Strategies for The Wealthy When it Comes to Drawdowns

Planning your retirement is a very crucial step for everyone, but being efficient and successful is the aim. What may help people are drawdown strategies by going for a monthly stream of income throughout retirement, downsizing the amount of taxes, and maximizing the benefits from the government.

Nevertheless, being wealthy enough to have the resources to retire quite well for the rich brings additional financial obstacles and complexities in retirement planning than is usual of a retired middle-class or affluent person. The repercussions of gift and estate taxes may be regarded by wealthy retired people. They might own special assets or investments, and they tend to have problems with gifting and donating to charity. The rich don’t generally have different issues with the retirement drawdown; they tend to have extra problems.

Income drawdowns for the rich, tax efficiency is very important, but their assets may come with challenges to value. This is because these assets tend to be art, intellectual property, a brand, or small businesses. The rich also may have more income than this wish or need, which is why many gift or donate to charity as strategies.

Let’s take a look at a situation with a 59-year-old woman named Margaret, that has gained a lot of money through a sky-rocketing coffee chain. Her chain is valued at around $20 million, and she has it outlined to pass down the business to her family line. She also has property valued around $5 million and has about $7 million in her IRAs.

Margaret wishes to start the process of handing off her business to the next in line, which is why she has cultivated an exit strategy and is beginning to plan out her retirement with her financial advisors.

In regards to Margaret’s situation, just considering her income and employment taxes isn’t sufficient for her to be tax-efficient. She is facing extra hardship. Over the exemption amount, federal gift and estate tax is a straight 40 percent.

For Margaret, over $12 million of her assets may be subject to the tax. Also, due to sunsetting tax regulations, this could rise to another rate of 50 percent in the year 2026.

The equation is pretty simple. Margaret must do her best to stay away from those gift taxes, even though that would have her generate additional income taxes, which could be up to 37 percent. If she gives away her assets, she would not be hit with some extra income taxes. However, this move would require a 40 percent gift tax. Therefore, tax efficiency recommends lowering her exposure to transfer tax and choose to place additional taxes on her income. There are several avenues this approach can be achieved.

There will be some examples of widely used strategies of estate planning that require taking extra income though avoiding taxes in regards to gift and estate. The list does not cover every matter, but the planning problems and resources exclusive to wealthy Americans are highlighted. All of these strategies are examples of “estate freezes” that effectively secure the value of appraising assets for purposes of estate tax. For the asset, a value is calculated, and that value remains set for the purposes of estate and gift tax, even when the worth of the underlying asset subsequently rises.

To pass her business down to her children, Margaret’s advisors might have her implement a well-known estate freezing method called a Grantor Retained Annuity Trust (GRAT). The main concept is that several or even the entirety of the stock in her business would be gifted to a trust. After, the trust would send her disbursements of payments. IRS tables are used to calculate this annuity’s value back to the grantor, and this figure would be used to decrease the gift’s value for transfer tax reasons. If Margaret’s business values above the IRS average, so all the extra appreciation remains out of the estate portfolio.

The distinction in her business between the low government rate and the high ROI is a positive tax arbitration. Margaret may save millions of dollars in gift and estate taxes on valued property if she lives long enough. The trade-off for this strategy is that she will receive income taxes on the payouts sent from the trust, and if she does not use those payments, they reflect the extra wealth that would then be liable to property tax if Margaret passes away.

A different method for Margaret to freeze the valuation of her business interest is to sell it via payment installments. When she has sold her business to her children, the appreciating value of the business will no longer be included in her estate. The only that will be applied to her estate would be the sales profit from the sale. The benefit of doing an installment sale is to prorate the transaction’s taxes through the years that payments are made. Part of each payment is a non-taxable return for the coffee chain, capital gain on the selling price over the tax basis, and ordinary revenue on the transaction’s interest. From the perspective of transfer tax, her estate would only bear property tax on the money paid to her during her lifespan that has not been used along with the balance of payments that are remaining. The asset is now fixed loan payments and not a company of appreciation. Like the GRAT method, for estate and gift tax reasons, this method freezes the worth of the business interest.

There are many different strategies in which Margaret can switch the possession of both her real estate and coffee chain so that she stops the appreciating values of her assets or estate and gift tax reasons. ⠀Each strategy has its own nuances. However, the main point is to develop an asset value that is frozen for the estate that she has and allow the appreciating part of her assets be moved over to her children. ⠀This move, hopefully, will be done with a reduced assessment for gift tax reasons. For instance, in a limited family partnership, she can place a bit of her coffee chain or real estate properties into this partnership. Her role in this partnership would be general partner, and her children would be sold or gifted the limited partnership interests. It helps her to deduct the value of limited partnership interests for gift and income tax reasons and caps the value for purposes of the estate tax.

