July 6, 2020

Written by Jennifer Arps, CFP®, Senior Client Advisor and Mary Ann Hennelly-Favata, CFP®, Senior Client Advisor

To view and download a PDF of this commentary, click here.

Uncertainty is pervasive these days. However, we are all familiar with Benjamin Franklin’s quote, “…nothing can be said to be certain, except death and taxes.”

With the 2017 tax law changes in the Tax Cuts and Jobs Act (TCJA), the amount of assets that someone can leave to his/her heirs without incurring estate tax increased significantly. Thus, individuals with an estate less than $11.4M may not be worried about incurring estate taxes at present. However, this generous lifetime exclusion is due to sunset in 2025 and, absent Congressional action, it will revert to approximately $6.8M ($5.49M inflation adjusted for eight years) effective January 1, 2026.

In today’s political environment, perhaps the one thing we can all agree on is the unpredictability of what will come next. It is conceivable that a change in national leadership could accelerate the terms under the sunset provision, and new legislation could reduce the estate and gift tax exemptions as quickly as they were increased.

To illustrate the impact of the estate tax sunset provision, an unmarried individual with an estate of $11.4M who has made no prior gifts and leaves all assets to his/her children on December 31, 2025, under the current law would have $0 estimated federal estate tax. The same unmarried individual leaving all $11.4M to children on January 1, 2026 would pay $1.84M in estate tax, and the children would share the after-tax remaining amount of $9.56M.

Considering the pending sunset provisions, we encourage all individuals who might have taxable estates in 2026 to proactively review their estate plans and formulate contingency plans. There is an opportunity in the short term, or over a period of years, to efficiently manage the use of the exemption amount currently available.

It is generally advisable to look at your estate planning documents every five years to ensure that your plan still works as you expected in view of changing tax laws and evolving family situations. The SECURE Act in December 2019 made sweeping changes to the beneficiary distribution rules for IRAs and qualified plans. It is especially important to review the beneficiary designations you have on file for your IRA. If you have named a trust as the beneficiary of your IRA, changes may be warranted to your trust document to ensure that required payouts can be tax-efficiently managed.

Many estate plans in the 1990s or 2000s relied on mechanisms such as an A/B or QTIP trust to utilize both spouses’ estate tax exemptions. However, with the federal use of “portability” of one spouse’s unused exemption to the other spouse, the terms in those prior plans may not be the best option, considering current federal and state tax laws.

A current benefit of the existing federal estate tax law is the “date of death step-up” in tax cost basis of appreciated property included in one’s estate. Conversely, assets gifted prior to someone’s death retain their tax cost basis, and the gift recipient pays income tax on all the appreciation when the asset is sold. When weighing whether to gift assets during one’s lifetime versus gifting assets at death, many aspects must be considered. The amount of gift appreciation, the time horizon of the donor’s life expectancy, the timing of the recipient’s desire to sell the asset, as well as current and estimated future income tax rates all factor into the equation. A numerical analysis is helpful in quantifying the benefits and weighing the different factors. When analyzing such considerations, it is paramount to understand an individual’s entire balance sheet, as well as the tax cost basis of each asset. What may be the right decision for one family could be completely different for another family.

Estate Tax Management Examples

If you have a large estate, now is the time to consider locking in the high exclusion amount before it could be reduced. Many have wondered what would happen if they utilized their high exclusion amount before it reverted to a lower amount. The IRS has confirmed that anyone who uses his/her lifetime exclusion after 2017, and prior to a new tax law change, is not at risk of a “claw back”.

Most individuals are hesitant to gift away assets that they might need in the future. There are strategies to explore which could allow a married couple to retain access to assets that one spouse gifted away. A spousal lifetime access trust (aka SLAT) created for the benefit of a donor’s spouse and children could be funded using a donor’s lifetime exclusion. This would allow a spouse to have access to the assets as a source of cash flow to support the couple’s lifestyle. This strategy works best with couples in long-term happy marriages.

An individual who does not currently have a taxable estate might be concerned that a particular asset could increase significantly over time, thereby creating a taxable estate in the future. A decent sized portfolio with a reasonable growth rate could grow into a taxable estate in the future. There are planning strategies that could be utilized to transfer “asset appreciation” out of your estate while utilizing little-to-no lifetime exclusions. A grantor retained annuity trust (aka GRAT) is a powerful tool that is best utilized in low interest rate environments like today. Assets are transferred by a donor to a GRAT in exchange for an annuity payment. The annuity payment is equal to the value of the asset transferred to the trust plus an IRS-prescribed interest rate return. The IRS-prescribed interest rate as of July 2020 is at a historically low rate of .6%. If the assets transferred into the GRAT appreciate at a rate greater than .6% (in this case), the excess appreciation grows outside of the taxable estate, and it is effectively transferred to beneficiaries without estate tax. The donor would have to survive the annuity term for this to be successful.

Integrated Income Tax Planning

It is widely anticipated that income tax rates could go up across the board with a change in administration. If you do not have estate taxes to worry about, you should be considering income tax planning in your estate plan. One opportunity is to plan for a “double income tax basis step-up” at the passing of each spouse on trust assets.

IRAs, 401ks, and other retirement plan assets have impending income tax liabilities due from you and/or your heirs. While the estate tax is susceptible to political changes, the income tax is even more so, and retirement assets are subject to both taxes.

The implementation of the SECURE Act (Setting Every Community Up for Retirement Enhancement) in December of 2019 greatly reduced the IRA stretch provisions. Inherited IRA beneficiaries are no longer able to defer required minimum distributions (RMDs) over their lifespans. The mandatory payout period for an inherited IRA has been curtailed to a maximum of 10 years, significantly shortening the deferral period. Therefore, this is a good time to consider a potential IRA conversion to a Roth IRA. Roth IRAs grow income tax free, and the original IRA owner does not have RMDs.

The CARES Act (Coronavirus Aid, Relief, and Economic Security), which passed in March of 2020, suspended the need for IRA RMDs for calendar year 2020. With lower mandated income requirements, an individual might opt to convert (some or all) IRA assets to a Roth IRA. This could be additionally advantageous if one expects income tax rates to increase in the future. Another consideration for individuals who are likely to have a taxable estate is the benefit of paying the income tax on the IRA Roth conversion. The income tax payment on the Roth conversion would reduce the assets in your taxable estate and, thus, reduce estate taxes.

No planning should be done in a vacuum. If your estate plan includes some level of charitable giving, an IRA asset is an ideal asset to gift to charity. Gifting IRA assets (pre-tax money) could save on income taxes and estate taxes. Depending upon your charitable intent and the size of your IRA, you might consider gifting some of your IRA assets to charity and converting some of your IRA to a Roth IRA. There are many options to consider.

Now is the time for you to prepare before any potential tax law changes are implemented. To properly assess your options, you will need an updated balance sheet. Schedule meetings with your trusted professionals (attorney, tax advisor, and wealth manager) to review your existing estate plan in concert with your updated balance sheet. Address recent tax law changes as well as anticipated future changes to determine if there are strategic steps that you should make while the opportunity exists.

Deciding on the implementation of an estate or gift planning strategy includes integration with your overall financial plan. The appropriate plan efficiently balances the funding of your lifestyle, managing your tax liabilities, and planning your family’s legacy. MRA offers a variety of wealth management services, which we are happy to discuss in more depth if you so desire.

 

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