Estate planning in a post-fiscal cliff world

As closely as many Americans have been monitoring the high-stakes political jousting over federal monetary policy in Washington, D.C., perhaps no one has been paying more rapt attention to Uncle Sam's adventures on the brink of the fiscal cliff than members of the estate planning community.

Now, with the American Taxpayer Relief Act of 2012 having provided clarity in what had been a cloudy tax policy environment, estate planning specialists such as Gail E. Cohen can get back to the business of helping clients. It sure beats watching CSPAN for the latest riveting developments in the fiscal policy debate.

"It's much more difficult to work with [estate planning] clients when you are uncertain as to what the tax landscape will be," says Cohen, vice chairman and general trust counsel at Fiduciary Trust Company International and chair of the New York Bankers Association. "For example, last year we really had no idea what Congress was going to do with the estate tax exemption. People had to make decisions and do things they perhaps might not have done [had there been clarity about the exemption level]. The fact that they have something they're calling permanent, I think, is very reassuring. It feels as though there's been a collective release of breath. People are able to think clearly again."

By permanence, Cohen refers mainly to the $5 million estate tax exclusion amount and the concept of portability, whereby a surviving spouse may use any portion of their deceased spouse's unused estate tax exclusion. Not only did the Taxpayer Relief Act make each of those permanent, it included a provision by which the exclusion amount will be adjusted for inflation each year, beginning with the 2012 tax year.

But as Connie Fontaine, associate professor of taxation at the American College, points out, when it comes to Washington's handling of tax policy, "there is no 'permanent.' It's permanent for now."

Since permanence is fleeting, especially with regard to tax policy, estate planners would be wise to build contingencies and flex points into the strategies they develop for clients, Fontaine and Cohen concur. "It's about drafting plans with as much built-in flexibility as possible, where you run the numbers on two or three different scenarios," says Fontaine.

With so many important tax policy changes already on the books and others potentially looming on the horizon, here's a look at some of the keys to estate planning in 2013 and beyond:

What Congress did: Fixed the federal estate tax exclusion at $5 million, indexed annually to inflation, putting the individual exclusion at $5.12 million for 2012 and $5.25 million for 2013 (double for married couples). Also, Congress permanently unified the federal estate, generation skipping tax (GST) and gift tax exclusion amounts. The lifetime gift tax exclusion applies only to gifts in excess of the annual gift exclusion limit ($14,000 per person for 2013).

Why it matters to estate planners: It's easy to assume that a higher federal estate tax threshold means fewer people in general will need estate planning services. "That's not necessarily the case," advises Cohen. "In fact, more people may need a greater degree of [estate] planning. Because their money is not being eroded by [estate] taxes, now there's more money for your family, so more needs to be protected."

In these situations, trusts will remain a vital—if not more important—estate planning tool, she adds, "to protect against creditors and against divorce situations, and for tax-favored wealth transfer. Someone with a more modest estate could use something like an ILIT (irrevocable life insurance trust) to provide liquidity for [heirs to pay] estate taxes, and to generally enhance the size of the estate."

Whether used inside or outside a trust, life insurance also remains a crucial estate planning tool, says Fontaine. "Maybe now [because of the increased exemption], you can afford more life insurance, so even if it's not in a trust and you end up paying some taxes on [the policy's death benefit], you'll still have more to leave for your family."

What Congress did: Increased the estate tax rate from 35 percent to a permanent 40 percent from 2013 forward, while permanently capping the gift and GST tax rates at 40 percent.

Why it matters to estate planners: Now is a good time for estate planners and their clients to "refresh" the life insurance policies they put in place for wealth transfer purposes to reflect the higher federal estate tax rate and exclusion level, says Thomas F. Scanlon, a certified financial planner and accountant with the firm Borgida & Company in Manchester, Conn.

It's also a good time to look at the broader taxation picture. Amid all the machinations at the federal level, don't overlook state tax policy considerations. "Depending on the state you live, you may have a state estate tax exclusion that's much less than the federal exclusion," observes Scanlon. "That's certainly something you need to address."

State-to-state distinctions in estate tax policy could weigh more heavily in today's tax environment, according to Cohen, with more wealthy people likely to seek ways to counteract the new, higher federal rate. For some, the best solution might be to change residency from a state that has its own separate, distinct estate tax, such as New York or Connecticut, for example, to one like Colorado or Florida, which lack a separate estate tax. "I think we're going to witness a lot of migration over the next several years among people who are facing paying both federal and state [estate] taxes," she says. "For those people, migrating to a state with no estate tax would be very meaningful."

What Congress did: Made permanent estate and gift tax exclusion portability, whereby a surviving spouse can use the unused portion of their deceased spouse's estate or gift tax exclusion, in addition to his or her own exclusion.

Why it matters to estate planners: Like the $5 million individual federal estate tax exemption, the portability provision first implemented in 2010 was widely seen as "too good to be true" and a strong candidate for elimination in the recent fiscal cliff debate. Now that portability not only has survived but been made permanent, estate planners can put it to use it with greater certainty, says Cohen. "We are very seriously thinking about it as a planning tool for very wealthy families. It opens up new possibilities for how you handle bypass trusts and, in that context, gifting strategies."

What Congress did: Extended through December 31, 2013, the provision allowing taxpayers over age 70-and-a-half to make qualified donations to charity from their IRA.

Why it matters to estate planners: The so-called Charitable IRA provision lives for another year thanks to the American Taxpayer Relief Act. As a result, taxpayers over the age of 70-and-a-half may donate up to $100,000 directly to a qualified charity from their IRA. While the donation isn't eligible for a charitable deduction, it does count toward their required minimum distribution and does not count as income. What's more, the assets are removed from the estate. "If you are thinking about giving money to charity," says Scanlon, "this is a good incentive to do so."

For more on estate planning, see:

A post-fiscal cliff guide to estate taxes

Fiscal cliff? What about the retirement cliff?

The road ahead for estate planning