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At the start of 2023, the uncertainty and economic turbulence we experienced in 2022 continued to dominate our economic outlook with respect to stock market volatility, increased interest rates, high global inflation, and fears of recession. Fast forward to the fourth quarter of 2023, and there is cause for optimism as more economic data are released, primarily driven by a strong labor market and wages keeping pace with inflation.* Nevertheless, the next couple of months will determine whether a recession will be occurring or whether the efforts of the Federal Reserve achieve the so-called “soft landing” for the U.S. economy.
Despite the current economic environment, there is a silver lining to be found—a number of new opportunities for valuable year-end planning. The federal estate and gift tax exemptions remain at an all-time high, and 2023 is the first year in which the SECURE Act 2.0 has been in effect, offering new approaches to income tax planning. Additionally, we are one year closer to material changes to the estate and gift tax environment, as they are set to revert to pre-Tax Cuts and Jobs Act (TCJA) amounts beginning in 2026. While you cannot control the uncertainty and outcome of the current economic or future tax environment, as the end of 2023 approaches, you can help create peace of mind for your future with a well-structured plan that you routinely review and revise to be sure it aligns with your personal, business, and financial needs and goals. Thus, there can potentially be some certainty amid the uncertainty.
In order to determine what income tax planning opportunities might be most advantageous for you to consider before year end, it’s important to first consider what the past year has looked like from an income level standpoint for you and your family. In a higher-than-usual income year, maximizing contributions to tax-advantaged accounts, accelerating income deductions, and tax-loss harvesting might play a larger role in your planning than in years past. On the other hand, a year with a lower level of income provides a separate set of opportunities, such as accelerating income and converting tax-deferred assets to Roth Individual Retirement Accounts (IRAs).
A second consideration is how recently enacted legislation might impact how you typically approach year-end planning. The year 2023 is the first in which the SECURE Act 2.0, which was signed into law on December 29, 2022, has been in effect. While this legislation includes approximately 100 provisions and various dates new rules go into effect, there are notable items that could influence your planning this year. Tailoring year-end planning to your current financial situation, while keeping in mind how new legislation may play a role, can help optimize your existing financial plan.
Opportunities to consider in a higher-than-usual income year may include:
Opportunities to consider in a lower-than-usual income year may include:
The federal unified estate and gift tax exemption for 2023 has been at an all-time high of $12.92 million ($25.84 million per married couple), up $860,000 from 2022 due to a significant inflation adjustment. The projected inflation adjustment to the exemption amount for 2024 will result in another significant increase of approximately $690,000, bringing the federal unified estate and gift tax exemption to approximately $13.61 million ($27.22 million per married couple) in 2024. While the size of the 2025 inflation adjustment will depend on the course of inflation over the next year, a further increase in the range of approximately $430,000 to $570,000 is currently projected.
Finally, the gift tax annual exclusion amount is projected to increase from $17,000 per donee this year to $18,000 per donee in 2024.
Given the now divided Congress, and absent some bipartisan compromise that would either extend or otherwise alter current legislation, many of the changes imposed under the TCJA—including these all-time high increased exemption amounts—will sunset after December 31, 2025, with the laws currently scheduled to revert to those that existed prior to the TCJA. While legislation could change at any time and, as such, plans need to be flexible to adapt to any such changes, there is no new tax legislation at this time. Thus, absent any new legislation, these high exemption thresholds are temporary and are currently set to expire and be significantly reduced at the end of 2025 to a pre-2017 level of $5 million, adjusted for inflation. The good news—there is still about two more years to take advantage of valuable planning opportunities to optimally utilize these increased exemption amounts. However, any difference in these higher exemption amounts and the post-2025 reduced amounts will be lost if not used. Therefore, there is a “use it or lose it” window of opportunity to engage in planning to take advantage of these increased exemptions, and proactively designing and implementing the proper gifting and estate plan will be important.
Depending on your assets, current estate and gift tax exposure, and broader cash flow and estate planning goals, there are a number of gifting strategies to consider implementing prior to 2026 to take advantage of this window of opportunity.
As a result of the continued market volatility in 2023, certain assets may be depressed in value. Gifting such assets, whether directly to a beneficiary or in trust, that have decreased in value but have the potential for rapid appreciation if the market rebounds effectively allows you to move assets out of your estate using less of your lifetime estate and gift tax exemption, while also allowing you to protect all future growth from any eventual increase in asset values outside your taxable estate. Similarly, assets previously transferred to grantor trusts with retained substitution powers also should be assessed for opportunities to move low-basis assets out of such trusts at a lower current value in exchange for higher-basis assets of equivalent value. Using a substitution of assets to “undo” prior planning strategies could allow you to mitigate capital gains on the lower-basis assets that have appreciated inside the trust by returning them to your taxable estate, and thus allowing them to benefit from the step-up in basis at death (thereby reducing income tax liability exposure), with no impact to your remaining available lifetime estate and gift tax exemption and no increase in the size of your taxable estate.
