Rising inflation, low tax rates (for now), increasing interest rates, and uncertainty in Washington, D.C. and beyond. These converging forces are the ideal reason to establish, or review, an estate plan. Everyone has an estate and should plan what happens to it. Different sized estates create different challenges to protect assets, mitigate taxation, and pass accumulated wealth to heirs.
A perfect storm of economic and political conditions highlights the benefits of incorporating today’s existing estate tax laws, structures, and available solutions into an estate plan. Those not taking advantage of current estate planning tools and strategies, and waiting out present conditions, do so to their own potential detriment. It has never been as important as it is today to preserve legacies through proactive planning.
The team at C3 Financial Partners brings decades of experience to the estate planning process. In coordination with clients’ other advisors, C3 Financial Partners helps navigate the complexities of planning, bringing actionable solutions in making an estate plan effective.
Given the current environment, inflation is almost certainly on the minds of everyone. Inflation is high and we are all definitely feeling the pinch. Consumer confidence remained muted in the most recent Forbes Advisor-Ipsos survey, with nearly 25% of consumers saying they’re spending more than usual and 37% saying they are saving less than usual. When it comes to estate planning, inflation represents a ‘hidden’ tax.
Purchasing power is erased as inflation soars, meaning all of us may need to spend significantly more to maintain our current lifestyles. Specifically, health care expenses, including potential future disability and long-term care expenses can accelerate the erosion of wealth. Aside from the effects of inflation, healthcare costs have already been rising at a rate of nearly 5% a year for the past 40 years.
Another consideration for an inflationary period is the ‘widow(er)’s penalty’ – the likelihood that a surviving spouse will experience higher taxes, higher healthcare costs, and a reduction in purchasing power. This longevity risk means that future liquidity may be of utmost importance, making it more difficult to stay invested in higher interest rate investments that would otherwise mitigate some of the effects of inflation.
Fortunately, life insurance may alleviate the challenges inflation brings to estate planning. An income tax-free death benefit provides immediate liquidity to pay taxes, provide for a surviving spouse, and to efficiently pass wealth to heirs. The cash value component of a policy, if structured properly, can permit access to a tax-free withdrawals and loans, providing money during the lifetime of the insured. Perhaps of growing interest are the various riders that can be added to many cash value life insurance policies. These riders can provide long-term care and disability payments, helping to preserve a policyholder’s cashflow.
Low Tax Rates (For Now)
Federal estate exemptions remain high and income tax brackets remain low. Currently, the top estate tax rate is 40% with a $12.06 million per person gift and estate tax exemption (2022). The exemption amount is set to be cut approximately in half at the end of 2025, and Congress is unlikely to prevent this reduction. The top marginal income tax bracket has remained at 37% since 2017 when it was reduced from 39.6%.
However, the Tax Cuts and Jobs Act is changing the top marginal bracket back to 39.6% at the same time the federal estate and gift tax exemption sunsets to $5 million per person, adjusted for inflation. These could both happen sooner if legislation is passed. Either way, the current estate and income tax environment presents a short planning window.
C3 Financial Partners can demonstrate how several life insurance strategies may be able to help during this window of optimal planning. There are flexible trust approaches to permit the purchase of life insurance to meet tax and liquidity obligations. Many trust strategies will keep life insurance proceeds out of an estate, but within reach for access to a trust-owned policy’s cash values. Other solutions include a multitude of charitable planning opportunities (often with tax deductions!) and the positioning of a cash value life insurance policy in an investment portfolio as a contingent asset class with a high probability of a stable rate of return.
Low Interest Rates
Yes, interest rates are rising (see our historical AFR rates) but there is still time to take advantage of some estate planning techniques that are more effective with lower interest rates. Lower IRC §7520 and applicable federal rates provide opportunities for tax-efficient transfer. For certain strategies to succeed, a client’s investments need higher returns than interest rates, and this is more easily accomplished when interest rates are lower. As an example, lending strategies can be more advantageous in a lower interest rate environment.
One such strategy is the use of private split dollar arrangements. You can read all about this strategy in our May 2022 blog post available here.
A low interest rate environment is also helpful to carrying out an asset sale to an intentionally defective grantor trust. The result of this unique type of trust structure (for now) is that the income of the trust is still the grantors for income tax purposes, but the assets of the trust are excluded from his or her estate for estate tax purposes. In other words, the trust is “effective” for estate taxes, but “defective” for income taxes.
Uncertainty in Washington D.C. and Beyond
Not knowing if, or how, future legislation or world events will impact the ability to meet long-term goals, those planning to wait could be ‘rolling the dice.’ Today, fairly favorable estate planning conditions exist, but this could change quickly. The Build Back Better Act was heavily debated in 2021 and appears to have stalled on its path to passage; though, other proposals are in the works. Past proposals provide insight into potential changes lawmakers could consider and propose again in another bill. The country has never seen anything like the tax laws currently being introduced in Congress, impacting everything from income taxes to inheritance taxes. Higher taxes are likely inevitable.
What those considering estate planning should realize is that some planning strategies could be taken away. Grantor trusts are under attack with the possibility that some assets could be includable in a grantor’s estate. A maximum duration could be applied to dynasty trusts and valuation discounts could be eliminated for “nonbusiness” assets.
C3 Financial Partners recommends considering these strategies while they are still available:
- Use higher estate and gift tax exemptions that are in effect;
- Make gifts now so that the value of these gifts, and any future growth, is removed from a taxable estate;
- Create and fund various irrevocable trusts such as irrevocable life insurance trusts, spousal lifetime access trusts and charitable trusts;
- Incorporate dynasty trusts into generational planning; and
- Leverage discounting opportunities.
The Clock is Ticking
Currently, the perfect storm of rising inflation, low tax rates, low interest rates, and uncertainty in our world presents the perfect opportunity to establish, or review, an estate plan. At C3 Financial Partners, we work with legal, accounting, and advisory professionals in developing and implementing strategies to optimize legacies to families and communities. We look forward to helping gain clarity in your goals and objectives, confidence that the right decisions are being made, and coordination with your other advisors.