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A Roth IRA is great, Tax-Free E/R Plan is better

Every tax newsletter, journal and other publication (I read a bunch of them in my never-ending struggle to stay current on the tax law) has had one or more articles on the virtues of Roth IRAs recently. Heres a quote from one of the more widely read newsletters: Making a Roth IRA pay-in [for your child] is a great idea this year. You can contribute $3,000 a year if the child earns that much...a $1,000

Every tax newsletter, journal and other publication (I read a bunch of them in my never-ending struggle to stay current on the tax law) has had one or more articles on the virtues of Roth IRAs recently.

Here’s a quote from one of the more widely read newsletters: “Making a Roth IRA pay-in [for your child] is a great idea this year. You can contribute $3,000 a year if the child earns that much...a $1,000 increase over last year [2001]”.

The article points out that a $3,000 contribution to a Roth IRA for a 15-year-old will mushroom to $88,000 per year, assuming 7% growth per year, at age 65. And to $124,000 if the Roth owner leaves it grow until age 70. Good stuff.

But a Roth IRA has some nasty rules that apply to all who want to play the Roth game:

  1. No earnings, no contribution (contributions are limited to earned income or $3,000, whichever is less);
  2. Earn too much and you are locked out of the game (a problem for many adults);
  3. Subject to a few exceptions, withdrawals taken prior to age 5912 are hit with a 10% penalty.

The good news: Although contributions to a Roth IRA are not deductible, withdrawals are tax-free (after age 5912).

Actually, there is another tax-advantaged way to pre-fund your child’s education that beats the pants off of a Roth IRA. It’s called a Tax-Free Education/Retirement Plan or an E/R Plan).

Here’s why a tax-free E/R Plan is better than a Roth IRA: Earnings don’t count, whether you have zero earnings or earn millions. Withdrawals are always tax-free no matter when taken and can be used for any purpose (typically, for a college education, to buy a home and for retirement).

You can start a Tax-Free E/R Plan at any age: for a newborn, a 15-year-old or a 40-year-old. And annual contributions (actually premiums for a specially designed life insurance policy) to the Plan have no limit. The accompanying table shows projected numbers for Plans for persons of different ages:

The numbers in the table do not pretend to give you all the details. But two important points are immediately apparent: 1) the power of funds compounding in a tax-free environment (life insurance); and 2) youth will be served (put those education and retirement dollars away early).

Want to learn more about how a Tax-Free E/R Plan can enrich you, your children and your grandchildren tax-free? We sell a publication covering E/R Plans. Contact the Book Division of Blackman Kallick Bartelstein at the address and phone number at the bottom of this column.

Deducting truck tires

The IRS finally has agreed with what we have thought has been (and now is) the law on truck tires. You’ll like the new rules: The original tires that come with a new truck must be capitalized and depreciation taken over the depreciable life of the truck.

What about replacement tires? The cost can be expensed when installed even though the useful life is more than one year. The new rule applies to tractors and trailers, as well as trucks. Tell your professional to look up 2002-27 for all the rules.

Where is my refund?

Just look on the internet. The IRS has a new system on their web site: Have your Social Security number, filing status and refund amount handy. Then, click on “Where’s My Refund?”


Annual gifts now ‘improved’

“Improved” is a common addition to the labels of many store-bought products. Well, this time the “product” is annual gifts and improved is the perfect word.

Lifetime gifts — usually to younger family members — are one way to guarantee cutting the IRS’ share of your wealth. Remember, the gift tax and estate tax can go as high as 50% percent.

Following are the five most asked questions about gift giving (asked by attendees at my wealth transfer/business succession/estate planning seminars), and my answers.

How much can I give to one person tax free? (Here comes the “improved” part.)

The first $11,000 (called the “annual exclusion”) of gifts made each year by the donor (the person making the gift) to each donee (the person receiving the gift) is gift tax free. The $11,000 starting in 2002 (up from $10,000 previously) is a welcome number. A gift by one spouse can be treated for gift tax purposes as if it were made one-half by each spouse. This is called “gift-splitting” and doubles the annual exclusion to $22,000 for married couples.

For example: Ed gives $22,000 to his son Ted. Ed and his wife Edna elect gift-splitting, which means that the gift is treated as if Ed and Edna each made a separate $11,000 gift to Ted. Both gifts are entitled to the $11,000 annual exclusion and are tax free.

Are all gifts of $11,000 or less tax free?

No. To qualify for tax-free treatment, to gift must be a gift of a “present interest.” A “future interest” blows the annual exclusion.

Let’s say Jed has three children and every year Jed gives each child $11,000 in cash. These are gifts of a present interest (the kids can spend, save or squander the money now) and Jed is entitled to the annual exclusion.

In example number 2, however, the facts are the same as in the previous example, except that the cash is put in a trust with instructions to the trustee to accumulate the income and give each child everything in the trust in five years (obviously, the future as opposed to now). This is a future interest. There is no annual exclusion. All the gifts are subject to gift tax.

Must I pay the gift tax in cash?

No. You can make up to $1 million in lifetime gifts (all the gifts you make during your life, in excess of the $11,000 annual exclusion(s), are added together) that can be paid with a special credit created by law.

For example, Edith could give her son Fred $1,011,000 in 2002 without owing any tax that requires a cash payment. If you are married, double the figures.

What can I give away?

Anything you own — the family business, bonds, real estate, an interest in a partnership, and so on. The amount of the gift is based on the fair market value of the property on the date of the gift. Your cost, or how you acquired the property, is immaterial.

Can I deduct the gift?

No, no, no — in spite of what you may hear elsewhere. Nor is the gift income to the recipient.

Gift giving is a superb tax-planning tool. Use it. But to maximize your tax savings, it should be coordinated with an overall lifetime tax plan and a separate estate plan.

Entertainment tax trap

The Internal Revenue Code is generously sprinkled with tax traps. Some of the worst traps await those who use a vacation home, apartment or yacht to do business entertaining.

Unfortunately, the rule of law [Section 274(a)] is clear: No deduction is allowed in connection with a facility used for business entertainment. The Tax Court in an old — but still the law — landmark case (Ireland, 89 TC 68) used a literal reading of this rule to disallow not only deductions for entertainment but also deductions for other valid expenses as well.

Here’s the sad story. A partner in a stock brokerage firm owned a beach house that he used regularly for business meetings. Even the IRS agreed that it was used primarily for business purposes. His own family did not use the property as either a vacation home or a residence. Occasionally, he would invite the families of business associates to accompany them to the meetings, which meant the beach house was used to entertain the families. The broker pointed out that if there was any business entertainment involved, it was incidental and insignificant and shouldn’t affect his deduction for depreciation of the beach house.

The Tax Court destroyed the broker’s argument. It held a facility used for even the slightest business entertainment is tainted for all income tax purposes. Result: No depreciation deductions. My opinion: Terrible law!

What can you do to avoid the Tax Court’s strict interpretation of the rule? Here’s the simple answer: Entertain elsewhere. According to this case, the most minute entertaining at the facility will jeopardize your deductions, even though you have met all other requirements. Don’t take the risk.

Irving Blackman is a partner in Blackman Kallick Bartelstein, 300 S. Riverside Pl., Chicago, Ill. 60606; tel. 312/207-1040, or via email at [email protected].