Retirement income planning is an important step for all Americans, and efficiency is the goal. Drawdown strategies can help individuals along the way by targeting a monthly cash flow during retirement, minimizing taxes and maximizing government benefits.
For the wealthy, however, being fortune enough to have the means to retire comfortably comes with additional financial considerations, hurdles and retirement planning nuances than is typical of a middle-class or affluent retiree. Wealthy retirees may be considering the implications of gift and estate taxes, they may own special assets (such as low basis, high-value closely-held businesses), and they often have issues regarding gifting and charitable donations. The wealthy don’t necessarily have different retirement drawdown issues; they have additional issues.
My previous post (https://www.forbes.com/sites/steveparrish/2019/09/10/the-secret-to-retirement-income-drawdowns/#e9637b859693) covered the basics of withdrawal strategies for the affluent. The key strategies identified are to obtain tax and portfolio efficiency and to generate an efficient order of withdrawals. The strategies for the wealthy are similar but seen through a different lens. First, just like for the affluent, tax efficiency is key. However, because the wealthy individual’s assets exceed the $11.4 million exemption for federal estate taxes, there is a new tax to add to the calculation. Further, the assets of the wealthy may be difficult to value. Examples often include small business ownership, personal brand, art and intellectual property. Finally, because of other planning strategies, the rich may have more retirement income than they need or desire. This adds the dimension of gifting and charitable donation strategies.
Consider the 60-year-old matriarch of a family with significant first-generation wealth due to her fast-growing business. We’ll call her Pat. Pat’s firm is worth $15 million, and she plans to keep it in the family. She also has appreciating real estate holdings worth $4 million and has built up $3 million in pension and IRA assets for retirement. Pat wants to work on business succession, so she has started the exit and retirement planning process with her advisors.
To be tax-efficient in Pat’s case, it’s not enough to just consider income and employment taxes. Pat is facing an additional tax burden, and it’s potentially huge. The federal gift and estate tax hits at a flat 40 percent rate above the exemption. In Pat’s case, over $10 million of her net worth is potentially subject to this tax and, because of sunsetting tax laws, her exposure to this tax may increase another 50 percent starting in 2026.
The math is straightforward. Pat should avoid as much in transfer taxes as possible (a 40 percent flat tax on principal), even if that means she incurs additional income taxes (a maximum of 37 percent marginal tax on income). If Pat were to gift away her wealth, she might avoid some future income taxes, but it would entail a 40 percent gift tax on part of the transfer. Instead, tax efficiency suggests that she lower her transfer tax exposure and accept that she will incur some taxable income to do so. There are numerous ways to accomplish this strategy.
Below are some examples of estate planning techniques commonly employed that involve taking additional income while avoiding estate and gift taxes. The list is not exhaustive, but it illustrates the planning issues and opportunities unique to wealthy Americans. All of these techniques are examples of “estate freezes” that help lock in the value of appreciating assets for estate tax purposes. A value is determined for the relevant asset, and that value stays fixed for estate and gift tax purposes, even if the value of the underlying asset increases afterward.
GRAT Pat’s advisors may have her deploy a popular estate freezing technique called a Grantor Retained Annuity Trust (GRAT) to transfer her business to her heirs. The basic idea is that Pat would gift some or all of the stock in her business to a trust. She would then take back a stream of payments from the trust. IRS tables are used to determine the value of this annuity back to the grantor, and this amount would be used to reduce the value of the gift for transfer tax purposes. If the business appreciates at a rate above the IRS rate (September’s rate is 2.2 percent), all the additional appreciation stays out of Pat’s estate. The difference between the low government rate and the high ROI on her business represents a positive tax arbitrage. If Pat lives long enough, she could potentially save millions in gift and estate taxes on appreciated property. The trade-off for this technique is she will incur some income taxes on the payments being made to her, and unless she spends these payments, they will represent additional wealth that can then be subject to estate tax when Pat dies.
Installment Sale Another way for Pat to freeze the value of her interest in her business is simply to sell it using an installment sale. If Pat has sold her business to her heirs, she will no longer include the appreciating value of her business in her estate. Rather, only the sales proceeds will be counted in her estate. Using an installment sale has the advantage of prorating the tax costs of the transaction over the years the installments are being made. Part of each payment represents a return of non-taxable basis in her business, capital gain on the sale price over her tax basis, and ordinary income on the interest element of the transaction. From a transfer tax standpoint, Pat’s estate would only incur estate tax on the amounts paid to her during her life that haven’t been spent plus any balance of installments still owing. The estate asset is no longer an appreciating business, but a fixed stream of loan payments. Similar to a GRAT, this approach freezes the value of her business interest for gift and estate tax purposes.
Entity Changes There are numerous ways Pat can change her ownership in both her business and real estate in order to freeze the values of these assets for estate and gift tax purposes. Each technique has its own quirks, but the basic idea is to create a fixed asset value for the property Pat retains, and let the appreciating elements of the assets be transferred to her heirs. Ideally, this not only transfers the appreciation out of her estate, but it is done utilizing a discounted valuation for gift tax purposes. For example, she could place some of her business or real estate assets in a family limited partnership. She would be the general partner, and she would gift (or sell) the limited partnership interests to her children. Handled correctly, this allows her to discount the value of the limited partnership interests for gift or income tax purposes, and it freezes the value for estate tax purposes.
