Ask Liz Weston

Get smart with your money

Inheritance

Q&A: Tax consequences of annuity conversion

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Dear Liz: Several years ago my wife inherited an IRA when her mother died. Her banker suggested rolling the IRA into an annuity with an insurance company. That company is difficult to deal with and not forthcoming about how the annuity is invested. She wants to convert the IRA into a certificate of deposit so it is insured by the FDIC. What are the tax consequences of doing that?

Answer: There are many different types of annuities. If your wife purchased an immediate annuity, which offers a stream of payments in return for a lump sum, then she probably can’t change her mind since those transactions are effectively irreversible.

If she purchased a deferred annuity, though, she has more options. Deferred annuities allow people to defer the stream of payments until later — often years or even decades in the future. In the meantime, the annuity may pay a fixed rate, a variable rate based on the performance of underlying investments, or an indexed rate based on a market benchmark.

Your wife won’t face taxes if she switches from a deferred annuity to a CD, since changing investments within an IRA isn’t considered a taxable event. The annuity itself may have surrender charges, however. Because annuities often pay advisors substantial commissions, surrender charges help discourage investors from withdrawing the money before insurers can recoup those fees.

These charges and high expenses in general make deferred annuities a poor fit for many investors, and many financial planners especially dislike seeing them in IRAs. A deferred annuity’s primary advantage is tax deferral, which an IRA already offers.

If your wife feels she was misled about this investment, she can make a complaint with her state insurance regulator.

Q&A: When selling a vacation home, here are the taxes to expect

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Dear Liz: I am one-third owner of a vacation house. My siblings own the other two-thirds. We inherited the house from a parent about 10 years ago. I want to sell my third to my siblings, who are willing and able to buy it. Can I do anything to avoid capital gains? Would it make a difference if I sell my interest over several years?

Answer: Vacation homes aren’t eligible for the tax break that allows people to exclude up to $250,000 in capital gains from their income when they sell their primary home. If the property was used full time as a vacation or second home, rather than as a rental, it’s also not eligible to be swapped for another property in a 1031 exchange. (These exchanges allow investors to defer capital gains on real estate investment properties.)

Selling your share of the property over time won’t eliminate the capital gain, but it would spread out the tax bill. Discuss your options with a tax pro to see which approach makes the most sense.

Q&A: Taxes and inherited IRAs

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Dear Liz: Thanks for the recent column concerning children getting an inherited IRA, because I’m in that situation. Is the attorney for the estate required to include tax information with the distribution, or is it up to my accountant to sort things out? And since I don’t really need the money right now, would I have options as to how I receive the funds to avoid a tax hit?

Answer: You can’t avoid a tax hit with an inherited traditional IRA. The money has to come out and the withdrawals are taxable. For beneficiaries who aren’t the surviving spouse, the account typically must be drained within 10 years. (There are exceptions for beneficiaries who are minors, disabled or chronically ill.)

You have some flexibility about how rapidly you take the money out, however. If the account owner hadn’t started required minimum distributions before dying, you can withdraw money at any rate you want, provided you empty the account by Dec. 31 of the 10th year following the year of the owner’s death.

If the account owner had started required minimum distributions, you must take a minimum distribution each year. These are typically based on your own life expectancy. In addition to those annual withdrawals, you’ll need to take out the remaining money by the end of the 10th year following the year of death.

There was initially some confusion about whether beneficiaries had to take yearly required minimum distributions or could wait until the 10th year to withdraw the funds, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. Because of that confusion, the IRS has waived the penalties for failing to take required minimum distributions when the IRA owner died in 2020, 2021 or 2022. The waiver of penalties would not be available if the IRA owner died in 2023, Luscombe said.

Leaving money in the account as long as possible means the balance has longer to grow tax deferred. But you also could face a whopping tax bill in that 10th year. Definitely discuss your options with your tax pro. While the attorney for the estate may help with some details — such as arranging to get the money transferred from the deceased owner’s account — it will be up to you to set up your own inherited IRA and to arrange for distributions.

Q&A: Inherited IRAs bring a tax bite

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Dear Liz: I have an IRA worth over $1 million and am taking required minimum distributions. When my kids inherit this, can they take it all out with no tax issues because it is an inheritance? Or will they have to take required minimum withdrawals when they are old enough?

Answer: Retirement accounts don’t get the favorable step-up in tax basis that other assets typically get when someone dies. Your children will pay income tax on any withdrawals from an inherited IRA and most likely will have to drain the account within 10 years.

In the past, IRA beneficiaries other than a spouse had to start taking required minimum distributions after the account owner’s death. They couldn’t put off required minimum distributions until their 70s, but they could base the distribution amounts on their own life expectancies. The so-called “stretch IRA” let most of the assets continue to grow tax deferred.

But the stretch IRA was eliminated for most beneficiaries by the SECURE Act, which Congress passed in December 2019. The reasoning was that retirement accounts were meant to support the original account owner in retirement, not to provide tax-deferred benefits to their heirs. There are certain exceptions for beneficiaries who are surviving spouses, minors, disabled, chronically ill, or within 10 years of the age of the original account holder.

Q&A: The Ins and Outs of Trusts

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Dear Liz: I liked your answer to the person who wanted to ensure a son from a prior marriage got an inheritance. You mentioned creating a trust so the surviving spouse can get income from the assets but then the son would inherit when that spouse dies. However, what’s to prevent the surviving spouse from using up all the funds so that the son is left with nothing after all?

Answer: These trusts typically put restrictions on how much the surviving spouse would be able to access and in what circumstances. If the surviving spouse is the sole trustee, of course, the temptation to ignore the rules could be great. Alternatively, the ultimate inheritor or a third party can be named as trustee or co-trustee.

But there’s no getting around the fact that the trusts create a conflict between the survivor and the ultimate inheritor. The survivor typically wants as much income as possible from the trust while the inheritor wants the trust to be left alone to grow.

Another issue is taxes. Assets in the trust will get a step-up in tax basis when the first spouse dies, but not when the surviving spouse dies.

Often, the best way to make sure someone gets an inheritance is to make an outright bequest rather than putting the money in a trust. If a surviving spouse needs income from the assets to make ends meet, though, a trust with a responsible trustee can help ensure the ultimate inheritor gets the inheritance that was intended.

An experienced estate planning attorney can help you sort through the available options and make the best plan for your loved ones.

Q&A: This spouse wants to keep an inheritance secret from the other spouse. Here’s a better idea

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Dear Liz: A good friend is leaving me money from her IRA after she dies. I have asked that the gift be designated as “sole and separate property” to me. As I am married and file joint state and federal taxes, can this money be kept separate for my use only? I prefer that my spouse not be made aware of this as they have different ideas about how to use our money.

Answer: Inheritances can be kept as separate property even in community property states where other assets acquired during marriage are considered jointly owned. Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

An inherited IRA, however, would be tough to keep secret if you file taxes jointly with your spouse. You’ll be required to take yearly minimum distributions to empty the account within 10 years, and those withdrawals will be taxed as income.

Few couples are entirely on the same page about money, but keeping financial secrets from each other generally isn’t the best way to cope with these differences. Instead, many people find it helpful to have some “no questions asked” money that they can spend as they please without consulting their partner.