A frequent concern for estate planning clients is how to avoid owing estate taxes at their death. Because the estate tax has become a political issue, some of these clients are also concerned about how the election results might impact the estate tax. The following is a basic explanation of the federal estate tax and some thoughts on what to expect over the next few years.
What is the Federal Estate Tax
The estate tax is a tax on the value of a person’s estate at the date of their death. If you add up the value of all your property (house, cars, personal property, bank accounts, life insurance, investments, retirement, etc.) you will have the approximate value of your estate. Next, add in significant gifts (currently greater than $15,000 per recipient per year) that you have made during your lifetime. If the total exceeds a threshold referred to as the “federal estate tax exemption,” you have a taxable estate and your estate may owe tax after your death.
The federal estate tax has changed significantly over the last 23 years. During that time, we have seen the federal estate tax exemption rise from $600,000 per person in 1997 to its current level of $11.58 million per person. This means that, while people who died with estates valued over $600,000 were taxed in 1997, a person would now need to die with more than $11.58 million to have a taxable estate. Over that same period, the top estate tax rate is fallen from 55% to 40%.
According to the Tax Policy Center, of the estimated 2.8 million people who will die in America in 2020, just 4,100 will need to file an estate tax return, and only 1,900 will pay tax. That is a decrease from 109,600 returns filed in 2001, and 50,500 estates that paid tax that year. Because of the increased exemption, fewer estates are required to pay federal estate tax, and those estates are generally taxed at a lower rate today than 20 years ago.
Individual states also have their own estate taxes. The State of Minnesota taxes estates valued over $3,000,000, but does not tax gifts made during the person’s lifetime. The State of Wisconsin does not have an estate tax or gift tax.
Sunset of the Estate Tax Exemption
The current estate tax exemption of $11.58 million is the result of legislation called the Tax Cut and Jobs Act passed at the end of 2017. The act increased the estate tax exemption from $5.49 million in 2017 to $11.18 million in 2018. The exemption amount adjusts each year with inflation.
Because of congressional budget rules, the 2017 increase in the estate tax exemption is temporary. Unless new legislation is passed, the increased estate tax exemption will expire at the end of 2025. At that time, it is expected to fall to approximately $6 million.
What to Expect in 2021 and Beyond
The estate tax has become a political issue. Generally, Republicans favor increasing the federal estate tax exemption, reducing the tax rate, or eliminating the estate tax entirely. Democrats generally favor a lower federal estate tax exemption, raising the tax rate, and possibly eliminating something called the “step-up in basis.”
Prior to the election, there was speculation that both the Presidency and the Senate could flip from Republican to Democratic control in 2021. Together with Democratic control of the House of Representative, this would have given Democrats the ability to pass legislation reducing the estate tax exemption prior to the end of 2025, instead of waiting for the sunset.
Biden made several policy proposals during his campaign that impact estate planning. Here are a few:
- Reduce the estate tax exemption to $3.5 million ($7 million for a married couple).
- Increase the estate tax rate from 40% to 45%.
- Raise the capital gains tax rate for people with more that $1 million in annual income. These capital gains and qualified dividends would be taxed at ordinary income tax rates of 39.6%.
- Eliminate the step-up in basis. The step-up in basis erases capital gains on most property passing at a person’s death. If the step-up were eliminated, tax would be imposed on unrealized capital gains regardless of whether the asset was sold following the person’s death.
While nothing is final until after the runoff election in Georgia on January 5th, it appears the country may end up with a divided government – Democrats controlling the Presidency and House of Representatives, and Republicans controlling the Senate. Most if not all of Biden’s proposed changes will be difficult to pass unless Democrats control the senate. Many of these proposals may need to wait until after the 2022 election, when another 34 Senate seats will be decided.
Even if Biden is unable to immediately achieve his proposed changes, the estate tax exemption sunset is still looming and the next election is only two years away. Clients with estates in excess of $3.5 million will need to pay attention over the next five years to changes that may impact how their estate will be taxed.