We have experienced yet another year of financial instability, both here and across the shores, which continues to engender some degree of anxiety among our clients. However, even in these uncertain times, there are year-end planning strategies you can employ to take charge of your family's future.
Take Advantage of Low Interest Rates, Valuation Discounts and the Increased Transfer Tax Exemption Amount
The current Federal estate, gift and generation-skipping transfer tax ("GST") exemption amount is $5,000,000, and will be increased for inflation to $5,120,000 in 2012. However, the legislation under which the exemption amount was increased to that level is set to expire on December 31, 2012 and, unless the law is changed, on January 1, 2013, the estate, gift and GST tax exemption amount will return to its 2001 amount of $1 million, and the tax rate will increase from its present level of 35 percent to the 2001 top rate of 55 percent. Thus, in the existing political and economic climate, it is conceivable that beginning, or even before, 2013, the unified transfer tax exemption amount could be decreased. Therefore, if you are considering making large gifts, you should make them now.
Asset values continue to be depressed, and interest rates remain extraordinarily low. As a result, this is a perfect time to implement wealth transfer strategies that are designed to exploit future appreciation. Several techniques rely on investment returns that outpace the interest rates set by the Internal Revenue Service. You should discuss with us now how intrafamily loans, sales to intentionally defective grantor trusts, grantor retained annuity trusts and charitable lead annuity trusts can enable you to pass assets to next generations at the lowest possible transfer tax cost (please see the June 2008 issue of Personal Planning Strategies, available on our Web site, for more details about those estate planning strategies).
Moreover, there still exists some concern that Congress, with the support of the White House, could pass legislation that effectively would eliminate valuation discounts of closely held interests, such as family limited partnerships. Currently, the appraisals required as evidence of the fair market value of assets involved in intrafamily transactions can take into account minority interest and lack of marketability valuation discounts. Typically, those discounts reduce the asset value by 30 percent. Many transfer tax reform proposals that have emerged over the past few years include provisions that would render those discounts impermissible. If any of those were to be adopted into legislation, the purchase price or gift tax cost of intrafamily transactions would be increased by that 30 percent.
It is uncertain how or when the law will change, but if you have been considering a plan to make major gifts or to give or sell interests in a closely held business or family limited partnership to your family members, this may be the most favorable time to move forward.
Exploit the Gift Tax Annual Exclusion Amount
In 2012, the gift tax annual exclusion amount per donee will remain $13,000 for gifts made by an individual and $26,000 for gifts made by a married couple who agree to "split" their gifts. If you have not already done so, now is the time to take advantage of your remaining 2011 gift tax exclusion amount so that you can ensure that gifts are "completed" before December 31, 2011.
In lieu of cash gifts, consider gifting securities. The assets that you give away now are likely worth significantly less than they once were (due to the continuing economic crisis) and their value hopefully will increase in the future. In other words, there already is a built-in discount, which should inure to the benefit of your beneficiaries when the economy fully recovers.
Your annual exclusion gifts may be made directly to your beneficiaries or to trusts that you establish for their benefit. It is important to note, however, that gifts to most trusts will not qualify for the gift tax annual exclusion unless the beneficiaries have certain limited rights to the gifted assets (commonly known as "Crummey" withdrawal powers). If you have created a trust that contains beneficiary withdrawal powers, it is essential that your Trustees send Crummey letters to the beneficiaries whenever you (or anyone else) makes a trust contribution. For a more detailed explanation of Crummey withdrawal powers, please see the December 2004 issue of Personal Planning Strategies, available on our Web site.
If you have created an insurance trust, remember that any amounts contributed to the trust to pay insurance premiums are considered additions to the trust. As a result, the Trustees should send Crummey letters to the beneficiaries to notify them of their withdrawal rights over these contributions. Without these letters, transfers to the trust will not qualify for the gift tax annual exclusion.
2011 Gift Tax Returns
Gift tax returns for gifts that you made in 2011 are due on April 16, 2012 (since April 15 falls on a Sunday). You can extend the due date to October 15, 2012 on a timely filed request for an automatic extension of time to file your 2011 income tax return, which also extends the time to file your gift tax return. If you created a trust in 2011, you should direct your accountant to elect to have your GST tax exemption either allocated or not allocated, as the case may be, to contributions to that trust. It is critical that you not overlook that step, which must be taken even if your gifts do not exceed the annual gift tax exclusion and would, therefore, not otherwise require the filing of a gift tax return. You should call one of our attorneys if you have any questions about your GST tax exemption allocation.
