2020 will be a year to remember for decades to come. In the world of tax and retirement planning, it’s brought opportunities for advisors to present to clients. But unlike those in other years, 2020’s opportunities should be seized now—taken advantage of before year’s end—because they may not be as effective afterward.
Here are the five best ideas for advisors to share with clients before 2020 ends:
Yes, these are always on the year-end, to-do list, but this year the tax benefits may be the highest ever because of historically low tax rates and possibly lower income for many due to the Covid-19 pandemic.
However, be warned. Today’s low rates will not last. The rates were already set to snap back to pre-2018 levels after 2025, but they could go higher as soon as next year. The Congressional Budget Office has reported that as of the end of fiscal 2020 (which ends on September 30, 2020) the U.S. budget deficit will reach $3.3 trillion, a level not seen since the end of World War II. Trillions more in stimulus spending may be in the works (or already done by the time you read this). According to the CBO, the national debt will exceed $20.3 trillion by the end of September 2020. To put this in perspective, that is set to exceed our total annual economic output, and this year’s deficit levels are more than triple those of 2019.
And it’s getting worse each day. On September 3, 2020, The Wall Street Journal said, “One way or another, we’ll be paying this off for the rest of our lives.” The paper added “there’s no such thing as free borrowing. Even the U.S. with all its economic power can’t keep piling up debt forever.” In other words, the bill will come due, and that bill will end up being paid mainly with tax increases. Those tax increases may come as early as 2021, no matter who is elected president.
That puts tax-deferred retirement savings in jeopardy. In essence, tax-deferred accounts like traditional IRAs include a debt that will have to be paid to the IRS at some point. It’s up to advisors to help clients pay that debt off at the lowest possible tax rates, and that may well be right now. That’s why advisors should be looking more seriously at Roth conversions now, before year’s end.
Advisors should contact every client with traditional IRAs and evaluate a 2020 Roth conversion. They should also communicate with the clients’ CPAs or other tax advisors to project the tax cost of a 2020 Roth conversion. It may be that for most clients the best strategy is to do a series of smaller annual conversions over time, using up the lower tax brackets each year while they last. You should also make sure that there are funds available to pay the tax, because once a Roth conversion is done, it is permanent. The tax will be owed. The Tax Cuts and Jobs Act of 2017 eliminated recharacterizations of Roth conversions beginning in 2018.
As 2020 winds down, this is the optimum time to project the tax cost of a conversion because most people by this time will have a reliable estimate of their 2020 income. And they may be able to convert larger amounts with a lower tax bite if the pandemic caused them business losses or unemployment. Remember, though, that unemployment insurance is taxable income, and many people received these increased payments.
Once funds are converted, today’s low tax rates are locked in, plus the funds in the Roth grow income tax free forever and Roth IRAs have no lifetime required minimum distributions (RMDs). Any IRA funds converted will lower these tax-deferred IRA balances and in turn lower the amount of future RMDs that could be exposed to higher taxes.
Some clients may think they will be in a lower tax bracket in retirement, but that doesn’t often happen, especially after a spouse dies and the surviving spouse sees their tax bills increase when they begin to file as single.
The bottom line here is that a Roth conversion removes the risk and uncertainty of what future higher tax rates can do to a client’s retirement income.
The best part of the Roth conversion is what it does in the worst-case scenario. Even if it turns out taxes do not increase (which is unlikely) or that maybe taxes go even lower for some clients (even more unlikely), the tax rate on Roth distributions in retirement will be zero. That is not a bad worst-case scenario.
Though Roth conversions will still be available in the future, advisors should still consider doing them in 2020 (to count, the funds must leave the IRA or company plan before year’s end).
In 2020, you aren’t even required to take money from your IRA distributions. The Coronavirus Aid, Relief, and Economic Security Act waived required minimum distributions for the year. But advisors should tell clients to look at taking voluntary IRA distributions anyway, even if they aren’t required. That’s because clients taking money out of these tax-deferred vehicles in 2020 might be able to do so at lower tax rates.
Since the required minimum distributions are waived for 2020, this presents a onetime opportunity for those subject to the minimums to convert RMDs instead to Roth IRAs (something they can’t normally do). Once the required distributions begin, they must be withdrawn as the first dollars out and cannot be converted. This makes Roth conversions more expensive tax-wise since the tax on RMDs must first be paid to convert any part of the remaining IRA or plan funds. But this is not the case for 2020, so this year presents a now closing window of opportunity to get this done.
