Written by: Deborah Cartisser
When people think about their estate, they often imagine it as one big “pot” of assets to be divided among their heirs. This approach, while seemingly straightforward, can lead to unintended consequences, particularly when it comes to the tax burden on the beneficiaries. Instead of focusing on the total value of the estate, it may be more effective to also consider the unique tax implications of each asset and how these might impact each beneficiary differently.
The Problem with Equal Splitting
Traditionally, many people plan their estate with the goal of splitting everything equally among their beneficiaries. The idea is that each child or heir receives an equal share of the total estate, which seems like the fairest approach. However, this method doesn’t take into account the different tax treatments of various assets, nor does it consider the individual financial situation of each heir. By taking into account the financial situation of each beneficiary in the estate planning process, analysis may show a better way of dividing and distributing the assets to ultimately preserve a larger amount of the family wealth.
For example, let’s say two children inherit equal shares of a traditional IRA. One child lives in a state with high income taxes and is in a higher federal tax bracket, while the other child is in a lower tax bracket and lives in a state with no income tax. Although they inherit the same nominal amount, the child in the higher tax bracket will end up paying significantly more in taxes, reducing the actual value of their inheritance. This discrepancy means that, despite an equal division of the estate, the children end up with very different amounts after taxes.
A Better Approach: Asset-by-Asset Planning
To avoid these disparities, a more sophisticated approach to estate planning involves considering each asset individually and how it aligns with the tax circumstances of the beneficiaries. This strategy, often referred to as asset-by-asset planning, focuses on maximizing the after-tax value of the estate for each heir, rather than simply dividing the estate equally.
For instance, if an estate includes a mix of pre-tax retirement accounts, non-qualified assets like real estate or stocks, and cash, the estate plan can be tailored to allocate assets based on the tax impact for each beneficiary. The retirement accounts, which are subject to income taxes when withdrawn, might be left to a beneficiary in a lower tax bracket. On the other hand, assets that benefit from a step-up in basis, such as real estate, could be allocated to a beneficiary in a higher tax bracket, since these assets might incur little to no tax when sold.
This approach not only ensures that each beneficiary receives a fairer share of the estate after taxes, but it can also increase the total wealth that remains in the family. By minimizing the tax burden on the estate as a whole, more wealth can be passed down to the next generation.
The Role of Advisors in Asset-by-Asset Planning
Implementing an asset-by-asset approach requires a deep understanding of both the assets in the estate and the financial and tax circumstances of each of the beneficiaries. This type of planning requires that the financial advisor has a detailed understanding of each heir’s financial situation as well as an understanding of family dynamics. The advisors working on an estate plan like this will have to regularly update the plan as financial circumstances, tax laws and the assets within the proposed estate are changed. When a change occurs that is significant enough to modify the distribution plan, a change to the estate documents must ensue. For example, significant changes in the client’s or beneficiaries’ lives—such as a child moving to a state with higher taxes or another child experiencing a significant increase in income may demand changes to the estate plan to ensure it remains equitable and efficient.
Real-Life Example
Consider the client who has an estate valued at $6.7 million, which she plans to divide equally among her three children. Her estate includes $1.5 million in pre-tax retirement accounts, $1.5 million in non-qualified assets, a $675,000 primary residence, and $3 million in life insurance proceeds.
If she follows the traditional approach of dividing her estate equally, each child would receive one-third of each asset. However, since the children are in different tax brackets, the after-tax value of their inheritances would vary. For instance, child 1 is in a high tax bracket and would receive less from the retirement account than her siblings, while child 2 is in a lower tax bracket, and would end up with more inheritance after taxes.
To create a more equitable distribution, an asset-by-asset approach is considered. In this scenario, the child who has the lowest tax burden, might receive a larger share of the retirement account, while the non-qualified assets and life insurance proceeds could be divided between the other two who have higher tax rates. By strategically allocating the assets in this way, the total after-tax value of the estate increases, and the inheritances are more balanced.
In one example, this approach resulted in an additional $155,000 being retained within the family, rather than being lost to taxes. This significant increase highlights the potential benefits of considering an asset-by-asset strategy.
When to Consider an Asset-by-Asset Approach
While the benefits of asset-by-asset planning can be substantial, it’s not always the right choice for every estate. This approach is most effective when there are significant disparities in the tax situations of the beneficiaries and when the estate includes a variety of asset types with different tax implications.
However, it’s important to recognize that this method can also introduce complexity and is likely to require ongoing adjustments. For example, changes in tax laws, shifts in the beneficiaries’ financial situations, or alterations to the estate’s asset composition could necessitate updates to the plan, which involves changing the estate documents. Advisors need to work closely with their clients to determine whether the potential benefits of an asset-by-asset approach outweigh the added complexity and maintenance that are inherent.
Estate planning is sometimes about more than just dividing assets equally among heirs. By considering the tax implications of each asset and the financial situations of the beneficiaries, an asset-by-asset approach may help ensure that more wealth is retained within the family and distributed in a fairer, more efficient manner. Financial advisors play a key role in implementing this strategy, providing valuable insights that can lead to a more successful and equitable transfer of wealth to the next generation.
Contact our team today to learn more about estate planning and how our experts can assist you. We’re here to give you one less thing to worry about and provide the attention you need.
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