There is a different kind of entity change that would also provide a freeze in estate. Margaret could recapitalize the coffee chain into a mixture of preferred and common shares. She would keep the preferred stock, and her children would be gifted the common stock. Rather than holding the common shares that are gaining in value very quickly, Margaret would hold stock that has a set value, which is the preferred stock. This would eliminate the increasing value of the coffee chain from her estate with a discounted gifts tax. Now, she would probably have to take preferred stock distributions as revenue to have this transaction eligible with the Internal Revenue Service.

An unusual, yet popular, strategy that the rich use is to establish a defective grantor trust on purpose. For the benefit of her children, Margaret would allocate several of her appreciating assets into an irrevocable trust. The trust would be paid any revenue that the assets generate. If this is implemented just right, this move would freeze the gift’s value for gift tax reasons and delete the assets from her estate for property tax reasons. However, the trust is drawn up in such a way that Margaret is taxed on the revenue of these assets. This is what the purposeful defect would be. Therefore, although the money is paid to the trust, Margaret will be the one to pay the income tax.

So how is this technique efficient? The reality is that somebody needs to pay the income tax on the profits that result from Margaret’s coffee chain and properties. Here is why it would make sense for Margaret to pay the tax: even though she is wealthy, Margaret herself would not hit the income tax bracket for the top 37 percent, only if her earning go over $510,310. On the other hand, a trust will have to pay the top 37 percent rate on all revenue that goes over $12,750. To be straightforward, Margaret is trying to prevent having to pay estate taxes as a wealthy citizen. She also lowers the value of her taxable estate if she pays the asset’s income tax. Basically, this would allow Margaret to give more value to her children without being liable for estate taxes. For instance, if the trust earns $1,000,000 in revenue and then pays the income tax, that would be over a third of the profit, the government ends up taking. Therefore, due to the grantor trust, the tax is liable for Margaret to pay, which allows the trust (essentially the children) to receive the full $1,000,000.

Much of the U.S. wealth is correlated with ownership of assets in real estate and business, which is why Margaret is a prime example. Just like most people probably would, the rich want to stay away from paying the 40 percent transfer taxes. That’s why financial advisors that Margaret goes to will more than likely advise doing one or more of the above-mentioned strategies. However, keep in mind that a majority of these methods of estate freezing require Margaret to earn income that is liable to income tax.

Drawdown strategies typically aim to defer, spread out, or avoid income taxes while maximizing retirement cash flow. However, the estate freeze ideas mentioned earlier involve taking back taxable income. With the intentionally defective grantor trust concept, Margaret incurs taxable income on payments she wouldn’t even receive. And even with the techniques where she does receive payments, such as a GRAT or an installment sale, it’s questionable whether she really needs this money for retirement income. Since Margaret has $7 million in her IRA accounts, does she really need these other payments?

The objective is still to be efficient. Margaret seeks income during her retirement years, minimizing taxes liable, and also maximize the benefits from the government. Though, she must approach the obstacle accordingly because of her wealth. For illustration, she may change the sequence she earns her income during retirement. Normally, someone that is of affluency defers the time she collects most of her IRA distributions. Therefore, she would scale back some of her after-tax assets in the initial years following her retirement, and delay the taxation on her IRA income.

But, Margaret should change the order of withdrawals due to her how much she is worth. Using her IRA earnings first and only utilizing after-tax assets later, if necessary, would be more efficient for Margaret. She thus pays revenue tax on IRAs, thereby reducing her taxable estate. She also raises the net value her children will gain by using her tax-inefficient IRAs as her income during retirement. First off, they acquire after-tax assets and not IRAs, which are liable to income tax. Secondly, her children will benefit from the basic rules that are stepped up.

When Margaret passes down her capital assets such as stocks and bonds to her children after her death, the tax basis of the assets will step up to the date of death value. It implies that on the sale of these assets, her children will face less tax on capital gains.

Another illustration is how rich people handle RMDs, which are payments that the person must take by law. If Margaret earns more income than she wants due to the estate freeze strategies, RMDs are not efficient for her. The RMDs will increase her taxable income and subject her to other expenses like the surtax of Net Investment Income (NII) and the evaluation of Margaret’s premiums for Medicare. Using a qualified charitable contribution (QCD) can prevent the tax liability of RMDs for Margaret if she wishes to donate. This move would let her redirect her RMD to charity, which she can contribute up to $100k and prevent the additional expenses of RMDs becoming added revenue.

Though it may seem that it is very different for the rich in regards to maximizing their drawdown, but it really is not. The rich are still faced with IRA vs. Roth IRA matters when they should receive their SS benefits, investment allocation and position, and what the best decisions should be for Medicare choices. Given the idea of purposely receiving income taxes to save on property taxes. The wealthy would still want to look for methods to reduce their overall tax liability.