Should elderly clients always defer income taxes?

In most situations, tax practitioners advise their clients to defer income taxes. However, with corporate and personal graduated tax rates and higher estate tax rates, it is often wiser for elderly clients to recognize income currently, rather than deferring it to future years.

Timing of Distributions

The first situation involves timing distributions taken from regular IRAs. In many situations, clients are advised to take only the minimum required distribution from a regular IRA on reaching age 70 1/2. Clients are also advised to have their IRA contracts written so that their minimum annual distributions are computed over joint life expectancies with their spouse, to have life expectancy factors recalculated each year and to use any other options that would result in the lowest required annual distributions.

Although these provisions should remain in IRA contracts, there is no penalty for withholding more than the minimum annual distribution. In fact, with graduated personal income tax rates and higher estate tax rates, it is often wiser to distribute more than the minimum annual distribution. For example, when the imposition of estate taxes is not far off, elderly clients should take more than the minimum annual distribution if they have not taken full advantage of their lower personal income tax brackets. Because personal income tax on a regular IRA distribution must be paid eventually, by the client or his beneficiaries, the personal income tax liability could be reduced if the annual distributions during the client's life were increased to take full advantage of his lower personal income tax rates. In addition, because the prepayment of taxes reduces the value of the client's estate, his net worth would be lower, thus reducing potential estate tax.

Converting to a Roth IRA

The second situation involves the conversion of a regular IRA to a Roth IRA. Because a client or his beneficiaries must eventually pay personal income tax on a regular IRA distribution, the decision to convert a regular IRA to a Roth IRA is currently an effective tax strategy; prepaying taxes reduces the value of the client's estate, thus reducing the potential estate tax. In addition, on distribution of the Roth IRA to the client's beneficiary, no income tax is due; the Roth IRA grows tax-free. Although the current payment of personal income taxes reduces the amount available to reinvest, the benefit of the reduction of estate taxes often exceeds the loss in the amount available to invest, especially when the imposition of estate taxes is near.

PHCs

The final situation involves a personal holding company (PHC) owned by an elderly client with significantly appreciated securities. Elderly clients are more likely to have a PHC because they have often retired and are no longer operating an active business. If a client's beneficiaries intend to liquidate the PHC after the client's death, it is wise for the PHC to begin selling a portion of the appreciated securities each year during the client's remaining life.. By selling a portion of the appreciated securities each year, the PHC can take advantage of the 15% and 25% corporate income tax brackets in years that they are available. If the appreciated securities are not sold each year, the PHC's liquidation would probably occur in one year and the gain on the sale or transfer of the entire portfolio would probably be taxed at an average corporate income tax rate of 35%.

The tax savings depend on the years remaining until liquidation of the PHC, the level of the PHC's ordinary income and the appreciation in the securities. If (1) the PHC's average ordinary income after the dividends-received deduction is $10,000 per year, (2) the years remaining until its liquidation is five and (3) the securities have a total appreciation of $200,000, the PHC could save approximately $34,800 in corporate income taxes and estate taxes by selling an equal portion of the appreciated securities each year (see Exhibit 1). The estate taxes would be reduced, because the prepayment of corporate income taxes reduces the PHC's value for estate tax purposes.

Exhibit 1: Appreciated Securities

Assumptions:

  Average ordinary income: $10,000 per year
  Remaining years until liquidation of the
    corporation: 5 years
  Average gain on securities sold each year:
    $40,000 per year
  Total expected appreciation/gain: $200,000

Selling an equal portion of appreciated securities
    each year:
  Gain per year                                           $40,000
  Incremental corporate income tax rate                       15%
  Additional corporate income taxes per year               $6,000
  Present value of tax payments; 5 payments, 8%           $24,000

Appreciated securities sold or transferred at
    liquidation of corporation:
  Total appreciation/gain                                $200,000
  Average corporate income tax rate                           35%
  Total corporate income taxes                            $70,000
  Present value of tax payment; 1 payment, 8%             $47,700

Overall corporate income tax savings:

  $47,700 - $24,000                                       $23,700

Estate tax savings based on minimum estate tax rate
    after considering unified credit ($6,000 per year
    for five years):
  $30,000 x 37%                                           $11,100

Total corporate income and estate tax savings:            $34,800

If the PHC does not want to disturb its investment portfolio, the appreciated securities could be repurchased immediately; there are no tax consequences, because the wash sale rules apply to recognized losses, not gains. Tax practitioners often recommend to their clients that they defer taxes as long as possible. However, as is illustrated, it may often be wiser for elderly clients to recognize income currently. With corporate and personal graduated tax rates and higher estate tax rates, tax practitioners may want to advise their clients to pay taxes earlier rather than later.

FROM PHILLIP J. KORB, MBA, MS, TAXATION, CPA, AND THOMAS E. VERMEER, PH.D., CPA, UNIVERSITY OF BALTIMORE, BALTIMORE, MD (NEITHER AFFILIATED WITH GRANT THORNTON LLP)