Q&A: How to pass on inheritance to your children

Dear Liz: I may inherit $500,000 but do not necessarily need the money for my retirement. Is there a way to pass that inheritance, or a part of it, to my two children without incurring a taxable event for myself or for them? I may want to ask my parents to add that to their trust or will.

Answer:
You can “disclaim” or refuse to accept all or part an inheritance. If you do so correctly, the assets will pass to the next beneficiary as dictated by the estate documents (or by state law, in the absence of a will or living trust). If you think you’ll want this option, definitely discuss this with your parents and their estate planning attorney so the documents can be set up properly.

Keep in mind that few families have enough wealth to be affected by gift or estate taxes. Only people who give away millions of dollars in their lifetime have to pay gift taxes, for example. If you decide not to disclaim and later give the entire $500,000 to your kids, you wouldn’t have to pay gift taxes until you gave away considerably more. Plus, gifts are tax free to the recipients.

Gift and estate laws are always subject to change, so definitely consult a tax pro before making any decision regarding either.

Q&A: Ask a tax pro before Roth conversion

Dear Liz: I’m almost 70, still working, and I’ve got a decent-size IRA as well as a 403(b) that I plan to move to an IRA when I retire. Because I have a pension and other investments, I don’t think I’ll ever need the money in the IRA and 403(b). Should I convert to a Roth now so my kids (31 and 28) won’t have to pay taxes when they inherit it? I’ve got the cash to cover the taxes for the Roth conversion.

Answer: That would be a generous move, but you should consult a tax pro to make sure you understand the implications.

As you know, converting a pre-tax retirement account such as an IRA, 401(k) or a 403(b) to a Roth IRA can generate a sizable income tax bill. Such conversions can push you into a higher tax bracket and, if you’re on Medicare, also may increase your premiums.

You may want to spread the conversion over several years, converting just enough each year to “fill out” your tax bracket and avoid Medicare surcharges. A tax pro can help with those calculations.

Q&A: Social Security and the tax torpedo

Dear Liz: People are typically advised to wait as long as possible (full retirement age or later) to take Social Security to maximize the benefit. If a couple has low expenses and substantial pensions, wouldn’t it make sense to take Social Security earlier, to preserve retirement funds to pass on to their heirs? Social Security payments stop upon death, whereas retirement accounts are passed on to heirs.

Answer:
If your primary concern is preserving an inheritance, maximizing your Social Security payments could help you reduce how much you have to withdraw from retirement funds in the long run.

Starting early also could make you more susceptible to what’s known as the tax torpedo, which is a sharp increase in marginal tax rates due to how Social Security is taxed when someone receives other income. People who only receive Social Security don’t face the torpedo, and higher-income people probably can’t avoid it, but middle-income people may be able to lessen the hit by delaying Social Security and drawing from their retirement funds instead.

One way to preserve assets for heirs is to convert traditional retirement accounts to Roth IRAs. This requires paying taxes on the conversions, but then you wouldn’t face required minimum distributions on the Roth accounts.

Calculating the best course can be difficult. You can pay $20 to $40 to use sophisticated claiming software such as Social Security Solutions or Maximize My Social Security to model various options, or consider consulting with a fee-only advisor.

Q&A: Here’s how taxes work on estates and inherited money

Dear Liz: Are all assets entitled to a stepped-up basis upon the death of the owner? My father died about a year ago, leaving my sister and me an estate of a little over $1 million. He had a Thrift Savings Plan that is apparently like a 401(k) for federal government employees. This is getting taxed at 37%. Also he had U.S. Savings Bonds and the interest on those is apparently taxable. I was under the impression all assets in an estate under $11 million were not taxable. Is this not correct?

Answer: That’s not correct. You’re confusing a few different types of taxes.

Estate taxes are levied on certain large estates when the owner dies, and those taxes are typically paid out of the estate. The current estate tax exemption limit is $11.7 million, up from $11.58 million last year. After 2025, the limit is scheduled to drop to $3.5 million, but even then very few estates will owe the tax.