Even if clients are not subject to required minimum distributions, it may pay for them to begin taking taxable distributions to get them into the lower tax brackets and begin reducing the future IRA debt that’s building for Uncle Sam. The funds could be used either to convert to Roth IRAs (as we discussed earlier) or for gifting or estate planning (which we will cover later).
For example, the IRA funds withdrawn can be used to purchase permanent cash value life insurance, which after the SECURE Act will prove to be a better estate planning vehicle than inherited IRAs. Like Roth IRAs, life insurance will grow tax free and the eventual proceeds to beneficiaries will be tax free as well. That’s a good use of IRA funds now. IRA or plan withdrawals taken this year can also be used for gifting to family members.
The point is that even though minimum distributions may not be required this year, the writing on the wall tells us we must start whittling down taxable IRA balances before the tax debt, like our national debt, balloons out of control. A tax debt in retirement can hamper a client’s spending power when they need it most—when the paychecks stop.
Qualified charitable distributions are the most tax-efficient way to make charitable gifts because they reduce taxable IRA balances at no tax cost. The name refers to a direct transfer of IRA funds to a qualifying charity.
The only downside here is that the QCD is not available to more people—only IRA owners and beneficiaries age 70½ or older qualify. The distribution is not available from company plans and not permitted to go to donor-advised funds or private foundations. So advisors must focus on those clients who will qualify in 2020.
Qualified charitable distributions are limited to $100,000 per year for each IRA owner, not per IRA account. That limit is large enough to work for most clients.
Although the SECURE Act raised the required minimum distribution age to 72, the QCD age remains at 70½. This gap means the charitable distributions can begin before RMDs kick in.
Some clients are not doing the charitable distributions for the year because RMDs were waived for 2020. But clients can still make these QCDs nonetheless. Even if there are no required minimum distributions to offset, the charitable distribution still allows clients to remove IRA funds at a zero tax cost. If the clients are giving to charity anyway, and they qualify for QCDs, then this is the way they should be doing their giving.
Most people no longer itemize deductions since they generally take the larger standard deduction, which is even larger for those age 65 and over (or blind) who receive an extra standard deduction amount. This makes it even more likely that those subject to required minimum distributions who qualify for qualified charitable distributions at age 70½ or older will not itemize and will receive no tax benefit for their charitable donations.
With qualified charitable distributions, however, you receive both the standard deduction and the tax benefit in the form of an exclusion from income. An exclusion is better than a tax deduction because it reduces your adjusted gross income, a key figure on the tax return. AGI determines the availability of tax deductions, tax credits and other benefits that will be allowable. It also determines the level of taxation of Social Security benefits and surcharges for Medicare Parts B and D income-related monthly adjustments, for example.
QCDs are the most tax-efficient way to reduce taxable IRA balances, because they reduce the balances to a zero tax cost.
It’s important that you, as an advisor, identify clients who might benefit from qualified charitable distributions before year’s end, because the funds must come out of the IRA by that time for the client to qualify for the distribution. Don’t cut it too close. Get this done early in December.
Plus, don’t forget about the new $300 additional charitable gifting exclusion from income for non-itemizers (for cash gifts)—a provision in the CARES Act.
The legislation also removed the 60% adjusted gross income limitation for charitable gifts for those who itemize. However, since most people do not give that much, the QCD will still provide a better tax advantage. If a client does give that much in cash contributions, it would still pay to first use up the $100,000 qualified distribution limit as an exclusion from income, and then use the itemized deduction for further cash gifts that now (for 2020 only) can be taken without the 60% limitation.
With the exploding deficits and expanding national debt, there is a new urgency for clients to make gifts now, before year’s end, because the golden age of gifting may soon grind to a halt. It’s time to play defense and protect your clients now. Gifts are lifetime transfers as opposed to inheritances received after death.
The 2020 estate and gift tax exemption is $11,580,000 per person ($23,160,000 for a married couple). These figures are scheduled to go back to $5 million and $10 million, respectively, after 2025 (there will also be inflation increases). However, these limits can easily be reduced much earlier by a revenue-hungry Congress. It pays to use them now or possibly lose them later. These limits apply to lifetime gifts as well as inheritances.
