Q&A: They want to give the caretaker the house she lives in without imposing a tax burden

Dear Liz: Our family owns a vacation home. A caretaker for the property lives in a smaller house next door that is also owned by our family. We consider her part of our extended family and would like to show our appreciation when the property is sold. Our wish would be to give the smaller house in which she lives to her as a gift, but we know the annual payment of property taxes would probably be too great a financial burden for her to live there as a retiree. (She is currently in her 50s.) Is there some sort of trust or fund we could set up that would cover her property taxes until her death without adding to her taxable income?

Answer: Yes, but there may be a better solution.

A trust can be set up to pay the property taxes or other property expenses during the caretaker’s lifetime, said Jennifer Sawday, an estate planning attorney in Long Beach. Trusts face high tax rates, however, and cost money to set up and administer. Plus, you have to find people willing to be trustees and backup trustees who are likely to outlive the caretaker. You also must decide what happens to the money when the caretaker passes away.

All these issues are surmountable, of course. Younger members of your family could be trustees, for example, or you could hire professional trustees. The money could be invested conservatively, or in tax-efficient mutual funds, to minimize taxes. Or it could be invested aggressively enough to pay the tax bill and still provide enough income to pay the property expenses.

Another, simpler solution would be to give her the cash outright. Gifts are not taxable to the receiver, so the gift itself would not increase her income taxes. She would have the burden of managing the cash, of course. Like the trust, she could invest to minimize taxes or more aggressively to potentially grow the money and offset inflation. Either way, her tax rates probably would be lower than the trust’s.

An estate planning attorney can help your family discuss the various options and set up the documents to carry out your wishes.

Q&A: Death, taxes and home sales: How to handle the mixture

Dear Liz: My wife and I bought our house 61 years ago in Southern California. The wife passed away seven years ago, and I became the sole owner. If I should die owning the house, I know my daughter will inherit and her tax basis will be the value of the house on that date. But if I sell the house, I’m not sure what my basis will be. Do I pick up the 50% of what the house was worth on the day my wife died and add to that the 50% of the original purchase price that would be mine? Or is my basis the original price of the house?

Answer: In most states, only your wife’s half of the home would get a new value for tax purposes at her death. In community property states such as California, though, both her half and yours get this step up in tax basis.

Tax basis determines how much taxable profit there might be when property and other assets are sold. For those who aren’t sure how tax basis works, a simplified example might help.

Let’s say Raul and Ramona bought their home for $40,000 in 1959. In 2013, when Ramona died, the home was worth $800,000. Today, it’s worth $1 million.

At her death, Ramona’s half of the home got a new tax basis. Instead of $20,000 (half of the purchase price), her half of the home now has a tax basis of $400,000 (half of its $800,000 value at the time).

In most states, Raul would keep the $20,000 tax basis on his half, so his combined basis in the home would be $420,000. If he should sell the home for $1 million, the profit for tax purposes would be $580,000.

In California and other community property states, the entire house gets a step up in basis to $800,000 when Ramona dies. If Raul sells the house for $1 million, the profit (or capital gain, in tax parlance) would be $200,000.

Of course, there would be no tax owed on this home sale, since Raul can exempt up to $250,000 of home sale profits. Raul could use Ramona’s home sale exclusion, and avoid tax on up to $500,000 of home sale profit, if he sells the home within two years of her death.

If Raul keeps the home until his death, on the other hand, it will get a further step up in tax basis equal to whatever the home’s fair market value is at the time (let’s say $1.2 million). If the daughter sells it for that amount, no capital gain tax would be owed.

Q&A: 2020 taxes bring another stimulus shot

Dear Liz: My 2019 tax return was electronically submitted May 11 and my income was low enough to qualify for a stimulus payment. I got my refund at the end of July but was told I wouldn’t get a stimulus check because my 2018 income was too high. The IRS agent on the phone said I could request the money when I filed my 2020 taxes. But isn’t that past the deadline? The agent sounded like he was just trying to get me off the phone.

Answer: He probably was, but he gave you the correct information. The IRS used the tax returns it had on hand this spring when it started sending out stimulus payments. Since your 2019 return hadn’t been filed, it used your 2018 income to determine how much, if anything, to send you.

