if it's sold immediately, there would be no capital gains on it. If it's sold sometime down the line, there will be capital gains on whatever additional little appreciation there is. There is a definite detriment now to going the trust route rather than having that step-up in basis.

Benz: You mentioned the step-up in basis. Those laws are essentially staying the same under this new tax package. I want to back up and talk about the gift tax. You mentioned that annual exclusion amount going up to $15,000 in 2018. If someone happens to exceed that $15,000 amount in a given year to a given beneficiary, they still have to file that gift tax form, correct?

Jacobs: They have to file the gift tax return. Then the excess over $15,000 gets deducted from their lifetime exemption amount. It would get deducted from the $11.2 million, whatever the excess over $15,000 is.

Benz: I find there is a lot of confusion about this gift tax thing, that people think that if I file that form that I'm going to have to pay some extra on my taxes in that year I made the gift. Not true, right?

Jacobs: Not true at all.

Benz: Let's talk about the implications for people who are charitably minded. The increased standard deduction that's now available on our income tax returns beginning in the 2018 tax year arguably makes charitable giving less attractive from a tax standpoint. Let's talk about that dimension for estate planning purposes. What does that mean for people who are charitably inclined who are also thinking about minimizing their taxes in the current year as well as over the long haul.

Jacobs: This is an indirect effect of the tax overhaul, and it results from the fact that fewer people will be itemizing their deductions on the Schedule A. The Schedule A has always been a system of moving parts so that to have enough deductions to file the Schedule A separately itemizing your deductions, you had to have more than the standard deduction to make it worthwhile. The standard deduction is roughly doubling now. It's going to be $12,000 for an individual and $24,000 for a couple. In addition, there is now a cap on the deduction for real estate taxes and state and local taxes. Together the deduction cannot exceed $10,000. Many people will not get onto that Schedule A, and on the Schedule A is where they would deduct the charitable donations.

You can give to charity during your lifetime or through your estate plans. If you give through your estate plan, the estate gets an estate tax charitable deduction. As the exemption amount went up, there was less incentive to give through your estate plan. The argument was, gift during life instead--you get the charitable income tax deduction in the year in which you make the donation, and you have the pleasure of seeing your gift put to good use.

The other thing that I think is going to happen as a result of this is that there will be a push by charities to get donors to make larger gifts during life through various giving vehicles so that they do get the current income tax benefit of the gift. Donors in turn will, if they go for that, will need to think about what their commitment is to specific charities or consider using donor-advised funds; that is to make a large contribution all at once to a fund from which you can then recommend grants in the future to individual charities that you support.

Benz: It seems like that strategy of bunching deductions together, maybe using the standard deduction in other years and itemizing in single high-impact years is a good strategy.

Last question for you Deborah is, these are really big numbers, $11 million, $22 million. Many people watching this will think, I know that I am never going to come close to those figures in my lifetime. Does that mean that it's safe for most people to ignore estate planning? What are the key reasons that they should still sit down with an attorney or at least take a stab at getting a basic estate plan, even if they don't think that the estate tax will ever hit them?

Jacobs: The main reason to do estate planning, and this has been true for quite some time as the tax reasons became less compelling, are nontax reasons. That is to say, to take care of the people you love and also to provide for your own well-being in old age, which is also part of estate planning because it involves appointing people to manage your finances if you can't. Nearly 2.5 million Americans die every year, and many of those people have not signed the basic documents needed to protect their loved ones and to protect their assets if they become unable to manage them themselves.

Everybody needs those documents whether you need to be concerned about taxes or not. I think that one of the things that's going to happen now that word has generally circulated that many people don't need to think about taxes is there's going to be a lot more do-it-yourself planning, both in terms of using software to do it your own simple will and not consulting advisors about other estate planning-related strategies.

One danger that I see in this is not so much the really big bloopers in the documents which in the past used to involve tax strategy or lack of tax strategy, but mismanagement of what are called nonprobate assets. That is, assets that do not pass under a will or a living trust but according to the beneficiary forms that we fill out. The most prominent example of that is retirement accounts, which still there is incredible misunderstanding about this, that these assets do not pass under a will or a living trust no matter what you do, and you must keep those beneficiary forms up to date.

Benz: Deborah, great advice here today. Thank you so much for being here to share your insights.

Jacobs: It's a pleasure.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.