Avoid Death Taxes with a Transfer on Death Agreement?


Reader Question: My father added a ‘transfer on death’ (TOD) agreement to his investment accounts which are valued at about $2.5 million. My two siblings and I are the beneficiaries of the TOD account. His total estate is approximately $3.25 million. He did this with the intention of keeping that part of his wealth out of his estate at his death, thereby leaving an estate of less than $1 million. If the exclusion drops to $1 million next year, will the investment portion of his assets, with the TODs in place be safe from estate taxes regardless of action/no action on the part of Congress? C.H.
Answer: The primary advantage of a transfer on death (TOD) agreement is that at death the money transfers to the designated beneficiary(s) by title rather than going through probate. Probate is a court process that can take both time and can be expensive. A TOD agreement will not remove the assets from your father’s estate for estate tax purposes.  As a reminder, this year the amount that can pass to heirs free of estate taxes is $5,120,000. This estate tax exemption amount set to drop to $1 million on January 1, 2013. Most advisors believe Congress will change the law sometime next year by raising the tax free limit to at least $3.5 million, but if they don’t, a lot of middle-income Americans will find themselves subject to death taxes. There are a number of strategies that your father could use to reduce estate taxes so I recommend he visit with an estate tax attorney or financial advisor as soon as possible. Certainly he should consider taking advantage of the $13,000 annual gift tax exemption. This would allow him to give up to $13,000 tax free each year to as many people as he chooses. That could mean you and your siblings as well as your children and spouses. 
Reader Question: My son, age 19, received a full academic scholarship plus an additional merit based scholarship of $7,000 paid directly to him. He wishes to invest this money to help pay for graduate school in 4 years. Do you suggest a Roth IRA for this investment? If not, what’s your recommendation? J.R.
Answer: First, please congratulate your son for me on a job well done! In order to invest in a Roth IRA, your son must have ‘earned’ income at least equal to his Roth IRA contribution. Scholarship money will not qualify as earned income. Even if he did qualify to invest in a Roth IRA, it is likely not his best choice because the rules impose a 10% federal penalty for withdrawal within five years of the Roth’s original inception. A better choice would be a college savings 529 plan. Like a Roth IRA, your money grows tax deferred and when used for qualified education expenses, withdrawals are tax free. For Alabama residents, you also receive a state income tax deduction for contributions up to $10,000 per year for joint tax filers ($5,000 single tax filer). Be sure to choose one of the low fee Vanguard investment options. Visit www.collegecounts529.com for more information.
Smart Tip: If you have never opened a Roth IRA account, do so as soon as possible in order to ‘start the clock running’. The 5-year rule that I mentioned above ends five years from the date of the first contribution, not five years from each contribution. Parents and grandparents could help teenagers and young adults by gifting the money to get a Roth IRA going as long as the child or grandchild has some earned income.