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Financial Planning > Tax Planning

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

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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. 

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.


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