2015 Changes to Income, Capital Gains, and Gift and Estate Tax Laws

I ncome Taxes: The top income tax rate for individuals with an "adjusted gross income" of making more than $406,751, or married couples filing joint returns with adjusted gross income of making more than $457,601 is 39.6%. In addition to that, there is a 3.8% medicare surtax on net investment income for higher income individuals that is a new tax on investment income earned in 2013 or later. The tax is part of the Affordable Care Act or "Obamacare" and will apply to net investment income. A single taxpayer with modified adjusted gross income of $200,000 and couples filing jointly with modified adjusted gross income of $250,000 will be subject to this tax. For a more detailed explanation of how this tax is assessed, see the Article titled "The 2015 Medicare Surtax".

Capital Gains Taxes: Short term capital gains, from the sale of property owned one year or less, are taxed as ordinary income. There are different tax rates for long term capital gains from the sale of property owned more than one year. The rate depends on your marginal tax rate. For individuals or couples with a marginal tax bracket of 10% or 15%, the long-term capital gains tax rate is 0%. For individuals or couples with a marginal tax bracket of 25%, 28%, 33%, or 35%, the long-term capital gains tax rate is 15%. For individuals or couples with a marginal tax bracket of 39.6%, the long-term capital gains tax rate is 20%.

Payroll Taxes. The "payroll tax holiday" has been over for a year now. You have already seen the change in your paycheck in 2013. The social security tax in 2011 and 2012 was 4.2% - in 2013 it returned to the usual rate of 6.2%. The medicare tax remains the same for lower income employees - it is 1.45%. There is a .9% surtax for higher salaried employees. The total payroll taxes (social security and medicare) for lower income individuals is 7.65%. For higher income employees, the payroll tax (social security and medicare) is now 8.55%. Only the employee pays the 0.9% medicare surtax. The employer does not pay the medicare surtax.

R etirement Plan Contributions. There are no changes in 2014. The maximum yearly amount that can be contributed to a 401(k), 403(b), and most 457 plans by an employee is still $17,500. Employees over the age of 50 are allowed to contribute an additional $5,500. The maximum contributions to traditional and Roth IRA's are $5,500. Individuals over the age of 50 are allowed to contribute an additional $1,000. There are phase-out rules for deductions for IRA contributions for higher income individuals and phase-out rules for Roth IRA contributions. Check with your accountant before making a contribution to your traditional or Roth IRA.

Estate and Gift Tax Laws. I'll start with the basics, which have not changed. All assets passing from one spouse to another are exempt from federal and Massachusetts estate taxes, due to the unlimited marital estate tax deduction. Estate taxes may be due from the estate of the surviving spouse, or a single or divorced individual, if the value of the assets included in his or her taxable estate exceeds a certain amount. If you are a Massachusetts resident and are unmarried, widowed, or divorced, no estate taxes will be due from your estate if the total value of the assets included in your taxable estate is $1,000,000 or less. If your taxable estate exceeds $1,000,000, your entire estate is taxed. An estate with assets valued at $999,999 will owe no Massachusetts estate taxes. An Massachusetts estate with assets valued at $1,000,001 will owe $33,200 to the Commonwealth. With proper planning, a married couple can shelter up to $2,000,000 from Massachusetts estate taxes. They can establish and fund two Revocable or Irrevocable Trusts and allocate their assets between the Trusts so that each has a separate taxable estate of $1,000,000. If you are a Massachusetts resident and own real estate in another State, you may owe estate taxes to that State as well as Massachusetts, depending on that State's estate tax laws. Maine, Vermont, Connecticut and Rhode Island and nine other States have an estate or inheritance tax. Connecticut also has a gift tax. New Hampshire, Florida and thirty-four other States have no estate or inheritance tax. Federal gift and estate taxes are not a concern to most people. In 2015, the federal estate and gift tax exemption increased to $5,430,000 per person. New portability provisions allow a married couple to shelter up to $10,860,000 from federal estate and gift taxes with minimal planning.

