IRA Planning Under the SECURE Act:  the Good, the Bad, and the Ugly

IRA Planning Under the SECURE Act: the Good, the Bad, and the Ugly

On December 20, 2019, President Trump signed the Setting Every Community Up for Retirement Enhancement Act of 2019 (the “SECURE Act”) into law.  This drastically changes the landscape for inherited IRAs and provides several other changes to current law.

The Good

            Under prior law, each account owner of their own IRA had to begin taking a “Required Minimum Distribution” by April 1st of the calendar year following the year in which they turned seventy and one-half (70.5) years old.  Under the SECURE Act, this now begins at age seventy-two (72), which allows for some additional deferral of income taxes.  The new rules only apply to individuals born on or after July 1, 1949.

The age limitation for contributing to a traditional IRA has been repealed entirely.  This means that as long as a person continues to have earned income, they may contribute to their traditional IRA.  This opens the door not only for additional contributions but also for other planning techniques, like the so called “back door Roth.”

The Bad

            Under prior law and with proper planning, a beneficiary of a decedent’s IRA could stretch the payments out over their life expectancy.  Many trusts were also created to take advantage of this rule.  The SECURE Act eliminates this rule, with only a few exceptions, providing instead only a ten (10) year window to withdraw the IRA funds completely.  The importance and impact of this change cannot be understated.  This will increase taxes payable by beneficiaries of IRAs and often push them into a higher tax bracket.  This rule also applies to 401(k) plans, defined contribution plans, and profit-sharing plans.

The exception to the new “ten (10) year rule” is that it does not apply to: a surviving spouse, a disabled beneficiary, a chronically ill beneficiary, a child who is a minor, or a person who is not more than ten (10) years younger than the decedent.

A surviving spouse may rollover an inherited IRA plan to be treated as if they were the owner.  Additionally, a surviving spouse may be the beneficiary of a “conduit trust” and receive payments over their life expectancy.  There is essentially no change from prior law for surviving spouses.

A disabled beneficiary has a very limited definition under the SECURE Act.  For example, the beneficiary must not be able to engage in any “substantial gainful activity.”  If a beneficiary qualifies, then they may receive payments over their life expectancy (including through an “accumulation trust”).

Likewise, a chronically ill beneficiary also has a very limited definition under the SECURE Act.  If a beneficiary qualifies, then they may receive payments over their life expectancy (including through an “accumulation trust”).

Careful consideration should be given to whether an intended beneficiary will qualify as disabled or chronically ill under the SECURE Act and also whether being the beneficiary of a “conduit trust” may be problematic from the standpoint of qualifying for means based governmental benefits in which case an “accumulation trust” may be desirable.

A beneficiary who is a minor at the time of the IRA owner’s death and is also their child, may receive payments over their life expectancy (including through a “conduit trust”) until they reach the age of majority, at which time they will be subject to the “ten (10) year rule.”

A person who is not more than ten (10) years younger than the IRA owner (who is also not a surviving spouse) may receive payments over their life expectancy (including through a “conduit trust”).

Under prior law, once you were receiving Required Minimum Distributions (after turning seventy and one-half (70.5) years old), you could contribute up to One Hundred Thousand Dollars ($100,000) per year directly to a charity and exclude that amount from your income.  The SECURE Act surprisingly did not change this age to seventy-two (72); but you would not see any benefit for such a gift until you had a Required Minimum Distribution (at age seventy-two (72)) to exclude the charitable gift from your income.  However, it did create a reduction on the amount that can be given to charity while receiving an exclusion from income.  The reduction is tied to the aggregate amount of any contributions to the IRA after age seventy and one-half (70.5) for which an income tax deduction is taken over the amount of any prior year reductions.

The Ugly

            There was so much certainty under prior law regarding inherited IRAs, that most people used a fairly standard approach for their beneficiaries to inherit IRA proceeds relying on a stretch payment (either over the life expectancy of each beneficiary or at least over the oldest trust beneficiary).  Nearly every estate plan with a revocable trust or “simple” Will includes the so called “conduit trust.”  Now, with the SECURE Act, any beneficiary of a “conduit trust” that does not fall into one of the exceptions discussed above may face real issues with complying with current law (and so will their Trustee).  That is because a typical “conduit trust” directs the Trustee to withdraw the Required Minimum Distribution each year and then distribute it from the Trust to the beneficiary.

