Several proposals in Congress this year target inherited wealth. These new rules, if passed, would significantly change estate planning for many families. While the changes will increase taxes, they will also create opportunities for forward-thinking advisors to add tremendous value to clients and their families.
These proposals have been delayed as the administration’s first priority has been to pass the infrastructure bill. To fund the bill, in part, Congress wants to increase income and estate taxes on the wealthy. And while Congress may talk about taxing billionaires, these proposals will also impact typical “Millionaire Next Door” clients at most wealth management firms.
Proposals to Increase Taxes Upon Death
Let’s take a look at three proposals currently being considered in Washington.
1. Eliminate the step-up in cost basis.
A step-up in cost basis means that upon death an asset has its cost basis reset to the date of death. The proposal would allow a one-time exclusion of up to $1 million of inherited capital gains. It also would allow the tax to be paid over 15 years if it occurs on an illiquid asset like a farm or business and if the heirs continue to operate it. Additionally, the existing capital gains exclusion for a primary residence ($250,000 for single filers or $500,000 for married filers) could carry into the estate.
2. Increase the estate tax paid by many families.
The 99.5% Act, proposed by Sen. Bernie Sanders (D- Vt.), would reduce the estate exemption from $11.7 million to $3.5 million; reduce the unified gift exemption from $11.7 million to $1 million per lifetime; raise the estate tax rate to a range of 45% to 65%; reduce the annual gift tax exclusion from $15,000 to $10,000 per donee, while imposing an annual limit of $20,000 per donor; and reduce certain tax benefits of trusts, such as generation skipping trusts, etc.
Currently, the estate tax exemption is $11.7 million ($23.4 million for a couple), which has effectively eliminated the estate tax for most Americans. Only about 1,900 estates paid an estate tax last year. Many advisors will recall the estate tax exemption was $1 million as recently as 2003. The increases since then have greatly simplified planning for most Americans. However, we should note that even without this proposal, the current exemption amount will sunset after 2025 and return to $5.49 million, plus inflation.
3. Increase the long-term capital gains rate for taxpayers in the highest tax bracket to 39.6%.
Since these taxpayers are also subject to the 3.8% Medicare surtax, the effective capital gains tax rate would be 43.4%. For states with income tax, it could reach over 50%. The government would take more than half of your client’s or their heirs’ capital gains!
Here’s the perfect storm of the three proposals: High-net-worth families will be hit with all three new taxes on death. They will be subject to an estate tax, they will lose the step-up in basis and their heirs could be taxed 43.4% on capital gains since there is no step-up.
Consider an individual who dies with $5 million. They would owe a 45% estate tax on $1.5 million (the amount above $3.5 million). That’s a $675,000 estate tax bill. If their cost basis was $1 million and the unrealized capital gain was $4 million, the heirs could owe another 43.4% on $3 million of capital gains. That would be another $1,302,000 in taxes, for a total of $1,977,000. Plus, the heirs might owe state income taxes on the capital gains since 17 states plus the District of Columbia have their own estate or inheritance tax of 0.8% to 20% on top of the federal estate tax.
It all adds up to massive new taxes that would have been zero today. Let’s consider eight strategies if the step-up in basis is eliminated and other changes enacted.
1. Harvest capital gains gradually. If the step-up in basis is eliminated, advisors may want to harvest capital gains gradually with the aim of keeping a client’s total unrealized gains to $1 million. For example, if a client has $2 million in gains, perhaps you could harvest $100,000 of gains for the next 10 years. The goal is for your client to pay the gains gradually at the 15% rate and save the heirs from being pushed into the top bracket of 43.4%. By paying the capital gains taxes during their life, your clients can also reduce their potential estate tax liability.
2. Shift high-growth investments to a Roth IRA. Beneficiaries inherit a Roth IRA income-tax free. For high-earning families, advisors should consider backdoor Roth contributions to move money annually into a tax-free account. If higher taxes are ahead, workers may prefer to use a Roth 401(k) versus a traditional 401(k).
3. Gradually convert traditional IRAs to Roth IRAs. By pre-paying taxes today, advisors can shrink the size of a client’s taxable estate and reduce the estate tax burden on the heirs by pre-paying the taxes today. The current income tax rates will sunset after 2025 so the next five years is a good window to make Roth conversions.
4. Encourage clients with substantial estates to give away their full annual gift tax exclusion each year. This is currently at $15,000 per individual. If they give appreciated securities, their recipients may be able to sell those positions and pay lower taxes, in some cases even 0% for long-term capital gains. Also, note that the direct payment [ITAL: direct payment] of someone’s medical or education bills does not count towards the annual exclusion. Counsel clients to make those payments directly to the doctor, college, etc., and not reimburse their children.
5. Plan for charitable donations. If clients make charitable donations, help them give away their most highly appreciated securities, rather than cash, through age 70½. This will reduce taxable gains, while they can still be eligible for an itemized deduction. Consider if a donor-advised fund makes sense for clients who want to establish a larger pool of charitable funds.
After age 70½, clients can make charitable donations of up to $100,000 a year from their IRA as qualified charitable donations (QCDs). QCDs can reduce income taxes so they have more budget to harvest capital gains from taxable accounts. You do not have to itemize to deduct QCDs and they count towards required minimum distributions. For most clients, QCDs will offer better tax savings than donating appreciated securities.
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Other Estate Tax Savings
6. If clients own two homes, consider selling the primary home. The proposal keeps the $250k/$500k capital gains exclusion for a primary residence, but additional homes would no longer receive a step-up on death. If your clients have multiple homes, they could use the primary residence exclusion during their lifetime by selling their current home and making a second property their next primary residence. Once they have lived there at least two years, the next home could also receive the exclusion.
7. Maximize client contributions to 529 College Savings Plans for their children or grandchildren. 529 Plans will pass outside of their taxable estate and will grow tax-free for the beneficiaries. 529 Plans will not be taxable under any of these proposals and will become a more important estate-planning tool for wealthy families.
8. Consider life insurance owned by an Irrevocable Life Insurance Trust (ILIT). Life Insurance proceeds are not subject to income tax to the beneficiary. Additionally, policies owned by an ILIT will pass outside of the client’s estate and not be subject to the estate tax. This didn’t matter as much when the estate exemption was $11.7 million. ILITs will benefit a lot more families if the estate exemption is reduced to $3.5 million.
“Thankfully, there is a lot we as advisors can do to offset some of these proposed taxes and reduce the burden on our clients’ estates and heirs.”
Higher Taxes Ahead?
I am proud to be an American and pay my fair share of taxes. Still, these proposals represent a potential massive tax increase on a lot of families. Many of your clients who have done a good job saving could have over $3.5 million before they pass away and easily over $1 million in capital gains, too. A client with $2 million today could reach $4 million in just 12 years with a 6% return. It could pay to be thinking longer term and educate your clients of their potential estate liability if they are on that trajectory.
The proposals in Washington will likely be merged and some compromise reached before a final version is up for a vote. We should wait and see what will happen before making any of these changes. Still, clients may be wondering how these proposals could impact them.
Thankfully, there is a lot we as advisors can do to offset some of these proposed taxes and reduce the burden on our clients’ estates and heirs. Last minute strategies won’t work here, though. Families need to be planning their transfer of wealth many years, if not decades, ahead of time.
Scott Stratton is the managing member of Good Life Wealth Management, a Registered Investment Advisor in Little Rock, Ark. You can reach Scott at firstname.lastname@example.org.