Roth IRAs Can Be a Great Planning Strategy: Advanced

The first advanced planning strategy is to use a Roth IRA to maximize the deferral on an inherited IRA. Prior to the SECURE Act, beneficiaries could take distributions over their life expectancy. For those dying after 2019 with IRAs, the SECURE Act applies. Under the Act, most beneficiaries must withdraw the assets from an inherited IRA by the end of the period ending at the end of the year that includes the 10th anniversary of the IRA participant’s death, i.e., the so-called “10-year rule.” With a traditional IRA, the problem is that if the beneficiary waits until the last year for maximum deferral, they’d have a large bump in income which would push them into higher tax brackets. For example, let’s say Mary inherits a traditional IRA with $1 million. If she waits until the last year, most of the IRA would be taxed at the highest marginal income tax rate. Conversely, if Mary inherits a Roth IRA, she could allow it to grow tax-free until the end of the “10-year rule.” Mary could withdraw the entire IRA in the last month of the period because distributions from a Roth IRA are not included in taxable income.

The other advanced planning strategy is to use a Roth IRA to reduce estate taxation. The value of an IRA is included in the taxable estate of the IRA owner. However, with a traditional IRA, income taxes would be owed on the balance upon withdrawal. But this does not reduce the value for estate tax purposes.

Let’s look at an example: Tom Taxpayer is in the maximum income tax bracket of 37% and lives in a state without a state income tax. Tom has a taxable estate and has an IRA of $1 million. If Tom converts the $1 million IRA to a Roth IRA, he’d pay $370,000 in income taxes, thus reducing his taxable estate by that amount. That reduction in his taxable estate would save him the estate tax on the $370,000 income tax paid upon conversion, or $148,000 with an estate tax of 40%. Of course, the payment of the income tax upon the conversion to a Roth IRA also would mean that the beneficiary who receives the IRA won’t have to pay income tax upon withdrawal.

Thus, the conversion to a Roth IRA can allow a full utilization of the 10-year rule and can act to reduce the taxable estate while providing an income tax benefit to the recipient.

Roth IRAs Can Be a Great Planning Strategy: Basics

An Individual Retirement Account (IRA) is a savings vehicle in which a deduction may be taken upon contribution (with limitations). The maximum contribution in 2021 is $6,000, and those age 50 and over may contribute an additional $1,000. While the assets are in the IRA, the income is not taxable. However, when distributions are taken in retirement, those distributions are included in taxable income.

A Roth IRA is almost the reverse of a traditional IRA. A taxpayer contributing to a Roth IRA does not get a deduction for the contribution. The earnings grow tax-free. And when the distributions come out, they are generally not taxable.

A taxpayer only qualifies to contribute to a Roth IRA if their taxable income is within certain limits. Married taxpayers filing a joint return may contribute the full amount if their income is below $198,000 in 2021. There is a phaseout and then the taxpayer cannot contribute anything if their income is $208,000 or higher. For an unmarried taxpayer, they may make a full Roth IRA contribution if their income is below $125,000 in 2021. There is a phaseout up to $140,000 and then no contribution is allowed.

While eligibility to contribute to a Roth IRA depends upon the taxpayer’s taxable income, anyone may convert their IRA to a Roth IRA. When they do a conversion, the amount of the traditional IRA is income taxable.

Let’s look at a quick example: John normally has income of $300,000 per year. He was furloughed until 2022 due to the pandemic. He has no income in 2021. He has a traditional IRA of $50,000. He could convert his traditional IRA to a Roth IRA and would pay tax at relatively low rates since his income is lower in 2021.

If a taxpayer doesn’t qualify to contribute to a Roth IRA, they may be able to contribute to a traditional IRA (deductible or nondeductible) and then convert that IRA to a Roth IRA.

One of the key factors in converting (or contributing) to a Roth IRA is whether the tax rate at the time of conversion (or contribution) will be lower than the expected tax rate at the time of distribution.

It’s Important to Have a Coordinated Estate Plan

An Estate Plan includes various different moving parts. The Revocable Trust may be the keystone of the plan, but it’s important to consider how the other parts of the plan will work with…or against…the plan.

Let’s look at a simple example. John had three children and he wished to leave his assets to them equally. He had $6 million in various assets. John hired an attorney to help him with a Revocable Trust leaving everything equally to his three children. The Trust was wonderfully drafted. He had a Pourover Will which poured into the Trust. Would this achieve his goal?

Not necessarily. Some of John’s $6 million in assets might not be controlled by either the Trust or the Pourover Will. Let’s say John had an IRA. The IRA beneficiary designation would control who would receive that asset. If the IRA beneficiary designation were to John’s Trust, the IRA would pass according to the terms of John’s Trust. All too often, retirement accounts and other assets have beneficiary designations which predate the Trust and haven’t been updated. Often when the IRA is established, it has only a small amount. In John’s case, he opened the IRA with $5,000. He named the person he was dating at the time, Betty. He never changed that beneficiary designation. He never even thought about it years later when his spouse died and he did a spousal rollover of her retirement plan into his own IRA. Nor did he think about it when he left his job and rolled his 401k into his IRA. Now he has $3 million in his IRA. At his death, that asset would pass according to the beneficiary designation, to Betty.

