how to create an aristocracy through democratic means

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.

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8 Responses to how to create an aristocracy through democratic means

  1. Darrell Tangman says:

    “Make, say, $8 million. Pay income taxes on it and put $5 million in an IRA…”

    This is considerably over-simplified. The example quoted from the Fiscal Times supposes $5M in an existing 401(k), which can’t be a very common occurrence but does work under the existing tax code. But if you haven’t earned the money and stashed it away over a lifetime, it gets much harder. The tax code only allows $5000 a year in IRA contributions ($6000 for fossils like myself); excess amounts are assessed a 6% excess contributions tax each year for as long as they remain in the account. That would reduce the effective return on the IRA to 2%, and since the IRS rules require paying tax on the earnings attributable to excess contributions, I doubt that the heir’s income from the IRA would in fact be free of income taxes, although at this point we’re into aspects of IRA inheritance not discussed in the IRS publications I’ve read.

    So Joe Billionaire can’t take advantage of the IRA loophole unless he was smart about starting a 401(k) quite a few years back. And the amount in the 401(k) has to be split up for more than one heir to take advantage of this loophole. And if we assume 3% inflation, the value of the IRA over the lifetime of the heir(s), in constant dollars, is reduced by nearly a factor of 10. $400M tax-free income over a lifetime sounds pretty impressive; $40M over that same lifetime is considerably less so – still $500K tax-free a year, which is pretty sweet, but that’s for a single heir. If Joe wants to do the same thing for each of four grandkids, they’ll each get about $133,000 a year in 2011 dollars, tax-free. Still very nice, but hardly outrageous.

    • thehandsomecamel says:

      You’re right — I didn’t mean to imply that you could cram for it like an exam. But it does seem that this must be common enough among those with a lot of wealth for the estate-planning consultant (Ed Slott, quoted above) to be advising people to use it. Perhaps not always at the $5 million level, but it does strike me as reasonable to assume that many people will be able to use this loophole (assuming they have the good fortune to die between now and 2013, or that the law is extended in its current form, of course). The Fiscal Times article notes that a Roth IRA of $100,000 (a pretty attainable amount) would net an infant grandchild a lifetime bonus of $8 million. Even granting that by 2075 $8 million will hardly cover the cost of a Soylent Green sandwich, that’s still a pretty sweet deal.

      The four grandchildren of Joe Billionaire will be able to live an upper-middle-class lifestyle for the rest of their lives literally without doing anything at all, and pay no taxes (at least as the law stands now, according to the Fiscal Times article). And the grandchildren of Jim Reasonably-Welloff will probably not be too worried about college loans, at the very least. (Assuming the same reduction by a factor of ten, $8,000,000/10/80years/4 grandchildren = $2,500/year/kid, which gets you $45,000 tax-free by the time the kid turns 18. Which, of course, wouldn’t fully cover the cost of college, but would get you a lot closer.)

      Whether it’s worthy of outrage depends, I suppose, on how much advantage you think this confers on the descendants of both the extremely wealthy and the moderately rich. (In addition to all the other lifetime advantages they receive, of course, including traditional inheritance, better education, and better health.)

      Of course, I have neither an IRA nor grandchildren. Perhaps when I am a rich old duffer looking to bestow beneficence on my family, I shall feel differently. 😉

      • thehandsomecamel says:

        (Of course, I probably should say: the advantage conferred to the grandkids of Joe Billionaire is vastly greater. Most people would probably say that the Reasonably-Welloffs ought to be able to help their grandkids out with college, but also that it’s a little irksome to think of Joe Billionaire’s kids getting a tax-free allowance of over $100,000/year for the rest of their lives. So the right policy course is probably some sort of progressive tax on this kind of inheritance, either as an income tax or as an addendum to the estate tax.)

  2. Darrell Tangman says:

    Another thing to think about is the effect the Generation Skipping Tax has on some family farms in the absence of a fairly large exemption. If a farmer has built up a farm consisting of two quarter sections (not uncommon – where center-pivot irrigation is used, irrigated plots are typically a quarter section) and his children die before him, he would be leaving an estate worth roughly $1.5 million. If the top tax rate is 35%, in the absence of the exemptions, his grandchild inheriting the farm would owe a bit over $1 million in estate tax and GST. If the farm is a full section, which would be a large farm, but not an unusual size for a multi-generation family farm, the heir would owe $1.4 million in combined estate and GST, even with the historical $1 million exemptions.

