You Come Bearing Gifts, You Leave With Double Taxation--What’s the Rationale?

Q Will you please explain how the gift-tax system works and what its rationale is? I gave my niece $12,000 to buy a truck. My contribution was made with after-tax money. Why do I have to pay a gift tax? I consider it double taxation.

--H.Y.D.

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A First, let’s explain what the so-called gift tax is really all about.

Our current tax system essentially treats the transfer of wealth--up to $600,000 per donor--the same whether the transfer was made during the donor’s lifetime or posthumously. Taxpayers are permitted to give away up to $600,000 during their lifetimes or after death without either the recipient or the donor owing any tax on that transfer. (Of course, this money has already been subject to taxation once, for the year it was accumulated.)

Once the $600,000 limit is crossed, donors are liable for taxes--you’re right, this is now double taxation--on the amount in excess of that maximum. Tax rates start at 37% and are graduated up to 55% (on $3 million). These limits and rates are the same whether the gift is given during the donor’s lifetime or not. If a gift comes after death, the donor’s estate pays any applicable taxes.

Now to your gift. Remember, all taxpayers are allowed to give away up to $600,000 tax-free in their lifetimes or at death. In addition, each of us may give any other person up to $10,000 a year over and above that limit. So $10,000 of your $12,000 gift to your niece is covered by that annual gift provision. The remaining $2,000 counts against your $600,000 lifetime limit.

You must file gift-tax Form 709 with your income tax return, but you owe no tax on that gift unless you have already given more than $600,000. Once you file Form 709, the government notes that your remaining exemption stands at $598,000. The same process is followed every time you exceed the annual $10,000 per-capita limit. Then at your death, any bequest beyond the remaining limit is subject to taxation.

How Low Can You Go With Loan Interest? Q I am going to lend my son $75,000. I want to charge the lowest rate I can without triggering a gift tax or other tax consequences. How much interest must I charge him to satisfy the Internal Revenue Service? Does it matter what the loan is used for? He is using the money to start a business.

--T.O.Q.

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A The answer depends on two critical factors: the interest rate you charge your son and whether he receives interest income on any of his own investments. If he does get interest income from investments, your loan would have to carry an interest rate equal to or greater than the “applicable federal rate” for family loans for you to avoid both gift- and income-tax consequences.

Should you charge less than the applicable federal rate--an amount that floats with the market and is set every six months--the forgone interest would be considered a gift from you and deducted from your lifetime gift limit of $600,000. You would also be required to claim as your income the amount of interest your son receives on his investments.

If your son receives no interest income from investments, you may lend him up to $100,000 and charge less than the applicable federal rate (or even no interest at all) with no gift- or income-tax consequences. How the proceeds of a loan between parent and child are used are of no consequence.

Is Pension Subject to Estate Taxes? Q My revocable trust is the beneficiary of my individual retirement account. I understand that any distributions from the IRA are subject to income taxes, but is the IRA itself subject to estate taxes?

--V.D.L.

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A The value of an IRA or any pension plan is included in one’s estate for the purposes of computing applicable estate taxes.

However, should your estate be left to your spouse, the unlimited marital deduction--which allows spouses to leave their estates to each other untaxed--would apply and no estate taxes would be levied. Of course, any withdrawals a spouse makes from an IRA are still subject to ordinary income taxes.

Should you leave your IRA to anyone but your spouse, it will be subject to estate taxes. However, the beneficiary is entitled to an itemized deduction on his or her income taxes for the estate tax amount paid on any withdrawal from the inherited IRA.

Some tax specialists recommend that an IRA be left to an individual rather than to a trust because individuals are afforded more latitude in handling the accounts.

In addition, the rules governing withdrawals are more lenient for individuals (and more lenient still for spouses) than for trusts.

However, this matter is complicated and can depend on several factors unique to each taxpayer. You would be wise to consult with a trusted professional before proceeding.

Emergency Cash Not Part of Portfolio Q I’ve read that we should all keep cash on hand for emergencies, but what I’ve never understood is whether we should count this emergency stash as part of our investment portfolio--that is, our holdings of stocks, bonds, real estate and assets. What is the common wisdom on this?

--R.R.

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A Conservatively speaking, money reserved for emergencies is not considered a true part of a family’s investment portfolio. Any money set aside for emergencies should be kept in accounts that are both easily accessible and not subject to the ups and downs of the market. This leaves you few options, virtually all of which pay minimal interest: bank accounts, money market accounts and certificates of deposit with staggered maturities.

You aren’t likely to get rich on such investments; in fact, they may barely keep pace with inflation. But they are very liquid, and you won’t have to worry whether the stock market is in a bull or bear cycle if you need to tap the account. The idea is to have ready cash in the event of an accident, illness or other dire circumstance.

Your investment portfolio is an entirely separate matter. This should be diversified among a variety of investments--stocks, bonds, real estate and other holdings. The mix should vary according to your age and investment goals.

You should review your holdings regularly to be sure the portfolio is in balance with savings goals that change as you age. You may start out saving for a home purchase. Your children’s education may be your next major objective, then it’s on to retirement savings.

You can find any number of books on this subject at your local library or bookstore. A qualified, trusted financial counselor--and I would recommend only for-fee planners--can also help you plot your course.

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Carla Lazzareschi cannot answer mail individually but will respond in this column to financial questions of general interest. Write to Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. Or send e-mail to carla.lazzareschi@latimes.com