Lynn Brenner's Family Finance

Can My Creditors Seize My Daughter's Trust Account?

Q: I've gotten into trouble with creditors because I've been unemployed for some time now. I manage a New York State trust for my daughter, which was set up by my parents. It is registered using my Social Security number. Can my creditors invade or freeze this account? -- FW via email

A: No. Your creditors have no legal claim on this money because it doesn't belong to you.

As the trustee, you're responsible for managing the account and distributing its assets to your daughter according to your parents' instructions, but you don't own it. You should take two steps to make this clear.

First, the title on the trust account should reflect its actual ownership. If your daughter's name is Charlotte, for example, and your name is Frances, the title of the trust account should be something like 'Charlotte Smith Trust, Frances Smith trustee.'  Ask the bank, brokerage, or mutual fund company where the account is set up to use the appropriate language; every institution has its own wording.

Second, the trust account shouldn't carry your Social Security number. That's going to confuse the Internal Revenue Service, as well as your creditors, because any income earned in the trust account that's reported to the IRS under your Social Security number will be reported as income to you.

A trust is a legal entity, and should have its own federal tax ID number. You can apply for one online. To learn more, go to www.irs.gov and download IRS Publication 1915, 'Understanding Your Individual Taxpayer Identification Number'.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are addressed only online.
(c) Lynn Brenner, All Rights Reserved.

Can I Withdraw My Principal From A Roth IRA in Less Than Five Years Without Triggering a Tax?

Q: I really appreciated your timely AARP magazine article "Roth Mania" . I have a question on one of the rules. You wrote: "Roth IRAs allow tax-free withdrawals of earnings after you're 591/2 and have owned the account for five years." Does this five-year rule refer to the principal and the interest earned, or just to the interest earned? -- PS via email
 
A: This rule is often misunderstood!  It applies only to the interest earned.

You can't withdraw the Roth IRA's earnings tax-free until you're over 59 and a half AND have owned the account for five years. 

But you can withdraw your principal anytime without triggering a tax or a penalty.

There is one exception: If you do a Roth conversion and you're under 59 and a half, you'll owe a 10% early withdrawal penalty -- but no income tax -- on converted principal that you withdraw within five years of doing the conversion, says Barry C. Picker, a New York City tax accountant and IRA expert.

If you do a Roth conversion and you're over 59 and a half, you can withdraw the converted amount tax-free and penalty-free at any time; but you can't withdraw earnings tax-free until the account is over five years old. 

The reason you can withdraw Roth IRA contributions tax-free anytime is that you've already paid taxes on them. If I contribute $2,000 to a Roth IRA, for example, I get no tax deduction for the contribution. The $2,000 is included in my taxable income for the year.

But of course, there's a major downside to tapping the account: If you withdraw your principal, the Roth IRA can't earn anything.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are addressed only online.

(c) Lynn Brenner, All Rights Reserved.

How Will I Be Taxed When I Sell Inherited Property? What's My Cost Basis?

Q: My parents deeded land to me and my siblings 10 years ago, keeping a life estate in the property reserved for themselves. Our last surviving parent died in November of 2009. We're trying to figure out how we will be taxed when we sell this land. I've had conflicting answers about what we should use as our cost basis. Some tax accountants have said we must use the original purchase price, and others say we can use the value of the property last November when our mother died. Which is correct? -- KF via email

A: Your cost basis is the market value of the property at the time of your mother's death last November.

In tax jargon, your cost basis for this property is 'stepped-up' to its market value.This means that if the land was worth $5 million last November -- why not use a nice fat hypothetical number? -- you can sell it for $5 million without incurring any capital gains tax.

By contrast, if you had to use the original purchase price as your cost basis, you'd owe a tax on the difference between your sale price and what your parents originally paid for the land. So if they'd bought it for $100,000 and you sold it for $5 million, your taxable profit would be $4.9 million.

Quite a difference, isn't it?

But as I'll explain in a moment, people who inherit assets from someone who dies in 2010 can't use the above example as a guide.   

That's because the rule in question is based on the relationship between two different taxes. One is the capital gains tax, which is the tax on your profit when you sell an asset that has appreciated in value since you acquired it. The other is the federal estate tax, which is the tax levied on assets that you bequeath to your survivors -- and as of January 1, we don't have a federal estate tax.

