2011 Q4 Year-End Family Tax Planning

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 1⁄2 . (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 1⁄2 .

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 Estate Tax Planning

As mentioned previously in this issue, decedents have a $5 million exemption from the federal estate tax for deaths in 2011 and 2012. Many states also impose tax on estates or estate beneficiaries. Depending on the state, people with a net worth of $1 million or more may leave their heirs with tax to pay. In addition, future legislation might reduce the federal estate tax exemption. As a result, you may want to take some actions by year-end 2011 that can reduce your heirs’ exposure to future estate tax.

Embracing the exclusion

Do you have more wealth than the amount you’re likely to need for yourself and perhaps for a surviving spouse? If that’s the case, use your annual gift tax exclusion for 2011 before year end. Once the calendar flips to January, you can use your gift tax exclusion for 2012, but you can’t go back and use any leftover exclusion from 2011. In 2011, the exclusion amount is $13,000 per recipient, and no limit exists on the number of recipients for which you can use the exclusion. Thus, married couples effectively have annual exclusions up to $26,000 per recipient to an unlimited number of recipients this year. Gifts in excess of $13,000 this year will be sheltered from gift tax by a $5 million lifetime gift tax exemption, per giver. Gifts in excess of the annual exclusion and the lifetime exemption are taxed at 35% in 2011 and 2012, the same rate that applies to estate assets over $5 million.

Great GRATs

Grantor retained annuity trusts (GRATs) may help reduce your taxable estate, if you anticipate having a large estate—and a potentially large estate tax obligation. If you act in 2011, you can take advantage of low interest rates, some relatively low asset values, and current tax law. The Obama administration has proposed tightening the rules on GRATs. Moreover, some Congressional leaders have expressed a desire to rein in the tax advantages of GRATs. You can take advantage of the current GRAT rules by creating a GRAT before any legislation takes effect. With a GRAT, you create a trust (so you’re the grantor) and contribute assets to it.  You set the term of the trust and the annuity you’ll retain; that’s the payout you’ll receive during the life of the GRAT. After the trust term, the assets will pass to the trust beneficiaries you’ve named, perhaps your children.

Example 1:  Sheila Simmons transfers stock worth $500,000 to a GRAT. She sets a trust term of  four years and agrees to receive an annuity of $135,000 a year from the trust. Suppose that the current IRS interest rate table sets the present value of receiving $540,000 over the next four years at $500,000. If so, Sheila has not made a gift and owes no gift tax. This transaction gives Sheila a return on her money of around 3% a year.

In this example, Sheila transfers stock that has lost value in recent years. She thinks the shares will appreciate by more than 3% a year over the next four years. If that happens, assets will be left in the trust when the GRAT terminates.  Sheila’s beneficiaries might receive shares worth $50,000, $100,000, or more when the trust terminates, free of any gift tax. If you create a GRAT, you’ll use the “Section 7520 interest rate” published monthly by the IRS, to put a value on the annuity you retain. The lower the interest rate, the greater the chance that the appreciation of the trust assets will result in a transfer of wealth to the trust beneficiaries with little or no gift tax.

Home runs

Qualified personal residence trusts (QPRTs) are similar to GRATs in some ways. You create a QPRT, transfer assets into it, set a trust term, and name trust beneficiaries who eventually will receive the assets from the trust. With a QPRT, however, the asset you transfer must be a house, and instead of receiving a flow of assets from the trust, as you do with a GRAT, you receive the right to use the house during the trust term. The house can be a principal residence or a vacation home. The transfer of the house to the QPRT is treated, for gift tax purposes, as a gift of the remainder interest in the house that the trust beneficiaries will receive at the end of the trust term. The value of the remainder interest is the value of the house at the time of transfer less the value of the right to use the house during the trust term. The value of the right to use the home is determined according to the length of the trust, the grantor’s life expectancy, and the Section 7520 interest rate as determined by the IRS for the month of the transfer. At the end of the trust term, you are allowed to live in or use the house if you wish. However, you must pay a fair market rent to the new owners—the QPRT beneficiaries. Such payments will move even more assets to your loved ones, free of gift tax.

Example 2: Phil Matthews, age 50, transfers a $1 million vacation home to a QPRT, setting the trust term at 25 years.  Using interest rates in effect at that time, the value of Phil’s retained interest is about $700,000. Thus, Phil has made a gift of $300,000, which will be amply covered by his $5 million lifetime gift tax exemption. Phil can continue to use the vacation home for the next 25 years. Assuming appreciation of less than 3% a year, the home will be worth around $2 million when the QPRT expires. At that point, the $2  million home will pass to the trust beneficiaries with no gift or estate tax due. QPRTs might make sense now that real estate values are depressed, if you assume the property will gain value in the future. With a QPRT, you can enlarge the gift tax break by creating a trust with a long term. However, you must outlive the trust term to get the estate tax exemption. If you die during the QPRT term, the house will go back into your estate. Our office can illustrate how various QPRT terms will result in smaller or greater gift tax obligations.