United States

Uncertainties in individual income tax and estate planning after TCJA

It's not so much the technicalities...it's the sunset

TAX ALERT  | 

Now, several months since the Tax Cuts and Jobs Act (TCJA) became effective, it’s hard to think of any aspect of an individual’s tax and estate planning that hasn’t been impacted by the new law, though the significance of that impact on any given individual will depend on a constellation of factors. What’s interesting, though, is that unlike some of the business provisions of TCJA such as the section 199A deduction, the uncertainties that can complicate an individual’s planning are less about technical interpretation of given provisions and more about whether the rubric of new rules will actually sunset after 2025.

We will take a practical look at how individuals might get a sense for (1) where and how TCJA may have impacted the way they do their compensation planning, investment planning, retirement planning, charitable giving, debt management, and estate planning and (2) what, if any, adjustments they might consider making in response to TCJA. We will first consider income tax planning and then estate planning, though interestingly enough, TCJA will cause many individuals to reconsider the income tax aspects of their estate plans. More on this later.

Income tax planning / compensation planning

Many individuals understandably believe that if their 2018 taxable income looks pretty much like 2017, then their bottom line tax bill for 2018 will be lower this year than last. Indeed, the reduction in marginal income tax rates is now being reflected in lower withholding from the paycheck. But there is much more to this than meets the eye, because at the end of the day (or, more accurately, at the end of the return), the impact of the changes in deductions, alternative minimum tax and other variables can obviously have meaningful impact on the bottom line tax liability. The point is that individuals should ask their tax advisors to run the numbers in a comprehensive fashion that takes into account all items of income and deduction to get an idea of how much the individual should pay in through withholding or estimates to avoid a penalty.

Moving from prudent tax compliance to planning, individuals have every reason to wonder whether the temporary nature of TCJA, much of which sunsets after 2025, should have any bearing on whether and how to defer income through 401(k) plans and nonqualified deferred compensation plans, the rules for both of which were left intact when all was said and done. Here again, the standard refrain, to run the numbers under varying assumptions about sunsetting, tax rates and investment returns, is probably the right one.

Investment planning

TCJA did not alter the tax rates for interest, dividends and capital gains. And it certainly didn’t repeal the 3.8 percent tax on net investment income. That said, the overall reduction in tax rates more generally might (underscore might) suggest that individuals should recalibrate the ‘break-even’ point at which it makes more sense to be in taxable vs. tax-exempt bonds. Anyway, the continuance of the 3.8 percent tax means that investors have to continue to factor it into their investment asset “location”, meaning how they allocate investments between taxable and tax-deferred accounts. They might even give renewed consideration to insurance vehicles that offer deferral on investment earnings, so long as they are satisfied that the policy is well chosen and efficiently constructed.

Asset location remains a worthy topic for all individuals, but one that is especially relevant for individuals who are on the cusp of retirement and could be in meaningfully lower brackets once the paychecks stop.

Of course, individuals will want to understand how these federal changes impact their state tax position and how that, in turn, might affect how they invest in fixed income.

Brilliant deductions

The doubling of the standard deduction and the $10,000 cap on deduction of state and local taxes obviously means that many individuals will no longer itemize deductions after 2017. For many, these changes represent a welcome ‘paperwork reduction act’. But for many others, these changes usher in a new era of complexity. Just by way of example, individuals who now won’t be able to deduct the taxes on their second (or third) homes might consider migrating the ownership of those homes to trusts designed and funded in such a way as to create a separate taxpayer that will be able to use the deduction more effectively than the individual/grantor. It remains to be seen how individuals will weigh the benefits of such creative techniques against their costs and complexity.

Consider the area of charitable contributions. TCJA preserved the deduction for charitable contributions, even enhancing the deduction limits for those who give only cash contributions. But many individuals who will itemize in some years and not in others will have to plot out their anticipated giving to see if it makes sense to ‘bunch’ their contributions in a year when they will itemize. Some individuals might want to take a fresh look at a donor advised fund as a vehicle for bunching the charitable deduction and then ‘warehousing’ the accumulated fund for future grants.

