Studies estimate that over the next fifteen years, society’s aging population will transfer an unprecedented $25 trillion in wealth accumulation to the next generation. The recent spike of the lifetime estate and gift tax exemption amount inflates the opportunities for successful wealth transfer.
While the government has taxed the transfer of assets at death since the late eighteenth century, the modern estate tax has existed in variations of its current format since 1917. Over the past two decades, the lifetime exemption has swelled 900% from $600,000 in 1997 to $5,490,000 ($5,000,000 indexed for inflation) in 2017. Except for inflation indexing, the 2011 $5,000,000 lifetime exemption remained unchanged until the passage of the Tax Cuts and Jobs Act (TCJA) at the end of 2017. The new tax law dramatically altered the wealth transfer environment by temporarily doubling the amount of wealth an individual can give away free of estate and gift tax. The inflation indexed lifetime exemption for 2018 is $11,180,000 but, like many provisions in the TCJA, the increased exemption is scheduled to expire December 31, 2025.
The lifetime exemption figure is automatically adjusted for inflation each year, a change made permanent by the American Taxpayer Relief Act in 2012. Since 2012, applicable inflation has averaged 1.65% annually. Despite the fact the TCJA changes the inflation method from Consumer Price Index to Chained Consumer Price Index which, simplistically stated, is a more modest measure of inflation, the lifetime exemption is expected to rise 1.97% to $11,400,000 in 2019. Assuming, for example, 1.5% average annual applicable inflation until the doubled exemption sunsets, we can expect the exemption to soar to nearly $12,500,000 by 2025. Upon resuming its pre-TCJA level of $5,000,000 in 2026, the inflation adjusted exemption is projected to be approximately $6,500,000.
The increased exemption is a powerful tool to effectuate significant transfer of wealth to future generations, estate and gift tax free. High net worth individuals should not minimize this time-sensitive opportunity to transfer wealth through efficient and effective planning. Adding to the impact of the increased exemption and precipitating further gifting opportunities, the generation-skipping transfer (GST) tax exemption also doubled to mirror the estate and gift tax exemption.
The tax law changes do not exclusively affect high net worth estates. Individuals that no longer have taxable estates would also be wise to review existing estate plans drafted during the era of lower estate exemption levels. Failing to evaluate and, if necessary, modify a plan in light of the current tax laws could cause adverse implications for one’s survivors. For example, a once-effective formula clause directing the allocation of the maximum exemption amount to a credit shelter trust at the first death could now undermine the estate plan. Without a limiting mechanism to sufficiently fund the marital trust as well, the surviving spouse could be financially restricted in the future.
Bear in mind that assets contributed to a bypass trust at the death of the first-spouse-to-die do not receive a basis adjustment at the death of the surviving spouse. Therefore, a more advantageous strategy might include employing a marital deduction plan and utilizing the first-spouse-to-die’s unused estate and gift tax exemption through portability. This strategy can help to maintain the financial flexibility of the surviving spouse and achieve two basis adjustments of the estate’s asset, one at each spouse’s death. Notably, however, the GST tax exemption is not portable so one must purposefully plan the allocation of this exemption. With a wealth of estate planning options available, the most optimal plan is wholly dependent on the circumstances of the individual or family. Ensuring that older estate plans still accomplish the desired objectives can help to prevent unintended consequences.
Future blog posts will contemplate effective uses of the temporarily-increased lifetime exemption.