Successful estate planning often depends on timing. With the passing of recent legislation and the economic disruption from the COVID-19 pandemic, now could be an opportune time to review your estate plan.
Congress passed the Setting Every Community Up for Retirement Enhancement (SECURE) Act in December 2019 with the ostensible purpose of encouraging individual retirement savings and making it easier for employers to provide retirement plans. As part of these changes, the new law dramatically alters the way qualified retirement plans are taxed when transferred to heirs.
In addition, the recent decline in value of privately-held and closely-held companies during the pandemic could allow estates with significant assets to transfer assets at low values.
Below, we explore these gifting opportunities and considerations your estate could keep in mind as you plan for the future.
The SECURE Act
The SECURE Act made a number of taxpayer-friendly changes, including repealing the maximum age limit for contributing to a traditional individual retirement account (IRA).
It also increased the age after which taxpayers must start taking distributions from their retirement accounts from 70 ½ to 72. These changes give taxpayers greater flexibility for deciding when to make contributions to, and withdrawals from, their retirement savings.
Inherited Qualified Retirement Account Taxes
To pay for these and other adjustments, Congress changed the way heirs are taxed on inherited qualified retirement accounts.
Under prior law, a beneficiary could generally withdraw assets from an inherited IRA over the beneficiary’s life expectancy. The assets could be withdrawn more quickly, but the law allowed the assets to be distributed over the beneficiary’s life expectancy.
The ability to stretch out IRA distributions over a beneficiary’s lifetime allowed the beneficiary to defer income taxes on the inherited IRA. The stretch could also potentially provide the beneficiary a lifetime stream of income.
These benefits made so-called stretch IRA planning quite popular. For many, a significant portion of their estate planning focused on maximizing the potential benefits their heirs would receive from inherited retirement accounts. Some planning focused on maximizing the amount left in qualified plans by choosing the order in which assets are consumed. It was common to suggest heirs should take distributions from taxable assets before nontaxable assets.
Other planning sought to allocate more of the retirement assets to heirs who might benefit from the security of a lifetime income stream, while allocating other assets to heirs who might be better at managing money. Provisions were added to wills and trust documents to implement these plans.
New 10-Year Rule
All that planning needs to be revisited in light of the SECURE Act. With a few exceptions, beneficiary’s must now withdraw all inherited qualified plan assets within 10 years.
For most beneficiaries, this will dramatically accelerate withdrawals and the period when the income tax will be paid. This change in timing is projected to increase federal tax revenues by $15.7 billion over the next 10 years.
The exceptions to the new 10-year rule are:
- Surviving spouses
- Minor children
- Chronically ill or disabled individuals
- Individuals within 10 years of the deceased person’s age
While useful, these exceptions might not quite be as beneficial as they first appear.
For example, a minor child isn’t exempted fully from the 10-year rule. Instead, the 10-year rule is only deferred until the child reaches the age of majority.
Not all minors qualify. The exception only applies to the minor children of the decedent; grandchildren, nieces, and nephews must still take out the full account balance within 10 years of the decedent’s death.
Chronically Ill or Disabled Individuals
The exception for chronically ill or disabled individuals only applies to someone whose condition existed on the date of the decedent’s death. If an heir were to become severely disabled even just a few weeks after the death, they’d still be subject to the 10-year rule.
The terms chronically ill and disabled have fairly strict definitions. An heir would need to be sick or disabled enough to qualify for Social Security disability benefits—assuming the individual would otherwise be eligible for such benefits—to meet the definitions.
Discretionary Trusts and Estates
Discretionary trusts and estates are more likely to benefit from the 10-year rule.
Under prior law, most trusts and estates had to withdraw 100% of qualified plan balances within five years. The prior law allowed a life expectancy payout for so-called look-through trusts based on the age of the beneficiary of the trust.
These trusts, however, were difficult to draft and administer, causing many to leave their retirement assets directly to individuals rather than in trust.
Under the SECURE Act, discretionary trusts are subject to the same 10-year rule as most individuals. This means in most circumstances, there’s no longer an income tax penalty for leaving retirement assets in trust.
With the passing of the SECURE Act, there are many planning factors to consider.
If you didn’t name a trust as successor beneficiary of your retirement accounts to avoid the five-year rule, you might reconsider that decision.
As mentioned above, trusts and individuals are now on the same footing with regards to the timing of the distribution of retirement assets. By leaving the assets in trust, you could provide your heirs an additional layer of creditor protection.
Charitable Remainder Trusts
If part of your planning involved providing for a child who, for whatever reason, frequently faces financial difficulty, you can still use your retirement assets to provide a lifetime stream of income. One option is to leave your retirement account to a charitable remainder trust (CRT), naming your child as the non-charitable beneficiary of the CRT.