The problem that arises is that for most beneficiaries there is no Required Minimum Distribution any longer.  Further, even if the Trustee used the old life tables to determine what it would have been under prior law, the amount withdrawn would not be sufficient to draw the IRA down in ten (10) years, as required under the SECURE Act.  Many “conduit trusts” prohibit the Trustee from withdrawing anything over the Required Minimum Distribution.  Without an update to the estate plan, compliance with current law will be difficult.

Conclusion

            Because there have been many changes under the SECURE Act, speak with an estate planning and tax attorney with significant experience in planning for IRA benefits.  You should not only review your estate planning documents, but also your beneficiary designations.  The good news is that there are several planning strategies that can be employed to address these changes (such as discretionary trusts and life insurance to provide for increased income tax liability), but there is not a one size fits all solution.

Decanting Trusts in Florida – When and How

Decanting Trusts in Florida – When and How

Is that irrevocable trust you created, or somebody created for your benefit, really set in stone? Prior to 2007, the answer would mostly be yes, but between 2007 and now, the answer became more complex.  Modifications without going to court are now more easily done, with certain limitations. One of the easiest methods of modifying an irrevocable trust is to use a doctrine called decanting. Decanting is a general term used to describe the trustee of an existing trust creating a new trust (also referred to as the “second trust”) and moving all assets of the old trust into the new trust. The result is that the old trust is terminated, and the new trust provisions govern use of the trust property.

A trustee may have various reasons to decant. It may be to convert a trust to a supplemental needs trust, to correct drafting mistakes, to make needed clarifications, or to adapt to changes in circumstances or in the law. Decanting can transform an irrevocable trust without the need for judicial modification. The catch with decanting, has always been that under prior Florida law, very few trusts contained the appropriate powers to allow a trustee to decant.

Florida has allowed decanting since 1940, but it was limited to a trustee who has the “absolute power” to invade the principal of the trust.  In other words, if the trustee has sole and absolute discretion regarding their distribution power over the principal of a trust and that discretion was not tied to any ascertainable standard (i.e. health, education, maintenance and support of the beneficiary), then that trustee has “absolute power.” Due to that limited framework, and changes in estate planning practice over the years, the number of trusts for which decanting was even possible was quite small.

The 2018 Florida decanting statute revision

However, in 2018, Florida revised the decanting statute in many significant ways. Now, there are three separate ways that a trustee may engage in a decanting:

  1.  A trustee may still decant if they are given “absolute power” in the trust instrument. This method of decanting provides the most flexibility for all parties.
  2. A trustee without “absolute power” may decant; such as a distribution power limited by the ubiquitous health, education, maintenance and support, or “HEMs,” standard. In this scenario, the trustee’s ability to have different provisions in the new trust will be limited, as discussed below.
  3. A trustee may decant from a trust that does not qualify as a “supplemental needs trust” to a trust that does qualify as such. There are important limitations for this type of decanting as well. 

One very important concept for clients and attorneys to discuss is whether the client would be opposed to a future trustee engaging in decanting. Decanting is now a default power of all trustees.  If the client does not want changes made to their plan in the future, then the drafting attorney may include a broad prohibition against decanting to effectively prevent the trustee from being able to effectuate that type of transaction.

In order to exercise the decanting power, the trustee must be an “authorized trustee.”  Generally, that will be a trustee who is not the grantor of the trust or who is not also a beneficiary of the trust.  If decanting is something that the grantor would like available as an option to deal with the unknown future, but they will only be naming trustees who are also beneficiaries, then a power should be included to allow that trustee to appoint a special co-trustee to exercise the decanting power granted in the trust (or by Florida statute). 

What are the different types of decanting?

If a trustee may distribute trust property in any amount and at any time in that trustee’s sole discretion, then they have “absolute power.”  While there are limits on how the second trust may differ, the trustee has the broadest authority in this situation. They may divide up interests of multiple beneficiaries, add additional guidance on trust distributions, change trustee succession, and more. Thus, the trustee can change substantive and administrative provisions.

