Mining the Generation Gap: Estate Planning Strategies for You and Your Parents

Under some circumstances it can be beneficial to transfer appreciated, income-producing assets to parents with the understanding that they’ll be returned upon the parents’ deaths. Another is to have them convert or roll over traditional IRA or qualified retirement plan balances into a Roth IRA. A sidebar discusses the expansion of the “kiddie tax.”

Mining the generation gap

Estate planning strategies for you and your parents

Shifting income to family members in lower tax brackets can be a powerful tax-reduction strategy. For example, it was common for parents to transfer income-producing assets to children in their teens and early twenties until the “kiddie tax” was expanded, making this technique far less effective. (See the sidebar “‘Kiddie tax’ isn’t just for kiddies anymore.”)

But don’t overlook your parents. If they’re in a lower income tax bracket and their estates are small enough that estate taxes aren’t a concern, there are several planning opportunities worth exploring.

Give and you shall receive

One of the most effective techniques is to transfer appreciated, income-producing assets to your parents with the understanding that you’ll get the assets back upon your parents’ deaths. In addition to slashing income taxes, this strategy may also erase any capital gains tax liability on the assets’ appreciation in value.

Here’s an example that illustrates the benefits: Mary is in the 35% federal income tax bracket and hasn’t used any of her gift or estate tax exemptions. Among other assets, she owns $300,000 of stock that pays a 5% “qualified” dividend. Her tax basis in the stock is $100,000. Mary gives the stock to her father, Jim, who’s in the 15% tax bracket. The dividends provide Jim with additional income of $15,000 per year.

This year, qualified dividends are tax-free for taxpayers in the 10% and 15% brackets. That means Jim won’t pay any federal taxes on the dividends, as long as his taxable income for the year is $35,350 or less. If Mary had held on to the stock, she would have paid a 15% tax on the dividend income.

After 2012, unless the law is changed, qualified dividends will be taxed as ordinary income. Jim will still have a big tax advantage, however, with a marginal tax rate of 15% that is nearly 25 percentage points lower than Mary’s 39.6% (assuming ordinary income tax rates also go up as scheduled).

When Jim dies, he leaves the stock, which has grown in value to $350,000, to Mary. Jim’s estate is well under the estate tax exemption amount, so there’s no estate tax.

In addition, as long as more than a year has passed since Jim received the stock, Mary is entitled to a “stepped-up” basis. In other words, her basis in the inherited stock is $350,000 — its fair market value on the date of Jim’s death — so she can turn around and sell it without triggering any capital gains taxes. If Mary had held the stock the entire time, she would have owed capital gains taxes on $250,000 in appreciation ($350,000 less her $100,000 basis).

Pay now, save later

If your parents have substantial balances in traditional IRAs or qualified retirement plans, they may want to consider converting them or rolling them over into a Roth IRA. Doing so ensures that the distributions will be taxed at your parents’ lower rate rather than at your rate after you inherit the accounts.

Here’s an example: Tom and Beth are in the 35% tax bracket. Tom’s parents are retired and have taxable income of approximately $35,000 per year. Tom’s mother has $150,000 in a traditional IRA, all of which was funded with tax-deductible contributions. Although Tom’s parents’ income is enough to meet their needs, Tom’s mother must withdraw taxable required minimum distributions (RMDs) from her IRA each year.

In 2012, Tom’s parents can have taxable income up to $70,700 without moving out of the 15% bracket. Tom suggests to his mother that she convert $35,000 of her IRA into a Roth IRA and name him as the beneficiary.

Tom also offers to give his parents the money they need to cover the federal income taxes of $5,250 ($35,000 × 15%) on the conversion plus any associated state income taxes. The gift is within the $13,000 annual gift tax exclusion, so there’s no gift tax.

Tom’s mother converts similar amounts each year until the entire IRA balance has been siphoned into the Roth IRA. The conversion accomplishes two important goals: First, it eliminates the need for Tom’s mother to take RMDs. (They aren’t required for a Roth IRA’s original owner.) Second, by paying tax on the converted amounts at his parents’ 15% rate, Tom saves tens of thousands of dollars in income taxes.

When Tom inherits the Roth IRA, he can withdraw as much of the funds as he desires tax-free, so long as the assets have been in the Roth IRA for the required period. Alternatively, he can withdraw tax-free only his RMD each year (RMDs are required for Roth IRAs inherited by someone other than the original owner’s spouse) and allow the remainder to continue growing tax-free over his own lifetime for his family. If Tom had inherited the traditional IRA, distributions would have been taxed at Tom and Beth’s higher rate.

A family affair

The estate planning techniques described show how you can work with your parents to minimize your family’s tax burden. Talk with your estate planning advisor about these and other strategies for making the most of family members’ lower tax rates.

 Sidebar: “Kiddie tax” isn’t just for kiddies anymore

The “kiddie tax” was designed to prevent parents from opening investment accounts in the names of their children to take advantage of their children’s lower income tax brackets. It works by taxing a child’s unearned income beyond certain limits at his or her parents’ marginal rate. For 2012, a child’s first $950 of investment income is tax-free, the next $950 is taxed at the child’s rate and any excess over $1,900 is taxed at the parents’ marginal rate.

Originally, the kiddie tax applied to dependent children who were 13 years old or younger. The tax was expanded in 2006 to include children age 17 or younger and again in 2008 to include children 18 or younger as well as full-time students as old as 23. The tax doesn’t apply to children who are married and file jointly or to children who aren’t dependents (that is, whose earned income provides more than half of their support).

Even with the expanded kiddie tax, you still may have income shifting opportunities if your children are age 19 or older (24 or older for full-time students) or fall under one of the above exceptions. Such strategies can reduce your family’s overall tax bite and preserve more wealth for future generations.

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