In some scenarios this strategy can actually reduce the after-tax amount ultimately available to the client and his or her family. The reasons for this are that the client is accelerating the income tax payable during his or her life, at a significantly higher income tax rate, and is not taking advantage of the full 10-year income tax deferral after his or her death, under the new tax law. If the owner has not reached his or her required beginning date, the negatives associated with accelerating taxable IRA withdrawals could be compounded by this strategy.
Prior to doing any Roth conversion in order to minimize income taxes to the designated beneficiaries after the account owner’s death, the planner must be mindful of the various potential negative aspects of the Roth conversion, including such negative factors as: (i) the likely significantly higher income tax rate payable by the owner under a Roth conversion, versus taking minimum RMDs during life, and the time value of the taxes saved by not converting; (ii) the taxable growth in the after-tax RMDs can be controlled, and in any event the growth will receive a stepped-up income tax basis at the death of the account owner, thus eliminating all income taxes on this growth up until the time of the account owner’s death; (iii) only 10 years of tax-free Roth deferral after the account owner’s death are permitted under the new law, thus undermining the post-death tax benefits available to Roth IRAs under the old tax law; and (iv) the IRA owner may need to use the IRA funds themselves to pay the conversion tax, and therefore be converting much less than the entirety of the IRA distribution.
Another early withdrawal option which may produce significant income tax saving benefits would be to apply an “amortization approach” to the withdrawals. Under this plan, beginning at age 72 or later, when RMDs are required, the account owner can determine his or her (or joint, if married) approximate life expectancy, and then take withdrawals over this period plus 10 years.
For example, if a couple both age 72 and retired, feels their joint life expectancy is approximately 15 years, they could withdraw their account assuming a 25-year amortization table and a five percent interest rate, with the designated beneficiaries making any annual withdrawals the couple did not take during their lifetime. The only modification to this plan would be for the designated beneficiaries to defer withdrawing all or some the balance until after they retire but within the 10-year window, if this step will lower their overall taxes.
The major difference between the amortization approach during the couple’s lifetime and a plan of just taking RMDs is that the withdrawals will be slightly greater in the earlier years and slightly less in the later years, which in turn will hopefully create a smoothing out of taxable income at lower tax brackets. The goal of this plan is to reduce the income tax rate at which the withdrawals will be taxed each year by avoiding a large bunching of income during the working years of the couple and/or of their designated beneficiaries. Annual distributions during the account owner’s lifetime which exceed his or her RMD amount can be rolled into a Roth IRA, if desired.
2. Pay all or part of the IRA portion of your estate to lower income tax bracket beneficiaries. The theory here is that, if we have to live with the new tax law, at least minimize its effects by planning our estates in a tax sensitive manner. Assume, for example, that a client has four children, two in high income tax brackets and two not. Why not consider leaving the IRA portion of the client’s estate to the children in lower income tax brackets, with the basis stepped-up assets to the others? Of course, a drafting adjustment should be made for the fact that the lower tax bracket children will be receiving taxable income, whereas the others will not be.
This plan can be taken a step further if the client is interested in leaving a portion of his or her estate to grandchildren and/or great grandchildren, who may be in lower income tax brackets than the children (subject, of course, to the Kiddie tax). Just because an existing plan to defer income tax on IRA assets over the lifetime of grandchildren and/or great grandchildren will no longer be possible, does not mean distributions to grandchildren and/or great grandchildren in lower tax brackets (and who are usually also more in number than children, thus spreading the income over more taxpayers) is not a beneficial income tax planning technique, due to the lower overall income taxes which may often result.
Finally, of course any charitable gift will want to first be made out of the IRA, etc., portion of the client’s estate. If carefully implemented, this type of estate planning can definitely make sense.
3. Withdraw additional IRA funds early and use the after-tax amount to purchase income tax-free life and/or long-term care insurance. This option is intended to combine options 1 and 2, above, but rather than withdrawing all or most of the IRA funds early, the technique merely “freezes” the current value of the IRA by withdrawing only the growth in the same or the RMD, whichever is greater, hopefully without increasing the account owner’s income tax bracket. All or a portion of the after-tax withdrawals are then reinvested in income tax-free life insurance, including so-called second-to-die life insurance which pays only at the death of both spouses, and is therefore cheaper than an individual policy insuring only one spouse.
The life insurance can then be left to the beneficiaries who are in the higher income tax brackets, with the balance of the IRA left to those in the lower tax brackets, including, if desired, grandchildren and great grandchildren (again, of course with any adjustments desired to account for the disparate income tax treatment of the beneficiaries, and with due regard being given for the Kiddie tax).