By James Lange, CPA

Presidential elections are often important re-evaluation moments for tax advisers. This is particularly true when the presidency shifts from one party to another. The same is true for 2021, but, I must confess, my recommended post-election tax planning is not radically different from what my plans were prior to Nov. 3, 2020. The strategies presented below work well with stable tax rates but can be life changing in times of rising income tax rates … and taxes are going up.

In this article, I will combine classic tax planning and fundamental tax-reduction principles as well as some newer strategies.

Going Up?

President Joe Biden has said, during his campaign and since being sworn in, that there will be no income tax rate increases for married taxpayers making $400,000 or less. But even if his administration holds the line for couples making less than $400,000 during his first term, increases for all are on the horizon because of how the Trump administration’s Tax Cuts and Jobs Act (TCJA) was structured.

Sunset provisions are a part of the 2017 tax law, meaning income tax rate increases are scheduled for 2026 even if a new tax plan does not occur. To oversimplify, 2026 rates could be more like 2017 rates (adjusted for inflation).

Other events that will generally increase tax payments may include an elimination of the step up in basis rules, which I think is more a question of when than if.

Also related to the TCJA, there could be changes to the standard deduction and the rules for itemized deductions. Remember, the TCJA increased the standard deduction while slashing the deductibility of previously itemized deductions, such as state and local tax payments.

So, over time, nearly all taxpayers will incur some tax increases.

For clients who make more than $400,000 and are working, there could be an additional Social Security tax of 12.4%, their marginal rate could rise to 39.6%, and itemized deductions could be capped for a tax benefit of 28%. For those with income over $1 million, capital gains rates could be taxed at 39.6%.

Potential tax increases are far more likely in the short term with Democratic control of the presidency, the House, and the Senate, but don’t be lulled into thinking that a major tax act can’t pass a divided Senate. After all, the 2001 Tax Act passed with a 50/50 Senate split with Vice President Dick Cheney casting the tie-breaking vote. Also, our government holds enormous debt (about $3.3 trillion), and we continue to add to it as we attempt to recover from the pandemic-induced economic crisis.

You don’t have to be Nostradamus to foresee taxes are going up.

What should you do with this information? I believe it would be wise to transfer some of your wealth from the taxable world to the tax-free world.

Taxable to Tax-Free

Roth IRA conversions should be the first thing to think of when transferring from taxable to tax-free. Roth IRA conversions are generally favorable if a client has the funds to pay the taxes on the Roth IRA conversion from outside the IRA given steady income tax rates. If taxes are going up, though, your clients and their families will likely be even better off to pay taxes now and not later.

There are other ways, however, to move from the taxable to the tax-free. For example, taxable withdrawals from a standard IRA can be directed to a 529 plan for the education of grandchildren or in the form of gifts. Gifts can come in many tax-advantaged forms:

• The beneficiary could be encouraged to contribute that money to their own Roth IRA.
• Life insurance purchasing, which in this context is ultimately a gift. The technique of withdrawing a small amount, perhaps 1% of the IRA, every year, paying income taxes on that withdrawal, and then using what is left to purchase a life insurance policy is a technique known as “pension rescue” that insurance professionals have advocated for decades.

Looking at some old pension rescue analysis, I had previously objected to some of the hypothetical comparisons between pension rescue plans versus limiting IRA distributions to the required minimum distribution (RMD). The problem was the projections usually assumed the beneficiary of the IRA would cash in an inherited IRA and pay the taxes immediately. Under old laws, inherited IRAs could be stretched over the beneficiary’s life expectancy, so, I didn’t think it was a fair comparison. With the SECURE Act of 2019, a beneficiary (subject to exception) must withdraw an inherited IRA by Dec. 31 of the 10th year following the IRA owner’s death. That is closer to the assumptions the life insurance professionals made, so the pension rescue technique is probably more attractive than it had been.

Gifts from Granny

The sunset provisions of the Tax Cuts and Jobs Act revert the estate tax exclusion to $5 million (adjusted for inflation) in 2026. Sen. Bernie Sanders introduced the “For the 99.5% Act” that could increase income taxes and goes back to the $3.5 million exclusion, so an even lower threshold is possible.

Regardless, the exclusion will go to $5 million (adjusted for inflation) in 2026 at the latest. Many estates will likely grow into the zone of federal estate taxation over the next several years. The rational thing to do is to begin making projections to see which clients could end up in a federal estate tax situation, and then be proactive in devising a plan for them.

For many clients, making $15,000 gifts ($30,000 per couple) per beneficiary is a simple and effective strategy. With a likelihood of a lower exemption, and assuming the clients don’t need the money, this path becomes obvious. Many clients should be considering this now, if they aren’t already doing it.

Among those clients who already have a net worth of $5 million (or $10 million if married), $15,000 gifts might be like closing the barn door behind the horse. More aggressive action may be needed. Personally, I’ve been advising a lot of high-net-worth clients to give their children $1 million in one form or another. Depending on how long your clients live and the investment rate made after the gift, the strategy could save more than $1 million in estate taxes for the family.

If you combine the strategies of paying tax on IRA withdrawals with making gifts you could reduce both income taxes and estate taxes. Perhaps it sounds like too much, but if a client has more money than they will ever spend, the math works.

