In the debate over which is better—the immediate tax deduction for contributing to a traditional IRA or the potential for tax-free income from a Roth IRA—the answer tends to turn on one’s assumptions about tax rates. Conventionally, one expects to be in a lower tax bracket during retirement, perhaps dramatically so. That favors the traditional IRA. These days, however, those at higher income levels have been told repeatedly that their tax rates will be going up in the future, perhaps sharply. If so, the advantage shifts to the Roth IRA.
Those who are convinced that they will face higher tax rates in the future may want to consider converting their traditional IRAs to Roth IRAs, locking in at today’s relatively lower income tax rates. Conveniently, Congress has made that possible for everyone, beginning January 1, 2010.
For 2009, only those whose adjusted gross income does not cross the $100,000 barrier (single or married filing jointly) are eligible to convert to Roth IRA status. The income cap comes off January 1, 2010.
What’s more, taxpayers who make the conversion during 2010 have an additional choice. The amount of the conversion may be reported as taxable income for the 2010 tax year, or 50% may be reported in 2011 and the remaining 50% in 2012. Normally, deferring the payment of a tax obligation is greatly to be desired. However, the 2011 and 2012 tax rates will be the ones applied to the deferral, so if those rates are raised, the delay could boost the ultimate tax obligation.
In addition to the possibility of tax-free account growth, the Roth IRA is exempt from the required minimum distributions at age 70½ that apply to traditional IRAs. Roth accounts give the retiree maximum flexibility in shaping and controlling income tax obligations during the year.
The estate planning dimension
Paying income tax on a large account all in one year is quite a haircut, one that will present an understandable psychological hurdle to many. One way to get over the hurdle may be to consider the estate tax savings that go with the conversion to the Roth IRA.
Imagine that Doris has a $500,000 IRA, that her income puts her in a 40% combined federal and state income tax bracket, that she is unmarried (so her estate won’t get a marital deduction) and that she will be in the top federal estate tax bracket at her death. The IRA will pass to a grandchild.
If Doris does nothing, the federal estate tax on the IRA will be $300,000. State death taxes may apply as well, depending upon where Doris lives. Despite that reduction in account value, distributions from the IRA to the grandchild will be taxable income,
further reducing the financial benefit of the account.
If Doris converts the IRA to a Roth IRA, paying $200,000 in income taxes, her taxable estate will be reduced by that same amount. That’s a $120,000 reduction in estate tax exposure. What’s more, the Roth IRA distributions to the grandchild will be tax free for life.
Think of it this way. If you paid your child’s income taxes, you’d be making a taxable gift. When you prepay the income tax by converting a traditional IRA to a Roth IRA, you are making an enormous tax-free gift to the account beneficiary. And there’s no limit on how large the gift can be.
Downsides
The conversion of a traditional IRA to a Roth IRA triggers a new five-year holding period to avoid tax penalties, so those with an immediate need for the money may want to consider partial conversions instead. A wide variety of credits and deductions may be affected by the conversion decision, so it’s important to get professional tax advice before moving ahead.
Still, it’s not too soon to be looking at your choices and developing a plan that meets your needs and those of your family. N
(October 2009)
© 2009 M.A. Co. All rights reserved.
Thursday, October 1, 2009
Is it over?
October 1, 2009. Speaking on the anniversary of the collapse of Lehman Brothers, Fed Chairman Ben Bernanke said that from a technical perspective, “The recession is very likely over at this point.” He cautioned, however, that the economy may remain weak. In its final meeting of the quarter, the Fed seemed to confirm that view, suggesting that economic activity had “picked up.”
Still, short-term interest rates were left unchanged. Stock markets were in agreement, as the recovery in the Dow Jones Industrial Average off its March low has been spectacular.
Unemployment
Employment tends to be a lagging indicator for economic recoveries, which is why no one expects much good news on this front for the rest of the year. But the bad news just seems to keep on coming.
• Nationally, unemployment hit 9.7% in August, the highest level in 26 years.
• Teen unemployment was at 25.5%, the highest rate since the Bureau of Labor Statistics began breaking out this figure in 1948.
• California’s unemployment reached a 70-year high. El Centro, California, recorded an astounding 30.2% jobless rate in July.
• The broader measure of unemployment, one that accounts for those who have given up on looking for work, reached 16.8% in August. That’s the highest since this measure was adopted in 1994.
Hopefully, the lag between the end of the recession and a return of job growth won’t be too long, or the recovery will be short-lived.
Given these grim statistics, it’s not surprising that the housing market continues to struggle. Some 7.58% of home mortgages were at least 30 days late on payments in August, a record. About 1.5 million mortgages are in the early stages of foreclosure, and another 1.2 million are in limbo—the borrower is in serious default, but the bank hasn’t begun foreclosure proceedings.
Inflation
In the fiscal year that ended September 30, the federal government issued a total of $7 trillion in bonds. Net borrowing needs were $1.7 trillion, nearly $1 trillion more than in the final year of the Bush presidency.