The longstanding rule is that heirs get a 'stepped-up' cost basis on assets that are subject to estate tax. This is true even if the estate in question is actually too small to owe any estate tax.

The practical result is that people have long enjoyed a stepped-up cost basis on most inherited capital assets. (I say 'most' because of course there are important exceptions. You never get a step-up on any asset that is inside a tax-deferred retirement account, for example.)

Because your mother kept a retained life estate in this property, 100% of its value is included in her taxable estate. Therefore you inherited it at its stepped-up cost basis. As I explained in an earlier post, even tax professionals sometimes get this wrong; that's why you've heard conflicting advice about it.

But Congress let the estate tax law expire on December 31, 2009.  Remember, you only get a step-up on inherited capital assets that are subject to estate tax. Because there is no federal estate tax at the moment, there's no step-up on inherited capital assets.

The good news for most people is that there is an exemption. "Each estate is entitled to a $1.3 million aggregate basis step-up, and a $3 million spousal step-up," says Bernard A. Krooks, a New York estate and elder law attorney.  

This means that a person who isn't married can still leave $1.3 million in assets that will qualify for the step-up. Someone who is married can leave $1.3 million of assets that get the step-up, plus an additional $3 million of assets to his or her spouse that will qualify for the step-up.

But the above exemptions don't apply to property in which the decedent had retained a life estate.  If your mother had died last week, you wouldn't get the step-up on your inheritance. The current situation is temporary, however. There's little doubt that the federal estate tax will be reinstated, probably later this year. When that happens the unlimited step-up will return.

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved

How To Divide an Inherited IRA Without Triggering Income Taxes: Don't Take a Check!

Q: My mother left an IRA on which she named her four children as beneficiaries, each of us to get 25% of the account. I have given the bank a copy of the death certificate.  I’ve talked to a lawyer, and he said that if my mother designated us as beneficiaries, and the bank has a death certificate, it can issue checks to the four of us.  My siblings are waiting on me for the go ahead to do this. But I guess I want to know what will happen before I do it. --CF, via email

A: That's a very wise policy! Here’s what will happen: If you take your inherited IRA in the form of checks from the bank, you and your siblings will owe income taxes on this money. Since each of your shares will be added to your 2010 taxable income, you might even be bumped into a higher tax bracket.

The lawyer you consulted may not know how IRAs are taxed. Unfortunately, the bank may not know either. Most banks know a lot more about how money goes into IRAs than about how it comes out.

To divide this account without triggering taxes, you and your three siblings should ask the bank to divide the IRA into four new IRAs … but not into new IRAs that list you as the owners! Your mother's name must remain on each of the new accounts as the deceased owner, with the name of each child on the account as its beneficiary. 

For example, if your Mom’s name was Joan Smith, each of the four new IRAs should be titled “Joan Smith IRA (deceased November 20, 2009) for the benefit of [insert name of one child].”

If necessary, insist on seeing a bank manager to make sure your mother’s name stays on the IRAs, says Barry C. Picker, a tax accountant and IRA expert.  Only a surviving spouse can transfer an inherited IRA into his or her own name. If any other beneficiary does that, the account stops being an IRA and is immediately taxable.  

If this is done right, each of you will have an inherited IRA that lists him or her as its sole beneficiary. At that point, if you wish, you can have your inherited IRA moved from your mother’s bank into your own bank – or to any other financial firm -- in a trustee to trustee transfer. (You open a new IRA at your own bank -- again making sure it's titled the right way, with your mother's name on it -- and the transfer is done by wire between the banks.)

As beneficiaries you must start taking minimum annual distributions from the account by December 31 of the year following your mother’s death; but the balance will continue to grow untaxed.

As the sole beneficiary on the account, you can take minimum distributions based on your own life expectancy, says Picker. This is one of the advantages of dividing the account correctly. If you keep an inherited IRA with four beneficiaries listed on it, the required minimum distributions must be based on the life expectancy of the oldest beneficiary.

Of course you can take more than the minimum distribution if you need it. But if you don't, why pay taxes on this money sooner than you have to?

Please send your questions to Lynn@LynnBrennersFamilyFinance.com.  I'm sorry I can't respond personally to every email. Questions are only addressed online.(c) Lynn Brenner, All Rights Reserved