Julia and Elena

I have written this letter and spent quite some time thinking about these things, but by no means have all the answers. I need your help to finish, so please spend at least some time and give your best effort to understand the issues I raise here. 

Let's open a discussion regarding our family's financial future. Mom has wisely accumulated a large net worth, and while she has made efforts to organize our inheritance, our current approach is not as tax-efficient as it could be. We have substantial assets to manage and we should ensure that the transfer from Mom to us supports the financial security of the family for many years to come. Some of the assets will be shielded from capital gains taxes because we receive a new step up basis when we inherit. But as of now, the estate minus Mom’s lifetime exemption is fully exposed to federal estate taxes and we need a plan to reduce that exposure and to provide resources for the future. We should consider using strategies of other wealthy families to minimize this tax liability, thereby ensuring both the preservation and transfer of wealth to our generation and the next. 

First I have to say that I don’t want anyone to feel over pressured to agree to anything they don’t want or understand. If we do nothing everything will be perfectly fine and there will be more than enough money for any of us to do just what we want and to take care of ourselves through any old age. Done right there will be even more to pass on when we are gone. I just don’t want anyone to be surprised by the size of either the inheritance or the tax bill it generates. Also, high net worth can introduce various financial vulnerabilities, such as risks from divorce settlements, personal injury judgments, or debt collection. We can protect ourselves the way rich families have for generations.

Next we have to define exactly how much our net worth is and how it's allocated across different accounts and investments. The largest part of it is split between two stock positions and account for about 75% of the total inheritance or about 82% of all stock holdings, so really any discussion about this mostly concerns what to do with 32000 shares of Microsoft and 57120 shares of Apple. Right now this is worth almost $31 million. This is held with about $5 million more stocks in a regular taxable brokerage account at Schwab for Mom’s revocable trust  for a total of $36 million. These stocks have been owned a long time and have appreciated so much that almost their whole value in capital gain. Any sale now triggers capital gains tax. There is also an IRA at Schwab worth $1.4 million with Julia, Elena and I listed as beneficiaries. Inherited IRAs have a very particular set of rules and are taxed on withdrawal as ordinary income, so really are part of another much smaller discussion to have with your own tax advisor. The house has $200,000 to $300,00 in equity and will transfer easily inside the revocable trust. All of the above and some cash and personal property add up to about $37.7 million subject to estate tax. Outside of the estate there is also an annuity/insurance policy from MassMutual that should pay about $5 million. In 2026 the lifetime gift and estate tax exemption is $15 million and Mom just signed an amendment to the trust to bequeath $2 million to Dan Sexton. We’ll also have to account for unreported lifetime gifts that have to be added to her current net worth. All of this helps us calculate the estate tax due and the inheritance coming should Mom leave us now.

Summary (in millions)

Stocks $36

House and 

other $0.3

IRA $1.4

Dan $2

Insurance $5

Gifts $1

Exemption $15

Estate Tax and Inheritance Calculation (in millions)

(Net Worth + Gifts - Exemption) = Taxable   Taxable * 40% = Tax Owed

($36 + $0.3 + $1.4 + $1 - $15) = $23.7    $23.7 * 0.4 = $9.48  

Tax  Owed = $9.48

Net Worth + Insurance - Dan - Tax Owed = Inheritance

$36 + $0.3 + $1.4 + $5 - $2 - $9.48 = $31.22        

Inheritance = $31.22 or $10.4 each

So as you can see the US Treasury will get almost a full share now and going forward it gets worse. Since all of the exemption is used up, for every $1 million gained Julia gets $200,000, Elena gets $200,000, I get $200,000 and the US Treasury gets $400,000. It won't take long for the US Treasury to get a larger share than any of us.

Lets explain a little about the estate tax and why we want to avoid it. Remember that any gifts over the annual exemption are considered part of the taxable estate. Mom has been sending everyone cash equal to the exemption for some time, but has never reported any other gifts. In 2026 the annual exemption is $19000 per person. The lifetime exemption keeps most families from paying the estate tax at all and is $15 million in 2026. Both of these exemptions are indexed for inflation. The estate tax rate collected from any estate valued more than the lifetime exemption is 40%. That is the highest rate the IRS wants for any tax and is due in total 9 months after the inheritance. Money paid out as estate tax will not be in our accounts compounding and creating wealth over time and you never make it up. If you start with less you end with less.

To continue we need to understand where this all could go. So I created some spreadsheets to try to model what might happen in the future given a starting investment balance and a potential annual withdrawal and setting a predicted return rate on that investment and inflation rate. You can see how the nominal balance increases but the spending power of that balance is adjusted down to compare it with today's dollars. Obviously the withdrawal and net worth increase very quickly. This is a fully interactive spreadsheet and you can change the starting assumptions in the top boxes and the grid will change to show the effect over future years.

(Table 1)

The 5 columns represent 20 years of time, the projected balance at the start of each year, a potential increase in the balance for the year,  a withdrawal adjusted for inflation each year and a total projected end of year balance. The last column adjusts that actual nominal balance to reflect its value in the first year's dollars. Inflation kills the value of the balance but the withdrawal amounts increase showing what can be spent and still have growth. Mom wants us to be able to do just what each of us decide to do and not worry about running out of money. These figures do not account for any impending taxes due (that comes next) but as you can see there is and will be plenty of money for the family’s future.

