Changes in the transfer tax laws effective January 1, 2006, will benefit many estate planning clients. However, these increases may cause some unintended results. For this reason, this is a good time for clients to review their estate plans to be sure that their goals are still being met under the new tax laws.
Estate Tax Exemption Increases. On January 1, 2006, the amount of wealth an individual can pass to others free of federal estate tax rose from $1,500,000 to $2,000,000. It is presently scheduled to increase again in 2009 to $3,500,000, to increase to an unlimited amount in 2010, and to drop back to $1,000,000 in 2011. Congress is expected to act within the next few years to change the amount of these exemptions again.
Generation-Skipping Tax Exemption Increases. The generation-skipping tax exemption also increased to $2,000,000 on January 1, 2006. Generally, the generation-skipping tax exemption is the amount which can be passed at death to persons two generations below the transferor (such as grandchildren) without triggering the generation-skipping transfer tax. Although it is allowed in the same amount as the estate tax exemption, it is not an additional exemption from estate taxation; in other words, it does not increase the estate tax exemption to $4,000,000. It is an entirely different tax that is being avoided by use of the generation-skipping tax exemption.
Lifetime Gift Tax Exemption Does Not Increase. Of note is the fact that the amount of wealth an individual can pass to others during his or her lifetime free of federal gift tax remains at $1,000,000. To the extent that a donor uses this exemption during lifetime, except as noted below, it reduces the amount the individual can pass within the estate tax exemption at death. However, to the extent that the donor uses the annual exclusion when making gifts, as explained below, the $1,000,000 lifetime exemption is not reduced. The same remains true for payments of tuition and medical expenses, as long as these are made directly to the provider.
Gift Tax Annual Exclusion Increases. Fortunately, individuals who wish to pass wealth through lifetime giving can continue to use the annual exemption, which was $11,000 during 2005. This annual exemption rose to $12,000 on January 1, 2006, and permits a donor to make gifts of $12,000 to any number of individuals each year thereafter without eroding the $1,000,000 lifetime exemption. If a consenting spouse joins in the gift, it increases to $24,000 per recipient.
Whose estate plan is likely to be affected by these increases?
The person whose estate plan uses a marital/residual formula. Married couples whose wealth exceeds the amount of the estate tax exemption (now $2,000,000) often use estate planning documents containing a marital/residual formula to reduce the estate tax exposure of the combined estates. With properly drawn estate planning documents and approximately $2,000,000 held by each spouse, this can allow this amount to be captured in a trust (often called a “credit shelter trust” or “residuary trust”) at the death of the first spouse and held for the lifetime use of the surviving spouse before passing to the children. In this type of plan, assets of up to $4,000,000 can be sheltered from estate taxation by using both spouses’ estate tax exemptions.
The marital/residual estate plan should be reviewed at this time to be sure that the credit shelter trust can be fully funded at the death of the first spouse. Simply put, each spouse will generally want to have at least $2,000,000 in his or her own name or his or her own trust after January 1, 2006. Disclaimers and other after-death techniques can also be used to shift assets into the credit shelter trust at the death of the first spouse, but the estate plan should be reviewed if these techniques are planned for to make sure that the assets are available to achieve the proper result.
The person whose estate plan is designed to pass the exemption amount to individuals other than a spouse. It is especially important for a person whose estate plan is designed to pass the exemption amount to individuals other than a spouse to review his or her plan. If a person planned that the maximum exemption amount would pass to others, with the expectation that this amount would not exceed $1,500,000, the increase to $2,000,000 may have the unfortunate result of shifting more wealth to non-spouse beneficiaries than the person intended. For example, some people provide in their estate plans for immediate distribution of the credit shelter trust to the children, while the marital trust remains available for the surviving spouse to use during his or her remaining lifetime. Since the increase in the exemption will generally cause the first $2,000,000 to pass to the children, the surviving spouse may have less than originally planned in the marital trust. For this reason, it is a good idea to review the plan to make sure that the increased exemption generates the right result for the family as a whole.
The person whose estate plan uses a generation-skipping formula. A person whose estate plan is designed to pass wealth to beneficiaries such as grandchildren, either directly or through generation-skipping trusts, often uses a formula designed to make maximum use of the generation-skipping transfer tax exemption. This exemption is presently set at the same amount as the estate tax exemption (now $2,000,000). If a client intends to pass the full $2,000,000 to grandchildren, this plan should continue to meet the client’s objectives. However, a review of the plan may cause the client to decide that this disproportionately benefits the grandchildren to the detriment of the children. This can lead to a revision to the plan to either increase the amount held in generation-skipping trusts available for the children’s lifetimes, or it may cause the client to decrease the amount of the generation-skipping exemption that is actually used so that more wealth passes to the children.
The person whose IRA or retirement plan constitutes a substantial part of the estate plan. A client’s retirement plan beneficiary designations should be reviewed regularly for two primary reasons. First, the client should take care to provide that the retirement plan is payable to the intended beneficiaries. Second, the client and the client’s advisors should take care to review the estate tax apportionment issues and income tax issues associated with the beneficiary designations. Since the increased exemptions in 2006 will allow more wealth to pass through the estate plan, a careful review of the beneficiary designations is increasingly important.
A review of the beneficiary designation forms is especially important when the plan is payable to a pass-thru type of trust and the client intends the trust beneficiaries to be able to use an optimum withdrawal period for the plan benefits. To secure these benefits, the beneficiary designation form itself generally should designate the separate shares of the trust for the beneficiaries to be able to use their own life expectancies for purposes of the required minimum distributions.
As with all retirement plan issues, however, each client should carefully review both the individual plan requirements and the client’s own choices with his or her advisors before making any final decisions regarding beneficiary designations. As always, clients are urged to meet regularly with their advisors to keep the elements of their estate plan working smoothly and efficiently to achieve their goals.