Ask Liz Weston

Get smart with your money

Q&A

Q&A: The rules have changed on inherited IRAs. Here’s what you need to know

By

Dear Liz: My husband and I have a combination of traditional and Roth IRAs naming our children and grandchildren as beneficiaries. With the passage of the Secure Act requiring distribution of inherited IRAs within 10 years, we want to revise our plan of leaving all of the investments to our children, as such inherited income would affect their tax bracket also. Do you have recommendations to alter the inherited IRAs to avoid this issue? Our annual fixed income puts us at the top of our tax bracket, meaning we usually cannot manage a traditional IRA to Roth conversion.

Answer: The Secure Act dramatically limited “stretch IRAs,” which allowed people to draw down an inherited IRA over their lifetimes. Now most non-spouse inheritors must empty the accounts within 10 years if they inherited the IRA in 2020 or later.

There are some exceptions if an heir is disabled, chronically ill or not more than 10 years younger than the IRA owner, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. These “eligible designated beneficiaries” can use the old stretch rules, as can spouses. Minor children of the IRA owner can put off withdrawals until age 21. At that point, the 10-year rule applies.

If you had a potential heir who qualifies, you could consider naming them as the beneficiary of a traditional IRA and leaving the Roth money to the other heirs. (The IRA withdrawals will be taxable while the Roth withdrawals won’t.) Or you could leave the IRA to the children in lower tax brackets and the Roth to those in higher tax brackets.

If you’re trying to divide your estate equally, though, these approaches could vastly complicate matters because the balances in the various accounts could be quite different. Plus, predicting anyone’s future tax brackets can be tough.

Another approach is to name your children along with your spouse as the primary beneficiary of your IRA. That way, the children would get 10 years to spend down this first chunk of your IRA money after you die. When your survivor dies, they would get another 10 years to spend down the remainder, giving them 20 years of tax-deferred growth.

Alternately, you could focus on spending down the IRA to preserve other assets for your kids. The stretch IRA rules encouraged people to preserve their IRAs, but now it may make more sense to focus on passing down assets such as stock or real estate that would get a valuable “step up” in tax basis at your death.

Converting IRAs to Roths is another potential strategy for those willing and able. In essence, you’re paying the tax bill now so your heirs won’t have to pay taxes later (although they’ll still have to drain the account within 10 years). It may be possible to do partial conversions over several years to avoid getting pushed into the next tax bracket.

There are a few other approaches that involve costs and tradeoffs, such as setting up a charitable remainder trust that can provide beneficiaries with income. These are best discussed with an estate planning attorney who can assess your situation and give you individualized advice.

Q&A: Figuring taxes on Social Security

By

Dear Liz: How will our Social Security payments be affected by any passive income such as from rental properties? We have two properties, which add $3,000 monthly to our current income. I plan on retiring at 72, which is six years away. My husband may retire earlier due to health problems. We will have savings as well as my 401(k) when I retire. Although my retirement income “pencils out,” I don’t know exactly what to expect from Social Security. How should I calculate my net income in retirement?

Answer: You could pay income taxes on up to 85% of your Social Security benefits if you have other taxable income. Examples of taxable income include wages, interest, dividends, capital gains, rent, royalties, annuities, pension payments and distributions from retirement accounts other than Roths.

To determine how much of your benefit is taxable, you would first calculate your “combined income,” which consists of your adjusted gross income plus any nontaxable interest you receive plus half of your Social Security benefits. If you file a joint return, you typically would have to pay income tax on up to half of your benefits if your combined income fell between $32,000 and $44,000. If your combined income was more than $44,000, up to 85% of your benefits would be taxable.

Q&A: How to figure your capital gains tax bite so the IRS doesn’t zap you

By

Dear Liz: We had big capital gains this year, and we owe taxes plus a penalty for not paying estimated taxes. Is there a way to plan ahead for taxes since every year is different regarding gains or losses? I know one option is to just pay estimated taxes quarterly based on the previous year’s gains. Apparently the mutual fund companies don’t automatically withhold the taxes.

Answer: Our tax system is “pay as you go,” which means the IRS expects you to pay taxes as you earn or receive income. If you fail to do so and your tax bill is more than $1,000, you may face penalties.

