How the New Federal Tax Law will affect your Estate Planning

In a big surprise to many people, when Congress passed a law to resolve the “fiscal cliff” in January, it retained the large ($5 million-plus) estate, gift, and generation-skipping transfer tax exemptions that had been available in 2011 and 2012. These taxes will now be 40% of amounts over this exemption.

Without this new law, the exemptions would have dropped to only $1 million at the start of 2013, with a tax rate of 55%.

The exemptions will now be $5 million in 2011 dollars, with adjustments for inflation each year. For 2013, they will be $5.25 million.

This is great news for people who want to transfer wealth to the next generation while avoiding taxes. It means that anyone who didn’t use the “window” in 2011 and 2012 to make large gifts without incurring gift tax has a reprieve, and can make those gifts this year.

That makes 2013 a great time to review your estate plan. While it’s possible to make large tax-deferred gifts right now, we don’t know how long this opportunity will continue, and it’s possible that Congress could change the rules again. Also, the Obama Administration has indicated that wants to restrict some other popular estate planning techniques, including grantor retained annuity trusts, valuation discounts, family limited partnerships, and dynasty trusts. So it might be wise to investigate these options now before they disappear.

How tax-free gifts work

The gift tax applies anytime you make a gift to someone other than a spouse or a charity. In general, you can give any person (or, in some circumstances, a trust) up to $14,000 a year without there being a gift tax. If you give someone more than $14,000 in a calendar year, then the tax applies to the excess.

However, you also have a “lifetime exemption.” Over the course of your lifetime, you can make gifts over the $14,000 annual threshold up to the amount of this exemption without paying tax.

The lifetime exemption isn’t necessarily a complete “freebie.” Any amount you use of your lifetime exemption is subtracted from your estate tax exemption, such that when you die, your estate taxes might be higher. But in general, the tax benefits of using the lifetime exemption far outweigh the disadvantages.

Since the lifetime exemption is $5.25 million for the rest of this year, you may be able to make gifts of up to $5.25 million this year without paying gift tax. Even if you already used up part of all of your lifetime exemption in the past, when the amount was smaller, you can now make very large additional gifts.

Many people can benefit from this situation by putting significant assets into a trust that will pay income to their children, and ultimately benefit their grandchildren.

Here are some of the benefits of such a trust:

  • Suppose you transfer an asset worth $1.5 million to a trust today, and by the time you die, that asset has increased in value to $2 million. The entire increase – $500,000 – will go to your heirs without being subject to estate tax.
  • Suppose the asset also generates annual income. For instance, over the course of the rest of your life, it might generate $300,000 in income. That entire $300,000 may also be able to go to your heirs without being subject to estate tax.
  • Suppose you set up the trust so that your children receive the income, and when they die, the trust assets go to your grandchildren. The entire trust, regardless of how much it has increased in value, will go to your grandchildren without any estate tax being due when your children pass away.
  • You will also have protected your children and grandchildren, because assets left in a trust for them generally can’t be taken away if your children or grandchildren incur debts, are sued in a lawsuit, get divorced, etc.

It’s a great idea to contribute assets that are temporarily reduced in value and that have the potential for significant appreciation. In the current environment, real estate might be a good example.

Remember, too, that the $5.25 million gift tax exemption is per person. So a married couple could contribute as much as $10.5 million.

Also, if you’re in a committed relationship with someone but you aren’t married to them, there may be significant tax benefits in using the $5.25 million exemption in order to share assets with the other person. (Remember that transfers between spouses aren’t generally subject to the gift tax, but transfers between unmarried couples are.)