The dust has finally settled - for the moment. And Congress has stabilized the estate tax situation, which has been in a state of uncertainty since the so-called "Bush Tax Cuts" formally expired in 2010.
The deal is this: The worst-case scenario in which all estates north of $1 million would have been hit with a confiscatory 55 percent tax on the excess was averted. That's great news for anyone with a good sized home, a small business or family farm, and/or a decent-sized retirement fund.
Instead, lawmakers came up with a top tax rate on estates of 35 percent, and set the basic exclusion amount at $5.12 million. This means that anyone who dies leaving an estate to a non-spouse of more than $5.12 million will also leave them with a tax bill of up to 35 percent of the excess. That basic exclusion amount will be adjusted each year for inflation in perpetuity. That is, until a future Congress tweaks the rules again.
Rules for spouses
Normally, surviving spouses are entitled to an unlimited exemption if they inherit property from their partner. There is no estate tax due on property left to a surviving spouse.
An exception applies, however, if the surviving spouse is not a U.S. citizen. The IRS wants its pound of flesh sooner or later, and if a widow or widower is not a U.S. citizen, they may expect their estate tax money now and impose a much less favorable exemption. Unless the country of citizenship of a surviving spouse has entered into a tax treaty with the United States stating otherwise, this means that exemptions for non-citizen surviving spouses can be as low as $60,000.
If one or more spouses is a non-citizen, it is important to enlist an expert with specific estate planning experience to get a handle on this - before it happens.
Estate taxes and same-sex partners
The unlimited spousal exemption to the estate tax doesn't apply to same-sex spouses, because the Defense of Marriage Act legally prohibits the IRS from applying the same rules to these couples that apply to heterosexual married partners.
The fact that some couples don't benefit from the unlimited spousal exemption or the full $5.12 million exemption amount that applies to citizens means that some individuals and couples will have to take extra measures to mitigate estate tax pain.
Some common examples of estate tax countermeasures:
A recent change to the tax rule allows a surviving spouse to use any portion of the $5.12 million exemption her spouse didn't use - effectively combining their exemptions to up to $10.24 million, under "portability rules." But this only applies to legally married heterosexual couples, under current law. For other couples, or where the estate is expected to exceed this amount (plus inflation), some couples may consider forming a bypass or A-B trust. Consult an attorney for information specific to trust documents, since only a licensed attorney can draw up trusts.
If you expect your heirs to pay estate tax, you may want to consider that in your life insurance planning. To do this, estimate the tax your heirs will have to pay on inherited assets. Unless your estate is cash-rich, you may need life insurance to provide the cash infusion your heirs need to avoid having to sell assets under pressure. You may need a permanent life insurance policy - which is designed to pay out no matter how long you live - rather than a term policy for this purpose. Term policies are designed to be very affordable for a limited number of years, but not designed to economically pay a death benefit for something that happens at or near your life expectancy, or beyond.
Convert Traditional IRAs to Roths
IRAs and other retirement accounts are part of your taxable estate. But you may be able to lower an eventual estate tax liability by converting a traditional IRA to a Roth IRA now. This generates an immediate income tax liability. But you or your heirs would have to pay income taxes on this money sooner or later anyway, when you take distributions. But you reduce the size of the estate by paying income taxes now - and therefore potentially reduce the dollar amount of the eventual estate tax. More and more employees are offering a Roth designated account option within 401(k)s as well - or if you have left the company or if your plan allows in-service withdrawals, you can roll your 401(k) into a traditional IRA and convert it to a Roth from there.
Traditionally, life insurance professionals have a key role in assisting clients and their families execute their estate tax mitigation strategies. They do this in concert with attorneys, tax professionals and financial planners. Each professional has a role to play.
Bob Adams is president of A SafeHarbor, a firm specializing in assisting families in having a calm retirement when faced with stormy financial waters. Visit aSafeHarbor.com or call 407-644-6646 for more information.