The Hidden Beneficiary

The Hidden Beneficiary

September 21, 2023

These days AI is constantly on the tips of our fingers, our lips, and our minds. The era of artificial intelligence has arrived in a crash, rather than a gradual descent. Six months ago I decided to take it out for a test drive–I asked ChatGPT a few questions, curious to see if I was in danger of losing my job any time soon.

It actually surprised me.

After a warm up round of good ideas for Mother’s Day (which it passed with flying colors), I started asking it about work. ChatGPT avoids giving investment advice like the plague–no surprises there. But then I asked a question about estate planning. It gave a beautiful response. Thorough, simple language, and even a small example thrown in to illustrate the point along with a reference to the law specific to Washington state.

It was also completely, unequivocally wrong. Remind me to bring ChatGPT as my wingman should I ever need to baloney-sandwich my way through an interview.

I did not leave it at that. Still curious, I responded, simply saying it was wrong. The following was the part that shocked me.

It was obviously embarrassed (there I go, giving it human emotions already), because it apologized politely. It then proceeded to explain exactly how it was wrong, referenced its mistake and then explained how the laws had changed recently. It then provided the correct answer and apologized again.

The laws hadn’t changed recently, but I thought it only right to treat politeness with politeness and give it an honorable out. It made me realize that this is worth doing a very bare bones explanation. If ChatGPT is confused, there are probably a ton of perfectly smart people who are confused as well.

In Washington, as well as 12 other states and Washington D.C., there is a state estate tax. It taxes someone when they pass away. For six states, there is an inheritance tax, which taxes the person receiving an inheritance. Maryland prestigiously sits in the middle of that lovely Venn diagram where they tax both the dead and the living. And across every state, on the federal level, there is also an estate tax.

The federal estate tax is not a pressing concern for most people. For a single person today, you would need a net worth of over $12,920,000 to pay a penny in estate taxes–the first $12.92 million is exempt from taxes. For a married couple, the first spouse can basically give their exemption to the other spouse. Translated, when the second spouse passes away, they could have $25.84 million in their estate and pay zero federal estate tax. Even for our clients, there are very few who would need to worry about this. However, tax code is set to revert back to old numbers at the end of 2025. This would lower the estate tax exemption to about $7 million per person–still very high and affecting a small percentage of families.

The same cannot be said of state taxes. In Washington, an estate with over $2,193,000 will start paying the tax. Most of our clients with that kind of wealth don’t consider themselves rich. It usually means they have a nice home and saved well during their working years. They might have a rental property or inherited some leftover money from their own parents.

It used to be that this tax affected far fewer people, but the exemption amount hasn’t changed much over the last 15 years. Thanks to inflation, many upper-middle class retirees are now exposed to the tax. And Washington’s top-end tax rate is tied for the highest in the country!

Very importantly (and this is where ChatGPT was completely wrong when I asked about it), you can’t give your spouse your exemption in Washington like you can with the federal tax. An estate can be taxed twice in a row–once when each spouse passes away!

This sets the stage for doing something about it.

For many of our clients, they come to us with wills already in place. They have gone online and taken care of it or seen an estate attorney to draft their documents. Those who have done this legwork are not necessarily ill-prepared. Their assets are typically set up to go to the people and causes they care about, as long as it is up to date.

However, they are often unknowingly leaving a hidden beneficiary of their estate. This beneficiary is not mentioned in the will, trust, or IRA documents. They are silent but waiting with their hands outstretched. For clients with a net worth over $2,193,000, they are often inadvertently leaving a legacy to the state of Washington.

By structuring their estate properly, this can be avoided. And for families well under the 2.193 million net worth mark, nothing may need to be done. But for those with higher net worths, there are helpful tools meant to reduce or eliminate the tax.

One increasingly popular tool is called a disclaimer trust.

A disclaimer trust is a flexible document–it is designed to allow a surviving spouse some choices. If they want, they can allow a trust or two to be created that will minimize the estate tax (the exact structure is a little beyond the scope of this article–I want people to read, not sleep or get lost!). Or, in case the laws or circumstances have changed from when the disclaimer trust was created, they can opt not to create new trusts and allow assets to proceed as is. With tax laws changing seemingly every year or two, the best options tend to be the ones that keep you from being trapped in a plan meant for a different time.

