Just when you may have felt you were understanding recent changes to tax laws, a possible change in Washington may signal a change again. How exactly they will be transformed won’t become apparent for quite some time, though, which gives investors a window of opportunity to sit down now with their financial advisory team and reassess their plans.
“Clients want to be well-positioned regardless of what the outcome of the election is,” says Colleen Carcone, Director of Wealth Planning Strategies at TIAA. With tax increases possibly on the table, “we want to make sure that everyone, regardless of wealth, has a long-term plan in place. Each client’s situation is going to be different, so we suggest they meet with their advisors one-on-one to discuss their situations, their goals, and how potential outcomes may affect their long-term planning.”
In this piece, we’ll cover the following:
- How the SECURE Act has changed wealth transfer—and how additional legislation could create more changes
- What the potential end to the basis step-up means for investors and those passing on or inheriting assets
- What a change in leadership could mean for the estate tax
- Planning strategies to help you pursue your long-term goals
SECURE Act impact becomes greater if tax rates increase
A potentially higher income tax may have a more significant impact on legacy due to the Setting Every Community Up for Retirement Enhancement Act, also known as the SECURE Act, which became law in late 2019.
For years, a pillar of legacy planning, particularly for high-net-worth investors, had been the so-called stretch IRA. This estate-planning strategy allowed the growth in assets in Individual Retirement Accounts inherited by nonspouses to continue on a tax-advantaged basis, for multiple generations in some cases. Beneficiaries still had to take and pay taxes on Required Minimum Distributions from the inherited IRAs, but the younger the beneficiary, the longer the life expectancy, and the less money they had to withdraw in any given year on a percentage basis. This allowed the remainder of the inheritance to keep growing for longer without incurring a tax hit.
In late 2019, however, stretch IRAs were rendered obsolete for most when Congress passed the SECURE Act, which dictates that the inherited IRA now be emptied within 10 years for most non-spouse beneficiaries. A 50-year-old inheriting money from an 80-year-old parent, for example, will now have to draw down the inheritance within 10 years rather than over their remaining 34-year life expectancy. Because RMDs are taxed as ordinary income, someone in their prime earning years may end up paying more in taxes.
Add in the potential that tax rates on ordinary income may increase, either because of political will or in order to pay for coronavirus-related economic stimulus packages, and the SECURE Act has “fundamentally changed” legacy planning, says TIAA Wealth Management Advisor Daniel Soo.
“A lot of the strategies that made sense in the past don’t make sense anymore,” he says. “Some clients are significantly concerned about potentially higher tax rates on a go-forward basis and are taking steps to lock in today’s tax rates.”
In response to the SECURE Act, many people have looked to other strategies to enhance their legacy goals. For example, converting a traditional IRA to a Roth IRA shifts the income tax burden to you and away from your heirs. Alternatively, funding a life insurance policy is another way to pass on a sizeable income tax free death benefit to your beneficiaries. For more information about planning in a post-SECURE Act world, see the TIAA analysis of strategies.
Capital gains on inherited wealth and the estate tax
One proposal that has been floated by the campaign of Democratic presidential nominee Joe Biden has been to change the way that capital gains are treated on inherited assets. Currently, there is what’s called a “step-up in basis” when an asset is passed down. So, if someone purchased a stock at $5 a share and it was worth $50 per share when it was passed down at the person’s death, the inheritor’s cost basis would be $50 per share. That means if they later sold the stock at $60 per share, they would only pay capital gains on the $10 per share increase since they inherited it.
The Biden plan considers eliminating that, which means the heirs of assets that have greatly appreciated over time could have a larger tax bill to pay when they sell those assets.