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Estate of the Union

How high lifetime exemption amounts and low interest rates add up to estate planning success.

When even dinner plans can go up in flames during COVID-19, some financial advisors may be tempted to put estate planning on the back burner for 2020. But while the world is a weirdly unpredictable place right now, we can successfully manage our clients’ projects by taking advantage of the historically high gift tax exemption amounts and low interest rates. Here are the three main factors you need to know—plus an investment to consider right now.

  1. Estate planning practitioners working with the ultra high net worth (UHNW) are focused on using the current lifetime exemption amounts ($11.58 million per individual), ahead of the November election. That’s more than double the amount of 2017 ($5.49 million) and ten times the amount of 2008 and before ($1 million). The lifetime exemption goes up by an inflationary factor each year, and many families haven’t made their current allowable gift yet for 2020. For example, if a couple had already made their maximum lifetime exemption gift in 2019, they would still have $360K they could give this year just from the inflation factor. So, most UHNW families will have some exemption left to consider before the end of the year. (Even the most organized, up-to-date ones!)
  2. Interest rates are the lowest they have been in most of our lives. The last time interest rates were this low, and the yield curve was this flat was the mid-1950s. Many estate planning techniques involve lending money to a trust that is established to benefit heirs.  This allows the trust to earn a higher return than the interest rate owed back to the grantor. You can set up a balloon loan, where principal and interest accrue for the duration of the loan. By accruing the interest, you are allowing the assets in the trust to grow off a larger base. Then, the difference between the investment returns and the accrued interest accumulate estate-tax free to future generations. While there are nuances, Grantor Retained Annuity Trusts (GRATs) and intra-family loans, including installment sales, are the top choices here. For example, in August 2020 an intra-family loan made at the mid-term rate (a 3-9 year loan) is pegged at 0.41%. As we tell clients: If you can earn more than 0.41% you can pass money onto the next generation without incurring gift taxes.
  3. An estate left to charity, even a private foundation or donor-advised fund, will pass entirely with no estate tax friction. Charitably inclined families are increasingly planning to provide for their heirs through gift-tax free estate planning (lifetime exemption gifts, etc.) and then leaving the bulk of their estate to a charitable cause or institution. These types of estate plans allow clients to fulfill their charitable goals and legacies while also providing for their children and grandchildren.

How it all adds up: Let’s say a healthy 55-year-old couple has a $100 million estate. If they take advantage of the current lifetime exemption gifts and do no other planning, they can move about $20 million to trusts for heirs. This leaves about $80 million on their balance sheet which presumably will grow over time. (Investment earnings on a sum this large will often outpace family spending.) The couple will still be able to make annual gifts to anyone ($15,000 individually, or $30,000 per couple, is today’s allowance for no gift-tax consequence) and they also can pay for health and education expenses for those they love without using annual exclusions or lifetime exemptions. The $20 million of lifetime exemption gift, coupled with their annual gifting and educational funding capacity can enable a family to pass significant wealth to future generations with no estate or gift tax cost.   Having taken care of their heirs, this will then give them the flexibility to invest, spend, or make charitable contributions at their discretion with the remaining $80 million. 

And here’s the twist: Once someone makes an exemption gift, the trustee must navigate investment decisions on behalf of the beneficiaries. One investment to consider with a portion of one’s gifting exemption is second-to-die guaranteed life insurance, which pays out at the death of the second insured. This influx of cash at the second death aligns with the liability of the estate taxes due after the second spouse’s death. If they have set up the trust that owns the insurance policy properly, it can swap or purchase assets in the client’s estate (sometimes at a discount). This provides the estate with liquidity to pay estate taxes without having to sell assets at potentially low valuations.  Second-to-die life insurance can provide a floor on the trust investment account (many clients will buy an amount of insurance equal to the trust corpus in an effort to principal-protect the trust); thus, the trustee, in theory, can invest in riskier asset classes with a higher return profile with the remaining trust assets.

Sophisticated investors can see permanent life insurance as a non-correlated investment. Effectively, since the death benefit pays out income-tax free to the trust, some see life insurance as a “zero-coupon bond with an uncertain duration.” Our rough math shows how a healthy 55-year-old couple would get approximately $5 of life insurance for every $1 of premium. So, if they allocated $4 million of their lifetime exemption gift to insurance, they would get about $20 million of insurance benefit for the trust. If the couple lived to age 90, the after-tax internal rate of return (IRR) on this “investment” would be approximately 5.4%. If they live to age 95, the IRR would closer to 4.6%.

The takeaway: Families fortunate enough to be thinking about minimizing the estate tax burden at their passing generally have $25 million or more of assets. The combination of a historically high lifetime exemption amount and historically low interest rates should lead to a productive late summer and fall for all of us in the advisory world. Keep your WiFi strong! (And treat yourself to a nice dinner out sometime.)

Aaron Abrahms is a Principal at Winged Keel Group and Kyle Boni is a Partner at Shade Tree Advisors.

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