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Death and Taxes: Considering a Financially Holistic Approach to Building Your Legacy


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Death and taxes have long been regarded as the only certainties in life. For individuals, these inescapable realities require thoughtful consideration when considering their financial futures. Considering both the need for tax-efficient strategies and preparing for the eventual transfer of wealth after death is a critical aspect of comprehensive financial planning. In this article, we will explore the interconnected relationship between death and taxes and discuss key strategies to ensure a well-rounded approach to transferring wealth.


Estate Taxes a.k.a. Death Taxes

To best understand the relationship between tax management and death we will first start by looking at the most direct link between the two, estate taxes.


Estate taxes, sometimes referred to as "death taxes," are imposed on the transfer of wealth upon an individual's death. These taxes can have a significant impact on the value of an estate and the inheritance received by beneficiaries. In recent years, estate tax exemption limits have been on the rise, providing relief for many individuals and their heirs.

This tax is levied on the value of a deceased individual's estate before the distribution of assets to their beneficiaries. Estate Taxes are calculated based on the total value of the estate, including real estate, investments, personal property, and other assets.


The estate tax exemption limit is the threshold above which an individual's estate becomes subject to federal estate tax upon their death. In other words, it is the maximum value an estate can have without being subject to estate taxes. Estates valued below the federal exemption limit are exempt from federal estate tax, while those above the limit are taxed on the portion of the estate's value that exceeds the exemption amount.


In 2021, the federal estate tax exemption limit was $11.7 million per individual and $23.4 million for married couples assuming portability elections are properly made. The exemption limit has continued to rise, notably increasing in 2017 with the passage of the Tax Cuts and Jobs ACT (TCJA) which doubled the exemption. This provided additional opportunities for individuals to shield their assets from estate taxes and preserve their wealth for their beneficiaries.


The significant increase in the estate tax exemption limit brought about by the Tax Cuts and Jobs Act (TCJA) is currently set to "sunset" or expire on December 31, 2025. Unless new legislation is enacted to extend the increased exemption limit or make it permanent, the limit will revert to its pre-TCJA level (adjusted for inflation) on January 1, 2026. This means that the estate tax exemption limit would be reduced, potentially subjecting more estates to federal estate tax liabilities. Individuals should stay informed about potential changes to estate tax laws and exemption limits and consult with estate planning professionals to ensure that their estate plans remain optimized for the current tax landscape.


For those who are likely to die with an estate more than the estate tax exemption amounts, below are some brief strategies that could be implemented to reduce or eliminate estate taxes:

  • Annual Exclusion Gifts: Make use of the annual exclusion by gifting up to the maximum amount allowed per recipient, per year.

  • Irrevocable Life Insurance Trust (ILIT): Utilize an ILIT to hold life insurance policies, which will keep the proceeds out of your taxable estate.

  • Family Limited Partnership (FLP): Create an FLP to transfer assets to family members at a discounted value, reducing the size of your taxable estate.

  • Charitable Giving: Make charitable donations, to potentially reduce the overall size of your estate.

  • Grantor Retained Annuity Trust (GRAT): Set up a GRAT to transfer assets to beneficiaries at a reduced gift tax cost.

  • Qualified Personal Residence Trust (QPRT): Establish a QPRT to remove the value of your primary residence or vacation home from your taxable estate.

  • Spousal Lifetime Access Trust (SLAT): Create a SLAT to provide financial support for your spouse while also reducing your taxable estate.

  • Dynasty Trust: Set up a dynasty trust to provide long-term benefits to your descendants and potentially reduce estate taxes for multiple generations.

Lifetime Goals vs. Legacy Goals

Because of the relatively high estate tax exemption limits, most investors will likely fall below this amount. Even so, taxes should remain a primary consideration when pursuing transferring wealth optimally to future generations. In general, tax planning is essential for maximizing wealth and ensuring that individuals can meet their financial goals. These goals generally can be divided into two categories: lifetime goals and legacy goals.


