Matt Johnston is an advanced planning attorney at Northwestern Mutual.
If you have significant wealth and have begun thinking about the financial legacy you want to leave future generations, you are far from alone. In fact, Cerulli Associates, a financial services research and consulting firm, projects that Americans will transfer as much as $72.6 trillion in assets to heirs through 2045. In what has been dubbed the “Great Wealth Transfer” by media outlets, most of this wealth will transfer from baby boomers to Gen Xers and Millennials. Moreover, Cerulli expects 42 percent of this wealth to come from high-net-worth and ultra-high-net-worth households.
To help maximize your wealth transfer, tax efficiency must be a top priority. By transferring your wealth in the most tax-efficient manner, you’ll pass along more of the wealth you’ve worked so hard to build and preserve for future generations. And while there are numerous estate planning tools available to help you achieve this goal, four key tax benefits and strategies play a role in estate plans for families with substantial wealth:
- The lifetime gift and estate tax exemption
- The annual gift tax exclusion
- The Generation-Skipping Transfer (GST) annual exclusion
- The GST lifetime exemption
While you are likely at least somewhat familiar with these tax benefits, even many financially savvy individuals are unclear on how these tax rules work and just how powerful they can be.
Here, we’ll discuss the federal estate, gift and GST taxes as well as their respective exemptions and annual exclusions. Then we’ll explore two gifting strategies leveraged by high-net-worth and ultra-high-net-worth families to maximize wealth transfer, and we’ll briefly cover state-level transfer and inheritance taxes.
Federal Estate and Gift Taxes
First, let’s dive into what federal estate and gift taxes are and how their annual exclusions and exemptions work.
The Estate Tax
The estate tax is levied on property you transfer at death. The value of your taxable estate above the lifetime estate and gift tax exemption, which will be $12.92 million in 2023, is subject to a flat tax of 40 percent, while amounts below that threshold do not incur tax at all.
The Gift Tax
The gift tax is like the estate tax except that it applies to property you transfer during your lifetime instead of property that you transfer at death. Indeed, it was created by Congress to prevent wealthy families from circumventing the estate tax by making lifetime gifts instead. It even has the same tax rates and shares the lifetime exemption with the estate tax.
The Lifetime Gift and Estate Tax Exemption
The lifetime gift and estate tax exemption affords every taxpayer an opportunity to pass on a certain value of property to heirs during life and/or at death without paying gift or estate tax. Because this is a unified exemption, the gifts you give during your lifetime can impact the exemption available for the property you transfer at death.
As a result of the Tax Cuts and Jobs Act (TCJA) of 2018, the exemption amount doubled from $5 million in 2017 to $10 million in 2018. What’s more, the exemption amount is adjusted annually for inflation. Thanks to high inflation in 2022, in 2023 the total exemption amount per taxpayer will increase by $860,000 to an all-time high of $12.92 million. While this increase is unprecedented, it’s important to highlight that TCJA provisions expire after 2025. So, unless Congress intervenes, plan on the lifetime gift and estate tax exemption amount reverting to pre-2018 levels of $5 million (adjusted for inflation) starting in 2026. In other words, this is a use-it-or-lose-it opportunity. The only way to take full advantage of these historically high exemptions is to use it before the sunset, or you won't be able to take advantage.
The Annual Gift Tax Exclusion
In addition to the incredibly powerful estate and gift tax exemption under current law, there is another tool at your disposal: the annual gift tax exclusion. As the name implies, the annual gift tax exclusion is applicable only to present interest gifts. The annual exclusion enables you to give away smaller amounts of money each year without paying gift tax and without impacting your available lifetime estate and gift tax exemption. In 2023, the annual gift tax exclusion rises to $17,000 per taxpayer, per donee, up from $16,000 in 2022.
The Federal GST Tax
Next up is the GST tax. Like the gift tax, this, too, was devised by Congress to address a planning strategy used by wealthy families. In fact, prior to 1976, generation-skipping wealth transfers were quite popular. The idea was that you could pass assets to multiple generations of your family while paying estate or gift tax only once rather than your wealth being taxed each time it passed through another generation’s estate. To partially block this strategy, Congress enacted the GST tax in 1976 and later updated it in 1986.
While the GST tax doesn’t impose a tax each time property passes to a future generation, it does add one level of tax on transfers that skip at least one generation. In other words, the GST tax is paid in addition to any applicable estate or gift tax on wealth transfers to grandchildren and the generations that come after them. The GST tax rate is the same as the estate and gift tax rates and is applied in a manner that makes the total tax liability of a generation-skipping transfer the same as it would be if it had transferred through two estates.
