Emerging Strategies Capitalize on Changing Tax Laws 

Key Takeaways:
  • Tax-efficient planning is key to helping preserving wealth across generations amidst changing laws.
  • New rules make tools like Roth IRAs, 529 plans and family partnerships essential.
  • Working with an advisor can help your estate plan adapt to evolving laws and family needs.

 

A 20-year study by the Williams Group, which analyzed 3,200 families, revealed a sobering reality: 70% of wealthy families lose their wealth by the second generation, and an astonishing 90% by the third. This startling trend highlights the importance of strategic financial planning when transferring wealth to the next generation. Without proper preparation, even the most substantial fortunes can erode over time. 

One of the most significant components of this process is ensuring the transfer is done in a tax-efficient manner. By minimizing tax liabilities, families can preserve more of their assets for their heirs. However, achieving tax efficiency is no small feat. Tax laws frequently evolve, and personal circumstances often shift, making it essential to revisit estate plans regularly. 

While the list of tax-efficient strategies is extensive and complex, several have gained prominence in recent years due to changes in tax laws. These emerging approaches are worth considering as families look for ways to protect and sustain their legacies for future generations. 

1.Estate Taxes

The Tax Cuts and Jobs Act (TCJA) of 2017 changed estate planning in significant ways, specifically by more than doubling the amount of the federal estate tax exemption and indexing it. As a result, the amount of an individual’s estate that is exempt from estate tax in 2025 is $13.99 million, and for married couples it is $27.98 million. 

However, certain provisions of the TCJA are scheduled to expire on Dec. 31, 2025, including the estate tax exemption. Unless Congress acts to make the current exemptions permanent, the estate tax exemption will return to the previous levels of $5.6 million for an individual and approximately $11 million for a married couple. 

As a result, estate planners have been very busy for the past year helping clients move assets into trusts and establish gifting schedules to help them minimize assets that might push their estates over the smaller exemption levels. 

Given the outcome of the 2024 election, it is expected that Congress will act to make the current higher estate tax exemptions permanent. But it is not a guarantee, and if you have not yet sat down with your estate planner to assess your situation, now is the time to do it. 

2. Passing On Pre-Tax Assets

It used to be common to use pre-tax instruments such as Individual Retirement Accounts (IRAs) or 401(k) accounts as vehicles to pass on cash assets to heirs. The “stretch IRA” was popular because an adult child could potentially enjoy decades of income from an inherited IRA. 

That changed in 2019 with passage of the SECURE Act, which stands for Setting Every Community Up for Retirement Enhancement. The SECURE Act changed the law governing inherited IRAs by requiring heirs to take all the distributions within a 10-year period. In other words, if a 25-year-old were to inherit a $1 million IRA, under the SECURE Act they now need to take large enough distributions each year to take the account down to zero in the tenth year. And since pre-tax assets are taxable upon distribution, heirs who inherit IRAs now have a larger tax liability each year than they previously had. 

3. Roth Solution 

Many retirement savers are reconsidering their strategies with regard to how to transfer wealth to the next generation as they – and more to the point, their children – grow older.  

Often the children are in their peak earning years when they inherit. If they are inheriting IRA assets, they have to compound those assets when they’re making the most money they’ve ever made. 

One solution is for older parents to stop funding traditional IRAs and switch to a Roth-basis IRA. That way, the taxes are paid before the money is invested in the Roth IRA, and distributions on the parent’s death are tax-free to the heirs. 

A similar solution is to fill up the smaller tax brackets by doing Roth conversions. When you take assets from a traditional IRA and put them in a Roth, that’s a taxable event. But if the parent is in the 22% tax bracket and the heir is in the 39% tax bracket, the tax liability is lower and the transfer of the Roth account to the heirs is tax free. 

4. 529 Plans 

A little-known strategy has emerged for using 529 education savings accounts as a vehicle to transfer wealth. Under the SECURE 2.0 Act of 2022, which governs a wide array of rules around retirement plan savings, excess funds in 529 education accounts can now be transferred into Roth IRAs for the account owner’s heirs. In the past, excess funds in an overfunded 529 could only be withdrawn with a penalty. 

5. Family Business Transfers 

The Family Limited Partnership has emerged as a widely used tool for transferring wealth that resides in a family-owned business. It enables adult children who are involved in the business to become minority owners by acquiring small portions over time. Because their ownership is a minority stake, the shares can be transferred at a discount rate, resulting in a lower tax liability as the transfers take place over time. 

If the shares are being gifted to the heirs in 2025, the business owner (parent) can gift up to $19,000 per recipient annually. The annual gift exclusion is applied per person both for the givers and the recipients. For example, spouses who own a business together can each gift $18,000 to their son and the son’s spouse, and remain within the annual gift exclusion. In other words, the parents could transfer a total of $72,000 annually in business shares without incurring any gift tax liability. Even if they gifted more, the parents would simply need to inform the IRS of how much of their lifetime gift tax exclusion they are using. The lifetime exclusion for 2025 is $13.99 million. 

In this scenario, no one pays any taxes on the gifted shares. But the gift does change who pays tax on the business earnings. If the heir’s share of the company is now 1%, they are liable for 1% of the taxes on the earnings, and the liability will rise as further shares are gifted each year. 

Keeping Assets in your Estate 

For some high-net-worth individuals, it is worth having a discussion with advisors about the wisdom of leaving some assets in their estate. Your heirs get a step-up in basis for all assets, so as long as the total estate is below the federal estate tax exemption – and as long as you don’t need the proceeds from selling any assets to live on – leaving them in the estate may be beneficial. This can be particularly true of business assets, such as a farm. 

If you would like to discuss options for transferring wealth to your heirs in a tax-efficient manner, contact an Adams Brown Wealth Consultant.