One of the chief benefits of the Tax Cuts and Jobs Act (TCJA) of 2017 is the reduced likelihood of federal estate taxes for many taxpayers. However, there remains a need for financial professionals to understand a number of issues that can have a significant impact on the transfer of property.

This article will highlight five key issues and potential strategies that may help reduce your clients’ tax burden.

Before we jump into the specifics, it’s important to understand the current federal estate tax.

First — for 2019 there is an $11.4 million federal estate tax exemption amount for each individual — almost double what it had been previously. Before recognizing there is an unlimited marital exclusion, for a married couple, this means that one spouse’s estate can set aside $11.4 million before estate tax exposure and the other spouse’s estate can exclude $11.4 million before it is exposed to federal estate tax. This figure is assuming no taxable gifts reduced the exempted amount.

Second — “portability” for surviving spouses is now permanent. This means that if one spouse (Spouse A for example) dies first and has a $22.8 million estate and leaves it outright to Spouse B – Spouse B will inherit the unused exemption from Spouse A in addition to his/her own (assuming  Form 706 is filed with Spouse A’s estate tax filing). By doing this, and assuming the exempted amount stays the same, $22.8 million can be left by the second spouse without exposure to federal estate tax.

Third — the estate and gift tax structure is unified. This means that each person can pass on to their heirs up to $11.4 million at death — without estate tax, or they can gift it to anyone while they are alive — without a gift tax. Taxable gifts, which in 2019 is any amount over $15,000 by any individual to any single individual, reduce the estate tax exemption available at death.

Probate

Probate is the legal process that completes a person’s legal and financial affairs after their death. During the probate process, a person’s property is identified, cataloged, and appraised. In addition, probate makes certain any outstanding debts and taxes are paid. It can be a complex process filled with very specific legal requirements. There are several issues that should be considered when managing probate, some of which can be mitigated by incorporating an annuity into your client’s portfolio:

1. Public Exposure — Probate takes place in a public court. That means everything is a matter of public record — there is no privacy. Anyone who wants to can find out exactly what was left behind (and how much each of a deceased person’s heirs received) and can review the court records for the deceased person’s estate. An annuity is one strategy that can help solve for this issue since annuity benefits pass to the beneficiary via beneficiary designation and typically avoids probate (assuming the estate is not the named beneficiary of the annuity).

2. Costs – Probate can be expensive. Even though probate costs are capped in some states, they may reach 5 percent or more of the estate’s value. That’s calculated on the gross value of the estate — before taxes, debts, and other expenses are paid. And if the probate process is challenged, the legal costs can rise. Annuity death benefits avoid the probate process when an individual is the beneficiary of the contract. Although the annuity value is still included in the total estate, this bypass may help reduce the cost of probate.

3. Multiple Estates — Two probate courts may be involved if someone lived in one state but left solely owned real estate in another. If that’s the case, there may need to be a probate case filed in each state (ancillary probate). Some states allow for a TODD (transfer on death deed) that can make this easier.

4. Time — Probate can take a long time — anywhere from a few months to more than a year. If there is a will, and one or more of the heirs chooses to contest the document, the process can take a lot longer. Since annuity benefits are not subject to probate when an individual is the beneficiary of the contract, they may have access to the proceeds sooner.

5. Probate at second death — Probate is often less complex when assets pass from the owner to a surviving spouse. Without pre-planning, however, probate may be a potentially complex undertaking at the second death. If annuity ownership changes due to spousal continuation at the first owners death, that surviving owner needs to make new beneficiary designations on the contract to achieve a probate-free transfer at death.

Income Taxes

Managing the amount and timing of your client’s income taxes could have a significant effect on both the original asset owner(s) and the beneficiary.

With temporary lower marginal income tax rates after the TCJA, retirement plan owners may benefit by paying taxes now and taking excess withdrawals from qualified accounts. For purposes of this article, excess income through withdrawals is basically taking income through withdrawals from tax deferred accounts balanced with tax deferral. Issues to consider within this category include prolonged tax deferral for large retirement plans inflating RMDs and increased income tax exposure for a surviving spouse due to the change in filing status from married filing jointly to single.  A surviving spouse’s income could be reduced, yet due to the change in filing status, the tax exposure could increase.

Prolonged income-tax deferral of large ($1 million+) retirement plans can trigger higher income taxes and other costs, such as Medicare Part B & D premiums, after age 70½, when required minimum distributions (RMDs) generally start.

It may be that accelerating IRA distributions before 70 ½ could benefit the current IRA owner as well as the beneficiary in some situations:

• By reducing income taxes on ordinary income by managing the withdrawals to “fill” a current lower tax bracket after retirement and before RMDs begin. Large forced distributions could trigger the 3.8 percent Medicare surtax on net investment income if the distributions exceed the income threshold and there is net investment income. Reducing those distribution amounts may eliminate exposure to the surtax.

• Medicare premium costs are based on two years prior modified adjusted gross income so large RMDs could increase premiums on some parts of Medicare.

