In the current environment, it may make sense to do Roth Conversions, which involves converting pre-tax IRA balances into tax-free Roth IRA balances while paying the related income taxes. Once the funds are in the Roth IRA, all future growth and distributions are tax-free as long as you meet the holding period requirements. With IRA balances at depressed values, Roth Conversions are more attractive due to the lower tax impact. Moreover, given the COVID-19 economic contraction, many families are in a lower tax bracket for 2020, which will lower the cost of the conversion. Also, we expect the highest marginal rate to increase when the TCJA tax cuts phase out on 1/1/2026 or earlier if Democrats make big gains in Washington in November.
Planning to Wealth is a big believer in having tax diversification between various taxable brokerage accounts, tax-deferred IRAs and 401K(s), and tax-exempt accounts like Roth IRAs. For those that might have large IRA balances relative to Roth IRA balances, 2020 might be the year to convert some of your regular IRA balances to Roth IRA to be more diversified from a tax perspective. Converting Roth IRA balances has several benefits when distributing assets from your accounts in retirement. The required minimum distributions (RMDs) would be lower in retirement, which lowers taxes and potentially lowers Medicare premiums as well.
Combat the Death of the “Stretch IRA”
The Secure Act from December 2020 implemented a “10-year rule” on non-spousal beneficiaries for IRAs, 401K(s), and other qualified plans. This is a potentially serious tax issue for families with large IRAs and qualified plans. No longer can families do a “stretch IRA” wherein the second generation was able to take distributions from inherited IRAs over potentially decades to maximize compounding, delay taxable distributions, and minimize the tax bracket impact. Most non-spousal beneficiaries now have 10 years to take distributions from inherited IRAs. This is most impactful for two types of beneficiaries: 1) 20-something and 30-something beneficiaries that aren’t likely prepared to handle immediate access to large IRAs and 2) beneficiaries in their 40’s, 50’s and early 60’s which will have to take distributions potentially during their peak income years in a compressed time frame.
As well, many families with trusts as beneficiaries will have to restructure their documents to comply with the new regulations. There are several strategies to minimize the impact of this new 10-year distribution rule including consistently doing Roth conversions over time to reduce the size of IRA balances, naming charitable remainder trusts as IRA beneficiaries to spread out the distribution of income, and naming non-spouses as partial beneficiaries to start the 10-year clock sooner to minimize bracket impact.
Consider Grantor Retained Annuity Trusts (GRATs) to Minimize Transfer Taxes
If used effectively, GRATs can be used to mitigate estate and gift taxes. The Section 7520 rate reset to an all-time low of 80 basis points for May 2020, which makes GRATs more attractive as an “estate freeze” strategy. Essentially, it only takes returns above this very low hurdle rate to be effective in this environment. For example, a 2-year $1 million GRAT that earns 5% each year will result in $65,000 being transferred to the beneficiary without transfer taxes or using any of the lifetime gift exemption. Given that gifted assets don’t receive a step-up in basis like inherited assets do, it probably makes sense to use assets with a relatively high basis for GRATs.
While most high net worth families don’t have to consider estate and gift taxes since they are below the $11.58 million estate tax exemption and lifetime gift tax exemptions ($23.16 million for married couples), the exemption amounts will revert to $5 million (adjusted for inflation) per person in 2026. Moreover, many families still have to worry about state estate and inheritance taxes. For example, estates in New York State over $5.85 million in 2020 are subject to estate tax rates of up to 16%.
