Planning for the Upcoming Estate Tax Exemption Reduction

The federal estate tax is a tax on the transfer of a person’s assets to heirs after death. A specific amount, the estate tax exemption, can be transferred tax-free, but this amount is not fixed. A scheduled reduction to the exemption will occur on January 1, 2026, creating a window for individuals to review their financial plans and understand how their assets will be passed to the next generation.

The Upcoming Exemption Reduction

The scheduled decrease in the federal estate tax exemption stems from the Tax Cuts and Jobs Act (TCJA) of 2017. This legislation doubled the base exemption to $10 million, which is then adjusted for inflation. A “sunset provision” in the TCJA will take effect on January 1, 2026, causing the exemption to revert to its pre-TCJA level.

While the exact figure will depend on inflation adjustments, it is projected to be approximately $7 million per individual. This reduction means estates that are not taxable today could face a considerable tax liability if death occurs in 2026 or later, as the federal estate tax rate on the amount exceeding the exemption is a flat 40 percent.

To illustrate, consider an individual with a taxable estate valued at $12 million. Under the current exemption, no federal estate tax would be due. If this individual passes away after the exemption reverts to a projected $7 million, their estate would have a taxable portion of $5 million, resulting in a federal estate tax of $2 million.

The Unified Credit and Anti-Clawback Rule

The federal gift and estate tax systems are linked through a unified credit, meaning the exemption amount can be used for large gifts made during a person’s lifetime or applied to the estate after death. Taxable gifts made during life reduce the amount of exemption available to the estate.

The temporary increase in the exemption created concern about a “clawback,” where estates could be penalized if large, tax-free gifts were made before 2026 and the exemption was lower at the time of death. The Internal Revenue Service (IRS) issued an “anti-clawback” rule in response. This rule clarifies that an estate will get the benefit of the higher exemption amount used for lifetime gifts. The estate’s tax credit is calculated using the greater of the exemption amount at the time the gifts were made or the exemption amount at the date of death, ensuring these transfers are not retroactively taxed.

Key Information for Planning

The first step in planning is to determine the potential value of your taxable estate. This involves a detailed inventory of everything you own or have a legal interest in. The IRS requires that assets be valued at their fair market value, which is the price they would sell for on the open market, not their original purchase price.

Your asset inventory should include all major holdings such as:

• Real estate, including your primary residence and any other properties
• Financial accounts, such as bank, brokerage, and investment accounts
• Retirement funds like 401(k)s and IRAs
• Business interests
• Valuable personal property like art or collectibles
• Death benefits from life insurance policies you own

Once you have a total value for your assets, subtract your liabilities to arrive at a net value. Common liabilities include mortgages on real estate, car loans, student loans, credit card debt, and any other outstanding personal or business loans. Having accurate, up-to-date documents for all assets and liabilities is necessary for an accurate calculation.

Strategies to Maximize the Current Exemption

For those whose potential estate value exceeds the projected 2026 exemption, several strategies can be used to take advantage of the current, higher exemption. Making outright gifts of assets to heirs permanently removes the assets, and any future appreciation on them, from the donor’s taxable estate. Utilizing the high lifetime gift tax exemption now can secure a significant tax-free transfer of wealth.

A Spousal Lifetime Access Trust (SLAT) is another strategy. This involves one spouse making a gift into an irrevocable trust for the benefit of the other spouse. This removes the assets from the grantor’s estate, but the beneficiary spouse can still receive distributions from the trust, providing indirect access to the funds if needed.

An Irrevocable Life Insurance Trust (ILIT) is a common tool. Life insurance death benefits are often included in a person’s taxable estate. By transferring ownership of a life insurance policy to an ILIT, or having the trust purchase the policy directly, the proceeds are removed from the taxable estate upon death. This ensures the full death benefit passes to beneficiaries free of estate tax.