Planning for estate tax vs. planning for income tax

Traditionally, the federal estate tax was extremely burdensome to wealthier individuals, and the bulk of estate planning involved finding ways to minimize this federal tax. In the last few years, though, the federal estate tax rates and exemption amounts have changed and become much less of a problem.

On the other hand, federal income taxes, capital gains taxes and other investment taxes have gone way up. And many states have increased their income, estate and inheritance taxes.

As a result, these days smart estate planning involves looking at all the different possible taxes that heirs might be facing, and figuring out how best to reduce the overall tax burden.

Here’s one example: Let’s say Linda owns some stock that she bought years ago for $30,000, and it’s now worth $100,000. She thinks it will continue to increase in value, and at some point she wants it to go to Adam.

In the past, it might have made sense for Linda to give the stock to Adam immediately. That’s because any further increase in the stock’s value would belong to Adam, not Linda, and when Linda passed away, her heirs wouldn’t have to pay federal estate tax on it (which could have been as high as 55%).

Today, however, it might make more sense for Linda to leave the stock to Adam in her will. Since federal estate tax rates are lower and the exemption amount is higher, Linda’s estate might not have to pay much (if any) estate tax as a result of keeping the stock.

Plus, if Adam received the stock as a gift and sold it, he’d have to pay capital gains tax on the $70,000 increase in value while it belonged to Linda – at today’s higher capital gains rates. But if he inherited the stock and sold it, his capital gains tax basis would be increased to the stock’s value as of the date Linda died, and he would avoid the tax.

As a further wrinkle, though, depending on the states where Linda and Adam live, there might be state estate taxes and/or state inheritance taxes, which now often kick in at much lower thresholds, and there might also be state income and capital gains taxes to consider. The state tax issues could further complicate the decision.

As you can see, it’s still necessary to do careful tax planning in order to leave as much as possible to your heirs – it’s just that the nature of that tax planning has changed. If you wrote your will years ago when the tax laws were quite different, you might want to review your estate plan now to see if it still makes sense under current conditions.