The Benefit of Transferring Wealth by Year End

Daniel B. Eagan

With US gift- and estate-tax rates slated to rise on January 1, it may be wise to gift assets before year-end. As my colleague Andrew Auchincloss explains below, you still have a rare (but fleeting) opportunity to transfer wealth tax efficiently.

A Valuable Opportunity 

No one is sure what President Obama and Congress will do about transfer taxes, but if they don’t act, transfer taxes will automatically revert to 2001 levels at the end of this year, raising the maximum rate from 35% to 55%, and decreasing the lifetime exclusion for an individual from $5.12 million to $1 million.  

In other words, at least through the end of this year, a couple that hasn’t previously used any exclusion could potentially act together to transfer $10,240,000 (twice the $5.12 million exclusion) to a trust for the benefit of their children without incurring any gift tax. With some additional planning, this amount could also be exempted from the generation-skipping transfer (or “GST”) tax so that it would benefit many future generations of the family. 

Of course, many people cannot afford to make such a gift today, but some wealthier Americans may be in a position to do so. To be certain, you first need to determine whether you have already achieved your core capital—the money you’ll need to cover living expenses, adjusted for inflation, for as long as you may live.

We calculate core capital by using our proprietary Wealth Forecasting System, which projects 10,000 future market environments to show the range of probable outcomes for your investment portfolio. Once you know the amount of your core wealth, you also know how much “excess capital” you may have—the remainder of your wealth. These are funds you might want to use for such purposes as gifting to children or charity.

If you have excess capital, the current opportunity could be quite valuable. Perhaps surprisingly, the real value of making a large gift now does not come, as many people assume, from simply getting $5.12 million (or $10.24 million for a couple) out of your estate. As the display below suggests, the most basic benefit comes from getting the future growth of the wealth out of your estate. The light greem portion of the chart quantifies this benefit by showing the median outcome in our projected range of outcomes for a 60% stock/40% bond portfolio over the relevant time frame.

Enhancing the Benefits of a $5 Million Gift

Note that the chart is not showing the expected growth of the gifted assets (which in typical markets would be much larger than $5 million after 40 years) but instead the expected benefit of avoiding estate tax on that growth. 

To measure the estate tax benefit, we make the conservative assumption that Congress will allow the tax rate and exclusion to revert to 2001 levels in 2013. We also assume that the amount of the gift—$5 million in this case—will be “clawed back” into the grantor’s estate and subject to estate tax when the grantor dies. Most practitioners do not believe that “clawback” will happen as illustrated, but even if the gift is treated in this worst possible way, it will still provide a benefit of more than $5 million over 40 years.

Paying Income Taxes for the Next Generation

A second major tax benefit of making a gift today comes from taking advantage of the so-called “grantor” trust rules. By making the gift into a grantor trust, you get to pay all income taxes on the trust’s investment income, even though the trust itself remains outside your estate for gift and estate tax purposes.

Paying income taxes for your kids’ trust is an economic gift that benefits them but is not treated as a gift under federal tax law. The dark green portion of the chart demonstrates the potent effect of this option, which effectively doubles the benefit of the gift. Note that the grantor trust option is not available for transfers made at the donor’s death (the donor must obviously be alive to pay income taxes for somebody else), and may not be available for lifetime gifts in the future, as the 2012 budget proposals from the current administration seek to limit this kind of planning. 

In sum, wealthy Americans who haven’t taken advantage of the generous gift-tax exclusion currently available need to consider action before year-end. Using conservative estimates for future market returns and tax policy, we believe that, in the median case, a $5 million gift could produce a cumulative inflation-adjusted benefit of more than $12 million over the next 40 years for your children and/or succeeding generations of your family.  

The views expressed herein do not constitute, and should not be considered to be, legal or tax advice. The tax rules are complicated, and their impact on a particular individual may differ depending on the individual’s specific circumstances. Please consult with your legal or tax advisor regarding your specific situation. 

The Bernstein Wealth Forecasting System, SM driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of asset returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate the linkages that exist among the returns of various asset classes; (3) take into account current market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

Daniel B. Eagan is the Head and Andrew S. Auchincloss is a Director of the Wealth Management Group at AllianceBernstein.

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