Q1 2021 How a CRT can work as a "stretch IRA" substitute The kiddie tax: What's new is old again Strike while interest rates are low ...
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Q1 2021 How a CRT can work as a “stretch IRA” substitute The kiddie tax: What’s new is old again Strike while interest rates are low Congratulations on your windfall! Now, for the caveats LENOX ADVISORS, A LEADER IN INDIVIDUAL SOLUTIONS AT NFP.
How a CRT can work as a
“stretch IRA” substitute
Until recently, if you named someone to name a charitable remainder trust will be distributed during retirement,
other than your spouse as the (CRT) as the beneficiary of your IRA when the beneficiary’s tax rate may
beneficiary of your IRA or qualified or qualified plan. be lower. If distributions are bunched
retirement plan, that person would into a 10-year period, they may be
have the option of taking distributions SPREADING DISTRIBUTIONS received during a beneficiary’s peak
over his or her life expectancy. earning years.
Stretching distributions over a
This strategy, commonly called a
beneficiary’s life expectancy offers Following the SECURE Act,
“stretch” IRA, offered significant
two primary benefits: beneficiaries must take distributions
advantages by allowing distributions
to be spread over decades. But the within 10 years, with a few
1. It allows the funds to continue
SECURE Act of 2019 drastically exceptions. As before, spouses
growing and compounding on a
reduced these benefits (with certain may take distributions over their
tax-deferred basis for as long as
exceptions) by requiring distributions life expectancies or roll the funds
possible, and
to be completed within 10 years. over into their own IRAs and defer
2. It often results in lower overall distributions until the age of 72.
Fortunately, there are still strategies taxes on the distributions. There’s also an exception for
you can use to replicate some of the disabled or chronically ill individuals
benefits of a stretch IRA. If you’re Stretching out distributions means or trusts for their benefit. Minor
charitably inclined, one approach is that a significant portion of the funds children may stretch distributions
2 | WEALTH MANAGEMENT ADVISOR
over their life expectancies until they percentage of the trust’s initial value However, under IRS guidelines,
reach the age of majority. But once (a charitable remainder annuity trust, the actuarial value of a charitable
they’re adults, the balance must be or CRAT). Or it may be based on a beneficiary’s remainder interest
distributed within 10 years. fixed percentage of the trust’s value, must be at least 10% of the trust’s
recalculated annually (a charitable initial value. The need to preserve a
USING A CRT remainder unitrust, or CRUT). CRUTs minimum value for charity can restrict
generally are preferable because the length of the trust term or the
If your intended beneficiary doesn’t
making annual recalculations allows size of payouts. This mandate may
fall within one of the exceptions,
payouts to keep pace with inflation even make it impossible to establish
naming a CRT as beneficiary of your
and ensures the funds will never a CRT for the life of certain younger
IRA or qualified plan can provide
be exhausted. beneficiaries.
some of the benefits of a stretch
IRA — assuming it’s structured
IRS GUIDELINES WEIGH YOUR OPTIONS
properly. A CRT is an irrevocable
trust that distributes a percentage of Because a CRT is a tax-exempt entity, A CRT can be a viable substitute
its assets to one or more individual the funds aren’t taxed until they’re for a stretch IRA, particularly if your
beneficiaries for life or a term of up distributed to your noncharitable beneficiary is expected to live a
to 20 years. After that, the remaining beneficiaries. If payouts from the long time. To determine whether a
assets go to charity. CRT are spread out over a 20-year CRT is right for you, work with your
term or a beneficiary’s lifetime, a Lenox Advisor along with your tax
The percentage distributed can CRT can, when structured properly, and estate planning professionals to
range from 5% to 50%, and annual provide benefits similar to that of a weigh the costs against the potential
payouts may be based on a fixed stretch IRA. benefits of stretching distributions
well beyond 10 years.
