Estate planning trade-off: Is it better to pay a large capital gains tax or a large estate tax?

Moving assets into an irrevocable trust is a well-known method to remove assets from your estate to minimize estate taxes upon death. However, these assets do not receive a stepped-up cost basis upon death, as assets within your estate do. Thus, these assets may end up paying a larger capital gains penalty in the future.

So is it still a good idea to move assets into an irrevocable trust? I created a financial model to answer this question. You can download a copy of the model here.

The Answer:

It depends (of course!), but generally, it is often a good idea to contribute assets to an irrevocable trust to minimize estate taxes. Check out our editable financial model to play with the inputs yourself.

What are the drivers?

Expected Lifetime: The longer you expect to live after contributing to the irrevocable trust, the better it is for your heirs. For example, if you were on your deathbed, your estate was worth $20,000,000, and the estate tax exemption was only $14,000,000, and your assets had substantial capital gains, I would NOT recommend moving the $14,000,000 into an irrevocable trust. It would be better to take the stepped up basis.

On the other hand, if you expect to live another 15-25 more years, then it’s more likely that moving assets to a trust is a better answer. However, the answer depends on your exact cost basis, starting level of assets, and expected rate of return.

Expected Return: The second factor is expected return relative to inflation. The estate tax exemption goes up every year according to inflation. Meanwhile, your invested assets go up every year according to market returns. Over time, equity market returns tend to outperform inflation significantly. However, if you invest in such a way that you don’t outperform inflation, then it might be better to keep your assets in your estate and pay the estate tax, rather than pay capital gains.

Cost Basis: If you contribute assets to an irrevocable trust with an extremely low cost basis, they are more likely to pay a larger capital gains than estate tax if they had remained in your estate. However, we did our analysis on a range of cost basis scenarios, and we found that the outcomes were not as sensitive to this as we had expected. See our sensitivity tables below.

Scenarios

Below are three scenarios:

1) Transfer $14M to Trust

2) Do nothing (assumes estate exemption remains at $14m)

3) Do nothing (assumes estate exemption reverts to $7m)

In each scenario, we assume 20 more years of life and then compare the tax implications of a large capital gain versus an estate tax. We assume 2.5% inflation for purposes of increasing the estate tax exemption.

As you can see, whether or not the estate exemption remains at $14,000,000, it could be advantageous to utilize an irrevocable trust and pay a future capital gain tax. In this example, we even computed a rather large capital gain tax of nearly $9.5 million, and that was still better than paying the estate tax in the future.

Sensitivity Analysis

Assuming the $14m exemption remains

Below is a sensitivity table showing the total tax savings from using an Irrevocable Trust and paying capital gains taxes as opposed to simply taking the estate tax. The starting assumptions are beginning with $14m and the estate tax exemption reverting to $7m. Annual return is 7% and inflation is assumed to be 2.5%.

As you can see, even when the cost basis is very low (only ~$1m), there are still some gains to utilizing an irrevocable trust, even if you only live 1-5 more years. However, the biggest gains come if you expect to live 15+ years. This is because of the estate tax exemption reverting to only $7m.

Assuming the $14m exemption reverts to $7m

In comparison, below is a sensitivity table where we assume that the estate tax exemption stays at $14m plus inflation. In other words, what happens if Congress were to extend the TCJA indefinitely?

In this case, the story is somewhat different. If estate tax exemptions were to remain unchanged, it becomes more important that you expect to live an addition ~10+ years before you start to see tax savings from an irrevocable trust, or that you contribute higher-cost-basis assets.

A secret weapon: the swap power

When setting up an irrevocable trust, talk to your lawyer about including a swap power provision. This provision allows the grantor (you) to swap assets in the trust for assets you currently hold, as long as the value is equal.

One optimal strategy would be to continually manage your trust to ensure that the trust holds your highest-cost-basis assets, while keeping your low-cost-basis assets in your personal estate. That way, after passing, your beneficiaries will enjoy a large step-up-basis on your estate assets, while allowing your high-cost-basis assets to pass on without being included in your estate.

When done correctly, this Swap Provision can mitigate some of the capital gains problems that come with irrevocable trusts. All of the above analysis was done without considering the power of the Swap Provision, making it possible that you could outperform our scenarios above.

Next Steps

If you are interested in learning more about trusts and how they might benefit you, contact us! At Toups Capital Advisors, we are fee-only fiduciaries who don’t make any money from commissions on the financial products we recommend, unlike many advisors and some large banks. We always put your financial well-being first. Initial consultations are always free.