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All Estate Plans Need to Be Reviewed and Probably Changed. Income Taxes Are Now More Important than Estate Taxes

Roger McClure June 14, 2013

Time to Review your estate plan.

Because of new tax law effective in 2013, many estate plans are out of date and will cause unnecessary taxes. This is because these plans were designed to save estate taxes. Because of the new law, most people will not pay estate taxes. However, most people’s estates could be subject to substantial income taxes.

No Step Up in Basis.

In plans of a husband and wife, they often have one or two trusts in which they leave their funds in a trust for the surviving spouse. This used to be a good idea to save estate taxes. But, now such a plan could cause unnecessary income taxes.

Fred and Fran.

Fred and Fran have an estate valued at $3,000,000 under the federal estate tax rules. Both Fred and Fran have trusts leaving their property to other spouse if their spouse survives them. Each trust owns $1,500,000 of property. They signed these trusts years ago before the changes in estate taxes when a $3,000,000 estate could have been subject to more than $500,000 in state and federal estate taxes.

Fred dies in 2013 and Fran implements the requirements of Fred’s trust by placing $1.5 million in Fred’s Family Trust set up to use Fred’s exemption from estate taxes. But since the per person exemption is $5,250,000 in 2013 ($10,500,000 for Fred and Fran) and their estate is way below that, Fred and Fran no longer have an estate tax problem. But, this old plan now has the following disadvantages:

Unnecessary Tax Returns and Complexity

Since Fred’s Trust is irrevocable and Fran’s control over it is limited, Fran must file annual income tax returns for Fred’s trust each year. If she does not take out all of the income each year from Fred’s Trust, the income could be subject to a 49% combined state and federal income tax rate even though she is in the 25% tax bracket. She does not like the expense and complexity of this return and it is an annual reminder that Fred is no longer with her. It used to be necessary to put up with this to save estate taxes. No more. It is now possible to eliminate this no-longer necessary annual filing of a trust tax return by giving Fran additional powers over Fred’s Trust.

Heirs May Pay Avoidable Income Tax.

When Fred died, the non-retirement plan assets owned by Fred received a step-up in basis to their current market value. For example, Fran and Fred bought their home 20 years ago for $200,000; it is now worth $600,000. They also had some stock investments. Fred paid $700,000 for the assets in his trust, now valued at $1,500,000. When he died, Fred’s Trust inherits this $1,500,000 at its current market value of $1,500,000 (step up in basis), thereby avoiding forever any capital gain on the $800,000 difference gained during Fred’s lifetime. But, the $1,500,000 in Fred’s Trust grows to $3,000,000 while Fran is alive after Fred’s passing. This was good planning in the past because any growth in Fred’s Trust escaped estate taxation when Fran died. But, now, it is a disadvantage. Today, Fred and Fran do not need estate tax trusts to escape estate taxes as long as the current law stays in place. When Fran dies, the gain from $1,500,000 to $3,000,000 in Fred’s trust is subject to a likely 30% state and federal income tax rate, a total of about $450,000 in unnecessary income taxes. A relatively small change could preserve the estate tax savings in the event they change the tax law again, but allow flexibility to avoid this income tax problem.

Make Changes Now.

To fix this problem, it is necessary to make a relatively small change to your estate plan.