Episode 305: RMDs and IRAs

By on October 6, 2023   /   Blog, The Legal Play Podcast   /   Leave a comment
RMDs and IRAs

RMDs and IRAs: What to Consider from a Tax Perspective

IRAs are popular retirement savings vehicles, largely because they offer tax advantages to individual Houston investors. Those advantages differ depending on the IRA. Traditional IRAs defer tax on any money or assets invested until you take distributions upon retirement. Roth IRAs tax income into the account upon transfer at your current tax bracket, and no additional tax is taken at distribution. This matters when you consider that any growth on your investments will be taxed accordingly in a traditional IRA, but not so in a ROTH.

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Another worthwhile consideration with traditional IRAs is the required minimum distributions (RMDs). Here, we’ll address what RMDs are and how they may affect a Houston individual’s tax planning strategy.

What are Required Minimum Distributions and When are They Required?

Beginning at an age specified by the IRS (and adjusted based on current life expectancy), owners of a traditional IRA account must begin taking RMDs. Currently, the age one must begin taking RMDs is 72 – or 73 if the taxpayer turned 72 after December 31, 2022.

RMDs are a check put in place by the IRS to prevent people from using their traditional IRA as a way to avoid taxes. Because traditional IRAs provide upfront tax benefits in the form of a deduction, taxpayers might avoid paying taxes on their IRA earnings if there wasn’t a requirement in place to prevent this.

RMDs are that incentive. If required minimum distributions are not withdrawn from an IRA account, an additional excise tax will be levied against the account. Starting in 2023, this tax is equal to 25 percent of the RMD not removed from the account. If the issue is corrected within two years, the tax may drop to 10 percent.

How to Calculate Required Minimum Distributions

Calculating RMDs can be complex, as taxpayers must be aware of what’s in their IRA account to accurately assess their RMD. The math isn’t too difficult, though, and it looks like this:

Value of the IRA account (as of December 31 of the preceding year), divided by a “distribution factor” that’s published on its Uniform Lifetime Table (Publication 590-B). Distribution factors range from 1.9 to 27.4, depending on the taxpayer’s age. As a taxpayer ages, their distribution factor drops. In other words, as the taxpayer gets older, their RMD increases.

For example, at age 78, a taxpayer’s distribution factor is 22 – derived from the IRS’s Uniform Lifetime Table. A 78-year-old has a traditional IRA that, as of December 31 of the previous tax year, was worth $100,000.

The RMD, in this example, is $100,000 divided by 22. That comes out to $4,545. So, this taxpayer would need to withdraw at least $4,545 out of their traditional IRA to avoid paying an excise penalty.

It is worth noting that RMDs are calculated for each account and must be withdrawn from each account to avoid penalties.

Want to Avoid RMDs? Consider Investing in a Roth IRA

The surest way to avoid RMDs is to invest in a Roth IRA instead. Roth IRAs provide their tax benefits upon withdrawal, not investment. As such, there is no need for the IRS to pressure Roth IRA holders into paying taxes on account funds as they’ve already been paid for.

The tradeoff is no immediate tax deduction, but many people are okay with this, as they assume their income bracket at retirement will be lower.

Taxpayers have the option to transfer, convert, or “rollover” their traditional IRA funds to a Roth IRA to avoid paying RMDs, but one must be aware of the tax consequences of this. Taxes must be paid on traditional IRA distributions into a ROTH account, and these distributions may temporarily kick an individual into a higher tax bracket that year.

A tax expert can help their clients make this traditional-to-Roth transition without overwhelming them with additional tax burdens.

When an IRA is Inherited: How RMD Rules are Applied

RMD rules also apply to inherited IRAs, as defined in the SECURE and SECURE 2.0 Act. These rules depend on whether there is a named beneficiary attached to the IRA, and what the beneficiary’s age is. Here are some common scenarios:

  • If the deceased spouse died before RMDs were required – One of the most common situations is for a spouse to inherit an IRA following their husband or wife’s death.

    If the spouse is the only beneficiary named in the IRA, they may transfer the IRA assets to their own IRA, or they may open an inherited IRA in their own name. If the assets are transferred, the surviving spouse’s age is what’s considered for early withdrawal and RMD purposes.

    If the assets are included in a newly opened IRA in the spouse’s name, RMDs start the year when the decedent would’ve turned 73 (so, the year RMDs would have kicked in for the deceased spouse) or on December 31 of the year after the decedent passed away. The later of these two dates is used for RMD purposes.

    The above rules apply only if the surviving spouse chooses to take distributions using their life expectancy as the guide. There are other options, though. For example, an inherited IRA in the beneficiary’s name may be liquidated immediately as a lump sum – and taxes will need to be paid out in the process. Or the beneficiary may opt into the 10-year rule, which requires the account to be completely liquidated at the 10-year mark following the decedent’s death. In this instance, distributions can be taken out right away without an early withdrawal penalty.

