Nothing is Certain for the Retiree But…. Taxes

By David E. Rosen* If you live or work in the United States, you are subject to taxation by the federal government and the state government of the state where you live. Here’s the bright side of paying income taxes: you must have made some money if you owe taxes. But even during retirement, when your income is likely to be lower, you are obligated to pay taxes.

There are two types of taxes: those that are due during life (Income Taxes) and those that are due after death (Estate Taxes). But there are ways of lowering each obligation through proper planning.

Taxes You Pay During Life: Income Taxes

Income taxes are calculated based on your taxable income, which (broadly defined) is your total income minus deductions permitted by the applicable tax code. Individuals may deduct an “exemption” called a personal allowance, and may also deduct certain expenses (e.g., interest on a home mortgage, state taxes, charitable contributions, etc.).

Capital gains (e.g. money you’ve made from profitable investments) are taxable, and capital losses (e.g., money you’ve lost on poor investments) are deductible but only to a point. Short-Term Capital Gains (profits from assets held for one year or less) are taxed at the same rate as income (10–39.6% in 2015). Long-Term Capital Gains (profits from assets held for longer than one year) and income from corporate dividends are taxed at a lower rate (generally 15% or 20) than income. Make sure that the investment advisor you work with considers the tax implications of all investments and trades.

One thing that seems counterintuitive is that Social Security income is taxable as income. If you receive a pension, Uncle Sam gets a piece of that too, just as he gets a piece of your dividend payments, and interest. On top of that, your Individual Retirement Accounts (IRAs) and 401ks may contain taxable assets, and withdrawals may be taxable. Naturally, inheritances are also taxable.

Many people incorrectly assume they will pay lower taxes upon retirement, but, depending on how you’ve saved for retirement and how well you’ve planned, you may very well remain in the same tax bracket when you retire that you were in during your working years.

Reducing Your Tax Burden in Retirement

When planning for retirement, you must factor in taxes. Tax laws can be complicated, and often change significantly from one year to the next. That’s why it’s important to consult a tax attorney or CPA when developing a comprehensive retirement plan. Smart planning for retirement, which should be done with a trusted accountant or tax attorney, will help minimize your tax burden.

Mutual funds are a commonly used, and perfectly appropriate, vehicle for investment, if chosen correctly to maximize your earnings and reduce your taxable gains. Funds with a low turnover rate incur fewer transaction fees and offer significant tax savings. That’s because increased trading (“turnover”) incurs taxable gains that are passed on to the investor as fees. Even if they’re called “fees,” understand that some of them are actually taxes that you’re paying indirectly. The best funds – those with low turnover, or trading, ratios, tend to be “institutional” funds that are typically only available through an investment advisor. If your money is held in a taxable account, you may want to consider “tax-managed funds” that engage in strategic trading to minimize taxes. That’s why it’s so important to combine your investment planning with your estate planning.

Even the purchase of individual stocks involves tax planning as you want to minimize Short-Term Capital Gains that are taxed at your ordinary interest rate. Working with an Investment Advisor can help provide the discipline not to overreact and take Short-Term Capital Gains that could negate any profits your gain.

Taxes that You Pay After Death: Estate Taxes

An estate plan protects your most important assets from taxes, as well as court fees, nursing homes expenses, etc. Of greatest concern are estate taxes that the federal government charges to your estate if it is above a certain threshold (currently a little over $5 million) unless you have taken steps to protect your estate from these taxes. Even if your estate is worth far less that this, the value of your home and other assets may cause your estate to be worth $1 million or more, which makes it eligible for Massachusetts state taxes. Between these two categories, your beneficiaries may lose between 41-55% of the value of your estate.

The IRS levies a tax—at a rate of 40% or more—on the right to transfer property upon death. You, or, more accurately, the Administrator of your estate, must detail everything you owned or had a financial interest in at the time of your death. This includes, but is not limited to, cash, securities, real estate, insurance policies, trusts, annuities, business interests, and intellectual property. The fair market value (not necessarily the same as the price you paid) of these things must also be appraised and disclosed. Taken together, these things form your “gross estate.”

Once your gross estate is ascertained, some deductions (and possibly reductions in value) apply. Examples of such deductions are: debts (including mortgages), estate administration expenses, and property that passes to a spouse or qualified charity. What remains after such deductions is the “taxable estate.” The value of all “lifetime taxable gifts” (gifts given after 1976), if any, is then added to it, and the tax is calculated.[i]

Simple estates containing cash, publicly traded securities, and easily valued property (but not jointly held property), can be handled without filing an estate tax return. If, however, the estate has combined gross assets and prior taxable gifts totaling $5M or more, then an estate tax return is required.

