When it comes to planning for a successful wealth transfer, timing is everything. Personal factors, including the birth of a child, marriage, divorce, an inheritance or a significant fluctuation in net worth, are catalysts that should prompt you to review your estate plan and consider transferring wealth. Similarly, economic factors — including changes to tax laws — also can present an ideal opportunity to reduce taxes your beneficiaries may face on the transfer.
R. Hugh Magill, chief fiduciary officer for Northern Trust, says that first and foremost you need to evaluate your own personal finances and ensure you are ready to transfer your assets, regardless of the tax benefits.
“The critical thing is to ensure that you first have sufficient wealth to provide for yourself and your dependents,” Magill says on determining the right time to transfer. “Once you have made that determination, then you can start thinking about transfers and tax saving strategies.”
Risks and Rewards
When you are ready to transfer wealth, you can consider many different strategies to maximize the tax savings for your beneficiaries. Irwin Saltz, trust practice leader for Illinois at Northern Trust, says you should focus on three factors when assessing when and how to transfer wealth, including the size and liquidity of your estate versus your cash flow needs; the age and maturity of your beneficiaries; and the overall tax implications of the transfer.
“Outright transfers may seem simple, but they can create complex problems,” Saltz says. “For example, an outright transfer to a second spouse may leave children from a prior marriage unprotected.”
In addition, you need to be aware of all the results of making a gift based on the nature of the assets you are planning to transfer, Magill says. “Transferring your home to a qualified personal residence trust will result, at the end of the trust term, in your beneficiary owning the home and you becoming a tenant in your own home,” Magill cautions. All wealth transfer strategies result in turning over the rights of ownership to someone else, whether to a beneficiary individually or to the trustee of a carefully designed trust for family members.
Take Advantage of the Current Market
If you are comfortable with the implications of the transfer, Magill adds that we are currently in a favorable environment for transferring wealth.
“It’s an extraordinary time for wealth transfer given the market,” Magill says. Although the drop in the value of your portfolio or your home may be painful to consider, the lower asset values can provide an opportunity to maximize your gifting strategy and minimize your overall tax burden.
Because gift taxes are based on the current value of assets transferred, you may want to consider making gifts of stock or property that has dropped in value as a result of the current economic situation. For instance, if you have an asset that has declined in value from $1.5 million to $900,000 today, and have not used any of your $1 million federal gift tax exclusion, you could transfer that asset to a beneficiary without triggering gift taxes. Assuming the market eventually goes back up, you have essentially transferred an extra $600,000 with no additional gifts taxes.
Understanding, and Using, the Marital Deduction
Married couples may be tempted to defer wealth transfer planning until the death of the second spouse, relying on the marital deduction that allows assets to pass to a surviving spouse tax-free, regardless of the amount. Loretta A. Ippolito, partner with the New York City-based law firm Willkie Farr & Gallagher, suggests that couples consider lifetime wealth transfer strategies as well.
“The marital deduction is merely the deferral of tax, rather than the elimination of tax, as any property passing to your surviving spouse will be taxed at his or her subsequent death,” Ippolito explains. “In order to fully exploit the exemptions available to both spouses, a credit shelter trust — funded with property equal to [the first passing spouse’s] exemption equivalent — should be created upon death. In doing so, both the property set aside in this trust, as well as property amounting to the surviving spouse’s exemption equivalent, can pass to your children free of federal estate tax.”
GIVING THAT ISN’T TAXING
By taking advantage of the lifetime and annual gift tax exemption amounts, you may be able to transfer a substantial amount of wealth to your beneficiaries tax-free. The 2009 federal gift tax exemption amount is $1 million. If you are married and your spouse also has assets in his or her name, you each are entitled to a $1 million federal gift tax exemption — potentially allowing you to transfer $2 million during your lifetime without incurring gift taxes.
Additionally, current federal law allows you (and your spouse, if applicable) to transfer $13,000 per year per recipient without incurring gift tax. Beyond the $13,000 (or $26,000 if you and your spouse each make a gift) annual exclusion, you can make qualified tuition transfers and payments for medical expenses without incurring gift tax, as long as you pay the provider directly. Creating a strategy that includes annual gifts can help minimize the tax burden you and your beneficiaries face as you transfer your wealth.
For couples planning to take advantage of the marital deduction, either alone or in conjunction with a credit shelter trust or other transfer strategies, it is important to ensure the transfer is properly structured. Also, if your spouse is not a U.S. citizen, the marital deduction is limited to transfers to a restrictive trust called a qualified domestic trust.
Planning for Unmarried Individuals
Single individuals have to work with a different set of tools when transferring wealth, according to Saltz.
“If you aren’t married, it is even more important for you to reduce your taxable estate by making effective use of lifetime gifting strategies,” he says.
Possibilities range from taking advantage of the annual gift exclusion (which was raised to $13,000 per recipient in 2009) to more complex structures such as family limited partnerships. But most importantly, it’s the effective use of lifetime gifting strategies that will provide the most significant tax savings when transferring wealth.
“If you are charitably inclined, you may want to take advantage of the opportunity offered by the unlimited charitable deduction under both the gift tax and the estate tax,” Saltz says. “Techniques like charitable gift annuities and charitable remainder trusts allow you to benefit both a charity and an individual beneficiary while reducing your overall estate tax burden.”
Interest Rate Opportunities
When it comes to straight economics, you can use today’s lower interest rates to your advantage when considering wealth transfers. Ippolito suggests that in addition to making standard gifts, you could consider transferring depreciated assets to a grantor retained annuity trust (GRAT).
“A GRAT allows you to transfer all future appreciation in excess of a certain IRS published interest rate out of your taxable estate,” she says.
Also, Saltz suggests taking advantage of the lower interest rates through an intra-family loan, where you make a loan to a family member.
“The loan recipient then invests the proceeds in assets that everyone hopes will have a total return in excess of the loan’s interest rate,” he says. “That future appreciation in excess of the loan interest rate will essentially act as a tax-free gift to the recipient.”
While taxes remain the major concern for most people, Magill offers another piece of advice when evaluating decisions to transfer wealth.
“Don’t start with taxes, start with your values,” he says. “Anytime you go through a major life event, it’s important to revisit why you are transferring wealth, and what you want to accomplish.”