Estate planning can be broadly defined as the process of accumulating, managing, conserving, and transferring wealth while taking into consideration legal, tax, and personal objectives. At the most basic level, this means ensuring that your assets go to the right individuals. As your estate gets larger, it is necessary to make sure assets are going to the right people, but also at the right time and with as little tax as possible.
Estate Tax Exemption
Many of the most common techniques involve the utilization of an individual’s federal estate tax exemption to shield assets from the dreaded estate tax (as high as 40%). This exemption amount allows an individual to transfer assets of equal or lesser amount free of federal estate tax. In 1976, the exemption amount was $60,000 per person1. In 2002, this amount had jumped to $1,000,000 per person1. In late 2010, Congress raised this limit to $5,000,000 per person2, which meant that a married couple had a combined exemption amount of $10,000,000 with which to shield themselves from estate taxes. However, without proper planning, one spouse could easily “lose” their exemption amount, by leaving all their assets to the surviving spouse causing the estate tax exemption to go unused. Essentially, you are not able to leave assets directly to a spouse and have them qualify for the estate tax exemption (they would pass estate under the unlimited marital deduction instead).
Bypass Trusts (aka Family Trusts)
To ensure that both estate tax exclusion amounts were used, many estate plans would consist of a “Bypass Trust” (also known as a Family Trust). These trusts are so named because they allow the deceased spouse to take advantage of their estate tax exclusion and allow assets to “bypass” the estate tax that would otherwise have been assessed at their death. However, by naming the surviving spouse as the beneficiary of the trust, that spouse would still have access to these funds. So common practice in estate planning would have all assets up to an individual’s estate tax exemption amount funded into a Bypass Trust and then have the remainder pass outright to the surviving spouse or into a Marital Trust.
While this strategy was great from a tax minimization standpoint, it slowly became less appropriate as the estate tax exemption amount grew. For most people today, if their estate documents are structured this way, it’s probable their heirs will find all of their spouse’s assets passed down in a Bypass trust.
In 2013 Congress permanently established the estate tax exclusion amount at $5,250,000 with annual inflation increases3. As of 2016, the current exclusion amount is up to $5,450,000 per person4. They also established portability for a deceased spouse’s unused estate tax exemption. This means that, unlike previously, if a spouse died without using their estate tax exemption (i.e. by leaving everything to their spouse) the surviving spouse could elect to have that exemption amount pass to them. By taking advantage of portability rules, the survivor could shelter the full $10.5 million from estate taxes. This means that the primary function of a Bypass Trust was no longer needed.
Income Tax Instead of Estate Taxes
With such high estate tax exclusion amounts the focus for most Americans has shifted from minimizing estate taxes, to minimizing income taxes that might result from the transfer of assets from one individual to the other at death.
When an individual dies, assets that are included in their estate receive a “step-up” in cost basis. Assets that are not included in their estate do not. So let’s say you have investment assets worth $1,000,000 at death, with a cost basis of $500,000. When you die, the cost basis would step-up to $1,000,000. If these assets are held in your spouse’s estate at their death, they would receive another step-up in basis at their death. However, if they passed by a Bypass Trust, they would not receive a step up in basis at the second spouse’s death. This means that your heirs would have a large income tax bill. Again, while estate taxes may no longer be an issue, income taxes are still an important consideration.
Many individuals want assets to be held in trust at their death for a variety of reasons. Trusts are great vehicles for protecting against creditors, predators, divorcing spouses, and financial mismanagement. While Bypass Trusts do not allow for a step-up in cost basis, Marital Trusts do. These trusts allow assets to be protected AND pass in a spouse’s estate thereby qualifying for a step-up in basis.
I review estate documents every week and what I have found is that many clients have documents that may not be appropriate for them. Almost every Will I see that was drafted in the 2000’s (before 2013) includes a Bypass (Family) Trust. If you were going to have your documents drafted today, I suspect that a Family Trust would not be included. If your estate documents include a Bypass (Family) Trust, you may want to meet with your estate attorney to see if this is still appropriate based on your situation. Due to the nature of our ever-changing legal environment, we recommend meeting with an estate attorney every three to five years to ensure that your documents are appropriate and still reflect your wishes based on current laws.
Bridgeworth does not offer legal or tax advice. You should consult with your own legal or tax advisor.
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