Another entity change that would facilitate an estate freeze is to recapitalize the business into a combination of common and preferred stock. Pat would gift the common stock to her heirs and retain the preferred stock. Instead of Pat owning the rapidly appreciating common stock, she would own preferred stock which has a fixed value. This would allow her to remove the appreciating elements of her business from her estate through discounted gifts. However, in order to qualify this transaction with the IRS, she would likely need to take preferred stock dividends as an income.
Grantor Trusts A common, albeit odd, technique used with wealthy individuals is to create an intentionally defective grantor trust. Pat would place some of her appreciating assets in an irrevocable trust for the benefit of her heirs. Any income from these assets would be paid to the trust. Done correctly, this transfer will lock in the value of the gift for gift tax purposes and remove the assets from her estate for estate tax purposes. Where the “intentionally defective” element of the trust comes in is that the trust is drafted such that the income from the assets is taxable to Pat. So, even though the trust, not Pat, receives the income, Pat is the party paying the income tax.
How is this tax-efficient? The fact is that someone will pay income tax on the gains that come from Pat’s business and real estate interests. It makes sense for Pat to be the party paying that tax. First, despite her wealth, as a single individual Pat would not reach the top 37 percent income tax rate until her income exceeds $510,310. A trust, in contrast, pays at the top 37 percent rate on all income exceeding a mere $12,750. Even more importantly, Pat as a wealthy individual is trying to avoid estate taxes. When she pays income tax on the assets in the trust, she is also reducing the value of her taxable estate. This effectively means it’s a way to gift further value to her heirs without being subject to estate taxes. For example, if the trust generates $1 million in income and had to pay tax on that income, more than a third of the $1 million would be chewed up by income taxes. Instead, because of the grantor trust, the income tax is attributable to and paid by Pat. The trust (and therefore eventually the heirs) receives the $1 million.
The Retirement Drawdown Conundrum
Much of the wealth in the U.S. is associated with ownership of interests in closely-held businesses and real estate, Pat being an example. And the wealthy typically want to avoid the sizeable 40 percent tax associated with transfer taxes. That is why Pat’s financial advisors would likely recommend one or more of the techniques discussed above. But note that most of these estate freeze techniques involve Pat receiving streams of income that are, at least in part, subject to income taxation.
How does this square with the retirement drawdown strategies discussed previously? Drawdown strategies usually aim to defer, spread out or avoid income taxes while maximizing retirement cashflow. Yet the estate freeze ideas discussed above involve taking back taxable income. In fact, with the intentionally defective grantor trust concept, Pat incurs taxable income on payments she won’t even be receiving. And even with the techniques where she does receive payments, such as a GRAT or an installment sale, it’s questionable whether she really needs this money for retirement income. Since Pat has a $3 million IRA account, does she really need these other payments?
Efficiency remains the goal. Pat still wants retirement income; she wants to minimize taxes; and she wants to maximize government benefits. Because of her wealth, however, she should tackle the challenge in a different way. For example, she might switch the order in which she receives her retirement income. An affluent individual would typically delay the date she takes the bulk of her IRA payments. Thus, in the early years after retirement, she would draw down some of her after-tax assets and thereby delay ordinary taxation on her IRA income.
However, because of Pat’s wealth, she should flip the order of withdrawals. It would be more efficient for her to take her IRA income first and only use after-tax assets later if needed. This way she pays income tax on the IRAs and thus potentially lowers her taxable estate. By using up her tax inefficient IRAs for her own retirement income, she is also increasing the net amount her family will inherit. First, they receive after-tax assets instead of inherited IRAs that are subject to ordinary income tax. Second, they benefit from the stepped-up basis rules. When Pat leaves her heirs capital assets such as stocks and bonds, the tax basis of these assets will step up to their date of death value when Pat dies. This means her heirs will incur less capital gains tax upon the eventual sale of these investments.
Another example pertains to how wealthy individuals deal with required minimum distributions (RMDs). If, because of employing estate freeze techniques, Pat is receiving more cashflow than she needs, RMDs are particularly unwelcome. They simply further raise her taxable income and expose her to other costs such at the Net Investment Income (NII) surtax and means-testing of her Medicare premiums. If Pat is charitably inclined, she could avoid the tax hit of RMDs by utilizing a qualified charitable distribution (QCD). This would allow her to direct up to $100,000 of her RMD to charity and avoid the added costs associated with taking RMDs into income.
It may sound as though it’s a different world for the wealthy in maximizing retirement drawdown efficiencies. But it’s not all that dissimilar. The wealthy are still dealing with the issues of Roth IRA versus IRA, when to elect Social Security, asset allocation and location, and the smart choices to make in Medicare options. Further, despite the logic of intentionally incurring some income taxes to save on estate taxes, the wealthy should still seek out ways to minimize their overall tax exposure. It’s just that drawdown strategies are more nuanced for the wealthy than for those who are middle-income and affluent individuals. Efficiency remains the goal.