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March Hot Topics


The Roth IRA

The new "Roth IRA" might be called a perpetual money machine. Although investors cannot deduct the contributions, earnings accumulate tax-free and there is never an income tax on distributions. The original owner cannot withdraw until age 59 and the account must be at least 5 years old. The annual contribution limits are $2,000 for individuals and $4,000 for couples. There is a phase-out of eligibility starting at adjusted gross incomes (AGI) of $95,000 to $110,000 for individuals and $150,000 to $160,000 for couples. Early withdrawal is permitted if the owner becomes disabled or for first-time homebuyer expenses (subject to a $10,000 lifetime cap).

When the owner dies, the IRA minimum distribution rules apply. If the designated beneficiary is young, minimum distributions will occur over the beneficiary’s lengthy life expectancy, thus extending the life of the Roth IRA and its ability to accumulate, then distribute earnings and profits tax-free. The beneficiary, of course, may withdraw more than the minimum at any time without tax or penalty.

Investors with existing IRAs may convert them to Roth IRAs. The conversion (rollover) will be taxed as an IRA distribution, but without penalty for early withdrawal. If the conversion is completed prior to the end of 1998, the taxpayer is treated as receiving gross income in four equal annual distributions.

Taxpayers with less than $100,000 in AGI (determined prior to the conversion) are eligible to rollover an IRA into a Roth IRA. Married taxpayers filing separately are ineligible for the rollover. Apparently, the $100,000 AGI limit applies to each taxpayer, which should permit joint filers with combined AGI greater than $100,000 to use the rollover, provided the individual’s AGI was less than $100,000. Note: The IRS disputes this interpretation, claiming that a couple’s AGI together cannot exceed $100,000.


AGI limitations for contributions to IRAs (currently $25,000 for individuals and $40,000 for couples) will increase at $5,000 per year for individuals and $10,000 per year for couples in 1998, 2002, 2003 and 2004. After 2004, the AGI limitations will be $50,000 for individuals and $80,000 for joint filers. Also, penalty-free withdrawals are permitted for first-time home purchases to a maximum of $10,000 or for educational expenses (without limitation).

If one spouse is an active participant in an employer-sponsored retirement plan, the other spouse is now eligible for an IRA deduction to a maximum of $2,000. This benefit phases out for couples with AGI between $150,000 and $160,000.

Beginning January 1, 1998, the general prohibition against investment in collectibles has been lifted for permitted certain platinum coins and certain gold, silver, platinum or palladium bullion.

Education IRA

Contributions to a maximum of $500 per year per beneficiary may be made to an Education IRA. The contribution limit is phased out ratably for individuals with AGIs between $95,000 and $110,000 and joint filers with AGIs between $150,000 and $160,000. These IRAs are created for post-secondary tuition, fees, books, supplies, equipment, and certain room and board expenses, but not elementary or secondary school expenses. Earnings in the IRA and distributions to the beneficiary are tax-free, provided the distribution does not exceed the qualified higher education expenses incurred by the beneficiary. Excess distributions will be taxed to the beneficiary (who might not have any other taxable income).

Any balance remaining in the IRA when the beneficiary becomes 30 years old must be distributed and the earnings portion of the distribution will be subject to ordinary income tax plus a 10% penalty, however, the IRA may be rolled over tax free to another Education IRA for the benefit of another member of the family (using the dependency definition), provided this occurs before the current beneficiary reaches age 30.

The HOPE credit or the Lifetime Learning Credit cannot be used in the same year that an Education IRA is distributed to a beneficiary.

Eligible students must be enrolled at least half-time in a degree certificate undergraduate or graduate program at an eligible educational institution. Also, the student cannot have a felony conviction for possession or distribution of a controlled substance. The Education IRA begins after December 31, 1997.

Estate And Gift Tax Changes

The current unified estate and gift tax exemption will increase over the next 10 years to exclude a taxable estate of $1,000,000 (see chart). Thus, in 2006 a married couple’s estate of $2,000,000 will escape estate tax.


Unified Credit Equivalent




















 After 1998, the $10,000 annual gift tax exclusion and the $1,000,000 generation skipping tax exemption will be indexed for inflation. The increase in both the annual gift tax and unified estate tax credit will permit larger gifts between parents and their children or grandchildren. The unified credit for foreign taxpayers with U.S. assets remains at $60,000 without increases for inflation.

Combining Gifts With The New Capital Gains Rates

Taxpayers may combine the larger gift tax exemption with the 10% capital gains rate applicable to children over age 14 who are also in the 15% tax bracket, by making gifts of appreciated stock. Note: Children under age 14 are taxed at their parents’ tax rate.