This strategy is mainly for your wealthier clients who may have an estate large enough to be subject to federal and possibly state estate taxes. These are probably your best clients, so they will value this advice. Whether they take it is a different story, since some (actually, many) clients have an aversion to parting with their money, even if the gifts go to their children or grandchildren.
Clients who have amassed these funds are still worried about losing control and about the possibility of the funds being squandered by those very same children or grandchildren, or the risk the funds could be lost in a divorce or taken by creditors. Of course, there are trusts available for these purposes, but that makes things more complicated.
Regardless, advisors need to present a year-end 2020 gifting plan now so clients can see the opportunities available to make tax-free gifts.
For clients who will be subject to a federal estate tax, gifting is less expensive because gifts are tax-exclusive, as opposed to inheritances, which are tax-inclusive. If the funds are left in the estate, the full value of the transfer at death is subject to the estate tax, so the funds used to pay the estate tax are taxed themselves, whereas gift taxes on lifetime transfers are only based on the gift amount received.
Advisors should talk to these clients and advise them of the gifting opportunities that are available now, and that might no longer be available after 2020.
There are three tiers of tax-exempt gifting:
1. The first is $15,000 annual exclusion gifts. These gifts can be made to anyone each year and they do not reduce the gift/estate exemption. These annual exclusion gifts are always tax free—even if the exemption is used up.
2. Unlimited gifts for direct payments for tuition and medical expenses. These gifts can be made for anyone, the amounts are unlimited, and they do not reduce the gift/estate exemption. These gifts are also always tax free—even if the exemption is used up.
3. The $11,580,000 lifetime gift/estate exemption in 2020. The IRS has stated that there will be no clawback if these exemptions are used now, even if the exemption is later reduced, so it’s important for clients to know they must use it or possibly lose it.
Gifts can be made to help family members pay the tax on Roth conversions or to pay for life insurance. Gifts for business succession planning are especially attractive now since many businesses, unfortunately, have seen their value drop during the pandemic. Gifts can also be made to help children or grandchildren pay down student loans. These are just some examples of gifting that might suit clients.
While gifting results in lower transfer taxes, beware: There’s a big exception to the gifting tax advantage—and that’s when you are giving property other than cash. In those cases, you must watch out for highly appreciated assets that will get a step-up in basis when the owner dies. The increase in basis would eliminate the income tax on any appreciation during the decedent’s life. Depending on the appreciation, this property would generally be better held until death and not given to others.
Gifts made now in 2020 lock in today’s gifting limits. There is no guarantee that these limits will hold up in the future.
The SECURE Act eliminated the stretch IRA for most non-spouse beneficiaries. This is effective beginning with deaths in 2020, so it is imperative for advisors to check IRA and company plan beneficiary forms for all their clients. This will reveal what may be the largest single asset in their estate plan.
Most non-spouse beneficiaries will be subject to the new 10-year payout rule, meaning that the entire inherited IRA will have to be withdrawn by the end of the 10th year after the IRA holder dies.
This includes most trusts named as IRA beneficiaries, and it could be clients need to make changes to these vehicles. For example, most conduit trusts will not work as originally planned since the entire inherited IRA will be left unprotected in trust after the 10 years. Many of these trusts will have to be upgraded to discretionary trusts to maintain the trust protection beyond the 10 years. But even then, the inherited IRA funds will still be taxed when that decade has passed, and that tax will be at high trust tax rates for any funds remaining in the trust and not distributed to the trust beneficiaries.
One solution here is to convert these IRAs to Roths to eliminate the post-death trust tax exposure or withdraw IRA funds now and purchase life insurance, which is a better and more flexible asset to leave to a trust.
It’s time to re-evaluate clients’ IRA estate plans, and, again, that begins with a beneficiary form review. Check to make sure that contingent beneficiaries are named and up to date. Make sure that the estate plans will still accomplish the clients’ goals after the changes brought about by the SECURE Act.
These are your five best 2020 year-end retirement, tax and estate planning moves. They will enhance your value to clients whose retirement savings will soon be exposed to potential tax increases after 2020. It’s only a question of when. It’s time to act now.