Imagine it’s the year 2000, and Sam and Pam Smith have a combined estate valued at $1.35 million, with each owning $675,000 in assets individually. Knowing there’s an unlimited marital deduction (spouses can transfer an unlimited amount of assets to each other without incurring gift or estate taxes), Sam and Pam Smith’s estate plan consisted of nothing more than what I call “I love you Wills” (Sam dies and Pam gets everything; Pam dies and Sam gets everything). At the death of the second spouse, their Wills direct the assets to be split equally by their two children.
The problem with Sam and Pam’s plan is it fails to utilize the first to die’s estate exemption. And while the marital deduction ensures there will be no estate taxes due at the first death, the forfeited estate exemption could result in estate taxes at the second death.
For example, if Sam dies first, Pam inherits his $675,000 putting the $1.35 million in her name solely. Assuming Pam dies in 2000, only $675,000 (Pam’s estate exemption) will pass estate tax free to her daughters. The remaining $675,000 will be subject to estate taxes, which in the year 2000, was at a top rate of 55 percent!
To solve this problem, many older estate plans incorporated tax planning strategies, such as a bypass trust, to utilize the estate exemptions of both spouses. A typical estate plan would fund the bypass trust at the death of the first spouse, with an amount equal to the available estate exemption at the time. The bypass trust would be available for the support and maintenance of the surviving spouse, but because the surviving spouse did not own the trust assets outright, it was not included in his or her taxable estate, and therefore, not subject to estate taxes.
In the Smith’s case, when Sam died, his $675,000 would have gone into a bypass trust, saving their children hundreds of thousands of dollars in estate taxes when Pam died.
15 years ago, there was a huge need for estate tax strategies, such as the bypass trust. Since then, however, the federal estate tax landscape has experienced dramatic changes. So much so, that for most individuals, federal estate taxes are no longer a concern and strategies, such as the bypass trust, are irrelevant.
For starters, the estate exemption (the amount of assets we can transfer estate tax free to our heirs when we die), has increased steadily from $675,000 in 2000 to $3.5 million in 2009. The Tax Relief Act of 2010 increased the exemption further to $5,000,000, albeit temporarily, but was later made permanent and indexed to inflation with the signing of the American Taxpayer Relief Act of 2012 (ATRA). With those inflation adjustments, the estate exemption is now $5,430,000.
Tax Relief Act of 2010 also introduced the concept of portability, another temporary provision made permanent by the ATRA. Portability permits the unused portion of a deceased spouse’s estate and gift tax exemption to be transferred to the surviving spouse. For example, if Sam passes away without using any of his exemption, Pam could use his unused exemption to pass on a total of $10.86 million in assets estate tax free.
As a result of these changes, many unnecessary bypass trusts will be created with varying degrees of negative consequences.
For example, there may be trustee fees associated with managing the bypass trust once it’s funded. Also a bypass trust is a separate taxable entity, requiring its own tax return. As a result, there will be the added cost of ongoing tax preparation fees once the trust is funded as well.
Furthermore, the federal tax brackets for trusts are more compressed than the tax brackets for individual and joint filers. For example, individual and joint filers don’t hit the top tax bracket of 39.6 percent until income reaches $413,201 and $464,850, respectively. On the other hand, trusts are exposed to the top 39.6 percent bracket once income reaches $12,301.
Finally, another potentially large cost is the loss of a second step-up in basis at the death of the surviving spouse.
For most, federal estate taxes are no longer an issue, but consideration must still be given to state estate tax laws as there are a number of states that impose estate taxes and inheritance taxes. State estate tax laws vary from state to state, but there’s no portability and estate exemptions are typically much lower – in the $1 million range.
Review your estate planning documents to ensure it’s still relevant for today’s federal and state estate tax laws.