Is the money in a trust I inherited taxable?

Gloria from Indiana asks:

Q: My mother recently passed away and I will inherit money from her trust. Is there an amount I can inherit without having to pay taxes, or is everything taxed? I had read about the Fed rule allowing inheritance under $2 million - but please explain.

A: Also known as a "death tax", many countries of the world charge a tax on any inheritances that you leave to your friends and family when you die. You may think that this is something that only those who are really wealthy should worry about, but it is becoming a growing concern for everyone. However, there are many things that a person can do before he/she dies to make sure that the inheritance you pass on to your loved ones does not get eaten up in taxes.

Setting up a trust is one way you can lessen the amount of inheritance tax that will be due when you die. A trust is a legal arrangement you can draw up so that you can give away some of your assets to individuals. The kind of trust you want to set up depends on the individual circumstances.

Discretionary trusts provide flexibility to the trustee regarding who will receive any inheritance and when.

Maintenance trusts provide for minors that you name as heirs in your will.

Interest in Possession Trusts provide an income for the beneficiary during their lifetime or for a specified period of time.

There are many different reasons why individuals would want to set up a trust. It helps you to make careful decisions regarding the handling of your assets after your death and protects your family with all the legal work required in probate court. You can set guidelines about how you want the inheritances to be dispersed, but the biggest benefit is to protect your assets from the Inheritance Tax.

In the United States, an inheritance tax is required on estates that are worth over $1.5 million and in the UK on estates valued in excess of £ 275,000. Luckily, the passing of an estate to a surviving spouse is exempt from the inheritance tax.

In some of the newer inheritance tax laws that have been passed in some of the states in the United States, changes have been made to reduce the amount of taxes due upon death. In Pennsylvania, for example, the property transferred to a spouse was only exempt from taxes if they had joint ownership of the property. In the changes, it is possible for one spouse to place property in trust for the husband/wife and then provide directives on how it is to be passed on to the children. Thus, the property is taxed at the time of the death of the surviving spouse – deferring the tax to the future. Of course, the husband/wife can elect to pay the taxes or choose to defer them. Many considerations have to be made before this decision should be made to reduce the overall amount of taxes.

The amount of tax you have to pay on your inheritance depends on your relationship to the deceased. Usually, a 4.5% tax is imposed on any inheritance passed on to family members and the rate increases to 10% or even 20% on inheritances passed on to friends. Transfers of inheritances between siblings are also subject to an inheritance tax of 12%, but 15% is applied to nieces and nephews. In the event of the death of a person under 21 years of age, there is no tax due on any assets that pass to the parents.

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Tax-deferred alternatives to a 401k plan

Dan from Washington writes:

Q: I'm not elegible to participate in my employer's 401K plan until July 2008. My income is such that any IRA contribution would not give me a tax deduction. What can I do to save for retirement and claim the full tax deduction?

A: We must first advise that our expertise lies in tax law, not giving investment advice. Always consult a financial professional for investment advice and guidance before making your decision.

There are several options that Dan could pursue.

Roth 403(b)

The Roth 403(b), also called the Roth 401k, does not allow you to avoid paying income tax on the amount that you contribute to your retirement plan. But once you retire, the amount that you withdraw from the retirement plan is not treated as taxable income. The maximum yearly contribution for a Roth 401(k) is $15,000 for individuals under 50 years of age, and $20,000 for individuals 50 years old and older. There are no limits to participation based on individual Adjusted Growth Income.

Roth IRA

This may be an option for some folks and can be started by any individual. There are limitations that apply to the Roth IRA though. A person may not contribute to a Roth IRA if the personal Adjusted Growth Income (AIG) exceeds $110k per year, or $160k for couples filing jointly. Furthermore, the maximum yearly amount for contribution is $4,000 for individuals under 50 years of age, and $5,000 for individuals 50 years old and older.

Other choices

If your employer does not offer a retirement plan or matching contributions, or if you need to rollover your retirement plan due to a change in jobs, there are also alternatives available from banking institutions and life insurance carriers. For example, some packages offer to match S&P 500 increases on a yearly basis and provide protection in the event that the market declines. With this type of plan, if the stock market increases substantially, so does your retirement, without risk of going down.

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Income tax refund loans are not a good deal

We don't have a question to answer for you today. Instead, from time to time when I don't have questions from you to answer, I am going to start occasionally offering tax tips that may come in handy in April.

Today's Tip: Tax refund loans are nothing but a way to get you to part with your hard-earned money.

Tax refund lenders tend to target low-income taxpayers, but people in the so-called "middle class" also fall victim to this scheme. And yes, it's a scheme. For a loan fee ranging from $29.95 to $89.95 plus electronic filing fees of $40 or so, you receive a loan for the amount of your refund within a day or two. When your refund is received in an account set up by the lender, the loan is repaid.

The average loan time is about ten days.

Now get this...the fees for the average refund of $2,000 are roughly equal to an annual percentage rate of 222%. Some taxpayers pay even more, according to the Consumer Federation of America and the National Consumer Law Center.

If you really need money this badly, you should be glad to learn that there are no-cost or low-cost methods of achieving the same result.

An easy alternative is to reduce your income tax withholding by filing a form W-4 with your employer and claiming more withholding allowances. This is a good thing as long as you don't overdo it and are able to put aside a bit for any taxes you might owe at the end of the year.

If it's hard to save, you can opt to have money automatically deducted from your check and deposited into a savings account each pay period.

Other ways to get your money back from the government sooner include filing electronically to speed up your refund. Electronic filers who have their refund deposited directly into their bank account can receive their refund within ten days of filing. If you don't have a bank account, this process will take a little longer though.

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