  • If the deceased spouse died after RMDs were required – If the decedent was old enough that IRA distributions were required, those requirements are passed on to the inheriting spouse.

    Inheriting spouses may transfer the IRA’s assets to their own IRA, or they may open up an inherited IRA in their own name. In the former’s case, the spouse must be the only named beneficiary. If an inherited IRA is opened in the spouse’s name, they may name additional beneficiaries for the account.

    However, RMDs are required and must be taken out starting the year of the decedent’s death if they would have needed to take an RMD for themselves.

    Alternatively, the surviving spouse may liquidate the IRA. Again, though, taxes must be paid on the assets immediately, and this may kick the inheriting spouse into a higher tax bracket for that year.

RMDs and IRAs Can Be Complex, So Work with a Reputable Tax Professional

As you can see, RMDs are a tricky subject for IRA holders. It’s even trickier when an IRA is passed to a beneficiary. If RMDs aren’t taken out on time, there may be severe penalties for failing to do so, but distributions can also move a taxpayer into a higher tax bracket – and burden them with additional tax obligations in the process.

There are a lot of moving parts where IRAs and RMDs are concerned, so it’s highly recommended that IRA holders consult with a trusted tax professional before taking distributions or naming beneficiaries. An experienced Houston tax expert can help their clients plan out their distribution schedule and ensure their tax burden remains minimal when handling account assets.

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Episode 304: Wills and Trusts: Advantages and Considerations

By on September 22, 2023   /   Blog, Estate Planning, The Legal Play Podcast   /   Leave a comment
Episode 304: Wills and Trusts: Advantages and Considerations

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Passing on property is anything but simple. Because of this, estate planning is an active field of law. The more property there is to pass on, the more complicated the process gets.

If the process isn’t properly managed, family members may not receive the assets reserved for them. If estate planning isn’t effectively managed, there could be significant delays, unforeseen taxes burdens, or privacy issues.

Legally recognized documentation is the primary tool through which estate owners can name beneficiaries, allocate assets, and ensure their final wishes are carried out. As such, wills and trusts are valuable elements of estate planning that can provide certainty and peace of mind.

To fully leverage the power of wills and trusts, it’s recommended that estate owners work with an experienced estate planning attorney and accountant. Depending on the exact circumstances involved, wills, trusts and other estate planning tools can be a challenge to set up properly. An expert accountant or attorney can ensure the estate owner’s wishes are accurately communicated through all estate planning initiatives.

Will and Trusts: A General Overview

Wills and trusts are used for the same general purpose – to ensure the right people receive the right assets when an estate owner passes away. How they go about this purpose is different, and those differences may dictate which approach – will or trust – makes the most sense for a particular estate holder.

Here’s a brief look at each:

  • Wills – Wills are legally recognized documents submitted to the court when the benefactor dies. The court then has jurisdiction over the will and may make legally binding decisions based off its interpretation of the document.

    Wills can resolve many of the concerns left behind by an estate owner’s death. They are used to name an executor – the person responsible for overseeing the will’s execution – along with naming beneficiaries, allocating estate assets, naming who will care for dependents, specify funeral preferences, and a few other important considerations.

  • Trusts – You can think of trusts like asset containers. They come in a variety of arrangements, but they’re all used to secure a variety of assets for a named beneficiary.

    Trusts can be complicated to set up, but they offer a couple of benefits that wills do not. We’ll go over a few common types of trusts later, as there isn’t a single best option for every estate owner.

Do Wills or Trusts Make More Sense for Texas Estate Owners?

The primary advantage that trusts offer is their probate-free nature. Probate is the court-mandated and court-guided legal process during which an estate’s assets are allocated to beneficiaries. In some states, probate can be a time-consuming, tax-heavy process that estate owners are encouraged to avoid, if at all possible.

In Texas, probate tends to be less burdensome than it is in most other states. For this reason, wills are a perfectly reasonable estate planning vehicle, even if it must pass through probate first. Further, wills are much simpler to set up than a trust, and a simple document may be all that’s required.

For high-value estates, a trust can provide a shield against estate taxes. Though these taxes don’t kick in until an estate is valued at more than $12 million, for estates that exceed this threshold, a trust can offset considerable tax liabilities.

Privacy is another factor that is often overlooked – probate is a matter of public record. For some families, especially those where inheritances may cause conflict, avoiding probate and public scrutiny may be a reason a trust is preferred over a will.

Intervivos vs Testamentary Trust – What’s the Difference?

