Estate planning for young families – Flexibility is the key
Younger taxpayers are faced with a dilemma: Should they minimize gift and estate taxes through lifetime gifts? Or, should they keep assets in their estates to help ease the potential income tax burden on their heirs? The right strategy depends on which taxes will have the biggest impact. If your remaining life expectancy is 30 years or more, however, this is nearly impossible to predict.
Today, your net worth may be well within the federal gift and estate tax exemption of $5.43 million ($10.86 million for married couples). But if your wealth grows substantially during the next 30 years — or if Congress decides to lower the exemption threshold — you may end up with a significant estate tax bill. Fortunately, a carefully designed trust can provide you the flexibility to take a wait-and-see approach.
It’s all about basis
When you transfer assets at death, your tax basis is “stepped up” to the assets’ current fair market value, allowing your heirs to sell the assets without recognizing capital gains. When you transfer assets via gifts, however, they retain your basis, so recipients who sell appreciated assets may face a big tax bill. From an income tax perspective, it’s usually best to keep assets in your estate and transfer them at death.
Estate tax planning, on the other hand, generally favors lifetime gifts. By transferring assets to the younger generation as early as possible — either in trust or outright — you remove those assets from your estate while asset values are low, thus minimizing gift taxes, while shielding future appreciation from estate taxes.
The best strategy is the one that will produce the greatest tax savings for your family. But if you wait until you know the answer, it may be too late. Let’s look at an example.
Frank, age 40, has a net worth of $5 million. In 2015, he transfers $1 million in stock (with a $500,000 tax basis) to an irrevocable trust for the benefit of his daughter, Margaret. When Frank dies 30 years later, the stock’s value has grown to $6.5 million. By giving the stock to Margaret in 2015, Frank avoided estate tax on $5.5 million in appreciation. However, because the stock retains Frank’s $500,000 basis, Margaret will incur a $1.2 million capital gains tax (assuming a 20% rate) if she sells it.
Assume that, when Frank dies, his net worth remains at $5 million and the inflation-adjusted estate tax exemption is $12 million. Even if Frank had kept the stock, his estate would have been exempt from tax, so there was no advantage to giving it away. And, if he had transferred the stock at death, the stepped-up basis would have erased Margaret’s capital gains tax liability. Under these circumstances, keeping the stock in Frank’s estate would have been the better strategy.
Suppose, instead, that in 2045 Frank’s net worth (apart from the stock) has grown to $10 million. Keeping the stock would increase his estate to $16.5 million, generating a $1.8 million estate tax (assuming a 40% tax rate). Given these facts, the estate tax savings are significantly larger than the potential income tax cost. So the family is better off if Frank removes the stock from his estate in 2015.
Bear in mind that this example is oversimplified for illustration purposes. To determine the right strategy, you also need to consider state income and estate taxes, as well as your beneficiary’s future plans. For example, if Margaret plans to hold the stock rather than sell it, income taxes are removed from the equation, so Frank’s plan should focus on estate tax avoidance.
Hedging your bets
It’s difficult to predict your family’s financial situation, and the state of estate and income taxes, decades from now. But with a carefully designed trust, it’s possible to hedge your bets, giving the trustee the ability to switch gears when the best course of action reveals itself.
Here’s how it works: You transfer assets to an irrevocable trust for the benefit of your heirs, relinquishing control over the assets and giving the trustee absolute discretion over distributions. The assets are removed from your estate, minimizing gift and estate taxes. If, however, it becomes clear that estate tax inclusion is the better tax strategy, the trustee has the power to force the assets back into your estate. (See the sidebar “How to return assets to your estate.”)
Handle with care
Even though the strategies discussed allow you to build some flexibility into your estate plan, it’s important to know the risks. For example, if you die before the trustee has had a chance to act, the opportunity for estate tax inclusion will be lost. Discuss the pluses and minuses of these strategies with your advisor before taking action.
Sidebar: How to return assets to your estate
The key to removing assets from your estate is to ensure that you retain no control over their use, enjoyment or disposition. Conversely, the trustee can force assets back into your estate by providing you with such control. Typically, this is accomplished by giving your trustee the authority to grant you a general power of appointment or name you as successor trustee.
For this strategy to work, the trust document must give the trustee absolute discretion over whether to invoke this authority. Moreover, you shouldn’t have the power to remove and replace the trustee.