Effective January 1, 2018, the Tax Cuts and Jobs Act of 2017 (TCJA) reduces individual and corporate tax rates, eliminates a host of deductions and credits, enhances other breaks and makes numerous additional changes.
One thing the TCJA doesn’t do is repeal the federal gift and estate tax, as originally contemplated by the House of Representative’s version of the bill. It does, however, temporarily double the combined gift and estate tax exemption and the generation-skipping transfer (GST) tax exemption, creating new estate planning challenges and opportunities.
Impact on Your Estate Plan
For the estates of persons dying, and gifts made, after December 31, 2017, and before January 1, 2026, the gift and estate tax exemption and the GST tax exemption amounts increase to an inflation-adjusted $10 million, or $20 million for married couples with proper planning (expected to be $11.2 million and $22.4 million, respectively, for 2018). Absent further congressional action, the exemptions will revert to their 2017 levels (adjusted for inflation) beginning January 1, 2026. The marginal tax rate for all three taxes remains at 40%.
According to some estimates, the increased exemption amounts will reduce the number of U.S. estates subject to estate tax from approximately 5,000 to around 2,000. But just because the possibility of estate tax liability seems remote for most families, it doesn’t mean the end of estate planning as we know it.
For one thing, there are many nontax issues to consider, such as asset protection, guardianship of minor children, family business succession, and planning for loved ones with special needs. Plus, it’s not clear how states will respond to the federal tax law changes. If you live in a state that imposes significant state estate taxes, many traditional tax-reduction strategies will continue to be relevant.
It’s also important to keep in mind that the exemptions are scheduled to revert to their previous levels in 2026 — and there’s no guarantee that a future administration won’t reduce the exemption amounts even further. As discussed below, however, the exemption increases planning opportunities that can help you shield your wealth against tax changes down the road.
Record-high exemption amounts, even if temporary, create a rare opportunity to take advantage of strategies for “locking in” those exemptions and permanently avoiding future transfer taxes. These include:
Lifetime Gifts: By using some or all of the increased exemption amount to make additional tax-free lifetime gifts, you can shield that wealth — together with any future appreciation in value — from taxation in your estate, even if smaller exemptions have been reinstated when you die.
Keep in mind, though, that lifetime gifts, unlike assets transferred at death, aren’t entitled to a stepped-up basis. This can increase income taxes on any gain realized by the recipients should they sell a gifted asset. So, when considering lifetime gifts, it’s important to weigh the potential estate tax savings against the potential income tax costs.
Dynasty Trusts: Now may be an ideal time to establish a dynasty trust. These irrevocable trusts allow substantial amounts of wealth to grow and compound free of federal gift, estate and GST taxes, providing tax-free benefits for your grandchildren and future generations. The longevity of a dynasty trust varies from state to state, but it’s becoming more common for states to allow these trusts to last for hundreds of years or even in perpetuity.
Avoiding the GST tax is critical. An additional 40% tax on transfers to grandchildren or others that skip a generation, the GST tax can quickly consume substantial amounts of wealth. The key to avoiding the tax is to leverage your GST tax exemption, which will be higher than ever starting in 2018.
Let’s say you haven’t yet used any of your gift and estate tax exemption. In 2018, you transfer $10 million to a properly structured dynasty trust. There’s no gift tax on the transaction because it’s within your unused exemption amount. And the funds, together with all future appreciation, are removed from your taxable estate.
Most important, by allocating your GST tax exemption to your trust contributions, you ensure that any future distributions or other transfers of trust assets to your grandchildren or subsequent generations will avoid GST taxes. This is true even if the value of the assets grows well beyond the exemption amount or the exemption is reduced in the future.
The TCJA makes several other changes that may have an impact on estate planning strategies. For example:
529 Plans: The new law permanently expands the benefits of 529 college savings plans. These plans, which permit tax-free withdrawals for qualified educational expenses, also offer some unique estate planning benefits.
Contributions are removed from your estate even though you retain the right to change beneficiaries or get your money back. And you can bunch five years’ worth of annual gift tax exclusions into one year. So, for example, in 2018, when the annual exclusion is $15,000, you can contribute $75,000 to a plan ($150,000 for married couples) without triggering gift or GST taxes or using any of your exemptions.
Under the TCJA, beginning in 2018, tax-free distributions from 529 plans can be used for elementary and secondary school expenses, not just higher-education expenses, making them even more valuable.
“Kiddie” Tax: The TCJA also makes an important change to the “kiddie” tax. One popular estate planning technique is to transfer investments or other income-producing assets to your children to take advantage of their lower tax brackets. The kiddie tax makes this difficult to do. Under pre-TCJA law, it taxes all but a small portion of a child’s unearned income at the parents’ marginal rate (if higher), defeating the purpose of income shifting. The kiddie tax generally applies to children age 18 or younger, as well as to full-time students age 19 to 23 (with some exceptions).
The TCJA makes the kiddie tax even harsher by taxing a child’s unearned income according to the tax brackets used for trusts and estates, which are taxed at the highest marginal rate (37% for 2018) once 2018 taxable income reaches $12,500. In contrast with all other filers, for a married couple filing jointly, the highest rate doesn’t kick in until their 2018 taxable income tops $600,000. In other words, in many cases, children’s unearned income will be taxed at higher rates than their parents’ income.
Charitable Planning: The TCJA raises the adjusted gross income limitation for deductions of cash donations to public charities from 50% to 60% from 2018 through 2025. On the other hand, because fewer people will be subject to federal gift and estate taxes, charitable strategies designed to reduce those taxes will be less valuable from a tax-saving perspective.