The problem with estate planning is how darn complex it is. Done right, estate planning juggles taxes, investments, and the effect on intended beneficiaries. Lean too far in one direction to the detriment of the others. And especially on the tax front, it can be like walking a financial tight rope. There are estate taxes, income taxes, and capital gains taxes to consider. Try to minimize one kind of tax too much and you run the risk of paying more overall.

Here are a few examples:

1. Capital gains tax: I have a client who purchased $20,000 of Microsoft in 1998 for $19.36 a share. Today, after reinvesting his dividends year after year, his shares are worth $545,794! If he were to sell today, he would be taxed at a total rate of 23.8%. That would be a hefty bill of $129,899! Over 96% of his investment is now capital gain.
Say he holds onto the shares because he doesn’t need them and intends to leave a legacy to his children. When he passes away, the capital gains become part of principal (or “basis”). His children could then sell the shares and pay zero capital gains tax.

This is what we call a “step-up” in basis. It is an effective tax savings tool. However, some trusts that are used to lower your estate tax will cause the assets inside the trust to miss out on the step-up. If my client put his Microsoft stock into the wrong trust, he could miss out on the step-up and create a large capital gains tax for his kids! His family might save 10% on his estate tax bill but wind up paying more in the long run because of the capital gains tax!

This exact same thing can happen to people who have owned a home for many years that has appreciated in price.

2. Income tax:
If you put something into a trust that generates income, that income is either taxed to a beneficiary or to the trust itself. Many trusts used to remove assets from an estate have income taxed to the trust itself. This can be a great thing: done right, it reduces estate taxes. However, you have to be careful: these kinds of trusts pay income tax like people do, except at a higher rate at lower income levels.

Here is an example: suppose someone wanted to reduce their estate tax down the road. They might place a rental property they own into an irrevocable trust meant for their family. Done properly, this could cause the rental to not be counted as part of someone’s estate and reduce their tax bill. Seems like a complete win, right?

Don’t dip your quill and sign just yet! If the trust retains the rental income and does not pass it through to someone else to be taxed, it will be taxed to the trust.

Let’s put some numbers to this: imagine the trust generates $30,000 of taxable income for the year after any deductions. The trust would pay an ugly $9,835.

A married couple with the same taxable income after deductions, meanwhile, would only pay $3,160!

A few years of that kind of difference and the income tax might just start to outweigh your estate tax savings.

3. Estate tax:
Some clients come to me thinking they are just out of luck. They don’t want to create an expensive trust that requires a trustee to oversee things–they are concerned about the cost to use some of these tools. They are right to consider that! But sometimes you can reduce your estate tax efficiently and without paying anything for documents or a trustee.

Many of our clients choose to give their causes and beneficiaries money or stock during their lifetimes. A single person can give $17,000 in 2023 to as many people or causes as they want and not have to worry about it causing a tax issue. A married couple can give $34,000, double that number!

Doing so removes the gift from your own estate, reducing your estate tax. A couple with a $3 million net worth in Washington saves 14% when they give money to someone while they are living. And it also keeps any future growth of that money from happening inside the estate!

It also helps in other ways. You as the giver see the benefits during your own lifetime! Recipients who are younger now may have lots of expenses like starting a family, buying a house, college, or starting a business. Meanwhile, their income tends to be less early in their working careers. If beneficiaries receive a huge pot of money later in life when you pass away, after a lot of their expenses have been paid, the gift may not have quite as meaningful of an impact on their life.

Some of my clients worry that giving too much early on can be harmful to their beneficiaries’ drive to make something of themselves. They don’t want them to become dependent on gifts every year, which can absolutely be an issue as I have written about before. When we decide whether to give, it needs to take into account not just the taxes you might save, but how a beneficiary will use the money.

A great idea if you are concerned about that: have a conversation. You can give every year and still allow a beneficiary to thrive. They could save more in their own retirement or accelerate the payment of their house. The gift could also be in the form of you taking the family on vacation so you know exactly how the money will be used. You can have great memories in the process, all while keeping the state out of your family’s wealth.

The moral of these examples? Come talk to us about estate planning, even if you are not a multi-millionaire yet. We can help you find solutions to this sometimes complicated puzzle. We will also read through your estate documents to see if there is anything unusual or outdated.

We are also happy to collaborate with your estate attorney or connect you with one who is willing to put the extra effort into making sure your wishes are honored in a cost, tax, and investment friendly way. We want to work together with them, making sure we are all on the same page. Sometimes we even pull your CPA or accountant into the huddle to ensure there are no surprises. With some planning and deliberate action, you can keep your wealth in the hands of the right people.



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