Estate planning Category
Dear Liz: I am a CPA and fairly knowledgeable about investing, but I have a question about my IRAs. I am 58 and my husband is in his mid-80s. We both are retired with federal pensions and no debt other than a mortgage. My plan is to start taking money annually from my traditional IRA in two or three years. I want to reduce the required minimum distribution I will need to start taking at age 701/2 and lessen the tax impact at that time. Should I put these annual withdrawals in my regular investment account or should I put them in the Roth IRA? My goal is to lessen the tax impact on my only child when he ultimately inherits this money. Does my plan make sense?
Answer: Your letter is proof that our tax code is too complex if it can stymie even a CPA. Still, it’s hard to imagine any scenario where you’d be better off accelerating withdrawals from an IRA and putting them in a taxable account.
A required minimum distribution “is merely a requirement to take the money out anyway,” said Certified Financial Planner Michael Kitces, an expert in taxation. “All you’re doing by taking money out early to ‘avoid’ an RMD [required minimum distribution] is voluntarily inflicting an even more severe and earlier RMD on yourself.”
In other words, you’d be giving up future tax-advantaged growth of your money for no good reason.
What might make sense, in some circumstances, is moving the money to a Roth. You can’t make contributions to a Roth if you’re not working, because Roths require contributions be made from “earned income.” What you can do is convert your traditional IRA to a Roth, either all at once or over time. You have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions. Whether you should convert depends on a number of factors, including your current and future tax rates and those of your child.
“In other words, if your tax rate is 25% and your child’s is 15%, just let them inherit the [traditional IRA] account and pay the lower tax burden,” said Kitces, who has blogged about the Roth vs. traditional IRA decision at http://www.kitces.com. “In reverse, though, if the parents’ tax rate is lower … then yes, it’s absolutely better to convert at the parents’ rates than the child’s. In either scenario, the fundamental goal remains the same — get the money out when the tax rate is lowest.”
If you do decide to convert, remember that the conversion itself could put you in a higher tax bracket.
“It will be important not to convert so much that it drives up the tax rate to the point where it defeats the value in the first place,” Kitces said. “Which means the optimal strategy, if it’s to convert anything at all, will be to do partial Roth conversions to fill lower tax brackets but avoid being pushed into the upper ones.”
Dear Liz: My partner passed away a little more than a year ago. I inherited his 401(k) and life insurance. I opened an IRA in which to place the amount of the 401(k), but the company told me that after a year (which is now), I have to withdraw the money over five years. Is that really required? I’d like to be able to have it on hand in case of an emergency but at the same time save it for our 2-year-old son’s college education.
Answer: Since you weren’t married, you don’t have the option of treating this inherited account as your own. That would have allowed you to delay withdrawals until after you turned 70 1/2 , if you wanted.
The fact that this is a non-spouse inherited IRA, however, doesn’t necessarily mean you’re bound by the five-year rule. That rule requires the IRA be distributed by Dec. 31 of the fifth year following the year of the original retirement account owner’s death. You may also have the option of beginning distributions based on your life expectancy. That would allow the bulk of the money to remain in the IRA, continuing to earn tax-deferred returns, and is usually a better choice.
Whether you have this second option depends on the terms of the IRA and the original 401(k) plan.
“It is important to check the IRA terms rather than rely on oral statements since the five-year option may be pushed when it is not required,” said Mark Luscombe, principal analyst for CCH Tax & Accounting North America. “It is also important to make a determination on the availability on the life-expectancy rule in the year after death since distributions must start under the life-expectancy rule in that year. Waiting too long could force one into the five-year rule by default.”
Dear Liz: My father passed away two years ago and my mother recently died as well. I will be getting about $50,000 from the sale of their house. Everyone tells me the tax on this will be very high, so I need advice about how not to give my parents’ money to the government. Their grandchildren should be able to see a legacy of their grandparents.
Answer: You need to stop listening to “everyone,” since these people clearly don’t know what they’re talking about.
You have to be pretty rich to worry about estate taxes these days. The money you inherit wouldn’t be subject to federal estate taxes unless your parents’ estates exceeded the federal exemption limit (which is currently more than $5 million per person). Some states have lower limits and a few have “inheritance taxes,” which base the tax rate on who is inheriting (spouses are typically exempt, and lineal descendants such as children pay a lower rate than others).
The vast majority of inheritors, however, won’t face any of these taxes. You should check with a tax pro, but chances are good your inheritance won’t incur a tax bill and you’ll be able to pass the entire amount along to your children without taxes as well if you wish.
Dear Liz: I have three credit cards that are in my name only, plus a small loan at my credit union. My husband did not sign for any of these, nor does he know the extent of my debt, which is about $10,000. If I should die before I can get them paid off, will he be responsible for my debt?
Answer: Your debts become an obligation of your estate when you die. That means creditors will be paid out of the assets you leave behind. The extent to which creditors can make a claim on jointly owned assets — such as, say, your home — varies by state. In a community property state such as California, debts are generally considered owed by both people in a marriage, so a jointly owned home would be fair game. In other states, creditors could go after assets co-owned by your husband if the debts were incurred to benefit you both.
