How the IRS Treats Foreign Property
QUESTION: I am a dual citizen of the United States and a country in South America. I inherited some property from my father 25 years ago when I was a child in my native country. I now want to sell it. I feel that I should not owe taxes to the U.S. government since I was not a resident when I inherited this property and have never seen a cent of return from any of it. What are my choices?--R. H.
ANSWER: Despite your opinion on the fairness of it all, our advisers say you have only one chance of legally escaping the long stretch of Uncle Sam’s tax-collecting arm once you sell your inherited property. This, of course, assumes that you recognize a gain on the sale.
According to our experts, all U.S. citizens--and residents--must pay U.S. taxes on their worldwide income. This rule holds even if the income is generated by the sale of property in a foreign country that has been held for years before the taxpayer became a U.S. citizen.
However, you should check with your accountant or other adviser to determine if you are eligible for the one potential loophole. If you are required to pay taxes on your gain in your native country, it is possible that a special tax treaty between the United States and that country will allow you to receive a credit on your U.S. tax bill for the taxes paid in your native land. Without knowing the country, we cannot advise you further.
Transferring Funds From a 401(k) Plan
Q: I am in my early 40s and plan to leave my job shortly. I know that when I leave my employer, I will be forced to transfer the funds in my 401(k) tax-deferred savings plan. Can you please tell me if it would be better to put these funds in an individual retirement account or in the pension plan offered by my new employer?--R. G. Y.
A: You should consider several factors before making a move. Either choice will allow you to take advantage of the special income-tax averaging allowed withdrawals from qualified pension plans. This advantageous tax treatment can save you thousands when you begin receiving distributions near retirement. To qualify using an IRA, however, you must put the 401(k) proceeds into a separate IRA that is segregated from all other retirement savings. The pension choice assumes that your new employer will permit the transfer.
What else is there to consider? If your new employer is a large corporation, chances are that its pension plan investments are guided by professionals who have access to some of the best advice available, as well as investment opportunities not normally available to individual investors. However, when you turn your account over to the pension fund, you lose control of it, and you may not like that. After considering these issues, only you can decide what strategy is best for you.
Withdrawing Funds From an IRA Account
Q: Is money received by a beneficiary of an individual retirement account subject to income taxes when it is withdrawn from an account on which no income tax has ever been paid?--A. R.
A: In a word: “yes.” You must pay income taxes on money withdrawn from an IRA, whether you are the account holder or its beneficiary.
However, the question you did not ask is whether you must, as a beneficiary, withdraw funds from an IRA you inherit. If you are the spouse of the account holder, you may roll the account over into an IRA of your own within 60 days of receiving it, and let the funds continue to accumulate tax-deferred interest. However, once you begin withdrawing the funds, they will be subject to income tax.
If you are not the spouse of the account holder, you must take distributions from the account--and pay income taxes on them--within the time limits prescribed by law. These limits vary, so you should ask your accountant for help.
Compound Interest Really Does Add Up
Q: In your column last week, a reader said he had a $100,000 annuity paying interest of 11.75% that would mature in seven years. He said by the maturity date, he would have earned about $117,000 in interest. How did that happen? I can’t get my math to come up with that figure.--M. W.
A: As amazing as it seems--and we did recalculate the math twice before publishing the letter--it’s true. The interest compounds. In the first year, the account accumulates $11,750 worth of interest, giving the account a total of $111,750. In the second year, the interest is calculated on this amount, generating a total of $13,130 in interest, which then gives the account a total of $124,880. Keep up the math in this fashion and at the end of seven years, you will discover that the account contains a total of $217,636.99.
Just for your reference, by our rough calculations, an account paying interest of 11.75% doubles in slightly more than six years. An account paying 7% doubles in nearly 11 years and an account paying 15% doubles in about five years.
