The Future Value Fallacy in Estate Tax Planning
One of the problems of technology is the implicit assumption that anything that can be calculated should be calculated. This often results in technological overkill, producing numbers, percentages, graphs, and other information that is meaningless at best and, even worse, potentially confusing and misleading.
A variety of software is available to calculate potential death taxes for estate planning purposes. For an overview of this kind of software, see “Technology : Probate,” 6 Prob. & Prop. (July/Aug. 1992) at 40. One popular option that software publishers have included in their software is to state a rate of growth for the estate (or individual assets in the estate) and calculate death taxes based on the future values of those assets. In a comparison of nine estate planning programs, all could project future growth in an estate over time, and four of the nine could project different rates of growth for different assets or categories of assets. See, Mabley and Stewart, “Update on estate planning software: A wide array of programs for varied needs,” Est. Plan. (Nov./Dec. 1990) at 340.
Even with that computational power, it is still necessary to ask if those calculations have any real meaning. Are there any tax planning decisions that require future value calculations? Are future value calculations more likely to confuse or mislead the client than to help form intelligent decisions?
What is Future Value?
When comparing two financial transactions or two tax events, it is necessary to take into account when the transactions or events occur. Obviously, a dollar today is better than a dollar a year from now, but how much better?
“Future value” is the value of an asset, bank account, or other fund on some future date, calculated using an assumed rate of interest or appreciation. “Present value” is the reverse calculation, taking the amount of a future payment and calculating the amount that must be presently invested to create that future value. For example, if $100 is put in a bank account with 6% interest, there will be $106 at the end of the year. During the second year, the account will increase by 6% of $106, or $6.36, so the account will have $112.36 at the end of the second year. During the third year, the account will increase by 6% of $112.36, or $6.74, for a total account balance of $119.10 by the end of the third year. The $119.10 is the future value of $100 after three years at 6%.
The exact mathematical formulas for calculating future values are not as important as some of the concepts behind the calculations. One concept that must be emphasized is that the future value of any given principal amount is always directly proportionate to the initial principal amount. So the future value of $1, based on a specified length of time and a specific interest rate, can be multiplied by any other amount in order to calculate the future value of that other amount. If $1, invested at 6% for three years, yields $1.191 after three years, then $10 invested at the same rate for the same period will yield $11.91, and $200 invested at the same rate for the same period will yield $238.20. Because of the “magic” of compounding, future values are not proportionate to the interest rate or the growth period. Doubling the interest rate does not double the future growth, and doubling the growth period does not double the future growth.
Deferring Income Tax
Most lawyers learned about future values and the time value of money in connection with tax shelters, qualified retirement plans, and other ways to defer income taxes. There is a significant advantage to deferring income taxes.
To illustrate the advantage of income tax deferral, assume $100,000 in income is deferred for 10 years and yet earns an investment yield of 6% during the deferral period. Assume also the effective tax rate is 33%, so the effective annual yield is 4% after taxes (two thirds of 6%) and the tax deferred on the $100,000 income is $33,000. Following is a comparison of the net future yield, with and without the tax shelter.
No Tax Deferral Tax Deferral Present Income $100,000 $100,000 Present Income Tax (33,000) 0 Net Principal for Investment 67,000 100,000 Future Earnings (after taxes) 32,176 48,024 Future Income Tax (deferred) 0 (33,000) Net Future Value (after taxes) $99,176 $115,024
The $15,848 difference between the net future values is exactly equal to the income that would have been earned by the $33,000 deferred income tax. The tax deferral increases the amount that may be invested, which increases the total earnings, which increases the net future value.
The advantage of a qualified retirement plan or individual retirement is even greater because the income earned during the tax deferral is also tax deferred, so the effective annual growth rate is higher. However, that additional difference is not relevant to this discussion and will not be illustrated.
Deferring Estate Tax Through the Marital Deduction
Having learned the time value of money as it applies to income taxes, it is natural for lawyers to assume that the same principles apply to estate and gift taxes. However, the same principles do not apply.