With this much money and the income it generates we will owe taxes. But Mom can maximize what our family keeps by systematically reducing her personal net worth and shifting where future growth occurs and choosing who covers the tax bills. This means that we can’t decide that taxes are due but we can decide who pays them and when they are paid. If a person in a lower tax bracket is assigned the tax debt then the taxes due are lower, and if the taxes are delayed then the funds otherwise paid as taxes can instead be invested and continue to grow over time. So she can freeze a portion of the value of her estate now by funding an irrevocable trust with a gift worth most of her lifetime exemption. This would be between $10 and $15 million. Because Mom’s estate has crossed the lifetime exemption limit, any future appreciation on her assets will face a 40% tax at her passing. To prevent this, wealthy families like ours use an irrevocable trust to "freeze" the asset values of a portion of our inheritance at today's prices. When Mom moves high-growth investments into this trust, she locks in their current valuation. If those assets double or triple over the next decade, all of that compounding growth occurs entirely outside of her estate. Since it was funded with the exemption the 40% tax never touches that growth, saving the family millions of dollars. That is how we decide when we pay the tax. Uncle Sam wants his money so there is a catch that we will get into later. This structure also allows you to decide who pays the income taxes, exactly as you envisioned. By setting this up as a grantor trust, the assets belong to the heirs, but Mom remains responsible for paying the annual income and capital gains taxes. Because Mom pays these bills out of her private funds, the investments inside the trust compound at a 100% tax-free rate for the family. Furthermore, every tax payment Mom makes acts as a legal, tax-free way to reduce her own taxable estate separate from her lifetime exemption. After she's gone, more smaller distributions can be made to each of us to try to keep us out of the highest tax brackets.  

Similar concepts affect charitable giving. Right now Mom makes various donations throughout the year then is able to take deductions from her income to reduce her taxes a bit. She does this in a most inefficient way. The only way she has money to donate is after tax has been paid leaving less available for charity, and any tax deduction is of this smaller amount. If instead Mom gifted her appreciated stock to a Donor Advised Fund set up at her broker, the stock could be sold and the proceeds avoid all capital gains tax. Any amount up to her income limit could be put in this fund and all of the donation is deductible. She would advise the broker to make donations in her name to the very same charities as before but more money would be available for helping her pet charities and less would go to taxes. She does not have to donate all that she puts into the fund leaving the remainder to grow tax free. Also she can appoint other members of the family as directors of the fund to donate or advise both now and after she's gone. The pets she donates to now could be taken care of long into the future, and we could choose other charities relevant to us. Consolidating the families philanthropy into one fund obviously reduces the low management fee even further.

Splitting the inheritance into 2 parts also helps us make sense of the different tax schemes available to us. One part of the inheritance will take advantage of the gift tax exemption and estate tax free growth in an irrevocable trust while the second part benefits from the higher step up basis and the elimination of capital gains tax. But, the first part leaves us owing capital gains calculated from the original basis and the other part owing full estate tax. We will pay one or the other on all of it so let's try to pay as little as we can. If we do things wrong we could even pay both on some of it.

I’ve created another spreadsheet to estimate just how much estate tax will be owed in the short term. The exemption is adjusted each year for 2.5% inflation but the other numbers are not inflation adjusted. I also did not include unreported gifts or any distributions so maybe they are a bit high. First with the full estate as it is now.

(Table 2)

Then if Mom puts $10 million into an irrevocable trust and is left with a smaller estate and remaining exemption.

(Table 3)

For this example after 5 years this would be a savings of  $$16,133,069 - $14,781,389 = $13,510,680 on an estate that has grown back to almost $37 million. This is using a 8% return after any other withdrawals. Different returns would give other results but this shows how the tax gets ridiculous very quickly.

Again to the first spreadsheet to see what the $10 million trust might earn. 

(Table 4)

This example uses a better return and a fairly high withdrawal. These assumptions could lead to a problem if the market crashed, or it could lead to lots of money to transfer. Unfortunately capital gains tax would be due on these distributions, but not the highest rate because each of us would get 1/3 of the distribution. We could also design the trust to pay out much less but act as a bank to lend money for things we might want, or even to set up the next generation. The key is that it can grow without any tax until or unless it is withdrawn.  The bottom line of a new plan with the irrevocable trust would mean a different type of inheritance. Maybe instead of each of us getting 10 -13 million all at once we receive 7-9 million plus 2 -300000 a year that increases as the market returns more. I don’t know everyone’s situation or expected income in the future, but I could live well on the trust distributions and let the other part of the inheritance buy a house growing each year that I did not need to touch that part. 

Finally I make a call to Elena and Julia for some action. Mom wants us to think of this money as ours now and then to help her make a decision about some next steps for her to take. We all have to understand how much money there is and how the law can work for us or against us affecting the future finances of our family. This is not the time to let someone else make decisions for you. We don’t have to act now but we can’t wait forever because it's not just Mom who is getting old. I’m sure both of you have done some planning for your old age and how you can help your children, but this might change your plans or add to them. Think about what you might want and what it might cost then lets find a way to make it happen. The Donor Advised Fund is a no brainer and I’m going to help Mom set that up in the next few weeks. It will be set up so that each of us can be a participant as much or as little as we choose. Creating some kind of durable family trust has also been proven to be the best way to handle multigenerational inheritances. We are not the only family to face this decision and we can investigate their many different structures that accomplish whatever goals we decide to have. But we’ll be trading some control for a more defined future outcome, so we have to exercise that control now when the trust is written. The provisions of the trust are difficult to change after the trust is set up. I do not know all of the options or how to write them into a trust but we will get that advice from professionals. Our job is to dream and to imagine a future that maybe we haven't envisioned ever before.

Your brother

David