Traditional to Roth IRA conversions: Don’t be tripped up by tax implications

Another good overview from The Boston Globe.

By Humberto Cruz
When you try to oversimplify tax matters, you often commit inaccuracies. I’ve found plenty, from slight to gross, in the nearly incessant media commentary about Roth IRA conversions. No wonder readers are confused.

As of this year, anybody with a traditional IRA can convert all or part of it to a Roth IRA. A Roth IRA offers the potential for future tax-free withdrawals. But if you convert, you will owe income taxes on the converted amount the same as if you withdrew the money from the traditional IRA (but with no 10 percent penalty, regardless of age).

That’s where the first inaccuracy creeps in. Many reports I’ve read state that if you convert, you will be taxed “upon conversion.’’ That phrase has led many readers to believe that as soon as you make a conversion you must send a check to the IRS for the taxes due on that conversion.

Not so. The taxable amount of the conversion simply counts as taxable income for the year. How much of the converted amount is taxable will depend on whether your traditional IRA includes nondeductible contributions.

If you have little additional income and enough exemptions and deductions, a small conversion may cost you little or even nothing in taxes.

But a big conversion can be expensive if the additional taxable income pushes you into a higher tax bracket and/or makes you ineligible for certain tax credits. You may be required to pay quarterly estimated taxes to meet your tax liability and avoid a penalty.

Another common inaccuracy is the assertion, and I quote, that “taxes from a Roth IRA conversion in 2010 can be split between 2011 and 2012.’’

The facts: If you convert in 2010, you can either report all the taxable income from the conversion on your 2010 tax return or report half of it on your 2011 return and the other half on your 2012 return. (You may not, as many readers believe, report one-third of the income for 2010, one-third for 2011, and one-third for 2012). The option to split the income exists for 2010 conversions only.

So, in reality, you may not have to start paying the taxes from a 2010 conversion until 2012, when you file your 2011 tax return.

Another inaccuracy is that it is the taxable income from the conversion and not the actual tax that may be split between the two tax years, said Kim Saunders, a tax analyst for Thomson Reuters.

“This seems a pretty important point to clear up,’’ an observant reader wrote. A large converted amount one year may push a taxpayer into a much higher tax bracket and result in a large tax bill that could be reduced by splitting the income. But a risk of income splitting is tax rates may go up for 2011 and 2012.

A decision on when to declare the income from a 2010 conversion does not have to be made until you file your 2010 return, Saunders said. By then, tax rates for at least 2011 will be known.

Vermont tax repeal effort draws controversy

News for our neighbors to the north.

Burlington, Vermont - February 7, 2010

As the Vermont legislature struggles to find $150 million worth of budget cuts this year, an attempt to roll back two tax increases is running into opposition. At issue are the capital gains and estate taxes, primarily affecting upper income Vermonters. But there's evidence that the two taxes are driving wealthier residents out of state to places like Florida.

The Vermont senate Economic Development committee met at Burlington city hall last week to hear testimony on repealing last year's increases on the state capital gains tax and the estate tax. Although farms were excluded from the death tax, as critics call it, the two taxes together raise tens of millions of dollars a year. And tax advisor Rick Wolfish told the panel the higher taxes are driving out high-income Vermonters.

"That is exactly what is happening," he told the panel, "that people are leaving the state. And CPAs and professionals are advising them."

Last year, the legislature lowered an exclusion on the estate tax from $3.5 million to $2 million. Tax experts say it's not just big Wall Street investors who get hit. Any Vermonter who built up a small business can get hit at anything over two-million of net assets, upon his or her death.

Wolfish said, "Under current law, if a taxpayer is considering the sale of a business, why not move to another state before the sale and pay no Vermont on the sale whatsoever?"

Real estate developer Ernie Pomerleau agreed. He said, "You know, there are people who can survive this, there are people who just say enough is enough. I can live someplace else."

Pomerleau has invested millions in Vermont development projects, creating jobs in the process. He says he'll never leave Vermont. "I'll die with my boots on here," he said. But Pomerleau said he knows others who already have left. "I know three dozen colleagues that are gone," he told the senators. "And I know you'll hear 'one comes in, one goes out.' The ones that go out have been here for forty years creating jobs, philanthropic, part of the energy of this community."

