Lynn Brenner's Family Finance

Is My Inherited IRA Subject to EstateTax?

Q: My mom passed away in November 2010. She was a New York resident and left an IRA with two beneficiaries, myself and my sister. Is that IRA considered an asset for the purposes of New York State estate taxes? The bank has already completed transfer of the IRA distributions. I’ve rolled my portion to a new IRA to avoid tax liability, and my sister took her portion in cash. I live in another state and I’ve been advised that this IRA wouldn’t be considered a taxable asset if mom had lived here. But I need to know if it is in New York. –DM

 

A: No matter what state you live in, your estate is the value of everything you own at the time of your death -- and that means everything, from your tax-deferred retirement accounts to the loose change on your bedside table. But not all states have an estate tax; and even the ones that do have an estate tax don't tax every estate.

New York taxes estates whose value is greater than $1 million. Let's say your mother’s total estate – including her IRA – was worth $1.2 million. In that case,  a New York estate tax is due on the $200,000 excess. If her estate was worth less than $1 million, there's no New York estate tax. (In case you're wondering, in 2010 there was no federal estate tax. In 2011 and 2012, federal estate tax appies only to estates worth more than $5 million.)

Don’t confuse estate taxes with income taxes. These are two entirely different sets of taxes, with different rules, tax rates, and exemptions!

Regardless of whether your mother’s estate was taxable, you and your sister will owe income taxes on the money you take out of her IRA. If the IRA is worth $200,000, for example, and you take a $10,000 distribution, that $10,000 is added to your taxable income for the year.

Your sister took her portion in cash. If she took it in 2011, she’ll owe income taxes on the amount of her cash distribution in April 2012.

You say you transferred your share into a new IRA to avoid tax liability. As I explained in an earlier post, that new IRA must still be titled in your mother’s name to preserve its tax-deferred status. Your name can be on the account too, but as its beneficiary, not its owner.

If you’ve done this transfer correctly, you’ll only owe income taxes on your annual IRA distributions. (You must take a minimum yearly distribution from the IRA based on your life expectancy.)  But the balance of the account will continue to grow tax-deferred.

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

There Are Only Three Reasons to Own Life Insurance

Q: Does it make sense for me to keep paying for a life insurance policy now that I'm 67 years old, my kids are grown and my mortgage is paid off? --OR, via email

A: Maybe not. At the very least, it's sensible to reassess your insurance needs at this stage of life, especially if you own a permanent policy -- a combination of a death benefit and a tax-deferred investment.

There are three basic reasons to own life insurance:

A) To replace your salary for your dependents when you die.

This is crucial when you're a breadwinner with a young family. If this is your reason to own life insurance, your best purchase is a term policy -- insurance with no investment component -- because it provides the biggest death benefit at the smallest cost. Permanent policies are much more expensive. The cost of term insurance rises as you age, but even in your 50s it's often the cheapest coverage available.

B) To make sure your heirs have cash to pay your estate taxes. 

Few people have to worry about how their survivors will pay estate taxes, because most people don't leave taxable estates. There is no estate tax on the assets you leave to your spouse. And under current law, what you leave to everyone else isn't subject to federal estate tax unless its value exceeds $5 million. True, the current law expires in 2013. And some states impose a tax on smaller estates. New York's estate tax law applies to estates worth more than $1 million, for example.

But even if your estate is taxable, buying life insurance to pay the taxes isn't a no-brainer. If the estate includes liquid assets, you might decide to let your heirs pay the taxes out of their inheritance. On the other hand, you may want to consider a life insurance policy if your survivors would be unable to pay the estate taxes without selling your business or taking taxable withdrawals from your IRA. 

(One caveat: If you want life insurance to pay your estate taxes, you must not own the policy yourself. A policy intended to pay your estate taxes should be transferred to another person or to an irrevocable life insurance trust -- after you've consulted a tax professional to make sure the transfer won't inadvertently trigger gift or income taxes.)

C) To invest on a tax-deferred basis.

If your kids are grown and your other assets are sufficient to provide for your surviving spouse, this is the main reason for still owning life insurance. 

So how good an investment is it?

That depends on your policy, says Richard Freeman, a fee-only financial planner at Round Table Services in Westport, Connecticut.