Before you stop reading because you think that you don't have an estate of $1,000,000, read this paragraph. Your gross taxable includes some items that are surprising, including:

  • the death benefits payable under all life insurance policies or accidental death policies, whether the policy is owned by you or provided to you as an employee benefit
  • the funds in all joint bank and investment accounts (unless a surviving owner can prove with convincing written proof that he or she has contributed some, or all, of the funds to the account)
  • the funds in all types of annuities, IRA accounts, 401(k) and 403(b) plans, profit sharing plans, and other types of tax-deferred retirement plans and accounts (even these funds will be subject to income taxes when the beneficiaries start making withdrawals from the plans and accounts)
  • stock options and other employee benefits with cash value
  • the value of your business, even if you are a sole proprietor
  • your interest in an LLC, partnership, subchapter-S corporation, or other business organization

Federal gift and estate tax laws. I will start with gift taxes because so many of you think that the federal government allows you to gift only $10,000 per person per year. First, the government can't stop you from gifting. Second, the government can tax your gifts, but unless you intend to gift huge amounts of money, don't worry about it. There are two types of gift tax exemptions. The first is the tax-exempt gift, which for many years, was $10,000 per person. But it has been increasing in recent years. The current annual federal "tax-exempt" gift is now $14,000. An individual can gift $14,000 each year to any number of individuals. The gift or gifts do not have to be reported on a federal Gift Tax Return unless the gift to any individual exceeds $14,000 in a calendar year. If you can afford to make gifts and you want to reduce liability for estate taxes, making tax-exempt gifts is an easy way to shift assets from your taxable estate to your children, grandchildren, or any other individual. Massachusetts does not have a gift tax, so gifting is an excellent strategy for a Massachusetts resident.

Example: Sarah, who is a widow living in Massachusetts, has an estate worth $2,000,000. She is 72 years old and has four children and eight grandchildren. Her income is sufficient to pay all of her living expenses. Without planning, her estate will owe about $100,000 in Massachusetts estate taxes after her death. If Sarah starts a yearly gifting program, giving $14,000 to her four children and eight grandchildren, she will be able to shift $168,000 each year from her estate to her children and grandchildren ($14,000 x 12). In about six years, she can reduce her taxable estate to less than $1,000,000 with this gifting program. In twelve years, her entire estate will be shifted to her children and grandchildren. Her children and grandchildren have promised that they will not spend the money that she is gifting to them. They will establish a Trust that will hold the money gifted to them until Sarah passes away. Due to the high trust tax rates, including the new 3.8% medicare surtax, the investment income earned by the Trust will be distributed to Sarah's children and grandchildren. When Sarah dies, each child and grandchild will receive their share of the trust funds. With the Trust in place, Sarah proceeds with her gifting program. She does not have to file a federal Gift Tax Return to report the gifts because they do not exceed $14,000 per person in any calendar year.

Massachusetts does not have a gift tax, so there is no reporting requirement for Massachusetts. If Sarah makes these gifts for the next twelve years, she will have shifted all of her estate to her children and grandchildren. No estate taxes will be due.

The next number will not effect many people - just the 1%. The federal gift and estate tax credit was increased again. In 2014, an individual can leave up to $5,340,000 to family members and friends, free of estate and gift taxes. Portability provisions allow a married couple to shelter up to $10,680,000 from federal estate taxes in 2014. Any estate that exceeds these amounts will owe estate taxes on the excess assets, which will be taxed at a flat rate of 40%. The estate of an individual with assets valued at $6,340,000, will owe estate taxes in the amount of $400,000 (40% of $1,000,000). The Massachusetts estate tax will be $553,520. The estate of a married couple with assets worth $12,680,000 will owe estate taxes in the amount of $800,000 (40% of $2,000,000) after the death of the surviving spouse. The Massachusetts estate tax will be $1,494,800. The federal estate and gift tax credit is known as the "unified credit" because it applies to a combination of lifetime gifts and distributions after death. The entire credit amount can be gifted during an individual's lifetime, in addition to the yearly $14,000 tax-exempt gifts. Any gifts in excess of $14,000 made to an individual in a calendar year must be reported on a federal Gift Tax Return (Form 709). If an individual gifts the entire amount as lifetime gifts, there will be no estate tax credit remaining. Whatever remains in the taxable estate at the time of death will be taxed at the rate of 40%. If an individual uses some of his or her unified credit to make lifetime gifts, the balance of the unified credit will be available to reduce the size of his or her taxable estate.

