Making a Plan to Deal with EGTRRA
John and Dee Owens, both 65, have a family business
that they expect to pass down to their son, John Jr., but they have other
children to whom they plan to leave their stock portfolio and retirement
accounts. Through a series of corporate
transactions, John Jr. will receive the stock owned by his father at no gift or
estate cost and in return, his parents will have income through a deferred
compensation and salary continuation agreement.
With their lifestyle and retirement security addressed, John and Dee
turned their attention to their remaining assets to see how they could best
pass them to their other three children who aren’t involved in the family
businesses. In 2002, the Owens’ jointly
held stock portfolio had a value of $5 million and John’s IRA was worth $1.5
million. They’ve decided to take only
the minimum distributions, as required by law, to stretch out their retirement
account. This lets them leave the stock
portfolio untapped to let it continue to appreciate as it has for the last 16
years.
When the Owens sat down to
discuss their planning needs with their tax, legal and planning advisors, they
were stunned to see how the estate tax “relief” they believed would protect
their estate really affected their planning.
With Congress constantly tinkering with the estate tax by trying to
raise the exempt amount, abolish the tax, or reintroduce the tax it has become
increasingly difficult to plan when the goalposts keep moving. After EGTRRA 2001, everyone agreed to plan
for what they knew today, keep their planning flexible and their options
open. The result was an integration of
several tactics and strategies designed to achieve a zero estate tax plan. With only two principal assets left to plan
for, and a desire to control their social capital, the Owens proceeded as
follows.
Their Stock Portfolio
Given the uncertainty about
the long-term nature of tax reform and estate tax relief, John and Dee decided
to act now, rather than hope for an unlikely repeal of the death tax. When the Owens saw how quickly their equity
values would grow away from their ability to exempt those assets from tax, they
created a family limited partnership to hold their stocks and some other
investment assets. After the partnership
started, the Owens made lifetime exemption gifts of limited partnership assets
to the kids, and then agreed to sell the remaining partnership units to an
“intentionally defective irrevocable dynasty trust” (IDIT) for the benefit of
their three kids and grandchildren. By
doing this installment sale, the Owens freeze the value, eliminate another
appreciating asset from their estate and transfer the growth to their
heirs. This leaves only the need to deal
with the “income in respect of a decedent” (IRD) assets found in their IRA and
note to clean up the loose ends. When
their planning is finished, there should be no estate tax on their assets at
death
Their IRA
By the time John and Dee
factored in the required distributions commencing at age 70 and viewed how
their remaining estate would appreciate to, and beyond, life expectancy, they
concluded that the IRS was likely to harvest significant taxes from their
estate. Even in 2010, when the federal
estate tax disappears for one year, there was still an income tax liability
projected with their IRA.
IRA planning has been in the news lately because of
relaxed new distribution rules and, some say, easier choices about beneficiary
designations. As a result, the common
advice for many is to make use of a “stretch IRA” as a way to delay recognition
of the deferred income for as long as possible.
That may make sense for many families, but they must understand some
quirky issues if the stretch option is used.
Firstly, only a surviving spouse has the ability to “roll over” and start
an IRA with new beneficiaries under his/her own life expectancy. Secondly, while the stretched IRA may protect
heirs from immediate income tax liabilities, it is not sheltered from estate
tax. This double dip by the tax
collector may ultimately reduce the value of the inherited IRA by 70%. Thirdly, after going through all of the
gyrations needed to stretch an IRA and protect it from tax, many younger
beneficiaries disrupt the planning by simply cashing in the IRA and paying the
tax. In their mind, it was free money
and there wasn’t any reason to wait to enjoy their inheritance. Fourthly, an IRA only produces ordinary
income, taxed at higher rates than capital gains due from stock sales and
lastly, the IRA can’t “step up” in basis like the inherited stock portfolio.
After the Owens reach age 70,
their qualified retirement account typically won’t appreciate as quickly as the
stock portfolio. Why? Even though invested just like their equity account,
the required distributions nibble away at the IRA’s growth. However, even with an account slowly eroded
by mandatory payments, the IRA has the potential to be a significant asset and
clients should know their options that include:
1.
Preserve the IRA
via minimum distributions for as long as possible and split it into multiple
accounts. Then name each beneficiary to
receive the proceeds over their life expectancies. Seek competent counsel in this area, as the
rules change based on the IRA owner’s payout status.
2.
Spend the IRA
(qualified retirement plan asset) and don’t pass anything to heirs. While this solves the estate and inherited
income tax problem, there is a timing issue (running out of money before
running out of time) involved unless the account is annuitized.
3.
Take withdrawals
from the IRA and buy life insurance to replace the value of assets transferred
to charity. Whether this option is
economical depends on the client’s age, health, tax status, and timing of death. Success also depends on the insurance ownership
being outside the estate to avoid unnecessary taxes on the proceeds.
4.
Take taxable
withdrawals from the IRA and set up a concurrent charitable remainder trust
with the appreciated equity portfolio.
Use the tax deduction to offset the IRA tax liabilities and the extra
cash flow to buy life insurance inside an irrevocable trust. Insurance proceeds structured in this fashion
are generally income and estate tax free, and more net wealth may accrue to the
heirs without concerns about a loss of step up in basis.
5.
Name a charitable
remainder trust (probably a CRUT rather than a CRAT) as the IRA beneficiary for
the surviving spouse, or name children as income beneficiaries if all of the
estate planning tax considerations have been addressed. Besides minimizing the immediate recognition
of ordinary income, it provides a structured way to ensure the heirs won’t fritter
away the proceeds. Additionally, it may
eventually allow capital gains income distributions from the trust instead of
being an ordinary income pump for life.
6.
Name a charity to
be the IRA beneficiary in order to establish a gift annuity for a surviving
spouse. It’s also possible to name
children as annuitants, but this has to be handled properly because of the
nature of the contracts and the potential for gift or estate tax liabilities.
7.
Name a charity as
the IRA beneficiary to pass to a nonprofit organization those assets subject to
tax. That lets heirs receive capital
assets that will step up in basis at death.
This choice is especially useful for clients with a desire to support
charity and do so tax efficiently.
© 2002 -- Vaughn W. Henry
Gift and Estate Planning Services
217.529.1958 -- 217.529.1959 fax