The GST Tax Lifetime Exemption
The GST tax lifetime exemption functions similarly to the lifetime estate and gift tax exemption. Indeed, the exemption amount matches the lifetime estate and gift tax exemption, which will be $12.92 million in 2023. It’s important to note that the GST lifetime exemption is separate from the lifetime estate and gift tax exemption (i.e., it is not a unified exemption). So, this means that if you deplete your lifetime estate and gift tax exemption, you won’t necessarily deplete your GST lifetime exemption, although when gifting to grandchildren and other future-generation family members, these exemptions can be applied concurrently.
The GST Tax Annual Exclusion
Like the annual gift tax exclusion, there is also a GST tax annual exclusion. The GST tax annual exclusion amount matches the annual gift tax exclusion amount, but the definition of what qualifies for the GST tax annual exclusion is more restrictive. For example, gifts to a life insurance trust might qualify for the gift tax annual exclusion but likely will not qualify for the GST tax annual exclusion. In 2023 the GST annual exclusion would enable you to gift up to $17,000 to a grandchild without incurring GST tax or impacting your lifetime GST tax exemption. Here again, the GST tax annual exclusion is separate from the annual gift tax exclusion, but they can be applied concurrently, so when gifting to grandchildren, you would typically leverage both exclusions simultaneously.
Leveraging These Tax Benefits
While on the surface these benefits are easy enough to understand, it’s worth taking a moment to walk through two hypothetical scenarios that demonstrate how high-net-worth and ultra-high-net-worth families may use these tax benefits to help maximize wealth transfer strategically. While these scenarios represent two prevalent wealth transfer strategies, numerous possibilities exist, making it important to collaborate with your financial advisor, tax professional and estate planning attorney on a strategy that best meets your goals.
Scenario 1: Married Couple With $60 Million of Assets
For the purposes of this example, let’s say you and your spouse have a combined $60 million of assets. You also share a desire to preserve as much of your wealth as possible for future generations. Speaking of future generations, you have adult children and several young grandchildren.
In collaboration with your financial advisor, tax professional and estate planning attorney, you decide 2023 is the right time to start planning, thanks to the historically high lifetime estate, gift and GST tax exemptions of $12.92 million per taxpayer that will be available in 2023. Because you are married, that means you and your spouse can transfer a combined $25.84 million into trusts for future generations, fully exhausting both sets of your exemptions.
While you’ve been able to transfer just under half of your net worth to future generations tax free, you are more than able to maintain your lifestyle well into the future with the funds that remain in your estate. So, to help amplify your financial legacy, you opt to leverage the annual gift and GST tax exclusions to help reduce your taxable estate at death by making annual gifts to each of your children and grandchildren. Over the course of many years, you make substantial reductions in your future taxable estate through these strategic gifts, helping you further maximize the financial legacy you leave behind.
Scenario 2: Married Couple With $30 Million of Assets
In this case, let’s assume everything is the same, but instead of $60 million of assets, you’ve got $30 million. While you are indeed ready to take advantage of the current legislation before it expires in 2026, you are concerned that transferring the full $25.84 million available to you as a couple may not leave you with enough assets to support yourselves well into the future.
Instead, you decide to maximize only one set of your lifetime exemptions by one spouse transferring $12.92 million into trusts for future generations. This strategy leaves you enough money to support your lifestyle well into the future while also capitalizing on what could be a once-in-a-lifetime tax saving opportunity under the TCJA should its provisions expire in 2026. And although it’s unclear exactly what the future lifetime exemption amount will be, by exhausting only one spouse’s set of exemptions, you’ve kept the other’s intact, preserving the additional exemptions for future use.
In the meantime, because you are very comfortable with the amount of money that remains in your estate, you decide to leverage the annual gift and GST tax exclusions, helping reduce your future taxable estate and ultimately transferring even more wealth to future generations.
What About State Taxes?
While the focus of this article is on minimizing federal transfer taxes, some states have their own transfer taxes and even inheritance taxes (which are paid by the receiving beneficiary). Be sure to speak with your financial advisor, estate planning attorney and tax professional to determine if you live in a state that levies its own transfer or inheritance taxes and, if you do, what steps you should take to help maximize your wealth transfer.
Start Your Wealth Transfer Plan Today
If you don’t have a formal wealth transfer plan in place, now is a great time to get one started. With historically high lifetime estate, gift and GST tax exemptions set to expire in 2026, families with substantial wealth may be looking at a once-in-a-lifetime opportunity for significant tax savings. Connect with your financial advisor today to get the process started.
Tax rates as of 2023, subject to change.
This article is not intended as legal or tax advice. Northwestern Mutual and its financial representatives do not give legal or tax advice. Taxpayers should seek advice regarding their particular circumstances from an independent legal, accounting or tax adviser.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and CFP® (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
As a senior director in the Advanced Planning department at Northwestern Mutual, I work with Northwestern Mutual financial advisors as they help clients achieve financial security.