The income tax strategies that can keep more of your wealth in your family's hands
In the last issue of Generations, we discussed how income tax planning is, in many ways, becoming more important than traditional estate planning. Now that we understand this shift, what can we do about it?
There are several techniques that we are incorporating more and more into estate plans. As is the case with most strategies, knowing your numbers and having clear goals is the precursor to success with them. As you read the article, consider the following question: What will success look like for my estate plan? Lower taxes? Greater control? Family security?
Micro Roth Conversions: Override the Limits of IRA Withdrawals
The traditional IRA is often the largest asset on your balance sheet. The challenge is that the money has never been taxed, and ultimately every dollar that comes out is taxed as ordinary income. This applies whether you take it out or whether your children inherit it. And with the changes passed in the SECURE Act, your children must empty an inherited IRA within 10 years of your death. What often happens is that those 10 years are directly correlated to your children's highest earning years, which puts that money into the highest tax brackets. A son or daughter earning $300,000 a year who inherits a $2 million IRA will send a painful amount to the IRS on a schedule they didn't choose.
So, what can you do? A Roth conversion is an excellent option. You pay income tax on the converted amount now, and in exchange, the money grows tax-free and comes out tax-free. This works for you and anyone who inherits the money.
Am I in a higher income tax bracket now than I will be later on, or than my children will be later on? If you're in a relatively lower bracket now, it may be worthwhile to convert some or all of your IRA.
Two things need to be true before you consider it.
- You should have money outside the IRA to pay the conversion tax. Paying it from the IRA itself defeats much of the purpose.
- You need a realistic picture of your future income, which is why we do the financial plan before we touch anything.
Over the years we have developed an approach I call the “Micro Roth Conversion”. This strategy avoids having to distribute an IRA in just 10 years and spreads it out over 20.
Here’s how it works:
Instead of converting a large IRA all at once and taking a huge tax hit in a single year, we start roughly ten years before life expectancy and convert about 5% annually. On a $2 million IRA, that's a $100,000 conversion each year. Meaningful, but manageable. By the time you pass, roughly half the account is in a tax-free Roth and half is still traditional.
Your children then inherit both accounts, and each has its own 10-year clock. They take the traditional IRA out slowly over its 10 years, spreading the taxable income as thin as possible. The Roth they don't touch until the very last minute, so it's growing tax-free the whole time. Then they take it out tax-free and can live on that income for the next 10 years after that.
There are many variables that need to be reviewed to ensure this works for your specific situation. Always make sure to run the numbers with your advisor before you act.
Life Insurance Can Be Powerful WHEN Utilized Properly
When we talk about life insurance as part of your estate plan, the main thing we focus on is that it grows tax-free and comes out tax-free. One other technique with significant benefits is holding your life insurance policy outside of your estate. When you do this, the death benefit is estate tax-free as well. There are very few places left in the tax code where money can do all three of those things — it really is one of the last living tax shelters.
Another option that clients are considering is a hybrid life insurance policy that combines life insurance with long-term care coverage. If you need the care, the benefits are there. If you never need it, the death benefit passes to your heirs, and some policies will even return your premiums in full. That matters, because a serious care event is one of the few risks that can genuinely devastate an estate. Many are surprised to learn that in the Naples, FL area, several years of memory care can run well over $1 million.
Will life insurance outperform the stock market and produce a great rate of return? No. But the primary use of life insurance in your plan is minimizing risk, and in the case of a hybrid policy, protecting your family from the devastating consequences of a healthcare event.
Charitable Giving: Give Generously & Benefit Greatly
Many of our clients give generously. Today’s tax code allows for gifting in a way that is tax-efficient but also benefits your organization of choice. The following are three scenarios we are seeing more often, with a short description of how to make the best of the situation.
You hold appreciated assets and need income. If you own stock or real estate you bought decades ago for a fraction of today's value, selling it means a large capital gains bill. On the opposite end, holding it means a concentrated position you're not comfortable with.
A Charitable Remainder Trust solves both problems. You contribute the asset; the trust sells it (paying no capital gains tax on the sale) and pays you approximately 5% or more per year for life at a very tax-favored basis. You also get a substantial income tax deduction the year you fund it. When you and your spouse are gone, whatever remains goes to the charities you name.
I had a client with an enormous amount of assets that had grown inside a tax-deferred vehicle. Instead of taking the assets out to live on and paying the tax all at once, he contributed them to a charitable remainder trust for his lifetime and his wife's. He was able to sell those assets inside the trust and receive an enormous amount of current income, taxed over a very long period of time instead of all at once. And instead of investing the net amount after taxes, he was able to invest 100% of those tax-deferred assets.
You give every year but get no deduction for it. This describes more people than you'd think. If your itemized deductions don't exceed the standard deduction (roughly $30,000 for a married couple), your charitable gifts produce no tax benefit at all. The technique here is bunching, where you concentrate multiple years of giving into one year, itemize that year, and take full advantage of the deduction. And if you don't want your charities to receive five years’ worth of gifts at once, you can put the money into a Donor-Advised Fund at a community foundation or a charitable gift fund like Fidelity or Schwab. You get the deduction when you fund it, and you distribute the money to your charities in later years on whatever schedule you like.
You're over 70½ and taking required distributions you don't need. A Qualified Charitable Distribution sends money directly from your IRA to charity. It counts toward your required minimum distribution and never shows up in your taxable income. If you're a retiree giving $20,000 a year anyway, routing it through the IRA instead of your checkbook is simply found money.