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The New Tax Law and IRAs

The 2010 "Tax Relief Act" affects planning for our clients' retirement benefits in three ways.

Natalie Choate, 01/14/2011

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The 2010 "Tax Relief Act," signed into law on Dec. 17, 2010, affects planning for our clients' retirement benefits in three ways.

Question: Does the new Tax Act affect IRAs and other retirement benefits?

Natalie: Yes. The Tax Relief Act of 2010 affects three aspects of planning for our clients' retirement benefits--lifetime charitable giving, Roth conversions, and estate planning.

Lifetime Charitable Giving From IRAs
During 2006-2009, an individual who was older than age 70½ had the ability to make transfers directly from his IRA to a public charity. Such "Qualified Charitable Distributions" were limited to $100,000 per year per donor, and were not includible in the donor's income as IRA distributions normally would be. A person could even use a Qualified Charitable Distribution to fulfill his minimum distribution requirement. But Qualified Charitable Distributions expired at the end of 2009.

Now, with the Tax Relief Act of 2010, Congress has revived Qualified Charitable Distributions and extended them for two more years--2010 and 2011.

This important news for our charitably-inclined older clients even has a unique provision with a very short time fuse. Congress realized it was a little late in mid-December 2010 to suddenly start allowing these charitable IRA transfers for the year 2010. So the law includes a provision allowing a person to make a Qualified Charitable Distribution in the month of January 2011--this month--and have the distribution count as a 2010 distribution! This may be the first time the Internal Revenue Code has included a provision that is good for only one month.

This special deal for January 2011 Qualified Charitable Distributions could be important to two groups of clients, but they need to act fast. First, any client who is over 70½ and who failed to take his IRA MRD in the year 2010 can make a Qualified Charitable Distribution in the month of January 2011 and have it count towards his 2010 minimum required distribution.

The other client that this one-month tax law helps is someone who would like to give $200,000 to charity from his IRA in 2011 and who did not make any Qualified Charitable Distributions in 2010. She can give $100,000 in January 2011 and have that "count" as her 2010 Qualified Charitable Distribution, and then give another $100,000 later in 2011 as her 2011 Qualified Charitable Distribution.

Roth Conversions and Recharacterizations
The 2010 Tax Relief Act does not directly affect Roth conversions. None of the rules regarding Roth conversions or Roth recharacterizations was changed at all. As was true in 2010, anyone can convert almost any type of plan or IRA to a Roth IRA--there is no income ceiling or filing status test. And as before, a person who did a Roth conversion in 2010 can elect to have his 2010 Roth conversions taxed entirely in the year 2010 or, instead, half in 2011 and half in 2012.

The new law does have an indirect impact, because it extended the Bush-era tax rates for two more years. Thus, people who did 2010 Roth conversions because they were afraid income tax rates would go up in 2011 (when the Bush-era tax cuts were scheduled to expire) no longer have that worry. Some of those people may decide to recharacterize (or "undo") their 2010 Roth conversions since the feared tax increase has been postponed for two years.

But remember income tax increases are still scheduled to occur--they have just been delayed a little. The Bush-era tax rates were only extended through 2012. In 2013, the old higher rates are scheduled to reappear, along with the new additional 3.8% surtax on investment income to pay for "health care reform."

Some clients may decide to keep their 2010 Roth conversions, but elect to have the income spread forward, half into 2011 and half into 2012. As of the beginning of December 2010 it appeared that no one would want to spread 2010 Roth conversion income forward into 2011 and 2012 because tax rates were scheduled to be higher in those years. Now that the Tax Relief Act has extended current tax rates for two more years, spreading the income from a 2010 Roth conversion forward into 2011 and 2012 may become more attractive and popular. After all, tax rates aren't going up, so you might as well keep the tax money in your pocket a little longer.

