Table 1. Expected After-Tax Wealth at the End of a 40-Year Investment Horizon for a Hypothetical Family with Initial Wealth of $100.
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
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.
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Risks of Tax Aware Strategies (Not Exhaustive)
1. Underperformance of pre-tax returns: tax aware strategies are investment strategies with the associated risk of pre-tax returns meaningfully underperforming expectations.
2. Adverse variation in tax benefits: deductible losses and expenses allocated by the strategy may be less than expected.
3. Lower marginal tax rates: the value of losses and expenses depends on an individual investor’s marginal tax rate, which may be lower than expected for reasons including low Adjusted Gross Income (AGI) due to unexpected losses and the Alternative Minimum Tax (AMT).
4. Inefficient use of allocated losses and expenses: the tax benefit of the strategy may be lower than expected if an investor cannot use the full value of losses and expenses allocated by the strategy to offset gains and income of the same character from other sources. This may occur for a variety of reasons including variation in gains and income realized by other investments, at-risk rules, limitation on excess business losses and/or net interest expense, or insufficient outside cost basis in a partnership.
5. Larger tax on redemption or lesser benefit of gifting: gain deferral and net tax losses may result in large recognized gains on redemption, even in the event of pre-tax losses. Allocation of liabilities should be considered when calculating the tax benefit of gifting.
6. Adverse changes in tax law or IRS challenge: the potential tax benefit of the strategy may be lessened or eliminated prospectively by changes in tax law, or retrospectively by an IRS challenge under current law if conceded or upheld by a court. In the case of an IRS challenge, penalties may apply.