For some, it’s hard enough to figure out where to go to dinner, let alone pick the right person to raise your kids or determine who to leave your prized possessions to in the event of your unexpected demise. Nonetheless, prudent estate planning requires tackling these as well as other tough, yet important decisions. Moreover, effective estate planning isn’t a one and done situation; rather, changes in your personal circumstances (i.e. marriage, divorce, sale of business, etc.) and tax laws, among other things, may require tweaking or outright redoing your will and other estate documents at various times throughout life.
With the recent passage of the Tax Cuts and Jobs Act of 2017 (TCJA), now is good time to dust off your old documents or think about creating new ones to make sure your estate planning goals and objectives are being adequately addressed.
Higher Estate Tax Limits
In addition to reducing corporate and personal tax rates, the TCJA provided significant estate tax relief by doubling the size of the personal lifetime estate tax exemption from $5.5 million to $11.18 million for individuals ($22.4 million for married couples). The new exemption limit is inflation-indexed, but will revert back to about $5 million in 2026, unless Congress acts to change the law once again.
The exemption means that if someone dies in 2018 with a taxable estate valued at $12 million, $820,000 ($12 million – $11.18 million = $820,000) would be subjected to an estate tax up to 40% and $11.18 million would be estate tax free to their heirs.
From the chart below, you can see that the $11.8 million is a far departure from 2003 levels when the exclusion amount was a mere $1 million or the $3.5 million in 2009.
Bypass and Credit Trusts
The substantially higher personal exemption should mean that most U.S. households will not have to pay estate taxes between now and 2025. So, why bother reviewing your will at all?
The thing to watch out for is that many older wills crafted when the exemption limit was much lower contain a provision that automatically transfers an amount “up to the lifetime exemption limit” into a “bypass trust” or “credit trust” upon one’s death. The deceased’s children are often named as the beneficiaries of the trust, rather than the spouse, although the surviving spouse could tap the funds in the trust under certain circumstances. This structure not only protects the assets against creditors, but also enables the assets to grow free from estate taxes for the benefit of the beneficiaries.
When the estate tax exemption was only $1 million or even $3.5 million, the bypass trust made a lot of sense. Married couples with estates valued at more than $1 million could move a good-sized portion of their estates into a trust from where the assets would grow free of estate taxes, although any appreciation in the assets would be subjected to capital gains taxes for the beneficiaries.
Now, with the high exemption so high, those with the bypass trust provision in their will could be putting a huge portion of their assets into a trust for the benefit of the children, leaving the surviving spouse without an estate.
The appeal of the bypass trust structure was also compromised in 2011 when the government introduced some other very favorable estate tax legislation for married couples called “portability.”
Portability
Portability allowed the deceased spouse’s unused lifetime exemption to transfer over (or “port”) to the surviving spouse’s estate. For example, if a married couple has an estate valued $15 million ($7.5 million each), and one of the two died in 2018, that would leave an unused portion of the deceased spouse of $11.18 – $7.5 = $3.68 million. As a result of portability, the surviving spouse would have $14.86 million ($11.18 + $3.68 = $14.86 million) shielded from estate taxes. The large exemption amount and ability to rollover unused amounts effectively eliminates estate taxes for most U.S. households. In addition, assets outside of a trust would ultimately receive a step-up in basis at the death of the second spouse, which eliminates any capital gains taxes that would have been paid if the assets were held in a trust.
Time to Review
All this does not mean that wills containing trust provisions should be scrapped. In fact, trusts still have many benefits if the circumstances warrant. It just illustrates the point that laws have changed significantly over the last decade and leaving your will as-is might result in some unintended consequences if not properly addressed.
So, add your will and estate documents to your summer reading list and perhaps give your estate planning attorney a call to clarify that your documents are aligned not only with your specific goals, but also with the current legislative and tax environment.