Don't Mess With Taxes

Welcome to Part 6 of the ol' blog's series on 2021 tax inflation adjustments. 
We started with a look at next year's income tax brackets and rates.
That first item also has a directory, at the end of the post,
of all of next year's tax-related inflation updates.
In today's post, we look at how the annual changes help investors,
high-earners and, eventually, estate heirs.
Note: The 2021 figures in this post apply to that tax year's returns to be filed in 2022.
For comparison purposes, you'll also find 2020 amounts that apply to this year's taxes, due April 15, 2021.

Leonardo DiCaprio not only played a rich man in "The Great Gatsby," he's also a very wealthy Hollywood celebrity. That means Leo has some special tax considerations. He and his rich peers also get some tax help from annual inflation adjustments. (Image courtesy Warner Bros. Pictures, United States/Roadshow Entertainment, Australia) 

Death and taxes are inevitable, but the very wealthy see their potential final tax bills shrink a bit every year when the Internal Revenue Service releases its annual inflation adjustments.

That's because the cost of living tweaks typically increase the amount of assets that are outside Uncle Sam's reach when the owner passes.

In addition, these annual tax-related adjustments help out investors.

These folks take advantage of the personal finance truism that it's better to make your money work for you than to work for your money, typically by investing in stocks and other assets. And when the investments are long-term, the returns are taxed at a lower rate.

Those are just a couple of areas where wealthier taxpayers get some help from the annual inflation changes. Read on for details on them and more.

Lesser tax bite for capital gains: Let's start before — hopefully well before — that final tax bill is tallied with the earnings that add to estates.

One popular way, even when the stock market goes crazy like earlier this year when the COVID-19 pandemic hit the United States, is to invest in stocks and other assets. The generally accepted approach here is to weather such down times by reviewing your assets, at least annually, and holding onto them for the long haul.

The hubby is a good example here. He still has a stock that his grandmother gave him when he was in elementary school. His sweet grandma was a conservative investor, so as you would expect, she gave her favorite grandson (OK, her only grandson) and his sister and female cousins a pretty staid investment.

It doesn't make major earnings' leaps, but the slow and steady approach has worked. He's had it for so long that its value is much, much more than when he received the stock. So when he does eventually sell it, the shares definitely will qualify for the lowest long-term capital gains tax rate.

Long-term capital gains are one of two tax possibilities. The other is, you guessed it, short-term capital gains.

Short-term gains are taken when you sell an asset owning it for a year or less. In these cases, the tax on the sale profit is the same as your ordinary income tax rate, which could be as high as 37 percent.

If, however, you hang onto the asset for more than a year before selling, your investment patience is rewarded with a generally lower long-term tax rate on any profits.

Three separate long-term capital gains tax rates: The taxes on the proceeds from assets held long term are 0 percent, 15 percent and 20 percent. Which one applies depends on your overall income and filing status.

Those three tax rates survived the Tax Cuts and Jobs Act (TCJA) changes made in 2017. But the tax reform law did revise the capital gains income brackets to which they apply. Those new brackets also are adjusted for inflation.

The earnings to which the three long-term capital gains tax rates will apply in 2021 are shown in the table below:

In addition to capital gains tax rates listed in the tables, higher-income taxpayers may also have to pay an additional 3.8% net investment income tax.

And yes, there are other capital gains tax rates for other holdings, like collectibles, but they are affected by inflation.

Uncle Sam also collects capital gains taxes on estates and trusts.

For 2021, the maximum zero capital gains tax rate applies to estates or trusts worth up to $2,700. The top earnings level for an estate or trust to be taxed at 15 percent is $13,250. The 20 percent rate applies to these entities worth $13,251 or more.

For estates and trusts in 2020, the maximum capital gains earnings are $2,650 for the zero rate; 13,150 for the 15 percent rate; and $13,151 or more is taxed at the top 20 percent capital gains tax rate.

Estate tax exclusion increase: Now about that estate tax that kicks in at the federal level. Uncle Sam has been collecting tax on what we leave behind for decades.

Yes, the estate tax itself died for the 2010 tax year. But Congress resurrected it the very next tax year.

And while anti-estate tax groups would have you think it applies to everything left by a decedent, there's also typically been a base exemption, also called an exclusion amount, that's untaxed at the federal level.

The federal estate tax exclusion amounts have over the years been adjusted for inflation. That's still true under the TCJA, which also dramatically upped that base amount. The annual inflation adjustments keep increasing the exclusion amount, meaning we can leave more assets when we leave this mortal coil and not have as much of it face any federal estate tax.

For 2121, the inflation adjustments will allow a rich individual to leave heirs a tax-free estate of up to $11.7 million. The 2020 exemption was $11.58 million per person.

Note, too, that's per person. That translates to an estate tax exemption amount of $23.4 million for a married couple next year. That's up from 2020's $23.16 million combined estate tax exclusion amount for a wedded duo.

When an estate exceeds those tax year amounts, then and only then is the federal estate tax, which can go as high as 40 percent, assessed on the overage.

These multimillion-dollar exclusion amounts mean that the hubby and I and our families and our friends will likely never have to worry about the federal estate tax, unless we win the lottery or we get new, richer friends!

Note, though, that you might have to worry about the state tax collector. More than two dozen states and the District of Columbia do have either an have an estate or inheritance tax — our old Maryland stomping grounds has both — and their exclusion levels are much, much lower than the federal level.

