By Chris J. Roe, CPA, PFS
One of the biggest concerns we hear from our high-net-worth clients is how they can lower their tax burden. Those concerns are only growing with the release of the Biden Administration’s tax proposals that look to raise income taxes on high-earning business owners, professionals, and the wealthy.
Their proposal includes:
- Increasing ordinary income tax rates at the highest level from 37% to 39.6%,
- Increasing dividend and capital gains rates to the top rate of 39.6% for taxpayers making over $1 million,
- Charging the 3.8% net investment income surcharge on S-Corp distributions,
- Eliminating valuation discounts on the transfers of interest where the family owns at least a 25% stake in the business,
- Treating the grantor’s payment of income tax on a trust as a gift,
- Treating transfer of appreciated property by gift or death as a taxable event,
- Limiting the benefits of certain estate planning techniques, such as grantor-retained annuity trusts and taxing sales to grantor trusts, or
- Limiting an exclusion of certain gifts to a total of $50,000 per year, not the $17,000 per donee exclusion.
If you take action now, it is possible to sidestep the above proposals should they become law. So, what are we thinking about and advising our wealthy clients to do? Here are a few suggestions:
- Use your annual exclusion gift amounts to transfer appreciated investments to children. If your child is independent and in a lower tax bracket, it may make sense to transfer appreciated investments you are going to sell to your child and allow them to sell and recognize the gain.
- Give your less wealthy parent assets. This is the same as giving to your child. Additionally, if your less wealthy parents do not sell the investment but pass away, you will get a step up in basis and avoid the tax. Your parents can even leave the money to their grandchildren or great-grandchildren, preserving your lifetime exemption.
- Donate appreciated stock to a charity. Always use appreciated investments to give to charity. You get a tax deduction for the fair value of the donation and avoid tax on the appreciation. Make sure you’ve held the investment for greater than one year. Also, lump your gifts into a single year using a donor-advised fund to ensure you maximize your itemized deductions.
- Set up a charitable trust. If selling appreciated assets, consider setting up a charitable trust to defer the gain over many years while still getting an income stream.
- Set up a Roth IRA for your child. If your minor child has earned income, you can contribute to a Roth IRA on their behalf – growing tax-free during the child’s lifetime.
- Create a trust for your spouse and make gifts and sales of assets. Your spouse may serve as trustee and make distributions to themselves and your children. Also, it is a grantor trust, so you can pay the income tax and make sales before any proposals of taxation pass.
- Set up a trust for your children. There is a way to establish a trust for your independent children that will tax them on the income the trust earns, not you. Consider gifting some of your business interests to the trust so the children can pay the tax at a lower rate than you – enhancing the overall family wealth.
- Consider using life insurance and annuities to shelter taxable income. Should the capital gains rates change on high-income earnings, you may consider using certain life insurance contracts and annuities to shelter investment earnings from current tax. It may be possible to kick the can down the road to a lower tax environment. Be cautious—the contracts need to be specifically designed and not just bought from any insurance agent touting the tax benefits of a contract.
- Utilize Roth IRAs. When high tax environments exist, Roth IRAs become important to have and grow for potential future use when you need funds but do not want to pay tax to access them.
- Utilize tax-deferred retirement plans. Look at your retirement plan’s design. When you are in the highest bracket, it makes sense to maximize tax-deductible contributions.
- Utilize 529 plans. While these are primarily meant to fund college, you may use them for other purposes if you are wealthy. These are generally protected assets from creditors, and investment earnings are not taxable annually. If you hold the funds long enough to get significant tax deferral and allow your children to possibly use them as a retirement vehicle, the overall tax deferral will more than makeup for the extra 10% tax, if a withdrawal is taken. By the way, it is possible your grandchildren or great-grandchildren can use them for education or their lifestyle spending. Think about the earnings compounding over, say, a 50-100 year period.
- Make a sale of assets to a grantor trust. Before any proposal becomes law, make a sale of assets to a grantor trust to provide the flexibility of forgiving the note or just taking back the asset to settle the note should the laws change. It gives flexibility. This should be done with care and proper counsel.
- Establish a grantor trust. While you may not want to transfer assets in trust currently, you may want to set up a trust now to give you flexibility in the future. The Administration’s proposal calls for the taxation of sales to the trust and taxes paid on behalf of the trust to be treated as a gift for trusts created after the new law is passed, not before.
- Limit the duration of the GST Exemption. Many wealthy families use what is referred to as a Dynasty Trust. It is a trust meant to be exempt from estate tax for many generations. The proposal wants to limit the time of the exemption. So to ensure you beat any law change, set up a dynasty now in a state that allows the trust to go on for a long time. Fund with a few small assets and allow it to be grandfathered under any law change. This will give flexibility if you want to gift assets to your children and grandchildren in the future.
- Use second-to-die life insurance to create a legacy. Should the step-up in basis be repealed, leveraging tax-free life insurance on you and your spouse to benefit children and grandchildren becomes much more attractive. When evaluating if a client should do this, we always analyze it from a return to life expectancy. Remember, life insurance is an asset that needs to be reviewed and managed. If it does not provide an attractive return. However, if structured properly, we believe every wealthy family should have some life insurance as part of the family’s diversified assets. This also leverages wealth that can pass in a dynasty trust should the law change.
- Using life insurance to achieve a step-up in basis. Life insurance is tax-free when received, and its earnings inside of a policy grow tax-deferred during its lifetime. Consider using it inside of a dynasty trustto grow assets for your grandchildren. When you die, they receive the benefits tax-free effectively, giving them a step-up in basis even if the law eliminates step-ups.
- Basis step-up using parents or grandparents. If your grandparents or parents are older and have no estate tax issues, consider setting up a trust for your spouse, children, and parents/grandparents. When your grandparents or parents pass, there is a way to make the trust includable in their estate and to achieve a step-up in basis, thus, avoiding income tax on all appreciation of the assets in the trust. This may change if no step-up becomes law but may be grandfathered if done before any law change.
As always, you should seek professional counsel before implementing any strategy, which should work within the context of your family’s overall financial plan. While saving taxes is important, it is not the end goal – it is part of a thoughtful, coordinated plan to manage and grow a family’s wealth over time. Should you need advice on your personal situation or want to discuss a strategy you believe will work for you, please feel free to reach out for a free consultation.
Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at firstname.lastname@example.org, or on the web at rxwealthadvisors.com.
While we are providing this as general advice, you should always consult your financial advisor, tax advisor, or attorney before implementing any of these strategies.