Income Tax Questions and Answers Excerpts from questions sent to questions@rushforth.org.

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Leaving an IRA to Spouse and Children

Answer: When deciding on the beneficiary of an IRA, one must consider the income tax and estate tax implications, as well as one's desires with respect to passing benefits to the intended beneficiaries. Congress wrote the statutes relating to IRAs so that the most flexibility for income tax planning is done by naming one or more specific individuals as beneficiaries rather than one's estate. Recent changes have made it easier to use trusts, but the rules are quite complicated.

Designating a spouse as the beneficiary of an IRA gives the surviving spouse the greatest flexibility. Assuming the survivor is a U.S. citizen, the designation of the spouse as a beneficiary will qualify for the estate tax marital deduction, and the survivor can elect to treat the IRA as his or her own or roll it into a spousal IRA. The new spouse may elect new pay-out options. Please note that designating a marital-deduction trust as an IRA beneficiary is not the same as designating the spouse as beneficiary. Subtantially different rules apply.

As you know, an IRA that passes to beneficiaries other than a spouse is subject to both the income tax (as it is distributed) and the estate tax (upon death). If the income tax and estate tax are applied at the same time, the combined taxes may leave the beneficiaries with a net amount of less than 20 cents on the dollar. (If the beneficiaries are grandchildren and the generation-skipping transfer tax applies, they will be lucky to get a nickel for every dollar.)

With IRAs, consider these planning options.

1. Plan A: Spend the IRA before you die. Children are unlikely to get more than 20 cents on the dollar because of the combined impact of the income and estate taxes. When spending money for your own needs, consider spending the IRA first. Yes, you will pay income taxes, but you will pay as you go during your lifetime rather than having your family pay the income tax in a lump sum or over a 5-year period

2. Plan B: Convert the IRA into Insurance. Consider withdrawing funds from the IRA to fund an irrevocable trust that will purchase insurance on your life. Yes, you will pay income taxes on the funds withdrawn, but when the insurance is paid into the irrevocable trust at your death, the death benefit will be undiminished by income or estate tax. In short, this method converts an asset that is subject to both the income tax and the estate tax into an asset that is subject to neither tax.

3. Plan C: Stretch the IRA. This does not work with the estate designated as a beneficiary, and that is why many people recommend against naming one's estate as the IRA's beneficiary. One needs to make the appropriate beneficiary designations that will allow minimum mandatory withdrawals to be based on a combined life expectancy of the account older and one or more other beneficiaries, such as children. Although the estate tax will still apply, the compounding of investments in an income-tax free environment can make up for some of that. This is most effective if the estate tax can be paid from funds other than the IRA itself. (You have to analyze the estate's source of liquid funds and calculate taxes under various scenarios to see what's best for any particular person.)

4. Plan D: Designate the account holder's spouse as primary beneficiary and one or more charitable beneficiaries as contingent beneficiaries. This does nothing for the account holder's children, but they would receive less than 20 cents on the dollar anyway. Uncle Sam will get the income tax on the minimum distributions made during the lifetime of the account holder and the spouse, but there is no income or estate tax when the charity or charities receive it.

5. Plan E: Consider converting to a Roth IRA: For some people, it may make sense to convert from a traditional IRA to a Roth IRA. A Roth IRA is not subject to the income tax when withdrawn by your beneficiaries. Not everyone qualifies for an IRA-to-Roth conversion, and it may not make sense for older persons who will not live long enough to recoup the tax imposed at the time of conversion. The only way to know is to have your accountant or other tax advisor help you "crunch the numbers".

Taxation of Trust Income

Answer: I will try to give you a general answer, but this actually is a quite complicated area of tax law. You will need to address specific questions to your CPA, trust and estate attorney, or other qualified tax advisor.

• If a trust is revocable by its settlor (creator), the trust's income is taxed to the settlor of the trust as if the trust did not exist. Frequently, the trust does not require a separate tax identification number, and no fiduciary income tax return (IRS Form 1041) is required. The settlor's social security number can be the trust's tax identification number, and trust income is reported on the Settlor's individual income tax return (IRS Form 1040).

• If a trust is irrevocable, the trust's income can be taxed to the settlor, the trust, or the trust's beneficiaries, depending on the terms of the trust. Most irrevocable trusts are designed so that the settlor is not taxed on the income, and, if that is true, then the income tax is paid by the trust (at the trust's steeper rates) if the income is accumulated and by the beneficiaries (at the beneficiary's rates) if the income is distributed -- or required by the trust to be distributed -- to the beneficiaries. On the other hand, some trusts are intentionally designed as "grantor trusts" so that the settlor pays the tax on all trust income, even if it is distributed to the trust's beneficiaries.

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ISOs and CRTs

Answer: Your advisors are correct. In order to avoid having the incentive stock option treated as ordinary compensation, you cannot dispose of the stock within two years after the option is granted or within one year of obtaining the stock. [See Internal Revenue Code §§ 421(a) and 422(a)(1).] If you transfer your stock to a charitable remainder trust (CRT) before the waiting period has expired, you would have to report the entire gain as ordinary income. If you wait until the waiting period has expired, you can contribute the stock to the CRT, the sale of the stock will generate capital gain (not ordinary income), and, as you know, the CRT itself does not have to pay income taxes on that capital gain.

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