• Accelerating IRA distributions could benefit the estate beneficiary if they supplant distributions from assets whose basis steps up at death of the owner.

• As mentioned above, a surviving spouse may be exposed to higher taxation due to the change in filing status. Lower RMDs may reduce that exposure.

There are many strategies that may help minimize retiree’s tax burden. Some of these may illustrate examples of implementing income benefits from deferred or immediate annuities.

Pre-Age 70½: Delay starting Social Security benefits — annuities can provide additional retirement income that could potentially reduce the client’s need to withdraw at earlier ages. Take advantage of delayed credits from Social Security and maximize its guaranteed payments while reducing IRA balance.

Post-Age 70½: Qualified charitable distributions (QCDs) — a nontaxable qualified charitable distribution up to $100,000 annually, from a client’s IRA. As long as the rules for the distribution are followed this can be a more effective tax strategy than a charitable deduction with after-tax dollars.

Any Time: Roth IRA conversions — if clients are concerned about paying higher taxes in the future, a Roth IRA conversion now may make sense. Partial conversions over the course of many years may be an option but beware!! TCJA eliminated the opportunity for conversions to be re-characterized — so the owner cannot reverse the conversion due to poor market performance.

Unneeded or excess withdrawals and RMDs that potentially push your client into the next tax bracket may be managed with pre- and post-tax minimizing options. Options include contributing to an HSA in the years before enrolling in Medicare, purchasing permanent life insurance that my allow for tax free loans or withdrawals, or funding an annuity that can provide beneficiary protection and/or tax deferral of after tax dollars. Consideration should also be given to further protecting retirement assets by purchasing long-term care insurance.

In many situations, non-qualified annuities can help with more than tax deferral that does not require RMDs at age 70 ½. Annuities can provide a guaranteed income stream that your client cannot outlive. They may also help with gifting — one option might be gifting any required distributions that are not needed for income to an annuity, which can help pre-fund a child’s retirement. Also the income may be used to fund a life insurance contract to help with offsetting taxes at death.

Protecting Transferred Assets

After the asset moves to a surviving spouse or other beneficiary, there is the potential for bad investment choices, misuse, or financial abuse. There are some situations where an annuity may help by controlling how the proceeds are distributed to the beneficiary that the client can control. This can be done through a provision in many annuity contracts that allows for the owner to pre determine how the beneficiary will receive death distributions:

• Bad investment/spending decisions wasting the asset — an annuitization option can provide a set income stream for a set period of time. And, because of annutization, the beneficiary does not need to manage payments or allocations — it basically takes care of itself.

• Divorce of a beneficiary can cause issues with ownership of assets — the annuity can be set to provide income to a beneficiary directly regardless of marital status.

• Spendthrift beneficiary who doesn’t manage money well — again, the annuity can provide a set income stream for a set period of time through annuitization or forced deferred stretch payments

• Deception or fraud — a predetermined payment option can help control the distribution of the funds automatically so there is less opportunity for abuse.

Income Continuity

Mitigating risk by leaving stable income for the surviving spouse can be important for many reasons. Let’s look at a few examples and how an annuity may help in these situations.

• Protecting pre-death standard of living — an annuity (an annuitized joint and survivor annuity) can provide annuity payments that continue for the life of the survivor.

• Helping the survivor avoid asset management decisions if the surviving spouse is not comfortable making those decisions — annuitized annuities are designed so the owner can experience lifetime annuity payments without demanding any day-to-day expertise.

• Reducing risk of financial abuse — an annuitized annuity will provide lifetime annuity payments. That adds a level of protection if owner is tempted to spend or give away larger amounts of money.

Once your client has identified their retirement income needs, the next step is to make sure your client has appropriate lifetime income sources (e.g., Social Security, pension income, annuities) to help meet those needs.

The more stable the sources of income, the more “stable” your client’s income will be in retirement. You can begin by asking your client what sources of reliable income they have, or what is their income stability percent? Income stability percentages are, in general, how much of the client’s needed retirement income will be stable and dependable. Your client can find the number by dividing the amount of guaranteed income they will have in retirement by the amount of income they will need in retirement.

Long-Term Care

Long-term care costs can create a significant income problem for the individual or spouse needing care as well as the survivor after the death of spouse who needed the care. Your clients might consider:

• Long-term care insurance to help cover costs

• Life insurance with a death benefit to the surviving spouse

• Products with built-in long-term care benefits or products that offer long-term care riders at an additional cost

After all, the depletion of assets during the care of one spouse can leave the surviving spouse in a difficult situation. Since the Tax Cuts and Jobs Act of 2017, the cost of creating after-tax money to purchase long-term care coverage is, for many taxpayers, lower than previous years.

Although the benefits or drawbacks of the TCAJ will be different for everyone, it’s important to work with your client to help them understand how the new tax environment may affect their specific situation. By providing strategies that can help them optimize their estate tax situation, you can significantly enhance your value as you work together to achieve their financial goals.

Kelly LaVigne is vice president of Advance Markets for Allianz Life.