The American Taxpayer Relief Act of 2012 includes significant changes to income tax rates, the estate tax exemption, and estate tax rates.  These changes come coupled with the new Medicare tax of 3.8% for net investment income in excess of certain thresholds that kicked in effective for the 2013 year creates a dramatic change in the world of estate planning.

The estate tax exemption is now set at five million dollars indexed for inflation ($5,250,000 for 2013) and the estate tax rate is set at a flat 40%.  These numbers were “made permanent”.  The estate tax law also includes now what is referred to as “portability” which allows the spouse of a deceased person to use the unused estate tax exemption or unified credit of the first spouse.

Historically, because of the high estate tax rates and the low unified credit, the focus in estate planning had been on estate tax savings.  Now with the new estate and income tax laws, which puts the income tax rate as high as 39.6% and the increase in the capital gain and qualified dividend rate from 15% to 20%, along with the additional Medicare tax of 3.8%, causes a shift from focusing on estate tax planning to income tax planning.

In the past, traditional estate plans typically used a “credit shelter trust” or “bypass trust” to utilize the estate tax exemption of the first spouse.  Assets in such a trust would be available for the use of the surviving spouse but would not be included in his or her estate for estate tax purposes at the death of the second spouse.  These trusts were necessary to avoid wasting the estate tax exemption of the first spouse.  The assets in these trusts would receive a “step up in basis” on the death of the first spouse but they wouldn’t receive it upon the death of the second.  That is simply because the assets would not be included in the estate of the second spouse to die.  This trade off was beneficial because the capital gains rate was 15% and the estate tax rate was as high as 55%.  This is no longer the case.  Furthermore, with portability, these trusts are no longer necessary in many cases.

The ideal approach now is to use a plan which allows the surviving spouse to make a decision at the death of the first spouse on whether to utilize the estate tax exemption at that time, or to save it and receive a second step up in basis upon the second to die.

Because income tax planning is now more important than estate tax planning in many cases, the traditional estate plan should be reviewed and revised to incorporate flexibility.  We are happy to work with anyone in reviewing their estate plan and revising same as is necessary.