tax planning

Be Very Careful with Inherited IRA's

Leaving someone an IRA as an inheritance can have a lot of tax advantages, and it's often a very good estate planning strategy. However, the rules for inherited IRA's are complicated, and it's easy to make mistakes. If you have recently inherited an IRA, or if you expect to inherit an IRA, it's important to speak to an estate planner or other advisor right away before you make any decisions about the account. And if you're planning to leave someone an IRA, you'll want to make sure that person knows what to do, so the tax benefits aren't lost through an innocent mistake.

The big advantage of an inherited IRA is that the assets may be able to remain in a tax-sheltered account and grow tax-free for years before they're taken out. So generally, you want to make sure the assets are left in the account for as long as possible.

The exact rules depend on the kind of IRA and whether the beneficiary is the surviving spouse of the owner. For example:

If a surviving spouse inherits a traditional IRA. There are a number of options, but the three primary ones are: 

  1. The spouse can roll the IRA into his or her own IRA. This is simple - there's only one account to deal with - and the spouse can postpone required minimum distributions (RMD's) until age 70 1/2 and calculate them based on his or her own life expectancy. The downside is that there's a 10% penalty on withdrawals before age 59 1/2, and there might be accelerated RMD's if the surviving spouse was older than the deceased spouse. 
  2. The spouse can transfer the assets into a separate account that's titled as an "inherited IRA." This is more complicated, but it might avoid the 10% penalty on early withdrawals and the accelerated RMD's. Because of the RMD rules, this option might be better in cases where the spouse who passed away hadn't yet reached aged 70 1/2.
  3. The spouse can take the additional step of converting the account to a Roth IRA. This can be smart in certain situations, such as if the spouse expects to be in a higher tax bracket later in life.

If someone other than a spouse inherits a traditional IRA. The beneficiary can transfer the assets into a separate "inherited IRA." The beneficiary will have to take RMD's starting the next year, but they'll be based on the beneficiary's life expectancy, not the owner's, which can save taxes. 

If a surviving spouse inherits a Roth IRA. There are two main options:

  1. The spouse can roll the IRA into his or her own existing or new Roth IRA. There are no RMD's, and  distributions are tax-free as long as the beneficiary is at least 59 1/2, and five years have passed since the original owner set up the account. 
  2. The spouse can transfer the Roth IRA assets into a separate "inherited IRA." With this method, the spouse will have to take RMD's, but there can be some tax advantages for early withdrawals. 

If someone other than a spouse inherits a Roth IRA. The beneficiary can transfer the assets into a separate "inherited IRA." The  beneficiary will have to take RMD's starting the next year. 

In addition, in all of the above scenarios, there are two other options:

  1. A beneficiary can always take an immediate lump-sum distribution. But unless this is absolutely necessary to pay bills, it's by far the worst choice tax-wise.
  2. A beneficiary can also disclaim the IRA assets. The advantage here is that the assets might pass to younger family members who can stretch the distributions out over many more years, thus compounding the tax benefits. Also, when the beneficiary dies, the assets won't be subject to estate tax.

Of course, a disclaimer makes sense only if the beneficiary doesn't need the assets to live on. Moreover, the beneficiary can't simply choose who will get the account; it will go to the person who would legally be entitled to it if the primary beneficiary hadn't been named as  beneficiary. 

This is an important point if you're leaving someone an IRA. You'll want to carefully consider who should be named as the alternate beneficiary - so that if the primary beneficiary chooses to disclaim, the assets will go to the right person tax-wise.

It's also possible to leave an IRA to a trust. This can have a number of benefits, such as protecting the assets from creditors and preventing a beneficiary from withdrawing the money prematurely and losing the tax benefits. However, it's very complicated and should only be done with expert advice. 

One thing to keep in mind is that a beneficiary may need to act quickly. For instance, there are strict time limits for rolling over inherited IRA assets into a new account.

Also, if an IRA owner passed away before taking out an RMD for the year in which he or she died, the beneficiary must take out the RMD before the end of the year or face a 50% penalty. (In fact, if someone dies late in the year without taking out an RMD, it's possible that the beneficiary won't even found out about the bequest until it's too late to avoid the penalty.)

Finally, if your estate plan involves leaving someone an IRA, it's critical to make sure your beneficiary designation form is filled out correctly and on file with the IRA custodian. If there's a glitch and the account ends up going through your estate rather than directly to the  beneficiary, the beneficiary might have to completely empty the account within five years, thus destroying most of the tax benefits.

Moving an Elderly Relative Could Trigger a Tax Problem

It's a common scenario: An elderly relative is no longer able to live alone, so family members sell the relative's house and have the relative start living with them or in a nursing home or assisted living facility that's closer to the family. 

One thing you might not consider during this stressful process is that if the relative moves to a different state, you might have just changed the person's official state of residence for tax purposes. And that could have a significant effect on his or her estate plan.