The kiddie tax: What’s new is old again
In late 2019, Congress reversed need to understand
significant changes to the federal the impact of the
“kiddie tax” that it had made only kiddie tax in its
two years before. Previously, the current form. Also,
kiddie tax applied the parents’ if you made gifts in
marginal tax rate to a child’s 2018 or 2019 and
unearned income in excess of a calculated kiddie tax
certain threshold ($2,200 in 2020). on your children’s
But the Tax Cuts and Jobs Act (TCJA) returns under the
made that income subject to the TCJA rules, you
tax rates for trusts and estates, might want to amend
starting in 2018 — thus pushing those returns. Here
some children into a higher tax are the details.
bracket than their parents.
DISINCENTIVE FOR
However, more recent legislation INCOME SHIFTING
(the SECURE Act) restored pre-TCJA
rules. If you’re contemplating a Established in 1986,
financial gift to your children, you the kiddie tax was
WEALTH MANAGEMENT ADVISOR | 3
designed as a disincentive to
income shifting by parents who,
to reduce their tax bills, transfer
SHOULD YOU AMEND YOUR
income-producing assets to their
children in lower tax brackets.
CHILDREN’S RETURNS?
By taxing a child’s unearned If your children paid kiddie tax in unearned income, the TCJA rules
income over a specified threshold 2018 or 2019, filing an amended may produce tax savings.
($2,100 in 2018 and $2,200 return could be beneficial.
in 2019 and 2020) at the Taxpayers may apply the Tax Suppose, for example, that in
parents’ marginal rate, the kiddie Cuts and Jobs Act (TCJA) rules 2018 a married couple in the
tax essentially eliminated the or pre-TCJA rules for those years 32% tax bracket gave their child
advantages of income shifting. In (see main article). Even though the an investment that earns ordinary
other words, except for a small SECURE Act was passed before income. Using pre-TCJA rules,
amount taxed at the child’s rate, the 2019 filing deadline, most unearned income beyond the
most of the income was taxed as tax software programs calculated $2,100 threshold would be taxed
if a transfer hadn’t been made. kiddie tax for 2019 under the at 32%. But using TCJA rules, it
TCJA rules. would be taxed according to the
Originally, the kiddie tax applied trust and estate rates as follows:
to children under 14, but in 2007 To determine whether you should
the age threshold was raised to file amended returns, your tax • Up to $2,550, 10%,
19 (24 for full-time students) as of advisor can calculate your child’s • The next $6,600, 24%,
the last day of the tax year. The tax liability under both sets of
tax doesn’t apply to children who • The next $3,350, 35%, and
rules. Many families find that
are married and file joint returns they’re better off using the pre- • Any income above $12,500,
or are 18 or older with earned TCJA rules and that it would pay 37%.
income that exceeds half of their to amend returns that followed
living expenses. the TCJA rules. But the TCJA rules So, depending on the amount
don’t always result in higher taxes. of income, the TCJA rules may
HARSH CONSEQUENCES At lower levels of your child’s save taxes.
By imposing kiddie tax at trust
and estate rates, the TCJA over $12,500. Long-term capital would be taxed at 37% for ordinary
created some harsh outcomes. That’s gain income over $12,700 was income and short-term capital gains
because for trusts and estates, the subject to 20%. In contrast, and 20% for long-term capital gains
highest marginal rates kick in at very the thresholds for married couples and qualified dividends. The married
low income levels. For example, in filing jointly were $600,000 for couple would have been taxed at
2018, trusts and estates were subject ordinary income and $479,000 for rates of 24% and 15%, respectively,
to the highest rate, 37%, on ordinary long-term capital gain and qualified on the same income.
income or short-term capital gains dividend income.
The TCJA kiddie tax was particularly
Say a married unfavorable for children of deceased
couple with military personnel, first responders
$250,000 in taxable and emergency medical workers
income made a who received certain government
substantial gift of benefits. Because these benefits
income-producing were considered unearned income,
assets to their child they were taxed at rates as high
in 2018. Income as 37%, even if the surviving
that exceeded parent was in a lower bracket,
the $12,500 and such as 22% or 24%.