The passage of the Economic Recovery Tax Act of 1981, and the unlimited marital deduction, permitted lawyers to make a choice. It was no longer necessary to pay any federal estate tax on the death of the first spouse to die. The tax could (in most cases) be deferred until the death of the surviving spouse. However, the assets that qualified for the marital deduction would be taxed on the death of the surviving spouse, and might be taxed at higher estate tax rates. In theory, the optimal estate tax result is achieved through equalization, so roughly half the marital assets are subject to tax on the first death and half the assets are subject to tax on the second death. However, which is better in practice, to pay some federal estate tax on the death of the first spouse, or to pay all the federal estate tax on the death of the surviving spouse?
The benefits of estate equalization are fairly easy to calculate. If a decedent has a $3.1 million estate and the surviving spouse has no estate, all taxes can be eliminated (assuming no state inheritance tax, no adjusted taxable gifts, and no nondeductible expenses) through a $2.5 million marital gift. (The other $600,000 is sheltered by the federal unified credit.) However, the surviving spouse will then have a $2.5 million estate, with an estate tax of $833,000. If a marital deduction is claimed for only half the original $3.1 million estate, both estates will be $2.55 million and the total tax bill will be $771,000, a reduction of $62,000. The maximum benefit from estate equalization is the difference between a $2.4 million estate added to a $3 million estate at the 55% bracket and a $2.4 million estate added to a $600,000 estate at the 37% bracket. That is “only” $222,000 of the $2.418 million in estate taxes payable in the combined estates, or a reduction of about 9.2% of the tax.
What are the benefits of estate tax deferral? For a simple illustration, assume that a $100,000 gift or bequest will earn income that will accumulate for 10 years, and that there is a choice between paying gift or estate tax either on the gift or bequest (the death of the first spouse) or on the death of surviving spouse after 10 years. Assume that any gift or estate tax will be payable from the gift or bequest, and the effective tax rate will be 33%. Assume also that the gift will earn an investment yield of 6% during the 10 years, but that the actual accumulations, after income taxes, will be only 4% (due to an effective income tax rate of 33%). A comparison of the net future values, with and without the estate tax deferral, is as follows:
No Tax Deferral Tax Deferral Present Gift $100,000 $100,000 Present Gift or Estate Tax (33,000) 0 Net Principal for Investment 67,000 100,000 Future Earnings (after taxes) 32,176 48,024 Future Gift or Estate Tax 0 (48,848) Net Future Value (after taxes) $99,176 $99,176
The results are the same in both cases! What happened?
What happened is that the deferred tax was calculated from the future value of the fund, including future accumulations, and not the past value of the original contribution to the fund. There is, therefore, no benefit from any tax deferral. (This result can be also be confirmed by simple algebra.)
If estate tax deferral through the marital deduction does not result in any economic advantage, and the deferral might result in higher estate taxes than the equalization of the estates, there is no point in doing a future value calculation, because there is no demonstrable economic advantage to deferring the tax.
The Accumulation Assumption
An objection to the preceding example is the assumption that income earned by the deferred taxes will be accumulated, not spent. It is often argued (or assumed) that any increase in income will be spent for the benefit of the surviving spouse, and so the increase will not be taxable on the death of the surviving spouse. The increase in income produced by the deferral of tax is (it is argued) an economic benefit to the surviving spouse.
This “spending benefit” argument is questionable. The argument assumes the surviving spouse will adjust his or her spending to the amount of income available, and will not change investments to increase or decrease current income. Even if this assumption were valid (which seems unlikely), it introduces a second variable into the calculation. Increases or decreases in spending by the surviving spouse will always decrease or increase the gross estate at the death of the surviving spouse and so affect the death tax liabilities and the net estate passing to the descendants. However, the question is not whether the surviving spouse should increase or decrease his or her standard of living, but whether the tax deferral is of any benefit to the descendants taking at the death of the surviving spouse. If it is assumed that the needs of the surviving spouse are fixed in annual amount, any increase or decrease in the future value of the estate will remain proportionate to the tax paid at the first death and, as already demonstrated, if the future value of the estate is proportionate to the tax paid, there is no benefit to tax deferral.