People who didn’t get checks or got too little aren’t out of luck. The stimulus checks were an advance payment of a credit that will be added to people’s 2020 tax returns. If you should have received a check but didn’t, you’ll get the full credit added to your refund next year.

Q&A: Missing refund update

Dear Liz: Thank you for including my previous email about a missing tax refund in your recent column. Just to update you, on Aug. 20 I checked the IRS “refund status” website and lo and behold, it showed they had received my mother’s paper return, processed it, and even approved the refund (with $3.59 interest no less)! The check is to be mailed on Aug. 27. So for those concerned about the delays: The IRS will indeed get to them eventually and, as you’ve previously advised, there is no need to call them and check. Their backlog is massive, so let’s keep them working on that.

Answer: Thanks for the update!

Q&A: Where’s that tax refund?

Dear Liz: Like the writer in a recent column, I received a stimulus check for my late mother and dutifully mailed the IRS a check as the agency requested on May 6. The check finally cleared on Aug. 12. So, yes, the IRS will absolutely eventually cash it. However, I’m still waiting for the federal tax refund for my mother’s final tax return, which I mailed on April 20. I figure if it took them over three months to just cash a check, it’ll be at least a couple more months, if not longer, to process the return.

Answer: You’re probably right, and — as the previous column emphasized — the IRS does not need calls from people about non-urgent matters as the agency slowly works through its massive backlog. If you can wait to talk to the IRS, in other words, you should.

Q&A:The IRS doesn’t need your worry

Dear Liz: My mother received a stimulus payment on behalf of my late father in April. Per an IRS directive on May 6, I returned the money to the IRS. As of Aug. 1, the check I sent has not been cashed. I have made two phone calls to the specific IRS phone number that deals with any stimulus payment issues and both times have been told, “Don’t worry about it.” Do you have any suggestions for us?

Answer: Yes. Don’t worry about it. And stop calling.

The IRS is dealing with a tremendous backlog that accumulated while its operations centers were shut down because of the pandemic. Although the centers have reopened, the pandemic is still affecting the agency and probably will do so for some time.

The IRS recently warned that “live assistance on telephones, processing paper tax returns and responding to correspondence continue to be extremely limited.” The IRS will cash the check eventually; your calls won’t speed that up and will unnecessarily tax an already overwhelmed system.

In the future, consider using the IRS’ online payment systems. They’re safer than sending checks in the mail and you’ll get instant confirmation that your payment was received.

Q&A: Side effects of IRA conversions

Dear Liz: I thought your readers would benefit from additional knowledge about Roth conversions. I started converting our IRAs to Roth IRAs when my wife and I turned 60 years old. Years later, I realized that our premiums for Medicare Part B and D were higher because our income in those years exceeded $174,000.

Answer: Triggering Medicare’s income-related monthly adjustment amount (IRMAA) is just one of the potential side effects of a later-in-life Roth conversion.

That’s not to say these conversions are a bad idea.

People with substantial amounts in traditional retirement accounts might benefit from transferring some of that money to Roth IRAs, particularly if the required minimum withdrawals that start at age 72 would push them into a higher tax bracket. They may have a window after they retire, when their tax bracket dips, to convert money and pay the tax bill at a lower rate.

Roths also don’t have the required minimum distributions that apply to other retirement accounts, so people have more control over their future tax bills.

Converting too much, however, can push people into higher tax brackets. Many financial advisors suggest their clients convert just enough to “fill out” their current bracket.

For example, the 12% bracket for married people filing jointly was $19,401 to $78,950 in 2019. A couple with income in the $50,000 range might convert $28,000 or so, because a larger conversion would push them into the 22% tax bracket.

But there are other considerations, as you discovered.

People with modified adjusted incomes above certain levels pay IRMAA adjustments that can add $144.60 to $491.60 each month to their Medicare Part B premiums for doctor visits and $12.20 to $76.40 to their monthly Part D drug coverage premiums. Higher income could reduce or eliminate tax breaks that are subject to income phaseouts, and conversions can subject more of your Social Security benefits to taxation.

At the very least, you should consult a tax pro before any Roth conversions to make sure you understand the ramifications. Ideally, you’d also be talking with a fee-only, fiduciary financial planner to make sure conversions, and your retirement plan in general, make sense.

