HERON FINANCIAL GROUP, LLC

Quick Take

January 20th, 2010

 

Estate planning pitfalls in 2010

 

For years we told clients that, "if you haven't updated your estate plan since 2002, you don't have an estate plan," reflecting the major changes in estate taxation that were implemented after the Economic Growth and Tax Relief Reconciliation Act of 2001.  Now we must update that remark to "since 2010" because the current tax environment is the most complex since income taxes were first applied nearly 100 years ago.

 

The current tax regime will "sunset" at the end of 2010.  The changes to exemptions, tax rates, gifting and generation skipping that that have applied for the last 8 years are set to revert to 2001 levels.  In principal, Congress can act to extend, or extend with modifications, the 2001 legislation.  However, with Washington tied up on healthcare reform, financial reform, and funding and supporting two wars, such legislation could fail to be enacted by January 2011.  Nobody at this point in time, not financial planners and investment advisors, not trust & estate attorneys, not the IRS itself, has any idea what the rules will be a year from now.

 

The wills and trusts that our clients have operated under for the last several years have to be updated again, but the issues are ever more complicated. 

 

So what do clients have to know, and what do they have to do?

 

For 2010 and 2011:

  • Estates of persons deceased in 2010 are exempt from tax, but the estate tax returns in 2011.
  • The "Generation Skipping Tax" has applied since 1976 to assets bequeathed to grand-children or great grand-children, most recently at the rate of 45% ON TOP of other estate taxes for a combined bracket of about 75%.  There is no GST in 2010, and then the rate reverts to 41-55% in 2011 for a max combined bracket of 75-80%.
  • In 2009, the first $3.5 million of an estate was exempt from combined estate tax and GST calculations.  In 2011, the exemption reverts to the $1 million that prevailed in 2001.
  • In 2010 assets transferred from an estate settlement no longer receive "step up in basis."  For example, if someone bought AT&T stock two generations ago and held onto to the original shares through all the splits, spinoffs and mergers, at least their heirs could start fresh by using stock prices on the date of death to establish a new cost basis.  Now somehow they have to calculate the historical basis using statements that may or may not exist.  Between 2000 and 2009, we established cost bases for all assets held by our clients in their custodial accounts at Fidelity.  We have no way of helping our clients' heirs establish a cost basis for a house, a painting, a stock certificate left in a bank vault.  Bottom line, our clients now must store and catalog information in such a way that their heirs can do those calculations.  Disaster!
  • The IRS will exempt the first $1.3 million in capital gains and additional $3 million in gains for a spouse, but that doesn't address the paperwork retention issue for anyone with at least $1.3 million in assets, which is the majority of our clients.
  • The maximum lifetime gift exemption is still $1.0 million per person even though the estate tax is gone.  After you use up the gift exemption, additional gifts are taxed at 35%, which is down from 45% in 2009 and down from 55% in 2001.  The gift tax rate will revert to 55% in 2011 if the current law terminates and no further legislation is enacted.
  • Clients can still give away a maximum of $13,000/year to an unlimited number of people without using their exemption.  Though this does not seem like a significant amount in the context of a seven figure estate, maximum gifts over 10 years removes $130,000/beneficiary from the estate AND the assets continue to appreciate outside the estate.  At 8%/year, those gifts would be worth $188,000 in the 10th year.
  • Clients can "front-load" 5 years of gifts to College 529 plans.  A single gift of $65,000 (5 years X $13K) to an infant at 8%/year is worth $140,000 at age 18, which we estimate will be half the cost of a 4 year program at a private university, or all 4 years at a public university.  Educational inflation unfortunately runs at twice the rate of general inflation.
  • Clients can make unlimited payments for educational or medical expenses for siblings, children and grandchildren, even in-laws (and you may be able to take a tax deduction for medical expenses.)
  • Roth IRA's but not conventional IRA's can be passed tax free to heirs and distributions are tax-free to the heirs (more on this topic tomorrow in our "Quick Take" on Roth conversions.)

