Americans are anxiously looking into the abyss of the fiscal cliff, which looms at the end of the year if lawmakers can't agree to a compromise to extend expiring tax cuts. From the expiring Social Security payroll tax break to the prospect of higher rates on capital gains, dividends, and ordinary income, the fiscal cliff's potential impact on income taxes is what's drawing the lion's share of attention among nervous investors.
But another, much-overlooked aspect of the fiscal cliff could end up imposing far greater taxes on the unlucky few who end up in its path. Despite the popular perception that estate taxes are only for the ultra-rich, scheduled changes in estate-tax laws will greatly broaden the scope of the tax, imposing it on a far larger number of families than have to deal with the tax currently.
What's up (and what's down) with estate and gift taxes
Unlike income tax, estate and gift taxes apply when you transfer property, either through lifetime gifts or through a will or trust after your death. The laws are extremely complicated, but in a nutshell, you're entitled to give unlimited amounts of money to a spouse, but there are limits on gifts or bequests to any other individual, whether related to you or not.
Through the end of this year, that limit, also known as the lifetime exemption for estates and gifts, is $5.12 million. Unless you have more than that amount, then at least for this year, you didn't really have to do much estate planning.
But in 2013, things could change dramatically. Unless current law changes, the lifetime exemption will go down to $1 million. Moreover, the current 35% tax rate on estates will rise to as much as 55%.
A million-dollar exemption may sound like plenty. But such a move would increase the number of estates subject to the tax nearly 15-fold, with an estimated 2% of all those who die in 2013 potentially having to pay a combined $40 billion.
More important, though, is a lower estate-tax exemption that would force many well-off but not super-rich taxpayers into dealing with this extremely complicated area of the law. Ultra-high-net-worth families, by contrast, are already well-versed in the techniques you can use to reduce or eliminate estate and gift tax liability. Consider the many corporate leaders who have taken such steps in recent years:
- As early as 2008, Facebook (NASDAQ:FB) co-founders Mark Zuckerberg and Dustin Moskovitz used a trust-based technique to make tax-free gifts of pre-IPO company stock. Collectively, the potential tax savings amounted to more than $100 million.
- Warren Buffett has made huge gifts of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) stock to the Gates Foundation over the years as part of a charitable pledge. Although Buffett has clear philanthropic intent, the gifts also qualify for charitable exemptions from estate and gift tax, saving his estate billions in taxes.
- George Lucas' sale of Lucasfilm to Disney (NYSE:DIS) for more than $4 billion was seen as an attempt to lock in low capital gains rates before they, too, expire at the end of the year. But the move also netted Lucas a substantial block of Disney stock, which he can use along with the cash he got for a variety of estate-planning techniques.
In the last weeks of 2012, the ultra-wealthy are racing to lock in as much of their exemptions as they can. Moreover, by making gifts now, gift recipients will benefit from future rises in asset values free of gift or estate tax.
In fact, with a technique known as a disclaimer, you can even push the deadline back nine months. With a specially designed gift to a spouse with an option to disclaim and have the gift go to others, the spouse has up to nine months after the gift to disclaim while still having gift treated as having been made in the current year. If rates turn out not to go up after all, the spouse can keep the gift or make a corresponding gift back to the other spouse, and in either event, the transactions will be treated as tax-free since they're between spouses.
Keep your eyes open
Estate planning techniques don't get a lot of attention, but they're a big part of how the wealthy stay that way. If the estate and gift tax exemption drops to $1 million, a lot of folks who've never seen themselves as ultra-rich will need to scurry to figure out all the rules that billionaires have dealt with for decades. If you're one of them, you'd best get moving now before the year ends.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.