Changes to the home mortgage interest deduction rules (now limited to interest on $750,000 of acquisition indebtedness incurred on newly purchased principal and second residences after Dec. 15, 2017), and curtailment of the home equity loan interest deduction for purposes other than acquisition indebtedness, could certainly cause individuals to rethink their plans. Of course, homeowners who have mortgages might want to recalculate the savings from accelerating their mortgage payments.

Estate planning

The estate, gift and generation-skipping transfer (GST) tax exemptions are approximately doubled to $11.18 million, effective January 2018. The exemption will be indexed. The estate, gift and GST tax rates remain at 40 percent. But all that is until 2026, when we will go back to what to landscape as we know it in 2017, albeit indexed. While not an actual provision of TCJA, the rules for stepped-up basis for inherited assets remain in place, which is why the income tax aspects of estate planning remain important to consider.

Clearly, doubling of the exemptions (and indexing thereafter) effectively repeals the estate tax for many individuals for whom it hadn’t already been repealed. Consider that as of 2018, a married couple will be able to leave their children $22.36 million and the children will get a stepped-up basis in any assets they inherit other than items classified as income in respect of a decedent. If one indexes that $22.36 million for maybe 2.5 percent inflation for say 20 years, you have approximately $35 million to leave your heirs and a stepped-up basis. Now, of course, potential sunsetting puts a big asterisk on the projection.

Estate planning amid the uncertainty

Married individuals who have a marital ‘A’/credit shelter ‘B’ trust arrangement should review their plans with their advisors now. With an $11.18 million exemption, spouses who have those A/B trust set-ups are going to be shocked. Shocked to learn how much goes into the ‘B’ trust and not into the spouse’s hands, or at least into a trust that gives him or her much freer access to the funds. Individuals should not be lulled into thinking that, because they don’t have ‘that much money’ they don’t need to take a quick look under the hood and see how the plan works. There may be many surviving spouses separated from their own money by a formula clause in a trust they didn’t understand.  

For certain, the greatest uncertainty will be shared by those who will not have taxable estates through 2025 but will if the rules sunset. Individuals in this part of the demographic could quite reasonably take a wait-and-see attitude about further wealth transfer planning. After all, they might be much more concerned about the impact of an approaching bear market on their finances than an approaching sunset on their children’s finances. Still, if they are curious about techniques that might enable them to take advantage of the higher exemptions but not give away the store to their financial futures, they can investigate spousal lifetime access trusts or other vehicles that can address their concerns as individuals and parents first and taxpayers second.

Of course, the expanded gift tax exemption creates opportunities for new, gift-tax-efficient wealth transfer, or for remedying problems with existing planning, such as with ‘underfunded’ irrevocable life insurance trusts or those terminally ill split-dollar plans with their ILITs that many have held off doing because of the gift tax consequences upon termination.

Perhaps the most interesting aspect of this part of the discussion is about income tax planning or, more particularly, planning for a stepped-up basis. Here, individuals might find it’s worth exploring such ideas as:

  • Gifting to parents with unused gift/estate exclusion to obtain step-up in basis on those assets at parents’ deaths,
  • Exercising ‘swap’ powers in their irrevocable defective grantor trusts to bring low basis assets back into the estate,
  • Reviewing the income tax basis trade-offs between using those ‘B’ trusts and portability, which can obviate some of the need for the ‘B’ trust in the first place but preserve a stepped up basis for assets in the surviving spouse’s estate, and  
  • Adding powers of appointment that will cause estate inclusion (and get a stepped-up basis for the included property).

Finally, planning for estate tax liquidity with life insurance will need to be more nuanced than ever, as the rising exemptions and (at least scheduled) sunsetting call for careful coordination of types of policies and how they are funded. Otherwise, individuals could be paying for more coverage than they need and for longer than they need it.

In summary, and at least with respect to many aspects of an individual’s planning, TCJA creates less uncertainty of technical interpretation than it does for its staying power. Still, there are any number of things that individuals should check into in order to be satisfied that they are taking what this new tax law gives them. 

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