King & Wood, P.A.

When are You Required to File a Gift Tax Return?

“Filing a gift tax return is something that might feel a little bit gratuitous—after all, you were gifting something, not accumulating income, so why would the IRS possibly need to be in the loop?”

The IRS wants to know how much you’re gifting over the course of your lifetime. This is because while gifts may be based on generosity, they are also a strategy for avoiding taxes, including estate taxes, reports The Street in a recent article “Do I Need to File a Gift Tax Return?”

Knowing whether you need to file a gift tax return is relatively straightforward. The IRS has guidelines about who needs to file a gift tax return and who does not. Your estate planning attorney will also be able to guide you, since gifting is part of your estate and tax planning.

If you give a gift worth more than $16,000, it is likely you need to file a gift tax return. Let’s say you gave your son your old car. The value of used cars today is higher than ever because of limited supply. Therefore, you probably need to file a gift tax return. If the car title is held by you and your spouse, then the car is considered a gift from both of you. The threshold for a gift from a married couple is $32,000. Make sure that you have the right information on how the car is titled.

What if you added a significant amount of cash to an adult child’s down payment on a new home? If you as a member of a married couple gave more than $32,000, then you will need to file a gift tax return. If you are single, anything over $16,000 requires a gift tax return.

529 contributions also fall into the gift tax return category. Gifts to 529 plans are treated like any other kind of gift and follow the same rules: $16,000 for individuals, $32,000 for married couples.

What about college costs? It depends. If you made payments directly to the educational institution, no gift tax return is required. The same goes for paying medical costs directly to a hospital or other healthcare provider. However, any kind of educational expense not paid directly to the provider is treated like any other gift.

Do trusts count as gifts? Good question. This depends upon the type of trust. A conversation with your estate planning attorney is definitely recommended in this situation. If the trust is a “Crummey" trust, which gives the beneficiary a right to immediately withdraw the gift put into the trust, then you may not need to file a gift tax return.

A Crummey trust is not intended to give the beneficiary the ability to make an immediate withdrawal. However, the withdrawal right makes the gift in the trust a “current gift” and it qualifies for the annual exclusion limit. Recategorizing the gift can potentially exempt the person giving the gift from certain tax obligations. Check with your estate planning attorney.

Even when filing a gift tax return, the amount of tax being paid is usually zero. This is because the gifts are offset by each person’s lifetime exemption. The IRS wants these returns filed to keep track of how much each individual has gifted over time. Unless you are very wealthy and making gift transfers from a family trust or to family members, it is not likely you will ever end up paying a tax. You are, however, required to keep the IRS informed.

Reference: The Street (March 31, 2022) “Do I Need to File a Gift Tax Return?”

 

Can I Pay Less Taxes on My Retirement Funds?

“You don't get to use all the money in your traditional 401(k) and IRA for retirement because you still have to pay taxes on it.”

No one likes paying taxes on retirement funds. However, unless you have a Roth IRA or SEP, funded with after-tax dollars, you will owe taxes on withdrawals. However, according to a recent article from U.S. News & World Report, “How to Pay Less Tax on Retirement Account Withdrawals,” there are strategies to reduce taxes on your retirement account withdrawals.

Avoid the early withdrawal penalty. If you take money from a traditional IRA before age 59½, the penalty is 10% plus the income tax due on the withdrawal. If you are in a pinch and need the funds, you would be better off taking withdrawals from a 401(k), which is penalty free if you leave the job associated with the 401(k) at age 55 or later. You might be able to avoid the penalty if the money is needed for a large medical bill, college costs or a first home purchase.

Roll over a 401(k) without tax withholding. Changing jobs? If you take money from a 401(k) when you change jobs, 20% is held for income tax. If you do not put the entire distribution directly into a new retirement account, you could end up owing income tax and the early withdrawal penalty. One way to avoid the tax withholding and penalties is to do a direct transfer from your 401(k) to the trustee of another 401(k) or IRA. Trustee-to-trustee transfers are not generally considered a taxable event.

