Tax Proposal Takes Aim at Estate Planning

Here’s what proposed changes will mean for your clients, says this wealth advisor.

By Michelle Clary
Michelle Clary
Michelle Clary

I find in my practice, one of the biggest considerations for retirees is how taxes will impact the amount of wealth they get to pass on. Higher taxes are now inevitable.

Between several years of accommodative monetary policy and massive federal spending to offset the economic damage of the COVID-19 pandemic, the government has borrowed a lot of money that it will eventually have to pay back. Although there is no clear indication of which of the numerous proposed changes to the tax code will eventually make it into law, I believe that advisors and their clients should be preparing now for bigger tax bills later.

As I look at the potential for changes, there are several sections of the federal tax code that I believe will have an impact on estate planning. There are three in particular that retirees should be looking at now.

The first to consider is the federal estate tax exemption.  The Tax Cut and Jobs Act of 2017 raised the exemption, which is $11.7 million per person for 2021. The House Ways and Means Committee recently introduced legislation containing elements of President Biden’s proposals that would reduce the estate tax exemption to $5 million per person. Some Democrats in Congress have suggested going even further and cutting the exemption to as little as $3.5 million. Even if Congress takes no action at this time on the exemption amount, that provision expires in 2026 and the exemption automatically drops down to around $6 million/person.

The reduction in estate tax exemption will mean many more people will be affected, and by itself that change would be significant enough. It becomes much more onerous when you add in the increase in the capital gains tax. Another thing to keep in mind is a potential removal of the step-up in basis provision. Although this surprisingly wasn’t included in the current House proposal, there’s no guarantee it won’t be revisited; the federal tax legislation still has a long way to go.

During the 2020 campaign, President Biden repeatedly promised that anyone making less than $400,000/year would not see their taxes go up. But those with income in excess of that amount may see a considerable increase in taxes given the scenarios I just outlined. The House bill proposes a top rate of 39.6% for taxable income exceeding $450,000 for couples, $400,000 for singles.

At this point, since these are all proposals, it’s hard for advisors to offer a concrete prescription for each client’s situation, but there are some steps that I recommend can be taken today to lessen the potential blow from future changes to the estate tax laws.

Seven Recommended Steps

  1. The first thing to do is to get clients to re-engage with the estate planning process. A plan drawn up five years ago, or even last year, may no longer be relevant in light of the proposed changes. The first step is for the advisor and client to sit down and go through the existing plan and consider how changes to the exemption, step up in basis and capital gains could affect that plan.
  2.  Another way to preempt the tax man is to contemplate the value of “gifting, either during the client’s lifetime or at their death, to individuals or to charitable organizations. This could be a direct charitable gift or through a donor-advised fund. Looking at it pragmatically, gifting can also help retirees protect their assets from changes to the step-up in basis. If the asset is gifted during the holder’s lifetime, the recipient of the gift inherits the original basis. If they are in a lower tax bracket, they can sell that position and wind up with lower taxes on the gain than the grantor.
  3. A third tactic would be to consider how the client’s wealth could be managed differently today given the possibility of these upcoming changes on the future estate. Consider the holdings in brokerage accounts where capital gains have been produced over time. Right now, the maximum rate of capital gains is 20% which, like it or not, most investors are willing to accept. But a return to the mid-1970s rate of around 40% would dramatically reduce how much of those investment gains could be passed to heirs. Each client’s situation will be different based on how they are currently invested, but this discussion presents an excellent opportunity for the advisor to add more value to the relationship. The key is to reevaluate everything and make sure the client understands that what was a good idea yesterday may not be tomorrow.  So, you may have more individual stocks in the portfolio, and municipal bonds become more attractive.
  4. One of the basic estate planning tools that many couples use is the funding of a marital trust on the death of the first spouse. Since such a trust needs to be set up in advance and drafted into legal documents, we suggest outlining in the estate planning documents the funding of that marital trust by a disclaimer. Depending on the estate tax at the time of the first spouse’s death, the surviving spouse has the option of disclaiming any assets above the exemption limit. Those assets would then transfer into the trust without being subject to estate taxes after the second passing.
  5. Advisors might also suggest that clients set up Irrevocable Life Insurance Trusts (ILTs) for their life insurance policies as a way to reduce the value of a taxable estate. It’s a good idea for clients to buy well-priced term insurance “now” that can be converted to coverage that will last through their lifetime.
  6. Advisors should also encourage their clients’ adult children, whether they are also clients or not, to take their own financial planning to the next level. Encourage them to get their own estate planning documents in order, make sure they are saving for retirement, and have adequate insurance and other protections. Clients will appreciate your efforts to get their heirs on firm financial footing so they will be prepared to make wise choices with gifted money. Younger adults that have a history of managing their own money tend to make much better decisions with gifted and inherited dollars.
  7. Keep open lines of communication with all the members of your client’s team of advisors: financial planner, investment advisor, accountant, insurance agent and estate planning attorney. For large estates, this team should meet formally at least once a year in order to provide the client with the best value.

“I believe advisors should also be keeping an eye on what’s happening with estate and other taxes at the state level which will likewise impact retirees’ financial futures.”

I believe advisors should also be keeping an eye on what’s happening with estate and other taxes at the state level which will likewise impact retirees’ financial futures. Local governments were also hard hit by the pandemic-related economic slowdown and need to make up for lost revenue and additional spending.

Additional Reading: 11 Changes in House Tax Proposal May Affect Your Clients 

There’s still a lot of uncertainty around the future tax picture, but that doesn’t mean we should wait for the other shoe to drop before we take any action. In my opinion, the more steps we take to protect clients now, the easier it will be to adjust when the laws actually change. Preparation and proactive navigation are the themes of the day when it comes to estate and tax planning.

Michelle Clary, CFP, ChFC, CLU, RICP is CEO/Senior Wealth Advisor with Piton Wealth in Kennewick, Washington and Kalispell, Montana. Piton Wealth is a part of Thrivent Advisor Network, LLC, a Registered Investment Adviser (RIA), located in Minnesota.

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