DACA Financial Group

The temporary repeal of the federal estate tax and the generation-skipping transfer (GST) tax in 2010 has created uncertainty for families that, in prior years, would have been unaffected by these taxes. Further adding to this dilemma is the likelihood that Congress will reinstate these taxes in 2010, possibly retroactive to January 1. Here is a brief recap of what we do and do not know, along with some issues and opportunities to consider.

What we know

• The federal estate tax and the GST tax (a separate tax on lifetime or at-death transfers to “skip” generations, such as grandchildren) are repealed for 2010, but are set to reappear in 2011 at pre-2001 rates. In 2011, the estate and GST tax exemption amounts will drop to $1 million (from $3.5 million in 2009) and the highest tax rate will jump to 55% (from 45% in 2009).
• The gift tax remains in place with a $1 million lifetime exemption and a tax rate of 35% (down from 45% in 2009).
• In prior years, inherited assets received a step-up in cost basis to the asset’s fair market value on the date of death. In 2010, inherited assets generally receive the lesser of the asset’s date-of-death fair market value or the decedent’s carryover basis. However, estates can exempt up to $1.3 million of gain for assets left to heirs, and an additional $3 million exemption can be allocated to assets specifically left to a surviving spouse.

What we don’t know

• Will Congress reinstate the estate and GST taxes at their 2009 levels, or will they create a new tax regime?
• Will any changes be retroactive to January 1?
• How will estates be expected to pay any retroactive taxes, especially if assets have already been distributed?
• What will individual states that link their own estate tax systems to the federal estate tax system do?

Issues and opportunities

It’s hard to know how to react to the uncertainty presented by the current estate tax situation. Should you change your estate plan and update your estate planning documents when it’s possible that your existing plan will once again be appropriate in 2011, or even sooner? For many, the answer is no, but for a few, the answer is definitely yes.

Generally, you should consult an estate planning attorney if:

• You are very old, very ill, or terminally ill
• You have a will or trust that allocates assets based on a “formula clause”
• You want to make gifts to individuals in the “skip generation”–those who are two or more generations below you
• You have assets with an appreciated value in excess of $1.3 million

Aged or ill need to review estate plans now

For those who are aged or terminally ill, if the repeal remains effective, your goal may shift from saving estate taxes to saving capital gains taxes. Thus, in response to the modified step-up in basis provision, you may want to reallocate the distribution of highly appreciated assets.

Your will or trust should authorize your executor or trustee to allocate the $1.3 million basis adjustment and the $3 million spousal basis adjustment in the most advantageous way, while allowing for the possibility of the reappearance of the estate tax. However, determining how to do so can vary greatly based on many different factors, including:

• Your cost basis in estate property and the amount of gain that would be realized if the property is sold in 2010
• The anticipated tax bracket of the beneficiary inheriting the property–the tax impact may not be as great for beneficiaries in a lower tax bracket
• Whether appreciated property placed in a bypass trust qualifies for the surviving spouse’s basis adjustment
• Whether property is expected to be retained by the beneficiary after it’s inherited, such as a farm or family business
• Whether capital gains tax can be avoided or minimized through other means, such as charitable gifting
• Whether the $250,000 federal income tax home sale exclusion applies to estate property that is a principal residence

Review documents for formula clauses

Your will or trust may provide that upon your death, a percentage or fraction of your estate, up to the applicable estate tax exclusion amount, will pass to a family trust (also referred to as a bypass or credit shelter trust) for the benefit of your children, with the balance going to a marital or residuary trust for the benefit of your surviving spouse.

If there is no estate tax at your death, such a formula clause may cause your entire estate to be transferred to your family trust, leaving nothing to the marital trust. If your surviving spouse is the beneficiary of both trusts, there may be no problem, but if your spouse has no right or access to assets in the family trust, then your surviving spouse could be unintentionally disinherited.

In light of these potential issues, it is best to review your estate planning documents with your attorney and make necessary revisions to ensure that your wishes are carried out. Your will or trust should be drafted to clearly reference what should happen if you die when there is no estate tax, or if the exclusion amount is greater or lesser than the 2009 amount ($3.5 million). Your documents will need to provide flexibility in their distribution provisions to accommodate the possibility of many varied scenarios.

If you’re inclined to make large gifts

The temporary repeal of the GST tax provides an opportunity to make gifts to skip beneficiaries free from the GST tax. You can make large gifts to grandchildren, subject only to the gift tax (at a 35% tax rate). If you don’t want to make a gift directly to your beneficiaries, you can gift to a dynasty trust which directs when beneficiaries are able to access their gifts. However, if the GST tax is imposed retroactively, some of those gifts may be subject to that tax after all. You’ll have to weigh this possibility against the potential tax savings of gifting without the GST tax to determine the best course of action for you.

