The Tax Cuts and Jobs Act essentially doubled the basic federal tax exemption amount set by the American Tax Relief Act of 2012 (ATRA). The new law established a $10 million federal tax exemption, indexed for inflation, but only until 2025 if Congress does not extend it. If the law is allowed to expire via its sunset provision, the basic exemption amount will revert to $5 million indexed for inflation established by ATRA. Indexed for inflation, the exemption was $5,490,000 in 2017.
For most people living and working in the United States, this is great because they will not be subject to federal estate taxation. However, there are still state tax exemptions that are lower than the federal exemption, for example $5.25 million in New York (raised from $1 million over several years) and $25,000 exemption under the law for the New Jersey Inheritance Tax, which varies between 11% and 16% after the exemption. New Jersey repealed its estate tax from January 1, 2018 but kept the Inheritance Tax. Even at around 12-15% tax rate, state estate tax can seriously dent an estate over the value of the state exemption. In New York, the tax rate is 18% or more, and in Pennsylvania it varies between 4.5% and 15% depending on who inherits the estate if it is not the spouse. Therefore, if you get blindsided by the state estate tax, it can still have a negative impact worth tens or hundreds of thousands of dollars.
What the new federal exemption means is that most of the previous estate tax planning complexity is gone and the estate planning has become simpler and more affordable because very few now need the ultra-sophisticated estate planning. So what can estate planning do for you in view of the new federal laws? Estate planning provides asset protection and control over assets beyond what a will can provide, insurance and retirement planning, tax savings on the state level, succession planning and avoiding probate, business succession planning, protection against lawsuits and judgments, protection against divorcing spouses, and protection against identity theft.
Succession planning and avoiding probate: a typical succession tool is a will (Last Will and Testament). However, what is little known is that a will has to be taken to court (probated) after the person’s death in order to distribute the estate according to the will. The probate process takes a minimum of 7-9 months, and frequently longer, during which time the assets are tied up. Also, a will is a gilded invitation to a will contest because special procedures exist for challenging wills in courts. If there is any kind of discord in the family, or any disagreements over who should receive the inheritance, it is very easy to challenge a will and tie up the assets in litigation for years. It is much more difficult to challenge succession planning that utilizes joint ownership, lifetime gifts, trusts, Family Limited Partnerships (FLPs), and LLCs/corporations for succession planning. Non-probate assets pass to heirs regardless of the will, depending on how the title is held: houses, bank accounts, stock and brokerage accounts, shares of corporations, and LLC interest may all be passed outside of the will, but it still helps to have a simple will just to make sure the after-acquired assets are accounted for, and guardians are appointed for minor children.
Protection from divorce: the frequently-quoted 50% divorce rate in the United State can devastate an estate even more so than the federal estate tax rate used to. With proper planning, you can make sure that your entire estate does not end in the hands of your second spouse and that half of your estate does not end up in the hands of spouses who divorced your children or grandchildren. Frequently, receiving unprotected inheritance serves as the final push towards a divorce because the spouse divorcing your child sees a financial incentive.
Asset protection: proper asset protection is important to ensure that you do not lose everything if you get sued or if you become suddenly ill. Same as with divorce protection, a number of trusts, Family Limited Partnerships, and LLCs/corporations are available to assist in asset protection planning. There are even special asset protection trusts that can be created under the laws of several states that go one step further in protecting your assets. Proper planning and maintenance of asset protection methods includes “decanting” the money and assets to a better trust if and when it is beneficial.
Life insurance: a life insurance policy is usually a major asset to pass on to the heirs, and the always-popular estate planning tool Irrevocable Life Insurance Trust (“ILIT”) can now be much simpler. It is no longer necessary to include certain complication provisions in ILIT trusts to preserve the lifetime gift amount for the rest of the estate, and certain annual paperwork for ILIT trusts was eliminated. You just need to set up the ILIT trust and buy the policy now.
Reduce you income taxes: depending on whether you expect to be in a higher or lower federal income tax bracket in retirement, proper planning can maximize your monetary gains by minimizing income taxes now and during retirement. Proper planning, life and health insurance policies, and solid retirement plans are important. A certain planning technique, for example, can minimize the income tax and allow borrowing against the insurance policy in the future. The restrictions on itemized deductions for many high-income taxpayers will soon make many, if not all, deductions disappear. The creative and careful use of income tax planning to shift income and shift qualifying deductions may provide valuable income tax benefits.
Lifetime gifts: the problem of state estate tax can sometimes be solved by gifting assets during lifetime using the new permanent federal exemption. However, this option has its own drawbacks and is not the best option for everyone, in part because of the cost basis of assets and the taxable gain. If an asset, such as a house, is passed to heirs at a person’s death, the cost basis of the asset is stepped up to fair market value for the heirs and leads to lower capital gains taxes, which, even with state estate taxes, may be better than the heirs paying high capital gains taxes. Gifting a highly-appreciated asset, like a house or stocks, or an asset that appreciates after the gift causes the heirs (to whom the gift is given) pay severe capital gains taxes.
Planning to be eligible for government benefits: the average life expectancy is longer and many will need some kind of long-term or nursing home care because of neurological and other diseases that develop with age, such as Alzheimer’s or Parkinson’s. However, Medicare will not cover all of your medical costs and private insurance is usually not an option or is too expensive. Medicaid is often the only alternative to rely on for long-term care in retirement. However, Medicaid eligibility is means-tested. If you have unprotected assets to pay for the costs of medical services, you will have to completely spend your assets and become impoverished before Medicaid covers the costs of your medical services. The cost of long-term medical care or nursing home can destroy even substantial savings quickly because these services cost between $10,000 and $15,000 per month in New York, and the average stay in a nursing home is two-and-a-half years. The costs will only increase with time.
Applying for Medicaid is not as simple as giving away everything to your children and becoming immediately eligible, and it is further complicated in cases of married couples. The Medicaid program reviews all transfers made during the five years preceding the Medicaid application, and it calculates a penalty during which long-term health care or nursing home services will not be covered if some of the transfers are gifts or transfers for less than market value. The Medicaid look back period can be avoided with careful advance planning.
Power of Attorney and Living Will/Health Care Proxy: a simple Power of Attorney will ensure that your children can make personal and financial decisions for you and sign legal documents should you lose your capacity to make the decisions and sign yourself. This includes proper Medicaid planning if necessary. If there is no Power of Attorney, your children will have to go through expensive and lengthy guardianship proceedings in court, and then the court may limit what they can do. A good companion to a Power of Attorney is a Living Will, medical directives for your treatment in case you become terminally ill without prospects of recovery.
In order to implement specific, tailored protection and planning, you should discuss these options with a knowledgeable attorney, and possibly with an accountant or financial advisor.