Manage your required minimum distributions. IRA and traditional 401(k) owners are required to take minimum distributions after age 72. Missing an RMD is expensive: the penalty is 50% of the amount you should have withdrawn, plus income taxes. However, if you are still working after age 72 and do not own 5% or more of the company you work for, you can keep delaying those RMDs from a 401(k) account held for you by your employer until you retire. For IRAs, you still have to take those withdrawals.

Be careful about distributions. Plan the distributions for the first year. You do not want to take two distributions and risk getting bumped into a higher tax bracket. The first RMD needs to be taken by April 1 of the year you turn 72 (or 70½ if you were born before July 1, 1949). The second and all subsequent distributions are taken by December 31 each year. If you delay the first distribution until April, you will end up taking two distributions, which could lead to a big tax bill.

Taking withdrawals earlier than age 72. By taking traditional retirement account withdrawals during your 60s, you can spread the tax bill over more years and enjoy the benefits of a lower tax bracket, reducing your overall lifetime tax bill. Try to take 401(k) or IRA withdrawals during a year when your income is low, like after you retire but before you take Social Security benefits.

Consider a qualified charitable distribution made directly from your IRA. Retirees 70½ or older can avoid income taxes on IRA withdrawals of up to $100,000 (or $200,000 per couple), if they make a QCD directly from their IRA to a qualifying charity. You can also donate part of your RMD and withdraw the rest of income.

Keep tax-preferred investments out of retirement accounts. If you have investments generating long-term capital gains in a retirement account, you will pay a typically higher regular income tax rate when you take the funds from the account. By contrast, you can lower the taxes by holding more highly tax investments (like Treasury inflation-protected securities, corporate and government bonds and funds generating short-term capital gains) within retirement accounts.

Balance retirement funds taxes with your overall retirement plan to try to minimize taxes. Do not neglect to discuss tax planning when you sit down with your estate planning attorney to create or revise your estate plan.

Reference: U.S. News & World Report (March 8, 2022) “How to Pay Less Tax on Retirement Account Withdrawals”

Is It Better to Inherit Stock or Cash?

“If you’re planning to leave your heirs any sort of inheritance, you’re already giving them a valuable financial leg up.”

To make an inheritance even more advantageous for heirs, it’s a good idea to streamline accounts and simplify what you own before you die, eliminating some complications during a very emotional time. The next three decades will see a massive transfer of wealth from one generation to the next, says a recent article “6 of the Best Assets to Inherit” from Kiplinger. If you might be among those leaving inheritances to loved ones, there are steps you can take to prevent emotional and even family-destroying fights resulting from problematic assets.

Cash is king of inheritance assets. It’s simplest to deal with and the value is crystal clear. If you have accounts in multiple financial institutions, consolidate cash into one account. Each bank may have different rules for distributing assets, so reducing the number of banks involved will make it easier. Just remember to stay within FDIC limits, which insures only $250,000 per bank per ownership category. Tell your children if they are going to receive a significant cash inheritance and discuss what they may want to do with it.

Cash substitutes. Proceeds from a life insurance policy are usually very cut and dried. When you pass away, the life insurance company pays beneficiaries the death benefit in cash, according to the beneficiaries named on the policy. Be sure to tell your heirs where the original policy is located. They’ll need to provide the insurance company with a death certificate and there may be a form or two involved. The proceeds are income tax free, although the death benefit itself is added to the value of your estate and might be charged estate taxes.

Bank products, like CDs and Money Market Accounts. You can set up these accounts to be Payable on Death (POD), so the person named can access the assets quickly after your death. Don’t put one person’s name on the account and hope they share with their siblings. That’s a recipe for family disaster. If your will has one set of instructions and the bank product names another owner, the bank will pay according to the titling of the account. The same goes for life insurance proceeds—the beneficiary designation supersedes instructions in a will.

Brokerage Accounts. Stocks, bonds, mutual funds and other assets held in a taxable brokerage account are easy to divide and value. They are also easy to sell and convert to cash. What’s more, they could give heirs a significant tax benefit. If you bought shares of Apple or IBM years ago and sold the stocks while you were living, you’d owe capital gains taxes. However, if the investments are inherited, the heir receives a step-up-in-basis, which means the investment basis goes to the market value on the day you die. It’s entirely possible for heirs to sell appreciated assets with no or little taxes due.