The effectiveness of several planning strategies use numbers derived from the federal funds rate; that is, the monthly published applicable federal rates (AFRs), which are most often used when loans are made among family members without banks involved, and the IRC Section 7520 rate (7520 rate), which is a factor used in making various calculations (remainder interests, charitable deductions, minimum thresholds) for estate planning strategies. As a result, certain planning strategies are more attractive in a higher interest rate environment. One such strategy that may become more appealing in light of rising interest rates is the charitable remainder trust (CRT), which combines philanthropy with tax planning. The CRT is an irrevocable trust that pays an annual payment to an individual or individuals (one of whom is typically the grantor) during the term of the trust, with the remainder passing to one or more named charities. Because the value of the grantor’s retained interest is lower when the Section 7520 rate is higher, the value of the interest passing to charity, and, therefore, the grantor’s income tax deduction, is higher. Further, the grantor’s taxable estate is reduced by the assets gifted to the CRT, as well as all future appreciation on such assets.
Another strategy that can benefit from a higher interest rate environment is the qualified personal residence trust (QPRT). A QPRT allows a primary residence to be transferred at a deeply discounted gift tax value and also freezes the value of the residence as of the date the QPRT is created. If the grantor survives the QPRT term, the residence (and any appreciation after the transfer) is excluded from the taxable estates of both the grantor and the grantor’s spouse. As the 7520 rate increases along with interest rates, the grantor’s right to use the residence during his or her lifetime increases, while the value of the taxable gift (the remainder interest) decreases, making the use of a QPRT more advantageous from an estate and gift tax perspective. Thus, whether you are considering implementing new gifting strategies, enhancing the planning structures you already have in place, or have previously used your exemption amount, valuable current and future exemption planning opportunities still exist in this higher interest rate environment.
In contrast, other strategies may become less appealing in light of rising interest rates. As with the CRT and QPRT, the ultimate success of strategies such as a grantor retained annuity trust (GRAT), an intentionally defective grantor trust (IDGT), and intra-family loans are linked to the monthly 7520 rate and AFRs. In times of rising interest rates, the GRAT assets will need to outperform the Section 7520 rate in order for the appreciation over the retained income interest to pass to the GRAT beneficiaries free of gift and estate tax. Selling assets likely to appreciate to an IDGT in return for a promissory note bearing interest at the applicable federal rate may produce significant gift and estate tax savings. However, as with a GRAT, the value of the assets sold must grow at a greater pace than the prevailing applicable federal rate in order for the appreciation to be transferred to beneficiaries free of gift or estate tax. Similarly, intra-family loans will need to charge a higher interest rate to avoid being treated as gift loans. While these strategies still may serve your planning goals, evaluating their performance is especially important in the 2023 interest rate environment, and you may wish to implement these strategies sooner rather than later to avoid further increases in interest rates.
A core tenet of year-end planning is the ability to evaluate your formalized financial plan and assess if you are still on course. Creating a custom plan that lays out your current financial situation and illustrates planning opportunities like those discussed previously is critical in mapping out how to achieve long-term goals. Confirming the accuracy of the assumptions made in your plan or readjusting those that may have changed over the course of the year can help ensure your financial plan is providing the best picture for you. You may find that how you previously have approached planning has not been within a formalized process. Speaking with your advisor about your year-end planning can be a great way to begin building your custom financial plan.
Remember that, like our lives, planning is an evolving process: Don’t set it and forget it!
Cost basis – The original value of an asset for tax purposes.
Grantor retained annuity trust - An irrevocable trust into which you can transfer assets that are expected to appreciate, providing the grantor with an income—in the form of annuity payments—throughout the trust’s term, usually a specified number of years.
Grantor trust - A trust created by the grantor that is a “disregarded entity” for income tax purposes and all income, deductions, and any taxes due from the trust are reported on the grantor’s personal income tax return.
Intentionally defective grantor trust - An estate-planning tool used to freeze certain assets of an individual for estate tax purposes but not for income tax purposes. The grantor pays income tax on any generated income, but the estate does not incur any estate taxes when the grantor dies.
Step-up in basis – The adjustment in the cost basis of an inherited asset to its fair market value on the date of the decedent’s death.
Substitution powers – A power provided under the trust instrument whereby the grantor is allowed to remove an asset or assets from the grantor trust, at any time, in exchange for an asset or assets of equivalent value.
Source for all data: www.irs.gov
This article is for informational purposes only and is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. There is no assurance that any investment, financial or estate planning strategy will be successful.
Wilmington Trust is not authorized to and does not provide legal or tax advice. Our advice and recommendations provided to you are illustrative only and subject to the opinions and advice of your own attorney, tax advisor, or other professional advisor.
The information in this article has been obtained from sources believed to be reliable, but its accuracy and completeness are not guaranteed. The opinions, estimates, and projections constitute the judgment of Wilmington Trust and are subject to change without notice.
Please see important disclosures at the end of the article.
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