Why it Sucks to be Rich

Mackenzie Scott, the multi-billionaire businesswoman and philanthropist formerly known as Jeff Bezos’ wife, has made a real stir lately with her lavish donations to a wide variety of charitable causes. Over the past year she’s given an astounding $8.5 billion to hundreds and hundreds of nonprofits – and left us normal folks wistfully imagining what we would do with such oodles of cash. 

Man, we think, it must feel good to be able to single-handedly save the whales, feed all the homeless of Manhattan, and fund every cancer study under the sun (not that that’s exactly what Ms. Scott has done, to my knowledge). Then we proceed to feel bad about ourselves, etcetera etcetera.

But if it’s any consolation, let me tell you that giving away large volumes of wealth is by no means easy or even necessarily helpful, regardless of the warm fuzzies that may come from doing so.

Since it’s my job to help other people figure out how to spend their money responsibly, I’ve seen firsthand how complex philanthropy can be, and how it can backfire. There’s a lot more to it than just throwing fistfuls of Bennies out your window to a cheering mob below. 

Why do I bring this up? Well, in my last post I broadly sketched the nuts and bolts of “estate planning;” that is, determining where you want your wealth to go after you die and arranging for it to go there. If you have enough money to be thinking about estate planning, then chances are that philanthropy and other forms of charitable giving have also crossed your mind.

But if any of these things are on your mind, there are a few hazards you should know to look out for, so read on. Even if they aren’t, and you’re just an average Joe killing time on a finance blog (we all have those days), you may find it gratifying to learn about the headaches of the one-percent and enjoy the schadenfreude of not having to deal with them yourself. 

Headache #1: giving people too much money

The Problem: Gift Tax

Everyone knows that you get to deduct charitable donations on your income taxes, at least if you keep track of them. But the IRS has a rather specific definition of “charitable donation;” basically, money that’s given to a registered nonprofit like a 501(c)(3). 

So spotting your deadbeat cousin a few thousand bucks for a car that actually runs, on the other hand, doesn’t count. In short, donations made to an organization are tax deductible, whereas gifts made to an individual are not. But here’s the real kicker: if you make a large enough gift to an individual, you could actually owe tax on top of it. 

Let’s say your deadbeat cousin gets a bolt of inspiration one day and builds a prototype for the world’s first pizza printer. He’s super stoked about it and wants to build a bunch of them to sell around the country. You have your doubts, but think it’s great that he’s finally dialed into something and you want to encourage that. 

So out of the goodness of your heart and expecting nothing in return, you give him $1 million to get this fledgling business venture off the ground, then congratulate yourself for not letting your vast riches turn you into a miser. But the IRS is unimpressed by your generosity; in fact, it may ensure your good deed doesn’t go unpunished. 

As of this writing, any monetary gift to an individual that exceeds the “annual exclusion amount” of $15,000 could be subject to the aptly-named “gift tax.” The gift tax rate can run anywhere from 18% to 40% of the total gift amount. You’ll at least have to disclose the gift on your annual tax return… though you may avoid actually having to pay it. Why’s that, you ask? Well… 

A (Possible) Solution: Your Lifetime Exclusion Amount

There is this thing in the tax world called the lifetime exclusion amount. You have it, I have it, we all have it. It’s the amount of value (cash, stocks, real estate, whatever) that you’re allowed to either give away or leave as inheritance before the IRS starts asking for their cut. But how does this help you get out of paying gift tax? 

Again, if you gift more than $15k to one person, then normally you’ll have to pay gift tax on the extra. But if you tell the IRS that you’d rather use up some of your “lifetime exclusion” instead, they won’t make you pay it after all. In effect, you’re asking them to consider the taxable amount in terms of the lifetime total of tax-free gifts that you’re allowed, rather than the annual total. And then they say, “Ok, guess we’ll revisit this when you’re dead.” 

The lifetime exclusion amount changes over time to keep up with inflation, but is currently set at a whopping $11.7 million (remember that number, by the way — it’s a key constant in the tangled math of rich-person problems). This means that many people, even fairly affluent ones, needn’t get within spitting distance of these taxes.

gift tax annual exclusion amount vs lifetime exclusion amount

If this whole arrangement seems weird, well, that’s because it kind of is. But consider some basic facts for background. First, the IRS doesn’t want rich people to wiggle out of paying taxes on their surplus wealth by giving it away – hence the gift tax. And it also doesn’t want them handing down estates that snowball to huge size over the course of generations – hence what’s called “estate tax,” which I’ll get into in a bit. 

Of course, the rich would prefer the freedom to do both. And this sets the stage for a glorious, ongoing battle of wits. Wealthy Americans keep finding inventive – and often convoluted – workarounds to minimize the effects of these taxes; meanwhile the IRS, in turn, creates its own workarounds – equally convoluted – to maximize them. It’s all rather entertaining to watch, especially if you’re on the outside looking in. There’s one tax in particular that illustrates this dynamic perfectly.  

Another Problem: Generation-Skipping Transfer Tax

In some cases, the older wealthy could split the difference between estate and gift taxes by giving a chunk of their wealth to their grandchildren. This normally counts as a gift and could therefore trigger the gift tax, but the benefits may outweigh that drawback. This is because skipping your kids and handing down wealth directly to your grandkids can reduce the amount of estate tax that is applied to it.