There's no one right answer for everyone on these questions. The new tax law is just one more factor to consider in the difficult decision of whether to recharacterize all or part of a 2010 Roth conversion and whether to include the 2010 conversion income in 2010 or push it forward into 2011-2012. Clients and their advisors can agonize about that all the way up to October 15, 2011.

Major Impact on Estate Planning
The most important effect of the 2010 Tax Relief Act has to do with estate planning. The new $5 million estate tax exemption, and 35% estate tax rate for estates over $5 million, will obviously eliminate estate tax worries for many clients in the so-called "mass affluent" category.

But the provision that most particularly impacts retirement benefits is a brand new concept in the Code, portability of the estate tax exemption. This is revolutionary. It means a husband and wife can leave their federal estate tax exemptions to each other. The first spouse to die can leave his $5 million exemption to the surviving spouse, so the surviving spouse will have a $10 million exemption. No longer do couples have to create "credit shelter trust" estate plans to make full use of both spouses' exemptions.

This will make estate planning easier for many couples, but especially when one or both spouses have most of their assets in the form of retirement plans and IRAs.

Here's an example. Joe and Lucia are married, with three children. Joe's only asset is a $5 million IRA, and Lucia's only asset is her $5 million IRA. With $10 million of combined assets they obviously want to make sure they take full advantage of their estate tax exemptions, so the full $10 million can eventually pass to their three children with no federal estate tax. Without portability of the estate tax exemption, the only way they could have taken advantage of their exemptions was for the first spouse to die NOT to leave his or her $5 million IRA to the surviving spouse. Under the old way of saving estate taxes for a married couple, we would tell Joe, don't name Lucia as beneficiary of your IRA! If you do, she'll wind up with $10 million of assets and only $5 million of exemption and your exemption will have been wasted!

Under the old way of estate tax planning, the only way Joe could make use of his federal estate tax exemption would be to leave his $5 million IRA either directly to the children or to a "credit shelter" or "bypass" trust for the life benefit of Lucia. Leaving the IRA direct to the children could be a good tax move, but most clients don't like it because it takes money away from the surviving spouse. Leaving the IRA to a bypass or credit shelter trust for the surviving spouse SEEMS to protect the surviving spouse financially, and it definitely saves estate taxes for the children by keeping the IRA out of the surviving spouse's estate, but it causes a huge loss of income tax benefits. There is no spousal rollover and no stretch payout over the children's life expectancy. Instead, the entire IRA gets dumped out into the credit shelter trust over the single life expectancy of the surviving spouse, a relatively short period of time.

So (prior to the new Tax Act) clients in Joe's and Lucia's situation had to make a hard choice: Do we go for the income tax benefits of the spousal rollover by leaving the IRA outright to the surviving spouse, even though that costs extra estate taxes by wasting the first spouse's estate tax exemption? Or do we save estate taxes by leaving the benefits to a credit shelter trust but give up on the long term deferral that would otherwise be available via the spousal rollover?

Thanks to the Tax Relief Act of 2010 clients will no longer have to make that particular hard choice. Instead, Joe can leave his $5 million IRA outright to Lucia and also leave her his $5 million estate tax exemption. Joe and Lucia can now get the income tax savings of long-term deferral of distributions via the spousal rollover, without having to waste one spouse's estate tax exemption to get it. When Lucia later dies, she will have a $10 million IRA and a $10 million estate tax exemption.

Of course, as with all estate tax planning, there are many factors to consider, too many to discuss here. And of course the new estate tax regime is scheduled to sunset at the end of 2012. But for now we have something that is nothing short of revolutionary in its impact on married couples who have a significant portion of their wealth inside retirement plans.

So Happy New Year everybody, and let's get to work!

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Natalie Choate practices law in Boston, specializing in estate planning for retirement benefits. Her book, Life and Death Planning for Retirement Benefits, is fast becoming the leading resource for professionals in this field.

The author is not an employee of Morningstar, Inc. The views expressed in this article are the author's. They do not necessarily reflect the views of Morningstar.
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