What You Need to Know
- New presidents typically make their mark on the tax code, and the estate tax is a likely target for Biden.
- The effect of taxes on estate planning stretches beyond the estate tax.
- Wealthy clients and those who are merely affluent have different goals and may need different strategies.
With Democratic majorities in the House and Senate and a Democratic president, the political winds have shifted abruptly and with them the likelihood of changes in estate taxes in the near future.
What taxes are likely to change with the new Congress? How will these taxes affect the various levels of wealth?
Advisors haven’t faced significant estate tax issues for all but the most affluent clients since the exemption increased to $11.18 million in 2018.
Each new administration since Jimmy Carter’s has passed tax legislation within the first year of taking office, and without a divided Congress there is a significant chance that more clients will face the prospect of a taxable estate.
4 Potential Areas for Tax Changes
Why are estate taxes a likely source of revenue? First, super-rich dead people aren’t a large or vocal constituency. Second, most Americans believe that the tax is applied to estates with a value lower than the exemption proposed by the Biden administration (pre-2018, or $5.5 million).
In a large recent survey, Harvard professor Stefanie Stantcheva finds that Americans believe the estate tax exemption is $2 million of wealth and that 364 in 1,000 pay the tax (not the 1 in 1,000 that pay currently). If Americans already think the tax is higher than the proposed increase, the political cost of lowering the exemption to $5.5 million may be modest.
There are four areas where taxes can affect estate planning, and they are not limited to the “death tax” associated with estate taxes.
1. Income, not estate, tax is the major tax issue for most affluent Americans.
With the new Congress, we may well see an increase in the marginal rate for high income levels, perhaps moving from a maximum of 37% back to 39.5%.
To make these increases more palatable, there will probably be trade-offs. For example, taxpayers may get back their unlimited deduction for state and local taxes, but see an increase in the rate on capital gains.
A primary area of concern is whether there will actually be a carryover of basis applied to the estates of wealthier taxpayers. This would significantly raise taxes and complexity at the time of death.
2. It’s doubtful whether Congress will immediately raise taxes on benefits.
The Secure Act, and a new version of this law being actively discussed in Congress, is attempting to make qualified plans more attractive; new taxes would be counterproductive to this cause.
Where we may eventually see an increase in benefit taxes is in payroll taxes. In order to shore up Social Security, Congress may levy an additional full Social Security tax (i.e., FICA) on earnings exceeding $400,000 — creating a doughnut hole with a heavy marginal tax increase on higher earnings.
This additional tax takes on even more importance for clients with large qualified balances facing a 10-year inherited IRA stretch. Imagine the impact on the after-tax value of an inherited IRA for a high-earning beneficiary if 12.4% were added to a 39.5% income tax rate.
3. All transfer taxes, including gift and generation-skipping taxes, are seen by many as vulnerable to tax increases.
Not only could we see the estate and gift tax exemption lowered to $5 million (or even lower), but we may also see popular estate planning concepts such as grantor retained annuity trusts (GRATs) severely curtailed.
A lowered exemption may sweep in more taxpayers than some realize. By extending the age at which required minimum distributions (RMDs) begin, some affluent families will build up qualified plan accounts to levels that are subject to estate taxes.
4. The real wildcard is individual state taxes.
Because states can’t print money, they will need to find revenue from somewhere — and soon. Thirteen states currently tax Social Security, 43 states have an income tax, 11 (plus Washington, D.C.) have an estate tax, and six have an inheritance tax.
Taxing the wealth that passes at death would seem a comparatively easy way for some of the states to increase revenue.
Strategies for the Affluent
The primary estate planning challenge for the majority of financial planning clients who may be classified as affluent (as opposed to wealthy) individuals is controlling lifetime taxes so that they can leave more to their heirs.
In light of the changes in the administration and Congress, a burgeoning estate planning issue for the affluent is the next generation and their taxes.
The client’s adult children may be the taxpayers who bear the greatest burden from higher taxes in the future. To the extent clients can lower taxes for their heirs, they are effectively passing on more to future generations.
While we don’t yet know what actions the new Congress will take, there are planning steps that affluent clients can take in anticipation of increased taxes on their estate plans.
The three key income tax strategies are deferring, advancing and leveling. It will make all the more sense to defer income into IRAs, nonqualified deferred compensation and tax-favored investments during high-income years. In some situations, however, advancing income is appropriate.
Roth 401(k)s, Roth IRAs and Roth conversions are attractive ways to not only save taxes later in retirement, but also leave tax-free income to heirs at death. And this strategy is more compelling now if tax rates are expected to increase in the future.
While deferring and accelerating taxes are seemingly in conflict, the controlling strategy will be maximizing the expected after-tax return from existing wealth.