The Ten Problems With Your Estate Plan And How To Fix Them Problem #5: Taxes

house and key

For ten years, the Johnson, Gasink & Baxter newsletter has been titled “Two Things Certain” in a nod to Ben Franklin’s famous quote: “In this world nothing can be said to be certain, except death and taxes.”  Problem #5 in our series, “The Ten Problems With Your Estate Plan And How To Fix Them,” deals with the issue of taxes faced by estates and the surprising uncertainty that surrounds death taxation.

            There are three specific areas of taxation to consider when planning an estate:

  1. Federal Estate Tax (a 40% rate),
  2. Federal Income Tax for the beneficiary (maximum rate of 37%), and
  3. Capital Gains taxes (maximum rate of 20%).

The specifics of how these tax schemes operate and interact are complex.  Most taxpayers do not fully understand their annual income tax filings, and fewer still comprehend the tax implications of their estate on their heirs’ inheritance.  Further complicating the issue, tax laws change annually and the legislation is long, dull, and confusing.  Even if you were in full command of the tax system today, it would invariably change between now and the time of your passing.  In the end, all that matters is the tax law in effect the year of your death.  As we do not know when our time may come, Estate Planners try to make educated guesses and design a plan that is flexible enough to work over time.  As this article goes to press, the U.S. Senate is considering the SECURE Act which could radically affect the tax treatment of retirement accounts after death.

Federal Estate Tax (or Death Taxes)

            In 2019, the Federal Estate Tax exemption is $11.4 million.  This means that estates smaller than $11.4 million owe no Federal Estate Taxes.  Estates larger than the $11.4 million exemption owe forty percent of the excess of the exemption.  For most, eleven million dollars is a princely sum, but readers should recall that the exemption has risen substantially in the past two decades (from an exemption of $600,000).  Once one includes the values of a home, investments, retirement accounts, and life insurance proceeds, an estate can quickly add up to $600,000.  The context is important because the exemption can change quickly and has changed many times in recent years. It is reasonable to expect that Federal Estate Tax law will change again, and it may change in a manner which increases the taxes due on your estate.

            Some states tax estates.  Such taxes fall into two categories—estate taxes and inheritance taxes.  Estate taxes are based on the size of an estate.  Maryland, for instance, charges an additional sixteen percent on estates that exceed the federal exemption as of 2019.  Imagine the surprise of an heir who expects to receive one hundred cents on the dollar and nets only 44% after federal and state estate taxes. Inheritance taxes are based on the relationship between a decedent and heir.  In Pennsylvania, you would owe:

  1. 0% on bequests to a charity, spouse, or child 21 or younger,
  2. 4.5% on bequests to descendants,
  3. 12% on bequests to siblings, and
  4. 15% on bequests to other heirs.

Virginia and North Carolina do not have any death taxes as of 2019.

            To avoid Estate Taxes, Estate Planners have used Living Trusts to artificially divide a married couple’s joint estate into two smaller estates.  This is commonly called an “A/B Trust” or a “Family/Marital Trust.”  The language we commonly used in trusts twenty years ago forces a trust to be split at the death of the first spouse, even if an estate now does not approach the $11.4 million threshold.  When updating older trusts, I often replace the old, mandatory A/B split formula with a more flexible “wait and see” clause called a disclaimer

Federal Income Tax

            We all are familiar with filing Federal Income Taxes.  The Federal Income Tax is graduated, which is to say you pay higher rates as your income increases.  An individual earning $25,000 a year pays 10% of the amount below $9,525 and 12% of the amount over.  The highest income bracket for an individual is currently 37% of income in excess of $500,000.

            For many of us, income is stable from year to year, so we do not experience much outside of the usual income tax brackets.  However, those who inherit large IRAs (and similar qualified retirement accounts) experience the same shock faced by lottery winners – meaning if you get a lot of income in one year, you will pay higher income tax rates than you are used to paying.  Piling a lot of income into one year is sometimes called ‘bunching’ in tax policy.

