Tax Smart or Tax Trap?
- By Milt x_Zall
- Aug 28, 2000
Tax moves that seem smart at first may wind up backfiring, resulting in
unnecessary taxes or lost opportunities. Here are four common tax traps
1. Over-eager tuition payers?
The Internal Revenue Service recently
allowed a grandmother to prepay eight years of private school tuition for
her grandchildren. Her $150,000 advance probably will save the family $75,000
in future estate taxes. Her strategy is drawing many imitators. But consider
possible downsides of this strategy. If the school holds the money interest-free
for eight years, the grandmother may miss out on potentially better investment
opportunities. In addition, if the children transfer to another school,
the prepaid tuition is forfeited.
2. Leave heirs IRAs, not irate
Affluent couples often use a credit shelter trust to use both spouses'
individual estate tax exemptions ($675,000 in 2000, rising to $1 million
in 2006). The trust can provide income to the surviving spouse for life,
with the trust's assets eventually passing to the trust's beneficiary free
of estate taxes.
But these trusts can trap couples with large individual retirement accounts.
Transferring an IRA to a credit shelter trust can forfeit decades of potential
tax deferral because the surviving spouse cannot roll over the IRA into
his or her name. The forfeited tax-deferred compounded returns could well
exceed the state tax savings of placing the IRA in the trust.
Instead, you might want to try this: Designate each spouse as primary
beneficiary of the other's IRA and name a credit shelter trust as contingent
beneficiary. Then upon the death of one spouse, the surviving spouse can
decide whether to disclaim interest in the IRA (which means he or she declines
to inherit the IRA) in favor of the credit shelter trust.
3. Running on AMT
Think it's smart to accelerate deductions? Don't forget the Alternative
Minimum Tax (AMT). Taxpayers are finding that accelerated deductions trigger
the AMT more often than they did previously. In fact, some taxpayers even
delayed paying 1999 state income and real estate taxes until 2000 because
they found themselves likely to be subject to AMT — which doesn't allow
deductions for state and local taxes. By delaying income tax payments, they
can use the deductions on their 2000 returns, when they may not be subject
4. More parents suffering from UTMA regret.
The Uniform Transfers to Minors Act (UTMA) and the Uniform Gift to Minors
Act (UGMA) allow taxpayers to shift income-generating and appreciated assets
to a child while retaining control of the assets until the child reaches
age 18 or 21 depending on state law. While income tax benefits are limited
for younger children's accounts, giving assets to 14- to 17-year-olds can
achieve significant savings without parents losing immediate control.
The catch is that transfers to children under UGMA and UTMA are irrevocable,
and upon reaching the age of majority, the child can use the assets as he
or she pleases. So for example, an 18-year-old could opt to use a substantial
UGMA account to circle the globe with friends instead of going to college.
UGMA and UTMA accounts also cut eligibility for college financial aid
because aid formulas typically calculate annual need based on as much as
35 percent of the student's assets but usually no more than 5.6 percent
of the parent's assets.
Some cash-strapped parents spend money from their children's account
to meet their own expenses, rationalizing that it's family money. They are
wrong. Every year, young adults sue their parents for breaching their fiduciary
duty — and they win.
Here is what you can do: Before your child turns 18, buy your child
a discretionary item — such as a car, a vacation or a fancy high school
prom — out of the funds in the account. Or open a tax-favored college savings
account instead. If the parent is the account owner, the child can't take
the money out and the funds generally won't eliminate financial aid.
—Zall, Bureaucratus columnist and a retired federal employee, is a freelance
writer based in Silver Spring, Md. He specializes in taxes, investing, business
and government workplace issues. He is a certified internal auditor and
a registered investment adviser. He can be reached at [email protected]