Understanding the Estate and Gift Taxes

     One of the most misunderstood areas of estate planning involves the impact of Federal Estate and Gift Taxes. While most people understand they pay Federal Estate Tax on inherited assets and Federal Gift Tax on gifts made, few people truly understand what creates liability for these taxes and who is responsible for paying them.

     The first point to understand is that Federal Gift and Estate taxes are integrated into a single transfer tax under a unified rate schedule and with a unified credit that imposes a single tax on transfers during life and at death. The Internal Revenue Service group gifts and inherited assets together for purposes of determining total tax owed and the amount of assets excludable before payment of either Federal Gift or Estate taxes

     Let us begin with the Estate Tax. The estate of a deceased individual pays Estate Tax on the assets transferred to non-spouses at the individual's death. The estate tax rate is a sliding scale that tops out at 40%.  The Tax Code includes an Exclusion, which currently allows an estate to transfer $5,430,000.00 before incurring any Estate Tax liability. In addition to this large Exclusion, the Tax Code provides that any assets transferred to a surviving spouse are exempt from tax liability. In addition, any portion of the Exclusion that the estate of the first to die of a married couple does not use can be used by the surviving spouse's estate at his or her death. This ability, commonly known as Portability, means that a married couple will need to transfer nearly $11,000,000.00 at death before paying any Estate Tax. The Tax Code ties the Exclusion amount to the cost of living and therefore each year the Exclusion grows allowing ever-greater tax-free transfers.

     A person can choose to make gifts during lifetime instead of making bequests at death, making Gift Tax an important consideration. The person making the gift is liable for paying the Gift tax, if any is due. As indicated above, Gift and Estate taxes are integrated into a single transfer tax, so that the exclusion from tax becomes a "lifetime exclusion" rather than an exclusion at death. Any exclusion used during lifetime against Gift taxes will reduce the exclusion available against Estate taxes. 

     As noted above, we offset any Gift Tax against the Lifetime Exclusion before any tax becomes due. There is also another exclusion against Gift Tax--the "Annual Exclusion. A The Annual Exclusion on Gift Taxes allows any person to give up to $14,000 to any number of people, each year without creating any Gift tax liability. This means that a husband and wife together can give the each of their three children and their spouses $28,000 each year, reducing the parents' taxable estate by $168,000 each year without paying any tax on those transfers, and without using the Lifetime Exclusion. If our couple wanted to give their children additional amounts in a year, every dollar over $14,000 per beneficiary then reduces the parent’s Lifetime Exclusion.

     As an example, if the parents want to make a $200,000 gift to each of their three children so that the children can purchase a home, the parents can give a total of $28,000 to each child and $28,000 to each child’s spouse tax-free using the Annual Exclusion. The remaining $432,000 in gifts to the children and their spouses will reduce each of the parent's Lifetime Exclusion by $216,000 and reduce their remaining Estate Tax Exclusion by the same amount.

     In estate planning, we employ strategies that can increase the benefit of each of these Exclusions for people able to make substantial gifts. We will discuss some of these in our next blogs. 

Adding Additional Protections for Inherited IRAs

     Last year the Supreme Court of the United States unanimously held that Inherited IRAs do not qualify for protection during a bankruptcy. Stating that the term "retirement funds" refers to money set aside for time when a person is no longer working, the Court stated that three characteristics disqualify the funds held in an Inherited IRA from the status of "retirement funds.” 

1. The owner of an inherited IRA cannot add additional funds to the account. 
2. Holders of Inherited IRAs must take distributions from those accounts without regard to the number of years until the account owner reaches retirement. 
3. The owner of an Inherited IRA may make penalty-free withdrawals from the account, up to the entire balance of the account, at any time without triggering the 10% withdrawal penalty found in the Internal Revenue Code.

     This important for any client who expects their retirement accounts to make up a large part of their estate, because this decision means that those inherited retirement assets do not enjoy the usual protection from creditors and will be at risk if one of their beneficiaries files for bankruptcy after receiving their inheritance. Presumably, those assets will also be at risk if a beneficiary divorces a spouse.  Thankfully, we already have a tool that addresses this concern and provides protection for beneficiaries. A standalone IRA Trust named as the beneficiary of a client's IRA can make distributions to the beneficiaries of the IRA Trust without exposing the inherited IRA to creditors. I

     Normally only an individual can be a "designated beneficiary" under an IRA, but if a Living Trust meets certain requirements it is considered a "see-through" trust and the Internal Revenue Code and Regulations treat the beneficiaries of the trust as the "designated beneficiaries" of the IRA. This allows those beneficiaries to stretch their distributions to receive the minimum required distributions over the life expectancy of the oldest beneficiary. In the event that it would be more advantageous for each beneficiary to take distributions over their own life span, it is possible to create specific sub trusts for each beneficiary under the IRA Trust to stretch distributions over the individual beneficiaries' lifespans. 

     For years, we have been using standalone IRA Trusts to assist clients who wished to place different restrictions on the distribution of their retirement and nonretirement assets or to protect beneficiaries from misusing the benefits of an inherited IRA by taking large lump sum distributions, or as protection against possible creditors or loss of assets in a divorce action. With this recent decision from the Supreme Court, a standalone IRA trust provides clients with the peace of mind that in the event one of their loved ones becomes one of the nearly 1,000,000 people who file for bankruptcy in the United States each year, their inherited IRA assets will remain protected.

     The law and regulations governing "inherited IRAs" and the use of IRA Trusts is expansive and complex. Before a client begins designating a trust as the beneficiary of a retirement account they should consult with a legal expert in that area. Additionally at the death of the account owner, it is important to seek additional advice as to the best way to retitle accounts or distribute the assets. If you or your clients have specific questions regarding this or any other planning matter please do not hesitate to contact us and we will be happy to provide you with an understanding of the consequences of any actions.