For instance, if someone moves from a state with no state estate tax to a state with such a tax, and he or she passes away, an estate tax might be owed on the value of the person's assets - even if he or she lived in the new state for only a very short time.

This is a significant danger because, while the federal estate tax generally doesn't apply to estates unless they're worth over $5 million, many state estate taxes start at a much lower figure. In Massachusetts, for example, the state estate tax threshold is only $1 million. 

Such an outcome could even lead to friction between heirs. For instance, suppose the relative's will leaves one child certain specific assets and the other child "everything else." The relative may have set things up so the children would receive more or less equal bequests. But under the law, if a state estate tax is suddenly due, all of it will come from the share of the child who gets "everything else." This could upset a careful estate plan and create family disharmony.

If you're thinking of moving an elderly relative to an out-of-state home or facility, it's a good idea to speak with an estate planner about the change. There might be ways to avoid having the relative be treated as a resident of the new state.

Of course, you might also discover that there are tax advantages to having the relative be treated as a resident of the new state, and you'll want to plan for that as well.

New Problem for Some Executors and Heirs

Executors who have to file a federal estate tax return, and some heirs who receive assets from an estate that is subject to the federal estate tax, may be facing a significant new problem as a result of rules just issues by the IRS.

The problem only affects larger estates - generally those where the deceased person's assets, large lifetime gifts, and life insurance proceeds total more than $5.45 million. But for those estates, it's a serious issue.

The problem stems from a law passed by Congress last year. The law says that an executor who files an estate tax return must now also fill out a form - called a Form 8971 - identifying all heirs to the IRS as well as the value of the assets to be distributed to them. Each heir must also be given a related form (called Schedule A) identifying the assets they will receive and their value.

If the estate is subject to the federal estate tax, then the heirs must use the value of the assets as stated on Form 8971 as their capital gains tax basis if they eventually sell them. There's a 20% penalty for claiming a different value.

(The idea was to prevent a perceived tax abuse where an executor claims a low value to save on estate taxes, and an heir later claims a higher value for the same asset to save on capital gains taxes.)

The IRS has just released proposed regulations explaining how all this will work in practice. And while the IRS's proposed rules clarify some things, they also highlight some serious issues.

For instance, Form 8971 must be filed fairly quickly after the deceased person's death, and an executor might not yet know exactly which estate assets will be given to which heirs, or which assets will be sold to fund a particular bequest. If that happens, then the executor must send the heirs a Schedule A that includes the value of all assets that could even conceivably be used or sold to fund their bequest.

So imagine that an estate is worth $7 million, and a distant relative or friend is going to receive an inheritance equal to 1% of the estate. That beneficiary might have to be given highly detailed and personal information about the entirety of the deceased person's financial affairs - something the deceased person almost certainly never expected to happen.

What's more, a relative or friend might look at the lengthy list of assets and assume that he or she is going to get a lot more than the actual bequest. This could leave an executor with a number of very angry and frustrated beneficiaries. 

The Schedule A form itself doesn't help much. Here's what it tells the heirs:

"you have received this schedule to inform you of the value of property you received from the estate of the decedent named above."

A beneficiary could read this and easily assume that he or she is receiving all the property listed.

Nor does Schedule A clearly explain (in language a non-expert could understand) the fact that heirs face a big penalty if they sell an asset and claim a different basis.

For this reason, many executors are going to have to go to some lengths to tell beneficiaries what they need to know and keep them from getting false hopes.

Another big problem is that, under the IRS's proposed rules, if an heir later transfers an inherited asset to a family member (or even just a portion of an asset), the heir must then file a second Form 8971, and must send a Schedule A to the family member. Many heirs will be totally unaware of this requirement, and as a result many family members might have no clue what the required basis is and end up inadvertently owing a 20% tax penalty.  

Here are some other important points in the IRS's proposed rules:

  • An executor who files an estate tax return has to file a Form 8971 even if no estate tax is owed, and therefor the heirs aren't legally required to use the value on the form as their basis. (This could happen, for instance, if there's a large marital or charitable deduction.)
  • If an executor is filing a return solely to claim "portability" of the estate tax exemption (so a surviving spouse can later use his or her own exemption plus the spouse's exemption), a Form 8971 doesn't have to be filed.
  • An executor who files a Form 8971 doesn't have to declare cash, assets in certain retirement accounts, or items of tangible personal property worth less than $3,000.
  • If additional assets are discovered after an estate tax return in filed, their capital gains tax basis will be zero unless the estate files a supplemental return.
  • If no estate tax return is filed, but one should have been filed, then all estate property will have a zero basis until a return is filed.

You should note that the IRS has only issued proposed regulations. Taxpayers can comment before they become final, and the IRS might tweak them later. But for now, we should assume the IRS means what it says.

Interest Rates Are Now Going Up - What Does This Mean for Your Estate Planning?