$12,700 thresholds
4 | WEALTH MANAGEMENT ADVISOR
To avoid such unintended PLANNING FOR THE FUTURE Alternatively, you could make gifts
consequences, the SECURE Act that won’t — or are less likely to —
Before you make financial gifts to
reinstated the pre-TCJA kiddie trigger the tax, such as growth (as
your children, consider the impact
tax rules, effective for tax years opposed to income) investments,
of the kiddie tax. The SECURE Act
beginning in 2020. It also gave tax-exempt or tax-deferred bonds,
made the tax more palatable than
families the option of applying the and contributions to Sec. 529
it was, but it still could thwart your
old rules on their 2018 and 2019 college savings plans. Talk to your
tax-planning goals. For children
returns. (See “Should you amend Lenox Advisor and tax professional
subject to kiddie tax, you might
your children’s returns?”) to explore options that make the
consider postponing gifts until
most sense given your family’s
they exceed the age thresholds.
circumstances.
Wealth transfer strategies
Strike while interest rates are low
Low interest rates create attractive
opportunities to transfer wealth
to younger generations in a tax-
advantaged way. Shifting wealth
may seem less urgent now that the
federal gift and estate tax exemption
and the generation-skipping transfer
(GST) tax exemption amounts
are both $11.7 million in 2021
($23.4 million, effectively,
for married couples). But these
exemptions are scheduled to
revert to previously lower levels
in 2026 — or earlier if a new
administration or Congress decides
to reduce them sooner.
The future of federal transfer taxes
and the fact that this is an election
year suggest that you might want GRATS A GRAT is an irrevocable trust that
to consider gifting strategies that pays you, as grantor, an annuity
A properly structured grantor
lock in current exemption amounts. (a periodic fixed dollar amount)
retained annuity trust (GRAT) can
Another advantage of acting now is for a term of years and then
be a powerful tool for transferring
that certain estate planning strategies distributes the remaining assets
wealth to your loved ones with little
benefit from the current low interest to your beneficiaries. When you
or no taxes while continuing to enjoy
rate environment. We discuss several transfer assets to a GRAT, the value
an income stream for a period of
general strategies you might consider of the gift to your beneficiaries is
years. It’s particularly effective if
with your Lenox Advisor. equal to the projected value of their
done when interest rates are low.
WEALTH MANAGEMENT ADVISOR | 5
remainder interests. Under IRS rules,
that value is calculated by assuming
the GRAT assets will grow at a
SELLING A BUSINESS TO AN IDGT
certain rate of return — known as the
Do you own a business? Selling it So long as the transaction is
“Section 7520” rate — regardless of
to a properly structured intentionally structured as an installment sale
their projected or actual growth rate.
defective grantor trust (IDGT) for the for fair market value, transferring
Assuming you survive the GRAT’s
benefit of the younger generation your business to the trust doesn’t
term, any appreciation in asset
may enable you to retain control trigger gift taxes. Typically, at least
values beyond the Section 7520 rate
of the company while taking 10% of the sale price is provided
(also known as the “hurdle” rate) is
advantage of low interest rates. as “seed” money to the IDGT. If
transferred to your beneficiaries free
An IDGT is an irrevocable trust your business generates a higher
of gift and estate taxes.
structured so that contributions are rate of return than the interest
The hurdle rate for a GRAT is treated as completed gifts for gift payments on the installment sale,
the published Sec. 7520 rate for tax purposes even though the trust that excess constitutes a tax-free
the month in which the GRAT is is considered a grantor trust for transfer to the trust.
established. In recent months that income tax purposes.
rate has dropped to well under 1%.
The lower the rate, the more likely beneficiaries, and the value of the enjoy deductions for the amounts
the GRAT will outperform it and, gift is determined in much the same paid to charity.
therefore, the larger the potential way. So the lower the hurdle rate,
tax-free gift. An additional benefit the larger the potential tax-free gift. INTRAFAMILY LOANS
of a GRAT is that it’s considered
a “grantor trust” — that is, you as The income tax treatment of a CLAT Loaning money to a family
grantor are treated as its owner for depends on whether it’s structured as member is another possible
income tax purposes. By paying a grantor or nongrantor trust. If it’s option. To avoid future conflicts or
the trust’s income taxes, rather a grantor trust, you’re entitled to a misunderstandings — not to mention
than having them come out of the charitable deduction up front based negative tax consequences — make
trust’s earnings, you essentially on the present value of the annuity sure you document these loans.