Assets that decrease in value fast: this is not for everyone. Let’s say you know your heir is going to take their inheritance and buy an over-the-top luxury item, like a new sports car or a yacht. You know the asset will lose value the minute it’s driven out of the showroom or launched for the first time. Rather than leave them cash to make a purchase, buy the car or boat yourself and leave it to them as an inherited asset. They lose value immediately, while reducing your taxable estate. You’ve always wanted a Lamborghini anyway.

Roth IRA—Best of All IRA Worlds. The Roth IRA is funded with after-tax dollars, and in exchange, retirement withdrawals and investment gains are income tax-free. If you leave a 401(k) or traditional IRA, heirs will owe taxes on withdrawals and unless they meet certain requirements, they have to empty the account within ten years.

Trust Fund Assets. This may be the best way to protect an inheritance from heirs. If you leave property outright to heirs, it’s subject to creditors and predators. Funds in a trust are carefully protected, according to the terms of the trust, which you determine. Your estate planning attorney can create the trust to achieve whatever you want. Inheritances in trusts are less likely to evaporate quickly and you get the final say in how assets are distributed.

Reference: Kiplinger (Dec. 9, 2021) “6 of the Best Assets to Inherit”

What is the Purpose of an ILIT?

“Life insurance is a sophisticated financial product, with as many variations and permutations as there are creative insurance companies (there are many) and creative insurance planners (there are even more).”

Life insurance falls into two categories: life insurance and death insurance. Life insurance is used to take advantage of the tax-free returns that qualifying insurance products enjoy under federal income tax laws. There is a death component. However, the main purpose is to serve as a tax-deferred investment vehicle. Death insurance is used to provide financial security for loved ones after the owner passes, with little or no regard for tax and investment benefits.

Using both types of life insurance in estate planning can be a complicated process, but the resulting financial security is well worth the effort, as reported in a recent article “Keeping an Eye on ILITs” from Financial Advisor.

The Irrevocable Life Insurance Trust is a somewhat complex trust structured under state trust law and tax strategies under federal income tax laws. ILITs have been tested in court cases, audits and private letter rulings, so an estate planning attorney can create an ILIT knowing it will serve its intended purpose.

Life insurance in an ILIT is owned outside of the estate and enhances the after-estate tax wealth for the surviving spouse and heirs. Because the trust is irrevocable, the transfer of ownership is permanent.

The annual insurance premium is typically paid by the insured to the ILIT, subject to “Crummey” withdrawal powers, named after a famous case, which gives named people the power to withdraw all or a portion of the contributed premium amounts within specified periods. The time frame depends on the trust—usually it’s 30 or 60 days, but sometimes it’s annually.

There are many nuances and details.  The ILIT lets an insured buy life insurance “outside of their estate” for estate tax purposes, lets the person treat insurance premiums as non-taxable gifts under the annual exclusion provisions and provides safety and security to the beneficiaries.

The ILIT is often used as part of a buy-sell agreement for privately held family businesses to make it possible for the business itself or business partners to buy out the equity of a deceased partner. The payment obligations may be funded by the proceeds from life insurance. In some cases, each partner buys a traditional insurance policy in an ILIT. The estate planning attorney working on a succession plan can provide advice on the most effective way to use the ILIT.

Another use for the ILIT is for wealthy families with illiquid assets, like an art collection or a large real estate portfolio. An ILIT holding a life insurance policy with a death benefit lets the beneficiaries use the proceeds to pay estate tax liabilities, without dipping into their own or the estate’s assets. The investment returns of the ILIT increase the policy owner’s wealth substantially, without increasing their taxable estate.

Reference: Financial Advisor (December 1, 2021) “Keeping an Eye on ILITs”

What Is the Best Thing to Do with an Inherited IRA?

“Inheriting an IRA from a parent has a unique set of rules you need to know, which will help you make the most of the money you inherit and avoid a tax-time surprise.”

When a parent dies and their adult child inherits a traditional IRA, knowing what to do can be the difference between an inheritance and a tax disaster. Many people take the money from the IRA account and place it into their own IRA. However, that’s a mistake, says the article “How to manage an inherited IRA from a parent” from Sentinel Source.com.

Any inherited IRA, whether it’s from a parent, sibling, or friend, cannot be simply rolled into your own account or treated as if it’s your own IRA. Instead, the assets must be transferred in a timely manner to a new IRA that must be titled as an “Inherited IRA” that includes the name of the deceased owner and the phrase “For the benefit of…” and your name. Different financial institutions may have small variations in how they title the account. However, this seemingly small detail is critical.

If a traditional IRA has more than one beneficiary, it must be split into separate accounts for each beneficiary. Each heir will treat their own inherited portion in the same way, as if they were the sole beneficiary.

It’s the heir’s choice to either set up a new Inherited IRA Beneficiary account with a financial institution or advisor of their own, or to create a new account using the prior institution. Sometimes using the same firm that held the account is easier, as long as the correct title is used.

The new owner of a Beneficiary IRA needs to know the rules to avoid costly penalties. After the SECURE Act became law in December 2019, most beneficiaries are now required to deplete an inherited IRA within ten (10) years of the original account owner’s death. This applies to any inherited IRAs where the owner has died after December 31, 2019.

The prior rules allowed Inherited IRAs to be depleted over the lifetime of the beneficiary, which allowed the accounts to grow tax-deferred and in many cases, be passed to a third generation, often referred to as “Stretch IRAs.” This option is gone.

There are no limits as to how much or how often withdrawals can be taken from the account, as long as it’s depleted in ten years. However, the withdrawals are taxable as regular income, so if you wait until the ten year mark and take out the entire amount, you’ll end up with a hefty tax bill.

There are exceptions to the withdrawal rule. A surviving spouse, a minor child, a disabled or chronically ill beneficiary, or a beneficiary within ten years of age of the original IRA owner may have a little more time to withdraw funds (and pay taxes on the withdrawals).

If inheriting an IRA from a spouse, you may transfer the IRA balance into your own account and delay distributions until age 72.

Consider your IRAs carefully when working with an estate planning attorney on the distribution of your assets. Will your heirs be able to pay the taxes on their inherited IRAs, or should they be converted to Roth IRAs to relieve heirs of a future tax burden? These are questions that your estate planning attorney will be able to address.

Reference: Sentinel Source.com (Sep. 18, 2021) “How to manage an inherited IRA from a parent”

Roth IRA has a 5-Year Rule

“Established in 1997, the Roth individual retirement account has long been a favored option for retirement savings, due to its promise of tax-free withdrawals in retirement.”

Roth IRAs are popular for their flexibility and the simplicity of putting after-tax dollars in and not paying taxes on withdrawals during retirement. However, making the most of a Roth IRA requires paying attention to the details, according to a recent article “What is the Roth IRA 5-Year Rule?” from U.S. News & World Report.

More specifically, there are certain five-year rules that can undo all the good that comes from using a Roth, if you don’t know them. Avoid paying penalties or fees, by understanding how the Roth IRA rules work.

The Roth IRA five-year rule applies to investment earnings, and not to initial contributions. If you make withdrawals of investment earnings before the five-year time period, you’ll get hit with taxes and penalties, no matter how old you are. Many people think that once they turn 65 or 70, they can tap their Roth IRA whenever they want, but that’s not true.

Once you’ve opened and funded a Roth IRA, you’ll have to wait five years until you can start taking tax-free withdrawals of your investment earnings. The clock starts ticking on the date you open the account and make your very first contribution.

After five years, there are still certain requirements that must be met to take out earnings without a penalty. Before you can take out tax-free withdrawals, you will need to be at least 59½ or older.

That’s even if your first contribution was made the year you celebrated your 58^th birthday. You’ll need to wait until age 63 before you may take qualified distributions from the account. The five-year rule applies, even if you opened the Roth IRA at age 70.

How is this time frame calculated? The IRS does it based on tax years. A tax year runs from January 1 to December 31. The deadline for contributions is the same as the deadline for filing taxes. Let’s say you funded a Roth IRA in April 2021 for the calendar year of 2020. The five-year rule begins on January 1, 2020. Apply the five-year rule, and you could begin taking withdrawals from the account on or after January 1, 2025.

What happens if you need to make withdrawals before the account hits that five-year mark? In that case, withdraw contributions to the account and not investment earnings.

If you’ve contributed money to a Roth IRA account, you can take that money out with no tax or penalty, no matter how old you are. However, make sure you meet all of the requirements. Remember that to avoid any taxes or penalties, you’ll need to leave the earnings in the account.

Reference: U.S. News & World Report (March 10, 2021) “What is the Roth IRA 5-Year Rule?”

Using Retirement Funds in a Financial Crisis

“U.S. has been making it easier for people to access long-term savings for emergencies, trading future financial security to stay afloat.”

For generations, the tax code has been a public policy tool, used to encourage people to save for retirement and what used to be called “old age.” However, the coronavirus pandemic has created financial emergencies for so many households that lawmakers have responded by making it easier to tap these accounts. The article “Should You Tap Retirement Funds in a Crisis? Increasingly, People Say Yes” from The Wall Street Journal asks if this is really a good idea.

This shift in thinking actually coincides with trends that began to emerge before the last recession. People were living and working longer. Unemployment and career changes later in life were becoming more commonplace, and fewer and fewer people devoted four decades to working for a single employer, before retiring with an employer-funded pension.

For those who have been affected by the economic downturns of the coronavirus, withdrawals up to $100,000 from retirement savings accounts are now allowed, with no early-withdrawal penalty. That includes IRAs (Individual Retirement Accounts) or employment-linked 401(k) plans. In addition, $100,000 may be borrowed from 401(k) plans.

Americans are not alone in this. Australia and Malaysia are also allowing citizens to take money from retirement accounts.

Lawmakers are hoping that putting money into pockets now may help households prevent foreclosures, evictions and bankruptcies, with less of an impact on government spending. With trillions in retirement accounts in the U.S., these accounts are where legislators frequently look when resources are threatened.

However, there’s a tradeoff. If you take out money from accounts that have lost value because of the market’s volatility, those losses are not likely to be recouped. And if money is taken out and not replaced when the world returns to work, there will be less money during retirement. Not only will you miss out on the money you took out, but on the return, it might have made through years of tax-advantaged investments.

The danger is that if retirement accounts are widely seen as accessible and necessary now, a return to saving for retirement or the possibility of putting money back into these accounts when the economy returns to normal may not happen.

IRA and 401(k) accounts began to supplant pensions in the 1970s as a way to encourage people to save for retirement, by deferring income tax on money that was saved. By the end of 2019, IRAs and 401(k) types of accounts held about $20 trillion in the US.

Boston College’s Center for Retirement Research has estimated that even before the coronavirus, early withdrawals were reducing retirement accounts by a quarter over 30 years, taking into account the lost returns on savings that were no longer in the accounts. For many people, taking retirement funds now may be their only choice, but the risk to their financial future and retirement is very real.

Reference: The Wall Street Journal (June 4, 2020) “Should You Tap Retirement Funds in a Crisis? Increasingly, People Say Yes”

 

How a Charitable Remainder Trust Works

 

“The most well-known ‘death’ tax is the Federal Estate and Gift Tax. However, the reality is that few people really have to worry about the cost of federal estate taxes.”

The least popular beneficiary is almost always the federal government. Most people are concerned that their estate will need to pay taxes and do what they can through estate planning to keep federal estate tax liability to a minimum. However, with federal estate and gift tax exemptions at $11.58 million per person this year, and twice that when properly used with the spousal exemption, most people don’t need to worry about the federal estate tax, explains The News Enterprise in the article “New federal law resurrects Charitable Remainder Trust.”

The passage of the SECURE Act, effective January 1, 2020, made big changes in how we need to plan for taxes for beneficiaries. Federal estate and gift tax exemptions did not change, but anyone who inherits a retirement account is likely to find fewer options than before the SECURE Act.

Charitable remainder trusts have been used for many years to avoid high capital gains taxes on appreciated assets. Appreciated assets are placed into trusts and no taxes are due on the transfer.  The donor also gets a charitable tax deduction. The amount in the trust grows, while paying out a small amount to beneficiaries in installment payments.

With the passage of the SECURE Act, non-spousal beneficiaries, with certain exceptions, must withdraw the entire amount of the qualified retirement account within ten years. Generally, beneficiaries may not roll the account into their own qualified account, and there are no required annual distributions. However, there’s a ten-year window to empty the account. Taxes are due on every withdrawal, whether it takes place over ten years or as a single withdrawal.

