Income Tax and Estate Planning With Your Parents

Taxpayers in high brackets may enjoy family tax savings by shifting taxable income to relatives in low brackets. However, the so-called kiddie tax limits the impact of shifting income to children. Shifting income to parents who are in a low tax bracket may be much more effective. Moreover, such income shifts can be profitably paired with participation in a parent’s estate plan.
Recent legislative changes have tightened the kiddie tax rules. Many
youngsters are now considered kiddies; full-time students under age 24 are included, for example. For these youngsters, unearned income over $1,900 will be taxed at their parents’ rate in 2011.
The kiddie tax does not apply to parents. Your parents may have relatively low income and substantial tax deductions, perhaps from unreimbursed medical expenses. In such a situation, you may be able to take advantage of their low tax bracket.
Senior strategies
Some examples can illustrate income- shifting to low-bracket parents.
Example 1. Roger and Kate Donovan are in the top 35% federal income tax bracket. Kate’s parents are in their late 70s, with taxable income—after all deductions—of around $40,000 a year. Kate’s father has $200,000 in a traditional IRA, all in pretax money. Because Kate’s parents live comfortably on their current income, her father has been taking only the required minimum distribution from his IRA.
In 2011, married couples who file joint tax returns can have up to $69,000 of taxable income and remain in the 15% federal income tax bracket. Therefore, Kate’s father can convert an additional $29,000 of his traditional IRA to a Roth IRA this year and owe only 15% on the taxable income generated by the conversion. Kate’s father executes this conversion and names Kate, his only child, as the Roth IRA beneficiary.
The Roth IRA conversion will add $4,350 to the federal income tax bill owed by Kate’s parents. To ease that burden, Roger and Kate might increase the birthday, anniversary, and holiday presents they give to her parents. In 2011, each individual generally can give up to $13,000 each, to any number of people, without incurring gift tax.
By making a Roth IRA conversion, the family is able to take money from the traditional IRA at a low 15% tax rate. Kate’s father can execute similar partial conversions each year, until he has moved all the money from the traditional IRA to a Roth IRA at a low tax cost.
Roth IRA owners never have to take required distributions. Moreover, all distributions from a Roth IRA are tax free after five years and after age 59½. (The age requirement does not apply to Roth IRA beneficiaries.) If Kate’s father has a pressing need for money before the five-year mark, he can withdraw the converted amount without owing income tax because he will already have paid income tax on the Roth IRA conversion. Otherwise, the money can keep growing inside the Roth IRA until it passes to Kate, who can take tax-free withdrawals.
Pretax money in a traditional IRA eventually will be subject to income tax, paid either by the account owner or by the beneficiary after the owner’s death. In this example, if the money is left in a traditional IRA, some withdrawals might end up being taken by Kate, who is in a high tax bracket.
Give and get
Other families may benefit by transferring assets from middle aged children to elderly parents, with the understanding that those assets eventually will pass back to the children.
Example 2. Brian and Jean Russell are in the top 35% federal income tax bracket. They have been helping to support Brian’s widowed mother, who has scant income beyond Social Security checks. Instead of making periodic cash gifts to Brian’s mother, Brian and Jean transfer $200,000 worth of dividend paying stock to her. The Russells bought that stock many years ago for $50,000. In 2011, each individual has a $5 million gift tax exemption, so Brian and Jean can make this gift without paying gift tax. (Gifts over $13,000 a year reduce the giver’s estate tax exemption, now set at $5 million.)
Assume the transferred stock pays a 4% dividend. If so, Brian’s mother will receive $8,000 per year in extra income: 4% of $200,000. Assuming the dividends are “qualified,” which is the case for most investment income dividends, low bracket taxpayers owe 0% tax. As long as Brian’s mother keeps her taxable income at $34,500 or less this year, she will owe no tax on the dividends. Brian and Jean would have owed 15% tax on the dividends if they had kept the shares.
In this example, Brian’s mother revises her will so that Brian will inherit the shares she now owns. Suppose Brian’s mother dies when those shares are worth $215,000. If Brian’s mother has lived for more than one year after the gift, Brian will have a $215,000 basis (cost for tax purposes) in the inherited shares. He can sell them for $215,000 and owe no tax. Therefore, no one will ever owe capital gains tax on the shares’ appreciation from $50,000. However, if Brian’s mother dies before a year has passed since the gift, he will not get a step up in basis.
These are a few ways that high bracket taxpayers might take advantage of parents’ low brackets. Our office can go over your personal circumstances and suggest ways to save taxes by teaming up with low bracket parents.