When you bought it, you saw a policy illustration showing how your investment (or cash value) would grow. But the illustration was a marketing tool, not a guarantee. Here's Freeman's explanation of how permanent insurance works:

Your premiums go into an investment box, from which the cost of insurance and expenses is deducted every month.

If things go worse than expected -- if the cost of insurance and expenses rises more than anticipated, for example, or if the investments underperform because, say, the financial markets crashed -- one of three things will happen: You'll have to pay higher premiums, or take a lower death benefit, or you won't be able to pull as much cash out of the policy as you expected.

If things go better than expected, you'll have the option to pay smaller premiums, or to increase your death benefit, or you'll have more cash to tap.

To find out how your policy is performing as an investment, you need an objective appraisal by someone who understands insurance but isn't paid to sell it -- i.e., not an agent. If your policy represents a substantial investment, it's worth paying a fee-only adviser like Richard Freeman or Glenn Daily for an in-depth analysis and assessment of your options. (One choice that sometimes makes sense, for example, is to exchange your life insurance policy for an annuity.) Fee-only advisers typically charge $200 to $300 per hour. If your policy isn't big enough to justify that expense, a much simpler but equally objective assessment from the Consumer Federation of America (CFA) will cost you only $85.  

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

A Will Is the Simplest Estate Plan and Very Often the Best

 Q:  I s there a safe way to do a ‘life estate’ for a sibling? Let’s say Mary, who is single and childless, owns her own house in New York State. Her divorced sister Sally lives with her. Mary wants her sister Sally to inherit her house. Mary also wants to make sure that she won’t be kicked out of her own house during her lifetime, by Sally or anyone else -- like Sally’s future husband if she remarries.   

Can Mary arrange things so that only her sister can inherit the house and no one else – like a husband or step-children if Sally remarries -- can have any legal claim on it? How can she avoid probate or any other problems or expenses with Sally inheriting the house?  When Mary gets older, she may need to apply for Medicaid assistance for nursing home care. How can she make sure Medicaid cannot lay claim to the house? 

Can Mary also make sure that her sister inherits whatever car she owns when she dies? Is there a way to avoid probate and extra expenses on that? Is there a ‘life estate’ for cars? – RE via email

A: Tell Mary to stop worrying about how to avoid probate!

The simplest way to make sure her sister inherits the house when she dies, but at the same time avoid giving her sister any control of the house during her lifetime, is for Mary to leave it to Sally in her will.

When Mary dies, her will goes through probate: Her executor presents the will to Surrogate’s Court. The court confirms that it’s a valid will and authorizes the executor to follow its instructions. And Sally gets the house (and the car). End of story.

As I’ve written many times, in New York this procedure is both quick and inexpensive. In most cases, it takes one to three weeks. New York’s probate fees range from as little as $45 to a maximum of $1,250. The maximum is charged on estates worth $500,000 or more. As for the legal fees, it’s a very simple matter to prepare and file probate documents. In the New York metropolitan area, the legal bill ranges from about $1,000 to $2,500.

A trust that avoids probate is going to cost more than probate!  (And if Mary's estate incurs any administrative or tax filing expenses, they'll cost the same with a trust as they do with a will.)

Okay, so what are the alternatives to a will?

One is to die intestate -- i.e., without a will. You say Mary is unmarried and childless. If her parents are deceased and Sally is her only sibling, if Mary dies intestate then by law Sally will automatically inherit everything she owns. There's no will, so there's no probate.

Or Mary could transfer the house into a recovable trust, making herself the trustee. As the trustee, Mary controls the house during her lifetime. As the trust beneficiary, Sally inherits the house. Trust assets don't go through probate.

Another option is to make Sally a joint owner of the house with survivorship rights. Jointly-owned property doesn’t go through probate; it automatically goes to the surviving joint owner. The downside: Sally owns half the house. She has the legal right to sell or mortgage her half during Mary’s lifetime -- although in practical terms, that wouldn’t be easy. Sally could also lose her share of the house in a lawsuit or a future divorce . The worst case scenario: Sally's creditors could force a sale to recoup their money from her half of the proceeds.

Alternatively, Mary could use the strategy you’re talking about, which is called a transfer with retained life estate: Mary transfers the house to Sally, but keeps a life estate for herself. When Mary dies, the house avoids probate and goes automatically to Sally. During Mary's lifetime, Sally would have the legal right to sell the house -- but because Mary has a life estate, she couldn’t be forced to move out. Any sale would be subject to her right to continue living there. If Mary herself decided to sell the house, she’d have to share the proceeds with Sally.