Another type of tax is the capital gains tax. This essentially taxes the profit someone makes when they sell a stock or other asset. Capital gains tax rates are typically 15%, but they can be as low as zero or as high as 20%, depending on the seller’s income.

Inherited assets that qualify for capital gains tax treatment also can qualify for the “step up in basis” that may reduce the tax bill, sometimes dramatically. If your dad paid $10 for a stock that was worth $100 when he died, you could sell it for $105 and owe taxes only on the $5 in appreciation since his death. The $90 appreciation that occurred during his lifetime would never be taxed.

Not all assets qualify for capital gains treatment, however. Retirement accounts, including 401(k)s and IRAs, are a good example.

People usually get tax breaks when they contribute and the accounts grow tax deferred. When the money comes out, however, the withdrawals are taxed as income regardless of whether it’s the original owner getting the money or the heir. Whoever makes the withdrawal pays the taxes.

Federal income rates currently range from zero to 37%. The 37% rate applies for singles with taxable income of $523,601 or more and married couples filing jointly with taxable incomes of $628,301 or more.

Q&A: Taxes on a home sale

Dear Liz: My wife wants to sell our home of three years for a $300,000 profit after an extensive remodel and move into our rental home. She wants to stay there for two years and then sell to take advantage of the capital gains exemption. If we do it her way, we lower our monthly mortgage payment but lose the yearly rental income of $30,000. Our income is around $130,000. Any input?

Answer: Each homeowner can exclude up to $250,000 of home sale profits from capital gains taxes if they have owned and lived in a property as their primary residence for at least two of the previous five years. Married couples can exclude up to $500,000. This tax break can be used repeatedly.

The federal capital gains tax rate is currently 15% for most people, so the full $500,000 exemption could save a seller $75,000 in federal capital gains taxes. If your state or city has an income tax, you could save there as well. California, for example, doesn’t have a capital gains tax rate, so home sale profits would be subject to ordinary income tax rates of up to 13.3%.

The math is a little different when you move into a property you’ve previously rented out, said Mark Luscombe, principal analyst for Wolters Kluwer. Over the years, you’ve taken tax deductions for depreciation of your property. When you sell, the Internal Revenue Service wants some of that benefit back, something known as depreciation recapture.

When you sell a former rental property, some of the gain will be taxed as income, even if you’ve converted the home to personal use, Luscombe said. The maximum depreciation recapture rate is 25%.

A tax pro can help you figure out the likely tax bill. Any tax savings would be offset by the net result of a move, such as the lost rental income (minus the lower mortgage payments) and the substantial costs of selling, including real estate commissions and moving expenses.

It’s not clear if you’ve already remodeled your current home. If you haven’t, please think twice about an extensive remodel if you plan to sell, because you probably won’t get back the money you spend. Home improvement projects rarely return 100% of their cost. You’ll typically get a better return by decluttering, deep cleaning, sprucing up the yard or putting on a new coat of paint.

Q&A: Protecting home sales proceeds from taxes

Dear Liz: My friend has been diagnosed with Alzheimer’s and is now living in a secure assisted living facility. After a year in this home, his sister finally sold his condo. Her tax person says he will take a big tax hit. I say it is totally medically ordered and he’ll need the money for his current housing ($5,000 a month) until he dies. I also question whether part of that $5,000 should be deductible because it is only ordered because of his illness. Your thoughts?

Answer: Your friend may not be able to protect all of his home sale proceeds from taxation, but he likely will be able to protect some.

If your friend lived in his condo for at least two of the previous five years before the sale, he will be able to avoid tax on up to $250,000 of home sale profits. Even if he fell short of the two-year mark, he likely would benefit from IRS rules that allow partial exemptions when the sale is due to “unforeseen circumstances.”

