Many clients and advisors alike viewed the estate tax reform enacted at the end of 2012 as the end of estate planning for the majority of their clients. While that may be true for estates under $10 million when viewed exclusively through the estate tax lens, the reality is that there are a myriad of reasons to continue to work in the estate planning market.
More important, however, is the client worth under $10 million who’s heirs are now facing a significantly increased tax bill as a result of estate tax reform.
Why is this more important? These clients may not see this coming until it’s too late – unless their advisor brings it to their attention.
the unique treatment of IRD assets
We all know about the issue of IRD (Income in Respect of a Decedent) assets and the tax that the heirs will have to pay upon receipt of said assets.
In fact, a good deal of planning work prior to estate tax reform dealt with using life insurance to prevent the erosion of the value of these assets based on “double taxation” in the form of both income and estate taxes.
Surely, the elimination of the estate tax on estates under $10 million also eliminated this issue?
What makes this a bit more challenging is the actual makeup of most estates and the way that IRD assets pass to beneficiaries. When viewed through the heirs’ eyes, the inheritance of IRD assets breaks down as follows:
Heirs receive the IRD assets directly as beneficiaries. The amount they receive is subject to ordinary income tax in the year it is received. The beneficiary, having just received a large lump sum, has the liquidity to pay it.
While writing a check is painful, they are still in the money, so to speak.
Estate tax is due from the decedent’s estate. The important part is that the estate tax, while not paid by the beneficiary of the IRA, can generate a rather massive tax deduction for the IRA beneficiary. In fact, the amount of estate tax attributable to the IRA is available as a deduction.
Why is this important?
The vast majority of estates are not subject to tax under the new limits enacted under ATRA. Most IRD beneficiaries have lost this deduction.
impact of new estate tax exemption limits
Consider the following, comparing a death under 2009 tax law versus 2013 (Click to enlarge):
How does this impact the beneficiary?
As you see in the table above, with the new estate tax exemption limits, the IRD deduction is gone. All $1 million is taxable, and the corresponding increase in income taxes due is going to hurt, particularly if what was once $1 million is further reduced by federal and state income taxes!
|Inherited IRA||$1MM||Inherited IRA||$1MM|
|IRD Tax Deduction||$400K||IRD Tax Deduction||$0|
|Net Taxable Income||$600K||Net Taxable Income||$1MM|
|Marginal Tax Rate||39.6%||Marginal Tax Rate||39.6%|
|Taxes Dues on IRA||$237,600||Taxes Dues on IRA||$396,000|
|Net after Tax||$762,400||Net after Tax||$604,000|
Additional lost to tax under new tax laws: $158,400 or 15.8%
This entire conversation leads back to a very familiar place: Selling life insurance to fund the taxes due on the IRD assets to prevent their being eroded by increased federal and state income taxes. IRA maximization is back ladies and gentlemen. In fact, it never left.
a growing problem
Adding fuel to the fire, so to speak, is the makeup of retiree’s assets today versus history.
In the past, income in retirement was generated largely by pensions and social security with personal savings representing the smallest portion of a retiree’s income. Today, personal savings has taken the place of the pension, and Social Security has remained static at best.
The result, of course, is larger and larger IRA balances, particularly in the demographic we are focused on today: The under $10 million crowd.
Fill out the form below to download our eBook, Examining IRA Maximization post-ATRA, and learn more about the potentially huge increase in income taxes for IRA beneficiaries under ATRA and the growing problem this represents for the under-$10 million market.