Private Client Services Year-End Planning

The estate tax continues to be hot topic even with the lifetime exemption continuing to rise with inflation adjustments.

For 2023, the gift tax annual exclusion limit is $17,000 per person. You could gift that amount from assets in your estate to any number of individuals, without triggering the gift tax. Married couples can double the gift tax exclusion limit to $34,000 if they agree to split gifts on their tax return.

Another strategy that does not use any exemption amount is the direct payment of tuition and medical expenses. These payments do not count as a taxable gift or use any of the exemption amount as long as the payments are made directly to the institution. These can be made on anyone’s behalf and are not limited to immediate family members.

For those worried about giving away too much, Spousal Limited Access Trusts (SLATs) are a good option. SLATs have become popular over the past few years due to their flexible terms and the increased transfer tax exemption amounts. SLATs allow a non-grantor spouse to be included as a beneficiary, which acts as a safety net because that beneficiary spouse can access funds later on if necessary.

Inflation and rising interest rates affect so many aspects of our lives – groceries, mortgages, business loans, and so forth – and we often forget that they affect our estate planning strategies as well. When the Federal Reserve increases the fed funds rate, there are usually increases to other rates, including the applicable federal rates (AFRs) and the section 7520 rate (the GRAT hurdle rate), both of which are used for estate planning mechanisms.

In an environment where these rates continue to rise, we look for silver linings. Interest rate changes are particularly relevant for estate planning techniques that involve split gifts, like those made to qualified personal residence trust (QPRTs), charitable remainder trusts (CRTs), and grantor retained annuity trusts (GRATs), as well as for more standard transactions like intra-family loans.

The popularity of split gifts in these environments is due to the way a gift’s value is calculated, which is by taking the fair market value and subtracting the retained interest. In situations where there is a high interest rate, the value of the taxable gift is reduced. If the taxable gift is lower, less exemption is required to be used to make the gift on a tax-free basis.

With QPRTs, you transfer your home into a trust, retain the right to live in it for a specified period of time, and then gift that property to designated beneficiaries (usually children/family members). Each piece of that split-interest gift is valued at the time the transfer is made. A higher interest rate means the value of the retained interest to live in the home is higher, which means that by default, the value of the remaining interest, or taxable gift, is lower. This is a nice way to keep a home in the family for generations.

With CRTs, you establish an income stream to a beneficiary for a defined period, followed by a gift to charity. The charitable deduction – the second part of the gift – is for the present value of the remainder interest passing to charity, meaning that the higher the interest rates, the higher the charitable deduction, which is positive for income tax purposes. It’s best to use low-basis assets with CRTs because you won’t recognize gain on the contribution, but the full fair market value will be used to compute the value of the income interest and the charitable deduction.

Other useful strategies in rising rate environments include intra-family loans and GRATs. These are slightly less appealing than they were in recent years given the swift rise in interest rates. With intra-family loans, you make a loan to a family member at the AFR rates set forth by the IRS. While AFRs are high, they’re still lower than average mortgage rates, for example, so if you have a family member who needs liquidity, this could be a good option.

GRATs are used to transfer appreciation in assets to named beneficiaries without the imposition of gift tax. They are particularly relevant for those who have used up their exemption amounts and are looking to transfer more wealth out of their estates. You transfer an asset into a GRAT, and to the extent that asset appreciates in value over the hurdle rate, that appreciation passes to your beneficiaries.

Recent changes involving retirement plan accounts within an estate plan are significant enough that you may want to review your estate plan to be sure beneficiary designations still reflect the intended income tax consequences, especially if the account is left to a trust. The income tax consequences of these accounts may vary depending on the type of account and the type of designated beneficiary.

It is crucial to understand how these assets will be taxed for the recipient, especially when the recipient is a trust. The age of the decedent and the type of beneficiary (e.g., surviving spouse, trust, charity, etc.) will affect how quickly the accounts must be liquidated, and therefore taxed, when in the hands of the beneficiary. The SECURE Act significantly affected the required minimum distributions, or RMDs, for a beneficiary that inherits a retirement plan account after January 1, 2020.

The estate and income tax consequences of these retirement accounts can make them an ideal asset to leave to a charity if you are charitably inclined. This shifts the income tax burden away from both your estate and your heirs to an entity not subject to income taxes.

Roth conversions have also become increasingly popular as the tax law has grown in complexity for these assets. A Roth conversion allows the taxpayer to convert the account from a pre-tax account to an after-tax account so that the income tax liability is generated by the taxpayer before death. This strategy avoids income tax consequences for the estate or beneficiary.

There are a few things to keep in mind for retirement planning at year-end. RMDs, which begin at age 73 (except for Roth IRAs), are one consideration. There is a complex set of rules around when distributions from inherited IRAs must be taken, so beneficiaries should work with their Withum Wealth planners for the correct guidance.

RMDs are counted as ordinary income and can push individuals into a higher tax bracket for a particular calendar year. Those who do not need the income may consider making a qualified charitable distribution from their IRA. This allows charitably inclined individuals to direct up to $100,000 from their IRA each year (at age 70½ and older) to a public charity, reducing the RMD – and thus, taxable income – by that amount.

In 2023, the maximum amount that can be contributed to an employer-sponsored plan is $22,500, with a $7,500 catch-up contribution for those 50 and older. That will increase to $23,000 in 2024, with a $7,500 catch-up contribution for those 50 and older. For IRAs, the contribution limit for 2023 is $6,500, with a $1,000 catch-up contribution for those 50 and older. This will increase to $7,000 in 2024, with a $1,000 catch-up contribution for those 50 and older. The deadline for 2023 IRA contributions is April 15, 2024.

Disclaimer:No action should be taken without advice from a member of Withum’s Tax Services Team because tax law changes frequently, which can have a significant impact on this guide and your specific planning possibilities.