I have never heard of transferring a car with retained life estate. It doesn't make financial sense to give away the future right to an asset that's going to expire before you do. And if you don't yet own the car, I don't see how you can transfer a future right to it.

What about Medicaid? It's true that under current New York law, Medicaid cannot claim assets that bypass probate. But that could soon change. 

It's unclear from your question whether Mary wants to make sure that even after her own death, no future husband or stepchildren of Sally's will ever have any legal claim on the house. But if so, it's beyond the scope of this column, and requires consultation with an estate lawyer. 

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 Reserve

 

 

 

How to Report a Capital Gain That Isn't Taxable

Q: My parents deeded land to me and my siblings 10 years ago, and reserved a life estate interest for themselves. Our last surviving parent died in November 2009. In an earlier post, you explained that  we wouldn't have a taxable gain when we sold the land if  the sale price was no greater than the land's market value when we inherited it.

My siblings and I sold the property in May of 2010. Now, as I start to prepare information for my income tax return, I'm not sure how to show that no capital gain is realized on my portion of the sale.

How do I file my tax return? I assume I need to show on the tax return that the transaction took place, even though no tax is due. Is that correct? –KF, via email

 A: Yes. You report the sale on your tax return, and show that there was no taxable gain.

As I explained in the earlier post, you inherited the land at its market value.  

After the sale, you should have received a Form 1099-S stating the amount that was paid to you at the closing. This form might have been sent to you by the mortgage company, or the bank, or the purchaser's attorney, or even the title company. The same firm also sent a copy of Form 1099-S to the Internal Revenue Service, reporting the amount you received.

You report the sale on Schedule D of Form 1040, says Alan E. Weiner, senior tax partner emeritus at Holtz Rubenstein Reminick in Melville NY.

'Date of purchase' in this case is the date of your last parent's death in November of 2009 -- the date you inherited the land.

‘Date of sale’ and ‘Sale Price’ are self-explanatory.

‘Cost or other basis’ is the land's market value at the date of your second parent's death, plus whatever expenses you incurred in selling the property.

The last column on Schedule D is 'Gain'.

If there is a capital gain, it will be a long-term gain even though you sold the property less than 12 months after inheriting it.  "Anytime you inherit property and sell it, it's automatically a long-term transaction," Weiner explains. (To make sure the IRS computer doesn't mistakenly flag a sale of inherited property as a short-term transaction, you can simply write 'INHERITED' on Schedule D instead of setting down a date of purchase, notes Barry C. Picker, a Brooklyn NY tax accountant.)  

If the land’s market value at the date of death is the same or lower than the sale price, there is no gain. In the current environment, that seems more than likely! Still, it’s a good idea to get an appraisal of the date-of-death market value as back-up in case you're ever audited. 

You don't have to spend several thousand dollars on a formal appraisal unless this is a major financial transaction, Weiner says.  You probably don’t need more than a letter from a local real estate broker estimating the land's value at your late parent's death. Keep that letter as documentation.

This is all quite straightforward if you and your siblings each received a Form 1099-S stating his/her share of the proceeds. But it’s possible that only one Form 1099-S was issued for the entire sale proceeds. Let’s say that's what happened -- and that the 1099-S for the whole amount has your name and Social Security number on it.

Of course, the property belongs to all of you and you shared the proceeds equally. But you mustn't confuse the IRS computer by reporting a different amount from the one on the 1099-S, says Weiner.

Here's what you do:

Report the full sales price on Schedule D, as it appears on the Form 1099-S. On the next line, write, "See note, attached."

On Schedule D, subtract the amount you're not responsible for. For example, if the total sale was for $300,000 and your share is $100,000, under ‘Sale Price’, you write '$300,000’ and under that you write ‘minus $200,000'.

In a note attached to the return, explain the situation. For example:

Keith Franklin, Paul Franklin, and Mary Franklin inherited X acres of land at Y location, on November 12, 2009. They sold it on X date 2010. The Form 1099-S was issued only to Keith Franklin. Paul Franklin and Mary Franklin are two-thirds owners, and they have reported two-thirds of the sale proceeds on their tax returns. Your note should include Paul and Mary's Social Security numbers and addresses.

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