On Dec. 17, 2010, the President signed the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act) into law. The 2010 Tax Act affects several big chunks of the tax code, including federal income tax, federal estate tax, the generation-skipping transfer tax (GST) and the gift tax. Most of its changes strongly benefit IRA clients, and many have fast-approaching deadlines that create an urgency to act now.
INCOME TAX CHANGES
The new legislation keeps the Bush era tax cuts in force through the end of 2012. Clients who converted traditional IRAs to Roth IRAs in 2010 (the first year when high-income clients could make Roth conversions) are in a group that benefits substantially from the extension of the tax cuts.
Those converting in 2010 had a special choice: They could split all the income from the conversion equally between 2011 and 2012, or they could include all the income in 2010. Now in 2011, clients must finally decide which option to choose. They must make the election by the due date for filing 2010 tax returns (including extensions), and once made, the election will be irrevocable.
Before the tax cuts were extended, it looked like this would be a difficult decision for many clients, particularly those at higher incomes. Pay now (for 2010) at lower rates, or defer the liability to 2012 and 2013 (for 2011 and 2012), but pay at potentially higher rates.
Under the new tax law, the debate is substantially simplified, and deferring the income from a 2010 conversion equally into 2011 and 2012 becomes the best option for most of your clients, all other factors being equal. Why pay tax now when you can pay later at the same rates? Clients who defer paying tax on Roth IRA conversions are essentially receiving an interest-free loan from Uncle Sam on their tax liability at the same time their savings are growing tax-free inside a Roth IRA.
Of course, for a small portion of your clients, including all the income from a 2010 conversion in 2010 will still be the best option. This is true if 2010 income is unusually low or your client has unusually high deductions, credits or exemptions for 2010.
ESTATE-TAX LAW CHANGES
A new $5 million estate-tax exclusion applies to deaths in 2010 as well as in 2011 and 2012, although executors of 2010 estates can choose the alternate rules that were in effect last year. For 2010, there was no federal estate tax, but there was also a limited step-up in basis. That left heirs facing the possibility of owing capital gains tax on the sale of appreciated assets. The new rules for deaths in 2010, 2011 and 2012 reinstate the step-up in basis, so no capital gains tax will be owed on capital assets that appreciated during the decedent's lifetime.
For those ultra-wealthy individuals who died in 2010, the most favorable option will most likely be no estate tax, but with virtually no step-up in basis. Those with estates of less than $10 million will likely want to opt for the new rules with a step-up in basis.
The other major change to the estate-tax law is that the applicable exclusion amount is now portable between married couples. Any excluson amount not used by the first spouse to die can be used by the estate of the surviving spouse.
For example, assume John dies in 2011. He leaves $1 million to his children and everything else to his wife, Mary. John made no taxable lifetime gifts. Therefore, John has $4 million of unused estate-tax exclusion, which passes to Mary. If Mary dies in 2012, her estate can exclude up to $9 million from federal estate tax using her own $5 million exclusion, plus the $4 million that John did not use.
Consequently, married couples now have up to $10 million of estate-tax exclusion. For most couples, it makes no difference which spouse dies first or how the assets are distributed after the first death. What does this mean for IRAs and other retirement assets? For many clients, especially married couples, federal estate tax no longer will be an issue, which means their planning strategies could change.
When planning for federal estate tax, most married couples can now name each other as sole IRA beneficiary. With $10 million of estate-tax exclusion available, there is a much lower probability that the estate of the second spouse to die will owe federal estate tax, even if he or she inherits an IRA from a spouse.
Some clients might want to update their beneficiary forms and name a spouse as sole beneficiary of their IRA instead of designating a credit shelter trust as IRA beneficiary. This could allow future beneficiaries to stretch required minimum distributions (RMDs) over a longer life expectancy, minimizing the impact of taxes and allowing the account to grow tax deferred over a longer period of time.
