Ask Liz Weston

Get smart with your money

Taxes

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.

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.

Q&A: Another view of house bequest

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Dear Liz: You recently answered a question about a mother who gave her home to her two children shortly before she died. You wrote that when a home is gifted, the recipients also get the original owner’s tax basis and thus there is no step up in tax basis at death. However, if the mother continued to live in the home and didn’t pay rent, an argument could be made that it wasn’t a real gift and the home should be included in her estate at death. Then the children could get the step up in basis and not owe capital gains taxes when they sell.

Answer: The estate tax experts at Wolters Kluwer tax research firm agree that if the mother continued to live in the house, IRS Code Sec. 2036(a)(1) could apply, “assuming that there was an express or implied agreement between the mother and the children that she would live in the home rent-free until her death.” Then the fair market value of the home could be included in the gross estate and the children would receive a step up in basis at the mother’s death.

A similar argument could be made if the mother had added the children as joint tenants and continued to live rent-free in the home until death.

Making such arguments to the IRS might require hiring knowledgeable tax and legal help, however. Plus, adding children to home deeds can create other problems. The children’s creditors could go after the house, for example, and transfers of home ownership can complicate Medicaid eligibility.

It would probably be much more cost effective to get tax and legal advice before changing a home’s deed than to hope your heirs prevail against the IRS afterward.

Q&A: Finding free tax help

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Dear Liz: You recently mentioned the AARP Foundation Tax-Aide Program as a resource for getting help with tax returns. I just want to point out that there are other, IRS-sponsored programs that provide free income tax assistance to the elderly and low-income taxpayers. These programs are Volunteer Income Tax Assistance (VITA) and Tax Consulting for the Elderly (TCE). The site where I’ve volunteered for many years does approximately 2,000 tax returns each year. A mention in your column would be a great way to spread the word about this valuable service.

Answer: Consider it done. The IRS has a tool to find VITA and TCE resources using your ZIP Code.

Q&A: Caught in the IRS backlog

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Dear Liz: In 2021, we helped two of our children buy a condo. One of them confessed she hadn’t filed taxes for several years. We worked on the returns together, and it turned out that nothing was owed. Meanwhile, the IRS has never acknowledged the delayed tax filings or refunded the (small) overpayments. Shouldn’t the IRS have completed these filings by now?

Answer: The IRS says it has processed all paper and electronic individual returns for tax year 2021 or earlier if those returns had no errors or did not require further review. Returns that were filed late, however, may still be part of the agency’s backlog.

Your child can try using the “Where’s My Refund?” tool on the IRS site or create an online account to check for possible updates. Keep in mind that there’s a three-year limit to claim a refund; after that point, the U.S. Treasury gets to keep the money.

Q&A: Grandma needs tax help

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Dear Liz: My grandma is 78, divorced, and has not filed taxes in the last decade. I was wondering what she should do because she is head of the household and taking care of three adopted kids and needs help.

Answer: Please help connect your grandmother with AARP Foundation Tax-Aide, which provides free virtual and in-person tax help. You may be able to help her make an appointment and gather the documents she’ll need to file those missing tax returns.

Your obviously busy grandma may have procrastinated on filing her taxes because she worried about a tax bill.

But depending on her income and circumstances, she may have been eligible for refundable credits or other tax breaks that could have put money back in her pocket. (The tax law provides a three-year window to claim a refund, so she would already have lost out on refunds from the earlier years.)

If she does owe taxes and penalties, the IRS has payment plans that could help. A Tax-Aide volunteer will explain her options for paying any overdue bills.