That’s not the only reason secret debts are a bad idea. Every day you hide these debts, you’re lying to your spouse about your true financial picture, both as an individual and a couple. Even if you keep your financial accounts strictly separate, you should have a clear idea of each other’s assets and obligations so you can plan your future together.
If you’re keeping mum because you’re worried your spouse will get violent, call the National Domestic Violence Hotline at (800) 799−SAFE (7233) for advice and help.
Otherwise, it’s time to come clean so that the two of you can work out a plan to pay off your debt and prevent you from incurring more.
Dear Liz: My father-in-law’s spouse recently died. He is 89 and not in very good health. He has assets of about $3 million and lives in a state (Pennsylvania) that has an inheritance tax. What can he do to avoid state taxes and make sure his assets go where he wants them to go? He does not like to talk about these things but I’m trying to help. I have no interest in benefits to myself but I would hate to see his assets go to the state.
Answer: It’s one thing to encourage a parent or in-law to set up estate documents that protect them should they become incapacitated. Everyone should have durable powers of attorney drawn up so that someone else can make healthcare and financial decisions for them if they’re unable to do so.
It’s quite another matter to urge a potential benefactor to make sure the maximum amounts possible land in inheritors’ laps, especially if he or she doesn’t want to discuss the matter. You may need to accept that not everyone is interested in minimizing taxes for his heirs. Your father-in-law’s resistance to talk about these things is a good indicator that you should back off.
It’s not as if the majority of his assets will wind up in state coffers anyway. Although Pennsylvania is one of the few states that has an inheritance tax, the rate isn’t exorbitant for most inheritors. (Unlike estate taxes, which are based on the size of the estate, inheritance taxes are based on who inherits. Your father-in-law doesn’t have to worry about estate taxes, since the federal exemption limit is now over $5 million and Pennsylvania doesn’t have a state estate tax.) In Pennsylvania, property left to “lineal descendants” — which includes parents, grandparents, children and grandchildren — faces tax rates of 4.5%. The tax rate is 12% for the dead person’s siblings and 15% for all others. Surviving spouses are exempt.
If he were interested in reducing future inheritance taxes, your father-in-law could move to one of the many states that doesn’t have such a tax. He also could give assets away before he dies, either outright or through an irrevocable trust. He may not be interested in or comfortable with any of those solutions. If he is, it’s up to him to take action. If he needs help or encouragement, let your wife or one of her siblings provide it. In estate planning matters, it’s usually best for in-laws to take a back seat.
Dear Liz: Could you advise us on how to protect our 93-year-old mother’s assets if she should become ill or die? She does not have a living will or a trust regarding her two properties.
Answer: “If” she should become ill or die? Your mother has been fortunate to have had a long life, presumably without becoming incapacitated, but her luck can’t hold out forever.
Your mother needs several legal documents to protect both herself and her assets. Perhaps the most important are powers of attorney for healthcare and for finances. These documents allow people she designates to make medical decisions and handle her finances for her should she become incapacitated. In addition, she may want to fill out a living will, which would outline the life-prolonging care she would and wouldn’t want if she can’t make her wishes known. (In some states, living wills are combined with powers of attorney for healthcare, and in others they are separate documents.)
These legal papers aren’t important just for the elderly, by the way. You should have these too, since a disabling illness or accident can happen to anyone.
Your mother also should consider a will or a living trust that details how she wants to parcel out her estate to her heirs. Of the two documents, wills tend to be simpler and cheaper to draft, but a living trust means the court process known as probate can be avoided. The probate process is public, and in some states (particularly California) it can be protracted and expensive. A living trust also could make it easier for someone to take over managing her finances in case of incapacity or death.
You can find an attorney experienced in estate planning by contacting your state’s bar association. Expertise and competence are important, so you may want to look for a lawyer who is a member of the American College of Trust and Estate Counsel, an invitation-only group that includes many of the best in this field.
If she or you are trying to protect her assets from long-term care or other medical costs, you’ll need someone experienced in elder care law to advise you. You can get referrals from the National Academy of Elder Law Attorneys at http://www.naela.org.
Dear Liz: You recently wrote about potential capital gains on the sale of a property that was a gift from the parents (“Gifting home creates unnecessary tax bill“). The husband of the seller made $75,000 a year in income and the seller didn’t work. Isn’t it true that if his taxable income remains in the 15% bracket (taxable income of $70,700 or less), they would owe no capital gains tax, at least as it stands for 2012? With standard deductions, he would fall into the 15% bracket.
Answer: It’s true that the capital gains tax rate is zero for people in the 10% and 15% income tax brackets. But the amount of capital gains is added to your other income to determine your bracket.
“The $75,000 of current income plus $85,000 of gain would put them well into the 25% tax bracket and subject to the 15% capital gain rate,” said Mark Luscombe, principal analyst for tax research firm CCH. “A standard deduction of $11,900 plus a couple of exemptions of $3,800 each for 2012 could make part of the $85,000 gain taxed at a 0% rate, but the bulk of it would be taxed at the 15% capital gain rate.”
