How the Rich Pass Down Tax-Free Wealth

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3:55You've probably heard the saying, the rich get richer. And you know what? It is true because the rich know how to pass on wealth tax-free. And I know this sounds shady, but there are a handful of tax loopholes that help the 1 % avoid Uncle Sam that are 100 % legit. Today, I'm going to tell you about three power plays that the ultra rich use to pass wealth on tax free. This will probably feel like watching an episode of Succession. Totally fascinating, but not really a plot line that you want to live out yourself. And I'll tell you exactly what I mean at the end of this episode. So here are the three power plays that the ultra rich use to pass on wealth tax free.

4:30Number one, the grantor retained annuity trust or GRAT. Number two, the irrevocable life insurance trust, aka ILIT. And number three, the family limited partnership. The through line is that each of these vehicles help rich people pass money onto their kids without shelling out a ton in taxes. But the way that these three strategies achieve that same result are a little bit different. So let's start with GRATS, grantor retained annuity trust. It is so jargon heavy, and I hate that, but it's not that deep. Basically works that you're the grantor and you put assets into a trust, typically things that you expect to really grow in value, like stocks or a business.

5:06In exchange, the trust pays you back a fixed amount, which is called an annuity, every single year for a set number of years. This payment is designed to return the principal plus interest, but not necessarily the investment interest. This is based on how much the IRS assumes the asset is going to grow. And this is often a vehicle that's used with big startup founders. Pretty much every big entrepreneur I know has a grad for their kids. In a sec, I'm going to give you an example with numbers, which I think will really help bring all of this into focus. But before that, I want to tell you exactly what makes this a loophole.

5:40At the end of the term, anything left over in the trust, meaning any growth above the IRS's assumed interest rate, goes to your beneficiaries tax-free. So that basically means if your assets grow faster than the IRS expects them to grow, all the gains go to your kids or your heirs without triggering any gift or estate taxes, which is very cool, especially if they grow a lot. So, for example, let's say you fund a grant with a million dollars in stock and the IRS puts the interest rate at 4%. You structure the grant to pay back the$1 million plus 4 % every year spread over the term of the grant.

6:19So let's say five years. These are fixed payments, not based on how the investment actually performs. So if your assets only grow 4%, everything gets paid back to you and there's nothing left for your heirs. But if your assets grow more than 4%, let's say 10%, the extra 6 % growth gets passed on to your heirs, gift and estate tax-free. This is the cool thing about GRATs. The future appreciation of whatever assets are in there escapes estate and gift tax if the grant is structured properly. Honorable mention here, it benefits you, not just your kids, because remember, during the term, you receive payments.

7:01There are a ton of financial vehicles like certain types of trusts and, of course, life insurance that only provide perks to your beneficiaries. So in some ways, gratts are like the opposite of life insurance because you get benefits while you're alive, which is sweet. But further adding to the life insurance foil analogy, for gratts, you have to outlive the term, that five-year period in the example I gave. If you, God forbid, pass away during the grat term, the assets are pulled back into your estate and taxed. So is a grat right for you? Well, I'll tell you, but not yet. I'm going to take you through the other two financial vehicles, and at the end, I'll tie everything up into a beautiful bow and break down which of these strategies might make sense for you.

7:45Okay, so let's talk about life insurance, specifically irrevocable life insurance trusts or islets. For most of us, we think about life insurance as a way to help survivors with expenses like paying off a mortgage or, I'm sorry if this sounds dark, funeral costs. For the ultra-rich, life insurance is a wealth transfer vehicle. An islet is a trust that owns, it's like a wrapper for the life insurance policy that you have on yourself. You fund the trust, typically with cash, and the trust uses that cash to pay the policy premiums. When you die, the life insurance payout goes into the trust, not into your estate, And that means your beneficiaries get the entire amount without it being subject to estate tax.

8:31So let me say this again. Your heirs get a tax-free payout. The death benefit is typically income tax-free, and thanks to the trust, it's also estate tax-free. Also, it doesn't hurt that because the policy is in a trust, the assets in the trust may be protected from creditors depending on your state laws. So for some ultra-wealthy people who are really worried about lawsuits, the extra creditor protection is really appealing. But these are complicado. I looked into these personally. First of all, these trusts are irrevocable, henceforth the name. That means once you set it up, you cannot take it back.

9:11You lose control of the policy, period, the end. It also means it's very hard and in some cases impossible to make changes. For example, I have one daughter right now. If I created an islet and I named her as the beneficiary and then I had another kid in a couple of years, I wouldn't be able to add the second kid as a beneficiary. There are some ways to work around it, but you have to be really thoughtful when you form your islet. For example, saying my children or my descendants instead of actually listing individual names. That's just one example. But if you're funding the ILEP by gifting money to the trust, you'll also potentially want to stay within annual gift tax exclusion limits.