Lifetime goals broadly exist for almost all individuals and include things such as retirement planning, education planning, home purchases, etc. Legacy goals are different from lifetime goals in that they extend beyond the immediate benefit of the individual and onto others whether it may be a partner, another generation, or philanthropic/charitable institutions. Of course, there are several tax strategies that can be employed to maximize these goals and to optimize an individual’s financial situation during their lifetime.


Some key tax strategies for optimizing these lifetime goals include maximizing deductions, such as mortgage interest and charitable contributions, to reduce taxable income; utilizing tax-deferred investment vehicles like IRAs and 401(k) plans to capitalize on tax-deferred growth; claiming relevant tax credits to directly lower tax liability; employing techniques like tax-loss harvesting to manage capital gains and losses; and implementing estate and gift tax strategies to minimize tax liabilities during the transfer of wealth.


These strategies can be powerful tools in preserving wealth and enhancing goals during an individual’s lifetime, but those with legacy goals will have to consider their own set of tax planning techniques to maximize this extended planning timeline.


It’s important to note that attempting to maximize a lifetime goal can sometimes come at the expense of a legacy goal or vice versa. Consider a basic example. Let’s assume that Jane Doe (a single individual) is primarily focused on maximizing her net worth during her lifetime. In doing so, she may forego establishing a will and other important estate documents. After all, the cost of establishing a will is more than zero and therefore will reduce the lifetime goal of maximum net worth. With that said, most people naturally understand the value of setting up a will, even though it serves little immediate benefit during their lifetime.


When it comes to taxes the same can often be said about needing to consider both lifetime and legacy goals. There are tax strategies that can be advantageous to one at the expense of the other. Below, we’ll consider two examples:


Roth Conversions

In simple terms, a Roth conversion is the process of transferring funds from a traditional IRA or other tax-deferred retirement account to a Roth IRA. The primary difference between the two accounts is how they are taxed. With a traditional IRA, contributions are tax-deductible, but withdrawals are typically taxed. On the other hand, Roth IRA contributions are made with after-tax dollars, and qualified withdrawals are tax-free. By converting dollars from a Traditional IRA to a Roth IRA, you pay taxes on the converted amount at your current income tax rate, essentially "prepaying" the taxes. This strategy can be particularly beneficial if you anticipate being in a higher tax bracket during retirement or if you believe that tax rates will increase in the future. The tax-free growth and withdrawals of a Roth IRA can provide more financial flexibility in retirement and potentially help you save on taxes later in life.


In some instances, a Roth conversion may result in increased taxes during an investor’s lifetime while also increasing the dollars ultimately inherited by future heirs. This may happen when an account holder converts their Traditional IRA to a Roth IRA, paying taxes on the conversion at their current, higher marginal tax rate. Although this may increase their lifetime tax liability, the benefits for their heirs may outweigh this cost. Once the assets are in a Roth IRA, all future growth and qualified withdrawals would be tax-free. By prepaying the taxes during the conversion, the account holder ensures that their heirs will not owe tax on the inherited Roth IRA distributions.


This strategy can be particularly effective if the account holder has a sizeable estate and expects that their heirs will inherit substantial assets, which could push them into a higher tax bracket. By converting to a Roth IRA, the account holder can help minimize the tax burden on their heirs and maximize the value of the assets passed down to the next generation.


This strategy has become even more impactful recently since the new inherited IRA 10-year rule for inheritors took effect in 2020. Under the new rule, most non-spouse beneficiaries of an inherited IRA must completely distribute the funds within ten years of the account holder's death, rather than over their own lifetimes as was the case under the previous "stretch IRA" rules. This accelerates the timeline for taxable distributions and could potentially push beneficiaries into higher tax brackets, thus increasing the tax burden on the inherited assets.


Non-Qualified Annuities

Non-qualified annuities are financial products that provide a stream of income in exchange for an initial investment made with after-tax dollars. They offer some benefits, including tax-deferred growth, no contribution limits, flexible payout options, and no required minimum distributions.


Given their tax-deferral properties, many individuals are attracted to these products even when there isn’t an income need. However, this lifetime deferral can come at the expense of their future heirs. Those who inherit non-qualified annuities will likely pay ordinary income rates on the growth generated from those products, when the taxes are inevitably owed. It’s important to remember that these assets will forego any step-up in cost basis like their non-qualified, non-annuity peers would receive.