The Massachusetts’ threshold for the estate tax requirement is much lower: $1 million.

The Massachusetts Estate Tax

Fortunately, the Massachusetts estate tax is not as high as the federal tax. It starts at 8% for assets over $40,000, and peaks at 16% for assets over $10 million. If the taxable estate is valued at less than $1 million,[ii] the tax doesn’t apply, but once that threshold is crossed, the tax applies, and begins chipping away at the estate beginning at the $40,000 mark.

One quirk of this type of tax assessment is that some people with estates over the threshold may prefer to divest some of those assets during their lifetimes to avoid the tax on their estates. For example, an estate with taxable assets of $1.2 million would owe approximately $50,000 in taxes. Faced with that reality, some people would choose to divest the estate of $200,001, e.g., by making qualifying gifts, to bring the taxable estate under the $1 million threshold.

Estimated Estate Taxes in Massachusetts

Reducing Your Massachusetts Estate Tax Burden

If you are a Massachusetts resident (or couple) and there’s any chance that your estate will be valued at over $1 million, there are three general alternatives to paying the tax:

  1. Spend Your Money and Give Gifts

Gifts of up to $14,000 per year are not taxed. Through advanced planning, you can make piecemeal annual transfers of assets to save your loved ones some tax expenses in the long run. For example, assume that Michelle owns a home worth $500,000, and has $250,000 in savings and investments, plus another $250,000 in assets in an IRA. Taking money from her savings investments could be detrimental for Michelle’s financial security. She could, however, transfer an interest in her home to her children in $14,000 annual increments.

Unfortunately, that strategy would not be advisable if the house had significantly appreciated since Michelle bought it due to the lifetime-gift-and-capital-gains tax consequences. Under that circumstance, Michelle could accelerate her IRA withdrawals, instead. If there is anything left in her IRA upon her death, those funds would pass on to Michelle’s children, and would be taxed at their respective individual income tax rates. If Michelle successfully reduced her estate to under $1 million with this adjustment, her heirs would save around $35,000 in estate taxes. (To be fair, we would expect the accelerated distributions to result in some lost earnings in the IRA, but on balance, the result should be a significant savings.) This way, Michelle gets the benefit of spending more of her money during her lifetime while still saving responsibly and ensuring that her heirs are not unnecessarily taxed.

  1. Give Away More Money and Bigger Gifts!

The $14,000 gift exclusion mentioned above just means that you don’t have to report gifts of $14,000 a year or less on your tax return. The federal lifetime gift tax only kicks in after you give away over $5.34 million worth of gifts. You should be very proud, indeed, if you find yourself required to pay the federal gift tax. There are situations in which giving away larger gifts reduces your total estate tax by bringing your taxable estate into a lower tax bracket.

Unfortunately, this approach will not help you avoid the estate tax altogether. That’s because, although there is no state gift tax in Massachusetts, lifetime gifts count towards the value of your estate. In the above example, we saw how Michelle could gradually reduce her estate’s value by making smaller gifts over time. If, instead, she gave one, lump-sum gift of the same amount ($100,001) on her death bed, her estate would remain above the threshold. That’s why “deathbed gifting” approach is no substitute for good, advanced planning.

  1. Create a Trust for the Surviving Spouse (Couples Only)

Money passing from a deceased spouse to the surviving spouse is not taxable. But if that money remains in the surviving spouse’s estate upon his death, it would then be taxed. If the surviving spouse does not need the money, the couple can plan to avoid this by passing enough assets to others (e.g., children or grandchildren) so that the surviving spouse’s estate remains below the $1 million threshold. This strategy works only up to a point; if you give away over $1 million, the estate will owe a tax, anyway.

Alternatively, the surviving spouse may refuse or disclaim some of the money. In that situation, the money, like any other property, would typically pass to the children. This approach may require difficult calculations at a difficult time, which is one reason why most clients opt to structure an estate to have assets pass directly into a trust established for the surviving spouse’s benefit. Such a trust would provide income for the surviving spouse during life without the remainder being taxed upon death. Again, this requires advanced planning with trusted counsel.

These options and decisions are complicated, and should be discussed with someone knowledgeable about  estate taxes.

  1. You may have heard of the “unified tax credit.” This was repealed in 2010. Instead, as of 2015, there is a “basic exclusion amount” of $5.43 million. Generally, if the total of the taxable estate and lifetime gifts is under that threshold, there is no Federal estate tax obligation.
  2. For purposes of determining whether an estate is taxable, prior taxable gifts (over $14,000) are included in the value of the estate. Such gifts do not factor into the actual calculation of the tax, however.

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