In addition, if you make a gift to an "inter vivos QTIP trust" for the benefit of a spouse, you must make a "QTIP election" on a timely filed gift tax return. If you "split" gifts with your spouse, both spouses must file a gift tax return and consent to gift splitting and, if you "front loaded" a 529 plan, a special election must be made to treat the gift as being made ratably over five years. If you have any questions on these issues, please give us a call.
Make Sure that You Take Your IRA Required Minimum Distributions by December 31, 2011
If you are the owner of a traditional IRA, you must begin to receive required minimum distributions from your IRA and, subject to narrow exceptions, other retirement plans, by April 1 of the year after you turn 70 ½. You must receive those distributions by December 31 of each year. If you are the current beneficiary of an inherited IRA (a traditional IRA or a Roth IRA), you must take RMDs by December 31 of each year regardless of your age. The RMDs must be calculated separately for each retirement account that you own, and you, not the financial institution at which your account is held, are ultimately responsible for making the correct calculations. The penalty for not withdrawing your RMD by December 31 of each year is an additional 50 percent tax on the amount that should have been withdrawn. Please consult us if you need assistance with your RMDs.
Convert Your Traditional IRA to a Roth IRA
Currently, there is no income restriction that precludes an individual from converting a traditional IRA (which is funded with pre-tax dollars) to a Roth IRA (which is funded with post-tax dollars) (although income restrictions remain in effect for contributions to a Roth IRA). You should consider whether to take advantage of the opportunity to accumulate tax-free income for your descendants in a Roth IRA.
Although income tax will be due on any converted assets, a conversion still may be advantageous, since assets in a Roth IRA grow tax-free and are not subject to required minimum distributions during your lifetime. This allows a Roth IRA to act as a "tax shelter" to hold wealth for your descendants (or other beneficiaries), particularly if you will not need to withdraw income from your Roth IRA during your retirement. More information on the benefits of a conversion to a Roth IRA may be found in the June 2009 issue of Personal Planning Strategies, available on our Web site.
In addition, for conversions that occurred in 2010, Congress provided a special deferral arrangement whereby you could have opted to have one-half of the converted amount taxed in 2011 and the other one-half taxed in 2012. If you did covert a traditional IRA to a Roth IRA in 2010 and deferred the tax, do not neglect to pay the deferred amount in 2012.
Review Your Current Estate Plan
Last year, after having permitted the estate tax lapse for one year, Congress finally did enact legislation that reinstated the Federal estate tax with a unified estate, gift and GST tax exemption amount of $5,000,000 in 2011 (and $5,120,000 in 2012). As noted above, the new legislation is scheduled to expire in 2013, at which point the exemption amount could be reduced drastically. In addition, there exists some fear, albeit doubtful according to our sources, that Congress will take action to reduce the exemption amount earlier than 2013 in order to raise revenue. Given the uncertain future of the transfer tax regime, it is vital to review your wills, revocable trusts and other documents to ensure that they will be successful in achieving your estate planning goals regardless of political whims.
For instance, do your estate planning documents account for the differences between Federal and state laws? If you reside in a state such as New York which imposes a tax based on a significantly lower exemption amount than that afforded under the Federal regime, and you do not have a will that adequately plans for that difference, your estate could unnecessarily owe $229,200 in state estate taxes.
Another consideration is how your existing estate plan utilizes your Federal estate tax exemption amount. For instance, an estate plan drafted in 2002 that bequeaths to your children an amount equal to the Federal exemption amount (which was then only $1,000,000) may no longer make sense if the exemption amount remains as high as $5,000,000.
Even if you are satisfied with the provisions in your current estate planning documents, do you and your spouse each hold individual title to sufficient assets to utilize your $5,000,000 exemption amounts? If not, any plan to pass to your heirs, tax-free, your combined exemption amounts – $10,000,000 under current law – may fall short of your expectations.
The above is true despite the addition to the estate tax legislation of portability between spouses of their exemption amounts. Currently, if the first spouse to die does not fully utilize his or her estate tax exemption amount, the unused amount is portable to the estate of the second spouse to die. However, portability may not survive into 2013. In addition, even if portability remains in place, uncertainties are built into how portability ultimately would be implemented if the surviving spouse remarries after the death of the first spouse. Furthermore, relying on portability rather than setting aside your $5,000,000 exemption amount in advance deprives your beneficiaries of any gains to that $5,000,000 during the time between the first and second spouses' deaths, which gain also escapes estate taxation. Finally, most state estate tax laws do not incorporate provisions for portability of exemption amounts between spouses. Thus, it still remains critical that your assets are owned in a manner that permits full use of the exemption amounts of both spouses.