If you’ve already begun a plan of gifting to grandchildren, either directly or through dynasty trusts, you should review your estate plan. If gifts to your grandchildren are based on your available GST tax exemption, those gifts may not be made if you die in 2010 when the GST tax is repealed. An estate planning professional may be able to amend your documents to include a different formula to account for the possibility that there is no GST tax exemption when allocating gifts to grandchildren.

What about state estate taxes?

Some states have their own estate tax, and many estate plans were drafted in contemplation of either or both a federal estate tax and a separate state estate tax. These plan documents also need to be reviewed in 2010. Your will or trust may direct that assets be allocated to a family or bypass trust to minimize the federal or state estate tax, when the capital gains tax is also a real possibility. How should assets be allocated now to take advantage of the repeal of the federal estate tax, to minimize any potential capital gains tax, or to utilize any state estate tax exemption? These questions require careful consideration and planning as there’s no “one size fits all” solution.

Conclusion

The tax law changes in 2010 have given rise to much confusion and many issues to consider. Inaction is the least favorable option. Keep abreast of the potential legislative changes that might occur in 2010 and work with your estate planning professional to update your plan documents to best carry out your wishes now and in the future.

Forefield Inc. does not provide legal, tax, or investment advice. All content provided by Forefield is protected by copyright. Forefield is not responsible for any modifications made to its materials, or for the accuracy of information provided by other sources.

Prepared by Forefield Inc. Copyright 2010.

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It is important to choose a Financial Planner wisely.  As this video from CNN.com explains it is important to make sure your advisor is a CERTIFIED FINANCIAL PLANNER^TM

CNN.com Video – Choosing a Financial Planner

A CERTIFIED FINANCIAL PLANNER^TM professional or a CFP^® practitioner is a financial professional who meets the requirements established by the Certified Financial Planner Board of Standards, Inc. While others may call themselves financial planners, only those who demonstrate the requisite experience, education, and ethical standards are awarded the CFP^® mark.

What are the requirements?

In order to obtain the CFP^® mark, an applicant must:

• Hold a bachelor’s degree from an accredited college or university
• Complete a CFP^® Board-registered education program
• Pass the 10-hour CFP^® certification exam
• Have at least three years of qualifying full-time work experience in financial planning
• Pass a professional fitness standards and background check

Once appointed, a CFP^® professional must meet continuing education requirements every other year in order to maintain the certification.

What does a CFP^® professional do?

A CFP^® professional is trained to develop and implement comprehensive financial plans for individuals, businesses, and organizations. He or she has the knowledge and skills to objectively assess your current financial status, identify potential problem areas, and recommend appropriate options. You’re also working with someone who’s demonstrated expertise in multiple areas of financial planning, including income and estate tax, investment planning, risk management, and retirement planning.

How is a CFP^® professional compensated?

Typically, financial planners earn their living either from commissions or by charging hourly or flat rates for their services. A CFP^® professional may use a combination fee-and-commission structure: you pay a fee for development of a financial plan or for other services provided by the CFP^® professional, who also receives a commission from selling you products. A commission is a fee paid whenever someone buys or sells a stock or other investment, or when someone buys insurance (such as health, life, or long-term care insurance) or annuities.

When calculating the cost to employ the services of a financial planner, consider fees, commissions, and related expenses, such as transaction fees and management fees related to the products he or she recommends.

How can a CFP^® professional help you?

A CFP^® professional can help you create a personal budget, control expenses, and develop and implement plans for retirement, education, and/or wealth protection. A CFP^® professional can offer expertise in risk management, including strategies involving life and long-term care insurance, health insurance, and liability coverage. He or she often can help with your tax planning or manage your asset portfolio based on your goals.

Specifically, a CFP^® professional can help you:

• Establish financial and personal goals and create a plan to achieve them
• Evaluate your financial well-being with a thorough analysis of your assets, liabilities, income, taxes, investments, and insurance
• Identify areas of concern and help you address them by developing and implementing a financial plan that emphasizes your financial strengths while reducing your financial weaknesses
• Review your plan periodically to accommodate your changing personal circumstances and financial goals

How to choose a CFP^® professional

Selecting a CFP^® professinal is like choosing a doctor for your financial health. Working with a CFP^® professional involves sharing very personal information and you will want to feel comfortable with the professional you’ve chosen. He or she should be knowledgeable, have integrity, and demonstrate a commitment to the highest ethical standards in the industry. Also, a CFP^® professional may offer services to a particular clientele, such as small business owners, corporate executives, or retirees, so be sure the planner you select works with people whose interests and goals are similar to yours.

