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Tax Talk with George Saenz

Ask the tax adviser

Tax-exempt money market accounts, and taxes on gifts from foreigners

When tax-exempt money market accounts are the right investment

Dear Tax Talk:
I have seen references to tax-exempt money market accounts by a couple of Bankrate advice gurus. One says that if you're in a high tax bracket or in a state with high taxes, a tax-exempt money market account is a possibility. That's me on both counts. How does this work?


Dear Sheri:
If you've got enough taxable income from salaries and investments, then you definitely should consider moving into investments that produce tax-free income, such as a tax-exempt money market account. Of course, if you are facing this problem, then you definitely should consult a financial planner who can properly design an overall financial plan considering your family, age and objectives. For example, although a tax-exempt money market account produces tax-free income, so does a low- or no-yield stock with long-term appreciation potential at preferential capital gains rates. This investment decision depends on your time horizon, asset allocation and risk tolerance, which are properly evaluated as part of an overall financial plan.

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On your specific question, a high marginal tax rate makes a tax-free investment more profitable than some taxable investments, after taxes are considered. Suppose your marginal rate for federal income tax purposes is 39.6 percent and you live in California, where the top rate is 9 percent. Since the California taxes are deductible for federal income taxes, your effective California rate is about 5.4 percent, for a combined rate of 45 percent. If you have the option of investing in a tax-exempt money market account that yields 5 percent, you have to figure how much a taxable investment would have to yield in order to make it better after taxes. To do this, divide the tax-exempt yield by 1 minus your marginal tax rate of 45 percent. Another way of looking at it is 1 minus your marginal rate is the amount of income you get to keep, 55 percent vs. the amount the government keeps, 45 percent. So the 5 percent tax-exempt yield divided by 0.55 results in a taxable yield equivalent of just over 9 percent. So if a 5 percent yield tax-exempt investment were available, you would have to earn more than 9 percent in a taxable investment to be better off, after taxes in the taxable investment.

An investment is tax-free because the federal government gives state and local governments the ability to issue federally tax-exempt interest bonds. This makes the cost of borrowing lower for the state and local governments. Unfortunately, most states tax their residents on tax-exempt interest earned on obligations of other states. Therefore, when researching a tax-exempt investment, you may want to consider a money market account that invests only in obligations of your state.

Taxes on monetary gifts from non-U.S. citizens?

Dear Tax Talk:
I received a monetary gift from my dad, who is a British citizen. Do I have to report this sum of money to the Internal Revenue Service?

Dear Fred:
You must be a very good son. A U.S. resident or citizen does not pay tax on the receipt of a gift or bequest either from a U.S. person or a foreigner. However, a few years back, IRS through an act of Congress started requiring that certain large gifts from foreigners be reported for information purposes. The motivation here is that certain U.S. persons with foreign connections were claiming that everything they received from abroad was a gift when in fact it was a disguised payment for services or from a trust fund. Since no reporting was required it was hard for IRS to pick up the fact that an individual may be underreporting income. Now that gift reporting is required, I speculate that IRS is scrutinizing tax returns that report little income and big gifts.

If the gift of money was from your dad individually, then report the gift if it exceeded $100,000. If you received the payment from a foreign corporation or partnership, then you must report the gift if it exceeds approximately $11,000. This threshold is adjusted annually for inflation and was $10,735 in 1999. The year 2000 amount hasn't been announced yet, so that is why I gave an approximate figure. The implication here is that businesses don't make gifts and therefore the chances that it is taxable are greater, which warrants greater IRS scrutiny. Form 3520, Part 4, is used to report the foreign gifts.


-- Posted Nov. 14, 2000


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