Estate Tax Changes Under Biden: Strategies for Affluent vs. Wealthy Clients

A quirk of our tax system is that many lifetime taxes have income thresholds that greatly affect the tax incurred on the next dollar of income. Examples include Social Security provisional income, Medicare Part B premiums, the 3.8% Net Investment Income Tax, and the qualified business income, or QBI, tax deduction for pass-through businesses.

An important tax management tool for estate planning will be to pay attention to the taxes paid on each additional dollar of earnings by managing tax brackets. Examples include tax recognition strategies such as bunching charitable deductions in alternating years. It can also involve product choices.

Also, immediate annuity and life insurance taxation may be preferable to certain capital gains strategies, especially if capital gains rates increase. 

In terms of helping the next generation save on their taxes, a new planning challenge has arisen with the cutback on stretch IRAs. Stretch IRA planning is still possible, but it is limited and must be targeted. 

For example, IRAs may first pass to the surviving spouse for life and thereafter be deferred until the end of 10 years for remaining children and grandchildren. In many other situations, however, the best strategy is to look for alternatives to stretch IRAs.

There is new interest in ideas such as withdrawing some IRAs during life to pay the premium on life insurance, the proceeds of which go to children and grandchildren. Instead of continuing to accumulate IRA balances, the redirection of some funds to insurance premiums will provide heirs with a known, tax-free bequest. 

Similarly, charitable remainder trusts are back on the radar as a tax-efficient way to provide a lifetime income yet pass on a legacy at death for the charitably inclined client.   

Strategies for Wealthy Clients

High-net-worth individuals face a different issue in planning for taxes in estate planning. The estate and gift tax rate is effectively 40% on principal versus a top income tax rate of 37% on income.

For now, unlike income tax, estate tax is largely avoidable for many high-net-worth individuals. The estate planning challenge is to evaluate taxation through the lens of the multi-generational family that will ultimately benefit from the wealth transfer. 

In many cases, it may be beneficial to pay more income taxes through the years in order to save significant estate taxes at death. 

The taxpayer’s state of domicile can have a big impact on the amount of wealth that can ultimately be transferred net of taxes. For example, New Yorkers may pay both a state and city income tax and an estate tax, and face the inability to self-settle assets for creditor protection. 

In South Dakota, these taxes do not apply and wealth can be passed on in perpetuity. To enjoy many of these benefits, you have to live in South Dakota; for some of them, however, it may be more a matter of where your assets live.

A wealthy client should consider using a different order for taking distributions during retirement than would an affluent family. Income taxes on retirement accounts (traditional IRAs, 401(k)s, etc.) are inevitable, and the Secure Act limited the ability to stretch taxation after death.

Consequently, to avoid having these assets subjected to estate and gift taxes, the wealthy taxpayer should consider using these accounts to fund their retirement income needs.

Appreciated assets such as real estate and family business ownership interests that currently receive a step-up in tax basis should be passed on at death through bequest. 

Since it is unknown when Congress will act on taxes, it is important to consider making moves now to gift and freeze assets. While the exemption remains high, gifting strategies using GRATs and grantor trusts should be considered — particularly since the IRS has indicated there will be no attempts to claw back the gift tax exemption.

Further, traditional estate freeze techniques such selling the family business or recapitalizing the business are more pressing than ever. If the client is charitably inclined, particularly during this period of very low interest rates, charitable lead trusts may be attractive.

Large amounts of wealth can be transferred to future generations for an especially low gift valuation.  

Strategies for Both Groups

A key strategy for dealing with possible tax increases is to retain flexibility. Any estate planning documents should allow changes in substantive provisions, potentially as early as this year.

For both affluent and high-net-worth clients, trusts are a particularly viable way to ensure flexibility. Not only can the trust allow the trustee to call an audible upon a change in tax law; state laws have recently become more liberal with ways to unwind a trust through the use of trust protectors and decanting.  

Perhaps the best advice for dealing with potential changes in tax law is for the client to coordinate the estate planning advisory team. Unless the advisory team works together in a time of rising taxes, the client may give away too much, save income taxes to the expense of more estate taxes at death, or deplete wealth with advisor fees for duplicative or contradictory services.  

Although conventional wisdom is not to let the tax tail wag the dog, this time may be different. Advisors need to consider a thorough reevaluation of a client’s estate plan in 2021 to ensure that inaction doesn’t lead to higher taxes in the future. 

One of the biggest challenges is convincing a client who wants to avoid taxes that paying more this year may be more sensible than waiting for what the future holds.

Steve Parrish is an adjunct professor of advanced planning at The American College of Financial Services;

Michael Finke is a professor of wealth management and the Frank M. Engle Chair of Economic Security Research at The American College of Financial Services.