The legislature raised estate and capital gains taxes to help close a looming budget deficit as Vermont was losing 20,000 jobs along with a lot of income tax revenue. One Progressive policy advisor says the state simply cannot afford to restore a capital gains tax break. Doug Hoffer testified, "We have four years of data from when the capital gains exclusion was adopted, in those four years it cost us over $150 million. Now, the highest year was $51 million in a single year. That's a big hole to fill."

But supporters of the tax repeal say the question comes down to whether high state taxes are killing the goose that laid the golden egg. Still, the fact that the economic development committee is the only legislative committee to take up the repeal indicates how difficult that is likely to be.

Andy Potter -- WCAX News

IRS Silent So Far On New US Tax Rules For Inherited Wealth

Our trusts are drafted in such a way to account for the change, but still going to be an interesting time figuring it all out.

By Martin Vaughan, Of DOW JONES NEWSWIRES

WASHINGTON -(Dow Jones)- The U.S. Internal Revenue Service is taking a wait- and-see approach on issuing guidance dealing with taxes on inherited wealth, unsure whether Congress will act in the next several months to change the rules again.

Advisers to the wealthy say they are left without a roadmap on a number of issues related to the disposition of assets left behind by those who have died since Jan. 1. In particular, they are looking to IRS for rules on how a new capital gains-tax regime that took effect this year will apply to estates.

"There are no forms that give us any idea how or what we are supposed to report," said Stephen Litman, an estate planner at the Minneapolis law firm of Leonard, Street and Deinard. "This leads to significant administrative challenges for families."

Congress is weighing whether to set permanent rules for taxing estates, and whether to make those rules retroactive to the beginning of this year, but such action is weeks, and maybe even months, away.

The 2001 tax-cut law was aimed at gradually eliminating estate taxes, but repeal proponents at the time lacked the congressional majorities needed to do so permanently.

As a result, the federal estate tax was repealed for 2010 only, and is scheduled to return in 2011 at rates similar to those in effect prior to President George W. Bush's tax cut legislation.

In place of the estate tax for 2010 is a capital gains tax that is levied when assets are sold. Heirs would have to pay capital gains taxes on the full appreciation in value of the asset from the time it was acquired by the deceased benefactor, a concept known in tax circles as "carryover basis."

That means that families have an additional step of searching records to establish the basis value of the asset, which was unnecessary when estate taxes were in place.

"Carryover basis rules have added another level of complexity," said Carol Kroch, head of wealth and financial planning at Wilmington Trust Corp. "Families will have to go through a more difficult process of valuing assets."

The 2010 law provides that heirs can get a "step-up" in basis, meaning no capital gains taxes would be due if the asset is immediately sold, for up to $ 1.3 million of the estate property. Surviving spouses can get a step-up in basis for an additional $3 million in property.

Families will have to decide which assets to protect from capital gains taxes with the basis step-up. For example, property that is to be sold in the near future might be a good candidate, to avoid an immediate tax consequence. It might also be wise to protect property that has been in the family for a long time, and therefore has a low basis, wealth advisors say.

All that said, Congress might pass legislation that reinstates the estate tax for 2010 and eliminates the carry-over basis rules, which would make all such planning moot.

That may explain why IRS for now is waiting for the legislative picture to come into focus.

"We are currently looking at the issues involved to determine the best course of action," said IRS spokesman Bruce Friedland.

Families generally have nine months from the death of the estate owner to file estate tax returns, so there is a little breathing room before they have to make decisions about how to allocate assets.

"I don't think anyone would be distributing assets yet," said Kroch. "Over time, estate executors will have to make a decision about how much to hold in reserve for the estate tax" in case Congress re-imposes it retroactively, she said.

Another option that is getting some discussion by congressional staff is an election that would allow the family members of people who died between Jan. 1, 2010 and when new legislation takes effect to choose between paying estate taxes, for example at the rates in effect in 2009, or the capital gains-tax regime under the current law.

As we celebrate the life and legacy of MLK

Yesterday, we celebrated the life of Martin Luther King, Jr., one of the main leaders of the American Civil Rights Movement.

Dr. King devoted all of his income and talent to the movement. He died intestate (no Will), leaving less than $30,000 in his estate. Some of that money was already earmarked for the movement.

