Tax law can make grandkids rich

Congress last year enacted temporary changes that allow for a massive estate-tax break through a Roth IRA. As a result, a grandchild could pocket millions, tax-free, over a life.

Sometimes Congress hands out a break that is so generous it seems it must be a mistake. This your a doozy: The ability to get a totally tax-free inheritance of $400 million or perhaps more.

Thanks to 2 recent changes in the tax code, investors with huge 401k accounts have a method to turn them into completely tax-free income for their grandchildren's lifetimes.

This is by far the biggest estate-planning break on record, created even as lawmakers debate over which tax giveaways should be killed to help shore up the federal budget.

"I call this tax break the government's going-out-of-business sale," says individual retirement account guru Ed Slott, that travels the country teaching advisers as well as accountants how to squeeze benefits out of the Roth IRA. "This is a tax break we can drive 10 Mack trucks through. It's an incredible opportunity to a totally tax-free transfer of wealth."

This massive estate-tax break was created last year in 2 steps. First, Congress lifted a $100,000 income restriction on that can convert a 401k to IRA to a Roth IRA, allowing even the wealthiest investors to convert. Then, late in the year, it raised the generation-skipping transfer tax exemption to $5 million until 2013. The GST exemption was previously $3.5 million as well as was scheduled to drop to $1 million this year before Congress stepped in.

Both of these provisions on their own create possibilities for important tax savings, upon conversion. But utilized in combination, the results are exponentially greater.

The Roth IRA has always been on a different playing field compared with alternatives, due to the fact it allows gains to be withdrawn tax-free. Funds taken from a 401k, regular IRA or other retirement accounts is subject to income tax rates. Also, the Roth doesn't need that minimum distributions be taken after we turn 70½, as other plans do. Thus if you don't want retirement plan assets to live on, the Roth preserves it best for heirs.

Certainly not everyone jumps at the chance to convert to a Roth IRA, because we have to pay income taxes on the assets moved into the account. And so if you plan to live off of retirement account assets, a conversion may definitely not make sense. But from an estate-planning perspective, when there are decades of gains ahead, the tax bill is a small price to pay for big benefits down the road.

With the new GST exemption, the estate-planning benefits that can be wrung from a Roth are eye-popping. Consider an extreme case: A wealthy individual converts a large 401k account to a Roth IRA as well as names a grandchild as the beneficiary. The grandchild, at age 1, inherits the Roth, whose assets have grown to $5 million. Due to the fact of the new $5 million GST exemption, the Roth assets would not be topic to estate tax or perhaps generation-skipping transfer tax.

Under Roth rules, an heir should take needed minimum distributions, but the distributions can be stretched over a lifetime, and assets left in the Roth can continue to grow tax-free. Based on a 1-year-old's 81.6-year life expectancy and assuming an average annual return of 8%, Slott calculates that the grandchild's lifetime income from the Roth would definitely be $408 million -- "completely without estate, gift, income and capital gains taxes," he says.

If both grandparents left a big Roth account to the same grandchild, the tax-free inheritance would be almost twice that amount, depending on the age of the grandchild whenever the second Roth is inherited.


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IRS Sends Tax Letters to Five Big Political Donors

Political donations are not tax deductible. If I were to contribute money to a political campaign, I can’t then claim a deduction for that contribution on my Form 1040. It’s not really “charitable,” is it? In fact, one big issue in the last Presidential election was the growing role of churches in politics and how churches could risk their non-profit status if they become too involved. Politics and charity are to be separate, with political donations being non-deductible and charitable donations being deductible.

Here’s where it starts to get tricky, as everything taxes seems to be. There are plenty of organizations that are political in nature whose “primary purpose” is political. The rub is that if you were to contribute funds to one of these obviously political organizations (wink wink not it’s primary purpose nudge nudge), you can get a tax deduction. I think anyone can support any organization they want, but if it’s political then you shouldn’t get a tax deduction from it!

The reason why this is bigger news is because the IRS recently sent letters to five donors because they were donating vast sums. Large enough that they fell under gift tax laws, which doesn’t kick in for this type of thing until you reach pretty large sums.

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Do Tax Shelters, Dodges, and Rolls Anger You?

I’m a big fan of Bloomberg Businessweek, especially their iPad app where you can download your subscription and take it anywhere, and recently they had a really interesting special report called How to Pay No Taxes – very good reading. It held a lot of insights into how the wealthy are able to avoid taxes in entirely legal, and very clever, ways. They’re all strategies that make sense when you’re moving millions of dollars around because the costs of paying accountants, lawyers, and the like are likely in the tens and hundreds of thousands of dollars. It makes less sense if you’re just moving several thousand around.

