First, let's look at the numbers. For 2020, the amount an individual (or in the case of a married couple, each spouse) can leave to heirs without the inheritance being subject to estate tax is $11.58 million per person. This is known as the federal estate tax applicable exclusion amount.* By aggregating their exclusion amounts, married couples can effectively shield as much as $23.16 million from federal estate taxes. If an individual has assets with a value greater than the exclusion amount, they may benefit from transferring assets during their lifetime. Even families with estates valued below the exclusion thresholds may want to explore proactive strategies to transfer assets during their lifetime.
Know the fundamentals
Before working on any estate planning strategies, you should first review the following basic estate planning rules:
A step-up in cost basis
The Internal Revenue Service (IRS) generally considers any increase between the price paid for an asset (the cost basis) and the price for which it is sold to be a "capital gain." In 2020, long-term capital gains tax rates—the rates applied to the proceeds from a sale of assets held for more than a year—range from 0% for taxpayers in the lowest income brackets to 20% for the highest earners (not including the 3.8% Medicare surtax on net investment income). Special rules not discussed here may apply, so plan to consult your attorney or tax advisor regarding your specific situation.
The cost basis of inherited assets receives a "step-up" to the current fair market value on the deceased’s date of death. The step-up can help mitigate the capital gains taxes owed by the heirs when these inherited assets are subsequently sold.
For example, say stock shares were purchased for $50,000 and are now worth $150,000. If the owner sold those shares, $100,000 would be included in income and subject to capital gains taxes. However, if the individual’s heirs inherited the shares, the cost basis would be stepped up to the present value of $150,000. If the heirs sold their shares for the $150,000 market value upon receiving them, there generally would be no taxable capital gain.
Unlimited marital tax deduction
Federal estate tax law provides for an unlimited marital tax deduction, which means that one spouse can leave their entire estate to the surviving spouse without incurring estate taxes, provided that both spouses are US citizens. Coordinating use of the unlimited marital tax deduction and the exclusion amount through portability (discussed below) can enhance estate tax exclusions.
A feature of the current estate tax law enacted by Congress, called "portability," has had a significant impact on estate tax planning. Portability rules allow the surviving spouse to take advantage of any unused portion of their spouse's exclusion amount, provided an estate tax return is filed and an election is made to preserve the deceased spouse's unused exclusion amount.
Taking advantage of trusts
There are 2 types of trusts often used by married couples in estate tax planning:
1. Credit shelter trusts (CSTs)
These trusts are sometimes referred to as bypass, family, or exemption trusts, and are typically funded with property having a value equal to the exclusion amount of the first spouse to die. Assets placed in a CST can be excluded from the estate of the surviving spouse if the exclusion amount of the first spouse to die is properly allocated to it, and the assets, including their increase in value, pass tax-free to the remaining beneficiaries—often the couple's children. However, the surviving spouse typically has limited control over assets once they're in the CST. Generally, the surviving spouse can access the trust's income, as well as principal that's used to pay for health, education, and living expenses. Access for other reasons may be granted at the discretion of the trustee in accordance with the trust documents.
2. Disclaimer trusts
These trusts offer another strategy to reduce estate taxes. They differ from CSTs in that they are optional and are activated only after the first spouse's death at the election of the surviving spouse, depending on their current situation. The surviving spouse can either accept the trust assets outright with use of the unlimited marital deduction, or disclaim all or a portion of them. If they disclaims assets in the disclaimer trust, the trust will function like a credit shelter trust that will "shelter" the assets, and their appreciation in value, from inclusion in the surviving spouse's estate. The exclusion amount of the first spouse to die is allocated to the disclaimer trust. If there is no tax reason to use credit shelter planning, the spouse can simply receive the assets outright. This allows tax-planning flexibility without creating unnecessary complications.
There's no one-size-fits-all approach to estate planning. Each individual or couple will have different needs and goals, which will call for distinct strategies. You should consult your attorney or tax advisor to discuss these strategies.