Additional information about Dr. King’s legacy is available on NPR’s Talk of the Nation entitled The Legacy of Martin Luther King Jr

Estate tax repeal seen bringing chaos

By Kim Dixon

WASHINGTON (Reuters) - The scheduled expiration of the tax on wealthy estates in the United States, unthinkable just days ago, has whipped the wealthy and their estate planners into a flurry of confusion over the changes to the controversial tax.

Under a quirk in the law, beginning on January 1 there will be a one-year repeal of a 45 percent tax on the value of estates over $3.5 million for individuals and $7 million for families.

"I'm going to be fending calls from people saying, 'Should I keep mom plugged in?'" said Carol Harrington, head of the private client group at law firm McDermott Will & Emery. "This is a disaster even if you are in favor of repeal."

Now, those who die on December 31 will pay the tax, while those who die a day later will not. In addition, the law's expiration unleashes a slew of changes, including for capital gains treatment of estates.

And because of the same quirky 2001 law that repeals the tax for a year, the estate tax is due to spring back to life in 2011 at a higher rate of 55 percent rate, which would be levied on estates with a value over $1 million for individuals.

The conventional wisdom had been that the Democrat-controlled Congress would pass an extension of current law. But opposition from Republicans to the tax and a U.S. Senate mired in a partisan health-care debate has prevented that from happening.

Once the current estate tax expires on December 31, those inheriting states will have to pay capital gains taxes on any assets sold based on the original price paid for the asset, after an exemption for the first $1.3 million in capital gains.

That is changed from the current law, which uses the market value of an asset at the time the estate is inherited as the basis for calculating capital gains on any future sale.

This will mean higher taxes for as many as 70,000 taxpayers, according to House Democrats, many more than will be impacted by elimination of the estate tax itself.

Tax experts say that the change will create a major problem because of the paperwork needed to establish the original investment price. Without documentation, the original basis goes to zero, meaning that the full sale price would be taxable after $1.3 million.

"Many people don't keep records," said Brenda Schafer, manager of tax analysis at the Tax Institute at H&R Block. "It's not like we can go back in time and get those records."

The estates of about a quarter of 1 percent of Americans would be subject to the estate tax under an earlier bill introduced by Democrats to extend it permanently, according to the Brookings Institution-Urban Institute Tax Policy Center.

CONSTITUTIONALITY OF A FIX

An aide to Senate Finance Committee Chairman Max Baucus said Baucus still holds out hope for an 11th-hour extension of the current tax, though most analysts are dubious.

"I am stunned that the Democrats, who have professed undying support for estate taxation all these years, have been in power for now this time, and not enacted" an extension," said Bill Ahern, policy and communications director at the conservative Tax Policy Foundation, which backs a repeal of the estate tax.

The tax has divided some Democrats, with conservatives from the party teaming with Republicans to propose a lower tax with a greater exemption level.

The battle will likely begin anew next year. Baucus said he will aim to retroactively reenact the tax at current levels, a policy backed by most Democrats.

But Clint Stretch, a former legislative counsel to the joint congressional committee on taxation, said there is a debate about the constitutionality of such a fix.

"Since scholars are divided in their opinions on whether the Constitution allows Congress to retroactively reimpose those taxes, litigation will result," he predicted.

And the politics are complicated by the reinstatement of the tax at a higher rate in 2011.

Progressive groups such as the Citizens for Tax Justice see this as the silver lining of a one-year repeal.

The specter of higher rates has led traditional opponents of the tax, such as the Chamber of Commerce and small business groups, to back a permanent extension of current policy.

Baucus to Try Next Year to Extend Estate Tax Retroactively

Washington Post
December 16, 2009

WASHINGTON -- Senate Finance Committee Chairman Max Baucus (D., Mont.) said he will try early next year to pass legislation ensuring no lapse in the estate tax, after Republicans blocked another effort to extend the tax for a three-month period.

Democrats had sought to extend the tax at its current, 2009 levels, but it now appears likely the tax will be repealed as scheduled Jan. 1. Mr. Baucus said he will try to move legislation early in 2010 that ensures that there won't be a window where wealthy estate owners who die will escape the tax.

