Dear Liz: I’m about 50 and have two early elementary school children. I make really good money and with the combination of all taxes the last dollar I make is taxed at about 50%.
I stand to inherit about $5 million from my parents. The problem is that about $3 million of that is in retirement funds. If those funds go to me, over the next 10 years I will have to take them as income and will lose half to taxes. I’m considering asking my mother to leave $1 million to each grandchild so that they can take it as income at a much lower tax rate, possibly saving $300,000 per kid. The problem is I am not sure I want my kids to have access to a million dollars the second they turn 18.
Is there any way I can avoid either giving them a ton of money when my parents die or me paying a ton in income taxes? Both kids already have 529s that will be filled in three to five years, so that is already out.
Answer: Not only is giving a million bucks to a teenager a bad idea, but the tax savings you’re hoping for may not materialize thanks to the kiddie tax.
Basically, unearned income above $2,700 a year is taxed at the parents’ rate, not the child’s, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. Unearned income includes interest, dividends, capital gains and taxable distributions from retirement accounts.
The kiddie tax can apply to offspring up to the age of 23 depending on their circumstances.
Minors who inherit a retirement account from a parent are required to take small distributions based on their own life expectancies until they turn 21. After that, they typically have to drain the accounts within 10 years. The 10-year clock starts immediately, however, when minors inherit a retirement account from anyone who is not a parent.
Another issue is that your parents’ retirement accounts don’t get the valuable step-up in tax basis at death that their taxable accounts would get, says Jennifer Sawday, an estate planning attorney in Long Beach. The step-up insures that no capital gains taxes are owed on the appreciation that occurs during the original owners’ lifetime. If your parents want to maximize the inheritance they leave, it would make sense to preserve those taxable assets as much as possible and spend down the retirement accounts, Sawday says. Another option is converting some of their retirement money to Roth IRAs, especially if their tax bracket is lower than yours and they’re willing to pay the taxes on the conversions. You’d still have to empty the Roths within 10 years of their deaths, but the withdrawals would be tax free.
Properly drafted trusts are another option to consider if your parents want to skip you and get money directly to their grandkids, Sawday says. Trusts allow distributions at specified ages (such as 25, 30 or even later). But trusts have complex rules and can have high tax rates. Your parents need to consult an experienced estate planning attorney as well as a tax pro before taking any of these actions.
Dear Liz: In a previous column, you answered a question from someone dealing with an unexpected bank levy by a state tax agency. The accountant who prepared the tax returns wasn’t responding to emails or calls. If an accountant ignores a client, then a complaint should be filed with the state’s board of accounting. If the accountant is licensed, the state board will likely follow up.
Answer: That’s a good suggestion. As mentioned in the previous column, many tax pros struggle to keep up with client communications during the busy tax season and may back-burner questions they don’t see as urgent. But if the ignored client still hasn’t heard back from their tax pro at this point, making a complaint to the board of accounting could be a reasonable response.
Liz Weston, Certified Financial Planner, is a personal finance columnist. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.