When you turn your attention to year-end tax planning, you probably focus on your own situation as a single taxpayer or as a married individual who will file a joint tax return. Broadening your horizons, though, may pay off. If you have relatives in a low tax bracket, some strategies can permit you to take advantage of their low tax rates. The outcome might be lower taxes and more money for you and your loved ones to spend or invest.

Coping with the kiddie tax

You may believe that shifting income from parent to student is a taxefficient way to build an education fund. You might, for instance, give taxable bonds to your children so they can receive interest in a low tax bracket. Similarly, you might give appreciated assets to youngsters, who can sell them and owe little or no tax on the gains. Such tactics can be useful, but they are limited by the so-called “kiddie tax.” This tax code provision caps the amounts of unearned income that can be taxed at a youngster’s rate. Excess amounts are taxed at the parents’ rate, so there may be no family tax benefit.

 Kid stuff

Recent legislation has changed the kiddie tax rules. In 2011

• everyone under age 18 is considered a “kiddie.”

• the same is true for full-time students under age 24, if their earned income is less than half of their support. Here, support is the total spent on a student’s behalf during the year.

• 18-year-olds are still considered kiddies even if they are not fulltime students, as long as their earned income is less than half of  their support.

In 2011, individuals subject to those rules owe no tax on unearned income up to $950. The next $950 of unearned income will be taxed at the child’s rate, which will be no more than 10%. Over $1,900, all unearned income will be taxed at the parents’ rate. The kiddie tax limits change periodically to keep up with inflation, so the $1,900 limit might move up to $2,000, $2,100, and so forth in the future.

Weighing the trade-offs

Even with the kiddie tax limits in place, some families might find tax benefits in income shifting.

Example 1: John and Karen Jackson hold $35,000 in a taxable bond fund yielding 5%. When their daughter Sarah is born, they transfer their shares in that fund to the newborn. If Sarah receives $1,750 (5% of $35,000) this year, she will owe no tax on the first $950 and $80 on the next $800, at a 10% rate. This can go on every year, permitting Sarah to build up an education fund at a very low tax rate.

Example 2: Brett and Caroline Morgan hold large amounts of stock in the company for which Caroline has worked for many years. This stock has appreciated sharply, so they would owe capital gains tax on a sale.

 At the end of each year, Brett and Caroline transfer shares to their three young children, who can sell the shares and report the long-term capital gain. The Morgans monitor the transfer and sale of shares so that their children do not report gains over the kiddie tax limit each year. This strategy allows the Morgans to cash in appreciated stock while the family pays little or no capital gains tax.

Do these maneuvers make sense? Any tax savings can help families bear expenses such as the increasing costs of college.

There are drawbacks, however. Some asset transfers may have to be reported on a gift tax return. Holding assets in a student’s name might reduce eligibility for needbased financial aid. Perhaps most important, assets transferred to a youngster eventually will be controlled by that youngster, who may spend the money on things other than higher education. Our office can help you quantify the tax savings available through income shifting so you can decide whether these tactics are worthwhile.

Income tax and estate planning with your parents

Although the kiddie tax limits the impact of shifting income to children, shifting income to retired parents who are in a low tax bracket may be much more effective. Moreover, such income shifts can be profitably paired with participation in a parent’s estate plan. The kiddie tax does not applyto retired parents. Your parents may have relatively low income and substantial tax deductions, perhaps from unreimbursed medical expenses. In such a situation, you may be able to take advantage of their low tax bracket.

Senior strategies

Some examples can illustrate incomeshifting to low-bracket parents.

Example 1: Roger and Kate Donovan are in the top 35% federal income tax bracket. Kate’s parents are in their late 70s and have taxable income (after all deductions) of around $40,000 a year. Kate’s father has $200,000 in a traditional IRA, all in pretax money. Because Kate’s parents live comfortably on their current income, her father has been taking only the required minimum distribution from his IRA.

In 2011, married couples who file joint tax returns can have up to $69,000 of taxable income and remain in the 15% federal income tax bracket. Therefore, Kate’s father can convert an additional $29,000 of his traditional IRA to a Roth IRA in late 2011 and owe only 15% on the taxable income generated by the conversion. Kate’s father executes this conversion and names Kate, his only child, as the Roth IRA beneficiary.

The Roth IRA conversion will add $4,350 to the federal income tax bill owed by Kate’s parents. To ease that burden, Roger and Kate might increase the year-end holiday presents they give to her parents. In 2011, each individual generally can give up to $13,000 each, to any number of people, without incurring gift tax.

 Pretax money in a traditional IRA eventually will be subject to income tax, paid either by the account owner or by the beneficiary after the owner’s death. In this example, Kate might take some withdrawals, in a high tax bracket, after her father dies and she inherits his IRA.

By facilitating a Roth IRA conversion, this family is able to take money from the traditional IRA at a low 15% tax rate. Similar partial conversions can be executed each year until all the money has been moved from the traditional IRA to a Roth IRA at a low tax cost.

Roth IRA owners never have to take required distributions. Moreover, all distributions from a Roth IRA are tax free after five years and after age 59 12 . (The age requirement does not apply to Roth IRA beneficiaries.) The five-year calculation begins at the start of the year, so a December 2011 Roth IRA conversion starts the five-year clock at January 1, 2011; after January 1, 2016, just over four years from now, all distributions from that Roth IRA will be tax free because Kate’s father is older than 59 12 .

If Kate’s father has a pressing need for money before the five-year mark, he can withdraw the converted amount without owing income tax because he will already have paid income tax on the Roth IRA conversion. Otherwise, the money can keep growing inside the Roth IRA until it passes to Kate, who can take tax-free withdrawals.

Give and get

Other families may benefit by transferring assets from middle-aged children to elderly parents, with the understanding that those assets eventually will pass back to the children.

Example 2: Brian and Jean Russell are in the top 35% federal income tax bracket. They have been helping to support Brian’s widowed mother, who has scant income beyond Social Security checks. Instead of making periodic cash gifts to Brian’s mother, Brian and Jean transfer $100,000 worth of dividend paying stock to her by year-end 2011 and another $100,000 in 2012. The Russells bought that stock many years ago for $50,000. In 2011, each individual has a $5 million gift tax exemption, so Brian and Jean can make this gift without paying gift tax. By spreading their gifts over two calendar years, the Russells get more use of the annual gift tax exclusion, set at $13,000 in 2011. (Gifts over $13,000 a year reduce the giver’s estate tax exemption, now set at $5 million.)

Assume the transferred stock pays a 4% dividend. If so, Brian’s mother will receive $8,000 per year in extra income: 4% of $200,000. Assuming the dividends are “qualified,” which is the case for most investment income dividends, low-bracket taxpayers owe 0% tax. As long as Brian’s mother keeps her taxable income at $34,500 or less this year, she will owe no tax on the dividends. Brian and Jean would have owed 15% tax on the dividends if they had kept the shares.

 In this example, Brian’s mother revises her will so that Brian will inherit the shares she now owns. Suppose Brian’s mother dies when those shares are worth $215,000. If Brian’s mother has lived for more than one year after the gift, Brian will have a $215,000 basis (cost for tax purposes) in the inherited shares. He can sell them for $215,000 and owe  no tax. Therefore, no one will ever owe capital gains tax on the shares’ appreciation from $50,000. However, if Brian’s mother dies before a year has passed since the gift, he will not get a step up in basis.

2011 Q4 Year-End Family Tax Planning
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