Tax deal reshapes estate planning landscape

The American Taxpayer Relief Act of 2012 (ATRA) that averted the United States’ descent over the “fiscal cliff” includes some welcome relief from both the large estate tax increases that had been scheduled to go into effect in 2013 and the uncertainty that has plagued the federal estate tax regime in recent years. The act addresses gift, estate and generation-skipping transfer (GST) tax rates and exemptions, as well as various breaks that may affect your estate plan.

Estate, gift and GST taxes

Beginning in 2013, ATRA sets a maximum tax rate of 40% for estate, gift and GST taxes. It also retains a $5 million unified estate and gift tax exemption and a $5 million GST tax exemption. Both exemptions are adjusted annually for inflation, so the 2013 exemptions will be a little more than the 2012 exemptions of $5.12 million.

Estate taxes will increase over those of 2011 and 2012 (and, in some cases, 2010), when the maximum tax rate was 35%. If Congress hadn’t passed ATRA, however, the increase would have been much larger: The maximum rate would have reverted to 55% in 2013 and the exemption amount would have dropped to $1 million (with no adjustment for inflation except for the GST tax).

ATRA also removes the veil of uncertainty surrounding federal gift, estate and GST taxes by making these changes permanent — or at least as permanent as any tax code provision can be. There’s nothing to stop Congress from modifying these taxes in the future. But the absence of an expiration date allows people to develop estate planning strategies with greater confidence.

Portability

ATRA also makes “portability” of estate tax exemptions between spouses permanent. When one spouse dies, his or her estate can make a portability election, allowing the surviving spouse to use the deceased spouse’s unused exemption amount.

Portability enables married couples to take advantage of their combined exemption amounts without sophisticated estate planning techniques, such as credit shelter trusts. A credit shelter trust makes the most of the deceased spouse’s exemption and, by limiting the surviving spouse’s control over the trust, keeps the assets out of the surviving spouse’s taxable estate. Portability, on the other hand, preserves the deceased spouse’s exemption even if the surviving spouse gains unrestricted access to the deceased spouse’s wealth.

Before ATRA, the value of portability was hampered by its temporary nature: It was available only in 2011 and 2012, making it risky for couples to rely on it. Permanence now makes portability a viable alternative to more complicated estate planning techniques.

Keep in mind, however, that trusts continue to offer significant benefits, including:

• Professional asset management,
• Protection of assets against creditors’ claims,
• Avoidance of transfer taxes on future appreciation,
• GST tax planning (portability doesn’t apply to the GST tax), and
• Preservation of state exclusion amounts in states that don’t recognize portability.

In addition, if a surviving spouse remarries, the benefits of portability with respect to the first spouse may be lost. (Portability is available only for the most recent spouse’s exemption.)

Other provisions

ATRA permanently preserves several other provisions that affect estate planning, including:

• The federal estate tax deduction (rather than a credit) for state estate taxes,
• Deferral and installment payment of estate taxes attributable to qualified closely held business interests, and
• GST tax protections, including deemed and retroactive allocation of GST tax exclusions, relief for late allocations, and the ability to sever trusts for GST tax purposes.

The act also extends through 2013 the ability of individuals age 70½ and older to make tax-free IRA distributions to charity (up to $100,000 annually).

Review your plan

Now that ATRA has brought some stability to the federal transfer tax system, your estate planning advisor can help you determine whether you should adjust your strategies. It’s also a good idea to monitor legislative activities in the coming months. Congress may make additional gift, estate and GST tax changes in connection with its deficit-reduction efforts.

Sidebar: Is it time for a Roth conversion?

The recently enacted American Taxpayer Relief Act of 2012 (ATRA) makes it easier to convert an existing traditional 401(k), 403(b) or 457(b) account into a Roth account — a potentially attractive tool for providing for your children or other heirs.

Contributions to Roth accounts aren’t pretax. However, qualified distributions —including earnings — are tax-free. Essentially, the choice between a Roth or a traditional account comes down to whether you want to pay the tax now or later. A Roth account may be more attractive if you wish to prepay the tax liability on an account you plan to leave to your heirs.

Under pre-ATRA law, participants in employer retirement plans were allowed to make “in-plan” Roth conversions only if they were entitled to take distributions eligible for a rollover. Generally, this prevented current employees from taking advantage of a Roth conversion. Now, if your employer’s plan allows it, you can convert a traditional retirement account into a Roth account even if you’re not eligible for a distribution.

Keep in mind that you’ll need to pay any taxes due on your account balance in the year of conversion.