An Introduction to Tax Strategy for Multi-Generational Wealth
Saving tax dollars often isn’t just about lowering what you owe this year or even lowering the next several years of tax bills. It’s about lowering taxes across your entire family for as long as possible.
Note that while there are countless valid tax reduction strategies out there, this article specifically focuses on just some of the strategies applicable for families.
Understanding the Problem
Leslie is in her late 60s, unmarried, and has three adult children who are her only heirs. She knows she can gift up to $16,000 of cash to each child during 2022 without being required to report any of these gifts to the IRS. Doing the math, she sees that doing so will move $48,000 out of her taxable estate when she passes away. To Leslie, this seems like a great way to leave her children more after-tax dollars. Even better, because her 2022 income is low enough to allow for it, Leslie can sell stock from her taxable brokerage account at a 0% federal capital gain tax rate to generate the cash for these gifts.
This all sounds like great tax planning, right?
Maybe not. Possible problems include:
Does Leslie even have “an estate tax problem”? For her taxable estate to be subject to federal estate taxes, she would need a taxable estate + lifetime cumulative taxable gifts of $12,060,000 in 2022. Very, very few US taxpayers meet this threshold, so perhaps Leslie doesn’t have a problem in the first place.¹
Yes, Leslie may have avoided federal capital gains taxes – and perhaps even state taxes – to raise the cash for the gifts, but possibly at a price. If Leslie has a traditional Individual Retirement Account (IRA) as many folks do, to take advantage of her low income and tax brackets a better move may have been to do a Roth IRA conversion rather than cashing in appreciated stock. A Roth conversion is a taxable transfer from a traditional IRA to a Roth IRA resulting in a lower traditional IRA balance. This means both a) lower Required Minimum Distributions starting age 72 as RMDs are calculated based on traditional IRA account balances, and b) her children will inherit at least some amount in Roth accounts which aren’t subject to income tax upon distribution.² Additionally, the tax basis of the securities in her taxable brokerage account will likely be stepped-to a higher market value upon her death meaning the gain disappears for her heirs. This makes the strategy of harvesting gains less desirable when compared to holding the securities and letting heirs inherit stepped-up assets. Of course, Roth conversions won’t provide the cash for any gifts she’d like to make currently, so her cash needs must be included in the analysis.
What about her children’s current tax situation? Leslie’s two older children – April & Andy – both have incomes on the low side. They’re excited about receiving the gifts and will immediately spend the money. Leslie’s youngest child, Donna, is a high earner who doesn’t need additional funds. Donna plans to deposit her $16,000 into her taxable brokerage account and invest it in dividend-paying stocks. In an attempt to treat all her children equally, Leslie has likely shifted earnings on Donna’s $16,000 into a higher tax bracket.
See what I mean? Tax planning is a family affair.
Top Priority
Here are a few of the areas where I regularly see confusion, missed opportunities, and even unintentionally expensive moves that can’t be undone.
Roth IRA conversions: Clients want to know “should I pay more tax now so I and/or my heirs will pay less taxes later?” The follow up question is “If it does make sense to do Roth conversions, how much should I convert?” The answers depend on a variety of factors, including your current age, life expectancy, long-term financial plan, sources and levels of income, state of residence both now and in retirement, asset levels inside and outside of retirement accounts, etc. Add to that the need to know who will receive your Roth accounts and other assets when you pass away and what their tax situation looks like. For example, if you’re in a high tax bracket and are leaving all your assets to a charity, it might not make sense to generate additional taxable income via Roth IRA conversions when the charity likely won’t pay taxes on any Roth accounts it receives. On the other hand, if your taxable income is fairly low, you have a large traditional IRA balance, and the sole beneficiary of your estate is your high-earning sister – that situation looks more suitable for a Roth conversion. In that situation, you may be able to pay tax now to leave her with a smaller traditional IRA balance – the distributions for which will likely be subject to tax at her higher rate. With so many variables to consider, deciding whether a one-time or series of Roth conversions is right for you necessitates a deep dive into your entire financial situation and at least some insight into how your beneficiaries will benefit – or not benefit – from the conversions.
Home sale gain exclusion: Do you want your children to have your home when you pass away so you plan to just give it to them now? Or maybe you want to retain ownership, but you’d like them to move in now that you’re finally making a permanent move to your beachside townhouse. Or are you and your spouse coming to your marriage each with a home and you want to keep both properties? Why does it matter what you do with your house? You could unknowingly jeopardize the taxable gain exclusion on the sale. The federal home sale gain exclusion is one of THE most significant tax benefits out there, and many folks take it for granted until after they’ve done something to lose it. The exclusion is for up to $250,000 of gain, and possibly up to $500,000 for married couples. However, it’s not a guaranteed benefit. There are rules for excluding this gain from tax. For one, you must both own and use the house as your principal residence for two out of five years leading up to the sale. This makes moving out and allowing someone else to live in your home a potential tax trap. Further, the gain exclusion can be used only once every two years. This, plus the ownership and use requirements, means some planning may be necessary when spouses come into a marriage each owning their own homes. Thinking about giving your house to your kids now? It may be preferable to let them inherit the home later or even sell it to them rather than gift it to them. Depending on your estate plan and other factors, death or sale may allow the home to transfer tax free while a gift may not because the recipient is now required to meet the gain exclusion rules themself. If you only remember one thing: make sure you discuss contemplated transactions regarding your principal residence with your tax advisor before the transaction takes place.
