Are New Taxes Coming?

It seems like only yesterday that the tax issues were finally settled after years of uncertainty, although it was actually 2012. Judging from the President’s State of the Union address last night, it appears that taxes may be in flux again.

First, a quick and dirty background on the estate tax law as it stands today. For those that pass away in 2015, there is no federal estate tax unless assets exceed $5.43 million for an individual, or $10.86 million for a married couple. The highest tax rate on assets subject to the federal estate tax (states have many, varying rules) is 40 percent.

There is another rule related to capital gains that applies to many taxpayers at the time of death, not just those subject to the estate tax. Outside of certain tax-deferred accounts like IRAs and 401ks, investors must pay capital gains tax on profits realized on the sale of certain assets like stocks and bonds during their lives.

If someone with unrealized capital gains passes away before realizing the gain (by selling the assets), then the “cost basis” for the asset is stepped up to the date of death value, meaning no capital gains would be due if the assets were sold right away after death.

For example, if I bought XYZ stock 10 years ago for $1 and it is now worth $20, I would owe capital gains tax on $19, if I sold the asset. If I died (shudder the thought!) today, there would be no capital gains on a sale at $20 because the cost basis would be stepped up from $1 to $20 at my death. My kids would inherit the XYZ stock, but their cost basis would be $20, based on the price when I died, not the price of $1 that I paid.

The new rule that Obama proposed entails getting rid of the ‘stepped up basis loophole.’ Personally, I had never thought of it as a loophole, but under the proposal, there would no longer be stepped up basis at death. Instead, my death would be treated at a “realization event,” better known as a sale. This means capital gains would be due as a result of my death.

The examples that I’ve heard on the radio haven’t done a good job explaining this proposal in my opinion. In one story, they gave the example of someone who left a $100 million investment with a $1 million cost basis and talked about how the stepped up basis rule as it stands today would cost the government $23.6 million in taxes (the $99 million gain times 23.8 percent in federal long-term capital gains tax).

That may be true, but the government would get $35.6 million in estate tax ($100 million minus the $10.86 million exception at a graduated 40 percent rate). This is a highly negative feature because in a sense, the death triggers a capital gain event – the inheritor can’t sell at a later date and pay the capital gains tax later.

Of course, the amount of tax due will be a bit lower than $59.2 million because the capital gains tax would likely be deductible against the estate tax. Still, it would represent a significant increase in taxes at death.

And actually, that’s not even accurate, because Obama is also proposing that the capital gains tax be increased from 23.8 percent to 28 percent (along with dividends) for high-income earners. The current federal tax is 20 percent with a 3.8 percent surtax, but based on several reports, the new rate would be a total of 28 percent for high income earners.

Separately, Obama is also proposing a cap on the value of tax-deferred accounts like IRA and 401ks. In the last presidential election cycle, Mitt Romney disclosed that his IRA had more than $100 million in assets, a highly uncommon circumstance. Obama would like to cap the value of an IRA at $3.4 million.

It will be interesting to see what kind of legislation can get through a Republican Congress during what amounts to a lame duck session, but regardless of what happens, this is a good reminder that tax laws are always in motion and it makes sense to regularly make sure that your plans are in order.

When done correctly, an estate plan isn’t a ‘one and done’ event, it’s an ongoing process.