    Lots of family farms have been broken up over the years because of estate taxes. When the GST also applies, it can be nearly impossible to keep a large farm intact. Only corporate farms escape the impact, and even there the ownership can be significantly diluted when a major shareholder dies.

    • thehandsomecamel says:

      I’m not sure I understand your math here. If there’s a $1 million exemption, and he leaves an estate worth $1.5 million, then the tax is on $500,000, right? How do his grandchildren end up owing over a million?

      Meanwhile [googles frantically!], Factcheck.org examines the question here: http://www.factcheck.org/article328.html and finds that, for example, “Of the 440 taxable family farm and business estates in 2004, two out of five paid an average rate of only 1.6 percent. These were taxable estates valued at less than $2 million.Very large estates valued at over $20 million paid at an average effective rate of just over 22 percent, a hefty tax bite but well short of “everything.””

      I frankly admit I’m out of my depth in terms of farm economy, but a $20 million+ farm does not sound, to me, like a “family farm” in the sense that we traditionally think of that. It’s not the family from Charlotte’s Web. It’s a large family-owned business. In 2004, the average worth of the family businesses and farms in the highest bracket was $105 million, and the average tax owed was $23 million. That’s a huge chunk of change, no doubt. But for the farmer with a $1.5 million estate, the average tax owed was only about $25,000. ( http://www.taxpolicycenter.org/numbers/displayatab.cfm?DocID=734&topic2ID=40&topic3ID=41&DocTypeID= )

      Can the small farmer afford that? According to Daryll Ray of the University of Tennessee ( http://newfarm.rodaleinstitute.org/columns/policy/2006/0713.shtml ), quoting a CBO report from 2005, “The report shows that in 2000, the number of farm estates that had to file an estate tax return was 4,641 and of those a little over one-third (1,659) owed any estate tax at all. Of the 1,659 who owed estate taxes only 138 did not have sufficient liquid assets to immediately pay the taxes due.” So about 8% can’t pay immediately — but if the estate is a farm, they have up to 14 years to pay the tax.

      But, again, I may be out of my depth, so if there’s something I’m not seeing here let me know.

      • Darrell Tangman says:

        I think I got carried away with complexity. The half-section, $1.5 million example was meant to illustrate why the $1 million (or larger) exemption is important, as without it the estate tax plus GST becomes essentially confiscatory for even a fair-sized farm. Not a terribly relevant exercise.

        I wasn’t aware of the 14-year thing. That certainly helps.

        Does leave me wondering what happens to a privately held family business worth around $100 million that suddenly faces a $23 million tax bill. More complicated than that, of course, since it’s the estate that owes the taxes, but I imagine that makes for a pretty substantial disruption.

  3. Darrell Tangman says:

    It seems to me that a lot of this could be enormously improved through simplification. An average Midwestern full-section farm is worth something like $2.5-3.0 million, so if the estate and gift tax rates were set at 25% with a $2.5 million exemption, most of the impact on family farms would be eliminated. (The average farm in Indiana is about 240 acres, and the vast majority are less than 640 acres; I suspect that’s pretty typical for Midwestern farms.)

    The Roth IRA thing could easily be fixed by making IRA-ness non-heritable. That is, the current value of the IRA would transfer tax-free, because that is consistent with the nature of a Roth IRA, but the heir could transfer it into a Roth IRA only under the same rules as would apply to the heir’s ordinary income. (This gets slightly complicated with spousal inheritance rules, but I don’t think generation-spanning serial marriage is common enough to warrant special handling in the tax code.)

    I would eliminate the Generation Skipping Tax. Anything that requires me to make a distinction between a 27-year-old recipient and a 26-year-old is too complicated. And under the GST rules, the taxability of a gift to the 27-year-old would change if he were adopted by one of my children! (This is, of course, entirely hypothetical in my case, lacking both children and enough money to exceed the lifetime GST exemption.)

  4. thehandsomecamel says:

    I can’t disagree — $23m on a $105m farm or business does seem disruptive. I could see lowering the top rate for farms and businesses…. which is, of course the kind of thing that leads to tax code complexity. There are days when my heart is entirely sympathetic to the flat tax people. (Those days were in April, as I recall.)

    But it does seem, intuitively, that there’s some benefit to treating a farm or a family business as a different kind of inheritance than cash or stocks (or a Roth IRA), even acknowledging that some inheritors will end up selling their inheritance. Hence, complexity!

    (In my so far lackadaisical and peripatetic readings about the law, it does seem that’s where a lot of the weird blind alleys in legislation and court precedents come from — this constant attempt to state simple rules, only to discover that such rules end up having intolerable consequences.)

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