Leaving a financial legacy is an important factor in financial planning for many retirees, particularly those with high net worth.
Whether the goal is to give loved ones a financial boost, strengthen their retirement or contribute to grandchildren’s education, proper planning can allow retirees to make an impact long after they pass away.
Taxes can be a significant factor in determining how much is left. If you aren’t tax-efficient in your strategy, you might be paying a large portion of your legacy to the government rather than your loved ones.
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Federal estate taxes begin at any amount of inheritance above $15 million for individuals, $30 million for married couples.
Beyond that, income and capital gains taxes on inherited assets can come back to bite.
As high-net-worth individuals plan their estates, it’s important to do so early and keep tax efficiency in mind. Here are three things to consider.
Pick the right trust
There are more than 30 types of trusts to consider, but they’re broken into two categories: Revocable and irrevocable.
A revocable living trust is usually where we start the estate-planning process — this type of trust can be amended by the original grantors/trustees during their lifetime, allowing flexibility and control of the assets.
An irrevocable trust doesn’t offer the same flexibility; under most circumstances, it can’t be changed unless all beneficiaries agree to make modifications, which can be a complicated process.
However, the benefit of an irrevocable trust is that it’s typically excluded from the additional estate tax applied to estates above the $15 million threshold.
Establishing clear goals while legacy planning can help distinguish whether revocable, irrevocable or both types of trusts should be a part of your plan.
Determining if your estate is above the threshold and subject to additional taxation is a good place to start. If it’s over, an irrevocable trust might be the best option to avoid further taxation.
However, because of the lack of flexibility, it’s important to choose someone you have faith in to be in charge of the trust, such as a loved one or your personal lawyer or financial adviser.
One type of irrevocable trust to consider is a charitable remainder trust. This option allows you to designate a portion of the trust to be donated to charities of your choice when the beneficiaries die. The income is distributed to the beneficiaries tax-free, and the remainder can be donated to charity when they pass away.
Consider step-up-in-basis
Understanding your capital gains situation can help determine if and when you should utilize tax-loss harvesting strategies to effectively limit your taxation, both in the present and future.
Step-up-basis means that when someone inherits an investment, such as property or stocks in a brokerage account, the asset’s cost basis is reset to its value on the date of the original owner’s death.
As a result, when the beneficiary sells it, they only have to pay capital gains tax on the appreciation that occurred after inheritance, rather than the total gain accumulated over the decedent’s lifetime. Depending on income levels, capital gains can be as high as 20%.
For example, Apple stock was worth about 30 cents in 1990, and it’s currently worth around $300. If you were to buy this stock 36 years ago and sell it today, you would owe up to 20% capital gains tax on your total earnings. If you leave it as an inheritance, the value resets at the current $300, and your beneficiaries can sell it with significantly less tax.
Good planning is knowing which stocks to sell and harvest now, and which stocks to save for the next generation.
Indexed universal life insurance might help
Many people only think of life insurance as an option to protect their family’s finances when they’re younger, in the event of an unexpected death.
However, life insurance can also be an effective way to pass on tax-free money or income when they pass away.
The widow’s penalty is often overlooked but can be detrimental for the surviving spouse. For example, if one spouse has a pension, the surviving spouse might lose some or all of that income.
In addition, Social Security benefits are reduced, as the surviving spouse only gets to keep the larger of the two benefits.
Not only do we need to plan for a reduction in income, but also an increase in taxation as the widow moves from the joint to single tax bracket; this double whammy can be difficult to manage.
An indexed universal life insurance (IUL) policy can help supplement the surviving spouse’s income. It’s typically funded over a period of time through monthly premiums, which can total up to thousands of dollars per year.
A portion of the premium covers the cost of insurance, including a death benefit, which can be more than $1 million, depending on the policy. The remaining portion contributes to the policy’s cash value accumulation.
The cash value can be invested in the market, typically using an index fund, contributing to the policy’s growth over time. When the owner passes away, beneficiaries will receive the death benefit, completely tax-free.
However, the cash value could be subject to capital gains tax.
This option might not be suitable for everyone, as it sometimes requires extensive health screenings, which are harder to pass as we age. But it can be one of the better tools to utilize if you plan and have the capital to do so.
Summary of high-net-worth estate planning
To recap, here are the key tools and strategies to consider for high-net-worth individuals creating an estate plan:
- Pick the right trust. Evaluate the different types of trusts, including revocable, irrevocable and charitable remainder trusts to maintain control and limit taxation
- Tax planning. Knowing when to utilize tax-loss harvesting strategies and when to save those stocks for the next generation. Be intentional about the assets you leave behind.
- Indexed universal life insurance. An IUL can help protect your family after your death and provide tax-free income, which can help offset the widow’s penalty
- Other strategies may include gifting or selling a family business to the next generation, which can be spread across several years to help reduce taxation now and in the future.
There’s a lot to keep in mind, but it’s important to get it right. I recommend speaking with a financial adviser to evaluate your unique situation and build a plan that works for you. You and your family deserve to protect and experience your full legacy.