If a trustee does not have “absolute power” because, for instance, they may distribute only for a beneficiary’s health, education, maintenance and support, then the changes in the second trust are much more limited. The changes in this situation are more likely to be limited to administrative issues, i.e. trust succession, investment powers, etc.

A trustee who has the power “to invade the principal of the first trust to make current distributions to or for the benefit of a beneficiary with a disability may instead exercise such power by appointing all or part of the principal of the first trust in favor of a trustee of a second trust that is a supplemental needs trust.” That provides a great deal of flexibility in the trustee being able to create a second trust that qualifies as a supplemental needs trust (also called a “special needs trust”). However, there are requirements specific to this type of decanting which you can learn more about in another article we wrote: How to Decant to a Special Needs Trust.

It is important to note, the exercise of the decanting power may not: (i) increase the authorized trustee’s compensation beyond the compensation specified in the first trust instrument or (ii) relieve the authorized trustee from liability for breach of trust or provide for indemnification of the authorized trustee for any liability or claim to a greater extent than the first trust instrument.  However, the exercise of the power may divide and reallocate fiduciary powers among fiduciaries and relieve a fiduciary from liability for an act or failure to act of another fiduciary as otherwise allowed under law or common law. 

Also, there are many other important tax considerations when it comes to decanting and it is important to ensure you are receiving the appropriate level of advice for this sophisticated area of trust and tax law.  First, the topic of decanting is on the “no rule” list for the IRS.  This means that it is not possible to request a private letter ruling and receive the IRS’s stamp of approval before engaging in a decanting.  Further, there are many tax traps for the unwary and each situation is unique, requiring special attention to tax issues.

Considerations before decanting in Florida

  1. The “absolute power” requirement in the prior statute is no longer a strict absolute requirement. Even if the trustee’s powers to invade principal are limited to an ascertainable standard, the power to decant can still exist.
  2. Although the new statute requires that a beneficiary be disabled to decant into a supplemental needs trust, decanting does not depend upon whether the beneficiary is currently eligible for government benefits or has been adjudicated incapacitated. Rather, a trustee must believe that the beneficiary may qualify for governmental benefits based on his/her disability or the trustee reasonably believes the beneficiary is incapacitated.
  3. While decanting rules have expanded, the notification rules have become stricter. There is a 60-day written notice requirement and the statute carefully outlines who must be notified of a trustee’s intent to decant and what documentation must be sent and received to satisfy its requirements. It does allow for a written waiver of the notice period to shorten the time frame to allow the trustee to act immediately. It is important to note that the 60-day notice require does not limit the right of any beneficiary to object.

In conclusion, Florida has greatly expanded the opportunities for a trustee to decant a problem trust.  The decanting process should include the trustee consulting with competent legal and tax advisors as well as the beneficiaries and interested parties to ensure the outcome is beneficial to all parties and complies with the law.  If you are a trustee of beneficiary and would like to know more about your options with decanting, please feel free to contact us.

What the Tax Cut and Jobs Act Means for Your Estate Plan

What the Tax Cut and Jobs Act Means for Your Estate Plan

Congress recently passed the Tax Cut and Jobs Act (“TCJA”) earlier this year, the largest revision to the tax code in thirty (30) years.  Among the many changes are significant increases in the Estate, Gift, and Generation-Skipping Transfer (GST) tax exclusion amounts.  In effect, this means that fewer families will be subject to such transfer taxes and that many estate plans will need to be updated to properly address the new law.  The changes under the TCJA present an important opportunity for high net-worth individuals and families to review their current estate planning documents and ensure that their plan is properly tailored to achieve their goals.

 

Overview of Changes
The most significant change is the doubling of the unified Estate and Gift tax exclusion amount – the combined amount that individuals can give away during life or at death before paying transfer taxes – from $5.59 million to $11.18 million per person.  The new tax law also preserves “portability,” a surviving spouse’s ability to retain any estate or gift exclusion unused by a deceased spouse, meaning that for married couples, the exclusion is effectively $22.36 million. This exclusion is inflation adjusted, but current law provides that this doubled exclusion sunsets December 31, 2025, after which estate taxes are slated to revert to current levels.