A CRT makes a stream of payments to a non-charitable beneficiary. Typically, those payments continue for the life of the non-charitable beneficiary. After the CRT completes making its stream of payments to the non-charitable beneficiary, any remaining assets are distributed to charity.
Using a CRT to replace the desired lifetime income from an inherited IRA isn’t an exact substitute, but it comes close. The CRT isn’t subject to income tax and the non-charitable beneficiary is only subject to tax on the payments from the CRT as they’re received—the tax deferral is quite similar.
CRT and IRA Differences
There are two major differences between CRTs and IRAs.
A CRT requires that any unused assets be paid to charity upon the beneficiary’s or beneficiaries’ death. This could replace a charitable bequest you were already planning to make.
Under prior law, the beneficiary of an inherited IRA could choose to take out money more quickly. With a CRT, the assets are essentially locked-in the CRT so the beneficiary has to wait for their monthly—or even quarterly, semi-annual, or annual—distribution.
In some situations, beneficiary’s might benefit from the financial discipline imposed by a CRT’s more predictable distribution schedule.
Lastly, in light of the changes made by the SECURE Act, you could reconsider who receives the so-called unused portion of your qualified retirement accounts.
Under the SECURE Act, the ability to stretch-out payments from these accounts over a beneficiary’s life expectancy is, generally, no longer available. In the hands of your heir, the unused portion of your retirement account might not be nearly as valuable as it previously would have been because an income tax will be charged on the amount left to your beneficiary.
As a result, you might want to leave a portion of your retirement accounts to charity. Assuming you already planned to leave some amount to charity, making that bequest out of your qualified retirement accounts will reduce the income tax your family will owe on their inheritance.
Most inherited assets receive a so-called step-up in basis; qualified plan assets are an exception to this general rule.
For a deeper dive into the SECURE Act, read 6 Ways the SECURE Act Could Impact Your Retirement and Estate Plans.
As COVID-19 continues to impact the economic landscape, the dramatic decline in the values of publicly-traded companies is the most noticeable, but many privately-held and closely-held company values have also seen similar reductions.
Hopefully, these reductions are only temporary and revert to normal levels when the pandemic subsides. Until then, assets can be transferred to your heirs at today’s low values. These transfers could allow for potentially significant growth rates and the opportunity to avoid gift and estate tax when values do return to a level of normalcy.
In 2020, the federal lifetime gift and estate tax exemption is $11.58 million. The lifetime exemption is adjusted for inflation each year, and the current amount is based on $10 million, adjusted for inflation from 2010.
In 2026, the available exemption is scheduled to decrease to $5 million, adjusted for inflation from 2010. The gift and estate tax rate is 40% on gifts or taxable estates above that threshold.
With the large exemption, few Americans will be subject to the gift or estate tax.
Interest Rate Cuts
In response to the COVID-19’s effects on the economy, the Federal Reserve (Fed) has cut interest rates, which makes interest rate sensitive planning more attractive. Each month, the IRS publishes rates that are used to value certain estate planning transactions. These rates have dropped substantially since the pandemic began.
For example, the April 2020 Internal Revenue Code (IRC) section 7520 rate, which is used to value interests in a Grantor Retained Annuity Trust, have dropped a full percentage point from the January 2020 rate. The new rate is 1.2%.
The rates used for intra-family loans, installment sales, CRTs, and charitable lead trusts, have seen similar reductions. These reductions will allow families to transfer more wealth with lessened income tax impacts.
Consider the following example of a couple who hopes to pass on assets to their children and grandchild.
The couple own 100% of B&B Industries, a company they founded together more than 30 years ago. As of January 1, 2020, B&B was worth approximately $50 million. In addition, they have a marketable securities portfolio that was worth $15 million. Today, the respective values of B&B and the portfolio are $30 million and $8 million.
The couple has two children. They also have one grandchild. The couple would like to transfer 40% of B&B to their children at 20% each. They hired a valuation expert in December 2019 who told them a 20% minority interest in B&B would be subject to a 35% valuation discount. Had they made the gifts on January 1, 2020, they would’ve had a total gift tax value of $13 million. If they were to make the same gift today, the total gift tax value would equal $7.8 million—consuming far less of their lifetime gift and estate tax exemption.
For hypothetical purposes only, assume the pandemic subsides and economic recovery returns to normal by the end of 2020 with values of the transferred interests the same as they were on January 1. Each child would own 20% of B&B Industries, with a total value of $13 million. The increase in value, $5.2 million, would never be subject to tax in the couple’s taxable estate.
We’re Here to Help
While many unpredictable factors related to the pandemic remain, acting ahead of potential economic recovery could allow you to leave more of your hard-earned wealth to your beneficiaries and lose less to taxes.
To learn more about estate-planning opportunities during this time, please contact your Moss Adams professional.
For regulatory updates, strategies to help cope with subsequent risk, and possible steps to bolster your workforce and organization, please see the following resources: