Spreading Around Your Retirement Wealth Tax Free
Heirs of Pablo Picasso, who died in 1973 in France without a will, paid estate taxes through the nose — by forfeiting the artist's masterworks to the French government.
Even though that art was used to create the Picasso Museum in Paris, the hefty tax bill was at the expense of daughters, sons, wives, lovers and associates who would have profited mightily by selling the works to collectors.
For mere mortals who are responsible about inheritance, there are many actions you can take during your retirement to make sure your children and grandchildren pay little or no federal taxes on your largesse.
First, hire an estates attorney or another professional specializing in taxes and estate planning who can assess your situation.
“With proper planning and a good idea of what a client’s goals are, there are a lot of opportunities to minimize the estate tax, even in this environment of not knowing what Congress is going to do with the credit or the estate tax in general,” says Atlanta estates and business attorney David Eastman, who has been practicing law for a quarter century.
And there are ways to lessen other types of taxes — capital gains, for one — by being smart about gifts and inheritance, explains Valerie Adelman, a certified financial planner, accountant and money manager in New York, who specializes in taxes.
Only eight states have an inheritance tax — Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania and Tennessee — so residents in these states will need to make a closer inspection.
Here five key considerations:
- Congressional gridlock
The year 2010 proved to be a tax holiday for heirs of those who died that year, due to the inaction of Congress.
Once again, Congress has a crucial decision before it: If it fails to act on the Economic Growth and Tax Relief Reconciliation Act this year, many more estates will owe taxes.
For the last two years, heirs have enjoyed a $5 million exemption and a 35 percent rate on inheritance tax. Should Congress do nothing, that exemption will drop to $1 million and the tax rate could rise to 55 percent.
- Gifting versus inheriting
The simple rule is that if your assets, such as real estate, a stock market portfolio, individual stocks and bonds or an art or vintage-car collection, have appreciated in value, it’s smarter and less costly for the recipient to receive the assets as an inheritance.
Say you bought a house for $20,000, but now it’s worth $500,000. If you gift the house to your children, it has the cost basis of the original purchase price — $20,000. If the heir who has received the house as a gift sells the property, he or she will pay a substantial capital gains tax, not on the $20,000, but on the half million, minus the $20,000.
The amount, $480,000, represents the profit or appreciation. If the same house being sold has been inherited and sold at the fair market value at the time of inheritance, the heirs pay no capital gains taxes on it.
“Any person can gift another person $13,000 per year without any tax consequences for either party,” explains Adelman.
Although the recipients need not be family members, this method of gifting is an effective way to transfer money between parents and children and grandparents and grandchildren, thereby reducing the size of their estate and thus, the tax amount that will eventually be due.
For instance, in a family with four children and six grandchildren, the husband and wife can gift $13,000 apiece each year to every child and grandchild, meaning that each of them may receive as much $26,000.
However, if the recipient places the gift in a fund and earns interest, he or she would owe income tax on any appreciation of that fund.
- 529 College plans
Education savings through 529 plans are another way to benefit all parties, while allowing the donors to divest themselves more quickly than through other methods.
The so-called 529 plan is a fund in which money grows tax-free, if the funds are used to pay for either college or vocational school.
Donors can give away up to $13,000 per student every year or a $65,000 lump sum in any one year, which covers five years of giving.
The money, which can go to anyone of your choosing, including children and grandchildren and nonrelatives, comes with no tax consequences for the recipient as long as it is used for qualified educational expenses mentioned above.
- Life estate
Finally, one estate-planning technique is to set up a life estate for your home. In doing that, you give possession of the property to heirs, thereby removing it from the estate and locking in its value, but you continue to live there through your retirement years.