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

Example: Husband and Wife (who are in the 28% tax bracket) purchased XYZ stock for $1,000 two years ago. They gift it to their son (who is in the 15% tax bracket). Under the gift tax rules, son receives a carryover basis of $1,000 in the stock and includes the time his parents owned the stock. One month later, son sells the stock for $11,000. Son has a $10,000 gain and pays $1,000 tax on the sale ($10,000 x 10%). If the parents sold the stock, the tax would have been $2,000 (10,000 x 20%); thus, the gift saved the family $1,000 in taxes.

The technical corrections bill provides that inherited assets will have at least an 18 month holding period. Thus, the sale by the beneficiaries falls within the new long-term capital gains rates. When possible, executors and trustees should consider distributing stock which has appreciated from the date of death (or the 180 day alternate valuation date, whichever valuation is used) to beneficiaries over age 14 who are in the 15% tax bracket, to take advantage of the 10% capital gains rate.

You can also leverage the new lower capital gains rates with the discount for 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 less than a majority interest in the asset.

The fractional-interest discount rules are as follows: Suppose 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 becomes worth $14,000, which is 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 since there is no "market" for only this interest and he also does not control the property.

Using this technique, one can gift a much larger percentage of property than the equivalent amount of cash. Also, one can leverage the annual gift tax exemption to reduce the donor’s estate for estate tax purposes while shifting the asset’s future appreciation to the donee. If the donee then sells the asset when he is over age 14 and in the 15% tax bracket, he will pay a 10% capital gains tax.

Thus, with a 30% discount, you and your spouse may effectively transfer much more, in fact, up to $28,500 of property per year, and remain under the $20,000 gift tax limit ($28,500 discounted by 30% is $19,950). Note: 30% is a typical discount percentage used, but there is no uniform standard discount. You will need an appraisal to justify the discount percentage applied to your particular asset.

Tax Benefits To The Donee

Using this technique, one can gift a much larger percentage of property than the equivalent amount of cash. Also, one can greatly leverage the annual gift tax exemption to reduce the donor’s estate for estate tax purposes while shifting the asset’s future appreciation to the donee.

For example, compare the difference between a gift of cash of $20,000, which earns 5% interest, and a gift of $28,500 of property valued at $200,000 (which is within the $20,000 annual gift tax limit, assuming a 30% discount). At the end of 10 years (using a simple interest calculation), the beneficiary’s stake in the property would be worth $42,750, but the bank account would have only $30,000. The interest earned on the cash would be subject to ordinary income taxes (currently a maximum federal tax rate of 39.6%), but the property’s appreciation is not subject to tax until the asset is sold, and then is subject to capital gains taxes (currently a maximum federal tax rate of 28%). In addition, the property may be part of a tax-free IRC Section 1031 exchange which would defer taxation until the property is later sold.

Selecting The Proper Asset

Your basis establishes your tax investment in an asset; it is used to measure your subsequent gain or loss. In most cases, your basis is the price you paid for an item. Assets received by gift, however, receive a "carry-over basis": The recipient's basis is the same as the donor's. For example: Suppose you bought 100 shares of IBM stock at $10 per share and that stock is now worth $100 per share. If you gift the stock to your son, his carry-over basis is $10 per share. However, if he sells the stock, he would have a $90 per share capital gain. Under the new capital gains rules, the holding period for the stock will include your period of ownership, and a sale by your child in the 15% bracket will produce a capital gains of just 10% (provided the combined holding period is 18 months or longer).

Family Owned Business Tax Relief

Next year, a new exemption for family-owned businesses goes into effect. In addition to the unified credit, there will be an exemption for a family owned business (regardless of the entity), not to exceed $1,300,000 (including the unified credit). The business must a) comprise at least 50% of the value of the estate; b) be an active trade or business in the U.S.; and c) owned 50% or more by one family, 70% or more by two families, or 90% or more by three families, so long as the decedent’s family owned at least 30% of the trade or business.

Additionally, the family members must have owned and materially participated in the business 5 out of the 8 years preceding the decedent’s death, and must continue to materially participate in the business for at least 5 years out of any 8-year period within 10 years of the decedent’s death. There are complicated recapture provisions if these requirements are not met.

Installment Payments Of Estate Tax For Closely Held Businesses

There is a new non-deductible interest rate of 2% on the first $1,000,000 in taxable value of the closely held business (computed after all applicable credits are considered). The interest rate on amounts over $1,000,000 will be equal to 45% of the rate applicable to underpayments of tax.

The effective date is for decedents dying after December 31, 1997, but estates electing to defer taxes under current law may elect to use the 2% rate instead of the current 4% rate for all future installments.



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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.**