Important steps to take now

For most people, the federal estate tax became a thing of the past at the beginning of this year. But that doesn’t mean you can entirely shove aside the task of estate planning—not if you care about who inherits your assets…how much of those assets your heirs get to keep after taxes…and who will make decisions for you if you’re unable to make them yourself.

What changed: Congress made permanent a high estate tax exemption—$5.25 million for people who die in 2013, with inflation adjustments in future years—rather than allowing it to automatically revert to $1 million this year with the expiration of Bush-era tax cuts. Under a provision called portability, that exemption can double when a surviving spouse assumes a deceased spouse’s exemption—and unlike in the past, you don’t need a so-called bypass trust to make this happen. Any estate assets below the exemption amount won’t be hit with federal estate tax.

That means any estate planning that you require now will likely be simpler and cheaper because of the new rules—but you still need to consider the following issues…

You might need to undo (or repurpose) existing trusts or family partnerships. Under the new rules, those existing estate plans actually might work against your heirs.

Example: A man stipulated in his will that a bypass trust be set up upon his death to preserve the estate tax exemption for his wife. Because the couple’s assets are well below the federal exemption, leaving that trust in place now could force the couple’s heirs to later pay higher capital gains taxes than they would without the bypass trust in place. That’s because assets placed in a bypass trust do not receive a “step-up in basis” upon the death of the second spouse—that is, heirs can’t minimize capital gains taxes because they can’t use the fair value of the assets at the time of the second spouse’s death as their new cost basis when they calculate capital gains taxes in the future.

Consider meeting with an estate-planning attorney to discuss the pros and cons of dismantling no-longer-needed trusts or family partnerships. Ask whether these estate-planning tools could be repurposed rather than dismantled entirely, since you have already paid to set them up.

Example: A family partnership originally set up to minimize estate taxes could instead be used to shift assets to low-tax-bracket family members to minimize income taxes.

Federal estate taxes aren’t the only estate taxes to worry about. Some states have estate tax exemptions much lower than $5.25 million.

If you live in one of these states, estate taxes could be a concern even if your estate is well below the federal exemption, but that doesn’t always mean it’s wise to set up a bypass trust as you might have in years past to avoid federal estate tax. While a bypass trust could help shield assets from state estate taxes, those tax rates are a small fraction of the federal estate tax rate. The trust may not save you enough in state estate taxes to make up for the additional capital gains taxes and Medicare taxes that your heirs might have to pay because of the loss of a step-up in basis.

Two potential strategies worth discussing with an estate-planning attorney if state estate taxes are a concern…

  • Give money to trusts that name your spouse and other heirs as beneficiaries. This counts as a gift, but only one state—Connecticut—imposes a state gift tax.
  • Use a bypass trust, but fund it only with assets that are unlikely to appreciate significantly, such as money market funds or certificates of deposit (CDs). The lost step-up in basis isn’t a major concern if there isn’t much appreciation.

Trusts provide asset protection. Placing assets in trusts can shield them from legal judgments against you. That’s particularly useful for doctors, contractors and people in other professions where lawsuits are common. Trusts also can protect assets from wasteful spending by young heirs who might not yet be ready to handle a windfall inheritance. It’s worth speaking with an estate-planning attorney to address such concerns.

Portability means relying on your spouse’s decisions. The now-permanent portability rule means that a married person can preserve his/her full estate tax exemption by leaving his assets to a spouse—rather than to a bypass trust.

But when you leave your assets largely or entirely to your spouse rather than to a trust, you depend on that spouse to later leave remaining assets to your intended heirs. Your hard-earned assets could end up wasted or in the hands of someone else entirely if your spouse has a falling out with your intended heirs…overspends…remarries…becomes enamored with a charity…or makes poor investments due to the onset of a degenerative mental condition.

Instead of leaving the assets to your spouse outright, consider putting them in a marital trust that allows your spouse reasonable access but protects your other heirs from the above risks. Such a trust might be funded with assets unlikely to see great appreciation to minimize the effect of the lost step-up in basis, as discussed above.

Reevaluate your life insurance. Life insurance was a popular estate-planning tool in years past. A policy’s death benefits could pass to an insured person’s heirs outside the taxable estate or benefits could be used to pay estate taxes.

Policies purchased for these purposes might no longer be needed now that the estate tax exemption is so high, but don’t just let these policies lapse. They still could be valuable for the income tax–free benefits that life insurance can provide to heirs. Review your life insurance policies with an insurance expert before making any decisions.

WHAT HASN’T CHANGED

You still should designate who will make your health-care and financial decisions if you’re incapacitated…and who will inherit your assets when you die. That means drafting and keeping up-to-date documents such as financial and health-care powers of attorney. It’s still also important to have a will to spell out how you wish to divide your assets after your death.

And be sure to name beneficiaries on your financial accounts, including brokerage, mutual fund and bank accounts, so that those assets end up where you want them.