            With regard to estates and IRAs, bunching has been avoided with the use of a ‘stretch IRA’—a tool which may soon be taken away as part of the SECURE Act. (We will provide updates in future emails as details emerge.)  Without a stretch IRA, an heir who inherits a large IRA will find the proceeds bunched into a few years. (In the pending legislation, the House and Senate currently suggest five or ten years.) Inheriting $100,000 a year over five years would push a middle-class taxpayer from the 22% or 24% bracket into the 32% or 34% bracket, and the taxpayer would owe 10% more in income taxes on that amount than they are accustomed to paying.  In addition, the increased income could trigger higher state income taxes and increased Medicare premiums.

If the SECURE Act is ratified and becomes law, clients will be well served to consider both converting traditional Individual Retirement Accounts to Roth IRAs and using IRA monies to fund their charitable giving.  Even under current law, clients need to remember that their traditional IRA and 401(k) assets have not yet been taxed and those untaxed assets could be a tax trap for themselves or their heirs down the line.

Capital Gains Taxes

Capital gains are a subset of income taxes.  Stated simply, capital gains taxes are a type of income tax for things you own longer than a year (a capital asset).  When you sell a capital asset and make money, you pay tax at the time of sale based on how much more you sold it for (your gain) than the price you paid for it (your basis).  Capital gains taxes are a good thing because the tax rates are far lower for capital gains (maximum rate of 20%) than earned income (maximum rate of 37%).  Let’s say you bought a lot for $5 and sold it for $50.  You would have a capital gain of $45 and pay $9 in capital gains taxes (20%).  At ordinary income rates, you could owe $16.65 (37%).

            Estates face an additional wrinkle.  After a person dies and his or her estate faces estate taxes, the capital assets that pass to the heirs descend to them with a ‘step-up in basis.’  Let’s go back to the prior example of the lot purchased for $5.  If my dad bought a lot for $5 and it is worth $50 at his death, I inherit the land with a basis of $50.  This means I owe capital gains only on the increase in value from Dad’s date of death which will save the family a lot in taxes.

            The step-up in basis is not well understood but is a huge tax benefit for American taxpayers.  To make the best use of it, you want to be very careful about making lifetime gifts of highly appreciated capital assets like land and stocks to the people who would otherwise be your heirs at your death.

            Further, a husband or wife gets a step-up in basis at the death of a spouse.  That surviving spouse gets a second step-up in basis when assets pay to the children or other heirs at his/her death.  Older trust plans often sacrificed this second step-up in basis to maximize the Federal Estate Tax benefit.  For families that no longer need to worry about the Federal Estate Tax, it is often a good idea to change their trusts to get two step-ups in basis instead of sacrificing the second step-up to claim an unnecessary Estate Tax Credit.

The Solution: Review and Update

            If you knew when you were going to die, you could wait and plan with full knowledge of how much was in your estate at your death and what the applicable law looked like at that point.  Since we all lack that clairvoyance, the best you can do is review your plan regularly.  JGB offers its clients two options for review: some clients opt into the TrustGuard™ annual review plan (enrollment begins in December 2019 for 2020), and our remaining clients receive letters at five- and ten-year intervals inviting them to a thirty-minute telephone conference to discuss their plan and any changes needed to keep the plan up-to-date with changes in the law and your family.

If you’ve received one of our letters inviting you for a review, please call (757) 220-9800 to schedule your review as soon as possible.

Our next installment will focus on Problem #6: Medical Decisions.


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*Did you know that the attorneys at Johnson, Gasink and Baxter, LLP have built their practice by working with great clients like you? We are offering an estate planning class for clients and friends about funding and common issues with estate planning. The next class is:

July 9th at 2:00 in our Williamsburg office

Don't let something happen to your friends and loved ones without proper estate planning in place! Please contact Brooke Heilesen at 1.877.790.4555 to reserve a spot in a class.

About the Author: 

Dan Gasink focuses his law practice on Wills, Trusts and Probate. He enjoys helping families through the difficult transitions of life and passing. Dan's law firm, Johnson, Gasink & Baxter, LLP solves clients' problems using careful planning, reliable procedures, hard work, and creativity.

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