Five Simple Tips to Saving Taxes.
1. Give your IRAs to charities
While qualified plans are a great way to accumulate money tax free, the proceeds are taxable to whomever draws the money out. If your IRA is paid out at the time of your death, it is not only subject to the current estate tax of 49%, but also the income tax of the recipient. You can have situations where the recipient only receives approximately 15% of the money, with the remaining funds going to the government.
Donations to a charity are deductible for both income and estate taxes. If you intend to make a charitable gift through your estate plan, consider using IRA money instead of other assets. The funds are transferred tax free, and your beneficiary’s income taxes will be reduced. While this strategy is not for everyone, those of you who are charitably inclined should consider using your qualified plans as the first choice for charitable gifts.
2. Make transfers at death, not during life
If you make a gift during your lifetime, such as adding a child to real estate title, that child is treated as having the same tax basis in the property as you. If you purchased real property for $100,000 and it is now worth $500,000, you generally have to pay income tax at capital gains rates on the profit from the sale. Your child would pay income tax on their share of the gain. This is what is referred to as the “carryover” rule.
Under current law, a beneficiary receiving an inheritance does so at a “step-up” in tax basis. This means that a property that they receive from inheritance is given a new fair market value as of the date of death, not the basis of the donor.
For example, in 2003 you inherit an estate consisting of $1,000,000 in stock. The stock was purchased in 1970 for $100,000. In 2003, that stock will be transferred to you without any estate tax. And, you receive the stock with a stepped-up basis of $1,000,000 despite the fact that it was originally purchased for $100,000. You can sell the stock for $1,000,000 and not pay any capital gains tax.
On the other hand, if the stock was given to you while the donor was alive, your carryover basis is $100,000. If you sold the shares for $1,000,000, you would have a $900,000 capital gain to report on your income tax.
3. Give a minority interest to beneficiaries
If you own 100% of an asset, the full fair market value of that asset will be included in your estate. On the other hand, if you own 98% of an asset, your interest will be appraised for less than 98% of the fair market value. How is this possible? It is widely accepted that the owner of a fractional interest is entitled to a discount in the fair market value of their interest. Because there is not as great of a market for fractional interests, rather than the entire ownership, and because the owner of a fractional interest typically has less control than a sole owner, appraisers routinely consider them to be worth less than the actual percentage of ownership. This is useful for estate tax purposes because the taxes are based upon fair market value as of the date of death. By making a small gift to your beneficiary, the savings in estate taxes can be substantial.
4. Use a trust
In a trust, there are two types of costs associated with the administration of an estate. The first has to do with fees incurred in court proceedings, the second has to do with taxes, including estate, gift and income taxes.
If your estate has a gross value of more than $100,000, the law generally requires a probate proceeding. This takes a minimum of 6 months, and your estate must pay fees to both an executor or administrator and their attorney. Those fees are based upon the size of the estate, and start at $6,300 for a $100,000 estate.
The second kind of administrative expense is the taxes owed to the federal government. In 2003, estate taxes are imposed on any estate in excess of $1,000,000 in net value. Those taxes start at 37% and very quickly increase to nearly 50%. With married couples, a trust can be used to preserve the exemption of $1,000,000 for each spouse. This can result in a savings of up to $490,000 in estate taxes. Through the use of a trust and other estate planning devices, it is possible to avoid the burden of estate taxes so that your beneficiariescan receive your estate in a nearly intact condition.
5. Spend it!
Yes, spend it. (It has been reported that spending can even be fun!) You are taxed on that which you own at the time of your death. Except for purchases which incur sales tax, your spending is not subject to any tax liability. Remember that you can also give away up to $11,000 per year, per recipient, without incurring any gift tax.
You can give away more than that if the money is spent directly for tuition or health care of certain dependents. If you are above the exemption for estate taxes, it is like using matching funds from the federal government. A well-designed plan to remove assets from your estate can provide both satisfaction and save a bundle on estate taxes.
With a little advance planning, all of your goals can be met. Your wishes will be carried out, administrative costs and taxes minimized, and you will have peace of mind.
By Christopher C. Jones © October 2003
