Wealthy families may benefit from certain estate planning strategies to minimize taxes on transferred wealth. These strategies may include life insurance, Roth IRA conversions, lifetime gifting, and others.
The Great Wealth Transfer is underway. Over the next 25 years, nearly 45 million U.S. households will transfer approximately $68 trillion to the next generation, according to Cerulli Associates. In addition, many provisions of the Tax Cut and Jobs Act of 2017 will sunset in 2025. This raises questions about future tax rates—especially on the wealthiest Americans.
Indeed, tax laws are always in flux. However, it’s safe to assume that Uncle Sam will want his share, no matter when you transfer your estate. If you expect to leave significant wealth to your heirs, proper estate planning is key. Fortunately, there are strategies you can leverage to minimize your family’s potential tax burden.
to minimize taxes on transferred wealth, consider the following estate planning strategies:
Strategy #1: Life Insurance
Depending on its size, your estate may owe federal and possibly even state taxes when it transfers to your heirs. Many wealthy families purchase life insurance policies to cover the potential tax liability and preserve the next generation’s inheritance.
Your beneficiaries can also use the payout to fund the expenses they incur settling your estate. A cash reserve can be helpful if most of your wealth is in illiquid assets like property and other valuables.
Strategy #2: Roth IRA Conversion
The SECURE Act of 2019 abolished the “stretch IRA” for most individual retirement account (IRA) beneficiaries. Previously, beneficiaries could stretch withdrawals over their lifetime to minimize their tax burden. Now, IRA beneficiaries must empty the IRA within 10 years of inheriting it.
This is especially problematic for traditional IRA beneficiaries, since withdrawals are taxed as ordinary income. If your heirs are high earners, the tax consequences can be significant. Not to mention, the required withdrawals can place them in an even higher tax bracket.
If you anticipate transferring a sizable account balance, a Roth IRA conversion may be an effective workaround. Roth IRA withdrawals are tax-free if the account has been open for at least five years. Meaning, your beneficiaries can keep the entire balance if transferred in a Roth.
Of course, a Roth IRA conversion doesn’t allow you to avoid paying taxes altogether. Instead, it’s a taxable event for you, the account owner. Therefore, it’s important to work with a financial planner to determine if a Roth conversion makes sense.
Strategy #3: Lifetime Gifting
In many cases, gifting is one of the simplest estate planning strategies to reduce taxes on transferred wealth. Each year, the annual gift-tax exclusion allows you to gift a certain amount (up to $15,000 in 2021) to as many people as you like without incurring the federal gift tax. Moreover, spouses can combine the annual exclusion to double the amount they can gift tax-free.
Cash gifts are most common. However, you can also use the annual exclusion to transfer personal property or contribute to a 529 college savings plan. Alternatively, the IRS allows you to pay educational and medical expenses on behalf of someone else without incurring federal taxes. The only caveat is you must pay the institution directly.
Strategy #4: Trusts
Trusts can be effective estate planning strategies to reduce taxes on transferred wealth. For example, a grantor retained annuity trust can be helpful if you’re transferring assets that are hard to value. In addition, lifetime credit shelter trusts allow you to maximize your annual gift-tax exclusion without immediately transferring your wealth.
Trusts are varied and complex. It’s important to consult your financial planner or estate planning attorney to determine if they fit within your estate plan.
Next Steps: Review these Estate Planning strategies With a Trusted Advisor
Your estate plan is a living document, meaning it will evolve as your family dynamics and financial situation change. Be sure to review it often to ensure it remains aligned with your wishes and identify additional strategies to reduce taxes on transferred wealth.
Sherwood Wealth Management specializes in the wealth management needs of sudden wealth beneficiaries. If you’ve recently inherited a windfall, we can help you develop a plan to protect and grow your newfound wealth and preserve it for future generations. To learn more, please schedule a call with our founder, Brian Littlejohn, CFP®, CFA®.