Tax Aware

The Value of Integrating Income and Estate Planning

Topics - Tax Aware

${ numberSection } ${ text }
The Value of Integrating Income and Estate Planning

In a recent Journal of Wealth Management article, 1 1 Close Sosner, Nathan, Joseph Liberman, and Steven Liu. 2021. “Integration of Income and Estate Tax Planning.”  The Journal of Wealth Management 24 (1): 78-104.    we discuss challenges of wealth preservation and growth faced by high net worth families. While it is not a surprise that a family that invests with income tax and estate tax efficiency in mind is much more likely to achieve its financial legacy goals than a family oblivious to taxes, the numerical advantages of tax efficiency described in the next paragraph are quite striking. In addition, we show that there is a significant value in integrating income tax efficiency and estate tax planning: Becoming efficient with respect to one tax should make the family even more eager to become efficient with respect to the other.


Table 1 below 2 2 Close Table 1 presents the same data as Exhibit 3, Panel B, in our article.   shows expected after-tax wealth at the end of a 40-year investment horizon for a hypothetical family which starts out with $100. The after-tax wealth is measured after income and estate taxes. Income tax efficiency increases across columns, from left to right, and estate tax efficiency increases across rows, from top to bottom. At the end of the investment horizon, the family that that is the most efficient with respect to income and estate tax achieves almost three times the after-tax wealth of a family inefficient with respect to both—$1,027 (bottom right) versus $359 (top left).

We offer a word of caution that, in pursuit of tax efficiency, investors should not disregard expected pre-tax returns. Rather, prudent investing, income tax efficiency, and estate tax planning should work in harmony to produce the best result for the family.


Table 1. Expected After-Tax Wealth at the End of a 40-Year Investment Horizon for a Hypothetical Family with Initial Wealth of $100.

Source: Integration of Income and Estate Tax Planning. We use Monte-Carlo simulated data. As the estate planning tool, we use grantor retained annuity trusts (GRATs). We model five-year consecutive, two-year consecutive, and two-year rolling GRATs scenarios, alternatively. All the GRATs are zeroed-out GRATs. The GRATs are implemented until the end of the investment horizon. For example, for a forty-year horizon there will be eight consecutive five-year GRATs, twenty consecutive two-year GRATs, and thirty-nine rolling two-year GRATs. To the extent possible, taxes are paid outside of the remainder trust. We use probability of death that increases with age from the “2012 IAM Basic Table – Male, ANB” produced by the Society of Actuaries. The simulations proceed as follows. First, wealth of the family accumulates at the after-tax rate of return which is determined by the pre-tax return and the tax characteristics of the investment process: the character of the realized income, gains, and losses, and the amount of unrealized gains. We draw annual pre-tax returns from an i.i.d. normal distribution with a specified mean and standard deviation. Tax characters are applied as a fixed fraction of the pre-tax return. The pre-tax returns and the tax efficiency of the investment are the key parameters of interest in our study and we vary these parameters as explained further below. For each set of return parameters, we draw 20,000 forty-year return histories. Second, we apply mortality to the return histories. For example, if the probability of death in a given year is 1%, we apply death event logic to 200 out of our 20,000 return histories every year. In the event of death, the value of the assets passing through the estate is reduced by the estate tax, their cost basis is stepped up to the fair post-estate-tax market value, and the assets are reinvested by the family until the end of the forty-year investment horizon. Assets that are already in the estate-tax-exempt trust at the time of death of the grantor are unaffected. We assume investment in the same assets both inside and outside of the trust and thus use the same time series of simulated returns—one of the 20,000—for both. Finally, at the end of the forty-year investment horizon, all the assets are liquidated, and liquidation taxes are paid. Assets that at the time of death were in the personal account of the grantor and thus received a step up in the cost basis at death face a lower liquidation tax than the assets that were in the remainder trust at the time of death and thus did not receive a step-up in their cost basis. If the wealth creator is alive at the end of the forty-year investment horizon, none of the assets, either in the personal account or in the trust, benefit from the step-up in the cost basis at death prior to liquidation. We show the average results across our 20,000 return histories with their respective estate tax and liquidation tax situations. The pre-tax return is assumed to have a mean of 6.8% and a volatility of 10.0%. Tax inefficiency is modeled through varying the fraction of highly taxed income and gains from 70.6% for the least tax-efficient investment to 0% for the most tax-efficient investment. We assume tax rates of 23.8% for low-taxed gains and income and 40.8% for highly taxed gains and income. We assume that the Section 7520 rate which determines the GRAT annuity payments is 2.4%.

Show more

This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance. 

This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein. 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such. 

The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. 

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor. The recipient should conduct his or her own analysis and consult with professional advisors prior to making any investment decision.


Risks of Tax Aware Strategies
Like any investment strategy designed to generate pre-tax returns, tax-aware investment strategies are subject to the risk of pre-tax returns meaningfully underperforming expectations.

Unavailability of potential tax benefits. The expected tax benefits associated with the tax-aware strategy may be less than expected or may not materialize due to the economic performance of the strategy, an investor's particular circumstances, prospective or retroactive changes in applicable tax law, and/or a successful challenge by the IRS. In the case of an IRS challenge, penalties may apply.