Tax Saving Ideas: Credit Shelter Trust and Roth IRA Conversion

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Tax Saving Ideas: Credit Shelter Trust and Roth IRA Conversion

Each year brings with it a fresh start and new opportunities. This year, take advantage of one of these beneficial tax strategies: the credit shelter trust, the reverse QTIP election, or Roth IRA conversions. Here we'll explain how they work and who should consider them.

Credit Shelter Trust: With a credit shelter trust (also known as an AB trust), you can leave your heirs at least twice as much money and avoid federal estate taxes. You do this by making the trust your primary beneficiary and your spouse the secondary beneficiary. Your spouse receives all of the income from the trust, but he or she doesn't have access to the principal. When you die, your spouse receives all of the trust assets free of estate taxes. Meanwhile, your children receive only what's left over-which isn't expected to be much if anything. If you want to make sure that your children eventually inherit most or all of the money in the credit shelter trust (but would like to continue protecting your spouse's interests), you can set up a QTIP trust. This will give you the added flexibility of appointing your trustee and selecting your children as income beneficiaries without jeopardizing your spouse's interest in the principal. (Be aware that if your estate is expected to exceed the federal dollar limit, you will lose some of the benefits of the credit shelter trust.)

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Reverse QTIP Election: When you elect to treat your spouse as your surviving spouse for federal tax purposes (called the "QTIP election"), you're entitled to an unlimited marital deduction. That means that if your estate is valued at $1  million and your spouse is $500,000, you can pass all of the assets to him or her without owing taxes. But if your estate is more than the federal limit (currently $2 million), using a QTIP election may jeopardize some of your benefits. That's because for every dollar over the federal limit that passes to your spouse, an additional one-third in federal taxes is charged. If you make a "reverse QTIP election," however, your spouse can inherit up to $1 million free of the estate tax and the balance would be taxed at only one-sixth above the limit.

Roth IRA Conversions: You can convert a traditional IRA into a Roth IRA on a tax-free basis if both your AGI and your modified AGI are less than $100,000. Your converted Roth would be allowed to grow on a tax-deferred basis, but you couldn't touch the principal until after five years have passed or you reach age 59½. You can make this move even if you don't expect to be in a lower tax bracket when you retire.

What is Roth IRA?

Roth IRA is an Individual Retirement Arrangement (IRA) that is sponsored by banks and other financial institutions. The major advantage of such accounts for individual investors is that annual contributions may be made to Roth IRA on a post-tax basis; the money invested in these accounts grows tax-free, and withdrawals at retirement are not taxed as income.

Any earnings that are withdrawn from the Roth IRA before the holder turns 59 1/2 years old is subject to a 10 percent early-withdrawal penalty unless certain conditions are met (the account owner becomes disabled or they pass away). There is also no requirement for minimum distributions during the Roth IRA holder's lifetime; as long as the account is open, one can continue to make contributions.

This tax-free withdrawal feature makes the Roth IRA especially attractive to retirees who are in a higher income bracket during their retirement years (when compared to when they made their contributions). For instance, say an individual contributes $5,000 into their Roth IRA every year for five years and then retires. If they are in the 28 percent tax bracket during their retirement years, withdrawing $21,000 (the cumulative amount contributed) from the Roth IRA would only yield $15,840 of after-tax income since they would not be taxed on withdrawals [$5,000*.28 - ($5,000 + $5,000 + $5,000 + $5,000)].

However, since they are older and in a higher income bracket during this five-year period of withdrawals, if the same amount was withdrawn from a traditional IRA instead, they would have to pay taxes on the full withdrawal amount at their marginal tax rate. Therefore, even though Roth IRA contributions are made after-tax, they will eventually allow retirees to pay less in taxes during retirement.