Estate Taxes and How to Reduce Them

Happy Sunday!

This week was made better by amazing conversations!

A common theme encountered was families trying to find a balance between spending today and saving for tomorrow. When it comes to our finances, we usually move through three phases as life progresses:

• Accumulation – Earning more than we need and saving the difference

• Preservation – Now there’s a nest egg. Don’t lose it, maybe grow it some more?

• Distribution – Hey, we’re old, let’s party and spoil the grandkids! Also, hospital bills

Moving between these stages is emotionally challenging, and it’s even more challenging for super savers who have worked their asses off to save relentlessly so they can retire early. There’s no green light that suddenly turns on in your kitchen letting you know you’ll be ok.

Here are some of the questions couples have: When is it ok to spend more than I need to spend? How do I overcome anxiety around spending? How do I communicate with my spouse about finances? How do I tell my spouse we can afford to spend more, they don’t believe me?

These are really emotionally charged conversations, and having an objective third party help identify the real fears that are being manifested and then put a plan in place to mitigate them can be liberating.

Before we dive into this week’s topic, here are some things I read this week that I thought you’d like

WSJ – How Seniors Can Do Smart Roth IRA Conversions

Sure, you can wait until you’re old, but it can also make sense to knock some Roth Conversions out while you’re young.  

NYT – High-Yield Savings Accounts Are Still a Good Deal

Yes, HYSA accounts are still a good place for some of your savings. They strike a good balance of liquidity, risk, and return. The amount of cash you hold is a balance though, not too much, not too little. I frequently encounter couples with kids holding what is objectively too much cash, and on the flipside encounter single dudes with too little.

Sitreps2Steercos – Job Board

Want a post-MBA job that doesn’t involve banking, consulting, or finance? Think defense tech is sexy? Sitreps has more than 10 job postings listed currently, and one might have your name on it.

Let’s dive in!

This month’s topic is ESTATE PLANNING. If you’ve gotten married, had children, bought a home, moved states, or grown your assets since the last time you signed a Will, it’s time to update your estate plan!

• Why Estate Planning Matters

• The Basic Documents You Need

• Trusts and Why You’ll Have (At Least) One

• Taxes and How to Reduce Them

We’ve discussed a lot of technical estate planning details this month, but this week I’ll break out my own estate plan and show you what some of those concepts can look like in practice. 

And we’re finally going to discuss taxes, because you know that’s one of my favorite topics. You might think income taxes are high, but estate taxes are often even higher at 40%.

Also, thank you Sitreps2Steercos for making amazing memes and generously sharing this one with me!

Taxes.

You’ve probably experienced all kinds of taxes, including sales tax, income tax, capital gains tax, property tax, social security tax, Medicare tax, personal property tax, excise tax, sin tax, luxury tax, etc. But there’s one more that reaches 40%, federal estate tax!

There are many legal ways to minimize estate taxes, but most people don’t have to worry about this because there is a non-refundable federal estate tax credit of $13MM and change. This means that if you die with an estate valued less than $13MM you won’t pay estate taxes to Uncle Sam. This amount changes periodically as Congress passes new tax laws, and the current limit will likely cut in half next year.

Also, a bunch of states have estate tax as well, which we aren’t going to get into, but the same principles that apply to federal estate tax planning apply to state planning.

So why should you care about estate taxes if your net worth is only $99,000, $350,000, $750,000, or $897,000 today?

Because if you are young, earn a lot of money, and are a diligent saver, the effects of compounding can bring your net worth to an absurdly high number by the time you actually die. And that would put you squarely in range of estate taxes.

Seriously, take a minute and do a future value calculation.

So why not give it all away just before you die?

Damn, that’s genius!

Too bad Uncle Sam has a Unified Gift and Estate Tax…….

There are strategies some of my clients use to reduce their estate tax through lifetime gifting, but those are topics for another day.

Without further ado, let’s see what an estate plan might look like in action!

Henry’s Estate Plan.

The components of my family’s estate plan include all the documents we’ve talked about in previous weeks (Wills, Trusts, Powers of Attorney, Healthcare Directives, etc), and this diagram is a simplified version with trustee and beneficiary names removed, but it’s more than enough for now and shows where assets flow after I die. A good estate plan will be flexible enough to account for changes while still remaining true to your intent when it was written.

So let’s examine how my estate plan utilizes multiple trust structures within the Will to minimize estate taxes while providing for my family.

Here’s an analogy to help understand this better:

Think of the “Family Trust” as a financial container that can only hold a certain amount of money 

• In this case, up to $5mm

• This $5mm pays no state or federal estate tax. Yay!