Dear Liz: You recently answered a question about capital gains taxes that stemmed from two siblings selling their parents’ home. The children had been added to the parents’ deed, presumably before the parents’ death. You mentioned that the capital gains tax would have been avoided if the parents had bequeathed the home rather than gifting it during their lifetimes. Presumably bequeathing the home at death would have necessitated probate and incurred inheritance taxes. Are these costs more than offset by the stepped-up tax basis received?
Answer: Your questions illustrate exactly why no parent should add a child (or anyone else) to a home deed without discussing the issue with an estate-planning attorney first. Too often, laypeople misunderstand what’s involved in probate and make expensive mistakes trying to avoid it.
In some states, probate — the court process that typically follows death — is relatively swift and not very expensive. Trying to avoid it isn’t necessarily cost effective. In other states, including California, the process potentially can take many months and eat up a good chunk of an estate. When that’s the case, it can be prudent to take steps during life to sidestep probate at death.
There are often better ways to do so, however, than adding someone to a deed. A living trust, for example, can be a good way to avoid probate and preserve the tax benefits of bequeathing, rather than gifting, assets. Living trusts can vary in cost, but a lawyer can typically set one up for $2,000 or $3,000. If you compare that with the $25,000 or more the siblings will pay in capital gains on a relatively modest home sale, you can see that the living trust probably is a better deal.
Now let’s turn to the issue of estate taxes. If the assets left by the deceased are substantial enough to incur estate taxes, they will do so whether or not the estate goes through probate. Avoiding probate, in other words, does not avoid estate taxes. Currently, only estates worth more than $5.12 million face federal estate taxes. That limit is scheduled to drop next year to $1 million, but will still affect relatively few estates.
Dear Liz: Your column on the tax issues that develop when parents deed their property to their children should help educate a lot of people. But sometimes this is done to reduce the parents’ assets so they will be eligible for Medicaid after the expiration of the look-back period. In this case, paying the capital gains tax is appropriate, because they are asking the state to pay potentially very large senior care bills.
Answer: Some would question whether it’s ever appropriate for seniors to deliberately impoverish themselves by transferring away assets in order to qualify for Medicaid, which pays long-term care expenses for the indigent. The “look back” period, in which states examine asset transfers before a Medicaid application, was established to discourage such maneuvers. Once again, it’s smart to get a legal opinion before transferring big assets. An elder-law attorney could weigh in on the pros and cons of Medicaid planning.
Dear Liz: My wife and her brother are selling their parents’ home. The parents transferred the deed to their children’s names years ago. My wife should receive about $85,000 from the sale. Our yearly income (one salary; she’s a stay-at-home mom) is around $75,000. My wife is worried about capital gains taxes and wants to reinvest in another real estate property because she’s heard that that will eliminate the capital gains tax. Is that correct? I would really rather invest that money in our current home (finish the basement into a family room, update some items) and pay off our car loan than worry about another property to take care of. What do you think?
Answer: A 1031 exchange is a tax maneuver that allows owners of business or investment property to swap the real estate they have with another property, a transaction that can defer (but not necessarily eliminate) capital gains taxes.
It’s questionable whether your in-laws’ home would qualify as business or investment property, said Mark Luscombe, principal federal tax analyst for tax research firm CCH.
“Were the parents paying rent to the children after the title was passed to the children? If the kids owned the property and the parents were living there without paying rent, I do not think that would constitute investment property,” Luscombe said. “Perhaps if the parents were still paying upkeep expenses and real estate taxes, that might approach the equivalence of rent.”
If there’s a chance the property might qualify, your wife should consult a tax pro experienced with 1031 exchanges for details. Otherwise, she’ll need to write some good-sized checks to the tax authorities. Currently the federal capital gains tax rate is a maximum of 15%, although it will rise to 20% on Jan. 1 if Congress doesn’t reach a compromise on the so-called fiscal cliff. Add to that any state or local taxes on capital gains.
You may think of these taxes as a small price to pay compared with the risk of owning a piece of rental property. Your wife may have another concern that she has not voiced, however: She may not want this legacy from her parents to disappear into the general family budget. She may feel an obligation to preserve and try to grow the money, rather than sinking it into home improvements and other consumption. Legally, gifts and inheritances are considered separate property owned only by the spouse to whom they were given, even in community property states where most other assets are considered jointly owned.
If she wants to keep this money separate, in other words, that’s her right. It would be nice if she carved out a small chunk for family consumption, but she’s under no obligation to do so. If a 1031 exchange isn’t possible or feasible, then she could consult a fee-only planner about other ways to invest the money for the future.
By the way, it needs to be said: This tax bill was avoidable. If your in-laws had, instead of gifting the property, waited and bequeathed it at their deaths, the home would have received a so-called step-up in tax basis. Such a step-up in effect eliminates the need to pay capital gains taxes on any home price appreciation that occurred during the parents’ lives. Any parent thinking of adding a child’s name to a real estate deed should first consult an estate planning attorney to understand the ramifications, since gifting property this way can be an expensive mistake.