As shown by the recent kerfuffle over the death of the stretch IRA, the IRS' controversial interpretation of the rules around its death, and the penalty relief extended late last week to IRA beneficiaries who have not complied with that interpretation, tax planning strategies are ever-changing.
1. Change in Tax Laws Is Constant, but Best Practices Are Fixed
Steffen says the first key lesson to understand about tax issues is that they are always changing, with the result being that tax planning is, generally speaking, best done over a shorter time frame compared with the long-term nature of the typical client's overall financial plan.
"There is no such thing as a permanent tax law," he says. "Change is just such a constant in this field."
As an example, Steffen points to the evolution in tax rates seen in the past five years, thanks mostly to the passage of the Tax Cuts and Jobs Act of 2017. That law substantially changed key rules for deductions, depreciation, expensing, tax credits and other tax items that affect all sorts of businesses and individuals.
At this stage, Steffen says, the TCJA-based changes are relatively well appreciated by clients and advisors. However, the cuts are set to expire in 2025, barring further congressional action.
"At this point, it's basically impossible to guess what is going to happen to tax rates beyond 2025, and that means we have to just focus on what we know today and plan accordingly," Steffen explains.
Steffen says it is rational, from a historical perspective, to assume that tax rates are likelier to go up in the future than down, but by how much and when is anyone's guess.
"What we can say confidently is that we are experiencing relatively low tax rates right now from a historical point of view, and that is true both for ordinary income and for capital gains," Steffen points out. "We can also be confident that the rates will continue to ebb and flow over time. It tends to be cyclical."
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2. Tax Issues Present Emotional Hurdles for Clients
For a variety of complicated and interrelated reasons, tax changes have a unique impact on people, Steffen says.
"Clients simply react differently to learning about new tax liabilities than they do to many other challenges," he says. "I think this is largely because people find it harder to see the tangible impact of their paying taxes."
Tax issues can also call to mind clients' deeply held political views, adding another layer of complexity to the puzzle. For their part, advisors can do a lot to help their clients keep taxation issues in perspective.
As a case in point, Steffen points to the fact that many clients in certain regions of the country felt a sense of dread or panic when they learned that there would be a new, substantially lower cap instituted at the federal level on state and local tax (SALT) deductions as part of the Tax Cuts and Jobs Act.
Steffen notes that many clients with this concern overlooked the fact that, in their particular situation, the overall reduction in tax levels would more than make up for the loss of the specific SALT deduction.
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3. Loss of Stretch IRAs Is a Genuine Planning Challenge for HNW Clients
Though the policy change happened nearly three years ago, Steffen says, the elimination of the stretch IRA continues to be an important point of focus when factoring taxes into clients' financial plans.
"The big thing a lot of tax-conscious advisors are focusing on right now is what is going on with the new 10-year window for distributing inherited IRAs," Steffen notes. "Under the current framework, most beneficiaries, not including spouses, have to distribute the value of the IRA within 10 years."
In many cases, Steffen says, this new framework will mean that clients face a bigger tax burden.
"You have to be prepared to have that tough conversation because, in most cases, the client and their heirs are going to pay more taxes because of this," Steffen says. "You can't avoid that basic fact, but you can take steps to mitigate that loss, depending on the client's unique situation."
Steffen says one key challenge is that it has been unclear whether a client must start taking distributions in the first year after the original IRA owner's death, or if it would be possible to backload the distributions in the 10-year window.
The confusion surrounds those beneficiaries who inherited an IRA in 2020 or later and were subject to the 10-year rule, where the entire inherited IRA balance would have to be withdrawn by the end of the 10th year after death.
In regulations proposed earlier this year, the IRS says that if these beneficiaries inherited from someone that was already taking required minimum distributions, then not only are they subject to the 10-year rule, but they will also be required to take RMDs for years one through nine after death.
Steffen says the required distributions in years one through nine may disadvantage those IRA inheritors who are near their own retirement, as it would make sense for many of these people to back-load the distributions until they stop generating their own income.
Under the proposed regulations, it appears this backloading won't be possible in cases where the IRA owner had already initiated RMDs, but a newly published IRS notice provides helpful relief by establishing that the normal 50% penalty for missed RMDs will not apply to such beneficiaries for 2021 and 2022. The IRS says it will finalize these regulations soon.
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