The Roth IRA and Estate Tax Changes

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, December 28, 1997

Copyright 1995-7 Robert L. Sommers, all rights reserved.

The Roth IRA and Estate Tax Changes


The Roth IRA

Under the right circumstances, the new "Roth IRA" could be a perpetual money machine. Although investors cannot deduct their original contributions, earnings accumulate tax-free with never any income tax on distributions. The original owner cannot withdraw until age 59 and the account must be at least 5 years old. Annual contribution limits are $2,000 for individuals, $4,000 for couples. Eligibility is phased out starting at adjusted gross incomes (AGI) of $95,000 to $110,000 for individuals, $150,000 to $160,000 for couples. Early withdrawal is permitted if the owner becomes disabled and for a first-time home purchase (subject to a $10,000 lifetime cap).

When the owner dies, IRA minimum distribution rules apply. If the designated beneficiary is relatively young, minimum distributions could occur over the beneficiary’s lengthy life expectancy, thus extending Roth IRA’s ability to accumulate wealth and distribute it tax free. Or, the beneficiary, may withdraw more than the minimum at any time without tax or penalty.

Investors may convert existing tax-deferred IRAs to tax-free Roth IRAs. The rollover will be taxed as an IRA distribution, but without the early withdrawal penalty. If the conversion is completed prior to 1999, the taxpayer is treated as receiving gross income in four equal annual distributions. After 1998, the rollover is taxed in the year of distribution.

Taxpayers with less than $100,000 in AGI (determined prior to the conversion) may rollover their IRA into a Roth IRA, but a married taxpayer filing separately, regardless of his or her AGI, is completely ineligible. Apparently, the $100,000 AGI limit applies to each taxpayer, regardless of marital status. Consequently, joint filers with combined AGIs greater than $100,000 can use the rollover, provided each individual’s AGI is less than $100,000. (Note: IRS disputes this interpretation, claiming that joint filers cannot use the rollover if their joint AGI exceeds $100,000.)

For additional information on the Roth IRA check these links:

Roth IRA Conversion Calculator

A downloadable Excel spreadsheet prepared by the accounting firm, Ernst and Young, for the Roth IRA conversion.

Estate Taxes

The Unified Estate and Gift Tax exemption will increase over the next 10 years to exclude a taxable estate of $1 million (see chart). Thus, in 2006 a couple’s community property estate of $2 million will escape estate tax. See the accompanying chart.

After 1998, the $10,000 annual gift-tax exclusion and the $1 million generation-skipping tax exemption will be indexed for inflation, permitting larger gifts between parents and their offspring. The unified credit for foreign taxpayers with U.S. assets, however, remains at $60,000 without increases for inflation.

Combining Gifts with the New Capital Gains Rates

Taxpayers may combine the larger gift-tax exemption (annual gifts after 1998 and the increase in the unified credit after 1997) with the new lower 10% capital-gains rate applicable to children over age 14 who are also in the 15% tax bracket, by making gifts of appreciated assets. Note: Children under age 14 are generally taxed at their parents’ tax rate.

When a gift is made, the holding period of the donor is tacked on (added) to the holding period of the donee. Therefore, if the child sells the asset at least 18 months after the donor acquired it, the new lower capital gains rate will apply.

Example: A husband and wife (in the 28% tax bracket) purchased XYZ stock for $1,000 two years ago. They gift it to their daughter (who is in the 15% tax bracket). Under the gift tax rules, the daughter receives a carryover basis of $1,000 in the stock which includes the time her parents owned the stock. One month later, the daughter sells the stock for $11,000. She has a $10,000 gain ($11,000 sales price, less her $1,000 adjusted basis) and pays $1,000 tax on the gain ($10,000 gain x 10%). If the parents had sold the stock, the tax would have been $2,000 ($10,000 x 20%); thus, the gift saved the family $1,000 in taxes.

Pending technical corrections legislation will provide that inherited assets receive an automatic 18-month holding period, thereby qualifying as long-term capital gains. When possible, executors and trustees should consider distributing assets that qualify for the lowest capital gains rate, which have appreciated from the estate’s valuation date, to beneficiaries over age 14 who are still in the 15% tax bracket so they can enjoy the lower 10% capital-gains rate.

You may also leverage the new lower capital gains rates with gifts of a fractional interest, to generate larger tax savings. A gift of property qualifies for a "fractional-interest" discount, if the donee (recipient) ends up with a minority interest in the asset.

The fractional-interest discount rules are as follows: You are married and own real estate worth $200,000. If you and your spouse gift $20,000 of the property, the beneficiary receives a 10% interest in the property. However, assuming the fractional interest is subject to a 30% discount, then the $20,000 interest is worth $14,000, much less than the spouses’ $20,000 annual gift tax-free limit. A discount is permitted since the fractional-interest holder cannot readily sell this asset because there is no regularly traded "market" for this interest and also because he does not control the property.

This technique, lets you gift a much larger percentage of property than the equivalent cash, while shifting the asset’s future appreciation to the donee. If the donee then sells the asset when he is over age 14 and still in the 15% tax bracket, he will pay only a 10% capital-gains tax.


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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**