The new law also increases the amount each person can make exempt from the GST tax.  As with the estate and gift tax exclusion, the new GST exclusion will increase from $5.59 million to $11.18 million per person (in 2018 as indexed for inflation).  Unlike with the estate and gift tax, however, there is no “portability” for GST taxes.  Thus, each spouse must use their own GST exclusion before they pass.

In addition to the changes made by the new tax bill, 2018 also brings a routine increase in the annual exclusion from the Gift tax to $15,000 per person, per year.  This annual exclusion allows each individual to make a gift of $15,000 to any other individual (and in some cases trusts) without reducing their lifetime Estate and Gift tax exclusion amount.

Review of  Your Estate Plan

The changes in the Estate, Gift and GST tax law mean that many estate plans should be revised to take advantage of tax changes, ensure existing tax formulas still achieve the intended results, or simplify complex planning that is no longer necessary and shift a focus towards income tax planning for beneficiaries. There are also certain planning opportunities that you may want to explore.

First, the increased exclusion amount may be an opportunity to unwind complex planning that may no longer be needed to minimize transfer taxes.  For instance, many estate plans created under assumptions of prior law provide that at the death of the first spouse, the deceased spouse’s assets are divided into two (2) separate trust shares: a Marital Trust for the benefit of the surviving spouse and a Credit Shelter Trust that may benefit the surviving spouse, your children and/or grandchildren, or combinations of those people. For married couples with large estates, this technique defers payment of any Estate tax until the passing of the second spouse.  The trade-off is that the Credit Shelter Trust may not benefit the surviving spouse solely and the income tax basis of the Credit Shelter Trust is locked into place upon the first spouse’s death.   Many couples who used such techniques to minimize Estate tax prior to the new increased exclusion amounts will prefer for the surviving spouse to retain greater control of assets and plan for the remainder beneficiaries to receive a step-up in income tax basis for all of the assets upon the surviving spouse’s passing. ShuffieldLowman can assist you with weighing that control over the asset protection and the certainty of the Credit Shelter Trust to determine what is best for each family.

As mentioned above, another scenario involving Marital and Credit Shelter Trusts may play out in other plans containing “formula gifts.”  Certain estate plans leave assets up to the Estate tax exclusion amount to a Credit Shelter Trust for the benefit of children or grandchildren and leave assets in excess of that amount to a Marital Trust for the benefit of the spouse.  Because the Estate tax exclusion amount is now so large, this could mean unintentionally disinheriting the spouse and leaving all assets to the Family Trust or just leaving significantly less to the surviving spouse than intended.

Next, we do not know if the federal increased exclusion amounts will not be extended and will in fact expire in 2025, which is what the TCJA provides.  Under a subsequent administration the exclusion amounts may even return to the lower levels of the past that existed for most of the 2000s.  If either of these events does indeed occur, then the current increase in the exclusion amounts provides a temporary, “use it or lose it” opportunity to transfer assets outside your taxable estate, thereby “locking in” the current exclusion amount before it is reduced and freezing values from future appreciation.  This estate tax planning might involve increased contributions to Irrevocable Trusts such as Irrevocable Life Insurance Trusts, Intentionally Defective Grantor Trusts (IDGTs), sales to these types of trusts, forgiveness of intra-family promissory notes, or other wealth transfer vehicles.  You may want to consider further planning using the increased exemption amounts to remove assets from the estate.

Finally, some clients may even wish to use the increased exclusion amount to unwind prior planning and bring assets back into their gross estate to obtain a step-up in basis in those assets to fair market value at the time of their death.  This type of planning is geared toward reducing income tax liability of your beneficiaries upon the sale of the inherited assets.

These are just a few examples of the many ways in which the TCJA may affect your estate plan.  The TCJA makes significant changes to the Estate, Gift and GST tax regimes. If your estate plan was implemented under previous law, it would be beneficial to review your plan to ensure it accomplishes your current goals in light of these changes. If you would like a comprehensive review of your estate plan, contact ShuffieldLowman today.

