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Why It's So Important to Update Your Estate Plan

As the rules related to estate taxes change, so should your estate plan. 

The federal estate tax — the tax levied on an heir's inherited portion of an estate if its valuation exceeds an exclusion limit set by law — was started in 1916 to help pay for World War I. The tax is levied on everything you own or everything you have interests in at death. At first, it did not apply to many people, but inflation and prosperity slowly began impacting it. From 1987 to 1997, the government tax on estates valued at more than $600,000 was 55%.

By then, folks who owned nice homes and who had substantial savings and investments started to worry that much of their money would go to the government rather than heirs. Each person has his or her own exemption; a married couple, then, has two exemptions.

However, if one dies, leaving everything to the spouse, the surviving spouse only has one exemption left. (For related reading, see: How Advisors Can Help Surviving Spouses.)

Minimizing Taxes

The legal profession came up with what it saw as a better way to deal with the estate tax: the A/B trust, otherwise known as the spousal or the family trust. This stated that one could leave an unlimited amount of money to a spouse free of tax. But one could also leave $600,000 to a trust — free of estate tax — that the spouse could use for his or her benefit, although it's not legally his or her property; this piece is called trust B, or the family trust. When the surviving spouse dies, the heirs inherit both the family trust assets ($600,000) and the surviving spouse's assets up to the $600,000 limit — for a total of $1.2 million free of federal estate tax. 

At a tax rate of 55%, this saves the heirs a whopping $330,000 in taxes. While in theory this sounds like a great solution, there are some drawbacks to consider when dealing with the A/B trust. (For further reading, see: Advanced Estate Planning: Using Trusts.)

Estate Planning Downsides

Beginning in 1988, the amount of the estate tax exemption that could be passed on to non-spousal heirs was gradually increased. In 2000 it went to $1 million and changed every other year until 2011; in 2012 the amount became fixed, the limit was raised to $5 million and it was indexed for inflation. In 2016, the estate tax exemption was $5.45 million and the estate tax rate was 40%. 

This means that fewer people will be subjected to the estate tax. Those who are may now be faced with the negative aspects of establishing trusts, which include inconvenience, administrative costs and capital gains taxes. In terms of inconvenience, setting up two trusts requires establishing separate banking and investment accounts to hold the assets of each trust. The surviving spouse may be allowed to use the income and assets in the family trust for health, education, maintenance and support, but he or she has to be careful that the heirs to the trust do not dispute the manner in which these assets are managed or dispersed. In the case of a blended family, this is where many problems arise.

Determining which assets go into the family and the spousal trust often requires the assistance of an attorney, CPA or a financial advisor. The income in the family trust requires a separate tax return and the tax rates on the two trusts are different. This means that the surviving spouse may need expensive professional help for the rest of his or her life.

Pain of Capital Gains Taxes

Dealing with capital gains taxes can be the biggest issue of all. When someone dies, the assets owned by the decedent have a step-up in cost basis. This means is that if someone bought stock "ABC" many years ago for $1 per share and dies when the stock is worth $100, the new tax cost basis on ABC is $100. If the heirs sell it for $100, there is no capital gains tax. If it is left to the spouse, the spouse receives the stepped-up cost basis. At the death of the spouse, the heirs receive a second stepped-up cost basis.

Only assets left to the surviving spouse (or to a spousal trust) receive a stepped-up cost basis at the survivor’s death. Because the assets in the family trust never become the assets of the surviving spouse, for tax purposes there is no second step-up in cost basis when the survivor dies. For example, if ABC is put in the family trust with a stepped-up cost basis of $100 and the stock is worth $200 per share when the surviving spouse dies, the heirs have to pay a capital gains tax of $100 ($200 - $100 = $100) when they sell. If it had been left to the surviving spouse, the capital gains tax could have been avoided.

If the estate plan documents were prepared years ago when the exemption was much lower, the result might be an actual increase in cost and an increase in taxes rather than a tax saving. This is why it may be time to meet with your attorney to bring your estate plan up to date. 

One More Change to Know

The new estate tax law also includes a provision called portability, which is officially known as the deceased spousal unused exclusion. Portability allows married couples to capture two estate tax exemptions without having to rely on the A/B trust plan.

An attorney should be consulted shortly after the death of a spouse to make sure that the deceased spouse’s exemption is retained. This does not require separate accounts for A and B trusts, which simplifies the tax life of the surviving spouse. It also preserves the step-up in cost basis when the second spouse dies. (For related reading, see: 6 Questions to Ask a Financial Advisor.)