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How to (NOT) leave behind a smaller legacy and pay more taxes

Jun 16, 2021
  • BlackRock

We pay all kinds of taxes during our lives: income, payroll, property, sales, etc. But perhaps least understood are taxes through transfers of wealth: gift and estate taxes.

For high net worth individuals, the surest way to leave behind a smaller legacy is to ignore this critical part of your wealth management.

But 2021 may be a critical year where potential changes to the rules loom. It’s a good time to invest a few minutes to refresh your memory on how it all works … as dry as it may be.

Estate and gift tax

The estate tax is a tax on property transferred at death. In 2021, the federal estate tax rate is 40% for any wealth that is left behind above $11.7 million, or $23.7 million per married couple.

The gift tax is the same, except it applies to property transferred while you are alive. Similar to the estate tax threshold, you cannot be taxed at the 40% rate until you have gifted either $11.7 million (single) or $23.4 million for married couples over the course of your life.

Some exceptions: you can generally give an unlimited number of people, each, up to $15,000 (or $30,000 for married couples) annually , which does not count towards this lifetime limit. And charity, tuition or medical expenses paid directly to the organizations are not counted toward the lifetime limit. And in general, you do not have to pay the gift or estate tax on property that you transfer to your spouse.

A quirk in the rules

In general, there’s no escaping the rules, but planning ahead can sometimes benefit you.

The $11.7 million threshold can be reached by gifts and the size of your estate combined. So if you’re an individual and have given $6 million to your children during your lifetime (beyond the annual $15,000 exclusion), and you leave behind an estate of $6 million for a total of $12 million transferred, you would have to pay the 40% on any amount transferred over $11.7 million.

But one small difference is that gift taxes are tax-exclusive, whereas estate taxes are tax-inclusive. In some cases, paying gift tax can be cheaper than paying estate tax.

Let’s say you’ve reached the $11.7 million giving threshold, and you have $20 million left in your estate.

  • Scenario 1: If you wait until death to pay the estate tax, you would pay $8 million (40%) in estate taxes.
  • Scenario 2: If you gift an additional $10 million at least three years before your death, you would pay $4 million (40%) in gift taxes, and then have $6 million left over in your taxable estate. At death, your estate would pay $2.4 million in estate taxes (40% of $6 million). So in total, you would be paying $6.4 million in taxes versus $8 million in Scenario 1.

But it gets complicated. Because if you choose to pay $4 million in gift taxes in Scenario 2, you could potentially lose out on the investment returns you would have had over several years.

As you can see, this requires advance thinking and planning.

State transfer taxes

There’s more, unfortunately. A number of states and Washington D.C. also assess their own estate or inheritance taxes, and the thresholds are typically much lower. Connecticut currently assesses a gift tax in addition to the federal gift tax. Overall, tax rates, exclusion amounts, and rules vary by state.

What’s changing in 2021?

Under a new administration, it’s natural to worry about what might change, and how your wealth might be impacted. But regardless of who’s in office, it’s good to stay up to date on the rules.

The $11.7 million threshold was established by provisions in the Tax Cuts and Jobs Act in 2017. Those provisions were always scheduled to sunset in 2025, which would revert the threshold back to about $5 million (adjusted for inflation).

In the last year or so, while on the campaign trail, President Biden proposed reducing the estate tax exemption to $3.5 million and increasing the tax rate to 45%. And recent tax proposals have also called for a reduction in the exclusion and an increase in the tax rate. But it can hard to predict what the outcome will be, and when new rules will be established and their effective dates.

The bottom line

In the face of uncertainty, consider these action items with regard to gift and estate taxes:

  • Talk to your financial professional team now. For higher wealth taxpayers, there may be a limited window of time to take advantage of the current exclusion amount before it is potentially reduced in the future.
  • Don’t wait until the end of the year to plan. Attorneys, accountants and appraisers will likely all be swamped at year-end, and it takes time to do thoughtful planning.
  • Don’t forget to factor in state transfer tax considerations into your planning, as appropriate.

Because the surest way to pay more taxes and leave behind a smaller legacy is to ignore these rules and hope for the best.

If you are a financial professional, reach out to your local BlackRock market team to see how you can partner with BlackRock and Aperio to build and manage portfolios that reflect your clients’ unique tax considerations.