Practical analysis for investment professionals
11 April 2012

Five Tax-Savvy Wealth Transfer Strategies

For most U.S. taxpayers, April 15 is a red-letter day. But that doesn’t mean tax matters should be filed and forgotten about until next year. There are several favorable estate, gift, and generating-skipping transfer (GST) tax provisions that are set to expire at the end of the year, unless Congress acts to extend them in the coming months. That means there is still time for your clients to take advantage of larger exclusions and lower tax rates.

But first, let’s recap where things stand. At the end of 2010, Congress passed the Tax Relief Act, which increased the gift, estate, and GST tax exemptions to $5 million per person, or $10 million for a couple. When the changes sunset on 1 January 2013, all three exemptions return to $1 million, with the GST tax exemption adjusted for inflation. The tax rates, meanwhile, jump to 55% from 35%.

It is also worth noting that President Obama’s fiscal year 2013 budget proposal, released on 13 February, recommended several changes, including limiting the generation-skipping transfer tax exemption to 90 years, lengthening the minimum term of grantor retained annuity trusts (GRATs) to 10 years from two years, and restoring estate tax rates to 2009 levels. (A Forbes article, “Obama Declares War On Rich Folks And Wealth Advisors,” provides a good overview of the proposals.)

With this in mind, here are some tax-smart wealth transfer strategies to consider discussing with your clients.

Establish a Dynasty Trust

As the name implies, this is a trust designed to protect wealth for multiple generations. Gail E. Cohen, vice chairman and general trust counsel at Fiduciary Trust International, explains that when assets are placed in dynasty trusts they pass from one generation to the next free of the estate tax. “None of the assets held by the trust are included in either the grantor’s taxable estate or any of the beneficiaries’ taxable estates,” she said. The higher exemption amounts present an opportunity to avoid gift and GST taxes. “If individuals still have their gift tax exemptions and apply their GST exclusions, the gifts will not be subject to gift tax when funding the dynasty trust,” Cohen explained. “And when the assets are distributed from the trust, future generations will not be subject to GST tax when they receive the assets.”

Couples who have not used up any of their gift or GST tax exemptions stand to get the biggest bang for their buck: they can now shelter $10 million from transfer taxes. The key to the trust’s longevity is that it must be located in a jurisdiction that does not limit how long a trust can last (in other words, the state needs to have repealed the Rule Against Perpetuities). Roughly half the states have such favorable laws, with Alaska, Delaware, and Nevada among the most favorable jurisdictions. You can find a complete list of the dynasty trust states here. (As an aside, for an interesting argument on why dynasty trusts should be eliminated, read “America Builds an Aristocracy,” an op-ed that ran in the New York Times in July 2010.)

Consider a Spousal Credit Shelter Trust

With this type of trust, says Cohen, one spouse can gift up to $5m into a trust that benefits the other spouse. The trust can also be structured to ultimately become a dynasty trust.

“Someone could create a spousal credit shelter trust for the benefit of the spouse, and then at the spouse’s death it can go on for the children and grandchildren and great grandchildren and beyond and in effect act like a dynasty trust,” she said.

One note of caution when making lifetime gifts: there may be a tax “clawback” at the estate level if the person who made the gift dies after 2012, when the exclusion will be lower (the tax will be on the difference between the two amounts). That said, it is far from certain how this will play out. For more on the clawback, read “Who’s Afraid of (Gasp!) CLAWBACK?” from Trusts & Estates and a follow-up, “Response to Reader Questions: Yes, Clawback is Real.”

Create and Fund a GRAT

A grantor retained annuity trust, or GRAT, is an irrevocable trust into which the creator of the trust, or grantor, transfers assets and, in return, receives a fixed annual payment, or annuity, paid from the trust for the term of the trust. At the end of the GRAT term, the trust’s remaining assets pass to the beneficiaries tax-free.

GRATs are especially attractive to people who have assets that they believe will appreciate significantly and want to ensure the appreciation is removed from their estate. In effect, what this instrument does is allow the grantor to transfer the appreciation of the assets to heirs free of the gift tax.

Cohen notes that the Tax Relief Act does not have any direct bearing on the timing of when to create a GRAT. However, there are ongoing rumblings from Congress about limiting the term of GRATs — and the president’s proposed budget specifically mentioned extending the minimum term. “It doesn’t need to be done this year, there is no real urgency, but for the fact that every so often, including last year, Congress tried to limit these trusts’ effectiveness by introducing a law the would require a minimum 10-year term for these trusts, and therefore they would become less desirable because the longer the term, the less flexible they become,” she said.

Once of the downsides of a longer-term GRAT is the risk that the grantor dies during the GRAT term. In that case, the trust property will likely be included in the grantor’s estate for estate tax purposes.

For more on the use of GRATs and other strategies, click through this concise and thorough presentation, “Top 10 Planning Opportunities for the $5 Million Gift Tax Exemption,” from law firm Katz Baskies LLC.

Give it Away

The current low-interest environment is very favorable for intrafamily loans, providing the loan is properly structured and well documented. The IRS has established special monthly interest rates for these loans, known as “Applicable Federal Rates” or “AFRs.” The rate is currently well below 1% for loans of three years or less. (Click here to read an article on the benefits of intrafamily loans. And to learn more about the potential hazards associated with these loans, and how to avoid them, see “Intra-Family Loans: Common Hazards and 10 Steps to Avoid Them” from Bessemer Trust.)

Roth IRA Conversions

Cohen said that with the threat of income taxes going up next year, one strategy wealthy clients should think about doing this year is converting a traditional IRA into a Roth IRA, “if they haven’t done it already and if it makes sense to do so.” Here is why: “Unlike a traditional IRA that is funded with pretax dollars, a Roth IRA is funded with after-tax dollars. While distributions from a traditional IRA are subject to income tax, distributions from a Roth IRA are income-tax-free. Ordinarily, taxpayers have expected to be in lower income tax brackets when they retire, so deferring income taxes until then has made sense. However, with the top Federal income tax rate currently at 35% but scheduled to surpass 43% by 2013, many taxpayers are rethinking this assumption,” Fiduciary Trust explained in “Does it Make Sense to Convert to a Roth IRA?

To learn more about planning opportunities from Fiduciary Trust’s legal team, read “Making Rare Gifting Opportunities Work for you in 2012.” You can also check out Deloitte’s handy primer that examines the uncertain tax environment and offers guidance on income tax and wealth transfer tax strategies.

And if you are wondering how best to advise clients given all the uncertainty surrounding taxes, you can get some tips in person by attending Robert N. Gordon’s session “What You Need to Do Now Before U.S. Taxes Increase in 2013” at the CFA Institute 65th Annual Conference in Chicago in May. Gordon is founder and president of Twenty-First Securities Corporation. He will discuss strategies for gift and estate planning and investment reallocation in 2012, among other topics. Gordon also has an upcoming feature article in the April issue of CFA Institute’s Private Wealth Management newsletter.

About the Author(s)
Lauren Foster

Lauren Foster was a content director on the professional learning team at CFA Institute and host of the Take 15 Podcast. She is the former managing editor of Enterprising Investor and co-lead of CFA Institute’s Women in Investment Management initiative. Lauren spent nearly a decade on staff at the Financial Times as a reporter and editor based in the New York bureau, followed by freelance writing for Barron’s and the FT. Lauren holds a BA in political science from the University of Cape Town, and an MS in journalism from Columbia University.

1 thought on “Five Tax-Savvy Wealth Transfer Strategies”

  1. Very useful strategy, I always look for how to save taxes, manage my finances but never practiced these things but I think its time to make a buzz on this.

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