Expect resistance. But acting in the best interest of your client is not always sunshine and rainbows. Make it simple: if enough money is available to satisfy all reasonable spending projections and there is still an excess, gifting is a reasonable strategy. It may become more important for a growing number of clients in the projected tax environment.

Life insurance as part of the gift could make sense, especially when combined with Roth IRA conversions, which reduce the size of an estate without reducing the value.

When we run numbers combining Roth IRA conversions and life insurance, we typically get wonderful results for the family. In one instance, the difference between a strategic long-term Roth IRA conversion plan combined with life insurance versus no life insurance and no Roth conversions (given what I thought were reasonable assumptions), provided benefits that amounted to $7 million. Obviously, each person’s or family’s savings will be different. But those numbers didn’t assume an estate tax, so the savings to someone who potentially could end up in a federal estate tax $5 million exclusion situation may be more. Even if federal estate taxes are a nonissue, there may be a state inheritance tax that could also be reduced by using these strategies.

There are many different techniques for making gifts: grantor retained annuity trusts, qualified personal residence trusts, family limited partnerships, generation skipping trusts, exempt trusts, grantor retained income partnerships, among others. But these aren’t the first strategies to which I look.

While many of these have their place and have worked well for a lot of clients, I have found that, even though they save families a lot of money, few clients want to deal with setting up and maintaining these entities. Estate attorneys love to set up these entities and trusts, but the clients and their CPAs are the ones who have to deal with tax compliance.

Don’t Trip on the Step-Up

It might be a mistake not to consider the implications of a likely increase in the capital gains tax for taxpayers with more than $1 million of income or the loss of step-up in basis that may apply to everyone. Maybe these considerations will free up your client to sell things now that probably should have been sold a long time ago.

A great mistake many people make – especially among those who have worked for one company over many years – is that they have 20%, 30%, 40%, or more of their investible assets in one or a few concentrated positions. To have 30% or 40% of anything – it doesn't matter what it is – is just dangerous. But they hang on, partly because they don’t want to pay capital gains and figure there will be a step-up in basis for their heirs when they die. Potentially, though, their heirs may not get the step-up in basis or get as favorable a capital gains treatment as exists today.

It is a good time to brush up on capital gains and capital loss harvesting.

To be clear, we don’t have any assurances or projected dates for these potential changes, but understanding they could be coming might motivate individuals to consider selling a portion of their highly appreciated assets, even if they must pay tax on the capital gain. Paying taxes at the current favorable capital gains rates could potentially be more advantageous than doing nothing and then losing the favorable capital gains position.

Let me provide some context surrounding a potential capital gains tax increase. Some proposals are calling for a rate increase on those with income exceeding $1 million for the tax year. For taxpayers with highly appreciated assets who are in a gain position exceeding this amount, planning opportunities need to be considered now. One option is to sell the appreciated assets on an installment sale basis. This allows taxpayers to take advantage of the lower rate by recognizing gain over time and keeping income below the point at which the rate increases. Depending on the facts and circumstances of the installment sale, the taxpayer could also realize some net investment income tax savings.

Another, slightly more technical planning tool to help guard against an increase in capital gain rates would be a charitable remainder trust. For the charitably inclined taxpayer, highly appreciated assets could be contributed to and then subsequently sold from the charitable remainder trust. Gain would not be recognized at the time of the sale, but rather over time as payments are made from the trust to the beneficiary. In this scenario, the grantor is also eligible for an immediate income tax deduction. These techniques should only be considered with the help of a tax professional.

A charitable remainder unitrust (CRUT) as the beneficiary of an IRA or retirement plan is another option. It has certain characteristics of the “stretch IRA.” By leaving an IRA to a CRUT, with heirs receiving an “income” from the CRUT, clients could save on taxes. In more cases than not, when we ran the numbers, the CRUTs weren’t more favorable than naming the children outright. That said, in some cases big IRA owners with federal estate tax issues might actually come out ahead with a CRUT compared to naming the children outright even without charitable intent. On the other hand, if there is charitable intent, it will be a potentially great solution for some.

Conclusion

Set up a review with your top clients. Do whatever you have been doing in your reviews (if you do them) and look to see if some of the transfer from taxable to tax-free strategies are appropriate for your clients. Make recommendations, or write a “prescription,” in which you outline specific action points.

And when you do, seriously consider charging premium rates to your standard hourly rates. You may blanche at the thought, but don’t. The value you are providing more than justifies a higher fee. Here’s an example of what I mean and how you can present that fact:

Joe, I ran the numbers and from what you’ve told me, you just won’t be spending all your assets. Look, it is clear: if you give $1 million to your kids now, you will potentially save them $1 million in taxes. I just showed you that you don’t need that $1 million for your own spending, so I strongly recommend that you consider making a million-dollar gift to your kids in one form or another.

How much do you think that is worth to your client?

James Lange, CPA and an attorney, is a principal and financial adviser with Lange Financial Group LLC in Pittsburgh. He is author of eight books, including his new The IRA and Retirement Plan Owner’s Guide to Beating the New Death Tax. He can be reached at admin@paytaxeslater.com.

Lange will speak more on this topic at PICPA’s Personal Financial Planning Conference webcast, so be sure to reserve Nov. 4, 2021, on your calendar.

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