Conservatives have been chipping away for years at the estate tax, a modest tax (well, all right — not that modest) on the children of extremely wealthy people when those children receive enormous windfalls for no work at all, i.e., their inheritances. They labeled it the “death tax.” They whittled it down to literally nothing over a ten-year period as part of the “Bush tax cut” package. And as that package was set to expire, they fought furiously (and successfully) to keep the estate tax from returning to pre-Bush levels.
But did you know that there are even sneakier ways to make sure your descendants are rich, rich, RICH? There are if you’re able to quietly manipulate the tax code in ways that most people don’t understand and never even hear about. But now you’re hearing about it, right here on this blog!
Okay, so the first thing is, passing wealth on to your grandchildren is a little different from passing it on to your kids, because you can make what are known as “generation-skipping transfers.” Take it away, Investopedia!
For years wealthy, individuals gave or bequeathed money and property to their grandchildren without paying federal estate taxes. Unfortunately for those individuals, the generation-skipping transfer tax put a stop to that; it was created to make sure that no one could skip over a generation in order to skip out on taxes.
A generation skipping transfer (GST) refers to the shift of property by gift or at death to a person who is two or more generations below that of the person granting the gift…. Many people use a grandchild as a skip person….
The GST tax is a federal tax imposed on gifts given to skip-persons to make certain that taxes are paid at each generational level and cannot be escaped through the use of a trust.
The tax is only due when a skip person receives amounts in excess of the GST estate tax credit. Fortunately, most people will never encounter the GST tax because the tax credit levels are relatively high. Since 2006, the GST estate tax credit has been $2 million per person, meaning that every taxpayer is entitled to a $2 million exemption.
That was written in 2009. Flash-forward two years, and watch as the law changes before your very eyes! The Fiscal Times reports:
“I call this tax break the government’s going-out-of business sale,” says IRA guru Ed Slott, who travels the country teaching advisors and accountants how to squeeze benefits out of the Roth IRA. “This is a tax break you could drive 10 Mack trucks through. It’s an incredible opportunity to do a totally tax free transfer of wealth.”
This massive estate-tax break was created last year in two steps. First, Congress lifted a $100,000 income restriction on who can convert a 401(k) or IRA to a Roth IRA, allowing even the wealthiest investors to convert. Then late in the year it raised the generation-skipping transfer tax exemption to $5 million until 2013. The GST exemption was previously $3.5 million, and was scheduled to drop to $1 million this year before Congress stepped in.
Both of these provisions on their own create possibilities for significant tax savings, upon conversion. But used in combination, the results are exponentially greater….
The Roth IRA has always been on a different playing field compared to alternatives, because it allows gains to be withdrawn tax-free….
Not everyone jumps at the chance to convert to a Roth IRA, because you have to pay income taxes on the assets moved into the account. So if you plan to live off of retirement account assets, a conversion may not make sense. But from an estate planning perspective, when there are decades of gains ahead, the tax bill can be a small price to pay for big benefits down the road.
With the new GST exemption, the estate planning benefits that can be wrung out of a Roth are eye-popping. Consider an extreme case: A wealthy individual converts a large 401(k) account to a Roth IRA, and names a grandchild as the beneficiary. The grandchild, at age one, inherits the Roth, whose assets have grown to $5 million. Because of the new $5 million generation-skipping transfer tax exemption, the Roth assets would not be subject to estate tax or generation-skipping transfer tax.
Under Roth rules, an heir must take required minimum distributions, but the distributions can be stretched over a lifetime and assets left in the Roth can continue to grow tax free. Based on a one-year-old’s 81.6-year life expectancy, assuming an average annual return of 8%, Slott calculates that the grandchild’s lifetime income from the Roth would be $408 million – “completely free of estate, gift, income and capital gains taxes,” he says.
This is a little hard to fathom, but it is, in fact, the law. Make, say, $8 million. Pay income taxes on it and put $5 million in an IRA — which, remember, is supposed to be an individual retirement account. The IRA was created to use as a source of additional income at the end of one’s life. But now, thanks to to clever rigging of the rules by Congress, it has become the mother of all estate-planning tools — an investment that can give a grandchild an 8000% return on investment, tax free. Nice.
This is not to impugn all wealthy people, of course. Some, like Abigail Disney, are frankly embarrassed by all this unseemly tax evasion through legislative manipulation:
Abigail Disney benefited greatly from a big inheritance but believes the estate tax should come back, at least to their levels last year.
“I take this position because I love my country,” says Disney, the granddaughter of Roy Disney, who helped build the Walt Disney Co. empire. “And the fact is, my grandfather could never have built his business anywhere else.”
Disney, a filmmaker and philanthropist, spent a lot of time shooting a film in Liberia. She says there, unlike the United States, there are no safe roads or schools and therefore no safe investments. And she says those who make money in a secure society like the U.S. also owe the society a debt….
“It’s absolutely an accident of my birth. And that’s sort of the point — that there shouldn’t be dynasties built around the simple good luck of being born related to somebody very wealthy,” she says.
Meanwhile, surprising no one, the extremely rich are now wealthier than they were before the financial crisis. And in other good news for rich people, Hank “Don’t Ask What The Money’s For” Paulson has a new job, so everybody can stop worrying about that guy.