Last Updated on May 25, 2021
In this episode of Adam Talks, IRA Financial’s Adam Bergman Esq. discusses President Biden’s estate tax plan, which eliminates the step-up in basis upon death, and some possible workarounds.
Adam recently talked about the estate tax, as proposed by Senator Bernie Sanders on an episode of Adam Talks. This expands on that show and what the Biden estate tax proposal looks like right now. A major concern is the elimination of the step-up in basis plus the increase in the capital gains rate.
How the Taxes Work Now
If you have assets, such as stocks, real estate or a family business that has grown substantially in value, you don’t pay taxes unless you sell the asset. Under the Biden estate tax plan, the gains on those assets would trigger a tax upon death. Right now, the income tax on those unrealized gains stands at 0%. An estate tax (up to 40%) would be due if one has over $11.7 million in assets upon death during 2021. That exemption is expected to drop to $3.5 million (doubled for couples).
For example, Steve owned assets worth $4 million, including $3 million of long-held stocks that he bought for a total of $1 million. The stocks are held in a taxable account. Under existing law, neither Steve (nor his heirs) would owe federal income tax on the $2 million of stock gains because the “cost basis,” the starting point for measuring taxable gains on assets, is “stepped up” to their value at the date of death, or $3 million. In addition, no estate tax would be owed because Steve’s total assets are below the estate tax exemption.
But if the law changes as proposed, Steve’s final income tax return would show $1 million of taxable gains above his $1 million exemption. In addition to the proposed 39.6% top rate, he could owe a 3.8% surtax on higher earners’ investment income. This could raise her federal bill on the $1 million of gains above the exemption from $0 to as much as $434,000, depending on his other income in the year he dies.
Step-Up in Basis
According to the Wall Street Journal, “the Biden proposal would blow up several longstanding tax concepts: That capital gains deserve a lower tax rate than wages and that people can inherit old assets without paying capital-gains taxes. Under the current tax system, the top capital-gains tax rate is 23.8%, compared with 40.8% on wages, with state taxes on top of both. Congress created the lower rate as an incentive to invest.”
Ever since the Revenue Act of 1921, the step-up in basis has been a powerful estate tax planning tool. Heirs would only pay taxes when they sell an asset, and only owe on the value increases since the original owner’s death. This is separate from the estate tax. The Biden plan would basically treat death as a sale of an asset. Every individual would have only a $1 million lifetime exemption. For example, if you pay $2 million for a business and its worth $12 million when you pass, you would owe no capital gains tax. If that is the only asset, no estate tax would be due. Under Biden’s plan, you would owe taxes on $9 million (the $10 million increase in the value minus the $1 million exemption).
The taxes would probably be due the following year, with some exceptions. If you are under the $1 million exemption, it’s unclear if you will get a step-up in basis like today without paying tax and be subject to today’s capital gains, or get no step up basis and gains will be subject to tax on sale.
What Can You Do?
One estate planning strategy to consider is “SLAT” or Spousal Lifetime Access Trust. A SLAT is “an irrevocable trust that one spouse establishes for the benefit of the other spouse. If properly structured, the assets in a SLAT are not taxable in either spouse’s estate and are not available to either spouse’s creditors.”
This is a great strategy for anyone with a business or appreciated assets who wants to take advantage of the $11.7 million taxpayer exemption in 2021. One can shield up to $23.4 mill in appreciated assets and get it out of your estate for tax and capital gain purposes at death. I have spoken to many friends and clients that are currently looking at SLATs and suggest you consider it if you are in a position to take advantage of its benefits. I would speak with a good estate planning attorney ASAP!
What About Retirement Funds?
The Biden estate tax proposal would not impose a new tax on them, because retirement-account withdrawals and conversions to Roth accounts are considered ordinary income, not capital gains. In fact, the step-up limit could make retirement accounts relatively more attractive by curtailing a major advantage of taxable accounts, which is no tax on gains at death.
Retirement investments would still be subject to estate tax, but no step-up in basis capital gains tax at death. Retirement funds will become the most tax favored investment assets. Americans will be looking for ways to get more of their funds into tax favored retirement funds that would not be subject to any of the increased capital gains tax rates or be subject to a step-up in basis if over the exemption amount.
I personally believe the estate tax and capital gains taxes already amount to a second or third layer of tax on the same income. The rationale to raise tax revenue to pay for the COVID-19 stimulus bills and infrastructure spending is reasonable, but believe the exemption should be closer to $10 million and not $1 million. I am worried that the increase capital gains rate will hurt the economy – but will be a boon for the retirement industry. Taxing unrealized gains at death while still levying the estate tax further compounds the total tax burden on saving and investment, which may be the highest tax burden on capital gains seen in nearly a century.