A unique feature of our tax system is that many lifelong taxes have income thresholds that have a large impact on the tax that is payable on the next dollar of income. Examples include Provisional Social Security Income, Medicare Part B premiums that are 3.8% Net investment income tax, and the qualified business income or QBI, tax deduction for pass-through companies.
An important tax management tool for estate planning will be to consider the taxes that are paid for each additional dollar of income through tax bracket management. Examples of this are tax recognition strategies such as the bundling of charitable deductions in changing years. It can also include product selection.
Immediate taxation on annuities and life insurance may also be preferable to certain capital gain strategies, especially when capital gain rates are increasing.
In order to help the next generation to save taxes, a new planning challenge has arisen with the cut IRAs stretch. Stretch IRA planning is still possible, but limited and must be carried out in a targeted manner.
For example, IRAs can initially be passed on to the surviving spouse for life and then deferred for remaining children and grandchildren until the end of 10 years. However, in many other situations, the best strategy is to look for alternatives to stretch IRAs.
There is a new interest in ideas like withdrawing some IRAs during life to pay the life insurance premium, the proceeds of which go to children and grandchildren. Instead of continuing to accumulate IRA funds, the diversion of some funds towards insurance premiums will give heirs a well-known tax-free legacy.
Similar, charitable rest trusts are back on the radar as a tax-efficient way to earn a lifetime income and still pass on a legacy in the event of death for the non-profit-oriented customer.
Strategies for Wealthy Customers
Wealthy individuals face a different problem when planning taxes in estate planning. The estate and gift tax rate is effectively 40% of the capital compared to a top tax rate of 37% of the income.
In contrast to income tax, inheritance tax is largely avoidable for many wealthy private individuals for the time being. The challenge in estate planning is assessing taxation through the lens of the multi-generational family who will ultimately benefit from the wealth transfer.
In many cases, it can be beneficial to pay more income taxes over the years to save significant estate taxes in the event of death.
The taxpayer’s country of residence can have a major impact on the amount of assets that can ultimately be transferred, net of tax. For example, New Yorkers can pay both state and city income tax and estate tax, and face the inability to self-settle assets to protect creditors.
In South Dakota, these taxes do not apply and wealth can be passed on permanently. To take advantage of many of these benefits, you must live in South Dakota. For some of them, however, it may be more a matter of where your wealth is located.
A wealthy customer should consider using a different order of distribution in retirement than a wealthy family would. Income taxes on retirement accounts (traditional IRAs, 401 (k) s, etc.) are inevitable, and the Secure Act limited the ability to extend taxation after death.
To avoid these assets from being subject to estate and gift taxes, wealthy taxpayers should consider using these accounts to fund their retirement income.
Appreciative assets such as real estate and family business interests currently receiving an increase in tax base should be passed on upon death by bequest.
Since it is not known when Congress will respond to taxes, it is important to take action now to free and freeze assets. While the exemption remains high, gift strategies using GRATs and Grantor Trusts should be considered – especially since the IRS has stated there will be no attempts to reclaim the gift tax exemption.
Additionally, traditional real estate freeze techniques like selling the family business or recapitalizing the business are more urgent than ever. If the customer is charitable, especially during this period of very low interest rates, non-profit lead trusts can be attractive.
Large amounts of wealth can be passed on to future generations for an extra low gift valuation.
Strategies for both groups
A key strategy for dealing with potential tax increases is to maintain flexibility. All estate planning documents should allow for changes to the substantive provisions, possibly as early as this year.
For wealthy as well as wealthy clients, trusts are a particularly viable way to ensure flexibility. The trust can not only enable the trustee to give an acoustic signal in the event of a change in tax law. State laws have recently become more liberal and offer ways to loosen a trust through the use of Trust advocates and decant.
Perhaps the best advice for dealing with possible changes in tax law is to have the client coordinate the estate planning advisory team. If the advisory team does not work together in times of rising taxes, the client can give too much away, save income taxes at the expense of more estate taxes on death, or deplete assets with advisory fees for duplicate or conflicting services.
While conventional wisdom is not to let the control tail wag your dog, this time around may be different. Consultants must consider a thorough re-evaluation of a client’s estate plan in 2021 to ensure that inaction does not result in higher taxes in the future.
One of the biggest challenges is convincing a tax-avoidant customer that it may make more sense to pay more this year than to wait for the future.
Steve Parrish is an Associate Professor of Advanced Planning at the American College of Financial Services.
Michael Finke is Professor of Asset Management and Frank M. Engle Chair of Economic Security Research at the American College of Financial Services.