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: Should you sell a house or let heirs deal with it? The taxes shake out differently

Dear Liz: My mother, who will be 101 later this year, is leaving me real estate in her trust. The value of it is $4.5 million. She has other assets that will put her estate over $5 million when she passes. I currently have an offer from someone who wants to buy the real estate. Is it better for her to sell it now and reduce the value of her estate? She has never exercised the option for the one-time sale of her primary residence tax free. What are the tax implications if it remains in her estate until she passes?

Answer: There’s no such thing as a one-time option to sell a home tax free. Decades ago, homeowners could defer the recognition of taxable gain if they bought another house, and homeowners 55 and older could exclude as much as $125,000 of gain. That was a one-time deal, so perhaps that’s what you’re remembering.

Since 1998, however, taxpayers have been able to exempt as much as $250,000 of capital gains from the sale of their primary residence as long as they owned and lived in the home at least two of the prior five years. Taxpayers can use this exemption as often as every two years.

Clearly, your mom needs to find a source of good tax advice, such as a CPA or other tax professional. If you have the authority to act on your mother’s behalf through a power of attorney or legal conservatorship, then you should seek the tax pro’s advice as her fiduciary.

Under current law, if she retains the real estate it would get a “step up” to the current market value as of her death. That means all the appreciation that happened during her lifetime would never be taxed. If she sells now, on the other hand, she probably would owe a substantial capital gains tax bill, even if she uses the exclusion. The tax pro will calculate how much that’s likely to be.

That tax bill has to be weighed against the possibility that her estate could owe taxes. The current estate tax exemption limit is $11.7 million, an amount that will continue to be adjusted by inflation until 2025. In 2026, the limit is scheduled to revert to the 2011 level of $5 million plus inflation. President Biden has proposed lowering the limit to $3.5 million and modifying the step up, but those ideas face stiff opposition in Congress.

An estate planning attorney could discuss other options for reducing her estate if she’s still with us as 2025 approaches. The tax pro probably can provide referrals.

Wednesday’s need-to-know money news

Today’s top story: How COVID-fueled crowdfunding can revive small businesses. Also in the news: How point and mile values have changed over the pandemic, the one trick to traveling cheaply, and this tool tells you what you owe the IRS before they come looking for it.

How COVID-Fueled Crowdfunding Can Revive Small Businesses
Tips for launching an effective campaign.

How Have Point and Mile Values Changed Over the Pandemic?
For the most part, airline miles are worth more than they were last year, while hotel points are worth less.

There’s Just One Trick to Traveling Cheaply: Flexibility
To fly for the lowest price, you should try searching without a specific destination or date in mind.

This Tool Tells You What You Owe the IRS Before They Come Looking for It
Beating the IRS to the punch.

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.

Tuesday’s need-to-know money news

Today’s top story: A Roth IRA could help you avoid taxes like the ultrawealthy. Also in the news: How one DUI can nearly double your car insurance, the Child Tax Credit scam, and flying first class for cheap(er) right now.

A Roth IRA Could Help You Avoid Taxes Like the Ultrawealthy
You, too, could lower your tax burden with the right investment account.

One DUI Can Nearly Double Your Car Insurance — Here’s How to Save
On average, auto insurance rates skyrocket 96% after a DUI, our 2021 rate analysis found.

Scam Alert: Child Tax Credit Is Automatic; No Need to Apply
The IRS won’t call, text or email you so beware of unsolicited communications.

You Can Fly First Class for Cheap(er) Right Now
Luxury travel is a bit more accessible.

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.

Monday’s need-to-know money news

Today’s top story: Haven’t filed your taxes yet? Act soon to avoid penalties. Also in the news: A new episode of the Smart Money podcast on free health insurance, a tax guide for small business owners, and Americans fear highest inflation in nearly a decade.

Haven’t Filed Your Taxes Yet? Act Soon to Avoid Penalties
Dealing with taxes can be a pain, but it’s better than the penalties you’ll face if you don’t file or pay on time.

Smart Money Podcast: Free Health Insurance and Finding Scholarships
A discussion about a provision in the American Rescue Plan that qualifies millions of Americans for free or lower-cost health insurance.

A Tax Guide for Small-Business Owners
Practicing good financial hygiene throughout the year takes some of the headaches out of filing business taxes.

Americans fear highest inflation in nearly a decade
Growing fears.

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.