make additional tax-free gifts to payments. But this deduction is
So long as your loan is structured
your beneficiaries. Note that, if the essentially recaptured in future years
carefully and you charge at
grantor dies during the GRAT term, as you pay taxes on the CLAT’s
least the applicable federal rate
the assets will be included income. For this reason, CLATs are
(AFR) of interest, it’ll generally
in the grantor’s estate for estate typically structured as nongrantor
be respected by the IRS. If your
tax purposes. trusts, in which the trusts themselves
borrower earns a rate of return on
are taxed on their income but also
the borrowed funds that’s higher
CLATS
than the AFR you charge, then the
A charitable lead difference between those returns and
annuity trust (CLAT) the interest paid to you constitutes a
works like a GRAT, tax-free gift.
except that the
annuity payments are AN IDEAL TIME
made to a charity
Current conditions make it an ideal
rather than to you.
time to take advantage of GRATs,
Like a GRAT, a
CLATs and intrafamily loans, but
CLAT transfers assets
it’s important to act soon. If interest
remaining at the
rates rebound, these strategies may
end of the trust term
become less effective.
to your children or
other noncharitable
6 | WEALTH MANAGEMENT ADVISOR
Congratulations on your windfall!
Now, for the caveats
Most Americans would welcome a soon as you receive it. Then let it sit means retiring early, starting
financial windfall. But receiving an there until you identify your goals — a business or something else. Until
inheritance, legal settlement or prize for example, for retirement or your you have a solid handle on the
winnings can be a mixed blessing. children’s education — and develop amount available after taxes and
For example, managing the money a plan. Waiting at least a month debt, you’ll probably want to keep
might require financial knowledge before you touch the money can working. Few windfalls are large
and experience you don’t have. help prevent impulse buys and other enough to see anyone all the way
Without a comprehensive plan mistakes you later regret. through retirement.
that takes into account your current
situation and future goals, you might Also realize that you may owe Finally, a word of warning: Be
quickly run through the money and taxes. Some windfalls, such as careful when asked for money.
be left with nothing to show for it. lottery winnings and certain legal Friends and family members
settlements, are subject to federal may expect to share in your
AVOIDING MISTAKES tax — as much as 37% federal tax bounty or may pitch “sure-fire”
if your windfall pushes you into the investment opportunities. Charitable
There are plenty of traps lying in top income tax bracket. State and organizations may ask for donations.
wait for people who receive a local taxes may apply as well. A tax The ability to support loved ones
sudden and sizable influx of cash. professional can help you determine in need or charitable causes is a
For example, fraudulent charities what you owe. real benefit of receiving a windfall.
may come knocking. Or you may At the same time, if you agree to
be tempted to immediately buy every request, you’ll quickly deplete
BEST PRACTICES
an expensive new car or luxury the funds. And if you give to every
vacation. Avoid these potential What you eventually decide to do
charity that contacts you without first
pitfalls by stashing your windfall in with your windfall depends on many
vetting the organization, you could
a bank or money market account as factors. But if you have certain types
end up a fraud victim.
of debt, you’ll probably
want to make that your
REWARD YOURSELF
top priority, especially if
it carries a high interest You’re only human, so it’s ok to
rate and the interest buy something small — particularly
isn’t deductible. Also, something you really need — to
establishing or boosting recognize your good fortune. Just
your emergency savings be sure to remember that your
can minimize the need windfall could help you achieve
to incur future debt. goals you once thought were out
of reach. To keep that dream
Next, consider where alive, contact your Lenox Advisor
you’d like to be five, as soon as possible. Your advisor
10 or 20 years into can suggest possible strategies
the future. Develop a to protect and grow your money
budget that will help and help you build a plan
you move toward your around them.
goals — whether that
WEALTH MANAGEMENT ADVISOR | 7Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC,90 Park Ave. 17th Floor, New York, NY 10016, 212.536.6000. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Lenox Advisor, Inc., its employees, or representatives are not authorized to give legal or tax advice. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal tax or legal counsel. CRN202301-276478
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