BY: DUT LeBLANC | Executive Vice President, Argent Financial Group
Federal tax laws have been mostly friendly to ultra-high-net-worth investors in recent years, but are likely to change under President Joe Biden — perhaps significantly. Although no specific 2021 tax changes have been announced, history tells us that some taxes — income and estate taxes, in particular — do tend to rise during Democratic administrations.
For ultra-high-net-worth as well as high-net-worth investors, any coming changes could result in a greatly increased tax burden. While nobody can predict what the future holds, any husband and wife worth $10 million or more should seek out a qualified wealth advisor who can help strategize for the most likely outcomes. Here are a few specific areas to watch out for:
Under a Biden administration tax plan, the biggest concern for ultra-high-net-worth families is a possible lowering of the estate tax exemption. This could necessitate a change in financial strategy for some families who have not previously been concerned before about passing down their wealth to children or other loved ones.
Since 2017, the exemption has been around $11.5 million per person, or $23 million per married couple — roughly double its pre-2017 level of around $5.5 million per person or $11 million per couple. The Biden administration has signaled a willingness to return the exemption to its pre-2017 level, and some commentators have suggested it could go even lower — as low as $3.5 million per person or $7 million for a married couple. If no changes are made, the current estate tax rate is set to expire after 2025 and return to the previous rate, plus annual adjustments.
The government doesn’t take in much money from estate tax right now because few people are wealthy enough to qualify for it. But if the exemption is lowered as part of 2021 tax changes, the estate tax will affect many more Americans with wealth between $10 million and $20 million who’ve previously been exempt. Those investors in particular should be looking at strategies for passing their wealth down to heirs without paying estate taxes — which fortunately do exist.
Step-up in cost basis
Another potential 2021 tax change for ultra-high-net-worth families to be aware of involves the “step-up” in cost basis on certain assets like stocks, mutual funds or real estate. Currently, when the original owner of those assets dies, their original value for tax purposes is reset, or “stepped-up,” to the date of the owner’s death — not the date on which they purchased the assets, which might have been many years in the past.
As a result, the person who inherits the assets can sell them right away and avoid paying capital gains taxes on what might be a sizable gain in value. Closing the step-up provision could result in a significantly greater tax burden to the heirs of inherited property, depending on the ultimate outcome of the legislation.
The effect of IRA changes
These potential 2021 tax changes become even more significant for ultra-high-net-worth investors when considered in tandem with the SECURE Act, which went into effect last year. Before the SECURE Act, a person who inherited an IRA or 401(k) could receive distributions for their entire life, providing a lifetime income source. Now, most beneficiaries are required to withdraw all those assets within 10 years after the death of the original account holder (an exception is given to spouses if they roll over the IRA to their own IRA).
For investors with a large amount of their wealth in IRAs, the tax burden to their heirs could be astronomical when IRA distributions and estate taxes are combined. (It should be noted that an income tax deduction might be available for the allocated portion of the estate tax that is incurred on the taxable IRA distributions.)
Here’s a simplistic example of how it could work, assuming that the top federal estate tax rate and federal income tax rate are 40% and state taxes are not included. We are also assuming that the first to die leaves all of the assets to their spouse and we are not considering that some may be left in a trust, both of which could result in variances in tax rates, tax basis and tax brackets.
Let’s say your net worth is $20 million, half in a retirement IRA and half in marketable securities. Under current law, there would be no estate tax on that money as it passes to your heirs after the second spouse dies. The IRA will still be taxed at its ordinary income tax rate, and because of the SECURE Act, the heirs would need to take out about $1 million a year, putting them in the top tax bracket. Out of that original $20 million, the heirs would keep $16 million or so.
Now, let’s say the estate tax exemption is returned to the 2014 rate ($5 million, plus annual adjustments). The exemption available would be at least $6.5 million per person, or $13 million per couple. The applicable estate tax might be about $2.8 million and the ordinary income tax over 10 years on the inherited IRA might be $4 million. In the end, the heirs would only end up receiving about $13.2 million out of their original $20 million inheritance.
What ultra-high-net-worth investors can do
It’s not too late for ultra-high-net-worth individuals and couples to start strategizing. If you and your spouse have $20 million or more in non-retirement accounts, several strategies might be worth considering.
One is making gifts. Individuals should consider annual gifting using the annual exclusion amount (for 2020 and 2021, the amount is $15,000 per person or $30,000 for a married couple).
In addition, using the lifetime gift tax exemption ($11.7 million in 2021), a wealthy person can give a large amount of money to other people over the course of their lifetime without having to pay gift tax. That amount is double for couples.
However, giving an outright gift might not be the best course of action in many situations. Gifts aren’t protected from creditors and could also be considered marital assets in the event of a divorce. Alternatively, putting those assets in a trust would offer these protections and others, such as allowing the trust grantor to specify terms under which it’s distributed out to beneficiaries.
Many families opt to use limited liability companies and family limited partnership arrangements where the parents control the operations of the entity and then make transfers to other family members utilizing minority and lack of marketability discounts. Because some of these arrangements can be complex, we at Argent work with our clients’ legal and tax counsel on the overall structure.
Time to start planning
For both ultra-high-net-worth and high-net-worth investors, the answer will often be a combination of strategies. But it is important to start figuring out now what the best plan is for your specific financial situation. Once COVID-19 is behind us, it is likely that Congress will start looking at tax law changes to start recouping the costs of relief during the pandemic.
The more wealth a person has, the more valuable it can be for them to have a qualified financial advisor in their corner. As wealth advisors and trustees, we at Argent work as an integrated team with our clients’ legal and tax counsel to help our clients meet their legacy and investment objectives.
Although we cannot know specifically what the future holds in terms of 2021 tax changes, there’s no time to waste when it comes to safeguarding your family’s financial future.
Dut LeBlanc is an executive vice president based in Argent’s Shreveport office. He joined Argent following his retirement from multinational accounting firm KPMG in 2019 after spending 40 years there. With Argent, Dut leads the company’s services for high-net-worth and ultra-high-net-worth clients through the company’s Argent Family Wealth Services line of business. Contact Dut at (318) 455-7930 or by email.