After reading many tax articles lately in various publications and even just listening to non-tax experts like my next-door neighbor, I’ve found that not only do many people believe that timing the stock market is pinpoint achievable, they also view that extreme gambling with the ever-changing tax code is never risky.
For example, a hot topic in many tax articles these days is gift taxes, relative to the estate tax sunset coming near the end of this year. As of January 1, 2013, the tax laws sunset to 2001 levels if not extended by Congress. This will result in the inheritance tax exclusion dropping back from $5 million per person to $1 million, with the tax rate increasing from 35% to a 55% top bracket.
That said, the gift tax exclusion, which allows individuals to give away assets in 2012 up to those exclusions mentioned above with a 35% rate, could actually look beneficial if the law does sunset in 2013 to a 55% rate. However, the issue I have with most advice given on this subject is that it’s a “no brainer” and that every client should give away all their assets in 2012. Rather, there should be a comprehensive outlook advising clients on a far more complicated matter than just a 35% tax rate versus the 55% tax rate possibility in 2013.
As such, I want to make it very clear that gambling on inheritance and gift taxes is no different than the points made in my article published in early 2010 entitled, “The Gamble of a Lifetime.” The article had a slightly different subject matter relative to taxes on Roth conversions, but the nature of the gamble is the same. Almost every advisor seems to be pushing their clients to give away all their assets to heirs, and pay the gift tax now at 35%, rather than an inheritance tax at 55% should they die after 2012 (assuming the law sunsets).
What I’d like to do here is touch upon a few thoughts that advisors may have not considered when discussing these issues with clients.
- Many advisors don’t have the tax expertise to consider all the possible tax scenarios in analyzing clients’ overall estate tax issues due to the differing types of assets the client may own. Assets could be classified as three types: non-qualified assets (after-tax); qualified assets (pre-tax); and tax-deferred assets (both pre-tax and after-tax combined). Advisors need to vitally understand the inner workings of each type, so I highly recommend seeking a certified public accountant and/or tax attorney to help in planning scenarios before making a blanket pitch for clients to give assets away.
- How client assets are to be disbursed does affect the future taxation of the assets once the heirs take possession, regardless of the estate or gift taxes due. I am referring to ordinary income tax (both and federal and state), as well as possible capital gains tax – which are all dependent on the type of assets in question.
- Just because the exclusion for gift and inheritance tax is currently $5 million per person, gifting the entire exclusion by the end of this year, in my view, doesn’t exempt these taxes forever if the law sunsets to 2001 levels of $1 million (assuming the client dies in 2013 or later). Per my opinion, the tax code does not clearly state that a client would keep the $5 million gift tax exclusion if the client dies once the inheritance and gift tax exclusion drops back to $1 million. Which means the $4 million previously gift taxed could still owe the full inheritance tax at death. Therefore, the overall situation would still result in tax being paid at death, regardless, at the combined possible rate of 55%.
- There’s a risk to gifting assets that may be needed by the giving client later in life, which becomes an issue for me on several levels. Once assets are gifted the right of ownership or control does not necessarily remain in the giver’s hands, but is now controleed by the giftee or heir. Furthermore, if assets are gifted without some form of trust protection from lawsuits, bankruptcies, etc., the assets of parents and family heirs could be lost forever, especially if possibly needed later in life for retirement, medical or emergency needs. Of course, there are various planning tools for creating trusts when considering gifting assets for these reasons. However, assuming the trust route is taken, you then have to consider trust income tax rates, which drastically progress to the higher brackets even at the $10,000 income level, rather than the normal individual tax rate brackets.
- Another concern involved with gifting property instead of allowing it to be inherited is the capital gains tax basis. Property that is gifted requires the tax basis for gain or loss to be carried over to the receiving party as their basis. If the property is inherited (meaning after death), the receiving party’s basis is usually the fair market value at the date of death. Based on those facts, it is usually more advantageous for heirs to receive assets after death rather than prior (such as a gift) since capital gains tax rates will also increase should the law sunset in 2013.
- Lastly we have issues of accounts like IRAs that have pre-tax money built up in a client’s estate. In this situation, not only is the IRA part of the total taxable estate for inheritance tax purposes, but it’s also subject to ordinary income tax if gifted to another person. That could cost not only income tax but possibly inheritance tax if the law does sunset to $1 million (assuming the client has assets far greater than the exclusion).
If allowed to pass through the inheritance process, most IRAs are allowed to convert to an IRA-beneficiary account that doesn’t require all the income tax to be paid immediately as would be required through gifting the IRA to another person (excluding charitable gifts). Therefore, as advisors make sure you know exactly what you are recommending to clients because IRAs are a completely different animal in the gifting-versus-inheritance tax equation.
Hopefully, I’ve shed a little more light on the complexity of the gifting-versus-inheritance tax dilemma. I apologize for not hitting on all areas of concern such as the generation skipping tax.
I hope the takeaway is for advisors is to analyze clients’ situations very carefully. It’s vitally important to assess the tax recommendation risks that gift and inheritance taxes pose. However, if a client has less than $10 million in net worth ($5 million per person assuming a married couple), I believe the potential gain is not worth the risk for a mere possible 20% tax benefit spread of 35% versus 55% (assuming no later capital gains tax would be owed on any of the gifted property). In my view, that would be another “gamble of a lifetime” and not worth risking.
Andrew D. Rice, CPA, AIF, CTS, WMS, is vice president of Money Management Services, Inc., an independent RIA firm in Birmingham, Ala. He is a Certified Public Accountant, Accredited Investment Fiduciary, Certified Tax Specialist and Wealth Management Specialist. He can be reached at [email protected].
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