Sep 08, 2021

Death and Taxes: Preparing for the Changes to the Estate Tax

Near the end of his life in November 1789, Benjamin Franklin wrote a letter to French scientist Jean-Baptiste Le Roy that contained one of his most famous proverbs: “Nothing is certain except death and taxes.”  Over 230 years later, Franklin’s infamous quote remains true.  Modern science has yet to deliver a way to escape death, and paying taxes remains a ubiquitous part of life.

Unfortunately, the threat of paying taxes does not end even after you pass away.  Although you paid taxes throughout your life, in certain situations, your estate may still owe state and federal taxes if you do not develop and implement an estate plan with your Financial Advisor and attorney.

In simplest terms, the estate tax is a “tax on your right to transfer property at your death.” And it’s not new. The taxation of property transfers at death existed for ancient Egyptians in 700 B.C., for Romans under the reign of Emperor Caesar Augustus and even across feudal Europe.[1]  In the United States, the estate tax has historically been a temporary tax to raise revenue in response to wars. Temporary estate and inheritance taxes were passed by Congress during both the Civil War and Spanish-American War.  In 1916, the outbreak of WWI and the economic anxiety associated with the Industrial Revolution motivated Congress to enact the estate tax in its most modern and permanent form.

Over the next century, Congress continuously modified the estate tax, changing the exemptions, tax rates, and marital deductions.   Most recently, Congress passed the Tax Cuts and Jobs Act in 2017, the largest overhaul of the tax code in decades.  The law increased the estate tax exemption for single filers to $11.7 million ($23.4 million for married couples) from $5.49 million.  The taxable estate (anything beyond the $11.7 million exemption) is taxed at a flat rate of 40% of the amount $1 million over the exemption threshold.  This increase in the exemption is temporary; without Congressional action, the exemption will decrease in 2026 to the last rate adjusted for inflation, which will be approximately $6 million per individual.

Since taking office in January 2021, President Biden has proposed several changes to the tax code, including potential modifications to the estate tax.  Members of Congress have discussed changing estate valuations from “step up in basis” to “carryover basis,” taxing unrealized capital gains over $1 million, and taxing capital gains and dividends at ordinary income rates.  But a divided Congress seems unlikely to pass legislation that drastically changes current law. Two modest adjustments, however, may ultimately end up passing by 2022.

1 - Shift the current flat tax rate of 40% to a progressive tax rate

Taxable Estate over Exemption Marginal Estate Tax Rate
 First $6.5 million  45%
 Next $40 million  50%
 Next $50 million  55%
 Everything over $50 million  65%

Chart by Robert W. Baird & Co. Inc.

2 - Lower the exemption threshold from the current amount of $11.7 million to $3.5 million for single filers

 Current Proposed  (Jan. 1, 2026) Sunset
 Exemption (per individual) $11,700,000  $3,500,000 $6,000,000
 Taxable Estate $1,600,000  $18,000,000  $13,000,000
 Tax Rate  40%  Progressive  40%
 Estate Tax Due $640,000  $8,675,000  $5,200,000

Chart by Robert W. Baird & Co. Inc.

Here is how the proposed legislation would affect the amount of estate tax due for a married couple with an estate of $25 million.  Under the current law, a married couple with an estate of $25 million would each utilize the $11.7 million exemption and wind up with a taxable estate of $1.6 million that owes $640,000 in estate taxes (about 40% of $1.6 million).  Under the proposed legislation, the exemption amount would be lowered to $3.5 million per individual, and a progressive tax rate would increase the estate tax due to $8.675 million.  As the chart above indicates, if Congress does nothing, the current exemption amount will sunset, which would also cause a substantial increase to the amount of estate tax due.

Although the current estate tax only affects approximately 0.1% of the U.S. population, potential changes to the tax rate and exemption amount could impact a much higher percentage of Americans.  Leaving the amount of your heirs’ potential inheritance to the whims of Congress is not a recommended retirement strategy.  Instead, the Financial Advisors of Baird Retirement Management and an experienced attorney can help you proactively develop an estate plan that preserves your heirs’ inheritance and continuously adjusts with the changes to the law.

Benjamin Franklin was right about the inevitability of death and taxes.  But that does not mean that your estate should pay more in taxes because your estate plan was not updated to properly reflect the current law.

This discussion is for informational and educational purposes only. It was obtained from sources believed to be reliable but there is no guarantee as to its accuracy or completeness. The legislation discussed remains a proposal at this writing. It is unknown if or when it might be passed. You should consult with your tax and legal professionals for information specific to your unique situation. Robert W. Baird & Co. Incorporated does not provide tax or legal advice

  [1] Darian B. Jacobson, Brian G. Raub, and Barry W. Johnson, “The Estate Tax: Ninety Years and Counting.” https://www.irs.gov/pub/irs-soi/ninetyestate.pdf

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