‘Step up’ to estate tax savings under this rule

With the current estate tax exemption as high as it is, how necessary is estate planning?

For many physicians, proactive estate planning may feel less relevant than it was in the past. The American Taxpayer Relief Act of 2012 (ATRA) provides relatively generous estate tax rates, limits, and rules for estates.

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Specifically, the ATRA reduced the top marginal federal estate tax rate from 55% to 40%, increased the federal estate tax exemption from $1 million to $5 million (adjusted annually for inflation), and made portability of the estate tax exemption permanent. The federal estate tax exemption is $5.43 million for 2015, and it will go even higher in future years if it continues to be indexed to inflation.

In most cases, estate planning for federal tax purposes now focuses on increasing the tax basis of transferred assets, reducing capital gains on asset sales, and taking advantage of capital losses while you're still alive.

If you continue to own appreciated capital assets (such as stocks, mutual fund shares, real estate, and collectibles) until you or your spouse dies, the tax consequence could be greatly reduced, or maybe even completely eliminated, when the assets are eventually sold. This taxpayer-friendly outcome is courtesy of Section 1014(a) of the Internal Revenue Code, which generally allows an unlimited federal income tax basis step-up for appreciated capital assets owned by a person who passes away.

NEXT: How rule works for appreciated capital assets

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Under this rule, the income tax basis of appreciated capital assets, including personal residences, are stepped up to fair market value (FMV) as of the date of death (or the alternate valuation date 6 months later, if applicable). When the value of an asset eligible for this favorable rule stays about the same between the date of death and the date of sale by the decedent's heirs, there will be little or no taxable gain to report to the IRS. That's because the sales proceeds will be fully offset (or nearly so) by the stepped-up basis.

If you are married and your spouse predeceases you, the basis of the portion of the home owned by your spouse, typically 50%, gets stepped up to FMV. This usually removes half of the appreciation that has occurred over the years from the federal income tax return. If you then continue to own the home until you pass away, the basis in the part you own at that point, which will usually be 100%, gets stepped up to FMV as of the date of your death (or 6 months later, if applicable). So your heirs can subsequently sell the property and owe little or no federal tax on the sale.

While hanging onto appreciated capital assets can be a tax-smart strategy, the opposite is true for depreciated capital assets (those with current FMV below cost). If these assets are sold, capital losses are triggered. They can be used to shelter capital gains from selling appreciated assets. However, if a depreciated capital asset is held until death, the tax basis will be reduced to the lower current FMV. So if the asset is then sold by the estate or an heir, there won't be any tax-saving capital loss.

Individuals should also consider giving appreciated capital assets (such as stock and mutual fund shares) to IRS-approved charities. The tax-saving advantage is that you can generally claim an itemized charitable donation deduction equal to the current FMV of the appreciated asset while also avoiding any capital gains tax on the appreciation.

Estate planning is a continuous process that should be reviewed on a regular basis to ensure you're atop the latest trends. Be sure to meet with your estate planner to make certain your current plan is still effective for your own personal situation.

NEXT: Changing beneficiaries on account and insurance policies

I updated my will and trust. Do I still have to change the beneficiaries on my account and insurance policies?

Don't depend on your will or living trust document to override outdated beneficiary designations. As a general rule, whoever is named on the most recent beneficiary form will get the money automatically if you die, regardless of what your will or living trust papers might say.

Naming a primary beneficiary may not necessarily suffice. You should also name one or more secondary (contingent) beneficiaries to inherit your money in case the primary beneficiary dies before you do.

Beyond just ensuring that your money goes where you want it to, another advantage of designating individual beneficiaries is that it can avoid probate, because the money goes directly to the named beneficiaries by "operation of law." In contrast, if you name your estate as your beneficiary and then depend on your will to parcel out assets to intended heirs, your estate must go through the potentially time-consuming and expensive process of court-supervised probate.

More Joel M. Blau, CFP, and Ronald J. Paprocki, JD, CFP, CHBC

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