As 2018 gets going and the recently passed new tax rules apply, I’m considering how things will play out. The new tax law is a veritable smorgasbord of new rules, some with far reaching impacts.
The increase in the lifetime estate exemption amount from $5.6mil to $11.2mil per person ($22.4mil per couple) is just such a game changer for many high net worth clients. This new, higher exempted amount has a sunset provision to limit its effects after 2025. Yet, with the exemption amount having risen multiple times in the past decade, the original $600k exemption from a decade ago is nearly twenty times that today. The direction is clear toward larger exempted amounts, and, as is often the intent, the backlash from taking away a benefit in the future sometimes results in a permanent codification. This happened when IRA gifts to charity (capped at $100,000 annually) became a temporary provision that renewed year after year, until it too was codified as permanent in 2015.
The moral of the story is that some high net worth investors may now find less motivation to do a Roth conversion on a traditional IRA. Up until now, one of the primary drivers of our advice to clients in recommending a Roth conversion had been the estate planning benefits. Roth IRAs use after-tax dollars to compound to a tax-free value in the future.
This is somewhat inverse to an IRA which uses pre-tax dollars to compound to larger, but taxable value later. The tax code has a weird provision that allows IRAs for wealthy people to get taxed twice. That’s because the deferred income tax liability inside an IRA is included in an estate’s value at the death of the second spouse. This would expose the IRA to ordinary income tax on the entire value and at the same time expose the full value to estate taxes. A million-dollar IRA in a $12 million (combined) estate was at risk of losing 80% of its value to the two taxes. A conversion to Roth prior to the second spouse’s death would expose the conversion to taxation now with tax-free accumulation going forward. While people are normally prewired to defer tax at any length, clearly paying the conversion tax would reduce an estate’s size by the amount of the tax paid prior to death. This would have the effect of reducing the estate tax then due at death since the already-paid tax would be out of the estate, in contrast to the untouched IRA having more value at twice the tax liability. With the exemption now raised to over $22 million per couple, you can see how wide swaths of investors are outside a reasonable “harm’s way” calculation for estate tax liability. Roth conversions can still make sense for a multitude of reasons, but clearly estate taxes on joint property under $22.4 million is no longer one of them.
Please give us a call if you need clarification on where you stand with the 2018 tax changes at 713-800-7150, or check with your tax professional.
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