The estate tax exemption sunset: What you need to know

The federal estate tax, often referred to as the "death tax" by its detractors, is a tax on the transfer of the estate of a deceased person. It is applied to the portion of an estate that exceeds a specified exemption limit. The estate tax is different from an inheritance tax, which is levied on beneficiaries; the estate tax is charged to the estate itself before distribution.

The exemption plays a vital role in estate planning, particularly for those with substantial assets. It determines how much wealth can be transferred to the next generation without incurring significant taxes.

The federal estate tax has been a part of the U.S. tax system for over a century, with its origins tracing back to 1916. Initially introduced as a means to generate additional revenue and address wealth inequality, the estate tax has undergone numerous revisions reflecting the nation's economic and political shifts. Over the years, the exemption amount and tax rates have fluctuated, often influenced by the prevailing economic conditions and legislative changes.

The current federal estate tax exemption, significantly increased by the Tax Cuts and Jobs Act of 2017, is set to "sunset" or revert to previous levels at the end of 2025.

Unless new legislation is passed to extend or modify this provision, the exemption amount will decrease substantially. This potential reduction prompts a need for proactive planning, especially for estates that may become subject to the estate tax under the reduced exemption.

In 2023, the exemption amount was $12.92 million per individual and $25.84 million per married couple, and in 2024 those amounts increased to $13.61 million and $27.22 million.

However, the provisions of the Tax Cuts and Jobs Act are set to expire on December 31, 2025, and the exemption is scheduled to revert to its pre-2018 level of $5.49 million per individual, adjusted for inflation. Assuming no legislative action is taken to extend the current exemption or make it permanent, this change will have considerable implications for estate planning. Based on current projections, the exemption in 2026 could be around $6.4 million per individual or $12.8 million per married couple, although the exact figures will depend on inflation. This means that estates exceeding these amounts may be subject to federal estate taxes, which can be as high as 40%.

The reduction in the exemption could significantly impact individuals and families with substantial assets, requiring them to reevaluate their estate planning strategies.

With 2025 around the corner, understanding the specific changes to the estate tax exemption is imperative for effective estate planning.

Because the exemption is expected to be nearly halved, many estates that currently fall below the threshold could be impacted. This shift necessitates a review and possible revision of existing estate plans.

Consider the case of a person who has an estate worth $15 million. Under the 2024 exemption of $13.61 million, their estate is partially taxable. However, if the exemption amount reverts, a larger portion of their estate will be subject to taxation. This change necessitates a strategic reevaluation of his estate plan to mitigate the increased tax exposure.

In a different scenario, if another person’s estate, which is valued at $7.4 million, remains unaltered, it would face no federal estate tax liability under the current exemption of $13.61 million. However, post-reversion, an estimated $1 million of their estate could be taxable, based on the estimated revised threshold of $6.4 million, illustrating the immediate need for proactive planning.

In the complex world of estate planning, strategically transferring wealth to minimize estate tax liability is a primary objective for many individuals with substantial assets. With the federal estate tax rate as high as 40%, effective planning is crucial to preserve wealth for future generations.

There are several strategies available to reduce estate tax liabilities through effective wealth transfer. These methods include lifetime gifting, establishing various types of trusts, creating family limited partnerships, engaging in strategic charitable giving, leveraging life insurance policies, transferring appreciating assets, utilizing GRATs, contributing to 529 plans and directly paying educational or medical expenses. Each strategy has its unique benefits and considerations, and should be chosen based on individual financial situations, goals and estate planning needs.

Lifetime gifting

A fundamental strategy is to utilize lifetime gifting. The IRS allows individuals to gift up to $18,000 per recipient per year without incurring gift tax (as of 2024). These gifts don’t count against the lifetime gift tax exemption, which mirrors the estate tax exemption ($13.61 million in 2024). For instance, by gifting the maximum annual exclusion amount to multiple beneficiaries over several years, a substantial amount of wealth can be transferred without any gift or estate tax implications. Larger gifts can also be made, but these will count against the lifetime exemption.

Utilizing trusts

Trusts are versatile tools in estate planning, serving multiple purposes, from asset protection to tax reduction. Irrevocable trusts, in particular, are crucial for estate tax planning. Once assets are transferred into an irrevocable trust, they are no longer considered part of the grantor's estate, hence not subject to estate tax upon their death. For example, a grantor can set up a bypass trust, which benefits the surviving spouse without the assets being included in their estate, thus avoiding estate taxes at the second death.

Family limited partnerships (FLPs)

Family limited partnerships allow for the management and transfer of family assets, including businesses and real estate, with tax efficiency. Parents can transfer assets into an FLP and retain control over them by holding the general partner interest. They can then gift limited partnership interests to their children or grandchildren. The value of these interests is often discounted due to lack of control and marketability, resulting in reduced gift and estate tax liability.

Charitable strategies

Incorporating charitable giving into estate planning can yield significant tax benefits. Charitable remainder trusts (CRTs) and charitable lead trusts (CLTs) are popular options. In a CRT, the grantor receives income for a set period, with the remainder going to a charity, thereby reducing the taxable estate. A CLT works in the opposite direction, where the charity receives income for a period, and the remainder passes to the beneficiaries, often at a reduced tax cost.