Or at least… it used to. 

This give-it-to-your-grandkids method was quite popular for a while, and can still be at least a little helpful in some circumstances. But at some point in the ‘60s or ‘70s, the IRS caught up and realized that people were using it to skip a round of estate taxes. As you can guess, they didn’t like that, so in 1976 they introduced the elegantly-named Generation Skipping Transfer Tax (GSTT). 

The GSTT states that if you gift or bequest inheritance to anyone younger than you by 37½ years or more, that money could be taxed at a rate of 40% – definitely worse than the regular old estate tax would have been. Like estate tax, however, this monster only kicks in if the total gifted amount exceeds $11.7 million. 

Remember that number? Exact same figure as the lifetime exclusion amount. 

In the midst of all the bureaucratic warfare between America’s millionaires and its government, the lifetime exclusion amount serves as a kind of compromise. It allows the wealthy to amass (and hand down, and give away) some pretty impressive fortunes, while ensuring that the government still gets its proverbial pound of flesh out of them too. 

In short, if you’re rich enough, you eventually just have to pick your poison. You can give away your wealth; you can punt it down the line to grandkids; you can stash it in your estate; or you can do some combo of the above. But if any of those strategies exceeds the all-purpose $11.7M threshold, you’re going to owe tax. 

And with that, let’s look at the second big reason why you don’t want to be rich –

Headache #2: dying with too much money

The Problem: Federal Estate Tax

I briefly alluded to estate tax in my last post, and it’s come up several times in this one as well, so it bears some explanation. As you’ve likely guessed by now, it’s a tax that is levied on a person’s total wealth – i.e. their estate – after they die. The weird thing is that technically your estate itself is the entity that “pays” estate tax. 

After all, you can’t pay it because you’re… you know… dead. But turns out your heirs don’t pay it either, because the tax is taken out before they even receive anything. The upshot of this is that, if you die wealthy enough to trigger the estate tax, then the government gets first dibs on your stuff, rather than your heirs! A tough pill for many to swallow.

Note, though, that I said if you die wealthy enough

The good news is that you have to be pretty dang rich when you die to end up owing estate tax. The tax is applied to however much of your net worth exceeds a certain dollar amount – guess how much that is? Although in this context this amount is known as the “estate tax exclusion,” it’s really the same thing as the lifetime exclusion amount we’ve been talking about, just viewed from a different angle. 

the lifetime exclusion amount in relation to estate and gift tax

As we explained earlier, you’re allowed to give a certain amount of wealth over the course of your whole life ($11.7M) before the IRS will demand a piece of the pie. When you make a gift that exceeds $15k, you can opt to use up some of that $11.7M cushion rather than paying gift tax. Conversely, if you do just pay the gift tax when it comes due, you’re in a sense reducing the likelihood that your estate will owe tax later. 

So if you’re rich, this trade-off could work to your advantage. Buuuuut it could turn out to be a trap as well. Revisiting our earlier example might illustrate this. 

A (Possible) Solution: Your Lifetime Exclusion Amount (Again)

Remember that $1 million you gave to your deadbeat cousin as a one-time gift? It exceeds the annual exclusion amount by $985,000 (1M minus 15k), meaning that you owe gift tax on that $985k extra. Or you would, except that you decided to put that gift toward your lifetime exclusion amount, thus effectively telling the IRS that they can instead tax it later as part of your estate.

Or that they might be able to, anyway. 

Say your net worth is $11.5M when you eventually die. So in theory, you just squeaked in under the exclusion amount and your estate won’t be taxed. Ah, but wait! Mr Tax-Man jumps out from behind the curtain, twirling his pencil mustache, and gleefully reminds you (or… your ghost? I dunno, I’m doing my best here) that there’s still the $985k gift you made to your cousin back when he was just starting his now-massive insta-pizza empire, which you didn’t pay tax on. 

I know, this example is getting out of hand, but bear with me.

Thanks to your Faustian prior deal with the IRS, your $11.7M exclusion amount has been reduced to around $10.7M ($11.7M minus $985k). And so your estate will now be taxed on the amount that exceeds $10.7M, not 11.7M. But perhaps that was worth it? Perhaps the tax now levied against your estate isn’t as bad as that gift tax would have been?

Well as it turns out… actually yes.

I’ll spare you the tortuous math, but your estate ultimately owes $261,950 in tax, while that gift tax would have come to $339,950. In other words, by choosing not to pay the latter, you basically saved enough on extra taxes to buy a condo (ok sure, not one in Seattle – but in plenty of other places)!

Of course, you couldn’t have possibly known ahead of time what your net worth would be when you died. To a certain extent you got lucky, and there’s a bevy of other traps that the wealthy American can still fall into…  

But I’ll save the rest of the dirt for the next post. Although the marketing gurus say that longer blog posts are better, I know in my heart of hearts that you could probably use a break from all the lingo and numbers. So if you’ve read this far, be sure to check out part two – once your brain has recovered a bit. 

on to part 2 →