Before you choose someone to work with, ask around. You may know a family member, friend, or colleague who has worked with someone they’d recommend. Also, be prepared to interview the prospective CFP^® professional. At your meeting, request a copy of form ADV or the comparable state form. A CFP^® professional who offers investment advice for a fee is required to file form ADV with the U.S. Securities and Exchange Commission (SEC) or with the state of residence of the CFP^® professional (although some exceptions apply). Form ADV contains information about the professional’s education, business, disciplinary history, services offered, fees charged, and investment strategies. In addition to form ADV, ask for the disclosure document that contains other important information regarding the CFP^® professional. Even if you don’t ask for the disclosure document, it must be provided to you at the time you enter into an agreement for services, or soon thereafter. Be sure to read the disclosure document carefully as well as any written agreements you enter into.

Questions to ask

Here are some questions you may want to ask a CFP^® professional to help you find the right planner for you:

• What is your education? What schools did you attend and what degrees have you earned?
• What licenses do you hold? Are you registered with the SEC, FINRA, or the state?
• Are you affiliated with any professional groups or organizations? Do you execute securities trades through a broker-dealer? Who is it?
• Does your practice concentrate in a particular area? What types of clients do you work with?
• What type of products and services do you offer? Are you limited as to the products and services you can offer me?
• How are you compensated for your services? Do you receive a commission for products you may sell to me?
• Have you ever been disciplined by any government board or regulatory agency?

Is a CFP^® professional right for you?

The financial world has become a very complex place. Even if you’re used to handling your own financial affairs, the time may be right to consult a CFP^® professional who can review your financial health and offer suggestions that may help you reach your financial goals.

For example, are you familiar with all the different investment opportunities that might be available to you? Are you on track to meet your financial goals such as saving for your child’s college education, securing enough income for a comfortable retirement, or protecting your assets against risks and lawsuits? A CFP^® professional can offer the analysis you need to help answer these and other important financial questions.

Note: Certified Financial Board of Standards Inc. owns the certification marks CFP^®, CERTIFIED FINANCIAL PLANNER^TM and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

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With the lure of tax-free distributions, Roth IRAs have become popular retirement savings vehicles since their introduction in 1998. But if you’re a high-income taxpayer, chances are you haven’t been able to participate in the Roth revolution. Well, new rules apply in 2010 that may change all that.

What are the general rules for funding Roth IRAs?

There are three ways to fund a Roth IRA–you can contribute directly, you can convert all or part of a traditional IRA to a Roth IRA, or you can roll funds over from an eligible employer retirement plan (more on this third method later).

In general, you can contribute up to $5,000 to an IRA (traditional, Roth, or a combination of both) in 2010. If you’re age 50 or older, you can contribute up to $6,000 in 2010. (Note, though, that your contributions can’t exceed your earned income for the year.)

But your ability to contribute directly to a Roth IRA depends on your income level (“modified adjusted gross income,” or MAGI), as shown in the chart below:

If your federal filing status is:	Your 2010 Roth IRA contribution is reduced if your MAGI is:	You can’t contribute to a Roth IRA for 2010 if your MAGI is:
Single or head of household	More than $105,000 but less than $120,000	$120,000 or more
Married filing jointly or qualifying widow(er)	More than $167,000 but less than $177,000	$177,000 or more
Married filing separately	More than $0 but less than $10,000	$10,000 or more

What’s changed?

Prior to 2010, you couldn’t convert a traditional IRA to a Roth IRA (or roll over non-Roth funds from an employer plan to a Roth IRA) if your MAGI exceeded $100,000 or you were married and filed separate federal income tax returns.

In 2006, however, President Bush signed the Tax Increase Prevention and Reconciliation Act (TIPRA) into law. TIPRA repealed the $100,000 income limit and marital status restriction, beginning in 2010. What this means is that, regardless of your filing status or how much you earn, you can now convert a traditional IRA to a Roth IRA. (There’s one exception–you generally can’t convert an inherited IRA to a Roth. Special rules apply to spouse beneficiaries.)

And don’t forget your SEP IRAs and SIMPLE IRAs. They can also be converted to Roth IRAs (for SIMPLE IRAs, you’ll need to participate in the plan for two years before you convert). You’ll need to set up a new SEP/SIMPLE IRA to receive any additional plan contributions after you convert.

What hasn’t changed?

TIPRA did not repeal the income limits that may prevent you from making annual Roth contributions. But if your income exceeds these limits, and you want to make annual Roth contributions, there’s an easy workaround. You can make nondeductible contributions to a traditional IRA as long as you have earned income at least equal to the contribution, and you haven’t yet reached age 70½. You can simply make your annual contribution first to a traditional IRA, and then take advantage of the new liberal conversion rules and convert that traditional IRA to a Roth. There are no limits to the number of Roth conversions you can make. (You’ll need to aggregate all of your traditional IRAs when you calculate the taxable portion of the conversion–more on that below.)

