Estate Planning & Tax Law Constantly Evolve | How to execute an estate plan based in fact rather than speculation
Satovsky Asset Management | NEW YORK, NY | 10/21/20
In a letter dated November 13, 1789 to his friend and French scientist Jean-Baptiste Le Roy, Benjamin Franklin, in providing an update of then current events in the United States, used a phrase that is still widely used to this day. Franklin wrote, “Our Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes”. While this idiom originally dates to more than 70 years prior to Franklin, it still rings true more than two centuries later: for sure, nothing is certain but death and taxes.
Franklin should have added an asterisk next to his quote, because what is much less certain is when you will pay taxes and how much you will pay in taxes. As we know, where there is uncertainty speculation will follow, which leads many people to rely on opinion rather than fact.
This is seen in news outlets today as people speculate on the outcome of our next Presidential election and how estate tax law may change based on a Joe Biden victory over President Trump.
At SAM we try not to speculate. Instead we formulate recommendations based on evidence, facts and what we know today. In this article we will explore the unpredictability of estate tax law, and actions you may wish to take given what is known and unknown in the current economic and political landscape.
The Certainty/Uncertainty of Estate Tax Law
The implementation of a “death tax” has a very long history as a source of funding for governments and a way to reduce generational wealth. It can be dated back to ancient Egypt in 700 B.C. and is well documented from 2000 years ago in ancient Rome under Caesar Augustus. In the United States, we have had a formal estate tax for over 90 years, and in different forms such as an inheritance tax dating all the way back to 1797.
Fast forward to the passing of the Taxpayer Relief Act of 1997. This sweeping piece of reform made more than 800 changes to the IRS code which included setting the estate tax exemption, e.g., the amount someone can pass to their beneficiaries at death free of estate tax, at $600,000 per individual with gradual increases until 2006 when the exemption would reach $1,000,000 per individual. This would be the basis for future increases in the exemption.
The 2001 and 2003 “Bush tax cuts” increased the exemption to $1,000,000 starting in 2002 and was scheduled to reach a historic $3,500,000 per individual in 2009, before being repealed altogether in 2010.
To everyone’s surprise, newly elected President Obama and Congress couldn’t reach an agreement on tax policy which lead to 2010 being the first year since 1916 that the United State didn’t impose an estate tax. President Obama further surprised Americans at the end of 2010 by increasing the estate tax exemption in 2011 to $5,000,000 per individual increasing with inflation.
At the end of 2017, President Trump signed into law the Tax Cuts and Jobs Act which doubled the estate tax exemption to $11,180,000 per individual for 2018, increasing with inflation, and once again being the highest in history. This exemption amount is scheduled to sunset back to pre-2018 levels starting in 2026 ($5,000,000 per person indexed for inflation).
As you can see, estate tax law is fairly uncertain as is evident with President Obama significantly increasing the estate tax exemption while many thought he would reduce it (or keep it at 2009 levels) based on his pre-election policy.
What is also uncertain is what estate tax would look like in the event of a Joe Biden victory. Biden’s proposed tax plan, should he win the presidency, includes reducing the estate tax exemption back to Obama-era levels and also repealing the step-up in basis rule. The step-up in basis rule increases the basis of assets inherited to the value on the decedent’s date of death, which significantly reduces the taxes that heirs pay upon sale of the inherited assets. In the past 50 years, there have been two significant efforts to try and eliminate the step-up in basis rule, both unsuccessful.
While the amount is unknown, what is fairly certain is that there will be an estate tax as there has been in all but one of the last 104 years. What else is certain? That lifetime gifts remove assets and appreciation from your estate, that interest rates are at historic lows (great for certain estate planning strategies), and that reduced asset prices make the current environment ideal for gifting. So knowing all of this, what can we do today to take advantage of the knowns and reduce the estate tax bite?
Annual Exclusion Gifts and Spousal Lifetime Access Trusts (SLAT) remove assets and appreciation from the estate
Removing the speculation of (1) what will the estate tax exemption be in the future, and (2) what will the estate tax exemption be in the year you pass away, the greatest benefits of gifting now is that you remove the assets from your estate, while also removing all future appreciation on those assets.
Take this example: in 30 years when you pass you have a taxable estate. Instead of making a $100,000 gift today, you hold on to those assets. If those assets were invested for 30 years earning a 7% return, that same $100,000 would grow to about $760,000. Using today’s estate tax rate of 40%, your estate would owe about $300,000 of estate tax on those assets. However, if you gifted the $100,000 today, those assets coupled with the appreciation of $660,000 would be outside of your estate for estate tax purposes.
