Qualified Terminable Interest Property--Sounds Complicated, and It Is

Q: My brother died in 1982 and left his estate to his wife in a trust that was to distribute income earned from his assets over her remaining lifetime. She died in 1997, and at that time I came into possession of the stocks that he had willed to me but were to remain in the trust to give his widow income. What is my tax basis in these shares? The value when my brother died in 1982, or when his widow died?

--A.N.

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A: The tax basis of your newly inherited shares depends on how your brother’s assets were handled at his death. That’s information that you haven’t provided but will need in order to sort out your situation.

According to Alexander Fried, a probate and estate-planning lawyer in Encino, the central issue is whether your brother’s estate elected to take a marital deduction on behalf of his widow on the assets that were left in trust for her.

More precisely, Fried says, you must determine if your brother’s trust was a qualified terminable interest property, or QTIP trust.

Why is this important? Because if it was a QTIP trust and a marital deduction was claimed, then the stocks you inherited, along with your brother’s other assets, would have been included in his widow’s estate and would be entitled to a step-up in tax basis upon her death. If the marital deduction was not claimed, the assets would not have been transferred to her estate, and would therefore not be entitled to a step-up in basis upon her death.

You would be wise now to consult the trustee of the estate to determine how this was handled.

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Q: Because of significant legal and medical expenses this year, my wife and I expect to have deductions far in excess of our 1998 income. We qualify to convert our traditional individual retirement accounts to Roth IRAs and would like to do so. But we would like to pay the taxes in one lump sum in 1998 to take advantage of the deductions we have, rather than spread it out over the four years that the government is permitting only for 1998. Is this possible?

--R.A.B.

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A: Although it would seem as though the government wouldn’t want to stop anyone from paying a tax bill quickly, what you propose is, unfortunately, not permissible, our experts say.

Taxes owed on Roth IRA conversions made in 1998, and only in 1998, must be paid over four years. Taxes owed on Roth IRA conversions made in 1999 and later must be paid with the tax bill for the year in which the conversion was made.

This situation apparently will leave you with more deductions than you can use in 1998, and they are deductions that you cannot carry forward to subsequent tax years.

What can you do? Perhaps you can delay payments on some of the bills until 1999 to spread out your deductible expenses. Another alternative would be to accelerate receipt of any taxable income you might have for 1998.

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Q: When I left my former employer two years ago, I rolled over my 401(k) account into an IRA. I would now like to convert this account to a Roth IRA. Are conversions of rollover IRAs permitted?

--E.E.

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A: Absolutely. Assuming that the taxpayer meets the income limits ($100,000 adjusted gross whether single or married filing jointly), rollover IRAs may be converted to Roth IRAs in the same manner that contributory IRAs are converted. And going forward, taxpayers who leave their employers and elect to take the proceeds from their 401(k) accounts with them may also convert them into Roth IRAs, assuming income requirements are met.

But in order to move 401(k) proceeds into a Roth IRA, taxpayers must first have them transferred to a traditional IRA. Then they may convert the traditional IRA to a Roth IRA. Why the two steps? So the government can collect the taxes on the money being converted.

Remember, your 401(k) account has been building on a tax-deferred basis. Before you can convert it into a Roth IRA, which will accumulate on a tax-free basis, the government is entitled to its due. The interim move to the traditional IRA provides this mechanism. The 401(k) funds check into the IRA on a pretax basis and essentially check out on an after-tax basis.

Also, please remember that if you take a lump-sum distribution of your 401(k) plan in order to put it into an IRA, you should not take possession of the money yourself. Have the transfer completed on a trustee-to-trustee basis between your 401(k) plan and your IRA. If you take possession of the money, it will be automatically subject to 20% withholding for taxes.

Although you will have to pay taxes on any of those funds that you ultimately convert to a Roth IRA, you should avoid at all costs paying the tax bill out of those funds in order to maximize the benefits of the Roth IRA.

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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 e-mail carla.lazzareschi@latimes.com.