Although the new law reduces the federal estate tax risk of naming a spouse as an IRA beneficiary and may provide additional tax advantages to future heirs, advisors should not simply recommend updating beneficiary forms to name a spouse without first doing appropriate due diligence. In some cases, the simplicity may pay off, but in other cases, more elaborate estate planning will still be appropriate.
Consider this example: Bill and Barbara have recently married. This is not the first marriage for each, and they both have children from previous marriages. Bill has become careless in handling his own finances, while Barbara has already married three times and is likely to walk down the aisle again if she survives Bill.
For such a couple, naming each other as sole IRA beneficiary might not be desirable. They may want to leave their IRAs to their respective children or name a trust that can be used to benefit the surviving spouse during their lifetime, while ensuring whatever assets remain pass to their own children. Clients who are concerned about asset protection for beneficiaries, or who live in states with low state estate-tax exemptions, still benefit from leaving IRAs to a trust (or other non-spouse beneficiary) rather than outright to a spouse.
Roth IRAs are generally desirable because all withdrawals are tax-free after five years and after age 591/2 (or death, disability or for a first-time homebuyer up to $10,000). Many clients also like Roth IRAs because unlike traditional IRAs, they have no RMDs, which may permit larger amounts to pass to beneficiaries.
With the passing of the 2010 Tax Act and the new $5 million exemption from estate tax ($10 million for married couples with portability), Roth IRAs have become even more valuable for many clients. These large exemption amounts create an unprecedented opportunity to create and transfer wealth. A married couple can now pass up to a $10 million Roth IRA to children (or other beneficiaries who are one generation, or less, younger) completely income and (federal) estate tax-free, even if the surviving spouse dies as the owner of all $10 million of the Roth account.
The GST tax exclusion has also been increased to $5 million. The GST is an additional tax (on top of gift or estate tax) on assets that are passed to individuals by skipping a living generation, such as grandchildren. Like the estate- and gift-tax exemptions, the increased GST exemption is effective only through 2012, but unlike the exemptions for estate and gift tax, the GST exemption is not portable. Any amount that goes unused during an individual's lifetime (or after death) is irrevocably lost.
If one spouse leaves all of his or her assets to the surviving spouse, the surviving spouse will be able to take advantage of a $10 million exemption from estate tax, but only a $5 million exemption from GST tax. Even though this latter exclusion is not portable between spouses, the larger exclusion might generate more gifts and bequests to grandchildren, great-grandchildren or other "skip" persons.
Naming grandchildren (and even great-grandchildren) as IRA or Roth IRA beneficiaries becomes more practical with a $5 million GST exclusion. This is a powerful planning strategy that should not be overlooked because the younger the beneficiary, the longer the life expectancy and the greater the potential tax benefit from an inherited IRA or inherited Roth IRA.
After a period of separation, the gift tax has been reunified with the federal estate tax, meaning clients can now give as much away during life as they can after death without incurring any transfer (estate or gift taxes). Each individual has a $5 million exclusion and like the estate tax, any unused exclusion passes to the surviving spouse.
The new larger gift-tax exclusion (up from $1 million in 2010) may impact various planning tactics for IRAs and company retirement plans. For example, say you have a client whose widowed mother has a large traditional IRA. With the larger gift-tax exclusion, your client might feel comfortable giving her mother money to pay the tax on a Roth IRA conversion, allowing your client to inherit the Roth IRA income and estate tax-free.
Similarly, retired clients can gift their middle-aged children money to pay the tax on conversions of their own traditional IRAs to Roth IRAs. If those children are going to inherit the money anyway, the larger gift-tax exemption could encourage gifts to facilitate Roth IRA conversions sooner rather than later.
Don't let the fact that this law is temporary delay any planning that needs to be done now to take advantage of these incredibly generous tax provisions. These benefits could be lost if they are not used now.
Ed Slott, a CPA in Rockville Centre, N.Y., is a nationally recognized IRA expert, speaker and author of several IRA books. He has also created programs to help advisors become leaders in the IRA marketplace. Visit his website at www.irahelp.com.