The Federal Reserve has begun raising interest rates. And while rates are still historically extremely low, they're probably at the start of a long, gradual increase. As a result, you might want to consider some estate planning techniques now that benefit from very low rates because an opportunity like this one might not come around again for many, many years.

Here are some ways to use the current low-rate environment to transfer assets to your heirs while avoiding estate and gift taxes:

Family loans. One idea is to loan money to a trust for your children, and then have the trust use it to make investments - or make a promising investment yourself, and then loan that asset to the trust. In return, you'll get a promissory note in which the trust promises to repay the loan with interest.

The IRS specifies a minimum interest rate, which you must observe in order for this arrangement to be considered a non-taxable loan rather than a taxable gift. However, this interest rate is near the lowest point it has ever been. As a result, you can charge minimal interest, and any investment returns above this rate will go to your children without being subject to estate or gift tax.

Installment Sales. If you want to sell a family business to a trust for your children, you can arrange to be paid in installments. This is often a good idea, because the trust can use the profits from the business to pay you off over time, rather than taking out a costly bank loan.

Again, you have to charge interest to the trust in order for the IRS to treat the delayed payments as an installment sale rather than a gift. But the required interest rate is very low, which means more assets will go to your children free of gift tax.

Grantor retained annuity trusts. You can put assets into a "grantor retained annuity trust," or GRAT, and then receive income from the trust (that's the annuity) for a certain number of years. When the trust expires at the end of the term, the assets remaining in the trust go to your beneficiaries. 

Here's why this is good: Let's say you put $1 million worth of assets into a 10-year GRAT, and at the end of that time the value of the assets has increased to $2 million. If you had simply kept the assets for 10 years and then given them to your heirs, you'd be subject to gift tax based on the $2 million. But if you put the assets into a GRAT now, your gift tax is based on the present value, or $1 million.

But even better, that $1 million is further reduced by the present value of the income stream you'll receive over the 10 years.

And here's where interest rates come into play - when the required IRS interest rate is very low, as it is now, the present value is much higher, and your taxable gift is much smaller.

There's one large drawback to GRATs, which is that if the donor dies before the term of the trust expires, the trust assets are added back into the donor's estate, and the tax advantages are lost. For this reason, choosing the term of the trust requires some thought. The longer the term, the greater the tax savings, but the greater the risk that the donor will pass away and the savings will be lost.

There are several ways to hedge against this risk. One is with "layered GRATs." For instance, instead of setting up a 10-year GRAT, a donor could put 10% of the assets into a two-year GRAT, 10% into a three-year GRAT, 10% into a four-year GRAT, and so on until there are 10 GRATs. Then, if the donor died halfway through the term, the family would still get half the tax benefits - and the donor could lock in today's low interest rates for all the GRATs.

Another option is to set up a short-term GRAT (two or three years) with an annuity that's equal to the present value of the GRAT assets. As a result, there's no estate or gift tax at all. With interest rates being so low, the trust has to pay very little interest to the grantor - and any appreciation in excess of the interest goes to the family beneficiaries tax-free.

Charitable lead trusts. These are trusts that make a payment to a charity each year for a certain number of years, after which the remaining assets go to your family beneficiaries. They're similar to GRATs, except that the annuity goes to a charity, and you get a charitable deduction.

Some people like this idea because it's a way to benefit a charity right now, in your lifetime, rather than after you pass away.

Charitable lead trusts are a good idea when interest rates are low, because low rates mean both a larger charitable deduction and a smaller gift tax on the assets that go to your family. 

Avoid Capital Gains Tax When Selling Investment Property

Did you know that it may be possible to avoid paying immediate capital gains taxes when you sell an investment property? That's true if you're planning to sell the property and invest the proceeds in another property shortly afterward. 

For instance, suppose you own a condo as an investment, and you plan to sell it and use the proceeds to buy another investment property. You might be able to treat the sale and subsequent purchase as a "wash," and defer paying any capital gains tax on the first property until you sell the second property.

This is known as a "like-kind exchange," or sometimes as a "1031 exchange" (after the section of the tax code that allows this).

There are some restrictions. For instance, the second property must be of a "like kind" - although it doesn't have to be the exact same kind of property. In general, you have to identify the second property within 45 days of selling the first property, and you have to close on the second property within 180 days of selling the first property. (In some cases, though, you can identify several properties within 45 days, as long as you close on one of them.)

Also, the proceeds from the initial sale must typically be held by a specially qualified third party while they're waiting to be used to purchase the new property.

In certain cases, it may be possible to close on the second property even before you sell the first property.

In the past, 1031 exchanges almost always involved real estate, but people are increasingly using them for other types of investment property, such as art. However, in order to qualify for such a tax break, you would have to show that you're actually in business as an art investor - simply selling a painting in your bedroom and replacing it with a new one probably wouldn't qualify.

A 1031 exchange can be complicated, and there's a lot of technical paperwork. But it might well be worth the effort if you can defer a significant capital gains tax.