OCEAN CITY — The sweeping tax reform passed in 2010 ushered in unprecedented opportunities for families to transfer wealth.
The estate and gift tax lifetime exclusions jumped to $5 million for 2011 (and $5.12 million for 2012) from $1 million, and the top tax rates fell to 35% on transfers exceeding that. The new rules meant that couples could — and still can — give as much as $10.24 million to their heirs tax-free.
But those increased amounts are set to expire at the end of 2012, so Congress will have to debate, once again, whether to extend the provisions. If they choose not to, the lifetime gift and estate exclusions will each revert to $1 million, and anything above that could be taxed at a rate as high as 55%.
No one can predict which way the political winds will blow, particularly given that 2012 is an election year. That’s why now is a great time to review your estate plan so you can take maximum advantage of the current law — and even consider strategies for preserving wealth in the event that the rules change.
Here are three steps to help you make that happen.
1. Review your strategy. If you haven’t looked at your will in the past two or three years, have your attorney review it to make sure the directives are still applicable and effective. For example, suppose your will dictates that, upon your death, your entire lifetime exemption will be placed into trust for the benefit of your children. That may have made sense when your will was originally crafted and when the lifetime exemption was still $1 million. Now that it’s $5.12 million, your entire estate might be funneled into trust, leaving nothing to your surviving spouse.
“Review the strategy to make sure the
funding of trusts is still relevant and, more important, that the trust (or trusts) won’t be over- or underfunded relative to what you expected,” says Christopher Colombo, first vice president, trust and estate planning specialist with Merrill Lynch’s Wealth
2. Figure out how much you can afford to give. There is no question that the current gift and estate tax law allows unprecedented transfer of wealth. Unlike the 2009 law, which allowed you to use only $1 million of the $3.5 million limit toward your lifetime gift tax exemption, today you can use all $5.12 million for lifetime gifting. The question now is how much you can afford to give and still stay comfortably on track for your own retirement.
Start by doing an assessment of your retirement needs. Working with your financial advisor, look at all your assets, your overall asset allocation and expected growth, your retirement goals and objectives, and the lifestyle you would like to have down the line.
“Then work backward to see what, if any, of your net worth is available for gifting,” Colombo says.
If you can afford to give away a substantial amount, consider making use of trusts to remove the assets and their future appreciation from your estate. That will protect them from lawsuits, creditors and even children who are not quite ready for an inheritance. With the generation skipping tax exemption at $5.12 million, you can utilize a dynasty trust administered in certain jurisdictions to safely transfer that amount to children and grandchildren without paying any estate or transfer taxes.
3. Freeze your estate. If, after completing your retirement needs assessment, you discover that you aren’t comfortable making a sizable gift to the kids right now, you can look at ways to freeze your estate at its current value and transfer any future appreciation to your heirs. Suppose you have an investment portfolio worth $1 million that you’re not ready to part with, but you’ve determined that you don’t really need the growth for your retirement. You can place the investments in a grantor retained annuity trust (GRAT), which can be structured to pay you an annuity of 50% per year, in shares of stock, for two years. At the end of that time, any growth that beats the IRS-imposed hurdle rate of return — currently at an extraordinarily low 1% to 2% — passes tax-free to heirs. You can also choose to let the growth remain in trust for beneficiaries.
Another option: If you don’t need the money from the first annuity payment, roll it over into a new GRAT for another two-year term. By using short-term rolling GRATs, you keep the money fairly liquid — you’ll have access to it if you need it — and also safeguard against having the GRAT voided should you die before the end of the term. Also, as a bonus for your children, if the stock is sold inside the trust, the capital gains tax is paid by you as grantor rather than by your heirs.
There is no downside because, if the portfolio does not appreciate, you simply take it back at the end of the term. “If you’re not comfortable giving away the money now, a GRAT is a good solution. It’s a freeze on future appreciation,” Colombo says.
Regardless of how the law might change after 2012, trusts offer a host of estate planning benefits. But as with any wealth transfer strategy, the decision to use one is best made in the context of your broader investment strategy.
(A Merrill Lynch Wealth Management Advisor. She can be reached at 410-213-8520.)