There are several types of trusts that can be arranged for estate planning purposes. Intervivos and testamentary trusts are two examples. Here is a summary of each:

  • Intervivos trusts – An intervivos trust is another term for a living trust. As the name suggests, intervivos trusts are created while the benefactor is still alive, which offers a few benefits. For one, intervivos trusts are the only trusts that avoid probate. Secondly, the assets used to fund a living trust can still be accessed and utilized by the benefactor. Once the trust’s owner passes away, a new trustee may be named through the benefactor’s will or through court appointment.

    An important note is that a living trust isn’t officially formed until it’s funded. Any assets not protected by the trust upon death (including assets designated to be put in the trust through a will) must pass through probate.

    Intervivos trusts may be revocable or irrevocable – more on that in a bit.

  • Testamentary trusts – Testamentary trusts are trusts that are established through a will. In other words, they do not exist before the benefactor’s death. Testamentary trusts do not avoid probate, but they do allow people to easily assign instructions with the trust’s assets. For example, with a testamentary trust, benefactors can specify that the beneficiary must be of a certain age before they may receive the trust’s assets.

    Testamentary trusts can also be modified while the benefactor is still alive, so flexibility is retained. Finally, testamentary trusts can be paid for through the estate’s assets, so they’re a low-cost option, compared to intervivos trusts.

Revocable and Irrevocable Trusts: A Quick Comparison

In addition to living and testamentary trusts, there are also revocable and irrevocable trusts to consider. Both are types of living trusts that sidestep probate – and that’s where the similarities end. Here’s a more detailed breakdown of each:

  • Revocable trusts – Revocable trusts are termed such because they can be modified after the trust documentation is submitted. That means the trust’s owner can change beneficiaries and the controlling trustee as desired. It also means the trust’s owner can access, add, or remove assets placed in the trust.

    There are some downsides with this flexibility, though. One, revocable trusts do not shelter assets from taxation. Income derived from a revocable trust is taxable, and those assets are also subjected to estate taxes following death. Another complication with revocable trusts is that they are not protected from lawsuits or other liabilities if they are levied against the trust’s owner. For individuals in professionals where legal liability is a concern – physicians, accountants, real estate agents – a revocable trust will not protect assets.

  • Irrevocable trusts – An irrevocable trust cannot be modified once the paperwork is submitted, except in extremely rare circumstances. At the minimum, the trust’s creator (if available), all named beneficiaries (both present and future) and the court must all approve any changes to the trust. It’s best to think of irrevocable trusts as set in stone, as once assets are placed in an irrevocable trust, the benefactor gives up all rights to those assets.

    The upside with irrevocable trusts is that the assets contained within are not subjected to estate taxes. Also, irrevocable trusts provide a durable shield against liability and creditors, which ensures beneficiaries receive the assets they are promised.

Estate Planning is Complex and the Stakes are High, so Consider Partnering with a Estate Planning Attorney

Ultimately, there isn’t a single best estate planning solution for every estate. The size of the estate, the assets it contains, the number and nature of beneficiaries, the relationship the benefactor has with beneficiaries, the need for privacy, and many other factors will determine which estate planning tools make the most sense.

The challenge is sorting through all of those estate planning options and determining which ones are the best fit. An estate planning attorney or accountant can provide valuable insight here, guiding their clients through the process and ensuring their client’s final wishes are prioritized following their death.

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Episode 303: Foreign Investment and Tax Considerations in the U.S

By on July 21, 2023   /   Blog, Real Estate, The Legal Play Podcast   /   Leave a comment
Foreign Investment and Tax Considerations in the U.S

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The U.S. economy attracts more foreign investment than any other, as it is stable and largely trustworthy. In 2021 alone, foreign investors pumped nearly $5 trillion in inward investments, much of this dedicated to real estate development. Opening the economy to so much foreign investment brings certain risks with it, but the truth is that the vast majority of noncitizen investors are just wealthy people looking to further their own interests.

Optimizing those foreign interests in America comes with challenges. Many of them are legal or tax-related, so it’s standard operating procedure for foreign investors to work with domestic parties for investment purposes.

Here, we’ll address how this dynamic works and what steps can be taken to minimize a foreign investor’s U.S. tax liability.

A Foreign Investor and a Domestic Developer: An Ideal (Limited) Partnership

The first step for foreign investors is to connect with a U.S.-based partner to invest in. There are numerous brokerage services that can facilitate this connection and simplify the process for investors. There are, of course, brokerage fees attached to this.

A common tactic for foreign investors is to partner with a domestic developer – if we’re talking real estate investment. Whether it’s a piece of land, a hotel, a golf course or any other piece of commercial real estate, foreign investors frequently partner with U.S. real estate developers in need of a capital infusion. The U.S. partner executes the job on the ground while the foreign partner supplies cash.

