Tax Time: Things to Consider

Many do most of their thinking about taxes during this time of year - when they just finished filing their returns (or just filed an extension).

Professionals typically respond to more tax questions during the first quarter of the year than at any other time.  The areas of interest these topics, among others:

·       Traditional IRAs

·       Roth IRAs

·       Pension plans

·       Social security benefits

·       Life insurance and annuities

·       Education savings accounts

Here’s a small sampling of the frequently asked questions, along with short answers to them.

1.     Question:  Is it too late for someone to take a required minimum distribution (RMD) for 2010 from her traditional IRA?

Answer:  If a taxpayer turned 70 ½ in calendar year 2010, she had until April 1, 2011 to take her RMD from her traditional IRA - so it is too late.

If the client turned 70 ½ in a year prior to 2010, she was required to take the distribution for 2010 by the end of 2010.  If the client fails to take the RMD by the deadline, the IRS imposes a special penalty tax of 50% on the amount that should have been distributed.

2.     Question:  Can a self-employed person contribute to both a Simplified Employee Pension (SEP) IRA and a regular traditional IRA in the same year?

Answer:  Yes, subject to normal limits.

An employer’s SEP contribution into the participant’s IRA is treated like a pension plan contribution from the employer - even where the participant is the owner of the company.

Regular IRA contributions can be made by the participant to his or her traditional IRA, up to the maximum annual limit.  For 2011, the maximum IRA contribution is $5,000 if under age 50 and $6,000 if 50 or over. However, the amount of the regular IRA contribution that can be deducted on the employee’s income tax return may be reduced or eliminated due to the fact that the employee is an active participant in a pension plan.

3.     Question:  I understand that company-owned life insurance must now have proper notice and consent forms signed prior to issue, and that the employer may be responsible for filing a tax form with the IRS.  Can you explain the rules?

Answer:  Normally a life insurance death benefit is income tax free.  In order to maintain the tax free nature of the death benefit from a business owned policy, the Section 101(j) rules must be followed.  Among other requirements, compliance with Section 101(j) requires a notice and consent form to be signed prior to the policy’s start.

The IRS also requires an employer to report the number of its policies subject to Section 101(j) on IRS Tax Form 8925 every year.

Living Trusts for Couples

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 significantly changed estate planning for 2011 and 2012.  One of the key changes was to increase the federal estate tax exemption amount from $1 million to $5 million per person.  So, for a married couple, they can theoretically pass a combined $10 million to their descendants without a federal estate tax.  One of the other key changes was to provide for the “portability” or transfer of the exemption from the deceased spouse’s estate to the surviving spouse.  This latter change may reduce some of the incentive to use living trusts.

One of the main reasons for using living trusts is to eliminate or reduce the federal estate tax.  In the past, if each spouse had a living trust and sufficient assets were transferred into each trust up to the exemption amount, the exemption amount of the first spouse to die was fully utilized, i.e., it was not lost.  As a result, the couple was able to maximize the transfer of wealth to their descendants.  This ability to use both exemption amounts has been a critical motivator for traditional A/B trust planning.  The recent addition of the “portability” or transfer of the unused exemption amount to the surviving spouse will likely translate into fewer living trusts for married couples. However, does this mean living trusts are dead for married couples? The short answer is “No.” There are many other good reasons to use living trusts for married couples.

The traditional A/B trust planning will still be needed if the spouses want to designate certain assets for children and other descendants, instead of the surviving spouse.  There is also the issue of control. For example, using the A/B trust planning will help ensure that the assets left in the B trust (or family trust) at the first death will eventually pass to the children and descendants of the couple, and not to any new children or new spouse of the surviving spouse.  This may be more of an issue if there is a significant age gap between the spouses, or if there has been a prior marriage.  Another good reason to consider A/B trust planning is creditor protection. The asset in the B trust (or family trust) can generally be protected from the creditors of the surviving spouse and children.  Another practical reason to consider A/B trust planning is that the current law is set to expire on January 1, 2013, and there is great uncertainty as to what will happen in 2013. Will “portability” survive?  There is not way to know.

One of the most important reasons to use the A/B trust planning model is the generation-skipping tax (GST).  (The GST is that nasty tax which is generally imposed when assets are transferred to grandchildren instead of children.) It should be noted that each person has a $5 million GST exemption.  While the federal estate tax exemption can be transferred to the surviving spouse, the GST exemption is not “portable” and will be lost if it is not used during lifetime or at the death of the first spouse to die.

It should also be noted that in the traditional A/B trust planning model, the assets left in the B trust (or family trust) are not subject to estate tax at the survivor’s death.  So, the assets can appreciate (hopefully) and the appreciation is not subject to further estate tax. On the other hand, if all of the assets are left to the surviving spouse, the appreciation is included in the estate of the surviving spouse and subject to estate tax at that time. This may be an important consideration depending on the total size of the combined estates.

There may be some situations where A/B trust planning is not as important or needed.  If it is overwhelmingly important for the surviving spouse to maintain full control of all marital assets, then A/B trust planning may not be needed. Also, A/B trust planning may not be needed where the couple is in a long-term committed relationship and the only children belong to both of them. Some other factors favoring a simple plan without trusts include: the couple has no real concerns about the possible remarriage by a surviving spouse; the couple intends for their children to be the primary beneficiaries of the estate when both spouses are gone; and asset protection concerns are not important.

In summary, living trusts are not dead as an estate planning tool for married couples, at least not yet.  They may be used less, but they are still very viable and valuable instruments. In light of the changes made by the 2010 Tax Relief Act, I am recommending that those with sophisticated estate plan have those plans reviewed.