By using a CRT, the full amount of the account may be transferred into the CRT, no taxes are due, and the donor (or the donor’s estate) gets a charitable deduction.

The trust is simply an instrument created, so that a beneficiary may receive regular payments, which may include the donor, beneficiaries or multiple beneficiaries, over the span of their lives, or in a set number of years, with the remainder interest of at least ten percent of the initial contribution paid to a qualified charity at the end of the trust.

This effectively creates a stretch for the IRA, with withdrawals being taxed to the beneficiary, over a longer time span. With only ten percent being required to be donated to a charity, those who plan on making a donation to a charity anyway receive a benefit, and their beneficiaries can receive a lifetime income stream.

Speak with your estate planning attorney to learn how a CRT could be part of your estate plan.

Reference: The News Enterprise (June 2, 2020) “New federal law resurrects Charitable Remainder Trust”

 

Retirement Fund Withdrawals Can Affect Social Security Benefits

“Social Security provides a guaranteed source of income in retirement, but what many don't realize is that you're not guaranteed to keep it all.”

Coordinating income in retirement takes a bit more thought than just collecting a paycheck. Take too much from Peter, you’ll end up paying Paul. Some retirees end up owing taxes on their Social Security benefits. If you want to avoid this scenario, master the details as explained in the article “Will My Retirement Fund Withdrawals Affect My Social Security Benefits?” from The Motley Fool.

It all depends upon your income. This is defined as your adjusted gross income, or AGI, plus nontaxable interest plus half of your annual Social Security benefits. The AGI is a person’s income for the year, minus certain tax deductions, like self-employment taxes and contributions to tax-deferred retirement accounts. Withdrawals taken from traditional IRAs or most 401(k)s, which are tax-deferred retirement accounts, do count towards the AGI. However, Roth retirement account withdrawals do not. The only nontaxable interest in your combined income calculation would be tax-exempt bond funds.

For example, a single person with an AGI of $20,000 with $1,000 in non-taxable interest and a $12,000 annual Social Security benefit would have a combined income of $27,000 ($20,000 plus $1,000 plus $6,000 totals $27,000).

Single taxpayers with a combined income of more than $25,000 and married couples filing jointly with a combined income of more than $32,000 could pay taxes on as much as 50% of their Social Security benefits. Single adults with a combined income greater than $24,000 and married couples filing jointly with a combined income greater than $44,000 could owe taxes on as much as 85% of their benefits.

But wait—here’s a detail you need to know. Because you could owe taxes on 50% or 85% of your benefits does not mean you’ll actually pay this much. There’s a Social Security benefit tax formula that will help you understand how this works. Your estate planning attorney or your accountant can help you figure out how this might impact your retirement finances.

Can you avoid these taxes? With the right plan, maybe. Most retiree’s sole source of income is Social Security and withdrawals from retirement accounts. Being smart with those withdrawals, can reduce the likelihood of owing taxes on Social Security benefits.

If you know that you are approaching one of the Social Security threshholds, try to avoid withdrawing more money from tax-deferred retirement accounts. If you have Roth accounts, try to live from them, because they don’t impact your tax status. Another alternative is to pinch pennies for a while, or simply take the plunge and pay the taxes.

Delaying Social Security benefits as long as you can, up to age 70, is another way to reduce the likelihood of owning taxes on benefits. Yes, you can start taking Social Security at age 62, but you must wait to claim your full benefits until you reach your full retirement age. If you start taking benefits early, you’ll get less than your full benefit, and that smaller amount will be permanent.

You can’t pay taxes on benefits that you’re not receiving. Delaying benefits will increase their size, which will reduce the amount to be withdrawn from tax-deferred accounts. This will lower your AGI.

It’s possible that you may not be able to avoid paying taxes on Social Security benefits. However, knowing your unique situation in advance and planning accordingly, will be better than living with a reduced budget because you didn’t know and didn’t plan.

Reference: The Motley Fool (Jan. 17, 2020) “Will My Retirement Fund Withdrawals Affect My Social Security Benefits?”