A step-up in cost basis is a powerful tool in its own regard. A "step-up in cost basis" is a tax rule that adjusts the value, or "cost basis," of an inherited asset when it is passed on after death. The cost basis of the asset is "stepped up" to its fair market value at the date of the owner's death. This rule can be extremely beneficial to the recipient because it can significantly reduce the capital gains tax owed if the asset is sold.


For instance, if an individual bought a stock for $10 (the original cost basis) and it was worth $50 at the time of their death, the beneficiary who inherits the stock receives a step-up in basis, meaning the new cost basis would be $50, not $10. If the beneficiary then sells the stock for $60, they would only owe capital gains tax on $10 per share (the difference between the sale price and the stepped-up basis), not $50 per share (the difference between the sale price and the original basis). This step-up rule, therefore, can result in significant tax savings for the heir.


At first, non-qualified annuities may appear to have the most beneficial tax treatment to their non-annuity peers, but it is often not the case when looking beyond the annuity owner’s life.


Don’t Forget Your Estate Plan

Death, though an uncomfortable topic for many, is a crucial aspect of financial planning. It’s important for individuals to prepare for the eventual transfer of wealth to their heirs, ensuring that their assets are distributed according to their wishes and in a tax-efficient manner. Proper estate planning can minimize estate taxes, probate costs, and potential family disputes while ensuring that the individual's legacy is preserved and their loved ones are cared for. Below are a few building blocks that should be considered when creating an estate plan:

  • Will: A will is a legal document that outlines an individual's wishes regarding the distribution of their assets and property after death. It also appoints an executor to manage the estate and carry out the instructions specified in the will. Creating a will ensures that an individual's wishes are honored and can help prevent potential disputes among beneficiaries. Moreover, a will can designate guardians for minor children, providing them with care and financial support in case of a parent's death.

  • Durable Power of Attorney: A durable power of attorney (DPOA) is a legal document that grants a designated person (agent) the authority to make financial and legal decisions on behalf of an individual (principal) in case they become incapacitated. This document allows the agent to manage the principal's assets, pay bills, and handle other financial matters. A DPOA ensures that an individual's financial affairs are properly managed during times of incapacity, providing peace of mind and preventing potential complications.

  • Healthcare Directive: A healthcare directive, also known as an advance medical directive, is a legal document that outlines an individual's preferences regarding medical treatment if they become incapacitated and unable to communicate their wishes. Healthcare directives can include living wills and healthcare powers of attorney. A living will provides instructions for end-of-life care, while a healthcare power of attorney designates a representative to make medical decisions on behalf of the individual. Healthcare directives help ensure that an individual's medical care preferences are respected, reducing the burden on family members during a difficult time.

  • Beneficiary Designation: A beneficiary designation is a legal specification of who will receive the proceeds from financial accounts, life insurance policies, or retirement plans upon the owner's death. By naming beneficiaries, individuals can bypass the probate process and ensure that assets are transferred quickly and efficiently to their intended recipients. Regularly reviewing and updating beneficiary designations is crucial to avoid outdated or conflicting information, which could lead to disputes or complications in the asset distribution process. These designations often supersede what is outlined in the will, so it is critical to ensure that these are up to date.

  • Trust: A trust is a fiduciary arrangement that allows a third party, or trustee, to manage and distribute an individual's assets according to the terms specified by the creator (grantor). Trusts can be useful for minimizing estate taxes, protecting assets from creditors, and maintaining privacy. There are various types of trusts, such as revocable and irrevocable trusts, each with its advantages and limitations. Trusts can be tailored to address specific needs and circumstances, providing greater flexibility and control over the management and distribution of assets.

Conclusion:

Death and taxes may be unavoidable, but with the guidance of a skilled financial advisor and estate attorney, individuals can navigate these complexities and create a comprehensive financial plan that addresses both aspects. By taking a holistic approach to taxes and end of life planning, individuals should be better equipped to maximize the transfer of wealth, minimize tax liabilities, and ensure that their financial legacies live on after they are gone.

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