The fiscal cliff has been averted—at least temporarily. The news has focused mainly on the effect of the tax deal on the housing market, that despite the deal your taxes are going up in 2013 anyway, and what the fiscal-cliff aversion means for the alternative minimum tax.
But what does the new tax law mean for estate tax?
What it means is that the 'free pass' remains at $5 million per person. Deborah L. Jacobs reports that, "Mostly what Congress did in this arena was to make permanent the system that has been in effect for the past two years." In other words, without congressional action the $5 million estate tax exclusion would have dropped precipitously from $5 million to $1 million per person, and the estate tax rate would have ballooned from 35% to 55%.
Instead, Congress voted to make last year’s $5 million exemption permanent and to raise the estate tax rate to "only" 40%.
How does this affect you?
First, nothing is permanent. While we now have much more certainty into the foreseeable future about the estate tax burden, if the economy stays on course for a recession—which very well could be the case since the real problem, how to reduce the deficit, was not solved by the deal—then everything is on the table for discussion.
CNN reports that the non-partisan Congressional Budget Office estimates that "the fiscal cliff deal approved by Congress will increase deficits over the next decade by close to $4 trillion, according to the Congressional Budget Office." If the growing national debt is not addressed, estate tax is no safer than the cherished mortgage interest deduction or the adoption credit.
Second, for young or growing families, their largest asset tends to be their life insurance policy. The death benefits paid on a life insurance policy are includable in your gross estate for estate tax purposes. For example, if you own $100,000 in assets and have a $1 million life insurance policy, your gross estate subject to estate tax is $1.1 million. This is well under the $5 million mark and theoretically you don't have anything to worry about.
But from a practical standpoint, if the next few years wreak the economic havoc that some predict, then Congress may very well reduce the 'free pass' to $1 million per person or even lower. All of a sudden, a family with a sizable life insurance policy could see the death benefits decimated by estate tax.
With an Irrevocable Life Insurance Trust (sometimes called an 'ILIT'), you can remove death benefits from your gross estate (so in our example above, your gross estate would be only $100,000 versus $1.1 million), but the sticking point is that if you have a currently existing policy you want to move into an ILIT to avoid estate tax on the policy, there is a three-year clock. If you pass away within three years of transferring the policy from your name to the name of your ILIT, the IRS ignores this special trust as if it never existed. It’s critical to get past the three-year mark.
On the other hand, if at the inception of a policy it is initially owned by your ILIT, there is no three-year clock.
The lesson from the fiscal cliff mess is that nothing is truly permanent. Estate tax has always been a moving target and promises to continue to be. If you have a life insurance policy, the only real harm with an ILIT is the simple record keeping each year as you pay the annual premium. With the help of an estate planning attorney, you can set up an ILIT and a variety of other estate tax saving trusts, depending on your needs and desires.