Estate Planning in 2010
There are several important tax matters to consider as we enter the New Year. The first is whether to convert your taxable Individual Retirement Account to a tax-free Roth Individual Retirement Account and the second issue is how to deal with the uncertainty over the estate tax.
Beginning this year, there is no longer an income limit for a Roth I.R.A. which will allows one to contribute after-tax income that can appreciate without any further income tax. Previously, the income limit was $100,000 a year for individuals. The question is whether it makes sense to convert an existing I.R.A., the proceeds of which are taxed when distributed, into a tax-free Roth I.R.A., the proceeds of which are not taxed when distributed. If an existing I.R.A. lost significant value recently, it may be prudent to withdraw the money, pay tax on that amount and then put the funds back into a Roth I.R.A. For those who do not see themselves falling into a lower income tax bracket at retirement or who believe tax rates will rise significantly, this could be a shrewd move. Significant benefits will accrue to those who plan to pass their Roth I.R.A. onto their heirs. And unlike regular retirement accounts, there is no minimum distribution requirement with a Roth I.R.A. and the tax-free treatment of its assets can be passed to your heirs.
As has been widely reported, Congress adjourned without making any changes in the estate tax law. This means that the estate tax has, at least for now, disappeared for 2010 before reverting in 2011 to the old rate of 55% for estates with more than $1 million. As of this writing, it is unknown whether Congress will pass a law in the upcoming year and if so, whether it will be retroactive (and whether that will be constitutional). The estate tax repeal, even if it does happen, comes at a cost. Previously, when a person died the value of his or her assets gets a "step-up in basis" which means that for tax purposes, the assets are valued on the date of death. Without an estate tax, this provision disappears and the appreciated value is subject to capital gains tax. To complicate matters, current law grants a $1.3 million "artificial basis" on assets of a single person and $3 million for couples if the estate tax disappears. For the rest of the assets, the heirs will have to determine what the original cost was and pay the capital gains on the appreciated amounts.
There is one important consequence of the estate tax repeal to consider which may be of importance to many families. If one has a last will and testament containing a “credit shelter trust” or “bypass trust,” this could have the unintended consequence of reducing or even eliminating what will otherwise pass to one’s spouse if death occurs this year.
Many last wills and testament establish a credit shelter trust to transfer assets equal in value to the amount exempt from estate taxes to one’s heirs. In prior years, this amount has increased from $1 million to $3.5 million in 2009. This was prudent planning at the time. Now that the federal estate tax has disappeared, at least for now, the provisions of the credit shelter trust could cause the entire estate to pass to the credit shelter trust to the possible detriment of one’s spouse.
Obviously, this uncertainty in the estate tax law is troubling to all of us and, hopefully, it will be settled before too long. In the interim, we can assist you in planning as best possible under the current circumstances.