Ask the Editors: Real-Life Taxes Questions and Guidance

In its March 2010 cover story, Kiplinger’s Personal Finance tackled real-life questions on the minds of many of our readers these days. Extending our mission of personal service, we invited readers to send us more questions to be answered in this exclusive online companion package.

Custodial accounts

Years ago, I set up a custodial account for my son, to be used for his college education. Now I understand that we may be penalized for having that account. How so?

If by “penalized” you mean “pay higher taxes,” you are correct. Custodial accounts, known as UGMAs or UTMAs, after the Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) once let parents shift the tax on earnings from their own higher rate to the child’s for assets of the parents moved more their own accounts to these accounts for their children. This made the accounts a great way to accumulate college savings.

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A change in the law, however, reduced this tax advantage. In 2010, children who are full-time students under age 24 pay no tax on the first $950 of investment earnings, and they pay the child’s rate on the next $950. But earnings above $1,900 are taxed at the parents’ marginal rate.

Custodial accounts can also harm your student’s eligibility for financial aid. The federal financial aid formula expects students to kick in 20% of their own assets to college costs before aid eligibility kicks in, and assets in UTMA and UGMA accounts are considered students’ assets. That’s a big bite compared to the 5.6% assessment on parent-owned assets. You can get around the problem by cashing out the account (you will have to pay any capital gains tax on the earnings) and transferring the funds to a 529 plan, where it is treated as a parental asset for financial aid purposes.

Home-buyer tax credit

We recently moved to Florida, where we own a manufactured home. We plan on selling this place or (if it doesn't sell in the present economy) renting it to snowbirds and buying a new manufactured home in the same community this spring. Will we qualify for the $6,500 tax rebate if we sign a home-building contract by the end of April 2010?

Assuming your current home in Florida is your permanent residence and you can supply five years’ worth of proof of homeownership such as real estate tax bills, property insurance or utility bills, you would qualify for the $6,500 homebuyers tax credit if you sign a contract for the property by April 30, 2010. You must close on the property by June 30, 2010.

Learn more about the home-buyer credits.

Energy credit

I hired American Solar Energy to install photovoltaic panels to generate electricity for my home in 2009. The cost was about $29,000 for a 4-kilowatt system. Once I was hooked up to my local utility , I received a rebate from SRP of about $12,000. This reduced my net cost to about $17,000. The big question: In calculating the federal energy tax credit, does the Feds' 30% credit apply to the total cost of $29,000 or to my net cost after the utility rebate?

The credit is based on your cost of the system after your state rebate. So the 30% tax credit would be applied to your net cost of $17,000. Learn about more ways the government will pay you to go green.

No energy credit

I upgraded my HVAC system on my home to the tune of $9,000 in early 2008. Can I amend my 2008 tax return and get an energy credit?

Unfortunately, there was no home energy tax credit in effect in 2008. The current $1,500 credit for installing energy-efficient windows, doors, insulation and home heating and cooling equipment applies only to 2009 and 2010. An earlier $500 credit was in effect in 2007.

Gift tax

My mother wants to help me and my wife. Can she give each of us more than $13,000 this year without tax implications for us?

Yes, she can give you more, but then she might have to pay tax on the amount in excess of $13,000. The giver, not the recipient, is the one who pays federal gift tax. Your mother would have to file a gift-tax return (Form 709) on any amount that exceeds the $13,000 annual per-person exclusion.

But we say “might” because the tax man grants a lot of leeway to givers when it comes to taxes. The law allows each person a $1 million lifetime exclusion from federal gift tax. You start building up to that $1 million limit for gifts that go above the $13,000 annual limit. So if your mother paid you each $20,000, she’d be adding $14,000 ($7,000 plus $7,000) toward that limit. Any amounts over $1 million trigger the gift tax, with rates as high as 35% in 2010. Note this: Any part of the credit used to protect taxable gifts (those more than $13,000 a year) from the gift tax effectively reduces the credit available to protect your estate from federal estate taxes after your death. Although the federal estate tax expired at the end of 2009, it is likely that it will be reinstated retroactively. In any event, the estate tax is scheduled to come back to life in 2011.

See The Gift Tax: Use it or Lose It and our report on Estate Planning.

Capital gains

We have read that if we are in the 10% or 15% tax bracket, we do not need to record capital gains on our income tax returns. However, given that we have a 1099 reporting the capital gains, what documentation do we need to show that we didn't report them on our 1040 because of the exclusion?

