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Taxes

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.

Q&A: Annuities can come with a tax surprise

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Dear Liz: I made a one-time purchase of a variable deferred annuity with a $10,000 inheritance I received about 25 years ago, based on a co-worker’s advice. Over the years I have not made any additional payments or withdrawn any funds. It matures in about a year with an option of withdrawing the lump sum, which was nearly $60,000 this year, or receiving monthly payments. Would I be subject to capital gains taxes for the entire $50,000 increase if I take the lump sum? Are there any special tax exemptions or rules I should be aware of?

Answer: The increase in your annuity’s value isn’t subject to capital gains taxes. Instead, the gain will be subject to higher — perhaps much higher — income tax rates, regardless of whether you choose the lump sum or monthly payments.

Variable annuities are insurance products that allow you to invest money tax-deferred for retirement. Like other retirement accounts, you could face penalties for early withdrawal in addition to income taxes if you take money out before you’re 59½.

Taking the lump sum could push you into a higher tax bracket and possibly cause a temporary increase in your Medicare premiums if you’re 65 or older. If you opt for monthly payments instead, you’re likely giving up access to the money in an emergency. (Annuitization means you’re giving up the lump sum you could have accepted in exchange for a stream of monthly payments that typically lasts for life.)

A tax pro can help you weigh the effects of the different withdrawal options on your finances.

Q&A: Should your retirement savings plan include life insurance? Here are some pros and cons

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Dear Liz: Are indexed universal life insurance products worthwhile, and how do they compare to a Roth IRA?

Answer: Both offer the potential for tax-free distributions in retirement, but indexed universal life insurance is a complex product with high expenses that’s not a good fit for most investors.

With a Roth IRA, virtually all of your money can go toward your retirement investment. (Most investments have fees of some kind, but you can minimize those by using exchange traded funds or low-cost index funds.) With permanent life insurance, some of your money goes toward paying premiums for the death benefit and other administrative expenses, including commissions for the person who sells you the policy. The remaining cash can be invested in accounts that are tied to the performance of a stock market index. Your principal is guaranteed, but the amount you earn is subject to caps.

Financial planners generally recommend that you first max out other retirement savings options, such as 401(k)s and IRAs, before considering investing through a life insurance policy. Also, you should be someone who needs permanent life insurance — the kind that is meant to cover you for the rest of your life. (Term insurance, by contrast, is a much less expensive option meant to cover you for a set term, such as 20 years.)

Some people do need permanent coverage. Their estates may be large enough to incur estate taxes that they want to pay with insurance, for example. Or they may have a special needs child who will require ongoing support. If you need permanent coverage, consider hiring a fee-only financial planner to help you sort through your options.