As you rightly note, though, you won’t know what your total capital gains or losses will be until year’s end. You wouldn’t want to pay taxes on a big gain one quarter only to have a big loss the following quarter. You can avoid the penalties by making sure your withholding and estimated tax payments equal at least 100% of the total tax you paid in the previous tax year if your income is $150,000 or less. If your income is over $150,000, your payments and withholding should equal at least 110% of last year’s taxes.

The alternative is to pay at least 90% of the tax you’ll owe on your estimated income for the current year. A tax pro can help you figure out how much you need to pay as well as offer tips for reducing your tax bill.

Q&A: When institutions won’t go paperless

By

Dear Liz: I have for years insisted on being paperless, not only for credit card statements and utility bills but also for tax documents such as the 1099-INT and 1099-DIV. My problem is that I receive income from two lifetime annuities and those of course generate 1099-R forms each year, which are mailed to me. I have requested to receive those as PDFs from the companies that execute those annuities, and they claim they cannot do so and are not required to. Are they right, or is there some federal regulation I can quote to force the issue?

Answer: The idea that a business can’t generate an electronic form for a customer is a little ridiculous, but there’s not much you can do to force these companies to get with the times.

The IRS requires that any person or entity that files more than 250 information returns — 1099s, W-2s and other forms that report potentially taxable income — do so electronically. But that requirement applies only to forms being sent to the IRS, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. There’s no requirement that such forms be issued electronically to individuals.

Which is unfortunate, since as you know getting forms electronically is much safer than having your private financial information sent through the mail. Since these companies are so insistent on clinging to paper, consider sending a letter — certified mail, return receipt requested — to the companies’ chief executives requesting that they join the 21st century.

Q&A: Sorting out trust confusion

By

Dear Liz: In a recent column you wrote of bypass trusts that “for many people this estate planning tool has outlived its usefulness.” In California, a trust avoids probate. Isn’t avoiding probate a reason to continue with a trust?

Answer: What you’re referring to is a living trust — a revocable (which means changeable) trust created while someone is alive. A bypass trust is irrevocable (which means not changeable) and typically goes into effect when someone dies. To further complicate matters, a living trust or a will can have provisions that create a bypass trust after someone dies.

Living trusts are indeed designed to avoid probate, the court process that otherwise follows death to settle an estate. Living trusts remain useful to many people who live in states where probate can be expensive and prolonged, such as California and Florida. Living trusts are also private, unlike wills, which typically become public record after death, and so are favored by people who want to avoid publicity.

Bypass trusts, on the other hand, were primarily designed to minimize or avoid estate taxes, which are no longer a concern for the vast majority of people. Bypass trusts have a number of disadvantages, so if you have one in your estate plan, you’ll want to consult an experienced estate planning attorney about whether to keep it.

Q&A: The ins and outs of I-bonds

By

Dear Liz: As you know, interest rates on certificates of deposit are extremely low. I was thinking of investing in government I-bonds. Can you discuss the pros and cons?

Answer: I-bonds are guaranteed by the U.S. government and currently pay an interest rate of 7.12%. But they do have some downsides.

The rate on Series I savings bonds is a composite of two rates: a fixed rate, which is currently zero, and an inflation rate, which changes every six months. The semiannual inflation rate is currently 3.56%, which translates into a 7.12% annual rate. This rate applies for I-bonds issued November 2021 through April 2022 and is good for the first six months you own the bond, according to Treasury Direct, the financial services site that allows you to buy securities including I-bonds directly from the U.S. government.

Although the rate can change, it can’t go below zero, so you can’t lose your principal. However, you also can’t cash in I-bonds for the first year, and if you cash them in before five years, you’ll lose the previous three months’ worth of interest.

Also, the bonds don’t pay interest to you directly. Every six months, the interest earned is added to the bond’s principal. That creates a new principal value, and interest is then earned on that value.

The bonds are exempt from state and local taxes but subject to federal taxes. You can opt to pay federal tax on the interest each year, but most people defer reporting the interest until they cash in the bond or it stops earning interest at 30 years, in which case it’s automatically cashed out and the interest reported to the IRS.

You can buy up to $10,000 in I-bonds electronically each calendar year. You can buy another $5,000 in paper bonds, but only if you use your tax refund to do so.