If estate tax deferral doesn’t produce any economic benefit, why would the unlimited marital deduction ever be used? Why isn’t estate equalization the norm rather than the exception? The answer is that there are several factors that make long-term calculations extremely uncertain. As long term considerations become more speculative, short term considerations become more important.
Future economic conditions almost never turn out as expected, which is why future values are so difficult to project with certainty. Who could have predicted that real estate values would decline in the 1990’s? Does it make any sense to pay taxes now to avoid taxes on values that might or might not exist in 15 or 20 years?
Tax laws can change rapidly and unexpectedly. Counting the Tax Reform Act of 1976, there have been at least six major tax acts in the last 17 years, several of which made fundamental changes in rates, deductions, and credits. A lawyer who recommends that a client elect to pay a tax that is reduced or repealed the following year will feel very silly.
Family situations can change. Marriages, divorces, deaths, and births can all alter taxes and estate plans in unexpected ways. A sudden and severe illness might also reduce a family fortune through large and long-term medical expenses.
The very uncertainty of life recommends a “bird in hand” approach to estate planning, deferring all taxes whenever possible, accelerating only those death taxes that appear to be unavoidable and will almost certainly be increased by a deferral. The “estate equalization” approach to estate planning is therefore usually reserved for surviving spouses who are very elderly, very ill, or already dead when the estate tax return is filed.
Other Tax Calculations
Besides marital deduction planning, future value calculations are sometimes used in generation-skipping calculations, liquidity (i.e., life insurance) planning, lifetime gift planning, and charitable remainder or lead trust planning. Although future value calculations may be useful in helping a client understand the benefits of taxable gifts during lifetime and the benefits (or costs) of charitable “split” gifts or trusts, future value calculations have little or no benefit in other types of planning.
The generation-skipping tax is a flat tax, based on the maximum federal estate tax rate. As illustrated above, a flat tax rate results in the same economic cost whether the tax is applied to a present value or a future value, so future value calculations are inherently meaningless when applied to the generation skipping tax. While there may be some interest in showing how a gift using the $1,000,000 generation-skipping transfer tax exemption might grow to a larger value at a future date, this is really a recreational application.
Future liquidity projections often are used to sell life insurance. But why should anyone pay premiums now for insurance that isn’t needed now solely to provide liquidity that might be needed to pay taxes at a future date?
One area in which future value calculations have some value and some meaning is lifetime gifts. It is easy to show the benefit of gifts that use the federal gift tax annual exclusion because those gifts are exempt from both federal gift tax and federal estate tax and a set of exclusions is effectively lost each year it is not used. However, gifts that use the federal estate and gift tax unified credit are more difficult to explain and more difficult for clients to understand.
A gift sheltered by the unified credit saves no tax during lifetime or on death. The benefit of the early use of the credit (during lifetime instead of at death) can be understood only by taking into account the future income or appreciation of the gift. It is the future income and appreciation that is removed from the estate without payment of any tax, and clients should be shown some examples or illustrations of the future value of the unified credit gifts in order to appreciate the potential benefits of those gifts.
Charitable remainder trust, charitable lead trust, and other “split” trust arrangements also require some form of future value calculations to evaluate. Determining whether a split gift is better than no gift (or a complete gift) requires assumptions about the annual cash flow from the gift and projections forwards or backwards to calculate the value of the interests of the various charitable and noncharitable beneficiaries.
The “KISS” principle (“Keep it simple, stupid!”) applies to estate planning more often than many practitioners are willing to admit. Future value calculations usually are speculative, confusing, and meaningless and generally should not be used in estate planning calculations or estate planning presentations to clients.