Although you don’t have to pay any capital gains taxes for 2009 if you are in the 10% or 15% income-tax bracket, you still need to fill out Schedule D to document your tax-free gains. Fill out the Schedule D tax worksheet and keep it for your records, and then carry the information over to Schedule D. To make it easier on yourself, use tax-preparation software or consult a professional tax preparer.

Individuals with taxable income or $33,950 or less and married couples with taxable income of $67,900 qualify for the 0% long-term capital gains rate on profits from investments they sold after owning them more than one year.

See more in Tax-Free Capital Gains Redux

Gains on savings bonds

I purchased Series I inflation-indexed U.S. savings bonds in 2001. I recently cashed them in with a substantial gain. Is this appreciation taxable and at what rate?

The interest you earned on your I-bonds is fully taxable on your federal return, but is exempt from state and local taxes

Here are the details, directly from the IRS:

* If you have not reported the increase in the redemption value of the bonds as interest each year, you must report all of the interest in the year the bonds are cashed or otherwise disposed of.

* If your total taxable interest for the year is more than $1,500, you report (and separately identify) the interest on Schedule B of Form 1040 or Schedule 1 of Form 1040A

* If your total interest is not more than $1,500 for the year, report the savings bond interest with your other interest on the "Interest" line of your tax return

Exception: Some or all of the interest may be excludable from your gross income if you pay qualified higher-education expenses for yourself, your spouse or your dependent during the year.

Gift or inheritance?

A relative gave me some silver bullion and his coin collections before he passed away. There is no documentation (will, etc.) showing that he passed these assets on to me. Do I consider them a gift or an inheritance? If I sell the silver bullion or coins, do I have to report any capital gains to the IRS?

Your relative’s generosity qualifies as a gift, so if you sell the asssets you must use the decedent's basis and you’ll owe capital gains taxes. The gain is considered a collectibles gain, which is taxed at a maximum rate of 28%. If there are no records, you’ll have to use a good-faith estimate of what the decedent paid. It’s too bad you didn't inherit the collection. In that case, you would have inherited what probably would have been a higher basis at the time of the original owner’s death.

See more: Figure the Cost Basis for Gifts.

MLPs and tax-sheltered accounts

I heard that it’s not a good idea to hold stock in a master limited partnership, such as an oil and gas pipeline, in a tax-sheltered account because dividends from these partnerships are subject to tax. Is this information accurate?

Master limited partnerships can generate a steady stream of income, but they can be a bit of a pain for individual investors. Much of the income they produce is tax-deferred until you sell the shares -- a nice perk. But the downside is that you must file additional federal tax forms, as well as tax returns in the states in which the pipelines operate. MLPs are best for investors who pay someone else to do their tax returns. If you hold them in an IRA or other type of tax-deferred account, you could get hit with a tax on something known as unrelated business taxable income.

Taxes and Roth conversions

Several years ago my husband and I each started after-tax IRAs with a plan to convert them to Roth IRAs in 2010. We thought this would be a good way to have some of our retirement money grow tax- free since we do not meet the income limits for investing directly in a Roth. Last week we called Vanguard to start the conversion process. We expected a simple procedure and no taxes, considering that the balances currently total less than the original investments and have no gains. Instead, we were told that only a percentage of the conversion would be treated that way because we own some rollover and other pre-tax IRAs from earlier years.

The Vanguard representative explained that we would each have to figure the percentage of our total IRA funds that were untaxed and pay taxes on that percentage even if we only converted the newest after-tax account. Our rollover accounts include years of 401(k) contributions and growth, so that would certainly minimize any tax advantage of converting the newer, smaller after-tax accounts. Is the information Vanguard gave us accurate?

Vanguard is correct. You can convert only a portion of your traditional IRA to a Roth IRA tax-free if your IRA contains both pre- and after-tax contributions. Over the past few years, Kiplinger’s has written extensively about this pro-rata rule regarding Roth IRA conversions. As we have said, the “back-door” funding of traditional IRAs with the intention of converting to a Roth IRA beginning in 2010 -- when the income limits on conversions disappeared -- works best if the ONLY contributions in your traditional IRA are after-tax.

But here’s a possible way out: Do you or your husband still have an employer-provided retirement plan, such as a 401(k), that accepts rollovers? If so, you can roll over your pre-tax contributions and earnings from your traditional IRA to your employer plan. Your IRA will be left holding only your after-tax contributions, which you can then convert to a Roth IRA tax-free.

If that’s not an option, you’ll have to follow the pro-rata rule on any amount that you convert to a Roth IRA. For example, if your traditional IRA is worth $100,000 and $20,000 came from after-tax contributions, then only one-fifth of any amount you convert to a Roth IRA would be tax-free. The remainder would be taxed at your regular income tax rates.