Final years: While death is often sudden, for those who have time to prepare, there can be room for tax savings opportunities that may allow your heirs to receive more after-tax dollars. A few ideas from situations I see among my client base include:
Capital loss carryforwards die with the person who generated them. Generating realized capital gains to use these carryforwards may be one answer, although that strategy can be somewhat moot if the securities’ tax basis will step to a higher tax basis upon death . Another move could be for an heir to make a gift³ of appreciated securities to the dying family member who can then sell them before the capital losses are forever lost.
Out-of-pocket, unreimbursed medical costs can quickly add up. Such costs that qualify as tax-deductible can sometimes be so significant that they create a meaningful drop in tax brackets, often wiping out taxable income entirely for someone previously in a higher tax bracket. This is an opportunity to generate additional taxable income inexpensively or even at no tax cost at all. An obvious candidate here is increased IRA distributions. As we’ve seen previously, IRAs aren’t the most desirable assets to inherit due to their tax treatment. Even if you have cash on hand to pay for medical costs, it may be a good tax move to cover those costs with IRA distributions rather than the cash if you can inexpensively absorb extra taxable income. This allows your heirs to receive more of the tax-advantaged cash rather than the tax-unfriendly IRA.
Rethink how assets are split among beneficiaries. Again, different assets will have different tax consequences for recipients. Let’s say you have a $60,000 traditional IRA balance and $60,000 in cash. Further, you want to leave the full $120,000 evenly to your favorite charity and your only child. A public charity will likely be indifferent to the type of assets it receives so consider naming it as the beneficiary of your traditional IRA. You can then leave the $60,000 in cash to your child. If you child were to instead inherit some or all of the IRA, they might pay tax on the resulting distributions, reducing their inheritance accordingly.
Other Situations
Married – with and without children Does it make sense to file a joint tax return? You might be surprised at how often filing separately results in significant tax savings given how tax law changes have played out in the last few years. Also, a couple living in community property states may end up with a different answer than a couple in a non-community property state, even if their tax situations are otherwise identical. Filing jointly may also unfavorably impact student loan repayment strategies. Adding children into the mix makes for even more challenging tax planning. 529 education plans, custodial accounts, “kiddie tax,” various education related tax benefits, etc. If you’re a business owner, could you legitimately have your children work for you? This could possibly be a deduction for your business while generating income tax free earnings to them. They may even be able to make Roth IRA contributions on those earnings. What about which spouse claims the children as dependents in the event of divorce? Is this clearly listed in your divorce agreement?
Estate Tax Planning While the current federal estate tax exemption is quite high, it likely won’t remain so indefinitely. Further, some states have estate and/or inheritance taxes of their own. For those who may have federal and/or state estate tax “problems,” the goal is to strike a balance between the sometimes competing concerns of estate tax reduction, income tax reduction, and long-term cash needs. A solid estate tax plan may include moving appreciating assets to a trust⁴ or even gifting outright to beneficiaries during life. For example, moving appreciated assets into a Charitable Remainder Trust removes those assets from the donor’s taxable estate, generates a current charitable contribution deduction for the donor, and creates a cash flow stream for the donor or other recipient.
Non-US Spouses and Family Members Beyond the scope of this article, note there are different tax rules, filing requirements, and pitfalls when transferring, gifting, etc. with folks who aren’t US citizens or residents. Make sure your and their tax situations and related rules are considered to arrive at optimal strategies.
Parting Thoughts
While this is certainly not a complete list of all the ways to go astray when considering family tax planning, the purpose is for you to be in the right mindset. If you have concerns about your own multi-generational tax plan, feel free to reach out at https://www.atlanta.tax/contact.
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¹ Does Leslie’s state perhaps have its own estate tax? It may and that would be another component to consider.
² At least per tax law as of this article’s original publication date. Your guess is as good as mine as to what happens down the road.
³ Gifting strategies generally have tax reporting requirements and numerous pitfalls. Do not gift assets without first consulting your tax advisor.
⁴ There are many flavors of trusts – or other vehicles such as family limited partnerships – to choose from depending on a variety of circumstances. Do not establish a legal entity such as a trust for asset preservation or asset transfer purposes without first consulting your tax advisor.
