Don’t make the common mistake of neglecting tax planning for your estate just because it’s unlikely that the estate will owe estate tax. It’s true that few taxpayers will ever face any federal estate tax—that’s because the amount exempt from tax has increased to $5.45 million for 2016 ($10.9 million for a married couple after the second spouse dies) or higher when adjusted for inflation in future years. However, the estate and heirs still might owe income tax, reducing the amount that the heirs will inherit, and that’s where estate planning can make a big difference.
A combination of wise estate planning now and prudent steps taken by your executor and/or trustee later can save on taxes. Here’s what you need to know about cutting taxes for estates of all sizes*…
Income Tax Can Hit Estates Hard
An income tax return must be filed for an estate for every year that it has income of as little as $600 until the estate is dissolved. The estate’s income tax, which applies to income received beginning on the date the person dies, is different from the deceased individual’s personal income tax, which applies to income received before the date of death and requires that an individual 1040 return be filed. (The heirs do not owe income tax when they inherit assets, but they may owe capital gains tax when they sell inherited assets such as stocks or property.)
And unfortunately, income tax brackets for an estate return are triggered at much lower levels than for personal tax returns. For example, for the 2016 tax year, the top 39.6% bracket doesn’t apply on an individual tax return until taxable income hits $415,050. But it applies to an estate (and a trust) when its taxable income hits $12,400. An estate’s income may include interest and dividends from investments, items owed to the deceased (such as rent), income from a private business, compensation paid by an employer after death and any other income received by the estate.
Generally, you want to reduce the amount of income tax that the estate will owe by reducing the amount of income it will receive and directing that money elsewhere. This may be more complex than it sounds and may include what you can do now and what you should make sure the executor of your estate or trustee of a trust knows to do.
What to Do Now
• Consider donating income-producing assets to charity now while you’re still alive rather than making bequests to charity in your will. That’s because the rules have changed. It used to be advantageous for an estate to reduce estate tax by making charitable donations. But if an estate doesn’t owe estate tax, then no tax deduction will be available for charitable donations made by the estate. By donating now, while you’re alive, you can take a tax deduction that your estate wouldn’t get—and by reducing the amount of income-producing assets that will be left in your estate, it also will reduce the estate’s taxable income. These assets might include stocks, bonds, mutual fund shares and real estate.
If you have already included in your will a bequest to charity and you don’t want to redo your will, you may be able to simply tell the charity that you will make a gift to it now in exchange for the charity sending you a letter that waives its right to receive the bequest that is already in your will, acknowledging that the current donation is an advancement of that bequest.
• Designate individuals as beneficiaries in retirement plans. Retirement accounts often are the most valuable financial assets owned by an individual, so they should be a key consideration in any estate plan.
If you don’t designate individual beneficiaries for your IRA, the IRA may be included in the assets to be distributed according to the provisions in your will…and income tax on it will be due within five years under IRA rules.
In contrast, if you do designate your spouse, children and/or other individuals as beneficiaries of your IRA, they may be able to stretch distributions from it over an entire lifetime, providing them with decades of tax-favored investment returns—a big difference. Keep in mind that unlike with a 401(k), your spouse is not automatically the beneficiary of your IRA.
• Consider creating a trust. If you create a trust and designate assets to put into the trust rather than into your estate, the trustee can manage the assets after your death to minimize taxes. You can give the trustee as much or as little discretion as you wish over how to distribute the assets and who receives them. The trustee could, for instance, stretch out distributions from the trust over a number of years and decide which are the most tax-efficient ways to make those distributions. A trustee could be anyone ranging from a spouse or an adult child to a financial institution.
Distributions include the income generated by assets in the trust. Be sure that the trust document permits inclusion of capital gains as a form of income that can be distributed in this way.
Example: The trustee, in conjunction with your heirs, might decide that in certain years it is best to give bigger distributions to young beneficiaries who have minimal income and so are in low tax brackets, such as those beneficiaries who are in college or starting out in their careers, rather than those who are in high tax brackets.
Reduce Future Capital Gains Tax
When an heir inherits certain of your assets, such as shares of stock or a piece of art, the asset’s tax basis is reset at the market value at the date of your death, instead of your original cost to acquire the asset. Future taxable capital gains or losses when an asset is sold by an heir are determined based on this tax basis, which is called the stepped-up basis if it is higher than your initial cost or the stepped-down basis if it is lower. The tax basis is subtracted from the eventual sale price to determine the capital gain or loss. A stepped-up basis lowers the capital gains taxes that heirs eventually must pay.
Example: A parent buys stock at a price of $20 per share…the share value is $50 when a child inherits the stock…and the child later sells the shares for $55 each. The child’s taxable capital gain is just $5 per share, even though the stock price rose by $35 since the parent bought it, because the stepped-up tax basis is $50.
How to make sure capital gains taxes will be minimized…
• Maximize the advantages of a stepped-up tax basis. Make sure that your executor or your trustee knows that he/she will need to carefully record the adjusted basis for each asset on your date of death so that your beneficiaries can use that basis whenever they sell assets in the future. This is especially important for valuable items that don’t trade regularly, such as real estate, shares in a private business, artwork, antiques and other collectibles that might require an appraisal. An appraisal obtained for a modest price may avoid a costly conflict with the IRS in the future. The executor or trustee also should make sure that your heirs who inherit shares in a mutual fund know to tell the firm that operates the fund to start using the stepped-up basis in its calculations of capital gains for the 1099 form it provides to the IRS each year.
• Beware the trap of a stepped-down basis. If the asset that you bequeath to an heir diminished in value from the time you acquired it, it could mean a greater eventual capital gains tax—or a smaller capital loss that is less effective in offsetting capital gains. To avoid this trap, review the assets now that will likely be in the estate and consider selling those that have diminished in value since you acquired them.
Caution: Keep in mind that the strategies described in this article have technicalities that may require advice from a financial professional.
*Some states have inheritance and estate tax rules that differ from federal rules, so consult a state tax expert.