Estate planning after the American Taxpayer Relief Act of 2012 (“Tax Act”) focuses on the kinds of assets clients have and the size of their wealth. Recall that in 2013, the top federal tax rate for ordinary income increases from 35% to 39.6%, and the long-term capital gains rate for many assets increases from 15% to 20%. Furthermore, starting this year, the Patient Protection and Affordable Care Act imposes 3.8% tax (“health care tax”) on net investment income of individuals, trusts, and estates after threshold amounts are exceeded.
Your estate plan can mitigate some of the effects of the Tax Act and Obamacare, but the same plan will not work for everyone. In crafting personal plans, here are ten of the best strategies to contemplate based on individual needs and goals:
1. Income Tax Planning for Investments. The 3.8% health care tax on net investment income applies to individuals, trusts, and estates after threshold amounts are exceeded. For persons, those amounts are as follows: single individuals with a modified adjusted gross income of over $200,000; married individuals filing jointly with modified adjusted gross income of over $250,000; and married individuals filing separately with modified adjusted gross income of over $125,000. For estates and for many trusts, the thresholds are much lower, but the tax only applies to their undistributed net investment income. Investment income includes interest, dividends, capital gains, rental and royalty income, among others. Because of these increases, it is now extremely worthwhile to engage in income tax planning for investments and to revisit how these assets are situated in your overall estate plan.
2. Shifting Income to Children & Grandchildren. Shifting income to children and grandchildren who are taxed at a lower bracket can reduce tax liability. The IRS curtails income shifting through a variety of mechanisms, including a doctrine that generally prevents individuals from assigning income to others. However, legitimate ways exist to shift income to benefit younger generations. Legitimate income shifting strategies involve gifting income producing assets to younger generations who are taxed at a lower rate so that the resulting income is not subject to a parent’s higher bracket. Caution is required, however, because after a certain amount, and taking into account the child’s age and student status, the income from such assets may be subject to something called the the Kiddie Tax, causing the income to be taxed at the parent’s rate regardless.
3. Shifting Income to Trusts & Estates. Another way to alter the tax bracket under which asset income falls is to donate property to certain kinds of trusts whose income is taxed at the beneficiary’s tax rate. Here, careful planning is required: if the individual who donates property into the trust retains control over the trust, asset income will be subject to his or her tax rate. Furthermore, net investment income earned in trusts and estates and distributed to beneficiaries is not subject to the 3.8% health care tax (at the trust level). [Note, however, that such distributions could push a beneficiary’s individual modified adjusted gross income amount over a threshold stated in Strategy 1, thereby subjecting him or her to the tax.
4. Charitable Remainder Trusts. Charitable remainder trusts (“CRTs”) are a win-win: donors and charity benefit. A non-charitable Trust beneficiary (or beneficiaries) is entitled to an income stream for a term of years or lifetime – which may be especially useful in retirement – and the remaining assets go to charity. Income earned in this kind if Trust is tax free thanks to the charitable deduction, which allows for maximum investment. For valuable collections, artwork, gold, silver, and the like – items typically taxed at a long-term capital gains rate of 28% (and now at 31.8% with the health care tax), CRTs may be especially useful planning tools. Eventually, beneficiaries do pay income tax on distributions made to them (based upon complex trust income tax rules), but if a beneficiary sits in a lower bracket than the Trust’s donor, tax liability may be effectively reduced. Furthermore, because income is paid over a period of time, thereby spreading the wealth, these trusts may help beneficiaries avoid the extra 3.8% health care tax by keeping them below the applicable thresholds after their other income sources are accounted for. For more on CRTs, click here.
5. Charitable Lead Trust. Contrary to the Charitable Remainder Trust, a Charitable Lead Trust makes income payments to charity, leaving the remainder to a non-charitable beneficiary, or beneficiaries. If the Grantor is considered the owner of the Trust, the Grantor can offset his or her income, up to a certain amount, in the year he or she donates property to the Trust via the charitable deduction (thereby potentially reducing income subject to the 3.8% health care tax). If the Grantor is not considered the owner of the Trust, the Trust can take a charitable deduction, up to a certain amount, on income it earns, thus reducing the amount subject to the 3.8% tax. Depending on who the non-charitable beneficiaries are, there may be estate and gift tax consequences; however, such taxes may be lower than they would be if the gift or bequest was transferred outright. There may also be generation-skipping transfer tax advantages to charitable lead trusts.
6. Defined-Benefit Plans and Defined-Contribution Plans. These are retirement plans offered through employment that allow for tax deferral. Generally, contributions to both plans can offset taxable income up to a certain amount, and while contributions remain in the account, there is no tax on interest, dividends, or capital gains. Note, however, that income tax is imposed upon withdrawal.
7. Converting from Traditional to Roth IRA & 401(k) Accounts. In contrast to Strategy 6 above, which is based on tax deferral, converting from traditional to Roth IRA and 401(k) plans generally means paying income tax on converted amounts now and thereafter making after-tax contributions. The benefit is tax free distributions in retirement. Conversion may make sense for individuals who foresee their tax bracket remaining the same or even increasing in retirement, and if such individuals have years before retirement (giving the accounts a greater chance to grow – tax free) paying the conversion tax now and income tax on future contributions may be worth it. Furthermore, Roth IRA & 401(k) account beneficiaries receive an income tax-free inheritance. For more on converting to Roth IRAs, click here.
8. Asset protection strategies. Must of estate planning is based upon protecting assets from immature beneficiaries, saving estate tax, and making sure that the correct individuals inherit at the right time. However, it is equally important to make sure that the inheritance that is being received is protected from future creditors, divorces and disgruntled spouses. Therefore, reviewing and updating your estate plan to make sure that your loved ones receive their inheritance in the correct fashion is important. Finally, there are methods to protect your own assets from your own future creditors. Many times this involves a self-settled asset protection trust.
9. Life Insurance. Usually, beneficiaries of a life insurance policy do not pay income tax on distributions to them, making these policies a great way to pass on your legacy. Be aware, however, that if an individual owns his policy at his death, the policy will be includible in his Estate for tax purposes. If, however, someone else owns the policy or if the policy is held in an Irrevocable Life Insurance Trust (“ILIT”), it may be possible to avoid the asset’s inclusion in the Estate. For more on ILITs, click here.
10. Portability is Not a Cure-All. The Tax Act made the ability to elect portability permanent. Portability is the ability for one spouse to add to his or her federal Estate tax exemption amount any unused portion of his or her deceased’s spouse’s federal Estate tax exemption. Note that a surviving spouse can only take advantage of portability if the deceased spouse filed a federal Estate tax return (for more on that, click here). Currently, the federal exemption amount is $5.25 million for those who pass away in 2013.
With the potential ability to pass along over $10 million tax-free to chosen beneficiaries, some individuals do not think they need an estate plan – but portability does not solve everything. As you can see from the strategies above, estate planning includes planning for your assets while you are alive and strategizing to reduce tax burdens created by the Tax Act and Obamacare. Furthermore, portability does not solve non-tax related issues, like planning for children who are likely to mismanage inherited money or surviving spouses who are likely to remarry.
Stay tuned for Tax Act updates as we wrap up 2013. For more information on the strategies above and how they might fit into your plan, contact Altman & Associates! (301) 468-3220 or firstname.lastname@example.org.
– Coryn Rosenstock, JD and Gary Altman, Esq.