Tax planning ideas.

• Author: Lusby, Roger W., III
• Position: Charitable bequests, social security benefits, residence rollovers, capital gains valuation

Consider income tax rates when making charitable bequests Income and estate tax planning need not always be complicated. Many clients, through wills, provide specific bequests to charitable organizations that are usually funded at death with cash from the estate. Clients and their heirs would benefit more if they simply designated the charitable organization as a beneficiary of their retirement plans up to the amount of the bequest. Since a retirement plan is "pregnant with income taxes," a noncharitable beneficiary will have to pay income taxes on the retirement plan proceeds as they are distributed; this significantly reduces the amount received by the heirs on an after-tax basis. A charitable organization, on the other hand, does not have to pay any income taxes on retirement plan proceeds. Thus, at current income tax rates, as much as $19,800 could be saved in income taxes by restructuring a $50,000 charitable bequest.

Consulting arrangements for retirees

Retirees are often confronted with extreme tax rates if they desire to keep working after retirement. Under the Revenue Reconciliation Act of 1993 (RRA), up to 85% of social security benefits are subject to tax for retirees with "provisional" income in excess of $44,000. In addition, the RRA removed the cap on the Medicare tax and increased marginal income tax rates to 39.6%. Retirees also have earnings limitations for social security purposes; a retiree under 65 years of age loses $1 of social security benefits for every $2 in earnings above $8,040. With such consequences, many advisers recommend that retirees not work.

Still, if arranged properly, many retirees can offer valuable services to their former employers as consultants. In Barrett, 58 TC 284 (1972), the Tax Court ruled that in limited circumstances, the performance of consulting services solely to a former employer did not constitute a "trade or business." Thus, a retiree could avoid social security and Medicare taxes on the income (although the Social Security Administration would have the right to "reclassify" the income as earned income for purposes of the earning limitations).

Note that a different result was reached in Baronet, 69 TC 609 (1978), in which a retired bank executive was held to have received self-employment income because he was only prohibited from providing similar services to banks located in the same town as his former employer.

This strategy does not come without risks for retirees. While the IRS...