 

We're not remotely going to attempt to offer strategies to optimize your estate with this "Quick Take."  Every client's situation is unique.  The only way to come up with the best plan is to sit down with a trust & estate attorney or an accountant who specializes in estate planning with a schedule of all your assets and copies of any wills or trusts.  Working out the details can take weeks, or even months and obviously will cost money.  Not working out the details could be EXTREMELY costly.

 

We will say that there is one year window that will most likely not be available again in our lifetimes to minimize estate taxes.  Our recommended strategy would be to prepare trusts and wills to push assets out of your estate in 2010, assuming that the estate tax returns in 2011.  If by remote chance, the estate tax is permanently repealed, it will be relatively easy to adjust estate documents to reflect that reality.

 

We can give you a short list of issues that are known to cause problems:

  • Dying intestate (without a will).  We've learned in recent conversation that several of our clients don't have wills ("doesn't everything go to my wife, parent, brother?")  If you want to guarantee your family years of frustration and expense, dying intestate is the way to go.
  • Holding assets jointly, (Joint Tenant with Right of Survivorship, Tenant in Common) with your spouse, whether liquid assets such as stocks and bonds, or hard assets such as real estate.  Sure, the assets conveniently move over to the survivor on your death, but you give up the value of the first exemption.  For example, let's presume that a couple holds $2 million in assets jointly in 2011, when the exemption reverts to $1 million.  If the husband dies in 2011, the $2 million flows to the wife, fine.  However, if she died the following year, only the first $1 million is exempt, the second million is taxed at 41-55%.  
  • If the couple had divided their assets evenly into two individual accounts of $1 million each (or even better two living trust accounts to take that part of their estate out of probate) then the husband could have used his exemption to fund a "bypass trust," which exists for the benefit of his wife while alive, and then terminates and distributes to his secondary beneficiaries on her death.  The first plan hits their combined estate with a tax of $410-555,000; the second plan incurs no tax at all.
  • Not checking whether the language which governs which part of an estate goes to a "bypass" versus a "marital" trust takes into account the changing levels of exemption.  For example, if a husband with a $10 million estate created a "bypass" trust that was supposed to fund the needs of his wife in retirement, while all the remaining estate was distributed directly to his children, the wife might find that the bypass trust contained $3.5 million if he died in 2009, all $10 million if he died in 2010, and only $1 million if he died in 2011.  This issue can be addressed by updating your estate papers with specific percentages or dollar amounts, and these numbers must be reviewed annually.
  • Not taking state taxes into account.  Families establish trusts according to the tax rules of one state, forget to update those trusts when they retire to a different state and get hit with unexpected taxes as a result.
  • Not looking into life insurance such as "second-to-die" policies that would enable you to "pre-fund" your estate taxes.  The earlier in life you purchase these policies, the lower your premiums will be.
  • Using an off-the-shelf "will-maker" software package.  By the time a planning error is discovered, there's no way to fix it!

 

Have no illusions that you can solve all these issues on your own.  We work very hard to keep current with estate laws, and even so we're reasonably confident we've made at least one misstatement in this survey.  Accountants in general struggle to keep up with the changes, while calls to the IRS on even routine matters have error rates of up to 40%.

 

Fortunately, we maintain a network of trust & estate attorneys, accountants and life insurance agents who specialize in estate planning.  We would be delighted to make introductions for any of our clients who need these services, and also will help you gather the information you need to make the best use of your time with these specialists.

 

  
                                                                                    Yours sincerely,                      
                                                                         DSE                                                          
                                                                                    David Edwards
                                                                                    President 

 

Heron Financial Group, LLC, is an SEC registered investment advisor providing fully managed investment and wealth management services to individuals, families, trusts, defined benefit plans and corporations.

HERON FINANCIAL GROUP, LLC.

www.HeronCapital.com

(800) 99-HERON

 

Heron Capital Management Inc. | 670 West End Avenue | 14th Floor | New York | NY | 10025