Financial Q&A: Tax strategies for passing assets on to children

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from the November 10, 2008 edition

Q: I have a traditional IRA and a variable annuity with a maturity date of April 2009. In discussing how to pass assets to my children, a financial adviser suggests that I take a full distribution from my IRA and take everything out of my variable annuity and invest it all in conservative equities. He says that because I'm in a lower tax bracket than my children, they would pay less in taxes than I would, and more of my assets would be passed on to them. Is this true?

I.L., via e-mail

A: If you pursue a one-time distribution of these two assets, you will likely be vaulted into a much higher tax bracket – one that is probably higher than your kids, says Joseph Montanaro, a certified financial planner with USAA in San Antonio, Texas.

If the goal is to provide your kids with a financial advantage, Mr. Montanaro says you might consider these other options:

•Convert your traditional IRA to a Roth IRA if you're eligible. You'll pay the taxes now, but your children won't pay income taxes on a Roth IRA that they inherit.

•Spread the regular distributions or conversions to a Roth IRA over several years, allowing you to potentially take advantage of favorable tax treatment (assuming tax laws don't change) and avoid a huge tax hit.

•Check your beneficiary arrangements. If your children are named beneficiaries for your existing IRA, they may have the flexibility to "stretch" out distributions based on their life expectancy. It's important to note that this will not apply if you name your estate as the beneficiary.

Q: If you cash in your E and EE savings bonds and roll them into an irrevocable trust, do you have to pay taxes on the interest of the bonds? The money is never spent, just rolled over.

S.H., via e-mail

A: You can have the ownership of your bonds changed from your name to the trust's name, says Tom Adams, who operates a website (savings-bond-advisor.com) devoted to discussions about bonds. As long as the trust leaves the same person responsible for the income tax on the savings bond interest, he says that changing the ownership isn't a taxable event.

But bonds already carry some of the advantages of a trust, so whether this is worth doing depends on your objectives in creating the trust. If your goal is to have your estate avoid probate court, you can use the bond's beneficiary designation to do the same thing. If your goal is to avoid estate taxes, there's no advantage to using a trust over doing the same thing in your will. If your goal is primarily to avoid legal fees, don't forget to count the fees for setting up the trust.

To transfer the ownership of your Savings Bonds to a trust, use Public Debt Form 1851. You can obtain a copy online at treasurydirect.gov/forms/sav1851.pdf.

If you cash the bonds, you will owe income tax on the interest earned by them, Adams says, whether you roll the money into a trust or not.