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Taxes

Q&A: Inherited IRAs and taxes

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Dear Liz: After reading your recent response on the taxability of inherited IRAs, I have a question. I am 53, divorced with no children, and have an IRA worth more than $1 million. I’ve always listed the beneficiary of the account as my estate, for no reason other than administrative ease (if I ever change my will, the IRA will follow along). However, from a tax perspective, is this unwise? In your recent response you state that non-spouse beneficiaries typically have up to 10 years to drain an inherited IRA. If these individuals don’t directly inherit the IRA, and instead it must first filter through my estate, do the payouts occur immediately and therefore create a greater tax burden that cannot be spread out for as many years?

Answer: If you die before starting to take required minimum distributions and the estate is your beneficiary, the IRA assets must be completely distributed by Dec. 31 of the fifth year following the year of your death, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. Designating individuals as IRA beneficiaries rather than the estate would allow them to spread the distributions over 10 years rather than five years. If you die after starting required minimum distributions, the remaining distributions would be made according to the single life expectancy tables for someone your age, Luscombe said.

The account also could be more vulnerable to creditors, depending on state law, and could be subject to the delays and costs of probate. In other words, choosing “ease” now can create a lot of discomfort later for your heirs.

“IRAs are very difficult in probate situations, and it’s better to name individuals to be beneficiaries directly on those accounts in almost all situations,” said Jennifer Sawday, an estate planning attorney in Long Beach.

Q&A: IRAs, pensions and taxes

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Dear Liz: I contributed to an IRA during my working years. I’m now retired. Both my and my spouse’s IRAs are Roths, so we have no required minimum distributions. I’d like to continue contributing to an IRA, but neither I nor my spouse have W-2 or self-employment income anymore. We do, however, both collect pensions, which are taxed as ordinary income. Shouldn’t we be able to make IRA contributions, as we earned these pensions by working, and they are taxed exactly the same as our paychecks were taxed?

Answer: Nice try! There’s no longer an age limit for contributing to an IRA or a Roth IRA, but the IRS insists that those who contribute have earned income — which means wages, salary, tips, bonuses, commissions or net self-employment income. Payments from pensions and retirement funds don’t count as earned income.

Q&A: Tax issues and trusts

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Dear Liz: You recently responded to a reader’s question about protecting an intended bequest. In the answer you wrote, “Assets in the trust get a step-up in tax basis when the first spouse dies, but not when the surviving spouse dies.” My understanding is that, in California and other states with community property laws, the basis of eligible inherited community property gets stepped up twice: once for the surviving spouse and then again for the person who becomes the final beneficiary of the asset. I thought that using a revocable trust does not affect this “double step-up.” A married couple whose principal estate asset at death is their jointly owned (and substantially appreciated) home may never explore the benefits of a trust if they believe that one-half of the anticipated step-up in basis will be lost. Might you clarify what the sentence in your column means?

Answer: The double step-up works somewhat differently from what you’re describing, and the trust in question is quite different.

A step-up in basis happens when someone dies and an inherited asset gets a new value for tax purposes. The asset is “stepped up” to the current market value, which means any appreciation that happened during the deceased owner’s lifetime is never taxed. (Basis also can be stepped down for assets that have declined in value.)

In most states, when one spouse dies, only half of a couple’s jointly owned assets gets a favorable step-up in tax basis to the current market value. The surviving spouse’s half doesn’t get a step up in value until he or she dies.

In community property states, however, both halves of the couple’s community property get the step up with the first death, said Los Angeles estate planning attorney Burton Mitchell. That’s what is known as the double step-up in basis. If the survivor dies owning the property, it gets yet another step-up in tax basis.

Now let’s move on to trusts. The double step-up in basis is not affected if you own property in a kind of revocable trust known as a living trust. Living trusts are designed to avoid the court process known as probate, and they can be changed during the creator’s lifetime (hence the term “revocable”).

The trust in question, however, was a bypass trust. The original letter writer asked how to make sure her son from her first marriage would receive an inheritance if she died before her current husband.

One of the options would be to create a bypass trust that gave the spouse income from her assets during his lifetime, with the assets transferring to the son at the spouse’s death. Such trusts can help ensure the assets actually get to the son someday and aren’t spent by the surviving spouse, or the surviving spouse’s next spouse. Among the disadvantages is the fact that assets placed in the bypass trust don’t get a step-up in tax basis when the surviving spouse dies.

Another type of trust to consider in this situation would be a qualified terminable interest property (QTIP) trust. Unlike the assets in a bypass trust, assets in a QTIP would be included in the deceased spouse’s estate, which means they would get a step up in basis when the survivor dies.

Clearly, this is a complex topic, so you’d be wise to get an experienced estate planning attorney’s advice.

Q&A: Is it a business or a hobby? The IRS has rules

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Dear Liz: After accepting a layoff in exchange for a separation package earlier this year, I have started writing articles for a subscription website. My stories have become popular enough that I’m starting to earn some money and expect a 1099-K this year. I have enjoyed the work and want to cultivate a dedicated audience. I need a few things to improve my output (dedicated laptop, improved writing software, etc.). These will cost more than I plan to earn this year from my new gig but I have cash from my severance. What are my best options? Should I wait until I’ve earned enough from writing before purchasing upgrades?

Answer: The IRS doesn’t want people writing off losses if they’re not making a serious effort to make money. This is known as the hobby loss rule.

The agency understands, however, that not every business turns a profit every year and many businesses have significant start-up costs that may exceed their income for a time. Generally, if you make a profit in at least three out of five years, the IRS presumes you’re engaging in a real business rather than pursuing a hobby.

If you’re planning to spend more than you make this year and write off the loss on your taxes, you’ll want to make sure you’re running this new business in a business-like way. Consider hiring a tax pro who can advise you about how to structure your company, keep good records and file estimated tax payments when necessary.

Your tax pro also can make sure you don’t inadvertently over-report your income.

Forms 1099-K are issued by third-party payment networks including Venmo or PayPal to report payments over $600, but those transactions can include personal as well as business payments. A client may have used Venmo to pay you for a story, for example, but you also may have received payments from friends for their portion of a lunch tab. Plus, if that client pays you more than $600 in a year, you’ll also be issued a Form 1099-NEC. You’d be double reporting your income if you used both the Form 1099-NEC and the Form 1099-K.

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: IRS and selling a home

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Dear Liz: How does the IRS know you sold your house? If you sell and buy another home, must you report it? Most folks I know sell, then buy a more expensive house. Seems like lots of moving parts for the parties, including the IRS, to have to track.

Answer: Not really. The title company or attorney handling the closing on a property sale typically generates a Form 1099 with the sales price of the home. The seller gets a copy and so does the IRS. Sellers who “forget” to account for the proceeds on their tax returns will soon get a reminder from the IRS, which typically just tacks the sale amount onto the sellers’ income and demands its cut, along with penalties and interest.