Betty could take the $3 million and not look back. She’d be under no legal obligation to give it to John’s children. In that case, John’s children would be out half their inheritance. If Betty is cooperative, she might disclaim the $3 million IRA and it would pass to the contingent beneficiary. In John’s case, he didn’t name a contingent beneficiary. So, we’d look to the custodial agreement. In John’s case, the agreement provides, if the primary beneficiary isn’t there, and there’s no contingent beneficiary, the assets would go to his estate.

Passing through the probate process, the assets would pass pursuant to John’s Pour Over Will to his Trust. This would get the assets to John’s three children. However, the IRA would have been unnecessarily diminished by the expenses of the probate process.

This turmoil could have been avoided if John had coordinated the Estate Plan. John could have changed the beneficiary designation on his IRA. He could have named his children outright, if appropriate, or he could have named his Revocable Trust. Without coordinating the Estate Plan, a large portion of the assets could go in unintended ways, just like in this example.

Trust Distribution Standards May Be Very Broad

Trust distribution standards may be very broad. In fact, the trustee could be given the authority to distribute to the beneficiary in the trustee’s sole discretion. This type of discretionary trust can provide asset protection if the trustee isn’t the beneficiary. However, if the beneficiary is the trustee, it would subject the trust assets to the beneficiary/trustee’s creditors (at least in most states). It would also cause inclusion in the beneficiary/trustee’s taxable estate. After all, the trustee would have a “general power of appointment” under Section 2041 of the IRC because the trustee could appoint the assets to themself as beneficiary. Conversely, if the beneficiary isn’t the trustee, they’d have no way to force any distributions by the trustee, which is why such a trust typically provides asset protection. Typically, a creditor stands in the shoes of the debtor.

However, the regulations to Section 2041 carve out an exception when the trustee is acting under an “ascertainable standard.” Certainly, if the trust mandated the trustee to distribute $1,000 per month to themself as beneficiary, that would not be a general power of appointment because it would be “ascertainable.” However, the limits of ascertainability are far broader.

Treas. Reg. 20.2041-1(c)(2) provides “a power is limited by [an ascertainable] standard if the extent of the holder’s duty to exercise and not to exercise the power is reasonably measurable in terms of his needs for health, education, or support (or any combination of them).” The regulation goes on to provide that the terms “support” and “maintenance” are synonymous. Many trusts are drafted with this “safe harbor” language from the regulations, “health, education, maintenance and support,” sometimes referred to as the “HEMS” standard. While the HEMS standard is an ascertainable standard according to tax law, it’s still very flexible and it’s difficult to say exactly what is required. But, it would allow a beneficiary to go to court to enforce the standard.

Let’s look at a typical example of the difference between a fully discretionary standard and a HEMS standard. Mary is the trustee of a trust and John is the beneficiary. If the trust provides for Mary to make distributions to John in her sole discretion, she would not be required to distribute anything to John. On the other hand, if the trust provides a HEMS standard, then Mary would need to make distributions to or for John’s benefit at least for a minimum level. But, Mary could decide to provide that minimum or more. For example, Mary could determine that John only needs a studio apartment in a working-class neighborhood. Conversely, she could determine John needs a larger home in a nicer neighborhood. Mary would have a similar level of discretion in other areas, as well. She could distribute enough for John to scrape by or enough for him to live more comfortably.

A HEMS standard, while ascertainable, isn’t specific. It provides a range in which the trustee may operate. If a dispute arose over the limits of that range, the court would be the final arbiter.

More to follow . . .

Revocable Trusts Are Not Always Treated the Same as an Individual

A revocable trust is usually treated the same as the individual who created the trust. For federal income tax purposes, a revocable trust is a “grantor trust” under section 676 of the Code. Therefore, all items of income and expense of the trust flow through to the grantor.

However, for some purposes, a revocable trust may not be treated the same as the grantor. Here are two examples.

First, let’s say John has an IRA and he makes it payable to his friend, Carlos. At John’s death (on or after January 1, 2020), Carlos would ordinarily have to take all the assets out of the IRA by the end of the year that includes the 10th anniversary of John’s death, the so-called “10-year rule.” If John named Carlos’ revocable trust, the result would be different. In that case, assuming Carlos were still alive at John’s death, Carlos’ trust would not qualify as a “look through” trust because it would not have been irrevocable by the date of John’s death. As a result, the IRA would need to pay out under the “5-year rule” applicable when a non-individual is the beneficiary.

Here’s another example of how a revocable trust and the individual may not be treated the same. Under Missouri law, a purchaser owes sales tax on a vehicle upon purchase. If that vehicle is stolen or destroyed and there are insurance proceeds, those offset the price of the replacement vehicle purchased and thereby reduce the sales tax. In a recent case, the Missouri Supreme Court held that a revocable trust wasn’t the same as an individual for purposes of the Missouri sales and use tax. In Collison, a couple (in their individual names) owned a vehicle and purchased a replacement vehicle in their trust. The Court didn’t allow the insurance proceeds the couple received from their first vehicle to be applied against the price the trust paid for the replacement vehicle.

While revocable trusts are treated the same as the grantor for federal income tax purposes, they may not be treated as the same for other purposes.