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Income Taxes and Estate Taxes, A New Trade-Off

questionmark.jpgUntil now, estate planners have primarily focused on reducing the potential estate tax bill for their clients. This was a sensible approach, since the estate tax rate has traditionally been quite high and the exemption from federal estate tax has been relatively low.

All this began to change in 2001, and now, with the 2012 Taxpayer Relief Act, the landscape is completely different: the estate tax rate is capped at 40%, and the exclusion is set at $5 million, and indexed for inflation ($5.25 million in 2013). Also, married couples will be able to use the unused exclusion of the first spouse to die, as long as the survivor files an estate tax return requesting it, which is called portability.

What this means for most families (who don’t have $5 million, let alone $10 million), is that reducing estate tax may not be the most important financial estate planning goal any more. Instead, families may want to focus instead on minimizing their exposure to capital gains taxes. Capital gains taxes are levied upon the difference between what someone buys an asset for (called ‘basis’) and what they sell that asset for–the lower the basis, the higher the gain, and the higher the tax. In 2013, the maximum tax rate for long-term capital gains (for assets held longer than one year) is 23.8% for high income families.

When a person dies, though, their assets receive what’s called a ‘stepped-up basis.’ If your mother owned stock in a company that she bought for $1 in 1964, and that stock was worth $100 dollars in 2013, you will inherit that stock at a basis of $100–its basis is stepped up to the value it had on the day your mother died. If you then sell that stock, you will be subject to capital gains taxes only on the difference between $100 and the sales price.

Here’s the trade-off: Your mother’s estate will be subject to estate tax on the stock at that stepped up basis, $100/share, too. Until now, most estate planners would have tried to use tools to remove, or reduce, the value of your mother’s taxable estate. Those tools would have reduced her estate, but they would also have limited that step up in basis. Because estate taxes have traditionally been close to twice the rate of capital gains taxes, this seemed like a reasonable trade off: reduce potential estate tax, even if it meant that your heirs would pay more in capital gains taxes when they sold the assets in the future.

Today, however, the logic is different–if your mother doesn’t have a taxable estate, retaining that appreciated stock in her estate has no estate tax consequence, and inheriting it at a stepped up basis saves you a lot in capital gains taxes.

For familes who do not have taxable estates under the current law, capturing this step-up in basis will represent a huge potential tax savings. Keeping assets in the older generation’s estate now means that the younger generation will escape paying capital gains upon the sale of highly appreciated assets. Suddenly, estate planners are trying to figure out what are the best assets to keep in an estate, rather than trying to get assets out of that estate.