 

Custodial IRAs for Your Child or Grandchild

Custodial IRAs for Your Child or Grandchild

With summer having just ended, now is the time to discuss the importance of saving for retirement with your children and grandchildren. Many parents and grandparents will have wanted their children and grandchildren to work over the summer so that they appreciate the effort it takes to earn an income. Therefore, many will have worked a summer job; that is by itself an important step to understanding the value of the dollar and the rewarding feeling of earning one’s own income. The money they have earned is usually spent (or saved) however they would like. While there is nothing wrong with this, the savvy parent or grandparent will take this opportunity to shift their focus to their future. By creating a custodial Individual Retirement Account (an “IRA”), the child or grandchild that is a minor may begin to learn about saving money, investing assets, publicly traded markets, the benefits of income tax deferral, retirement matching programs, and the time value of money.

So long as the minor has earned income for the year, they may create and/or contribute to their own IRA (either a Traditional IRA or a Roth IRA). Legal title to the account will rest in their legal or natural guardian as custodian of the IRA that is held for their benefit. The amount that may be contributed to the custodial IRA is limited by the lesser of the usual annual contribution limits for IRAs (i.e., Five Thousand Five Hundred Dollars ($5,500) in 2015), or the total amount of the minor’s earned income in that year. Also keep in mind that most financial institutions have a minimum account balance requirement. Often this could be One Thousand Five-Hundred Dollars ($1,500) or more, which may be less than what the minor earned during their summer job. There are however financial institutions that only require a One Hundred Dollar minimum balance ($100).

For example, let’s say a grandchild earned Two Thousand Dollars ($2,000) this summer. The grandchild has several options, such as: (1) keep the Two Thousand Dollars ($2,000) and do with it what they will, (2) contribute all or a portion of it to their custodial IRA, (3) keep all of it, while a parent or grandparent makes a gift to the minor that may be used as a contribution to their custodial IRA, or (4) a combination of the second and third options.

To illustrate these options, we will describe the second, third, and fourth scenarios. The second scenario will not be very appealing to the minor. That is natural, as they just worked very hard for their income (perhaps for the first time in their life) and the thought of saving the money for retirement is a foreign concept to them. Most minors will need some encouragement to get excited about retirement savings. The third scenario is the “have your cake and eat it too” option. There is nothing wrong with that in this context. The parent or grandparent may just wish to help start their retirement savings process and hope that it will engage the minor and turn on a light bulb for them. However, the fourth scenario is the most likely to cause the minor to become actively engaged in the discussion about saving and investing for their future, since they have skin in the game now. Their grandparent could talk with them and explain that if they agree to set aside One Thousand Dollars ($1,000) of their own money for their future by creating an IRA, then the grandparent will also give the grandchild One Thousand Dollars ($1,000) for that purpose. The grandchild has One Thousand Dollars ($1,000) of spending money and Two Thousand Dollars ($2,000) for their retirement.

The next big decision is whether to create a Traditional IRA or Roth IRA. If the minor is being claimed as a dependent on an adult’s income tax return, then you should first check with the CPA preparing that adult’s income tax return. It is likely that the minor would not be able to claim an income tax deduction for contributions to a Traditional IRA. Therefore, a Roth IRA is usually the preferred choice. Moreover, once the minor begins taking their Required Minimum Distributions (in the distant future), the withdrawals will be income tax free and will have had forty (40) or more years to grow tax free. For instance, assuming an average rate of return of six percent (6%), that Two Thousand Dollar ($2,000) contribution would become Twenty Thousand Five Hundred Seventy One Dollars ($20,571) forty (40) years later. If the minor continues to make annual contributions to their IRA, this growth only compounds over time.

It is also important to remember to fill out the beneficiary designation for the custodial IRA. Think through who is the likely choice as primary and contingent beneficiaries for the minor. If you feel the minor is mature enough to take part in this discussion, then ask them their opinion and desires on the matter. After all, the minor will eventually become owner of the IRA once the custodianship ends.

