LUTZ BUSINESS INSIGHTS
why high net-worth families should review their estate plans pre-election
joe hefflinger, DIRECTOR & INVESTMENT adviser
PUBLISHED: SEPTEMBER 15, 2020
Election day is fast approaching, and with it comes the potential for sweeping changes in our political landscape. While nobody can predict the outcome, those with a high net-worth (in this case, I’m referring to a net worth approaching $20 million) would be wise to start evaluating their current estate plans now.
2020 could be looked at in hindsight as the end of a golden era in estate planning. We have witnessed asset values depressed due to the impact of COVID, historically low interest rates, historically high estate and gift exemptions, and certain key estate planning techniques that are still viable. These all combine to create an ideal environment for the transfer of wealth to future generations in an extremely tax-favorable manner.
A change in our political climate, coupled with our country’s deteriorating fiscal position, could potentially change the estate tax laws. So, there is no time like the present to be considering all your options. And for those of you who may be hesitant about gifting assets now, know that some of these options may allow you to preserve some level of access to the assets you would be gifting.
The Estate & Gift Tax Laws – a Refresher on Where we are Now and Where We’ve Been
Currently, the federal estate and gift tax laws in our country work in tandem, which means you have a certain dollar amount which you can transfer to your heirs either while alive or at your passing, tax-free. The exemption amount in 2020 is $11.58 million per individual. This is effectively $23.16 million for married couples as portability allows a surviving spouse to use a deceased spouse’s unused exemption.
You are free to gift away assets up to the exemption amount during your lifetime with no gift tax owed. Still, every dollar you gift away during life has the corresponding effect of decreasing the amount of assets you can leave to your heirs at death estate-tax free, dollar for dollar. An important caveat to this is any gifts you make pursuant to the annual gift exclusion amount (currently $15,000 per individual, or $30,000 per couple, to any number of different beneficiaries per year) doesn’t count towards your lifetime gift exemption.
For any assets that become subject to federal gift or estate tax, the current tax rate is 40%. This is down from 55% as recently as 2001. Without getting too deep, in addition to the estate and gift tax there is also a generation-skipping transfer (GST) tax that is levied when transfers are made to someone two or more generations below (e.g., to grandkids or below). Right now, the GST exemption levels and tax rate mirror those already discussed for the estate and gift tax.
You may be saying to yourself, “that seems like a really big exemption amount,” and you’d be right! To put how favorable the current exemption levels are in historical context, check out the following chart.
As you can see, going back to 2001, exemption amounts used to be substantially smaller, and the tax rates used to be higher. Note that the exemption levels doubled in 2018 pursuant to the Tax Cuts and Jobs Act of 2017, but also understand that these higher levels are scheduled to “sunset” in 2026. At this time, they will automatically revert back to their prior levels (adjusted for inflation; this is estimated to be around $6.5 million). However, if Congress and the President agree to change them, these exemption reductions could be much larger and could happen much sooner.
What a Biden Presidency / Democratic Controlled Congress Could Mean
It’s not my place to speak to the merits or validity of either political party’s policies, whether that’s in regard to tax rates, estate laws, or anything else. You don’t come to your financial advisor for political commentary, and I have no desire to provide any. That being said, as an advisor, it is my job to help clients understand what changes may be coming if the political climate turns and how they could be impacted personally. Note that it’s possible the following changes (if they occur) could be made retroactive to January 1, 2021.
Decrease in the Estate/GST and Gift Tax Exemption
Joe Biden has previously indicated that the exemption for estate and GST could be lowered to pre-Obama levels, which could be as low as $3.5 million per individual, with a gift exemption as low as $1 million (see 2009 in the chart above).
Increase in the Estate and Gift (and Capital gains) Tax Rates
It’s also possible we could see an increase in the estate and gift tax rates, which currently sit at 40%. It’s unclear at this point what that means, but a return to the 45-55% range we’ve seen in the past 10-20 years is possible. While we’re talking about tax rates, Biden has also suggested raising the rate on long-term capital gains to the rate imposed on ordinary income (at least for those with higher incomes, e.g., $1 million or more).
Change in the Basis Rules at Death
Under current law, your heirs will typically receive any assets you leave them upon your death with a “stepped-up basis,” meaning they get to hold those assets with a basis equal to their fair market value on the date of your death. At various times, Biden has floated the idea of eliminating the basis step up at death (meaning heirs would take a lower carryover basis instead) or alternatively the realization of capital gains at death (meaning the deceased individual’s estate would owe capital gains tax on appreciated assets at death). This could obviously be a big deal for your heirs if you hold assets with a large amount of appreciation.
Restrictions on Favorable Estate Planning Techniques
Based on recent Democratic proposals over the past few years, there is also speculation that they could seek to limit the use of valuation discounts and grantor retained annuity trusts (GRATs). It’s currently common when transferring an interest in a closely held business for estate purposes to discount the value based on a lack of control and a lack of marketability (which has the potential effect of increasing the amount of assets you can transfer estate and gift tax free). Similarly, GRATs are currently a popular estate tool and are used to potentially transfer the future appreciation of an asset free of estate and gift tax.
Note that regardless of the outcome of the upcoming election, the fiscal strain caused by COVID could itself be the catalyst for our elected officials to revisit the estate landscape as a source of additional revenue in a time when it may be sorely needed.