Meanwhile, medical expenses, including some long-term care expenses, are potentially deductible if they exceed 7.5% of someone’s adjusted gross income. Assisted living expenses may qualify as deductible medical expenses if the resident is considered chronically ill, which means they cannot perform at least two activities of daily living (eating, toileting, bathing, dressing, getting in and out of bed and remaining continent) or they require supervision because of cognitive impairment, such as Alzheimer’s disease or other forms of dementia. The personal care services must be provided according to a plan of care prescribed by a licensed healthcare provider. Typically, assisted living facilities prepare such care plans for their residents.

Q&A: Filing taxes after a spouse’s death

Dear Liz: I am writing this email on behalf of my 88-year-old dad. He wanted to ask you this question: “My wife passed away Jan. 7, 2020. In filing my 1040 income tax for 2020, am I allowed to file as a married couple or required to file as a single person?”

Answer: Your dad can use “married filing jointly” with his deceased spouse for the year of her death, assuming he didn’t remarry in that year.

If your dad claimed one or more qualifying dependents — a child, stepchild or adopted child — he might be able to file as a qualifying widower for the following two years as long as he paid more than half the cost of maintaining his home and it was the main home of the dependent or dependents. Most people your dad’s age no longer live with their kids or claim them as dependents on their tax returns. But if he did, this could preserve the larger standard deduction and other benefits of filing jointly for another couple of years.

Q&A: Paying taxes with plastic

Dear Liz: I am selling a rental property that I have owned for several years. I know I could do a 1031 exchange, which would allow me to put off the tax bill by investing in another commercial property. But I just want out. I’ll pay the capital gains tax and invest the rest of the proceeds. I am considering paying the taxes by credit card and taking on the 3% premium to get rewards points offered through the card issuer. Is this a dumb idea, or does it have some merit?

Answer: The companies that process federal tax payments have processing fees of just under 2%, not 3%. You’ll still want to make sure you get more value from your rewards than you pay in fees, and that’s not a given. If your card offers only 1.5% cash back, for example, charging your taxes doesn’t make a lot of sense. But the math changes if you can get more than 2% in rewards, or if you could use the charge to help you meet the minimum spending requirements for a new credit card with a generous sign-up bonus.

If you do charge your taxes, you’ll obviously want to pay the balance in full before incurring any interest.

Q&A: Don’t file an amended return after the stimulus tax break. The IRS is begging you

Dear Liz: You might want to inform your readers that they do not need to file an amended return if they filed before Congress passed its most recent stimulus plan, which excludes the first $10,200 of unemployment benefits. The IRS will automatically recalculate their taxes and refund the taxes paid on that amount of benefits.

Answer: In fact, the IRS is begging people not to file amended returns. (An exception, the IRS has said, is for those who the tax reduction would make newly eligible for the earned income tax credit or other tax breaks for lower income people.) The agency is still processing a backlog of returns and correspondence while issuing a third wave of stimulus payments and gearing up to send monthly child credit payments to millions of families.

You may need patience, however. The IRS has promised to refund any taxes paid on the first $10,200 of unemployment benefits earned last year, but has said the money will go out “this spring and summer.”

Q&A: IRAs and tax considerations

Dear Liz: I’ve been researching the backdoor Roth IRA and I am finding some conflicting information regarding taxes owed on the conversions. I have two sizable rollover IRAs and one small ($1,600) traditional IRA. Can I make an after-tax contribution to the traditional IRA and convert that to a Roth and pay tax only on that IRA or do I have to consider all three IRAs?

Answer:
Sorry, but you have to consider all three. The tax on your conversion will be based on the pre-tax portion of all your IRAs combined, not just the IRA where you make your contribution.

Backdoor Roths allow people to get money into a Roth when their incomes are too high to make a direct contribution. Instead, they contribute to a traditional IRA and convert that to a Roth because conversions don’t have income limits. Conversions require paying taxes proportionately on your pre-tax contributions and earnings, however, so the technique may not be advisable when you have sizable pre-tax IRAs that will trigger a large tax bill.