Many observers expected that the borrowings would have an inflationary impact, but there is no sign of that to date. Perhaps the poor employment numbers and slack in the economy are responsible. For the 12 months that ended August 31, the Consumer Price Index (CPI) was down 1.5%. Health care costs are rising relentlessly, but otherwise inflation remains tamed.
Some CPI components:
% change
Food at home -1.6
Food away from home 3.0
Gasoline -30.0
New vehicles 0.5
Used cars and trucks -5.4
Medical care services 3.2
Energy
The upside of higher oil prices is that it stimulates more exploration. Good news—more than 200 discoveries of oil and gas deposits already have been announced this year. Roughly 10 billion barrels of oil were discovered in the first half of the year. At that pace we could reach the best rate of discoveries since 2000.
However, much of the newly found oil is only worth recovering when the price of oil is $60 per barrel or more. The fact that the price fell to $34 per barrel last December worries some oil executives, especially when coupled with continuing U.S. economic weakness.
(October 2009)
© 2009 M.A. Co. All rights reserved.
Still, short-term interest rates were left unchanged. Stock markets were in agreement, as the recovery in the Dow Jones Industrial Average off its March low has been spectacular.
Unemployment
Employment tends to be a lagging indicator for economic recoveries, which is why no one expects much good news on this front for the rest of the year. But the bad news just seems to keep on coming.
• Nationally, unemployment hit 9.7% in August, the highest level in 26 years.
• Teen unemployment was at 25.5%, the highest rate since the Bureau of Labor Statistics began breaking out this figure in 1948.
• California’s unemployment reached a 70-year high. El Centro, California, recorded an astounding 30.2% jobless rate in July.
• The broader measure of unemployment, one that accounts for those who have given up on looking for work, reached 16.8% in August. That’s the highest since this measure was adopted in 1994.
Hopefully, the lag between the end of the recession and a return of job growth won’t be too long, or the recovery will be short-lived.
Given these grim statistics, it’s not surprising that the housing market continues to struggle. Some 7.58% of home mortgages were at least 30 days late on payments in August, a record. About 1.5 million mortgages are in the early stages of foreclosure, and another 1.2 million are in limbo—the borrower is in serious default, but the bank hasn’t begun foreclosure proceedings.
Inflation
In the fiscal year that ended September 30, the federal government issued a total of $7 trillion in bonds. Net borrowing needs were $1.7 trillion, nearly $1 trillion more than in the final year of the Bush presidency.
Many observers expected that the borrowings would have an inflationary impact, but there is no sign of that to date. Perhaps the poor employment numbers and slack in the economy are responsible. For the 12 months that ended August 31, the Consumer Price Index (CPI) was down 1.5%. Health care costs are rising relentlessly, but otherwise inflation remains tamed.
Some CPI components:
% change
Food at home -1.6
Food away from home 3.0
Gasoline -30.0
New vehicles 0.5
Used cars and trucks -5.4
Medical care services 3.2
Energy
The upside of higher oil prices is that it stimulates more exploration. Good news—more than 200 discoveries of oil and gas deposits already have been announced this year. Roughly 10 billion barrels of oil were discovered in the first half of the year. At that pace we could reach the best rate of discoveries since 2000.
However, much of the newly found oil is only worth recovering when the price of oil is $60 per barrel or more. The fact that the price fell to $34 per barrel last December worries some oil executives, especially when coupled with continuing U.S. economic weakness.
(October 2009)
© 2009 M.A. Co. All rights reserved.
GRATs
The Grantor Retained Annuity Trust (GRAT) has been getting quite a bit of attention from estate planners recently. The reason is that low market interest rates create a window of opportunity for passing assets to heirs without incurring much, if any, estate or gift tax.
The GRAT is established for a set number of years. During the term of the trust, the grantor is paid an annuity, a fixed dollar amount, every year. When the trust terminates, the assets left in the trust pass to the grantor’s heirs. A gift tax, due when a GRAT is funded, is imposed upon the actuarial value of what the heirs will receive when the trust terminates. Estate planners can use two factors to reduce that tax exposure almost to zero: They can lengthen the term of the GRAT, or they can increase the annuity retained by
the grantor.
The value of the retained income interest and the value of the remainder for the heirs must take current interest rates into account. If the trust earns more than the IRS tables predict it will earn, the excess will pass to the heirs free of estate or gift tax. During a period of very low interest rates, such as we have today, the chance of beating the IRS interest rate is very good.
On the other hand, if the trust’s investments underperform, it may be exhausted before the end of the term, leaving nothing for the heirs. Finally, if the grantor dies before the trust comes to an end, the assets will be included in the grantor’s estate, defeating the estate planning objectives.
Future considerations
The advantages of GRATs have become so pronounced in the current market environment that the President’s tax proposal to Congress earlier this year included a new restriction for such trusts in the future. They will have to have a trust term of at least ten years in order to be effective for federal tax purposes.