Estate Moves High Net-Worth Families Could Consider Before Year-End
Given the potential estate law changes that could be made effective as soon as the start of 2021, what estate updates should high net-worth families be considering now? Here are a few to consider:
If the estate and gift exemptions are reduced next year, you could miss out on a great opportunity to pass a large amount of wealth free of tax. To lock in the use of the current larger exemption this year, you’d need to be in a position to have at least one spouse transfer upwards of $11 million out of their estate. These types of outright gifts are commonly made to irrevocable trusts for the future benefit of your children and/or grandchildren. Treasury Regulations from 2019 indicate that transfers covered under an individual’s exemption in the year of transfer can’t be “clawed back” later at their death if the exemption has subsequently been reduced.
If the thought of transferring that amount of wealth outright this year makes you uneasy (and it probably does), talk to your estate attorney about a spousal limited access trust (SLAT). If structured correctly, SLATs can potentially allow for trust distributions of the transferred assets back to the transferor’s spouse during their lifetime. You wouldn’t go down this route if you expected to need the funds again in the future. But if there is some type of unexpected financial hardship down the road, it can be comforting to know that you have the ability to access the funds again (indirectly through your spouse) if needed. Obviously, the possibility of a future divorce or the premature death of the spouse beneficiary needs to be considered.
Estate “Freeze” Techniques
If you aren’t comfortable making a large outright gift, an estate freeze may be a better fit for you. A freeze transaction has the net effect of removing the future appreciation of an asset (above a predefined “hurdle” rate established by the government) from your estate. There are several different structures to accomplish this, some of which involve transferring assets to a trust in exchange for a promissory note equal to the fair market value of the assets sold. The transfer to the trust can be structured as either a sale or a gift, depending on whether you want to use up some exemption (and if so, how much).
The use of a promissory note can provide added flexibility. If the potential estate law changes discussed above seem more certain at a later date, it may be possible to “forgive” the note, which would then be treated as a completed gift that would use up some exemption. On the other hand, if you later decide you don’t want to part with the asset, the trust may be able to pay back the note “in kind” by transferring the asset back to you.
Two of the more common freeze structures are intentionally defective grantor trusts (IDGTs) and GRATs (referenced above). Your estate attorney can highlight the key differences between each and which might be a better fit for your situation. Both IDGTs and GRATs can be powerful tools under current law, especially in our low interest rate environment, when the hurdle rate that the transferred asset has to beat is so low. These tools can also be leveraged even further if you have an asset to transfer whose value can be discounted when transferring for estate purposes (as discussed above). However, keep in mind that future estate law changes could impact the ability to use both discounts and GRATs.
Start the Planning Process Now
So, what does all of this mean to you? If your personal balance sheet is approaching the $20 million range, it means you should at least be reaching out to your estate attorney and other advisors now to discuss what impact these potential changes could have on your personal planning. If you are uncertain about what amount of assets you can transfer and still have enough left over to live on comfortably, we at Lutz Financial can do a cash flow analysis to help you better answer that question.
From a timing perspective, keep in mind that high-level estate planning of this nature usually takes some time to complete (and your attorney will likely get harder to book as year-end approaches). If appraisals may be needed, those take time as well, as can applying for a federal tax identification number for a newly formed trust. Also, consider that it’s entirely possible that we may not know the results of the presidential election (and other key congressional races) for some period of time after election night. So, waiting to start this discussion until after the election may not allow enough time to get it done before year-end. Whether you ultimately decide to make any estate updates before year-end or not, it’s essential that you at least talk to your advisors and understand your options.
Important Disclosure Information
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.
ABOUT THE AUTHOR
JOE HEFFLINGER, JD, CFP®, CAP® + DIRECTOR & INVESTMENT ADVISER
Joe Hefflinger is an Investment Adviser and Director at Lutz Financial. With 15+ years of relevant experience, he specializes in comprehensive financial planning and investment advisory services for professionals, business owners, and retirees. He lives in Omaha, NE, with his wife Kim, and daughters Lily and Jolie.
AREAS OF FOCUS
- Retirement Cash Flow Planning
- Insurance Planning
- Estate Planning
- Business Owner Exit Planning
- Charitable Planning
- Tax Planning
AFFILIATIONS AND CREDENTIALS
- National Association of Personal Financial Advisors, Member
- Financial Planning Association, Member
- Nebraska State Bar Association, Member
- Omaha Estate Planning Council, Member
- CERTIFIED FINANCIAL PLANNER™
- Chartered Advisor in Philanthropy®
- JD, Creighton University School of Law, Omaha, NE
- BS in Economics, Santa Clara University, Santa Clara, CA
- Partnership 4 Kids - Past Board Member
- Omaha Venture Group, Member
- Christ the King Sports Club, Member
- Build Back Better Act + Impact on High Net-Worth Family Estate Planning
- Long-Term Care Planning 101
- Why High Net-Worth Families Should Review Their Estate Plans Pre-Election
- Portfolio Management for Retirees During a Financial Crisis
- It's Time to Review Your Personal Umbrella Policy
- Will I Outlive My Assets?
- Planning for Health Care Costs in Retirement
- The Opposite of Spoiled: A Book That Helps Parents Talk to Their Kids About Money
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