Q&A: IRS pays interest on late refunds

Dear Liz: I filed my return electronically with direct deposit. I have yet to receive my refund or that stimulus relief check. We have to pay interest on any late tax payment. Will the IRS pay interest on late refunds?

Answer: The IRS has said it will pay interest on late refunds if the return was filed by July 15, the extended tax deadline. The interest “will generally be paid from April 15, 2020, until the date of the refund,” the IRS says on its site. Don’t expect to get rich: The interest rate for the second quarter, which ended June 30, is 5% a year, while the interest rate for the third quarter, which ends Sept. 30, is 3% a year.

Q&A: IRA conversions and taxes

Dear Liz: You recently advised a reader that if their income was too high to contribute to a Roth IRA, they could still contribute to an IRA or any after-tax options in their 401(k). You didn’t mention a two-step Roth IRA — first making a nondeductible contribution to an IRA and then immediately converting that amount to a Roth. That way those people whose income is too high to contribute to a direct Roth IRA can still have a Roth IRA using the two-step process.

Answer: This is known as a backdoor Roth contribution, which takes advantage of the fact that the income limits that apply to Roth contributions don’t apply to Roth conversions. Conversions, however, typically incur tax bills and don’t make sense for everyone. If you have a substantial amount of pretax money in IRAs, the tax bill can be considerable. (The tax bill is figured using all your IRAs, by the way. You can’t get around it just by contributing to a separate IRA that you then convert.)

Incurring that tax bill could make sense if you expect to be in the same tax bracket in retirement, or in a higher one. If you’re young and a good saver, it’s a good bet that will be the case. Roth conversions also can be advisable later in life if your tax bracket could jump when you reach age 72 and have to start taking required minimum distributions from your retirement accounts.

If you expect to be in a lower tax bracket in retirement, however, you probably should forgo Roth conversions because you’ll pay more now in taxes than you would later.

Of course, if you have little or no pretax money in your IRA, then backdoor conversions get a lot more attractive because the tax bill would be minimal. Otherwise, you should seek out a Roth conversion calculator to get a better idea of whether a conversion might be the right choice.

Q&A: Retirement accounts and taxes

Dear Liz: I am 41 and have had a traditional IRA for about two decades. I funded it for the first 10 years, taking a tax deduction for the contributions. Since I’ve had a 401(k) with my employer for the past several years, I obviously cannot take a deduction for the IRA amount, but I could still put money in. My 401(k) is fully funded, as is my husband’s. Does it make sense to also fund our IRAs with post-tax, nondeductible amounts? I realize any gains we make will be taxed at withdrawal, but I also know that as long as the money stays in the IRA, it can grow tax deferred.

Answer: First, congratulations on taking full advantage of your workplace retirement plans and still being able to contribute more.

You potentially can deduct contributions to IRAs when you have a 401(k) or other workplace retirement plan, but your income must be below certain limits. You can take a full deduction if your modified adjusted gross income is $104,000 or less as a married couple filing jointly. After that, the ability to deduct the contribution starts to phase out and is eliminated entirely if your modified adjusted gross income is $124,000 or more. (If you don’t have a workplace retirement plan but your spouse does, the income limits are higher. The deduction starts to phase out at $196,000 and ends at $206,000.)

If you can’t deduct contributions, you can look into contributing to a Roth IRA — but that too has income limits. For a married couple filing jointly, the ability to contribute to a Roth begins to phase out at modified adjusted gross income of $196,000 and ends at $206,000. If you can contribute, it’s a good deal. Roth IRAs don’t offer an upfront tax break but withdrawals in retirement can be tax free. You also can leave the money alone for as long as you want — there are no required minimum withdrawals starting at age 72, as there typically are for other retirement accounts.

If your income is too high to contribute to a Roth, you could still contribute to your IRA or to any “after tax” options in your 401(k). But you might want to consider simply investing through a regular taxable brokerage account. You don’t get an upfront tax deduction but you could still benefit from favorable capital gains tax rates if you hold investments for a year or more. Furthermore, you aren’t required to take withdrawals. That flexibility can help you better manage your tax bill in retirement.