Year-end estate tax planning
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
While most tax planning at year end revolves around income taxes, there are also estate tax planning opportunities that should not be overlooked. This article explores some which should be considered.
Annual exclusion gifts
In 2013, the annual gift tax exclusion increased from $13,000 to $14,000 (married couples can now give up to $28,000 per donee). That number is indexed for inflation in increments of $1,000. It remains at $14,000 for 2014. Persons whose estates exceed the federal estate tax exemption ($5.25 million and $10.5 million for a single person and married couple, respectively, in 2013), and even persons whose estates exceed the typically much lower state death or inheritance tax exemption should consider using their $14,000 annual exclusion before year end. If they don’t, under this “use it or lose it” system, they can’t double up in 2014. Donors choosing to take advantage of this tax break do not have to file a gift tax return and they do not eat into any of their federal gift, estate and generation-skipping tax (GST) exemptions.
In making annual exclusion gifts, consider both estate and income tax consequences. To minimize estate taxes, gift property with the greatest appreciation potential. To minimize income taxes, don’t gift loss property. Instead, consider selling the property to realize the loss and then gift the sales proceeds.
Annual exclusion gifts can be made outright or in trust. If the gift is made by check, the donee (or trustee) must deposit the check in 2013, and it must clear in the ordinary course of business (which can happen this coming January). Gifts of securities held in street name are considered transferred on the date the brokerage firm transfers title (which normally takes one or two business days). In either case, for gifts in trust, Crummey withdrawal powers have to be given to the beneficiaries in order to qualify for the annual exclusion.
Paying for a child or grandchild’s post-secondary education with a Section 529 plan offers a way to accelerate annual exclusion gifts. Section 529 plans allow the donor to make five years’ worth of annual exclusion gifts in a single year ($70,000 for a single donor; and $140,000 for a married couple). Such gifts are treated as if they are made ratably over the current year and the next four years. If the donor dies before the end of the five-year period, a prorated portion of the contribution is included in the donor’s estate.
Qualified dividends and capital gains
Even persons who are not concerned about state or federal estate taxes should consider using their annual gift tax exclusion to help reduce income taxes. For example, a married couple with taxable income of $450,000 is subject to a 20 percent tax on qualified dividends and a 3.8 percent Medicare surtax. If they were to gift a portion of their dividend-paying stocks to a child age 24 or older in the 10 percent income tax bracket ($0 to $8,925) or 15 percent income tax bracket ($8,926 to $36,250), there would be no tax on the dividends.
Assume that the same couple, fearing a correction, wishes to sell some appreciated stocks or mutual funds, . Once again, they would be subject to a 20 percent capital gains tax and a 3.8 percent Medicare surtax. However, if they were to gift those stocks or mutual funds to a child age 24 or older (in a 10 percent or 15 percent income tax bracket), the child may owe 0 percent on the sale (depending on the amount of the gain). However, for an older donor or one in poor health, this strategy may not make sense because of the stepped-up basis available at the donor’s death. Thus, gifts of dividend-paying stocks and appreciated assets to retired parents with modest incomes or to young adults can save income taxes. However, gifts to children under 19 years of age and children aged 19 to 23 who are full-time students (and whose earned income does not exceed 50 percent of the annual expenses for their support) may trigger the “kiddie tax”. As such, the unearned income they receive in excess of $2,000 (for 2013) is taxed at their parents’ highest rate.
Consider making gifts to charity. When appreciated securities are donated to charity, the donor escapes the capital gains tax and the charity doesn’t pay them either. The donor can deduct the fair market value of the securities, which reduces taxable income; and the donated securities are removed from the donor’s estate. Moreover, persons with non-taxable estates who are planning to make testamentary charitable gifts should consider making those gifts during lifetime to obtain a charitable income tax deduction (since there is no need for an estate tax charitable deduction).
For IRA owners who will be 70½ by year end, consider making up to $100,000 in cash donations to IRS-approved charities directly out of the IRA. These are so-called “qualified charitable distributions” (QCDs). Because QCDs are tax free and no charitable deductions are allowed for them, QCDs don’t directly affect the donor’s tax bill. However, QCDs do count as withdrawals for purposes of meeting the donor’s required minimum distributions. Note that the QCD privilege will expire at the end of this year unless Congress extends it.
Distribute trust income
Trusts have a much lower threshold ($11,950 in 2013) with respect to the top income tax rate (39.6 percent) and the Medicare surcharge (3.8 percent). Therefore, if the trust agreement allows income to be distributed to the beneficiaries, the trustee should consider doing so. This will shift the income tax liability to the beneficiary’s tax bracket. However, be aware of the kiddie tax discussed above. Roth conversions
For persons with traditional IRAs, consider the benefits of converting some or all of the IRA to a Roth IRA. A conversion allows the account owner to turn tax-deferred future growth into tax-free growth. Estate planning advantages are an added benefit. Since Roth IRAs don’t require the account owner to take distributions over his/her (or his/her spouse’s) lifetime, the entire account can grow tax free for the benefit of children and grandchildren.
Year end is also a good time to review one’s life insurance portfolio. Life insurance can be used to replace lost income (upon the breadwinner’s premature death), to pay estate taxes, to equalize assets passing to children who aren’t involved in a family business, and/or to pass leveraged funds to heirs free of estate tax (if the policy is owned by an irrevocable life insurance trust).
For persons with taxable estates, the rising interest rates will make GRATs, CLATs and installment sales to intentionally-defective grantor trusts (IDGTs) less attractive. In January, 2013, the IRC Section 7520 rate (used with GRATs and CLATs) was 1 percent; and the mid-term Applicable Federal Rate (typically used with installment sales to IDGTs) was 0.87 percent. For November, 2013, the IRC Section 7520 rate is 2 percent (resulting in a larger taxable gift with a GRAT or CLAT) and the mid-term AFR is 1.73 percent (resulting in more funds being returned to the grantor). Thus, if one anticipates rising interest rates in the Treasury market (upon which the Section 7520 rate and AFRs are based), GRATs, CLATs and IDGTs should be implemented sooner than later.
Finally, persons may need to make revisions to their estate plans that have nothing to do with taxes (i.e., births, deaths, changes in assets, state law changes, etc.). For same-sex couples who are legally married, the Supreme Court decision in Windsor (repealing DOMA) offers estate planning opportunities (i.e., the unlimited marital deduction, doubling the annual exclusion and estate/gift/GST exemption amounts, IRA rollovers, etc.).
For clients with non-taxable estates, the advantages and disadvantages of relying on portability (which is now permanent) instead of utilizing credit shelter trusts should be reviewed. Year end is a good time to review one’s estate planning documents, the selection of guardians and fiduciaries, the choice of recipients, the pros and cons of portability, and beneficiary designations.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.