9:49$19 ,000 per recipient as of this year. If the trust has multiple beneficiaries, you can gift that amount per beneficiary annually without using up that lifetime exemption. By the way, for this year, the exemption is almost$14 million per individual or$28 million for a married couple. So you have to hit that amount in your lifetime for this thing to even matter. which sounds like high-class problems, but let's dream here. Important, there is something called the crummy letter, yes, that's a real thing, that the trustee sends to beneficiaries, letting them know that they have the right to withdraw the gifted amount.

10:22It's a weird formality, but it's necessary to qualify for the gift tax exclusion. Again, let's dream. Next, a family-limited partnership, which is kind of exactly like it sounds. It's a business entity often holding a family business or real estate that's structured to keep wealth in the family while minimizing taxes. You set it up by creating a limited partnership and transferring assets like your business or your property into that entity. You keep control by being the general partner and you give shares of the partnership at a discounted value to your kids or your heirs. Why discounted? Because limited partnership interests are considered less valuable due to the lack of control and marketability and liquidity here.

11:08That means if you gift 10 % of the family limited partnership, the IRS might value that gift at less than 10 % of the total assets. This move is all about control. As general partner, you control the decisions even if you have given away most of the equity. You can gift more while staying under the tax limits due to valuation discounts. But if you do go this route, you have to be prepared for the fact that the IRS is going to likely be looking at you very closely. You need to make sure that you have structured this partnership correctly to avoid any penalties or, my biggest fear, audits. So that means that you're probably going to need attorneys, accountants to make sure that you're checking all the right boxes here.

11:52For family limited partnerships, you can also gift partnership shares within that lovely annual gift tax exclusion limit or use your lifetime estate and gift tax exemption, which is so high. Remember,$14 million per individual,$28 million for married couple. These three strategies are the secret weapons of big family dynasties. But, and this is the question I've been alluding to this entire time, should you and I use them? Because while all of these moves are totally legit and very effective at minimizing taxes and preserving long-term, beautiful generational wealth, they are not cheap to set up and they are not for everyone.

12:30So here's the honest truth. A grat is going to make a lot of sense if you already have a high growth asset like a private business or a really large stock position in a growth company that you're expecting to significantly appreciate. So think startup founders, business owners about to IPO, someone doing a low basis investment that's poised to take off. If that's not you, a grat probably overkill. And in Islay, it's great for high net worth individuals who expect to leave behind a large estate and want their heirs to receive life insurance proceeds free of estate taxes. But again, it is complicated.

13:09It's expensive to set up and to maintain, and it's very rigid because of the irrevocable part. If your financial picture is still evolving, this is probably not the right tool for you just yet. A family-limited partnership might start to make some sense if you're legitimately worried about hitting your lifetime estate and gift tax exemption. I know it's a big number. If you're not close to it at all, you probably, though, do not need to spend the time and the legal fees structuring an FLP. The bottom line here, these wealth transfer strategies are like surgical tools. They are powerful, they are precise, but they're best used by professionals.

13:48And just because you can do something doesn't necessarily mean you should, but you should know about them. For most people, these tools don't make sense until you hit a certain wealth level or complexity with your life for your assets. But, and this is a very important takeaway, being tax savvy and intentional about estate planning is important for everyone. Know your options because that mindset does not require a net worth in the millions or billions. It just takes a little bit of strategy. For example, open a custodial Roth IRA for your kid if they have earned income. Great for teaching, investing early, and those contributions grow tax-free.

14:29It's free to set up. I've done a bunch of episodes on this. I will link those in the show notes. Or gift appreciated stock instead of cash when making charitable contributions so you avoid paying capital gains taxes and the charity still gets the full value. Estate planning feels like a drag. It still feels like that in my family too, but it's necessary and it is no longer optional for anyone building real wealth. And if you want to stay wealthy across generations, you definitely need a strategy. For today's tip you can take straight to the bank. If you're loving this old money lore, I'll pull the curtain back on another move the rich use to get richer.

15:08The private foundation, a.k.a. the giving and keeping strategy. This doesn't really fall under the umbrella of tax strategies for passing on tax-free inheritance, but it is a way to get a tax deduction and keep control. A private foundation is a type of nonprofit that you create and control. You donate the money or assets like stocks into that foundation and you get a tax deduction. But here's the kicker. The foundation can be run by you and your family and you get to decide how and when the money is given out. And pro tip, you can hire family members to run the foundation, work for the foundation, and pay them a reasonable salary.

15:43That's yet another way wealth stays in the family.

15:51Money Rehab is a production of Money News Network. I'm your host, Nicole Lappin. Money Rehab's executive producer is Morgan Lavoie. Our researcher is Emily Holmes. Do you need some Money Rehab? And let's be honest, we all do. So email us your money questions, moneyrehab at moneynewsnetwork.com to potentially have your questions answered on the show or even have a one-on-one intervention with me. And follow us on Instagram at moneynews and TikTok at moneynewsnetwork for exclusive video content. And lastly, thank you. No, seriously, thank you. Thank you for listening and for investing in yourself, which is the most important investment you can make.

16:33Thank you.