Tax Smart or Tax Trap?

Tax moves that seem smart at first may wind up backfiring, resulting in

unnecessary taxes or lost opportunities. Here are four common tax traps

to avoid.

1. Over-eager tuition payers?

The Internal Revenue Service recently

allowed a grandmother to prepay eight years of private school tuition for

her grandchildren. Her $150,000 advance probably will save the family $75,000

in future estate taxes. Her strategy is drawing many imitators. But consider

possible downsides of this strategy. If the school holds the money interest-free

for eight years, the grandmother may miss out on potentially better investment

opportunities. In addition, if the children transfer to another school,

the prepaid tuition is forfeited.

2. Leave heirs IRAs, not irate

Affluent couples often use a credit shelter trust to use both spouses'

individual estate tax exemptions ($675,000 in 2000, rising to $1 million

in 2006). The trust can provide income to the surviving spouse for life,

with the trust's assets eventually passing to the trust's beneficiary free

of estate taxes.

But these trusts can trap couples with large individual retirement accounts.

Transferring an IRA to a credit shelter trust can forfeit decades of potential

tax deferral because the surviving spouse cannot roll over the IRA into

his or her name. The forfeited tax-deferred compounded returns could well

exceed the state tax savings of placing the IRA in the trust.

Instead, you might want to try this: Designate each spouse as primary

beneficiary of the other's IRA and name a credit shelter trust as contingent

beneficiary. Then upon the death of one spouse, the surviving spouse can

decide whether to disclaim interest in the IRA (which means he or she declines

to inherit the IRA) in favor of the credit shelter trust.

3. Running on AMT

Think it's smart to accelerate deductions? Don't forget the Alternative

Minimum Tax (AMT). Taxpayers are finding that accelerated deductions trigger

the AMT more often than they did previously. In fact, some taxpayers even

delayed paying 1999 state income and real estate taxes until 2000 because

they found themselves likely to be subject to AMT — which doesn't allow

deductions for state and local taxes. By delaying income tax payments, they

can use the deductions on their 2000 returns, when they may not be subject

to AMT.

4. More parents suffering from UTMA regret.

The Uniform Transfers to Minors Act (UTMA) and the Uniform Gift to Minors

Act (UGMA) allow taxpayers to shift income-generating and appreciated assets

to a child while retaining control of the assets until the child reaches

age 18 or 21 depending on state law. While income tax benefits are limited

for younger children's accounts, giving assets to 14- to 17-year-olds can

achieve significant savings without parents losing immediate control.

The catch is that transfers to children under UGMA and UTMA are irrevocable,

and upon reaching the age of majority, the child can use the assets as he

or she pleases. So for example, an 18-year-old could opt to use a substantial

UGMA account to circle the globe with friends instead of going to college.

UGMA and UTMA accounts also cut eligibility for college financial aid

because aid formulas typically calculate annual need based on as much as

35 percent of the student's assets but usually no more than 5.6 percent

of the parent's assets.

Some cash-strapped parents spend money from their children's account

to meet their own expenses, rationalizing that it's family money. They are

wrong. Every year, young adults sue their parents for breaching their fiduciary

duty — and they win.

Here is what you can do: Before your child turns 18, buy your child

a discretionary item — such as a car, a vacation or a fancy high school

prom — out of the funds in the account. Or open a tax-favored college savings

account instead. If the parent is the account owner, the child can't take

the money out and the funds generally won't eliminate financial aid.

—Zall, Bureaucratus columnist and a retired federal employee, is a freelance

writer based in Silver Spring, Md. He specializes in taxes, investing, business

and government workplace issues. He is a certified internal auditor and

a registered investment adviser. He can be reached at miltzall@starpower.net.