As 2020 has been a unique year, advisors would do well to take some new directions when they meet clients in December to talk about taxes. Specifically, two major tax laws enacted within the last 12 months should be on the agenda, as well as the impact of the economic weakness caused by the pandemic.
The SECURE Act of 2019 became law last December. Perhaps its most noteworthy provision is the 10-year rule: starting with deaths this year, most non-spouse beneficiaries of tax-deferred retirement accounts must distribute — and pay tax on — the entire balance within the following decade. This may make Roth IRA conversions in 2020 especially attractive as the account that’s eventually inherited can escape income tax upon withdrawal, even if the beneficiary has seen the account grow significantly.
“Roth conversions should be considered if this is a low-income year for the client,” says Clarissa Hobson, advisor, CFP and director of financial planning at Transform Wealth in Greenwood Village, Colorado.
Hobson says that income tax rates in effect for 2020 are relatively low, so clients might be able to move money from pretax to after-tax territory at tax rates of 24%, 22% or even 12% if the COVID-19 crunch has resulted in sharply lower reported income this year.
Moreover, tax rates might rise sharply in the future, especially for high earners. “For those likely to be impacted, it may make sense to accelerate some income into 2020,” she says. “And acceleration strategies may include Roth conversions.”
The legislative parlay that produced the SECURE Act was filled out with passage of the CARES Act in March. This law includes permission for “qualified individuals” — those whose health or finances have been impacted by COVID-19 — to take penalty-free distributions up to $100,000 from their retirement accounts this year, regardless of their age.
“They can spread the income tax payments over 2020, 2021 and 2022,” says Hobson. “This can help clients who think they might need funds. They also have the ability to recontribute the funds (and thus receive tax-free rollover treatment) if it turns out the funds are not needed.”
People who aren’t worried about cash flow also might benefit by acting on this CARES provision by year-end. “We have clients who are qualified individuals who will withdraw $100,000 from their IRA this year and put the money into low-dividend growth stocks,” says Alan Gassman, partner at Gassman, Crotty & Denicolo, a law firm in Clearwater, Florida.
“They will use their own other money to recontribute to the IRAs in 2022,” he says. “This way, any growth that occurs can escape being taxed at ordinary income tax rates when eventually withdrawn. For married couples, the amount withdrawn can be $200,000.”
Gassman says these clients could hold the stocks until they die. “The family probably will never have to pay tax, even at capital gains tax rates, on any appreciation.”
Assuming the growth stocks are in a taxable account and the current basis step-up rules remain in effect, heirs can inherit with a date-of-death basis and any prior gains won’t be taxed on a future sale.
The combination of two major tax laws passed within four months of each other can create some interesting puzzles for advisors to solve.
For instance, SECURE changed the starting age for required minimum distributions from 70 1/2 to 72 for people reaching age 70-1/2 in 2020 or later, but kept the age for qualified charitable distributions at 70 1/2. Then CARES waived RMDs for 2020.
Consequently, clients at least age 70 1/2 can decide whether or not to make QCDs from their IRAs in 2020, up to $100,000 per person. “This is more advantageous than taking a distribution and making a donation to charity that may or may not be deductible as an itemized deduction,” says advisor and CPA Barry Picker of Meisels Kunstler Picker & Auerbach, an accounting and wealth management firm in Cedarhurst, New York.
“A client whose itemized deductions, including the contribution, are less than the relevant standard deduction, will not receive a tax benefit by making a donation that would count as a standardized deduction,” Picker says. The tax benefit from a 2020 QCD comes from reducing money held in tax-deferred IRAs without owing income tax.
Moreover, clients who are short of cash in these pandemic times — the knockdown from the lockdown — may be able to maintain their typical donations by using QCDs if they’re in the right age range. RMDs are scheduled to return in 2021, so reducing IRA balances in 2020 without generating a tax bill also can reduce future taxable distributions.
As Picker points out, “This also may reduce adjusted gross income and, as a result, increase the medical expense deduction, reduce the taxability of Social Security income and reduce the 3.8% net investment income tax, all of which are calculated based on AGI.”
In other words, seniors who want to keep up their contributions to increasingly needy charities this year can still do well while doing good.
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