One popular gifting strategy that is getting a lot of attention is called a Spousal Lifetime Access Trust or SLAT. A SLAT is an irrevocable trust created by the donor for the benefit of his or her spouse. The advantage here is that a person can remove assets and all future appreciation associated with those assets from the estate, and still retain control or access to the assets through the spouse for whom the trust is created. Often overlooked is the fact that the grantor will lose control and access to the trust in the event of the spouse’s death, or divorce. This is the inherent risk with SLATs. Therefore, assets needed for a sustainable draw in retirement should not be irrevocably gifted into trusts for which continued access is not guaranteed.
Another popular strategy is making gifts of the Annual Gift Tax Exclusion amount (“annual gifts”). Annual gifts were part of the Tax Relief Act of 1997 and were indexed for inflation to keep pace with the economy. For 2020, the exclusion amount is $15,000 per person per beneficiary. Annual gifting is often underestimated as a powerful estate planning tool. However, over time it can serve to pass a significant amount of assets to the next generation. By way of example, a married couple with 3 children and 3 grandchildren can gift $180,000 on an annual basis without using their lifetime gift tax exemption, filing a gift tax return, or paying any gift tax.
Low interest rates create estate planning opportunities for Grantor Retained Annuity Trusts (GRAT) and other strategies
Several estate planning techniques utilize the IRS Section 7520 Interest Rate or Applicable Federal Rates (AFR), which are at historic lows making it a great time to implement these strategies. These include intra-family loans, Grantor Retained Annuity Trusts (GRAT) and sales to Intentionally Defective Grantor Trusts (IDGT).
A Grantor Retained Annuity Trust, or GRAT, is a type of irrevocable trust that allows a grantor to pass assets to his or her beneficiaries using little to no gift tax exemption. A grantor contributes assets with appreciation potential to a trust and receives an annuity stream for a fixed term. Any appreciation in excess of the IRS Section 7520 rate, the “hurdle rate,” passes to the beneficiaries free of gift tax. Therefore, the goal is to grow the value of the assets in the GRAT over the IRS Section 7520 Interest Rate. The lower the hurdle, the better the chance to exceed it, which means more assets pass to your heirs.
The October 2020 IRS Section 7520 Interest Rate is 0.4% meaning any growth above 0.4% will transfer to heirs gift tax free. The downside of GRATs is that you’re not removing assets from the estate since you’re getting back an annuity stream. Additionally, you run the risk of the assets not appreciating, or the grantor dying before the term of the GRAT expires (upon which everything comes back into the estate).
Reduced asset values can create opportunities including Roth Conversions for gifting at a discount
We have experienced significant volatility in 2020, and while many asset classes have rebounded significantly since their March lows, other have not.
If you hold illiquid investments, real estate for example, now may be the ideal time to have it appraised and gifted at a reduced value, which will use less of your estate tax exemption.
Another strategy to take advantage of when prices have fallen is a Roth conversion. Any person, at any income level, can convert any portion of a traditional IRA to a Roth IRA. While a traditional IRA is funded with pre-tax dollars, grows tax free, and is then taxed upon distribution, a Roth IRA is funded with post-tax dollars, grows tax free, and is never taxed on distributions.
Roth IRAs have many benefits – such as diversifying the tax characteristics of your balance sheet – but also are one of the best assets to pass on to the next generation. The original account owner of the Roth does not have to take Required Minimum Distributions (RMDs) from a Roth IRA which allows it to grow tax-free for a longer period of time. Once the beneficiary inherits the Roth IRA, he or she does not have to pay income tax on the distributions since the tax was pre-paid. Because ordinary income tax is paid in the year you convert the traditional IRA to a Roth IRA, doing so when asset prices have dropped will lead to a lower tax bill.
When converting to a Roth, usually the best strategy is to convert over a number of years to spread out the tax liability. Also, prepaying the tax for your heirs has the effect of reducing your estate, which could be good or bad depending on your financial situation.
You’ll often hear people say don’t let the tax-tail wag the dog, meaning you shouldn’t let current and possible future tax law impact investment and financial planning decisions. The first thing to consider prior to making any estate planning gifting decisions is, can you afford to give up a portion of your wealth?
Ultimately if the assets will be needed to draw from in retirement, or what we call the financial freedom phase, it may not make much financial sense to give them away to a trust, or to children and grandchildren. However, if your balance sheet and cash flow are strong enough to sustain such gifts, now may be the perfect time to consider some of the strategies laid out in this blog.
Before making any decisions on gifting, we recommend consulting with your estate attorney. Please also reach out to your SAM team to review your Big Picture so we can collaborate on the best possible path for you.
At SAM our dedicated team of professionals consider it our fiduciary duty to provide clients with the highest standard of care and service in the advisory world. To learn more about how we may help you, get in touch with a SAM advisor today.
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Satovsky Asset Management is an independent investment advisory firm, our main priority is to align our interests with those of our clients. Our integrated approach to wealth management takes into consideration the context of your entire financial picture and enables us to create an investment structure aligned to your unique needs and goals.