Calculating the conversion tax

When you convert a traditional IRA to a Roth IRA, you’re taxed as if you received a distribution with one important difference–the 10% early distribution tax doesn’t apply, even if you’re under age 59½. (The IRS may recapture this penalty tax, however, if you make a nonqualified withdrawal from your Roth IRA within 5 years of your conversion.)

If you’ve made only nondeductible (after-tax) contributions to your traditional IRA, then only the earnings, and not your own contributions, will be subject to tax at the time you convert the IRA to a Roth. But if you’ve made both deductible and nondeductible IRA contributions to your traditional IRA, and you don’t plan on converting the entire amount, things can get complicated.

That’s because under IRS rules, you can’t just convert the nondeductible contributions to a Roth and avoid paying tax at conversion. Instead, the amount you convert is deemed to consist of a pro-rata portion of the taxable and nontaxable dollars in the IRA.

For example, assume that your traditional IRA contains $350,000 of taxable (deductible) contributions, $100,000 of taxable earnings, and $50,000 of nontaxable (nondeductible) contributions. You can’t convert only the $50,000 nondeductible (nontaxable) contributions to a Roth, and have a tax-free conversion. Instead, you’ll need to prorate the taxable and nontaxable portions of the account. So in the example above, 90% ($450,000/$500,000) of each distribution from the IRA in 2010 (including any conversion) will be taxable, and 10% will be nontaxable.

You can’t escape this result by using separate IRAs. Under IRS rules, you must aggregate all of your traditional IRAs (including SEPs and SIMPLEs) when you calculate the taxable income resulting from a distribution from (or conversion of) any of the IRAs.

Special deferral rule for 2010 conversions only

But even if you have to pay tax at conversion, TIPRA contains more good news–if you make a conversion in 2010, you can take advantage of a special deferral rule that applies only to 2010 conversions. You can report half the income from the conversion on your 2011 tax return and the other half on your 2012 return. Or you can instead elect to report all of the income from the conversion on your 2010 tax return.

For example, if your only traditional IRA contains $250,000 of taxable dollars (your deductible contributions and earnings) and you convert the entire amount to a Roth IRA in 2010, you can report half of the resulting income ($125,000) on your 2011 federal tax return, and the other half ($125,000) on your 2012 return. Or you can instead report the entire $250,000 on your 2010 tax return.

Should you use the special 2010 deferral rule? The answer depends in part on your tax rate in 2010 versus what you think your tax rates will be in 2011 and 2012. Keep in mind that tax rates are scheduled to increase in 2011, if the Bush tax cuts are allowed to expire. The top tax rate will increase to 39.6% in 2011, up from 35% in 2010.

And speaking of employer retirement plans…

You can also roll over non-Roth funds from an employer plan (like a 401(k)) to a Roth IRA. Prior to 2010, the income limits and marital status restrictions also applied to employer plan rollovers to Roth IRAs (commonly referred to as conversions). As with traditional IRA conversions, these restrictions have been removed beginning in 2010, and now anyone can roll over funds from an employer plan to a Roth, regardless of income level or marital status.

Like traditional IRA conversions, the amount you convert will be subject to income tax in the year of conversion (except for any after-tax contributions you’ve made). But the good news is that the special deferral rule discussed earlier also applies to amounts you roll over from an employer plan to a Roth IRA in 2010. You can report half of the conversion income on your 2011 tax return, and the other half on your 2012 return, or you can instead elect to report all of the income on your 2010 tax return. And even non-spouse beneficiaries can roll over inherited employer plan funds to a Roth IRA, as long as it’s done in a direct (not 60-day) rollover.

Is a Roth conversion right for you?

The answer to this question depends on many factors, including your current and projected future income tax rates, the length of time you can leave the funds in the Roth IRA without taking withdrawals, your state’s tax laws, and how you’ll pay the income taxes due at the time of the conversion.

And don’t forget–if you make a Roth conversion and it turns out not to be advantageous (for example, the value of your investments declines substantially), IRS rules allow you to “undo” the conversion. You generally have until your tax return due date (including extensions) to undo, or “recharacterize,” your conversion. For most taxpayers, this means you have until October 15, 2011, to undo a 2010 Roth conversion.

A financial professional can help you decide whether a Roth conversion is right for you, and whether you should take advantage of the special deferral rule for 2010 conversions.

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Forefield Inc. does not provide legal, tax, or investment advice. All content provided by Forefield is protected by copyright. Forefield is not responsible for any modifications made to its materials, or for the accuracy of information provided by other sources.

Prepared by Forefield Inc. Copyright 2010.

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