Once the Family Trust is full, the next container is filled, in this case “Marital Trust #1”

• This container holds assets subject to state estate taxes but exempt from federal estate taxes

• Vermont levies a 16% estate tax on estates over $5mm

Then there is a final container, “Marital Trust #2” that can hold an unlimited amount

• Everything in this container will be taxed by Vermont at 16% and Federally at 40%.

• That sucks

So why divide the assets into multiple trusts? 

Because each trust has a different purpose.

Marital Trust.

The Marital Trust is designed to provide for my spouse during her lifetime. If I die early and have not used up my entire lifetime estate exclusion amount, this trust ensures my wife can use my remaining amount towards her own estate taxes. She can also defer my estate taxes until her death, postponing that inevitable haircut Uncle Sam will give the account so she can spend and gift more along the way.

In our case, the trustees will ensure my spouse is the primary beneficiary and will put her needs before my children’s needs when distributing assets. Basically, the trustee will let her spend down what would otherwise be our children’s inheritance. You could structure your trust documents differently.

Family Trust.

These are sometimes called “Bypass Trusts.”

Unlike the Marital Trust that favors my spouse, the Family Trust can only distribute a limited amount to my spouse so that it preserves the majority for our children. If she remarries, do I want her spending all assets our children would have inherited? On the flipside, if the Marital Trust is depleted, do I want my spouse to have nothing while our children spend everything?

This trust balances preserving assets for our children while still supporting my spouse.

Retirement Assets

You might have noticed that our IRAs, Roth IRAs, and 401ks didn’t go into one of these trusts.

These retirement accounts have favorable tax characteristics that in our case were maximized by staying OUT of a trust and passing directly to the desired recipient. Remember that these retirement accounts can pass “by title,” so they can move independently of our Will.

Just because they move independently does not mean we aren’t planning for them holistically.

“Ok, I still don’t understand the tax benefit!”

Let’s look at the Family Trust to see the impact.

Fill the Trust. When I die, I fund the Family Trust with $5 million, which uses my estate tax exemption. This locks in the exemption amount at the time of my death, ensuring the $5 million is not subject to estate taxes now or in the future.

Grow the Trust. Assume my Wife lives 15 more years after I die and the account returns 7%, resulting in a balance just under $14 million. Importantly, this growth is outside of my spouse's taxable estate, meaning neither Vermont nor the federal government can tax this appreciation upon her death.

Taste the rainbow. The Family Trust received an "all clear" when it was funded at my death. No further estate taxes apply, even if the account grows significantly. My spouse can benefit from the trust (e.g., income distributions), but she does not own the trust assets directly, so they are not part of her taxable estate.

This process is similar for Marital Trust #1, except that the initial account balance would be different and after those 15 years it would be subject to Vermont estate tax.

So you tell me, which account would you rather spend from today if you were the surviving spouse?

• The Family Trust that goes to your beneficiaries estate tax free

• The Marital Trust #1 that goes to your beneficiaries after being taxed at 16%

• Or Marital Trust #2 that goes to your beneficiaries after being taxed at 56%

I’d spend from the Marital Trust that’s being taxed at 56%, because spending $1,000,000 from that account reduces an inheritance by only $440,000, whereas spending $1,000,000 from the Family Trust reduces that inheritance by a full $1,000,000.

Bringing it back.

Remember, these are nuanced decisions that shouldn’t be made in isolation or haphazardly. I’m not a lawyer, nothing I’ve covered was legal advice. What we’ve discussed is simply an example of what I’ve done and not necessarily what’s best for your unique situation.

I have clients with vastly different estate plans, all tailored to suit their own unique situations. My estate plan is optimized for my family, and their estate plans for their families, but our estate plans would not be optimized for each other’s families.

Yes, we have the same estate planning documents in place, but the contents of those documents are very different.

Investing in quality guidance is absolutely worth it. I was happy to pay my estate planning attorney to ensure my family’s documents were aligned with our values. If these are the items you’re considering, it’s probably time to talk to someone rather than relying on Google and ChatGPT for your answers.

If you are looking for help with your wealth management and tax planning, feel free to head over to this link and apply to work together.

I have room to onboard 2 more clients this year.

Hope you have a great week and a happy Thanksgiving.

-Henry

P.S. Next week there will be no newsletter. I’ll be spending time with my daughters while they are home from school, recovering from my favorite holiday, and hunting. I’ll also try to avoid the Turkey Trot Alyssa will inevitably sign us up for.

---