Life insurance

Life insurance, often overlooked, can be a strategic tool in estate planning, especially in addressing potential federal estate tax liabilities. As estates grow in value, particularly those including substantial assets like farmland or family businesses, they often face significant estate taxes upon the owner's death. Life insurance can provide the necessary liquidity to pay these taxes without the need to sell off valuable assets, preserving the estate's integrity and ensuring its smooth transition to the next generation.

When an individual passes away, their estate often comprises various illiquid assets, such as farmland or a stake in a family business. These assets can be valuable but not easily converted into cash. If the estate is subject to federal estate tax, the heirs may be forced to sell these assets quickly, often at a lower value, to meet the tax obligations. Life insurance offers a solution by providing immediate liquidity through the death benefit.

The key to maximizing the benefits of life insurance in estate planning is proper structuring. One common method is to establish an irrevocable life insurance trust (ILIT). An ILIT owns the life insurance policy, and upon the policyholder's death, the trust receives the death benefit. Since the ILIT owns the policy, the death benefit is not considered part of the taxable estate, thereby not increasing the estate tax liability.

Gifting appreciating assets

Gifting assets expected to appreciate in value, such as stocks or real estate, can be advantageous. Transferring these assets during the grantor's life moves the future appreciation outside of their estate. The recipient takes on the grantor's basis in the asset, which may have capital gains tax implications if sold, but the key advantage is removing the asset's future growth from the taxable estate.

Grantor retained annuity trusts (GRATs)

GRATs are a sophisticated tool for transferring asset appreciation. The grantor places assets into the GRAT and receives fixed annuity payments for a term. If the grantor survives the term, the remaining assets pass to the beneficiaries, often tax-free. This can be particularly effective for assets expected to appreciate rapidly.

529 college savings plans

Contributions to 529 plans are an excellent way to transfer wealth for educational purposes while reducing estate size. Though contributions are considered gifts, they are eligible for the annual exclusion. Moreover, one can make five years' worth of contributions in a single year without incurring gift tax, making it a strategic choice for grandparents looking to reduce their estate size.

Direct payment of medical and educational expenses

Paying for someone's medical or educational expenses directly, rather than giving them the funds, is another effective wealth transfer method. These payments do not count toward the annual gift exclusion and can be made in addition to other gifting strategies.

In summary, effectively reducing estate tax liability requires a blend of foresight, knowledge and strategic implementation of various tools like lifetime gifting, trusts, FLPs, charitable strategies, life insurance and more. Each strategy comes with its nuances and must be tailored to individual circumstances. Professional advice is crucial in navigating the complex landscape of estate taxes to ensure that one’s legacy is preserved and passed on according to their wishes.

Portability, which allows a surviving spouse to use any unused federal estate and gift tax exemption of their deceased spouse, is not directly impacted by the sunset provision. However, the potential reduced exemption amount post-2025 would consequently lower the total amount available for portability.

Estate plan portability is a relatively recent addition to estate planning in the United States, introduced with the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. It’s a concept that allows married couples to more efficiently utilize their federal estate and gift tax exemptions.

Portability has become an essential tool in estate planning, particularly for couples seeking to maximize their exemptions and reduce their tax burdens. However, it should not be the sole strategy. Couples should consider other tools like trusts, especially for issues like asset protection and state tax liabilities.

The potential for upcoming changes to the estate tax exemption threshold are of significant importance for individuals and families engaged in estate planning and wealth transfer. The Tax Cuts and Jobs Act of 2017 substantially increased the federal estate tax exemption, but this is set to revert to its pre-2018 level at the end of 2025. Unless legislative action extends the current exemptions, the amount will drop in 2026 to an estimated $6.4 million per individual and $12.8 million per couple, adjusted for inflation. This reversion necessitates a proactive approach to estate planning, as many estates that currently fall below the threshold could become taxable.

As potential changes to the exemption amount loom, there is a need for strategic responses. These strategies include lifetime gifting, where individuals can use the annual exclusion and lifetime exemption to transfer wealth without incurring taxes; trusts, particularly irrevocable trusts, which remove assets from the estate; family limited partnerships (FLPs) for managing family assets; charitable strategies involving CRTs and CLTs; life insurance policies structured through ILITs to provide liquidity for paying estate taxes; gifting appreciating assets; using GRATs to transfer asset appreciation; and making contributions to 529 college savings plans. Direct payment of medical and educational expenses also offers a tax-efficient method of wealth transfer.

Portability, allowing a surviving spouse to utilize any unused federal estate and gift tax exemption of their deceased spouse, remains a vital element of estate planning. Although not directly affected by the sunset provision, the reduced exemption amount will lower the total available for portability.

These strategies, coupled with professional guidance, are key to navigating the complexities of the changing estate tax landscape. Staying informed and adaptable to the evolving tax laws will be critical for effective estate planning and preserving legacies.