Estate Planning is More Complex if You Live in Oregon and Have a Large Retirement Plan
For many people, the largest asset in their estate is their 401K, retirement plan or IRA. With recent changes to Federal Estate Tax Law increasing the exemption in 2014 to $5,340,000 per person, indexed for inflation, and making this new exemption “portable” between spouses, planning your estate if your primary asset is a Qualified Retirement Plan is much simpler than in the past. While Oregon still maintains a $1,000,000 exemption before taxing estates, the change in federal law provides options for both estate tax and income tax savings.
CHANGES IN ESTATE TAX
The federal estate tax exemption increased in 2014 to $5,340,000. This is purported to be a permanent change. The exemption is indexed for inflation, so it increases each year. This exemption is per person.
The new law now makes the exemption “portable” between husband and wife, meaning that if the first spouse to die does not use all of his or her exemption, then the exemption can be transferred to the surviving spouse.
In addition, under current law, the maximum federal estate tax rate is 40%.
For higher income individuals there is now a 3.8% surtax on net investment income. The highest marginal tax rate on individuals is 39.6% on ordinary income, and 20% capital gains tax. Individuals can give up to $14,000 per donee that is also exempt from Gift Tax.
HOW THE NEW LAW AFFECTS ESTATE PLANNING FOR MARRIED COUPLES
If a couple has a very large retirement account the new law not only simplifies planning, but provides a means to drastically reduce estate and income taxes. Prior to the passage of the new law a couple with largely retirement plans as their major asset had the option to leave the retirement benefits to their surviving spouse who could then make a spousal rollover to another IRA account in order to obtain income tax benefits. The surviving spouse would be able to gain the income tax benefits because she or he would not be required to take minimum distributions from the account until the deceased spouse would have been 70 and a half years old, and the surviving spouse can stretch the period for determining what has to be withdrawn over his or her life expectancy if they are younger than the deceased spouse.
Because there was no “portability” of the deceased spouse’s federal exemption, couples often had to leave retirement benefits to a “Credit Shelter Trust” to save estate taxes through the applicable federal or state exemption, but the surviving spouse was then subject to income taxes due to the loss of the spousal rollover.
THE NEW LAW ELIMINATES PROBLEMS WITH PLANNING FOR RETIREMENT BENEFITS
Under the new law, if a couple’s combined assets are under $5,340,000 in 2014, they are not subject to federal estate taxes. For a couple whose combined assets are greater than $5,340,000 and have a substantial amount of their estate in retirements plans, the first spouse to die can now leave his or her retirement benefits to the surviving spouse, and leave his or her unused federal estate tax exemption (“DSUE”) to the surviving spouse so at the time of their death they will have a double exemption to prevent taxes on all inherited assets and the assets will be exempt from federal estate tax. In Oregon, this choice is more complicated because the Oregon inheritance tax exemption is on $1,000,000 and is not indexed for inflation. Further, the Oregon exemption is not “portable.”
A couple can have $10,680,000 in assets and still avoid federal estate tax on the first and second death if their primary asset is retirement benefits. Assuming the husband dies first, he can leave a $10,680,000 retirement account outright to his wife. After death, the husband’s executor can make an election to port or transfer the husband’s DSUE to his surviving wife. When the retirement account is transferred to the wife she can do a spousal rollover of the account and gain income tax savings by spreading the receipt of income over an extended period of time. When the surviving wife dies, if she has an IRA or Qualified Plan in excess of her federal exemption amount, she can use her husband’s DSUE if it was ported to her to increase the federal estate tax exemption. Thus, IRA accounts can now be transferred to the surviving spouse directly without setting up complicated trusts as in the past in most states. However, because Oregon has a state estate tax which starts at a lower amount of assets; trust planning may still be necessary.
THERE ARE REASONS A COUPLE MIGHT STILL WANT TO USE A TRUST FOR RETIREMENT BENEFITS
One of the biggest reasons for continuing to use Trust planning is the fact that the Oregon estate tax exemption is $1,000,000, and transferring the IRA account on the second spouse’s death could trigger Oregon Inheritance Tax. Other reasons for using a trust is to preserve assets for the couple’s existing children, in case the surviving spouse remarries and favors the children of the second marriage over the children of the first marriage. If the account owner is concerned with controlling IRA distributions rather than adverse income tax consequences. Some couples have concerns about vulnerability to creditors which can be protected through the use of trusts. Finally, a couple may need to use a bypass trust and fund it with IRA assets when other assets are insufficient to take advantage of the Oregon estate tax exemption.
If the estate is not primarily retirement benefits, then tax wise the choice between use of trusts and leaving assets outright to the spouse, while depending on the facts of each case, is usually neutral. Under the new tax law, in a decoupled state like Oregon that has its own tax exemption level, the new planning model requires that each asset be analyzed for basis, income generated, and potential for appreciation to determine the income tax and estate tax potential liability before a plan can be recommended that is in the best interest of the couple.
The ability to leave a retirement account to the surviving spouse, and also preserve the unused federal estate tax exemption under “portability” in a decoupled state like Oregon with its own estate tax and lower exemption level than the federal estate tax, provides a challenge to planning for qualified retirement accounts, but also opens the door of opportunity for simpler and effective estate plan. The new law is especially useful for couples who do not otherwise have sufficient other assets to fully fund a Bypass Trust.
There are many complications to handling retirement accounts and careful attention has be given to the terms of the retirement plan, the exact language of the beneficiary designation of the plan, and the drafting of estate planning documents. While there are multiple estate planning options, some qualified retirement plans simple do not provide for distribution patterns that will reduce taxes for the account holder’s beneficiary.
Even though the rules are now simpler, it is still very complicated and loaded with traps that can result in additional taxes. If you have a large amount in retirement plans and your estate is potentially subject to paying either federal or Oregon estate taxes, a consultation with an estate planning attorney can save you and your family members taxes and other expenses in the long run.