As I read the article, I was about to get annoyed at all the sheltering and dodging until I realized it’s just part of the game. Our tax structure has gotten so complicated, it’s basically a game. Consider this – the United States has one of the highest corporate income tax rates at 35%. Yet, after all the loopholes and credits and other tax breaks, corporations, in aggregate, pay about average. The difference is that certain industries pay a lot less and others pay more.

It’s like playing a game and finding out that one of the other players has discovered the optimal strategy before you do. They’re beating your pants off because they’re smarter than you. Can you really get that upset because they figured it out? I suppose you can get upset at anything but the reality is that you have to change the rules… right?

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What Do You Really Pay in Taxes Over Your Lifetime?

The following is a guest post from Richard Barrington who writes for MoneyRates.com about financial topics including bank rates. His opinions do not necessarily reflect those of Quicken Loans.

Sometimes, the biggest expenses turn out to be the ones you pay little by little over a long period of time. These expenses come out of your wallet incrementally, so they may not seem so bad from paycheck to paycheck, but when you add up all the charges, the result can be shocking. A perfect example: your lifetime tax bill.

According to an analysis by MoneyRates.com, even if you earn an average income over the course of your lifetime, your federal tax bill could total in the hundreds of thousands of dollars. If you are lucky enough to earn a six-figure income, then you might be looking at a million-dollar lifetime tax bill. Something to think about as you take a look at 2011 income tax brackets.


Your lifetime tax bill: crunching the numbers
Of course, there are dozens of variables that will determine your lifetime tax bill, but a straightforward example is a good place to start for illustration purposes. Assume a single person using standard exemptions and deductions, and earning an average wage. According to the Bureau of Labor Statistics, the average income across all occupations in the U.S. is $43,460. Under the circumstances described, this taxpayer would have a tax bill of $4,713 on a 2010 federal tax return.

Project that over the course of a 40-year career, and this taxpayer would be looking at a lifetime tax bill of $188,520. Of course, no one earns the exact same amount over the course of 40 years, but the assumption here is that this taxpayer earns a career average of $43,460, so that lower wages in the early years are balanced out by higher wages in the later years.

Of course, one other reality to take into account is inflation. Applying a 3 percent annual inflation rate to the tax liability gives this average earner a lifetime tax bill of $355,366.

Now assume that you are fortunate enough to earn an average of $100,000 (in today’s dollars). Using the same background assumptions, this would give you a 2010 tax bill of $19,098. That would create a lifetime tax bill of $763,920, or $1,440,013 when adjusted for inflation.

That’s your federal tax bill. Depending on where you live, you may be paying even more when state and local taxes are taken into account. Imagine if you were able to save just a little more on your taxes each year and put this money into your savings account. Over a 40 year period, this could also amount to a significant sum.


3 tips for living with taxes
If the prospect of a million-dollar tax bill gets your blood pressure up, try these three basic tips for managing your tax liability:

1. Give your tax return the care and attention it deserves. Given the amount of money at stake, maybe dashing through it at the last minute isn’t the best strategy. Take time to check your tax return for errors and commonly missed income tax deductions.
2. Keep thorough records. Medical, educational, and charitable payments are prominent examples of expenses that may be deductible, so hang on to those receipts.
3. Make the most of retirement plan deductions. IRAs and employer-sponsored plans can allow you to defer taxes until retirement, and this can mean paying a lower tax rate when you eventually realize that income.

Finally, while the size of your lifetime tax bill can and should make you intolerant of government waste, it is also worth thinking of the valuable services you get from the government. If you imagine the cost of trying to replicate those services out of your own pocket, the size of your tax bill may not seem like such a bad deal after all.

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Check Your Tax Withholding

Are you doing your taxes and surprised at the amount you owe or will be getting back as a refund? A large refund or tax bill is a sign you didn't have the correct amount withheld from your paycheck. One of the easiest things you can do to maximize how much you bring home with each paycheck and avoid paying Uncle Sam too much is to adjust your?tax withholding. ?Sure, it's always nice to get a refund check in the spring, but you're really just giving the IRS an interest-free loan when you could have been making use of those extra dollars. That could mean more money in your pocket each month to put towards everyday expenses, pay down debt, or tuck away for retirement.

Having proper withholding isn't just for controlling refunds, but it is even more important if you find yourself on the other side of the coin and need to write a check to the IRS come April. Nobody likes shelling out more money for taxes, so having your withholding set up appropriately can prevent this. It is a fine line to walk in order to put as much money in your pocket without having to pay up at the end of the year. Luckily, the IRS can help you determine how to set your withholding. Check out the IRS withholding calculator.

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