Example: John, who is divorced, owns a small company, a primary residence, a vacation home, the building where his company is located, investments, and retirement plans and accounts, with a total value of $6,640,000. This year, he has decided to gift his vacation home, worth $780,000 to his daughter, Melissa, and the company's real estate, worth $1,560,000, to his two sons. He is also starting a gifting program of the company's stock to his sons, John Jr. and David, giving each of them stock valued at $14,000 each year. To be fair, he will gift $14,000 in cash to his daughter each year. On the Gift Tax Return that will be filed for calendar year 2013, the gifts are reported as follows:

Vacation home to Melissa:$ 780,000
One-half interest in corporate real estate to John Jr.$ 780,000
One-half interest in corporate real estate to David$ 780,000
Shares of stock to John Jr.$ 14,000
Shares of stock to David$ 14,000
Cash to Melissa$ 14,000
Total:$2,382,000
Deduction, tax-exempt gifts( 42,000)
Taxable Gifts$2,340,000

John can deduct the first $14,000 of each gift made to his children, for a total deduction of $42,000 (3 x $14,000). After these deductions, he has used $2,340,000 of his unified credit. He has reduced his taxable estate to $4,300,000 ($6,640,000 minus $2,340,000). His unified credit has been reduced to $3,000,000 ($5,340,000 minus $2,340,000). If he lives for another fifteen years, making tax-exempt gifts of stock to his sons and cash to his daughter each year, he will reduce his taxable estate by another $630,000 ($14,000 x 3 x 15). At the time of his death, sixteen years later, his taxable estate will be $3,670,000 ($4,300,000 minus $630,000). It is impossible to know what the federal estate tax exemption will be in fifteen years. It is now indexed to inflation. It increased from $5,250,000 in 2013 to $5,340,000 in 2014. If it continues to increase at the same rate, or higher, it is likely that no federal estate taxes will be due from his estate.

That said, nothing is more volatile than federal estate taxes. I have lost count of the time that the federal estate tax laws have changed in my 33 years of practicing law. So I am still advising my wealthier clients to make gifts. If there is a sudden freeze of the federal estate tax exemption at its current level of $5,340,000, federal estate taxes will be due from John's estate. The use of the remainder of his unified credit ($3,000,000) will reduce his taxable estate to $670,000. The federal estate tax due from his estate will be 40% of $670,000 or $268,000. The Massachusetts estate tax, which is based on what John owns at the time of his death ($3,670,000), will be $246,080, assuming there are no changes to the Massachusetts estate tax laws. The total estate taxes due are $514,080.

If John had not made lifetime gifts, his estate would have owed $591,920 in Massachusetts estate taxes and $520,000 in f ederal estate taxes, for total estate taxes of $1,111,920. The tax savings with this gifting program is $597,840.

Lifetime gifting is a good strategy for a Massachusetts resident because Massachusetts does not have a gift tax. Gifting assets that you expect will increase in value in the future, such as your company's stock or real estate, are good assets to gift because you will be using less of your combined estate and gift tax credit.

If you would like more information about these changes to the tax laws, how they effect your existing estate plan, or if you would like to establish an estate plan to minimize or eliminate estate taxes, please contact us to schedule an appointment.

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