If such a change to the tax code is made, it very likely will be part of a larger estate tax reform plan that keeps the federal exempt amount at $3.5 million, freezing the estate tax rates at 2009 levels. For married couples, that means $7 million can be sheltered from federal estate tax with some basic planning. Such a move could limit the need for more sophisticated strategies, such as GRATs, for wealthier families.
(October 2009)
© 2009 M.A. Co. All rights reserved.
The GRAT is established for a set number of years. During the term of the trust, the grantor is paid an annuity, a fixed dollar amount, every year. When the trust terminates, the assets left in the trust pass to the grantor’s heirs. A gift tax, due when a GRAT is funded, is imposed upon the actuarial value of what the heirs will receive when the trust terminates. Estate planners can use two factors to reduce that tax exposure almost to zero: They can lengthen the term of the GRAT, or they can increase the annuity retained by
the grantor.
The value of the retained income interest and the value of the remainder for the heirs must take current interest rates into account. If the trust earns more than the IRS tables predict it will earn, the excess will pass to the heirs free of estate or gift tax. During a period of very low interest rates, such as we have today, the chance of beating the IRS interest rate is very good.
On the other hand, if the trust’s investments underperform, it may be exhausted before the end of the term, leaving nothing for the heirs. Finally, if the grantor dies before the trust comes to an end, the assets will be included in the grantor’s estate, defeating the estate planning objectives.
Future considerations
The advantages of GRATs have become so pronounced in the current market environment that the President’s tax proposal to Congress earlier this year included a new restriction for such trusts in the future. They will have to have a trust term of at least ten years in order to be effective for federal tax purposes.
If such a change to the tax code is made, it very likely will be part of a larger estate tax reform plan that keeps the federal exempt amount at $3.5 million, freezing the estate tax rates at 2009 levels. For married couples, that means $7 million can be sheltered from federal estate tax with some basic planning. Such a move could limit the need for more sophisticated strategies, such as GRATs, for wealthier families.
(October 2009)
© 2009 M.A. Co. All rights reserved.
Ask a trust officer: Federal estate taxes
DEAR TRUST OFFICER:
What’s up with the federal estate tax? I heard that it’s suspended next year, for one year only? Should I review my will?
—DEATH TAX TARGET
DEAR TARGET:
You heard correctly. As of January 1, under current law, the federal estate tax will be suspended, replaced by a complex new tax regime with the shorthand name “carryover basis.” In effect, greater capital gains tax receipts would offset, to some extent, the loss of estate tax revenue at the death of wealthy individuals. After one year of that experience, the federal estate tax roars back in 2011, with a $1 million exemption and a top tax rate of 60%. (In contrast, this year the exemption is $3.5 million, and the top rate is 45%.)
This roller-coaster ride was built in 2001 for political and budgetary reasons. Unfortunately, the focus on health care reform has left precious little time for Congress to devote to estate tax reform. Consequently, the emerging scenario considered most likely is a one-year patch, extending the 2009 tax rules into 2010 only. That would permit the Congress to take more time next year to work out a comprehensive plan for taxation at death.
Cynics point out that it also gives Congress the opportunity to allow a major tax increase to be implemented through simple inaction. As resistance to deficit spending has mounted, the need for new tax revenue has grown.
What does all this mean for your estate plans? Vigilance will remain important, but a one-year patch will be less disruptive than the alternative of implementing carryover basis. Given the near-term revenue loss associated with doing nothing, Congress seems very likely to push something through late in the year.
Do you have a question concerning wealth management or trusts? Send your inquiry to [trustofficer@bankname.com].
(October 2009)
© 2009 M.A. Co. All rights reserved.
What’s up with the federal estate tax? I heard that it’s suspended next year, for one year only? Should I review my will?
—DEATH TAX TARGET
DEAR TARGET:
You heard correctly. As of January 1, under current law, the federal estate tax will be suspended, replaced by a complex new tax regime with the shorthand name “carryover basis.” In effect, greater capital gains tax receipts would offset, to some extent, the loss of estate tax revenue at the death of wealthy individuals. After one year of that experience, the federal estate tax roars back in 2011, with a $1 million exemption and a top tax rate of 60%. (In contrast, this year the exemption is $3.5 million, and the top rate is 45%.)
This roller-coaster ride was built in 2001 for political and budgetary reasons. Unfortunately, the focus on health care reform has left precious little time for Congress to devote to estate tax reform. Consequently, the emerging scenario considered most likely is a one-year patch, extending the 2009 tax rules into 2010 only. That would permit the Congress to take more time next year to work out a comprehensive plan for taxation at death.
Cynics point out that it also gives Congress the opportunity to allow a major tax increase to be implemented through simple inaction. As resistance to deficit spending has mounted, the need for new tax revenue has grown.
What does all this mean for your estate plans? Vigilance will remain important, but a one-year patch will be less disruptive than the alternative of implementing carryover basis. Given the near-term revenue loss associated with doing nothing, Congress seems very likely to push something through late in the year.
Do you have a question concerning wealth management or trusts? Send your inquiry to [trustofficer@bankname.com].
(October 2009)
© 2009 M.A. Co. All rights reserved.
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