Typically, the investor and developer form a limited partnership (LP) to manage this professional relationship. LPs are a favored choice for real estate development for a couple of reasons, including:

  • Limited liability for investors – In an LP arrangement, the domestic partner is considered the “general partner” while any foreign investors are considered “limited partners.” Limited partners are only liable up to the amount of their investment, so foreign investors have a liability shield that protects them.
  • Minimal commitment – Limited partners are not involved with the day-to-day operations tied to their investment. This responsibility falls on the general partner (the U.S. developer), so foreign investors can put their money to work without committing time.

Which Tax Structure Makes Sense for a Domestic Company Working with a Foreign Investor?

The foreign and domestic parties are usually tied together through an LP, but there’s still the matter of corporate tax structure.

When an LP is formed between a foreign investor and U.S.-based developer, the next step is usually to set up a domestic company that serves as the LP’s business instrument. In other words, a new corporation is formed to ensure tax and legal compliance, and to simplify the distribution process when it’s time to pay foreign investors.

In most cases, a C-corporation provides the desired tax structure for the new company. This company is formed in a state that has stable, corporation-friendly laws in place – Delaware, Nevada and Texas are three examples.

Why is a C-Corporation Tax Structure Preferred for Foreign Investment?

C-corporations are not pass-through entities. They are required to pay corporate taxes on top of capital gains, which are added to the company’s income. As such, they do not enjoy the same tax benefits as a pass-through organization. Further, loss and depreciation, which can offset corporate tax burdens, are usually not relevant during the initial years following the C-corp’s founding. With all this in play, what makes C-corps the optimal choice for foreign investors?

First, domestic developers often provide an increased rate of return to foreign investors to offset the increased tax burden.

Second, when leveraging a C-corp tax structure, certain withholding and reporting requirements are not triggered until distributions are paid out to investors. This simplifies tax planning and usually gives foreign investors additional flexibility in managing their investment instruments. Further, C-corporations have a long, well-established legal history that makes it easier for non-U.S. parties to invest in. In fact, foreign investors may not own stock or assets in some corporations, including S-corps. Tax laws prohibit it.

As such, C-corps provide an ideal mix of accessibility and planning advantages that foreign investors can fully leverage.

Why Foreign Investors are Better Served with a U.S.-Based Attorney and Accounting Expert

Unsurprisingly, tax laws and accounting procedures are complex where foreign investors are concerned. If not properly planned and reported, foreign investors may be on the hook for a deep tax cut or may be barred from investing altogether. Given the complexity involved, it’s necessary for investors to hire an attorney in their home country and a U.S.-based attorney. Ideally, this attorney has accounting expertise and experience working with real estate investors.

There are a few important advantages to working with a U.S. attorney, including:

  • Helping resolve any language or cultural barriers – There’s a great deal of paperwork associated with managing a foreign investment, and this can pose a language barrier that leads to costly mistakes. Cultural issues can also be in play, as the investor’s expectations may not align with what the developer is experiencing on the ground.

A U.S. attorney can smooth these issues over and work directly with the investor’s home attorney to ensure all parties are moving in the same direction.

  • Establishing a clear accounting trail for security law purposes – The U.S. has standing economic sanctions against a handful of nations, including Russia, Iran and others. Investment flowing from these countries is barred under U.S. securities law, so it may be necessary to create a clear accounting trail for certain investors. This is done to confirm that a particular investor is indeed allowed to seed a project with capital.
  • Helping avoid, or mitigate, double taxation – Double taxation is a widespread concern among foreign investors, as both the U.S. and the investor’s home country will both attempt to take a bite out of any distributions.

A U.S. attorney specialized in accounting practices will be aware of any tax provisions, such as tax treaties, that can be used to avoid or reduce the impact of double taxation, ensuring foreign investors are able to secure more of their distributions.

  • Planning around FIRPTA for taxation purposes – FIRPTA is a federal tax law created specifically for foreign real estate investments. Under FIRPTA, there are certain withholding and taxation requirements that property investments must follow if they are tied to a foreign investor.

For example, when a real estate property connected to foreign investment is sold, a certain portion (10 to 15 percent, depending on the sale price) must be withheld for tax purposes. There are exceptions to some of these taxation and withholding requirements, and an attorney knowledgeable in FIRPTA law can leverage them for foreign investors.

There are Major Complications Involved with Foreign Real Estate Investment, But They Can Be Managed with the Right Legal and Accounting Team in Place

Trillions in foreign investment are dumped into the U.S. every year, much of it allocated to real estate development. America’s excellent reputation as a safe investment haven means this trend isn’t going anywhere.

If you’re a non-U.S. investor looking to take advantage of this trend, a proven way to optimize your investment is to have experienced advisors and experts facilitating the process. This includes working with a U.S. attorney and accounting team that knows the ins and outs of U.S. tax law.

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