Repeat After Me: Consulting a Tax Pro Can Save Time and Money

Question: My wife and I live on Social Security, my pension and our individual retirement accounts. Last year we took $10,000 out of one of our IRAs and gave it to our son and daughter-in-law to help with the down payment on their house. We filed a gift tax form and made estimated tax payments using a form the IRS sent us.

Now we’re doing our taxes and it turns out that $10,000 gift put us in a higher tax bracket, which means we’ll pay a bundle. But I recently read in your column that each person can give up to $11,000 a year to anyone without paying gift taxes. So I’m wondering: Was our gift taxable after all?

Answer: Here’s another case in which a consultation with a tax pro could have saved time, money and hassle.

You shouldn’t have filed a gift tax form when you gave your son the money. You were allowed to give him that much without gift tax consequences.

You probably owe income taxes on the withdrawal, though, because it came from an IRA.

Although earnings in an IRA are tax-deferred, you generally must pay income tax on money that comes out (unless the money comes from a Roth IRA, which allows tax-free withdrawals).

People are allowed to take $10,000 out of their IRAs to purchase their first home or to help a parent or child buy a first home. They still must pay income taxes on the money, but they avoid the 10% penalty for early withdrawal that might otherwise apply.

You can try to fix this yourself, but it’s probably best to take your paperwork to a tax professional and have him or her sort this out for you. The pro will make sure you get credit for the estimated taxes you paid and help you fix the gift tax return you filed in error.

Tax law can be confusing, which is why many people find it helpful to get a tax professional’s advice now and then. Anyone who’s tapping a retirement fund, or who’s planning to make a large gift, would benefit from first running the plan past a certified public accountant or enrolled agent.

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You Can’t Avoid Taxes by Giving Away Money

Q: After reading your advice about gifts and taxes, I started to wonder whether I could make disbursements from a trust fund and give the money to other people without having to pay taxes on the money. What I am not sure of is whether the $11,000 amount is the total I’m allowed to disburse without gift taxes or whether that is the total that the receivers will not have to pay tax on.

A: Neither, and nice try, but any money you take out of your trust fund probably would incur income taxes.

Like the previous reader, you’re stumbling over the differences between the gift tax system and the income tax system. They’re quite different, but people get tangled up about them all the time. Some people even think they can deduct money they give to an individual, such as a family member, a friend or the panhandler they pass on the way to work each day. (In fact, only gifts to qualified charities qualify for the charitable donation deduction, and then only if you itemize your deductions on your tax return.)

To repeat: You can’t avoid income taxes that are otherwise due by giving the money to individuals. Chances are, though, that there won’t be any gift tax consequences to your generosity, unless you give more than $11,000 to any one person each year or give a total of more than $1 million during your lifetime. And gifts are tax-free to the people who get them.

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Determining Insurance Needs Is the Best Policy

Q: My wife and I have had whole life policies for about 12 years. I could purchase larger amounts of term life insurance for both of us with larger death benefits and still have money to invest. Should I cancel my whole life and buy term? Or should I keep the whole life policy? I’m 40, my wife is 36, and we have two children younger than 8.

A: You’re coming at the question backward. First you need to determine how much insurance you need. Then you can make some decisions about which type of insurance you should own.

There are lots of rules of thumb about how much insurance people should have, but most of these rules aren’t very useful. You’ll hear, for example, that people need life insurance equal to five to eight times their income. That would result in too much insurance for single people, who often don’t need life insurance, and perhaps too little for many people with big families, big debts or disabled children.

You’re better off spending a little time with the “insurance need” worksheet at www.latimes.com/money. You’ll also find a primer there on the different kinds of insurance.

Whole life policies, such as the ones you own, tend to be much more expensive than term life insurance. But whole life policies can offer lifetime coverage and an investment component that term life does not.

The most important thing is to buy enough insurance to protect your family.

If you can’t do that with a whole life policy because you can’t afford the premiums, then get term insurance.

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Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the personal financial planning certificate program at UC Irvine. Questions can be sent to her at moneytalk@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012. She regrets that she cannot respond personally to queries. For past Money Talk questions and answers, visit The Times’ Web site at www.latimes.com/moneytalk.