Tax-free gifting, too: If you are lucky, hard working or a smart investor (or any combination of those) and have or expect to accumulate an estate that will face the federal estate tax, planning for that eventuality is key.

The good news is that there are some moves you can make to keep your estate out of Uncle Sam's hands once you're gone.

One of the easiest estate-planning tools is giving away some of your wealth while you're still around to get the thanks.

The tax code allows you to give a specific amount, known as an annual exclusion, in gifts to others. This will help reduce your estate's value and there's no tax ramifications for the gift recipients.

For 2020, that exclusion amount is $15,000 per person. It stays at that level for the 2021 tax year.

Like the estate tax exemption, the $15,000 limit this and next year (and whatever amount it might be further down the line) is per person. That means if you're married, you and your spouse each can give $15,000 to the same person.

Pulling out my handy calculator, that also means that a married couple with three kids and five grandchildren can each give $30,000 in 2020 and again in 2021 to those eight family members for a combined gift total of $240,000 each year without facing gift tax consequences.

And despite my example, you (and your spouse) also can give these $15,000 gifts each year to folks beyond your family. That's right. There's no familial relationship requirement. So if you have some spare cash and really enjoy the ol' blog, just let me know.

Also, the gifts are not limited to dollars. You can give assets valued up to the limit, such as gifts of real property and family heirlooms.

By bestowing your cash and property beforehand, you can reduce the amount of your assets left to be distributed after you're gone. This is a good way to dole out your estate the way you want and keep its value under the amount that will trigger the federal estate tax.

Even better, as mentioned earlier, those gifts are not taxable to the recipient.

Best of all, as long as you follow the rules, the gifts you won't face any gift tax.

Adding up all those gifts: The major tax-related gifting rule is, of course, that you can't just give away all your riches to escape the tax collector. That's why the lifetime gift exemption, aka the unified credit against the estate tax, was created.

As the name indicates, the lifetime gift exemption is the total amount of gifts that can be given away tax-free by a person over his or her lifetime to any number of people.

It's easy to keep track of because it's the same as the annual estate tax exemption amount.

Again, for 2020 that's $11.58 million or $23.16 million for a married couple and, thanks to inflation, $11.7 million or $23.4 million for a married couple in 2021.

This unified limit is necessary because without it, rich folks might be tempted to simply give away the bulk of their money or property while living to avoid estate taxes after death.

If you do go over the lifetime gift exclusion, you will owe a 40 percent tax on those excessive gifts.

Counting the kiddie tax: Your children and investments also come into tax consideration well before estate tax and gift implications, especially if you including them in your family's wealth building and preservation.

Children often receive monetary gifts from wealthy parents and, as in the hubby's case, grandparents. Such family financial gifts often are invested by the young recipient person, which is a good way to teach the child about making money work for them rather than just working for money.

However, all these family members need to be aware of potential tax costs here. Specifically, the young investors and their parents need to keep an eye on the annual amount of their unearned income. This is money from things like dividends and interest, not the money young people earn from jobs.

When young people — up to age 23 if a full-time student or 18 if not going to college — have unearned income that exceed certain limits, the kiddie tax comes into play on those successful investments.

The kiddie tax first appeared in 1986 as a legislative way to close a tax loophole for the wealthy. After a certain earnings level, a child's investment income was taxed at the same rate as that of their parents. By effectively raising the potential tax on the youngsters' passive income, the idea was that well-to-do adults wouldn't be so inclined to shift their wealth by putting it in their lower-taxed children's names.

So what's the earnings amount that triggers the kiddie tax?

For 2021, a young investor's first $1,100 of unearned income is not taxable. That's the same as the 2020 limit.

Then the next $1,100 in unearned income for both 2020 and 2021 is taxed at the child's tax rate, typically the lowest 10 percent rate.

Only when a child's investment earnings top the combined limit — for this and next tax year, that's $2,200 (the untaxed $1,100 and the next $1,100 taxed at the child's rate) — is the young financier's excess unearned income taxed at the rates that apply to trusts and estates.

Or parents can opt to include a child's gross income in the adults' gross income and calculate the kiddie tax there. One of the requirements for this parental election is that a child's gross income for 2020 and 2021 must be more than $1,100 but less than $11,000.

Estate and trust tax rates: Wait. There's an estate tax and estate and trust taxes, too?

Yes. Earnings from trusts and estates have their own tax rate schedule for income that trustees choose to retain rather than distribute to beneficiaries.

Under this system, higher rates kick in at lower income levels than the tax rates and income brackets for individual taxpayers. The design intentional to keep trusts from being used as tax shelters.

However, the TCJA lowered tax rates for trusts and estates, just like it did for individuals, at least through 2025. It also reduced the number of trust and estate tax brackets from five to four.

The estate and trust tax rates for 2020 and 2021 are shown in the table below.

Get tax help, more inflation updates: Obviously, when you're talking inter-generational income and how to make, preserve, distribute and pay taxes on it, things, like families, can get very complicated very quickly.

I guess being wealthy is not as easy as it looks. But I'd certainly be willing to give it a try.

If you are at a higher income level and need to consider any of these family wealth and investment issues, remember that this post and inflation amounts are just informational. Before you go trying to set up a tax-wise estate plan, your best first move is to hire a good financial and tax adviser.

And speaking of information, we'll have more 2021 tax inflation figures in the upcoming final four parts of the ol' blog's annual series. You can check out the five inflation items already posted and get a preview of what's to come at the end of Part 1's look at next year's tax brackets.

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