Assuming that the parent or grandparent does make a gift to the minor, then what are the tax consequences to the donor? Because the donor would be making a cash gift to the natural or legal guardian of the minor, for that minor’s benefit, it will qualify for the Gift Tax Annual Exclusion since it is a present interest. That means that the donor may give up to the maximum contribution for the custodial IRA ($5,500) (assuming that the minor earned at least that much income) and because that amount is less than the Gift Tax Annual Exclusion amount i.e. Fourteen Thousand Dollars ($14,000) in 2015, it will be excluded from being a taxable gift, will not reduce the donor’s Estate or Gift Tax Exemption Amount, and no Gift Tax Return (Form 709) will be required to be filed (assuming the donor made no other taxable gifts).

If you would like to discuss this, or any other gifting strategy for the benefit of minors, please feel free to contact us and we will be happy to go over your options with you.

Custodial IRAs for Your Child or Grandchild

Using Life Insurance and Irrevocable Trusts to Provide Liquidity for the Payment of Estate Taxes

One of the most frequent problems faced by families subject to the Estate Tax (a married couple having made no prior gifts must have a net-worth of over $10,680,000 in 2014 to be subject to the Estate Tax) is how to actually pay the taxes.  Very often a family owned business makes up the bulk value of the estate.  This business is typically not publicly traded, and is not an easy asset to sell quickly for a good price (that is if the family even wants to sell the business, which is often not the case).  If the family does not own other liquid assets sufficient to pay taxes, then they are placed in a very tough situation.

For instance, let’s assume that Bob and Susan own a business that provides a service, such as pest control.  With proper estate planning, upon the first spouse’s death no Estate Taxes will be owed, due to the “Unlimited Estate Tax Marital Deduction.”  However, when the second spouse passes away, there may be taxes owed depending on the values of all of the assets.  If Bob and Susan own a house valued at $1,000,000, vehicles and boats valued at $300,000, checking and savings accounts in the amount of $100,000, brokerage accounts in the amount of $700,000, retirement accounts in the amount of $200,000, and the value of the business for Estate Tax purposes is $15,000,000, then the approximate Estate Tax liability under current law would be $2,648,000.  However, they only have true liquidity in the amount of $800,000.  This presents a real problem for their children.

If Bob and Susan decided to be proactive and insure against this risk, then they may choose to take out a “second to die” life insurance policy with face value of $3,000,000.  Bob and Susan probably feel pretty good about this decision and think that their children will be able to continue the business and pay any required taxes.  However, because they were owners of the life insurance policy, the face value is also included in the calculation of their assets for Estate Tax purposes.  Now the approximate Estate Tax liability would be $3,848,000.  This situation is much better for their kids, but is still troublesome.

The better solution for Bob and Susan would be if they created an Irrevocable Trust (often referred to as an Irrevocable Life Insurance Trust, or ILIT).  They would appoint a third party, such as a trusted friend, relative, or advisor, as Trustee of the ILIT.  The Trustee would purchase the same exact life insurance policy, and would be the legal owner of the policy.  Therefore, the face value of the policy is not included in Bob and Susan’s Estate Tax calculation and the approximate tax liability would be $2,648,000.

The policy would be paid for by gifts to the ILIT made by Bob and Susan.  The ILIT will ultimately benefit their children in the same way that their Revocable Trusts do; however, the Trustee of the ILIT will also be given the power to deal with and do business with the Trustee of the Revocable Trusts, and the Personal Representatives of their Estates.  When the second to die of Bob and Susan passes away, the ILIT will receive a check for $3,000,000.  The Trustee of the ILIT can use that liquidity to purchase unmarketable assets, namely as a portion of the family business, from the Revocable Trusts and/or Estate of the survivor.  Thus, the liquid assets end up in the hands of the person who must pay the taxes, and the children inherit a larger amount than would otherwise be the case.  It is important however, that the ILIT does not require the Trustee to pay the policy proceeds to the Revocable Trust or the Estate of Bob or Susan; otherwise the face value will be included in the Estate Tax calculation.

At the end of the day, $2,648,000 worth of the family business was purchased by the ILIT and is held for the benefit of the children.  The Trustee under the Revocable Trusts used that cash to pay off the Estate Taxes.  The children did not have to dip into their personal assets to pay the taxes, nor did they have to use up all of their parents’ liquid assets, nor did they have to sell the family business for peanuts in a “fire sale.”  This type of planning is a very good solution for many families and is a very flexible estate planning tool.