"We clearly will work to do this retroactively, so that when the law is changed, it will have retroactive application," Mr. Baucus said on the Senate floor Wednesday.

Mr. Baucus sought unanimous consent from the Senate for a two-month extension of the tax, warning that allowing the tax to be repealed pending congressional action would create unnecessary confusion.

But Republicans said the repeal should be allowed to take effect, as provided under current law. "The problem doesn't have to exist if they'll just leave the existing law alone, and let the rate go to zero, where everyone wants it anyway," said Sen. Jon Kyl (R., Ariz.).

In 2009, estate wealth above $3.5 million, or $7 million for married couples, is taxed at a 45% rate. The estate tax will disappear in 2010, replaced by a capital-gains tax paid when heirs sell inherited assets. Then in 2011, unless Congress acts, the estate tax will return to tax estates above $1 million, or $2 million for couples, at a 55% rate.

Mr. Baucus called that a "yo-yo effect."

"It's so irresponsible to further the yo-yo effect by allowing current law to expire, and create this massive confusion," he said.

House votes to make estate tax permanent

By Kim Dixon
December 3, 2009

WASHINGTON (Reuters) - The U.S. House of Representatives passed a permanent extension of the federal estate tax on Thursday, but the measure, which taxes estates at rate of 45 percent after exempting the first $3.5 million, is likely to be changed in the Senate.

The current tax is due to expire on December 31 but return in 2011, when it will exempt just the first $1 million of an estate while taxing the remainder at a rate of 55 percent.

Keeping the current rate would cost the government $234 billion of revenue over 10 years, according to a congressional tax committee.

The bill passed 225 to 200, drawing all its support from Democrats.

"The estate tax is critical to prevent a permanent aristocracy from arising in this country," said Jared Polis, a Colorado Democrat who said, as one of the wealthiest members of the House, he would pay the tax under the bill.

Republicans blasted the bill and called for complete repeal of the tax. "Death in and of itself should not be a taxable event," said Dave Camp, a Michigan Republican.

Preserving the 45 percent rate and the $3.5 million exemption indefinitely will be much harder in the U.S. Senate because of the cost. In addition, Senate lawmakers are consumed by the healthcare reform bill debate, which could continue into January.

Given the price tag, the bill is "pretty much a non-starter" in the Senate, analyst Anne Mathias at Concept Capital said.

A likely compromise in the Senate is a one-year extension of current law, which would raise some money because of the 2010 phase out.

The estates of about a quarter of one percent of Americans would be subject to the tax under the House bill, according to the Brookings Institution-Urban Institute Tax Policy Center.

The non-partisan Congressional Budget Office reported in 2005 that fewer than 2 percent of all estates have had to pay estate taxes in recent years.

Republicans warned Democrats would suffer at the ballot box if they extend the tax, citing Americans' general dislike of any new taxes.

Democrats countered by citing prominent estate tax proponents, including investors George Soros and Warren Buffett, who has argued the tax helps keep America a meritocracy.

BUSINESS GROUPS SPLIT

Business groups are divided on the legislation.

The Chamber of Commerce has long called for the abolition of the estate tax, although recently said it was willing to back a continuation of the current law.

"The uncertain nature of the estate tax regime over the next two years is a major concern for business, many of which are struggling in this current economic downturn," Bruce Josten, a lobbyist for the Chamber, said in a letter to lawmakers on Wednesday backing the Democrat's bill.

The National Association of Manufacturers urged rejection of the bill, saying its members pay tens of thousands of dollars in fees for estate planning.

CAPITAL GAINS RELIEF

The House bill contains capital gains tax relief for those inheriting estates by repealing so-called carry-over basis rules.

With no action, those inheriting estates after December 31 will have to calculate capital gains taxes based on the original price paid for the property.

"People will be stuck with large tax bills forcing liquidation if they were forced to pay a capital gains tax on a 1959 basis," said Polis, the Colorado lawmaker. "Do opponents truly believe making families pay capital gains is better?"

The American Farm Bureau, the nation's largest agricultural group representing all sizes of farms, opposes any estate tax but backs the portion of the bill that repeals the cost basis rules. The group had no data on how many of its members would be impacted by the tax.

(Editing by Steve Orlofsky and Tim Dobbyn)