Caution: Although setting up this type of joint account is convenient and inexpensive, problems may result, especially because the joint owner you name will inherit the account no matter what it says in your will. An overreliance on joint ownership may rob you of flexibility and result in the payment of unnecessary tax, as explained below.
Advantages: In small doses, joint ownership can be useful.
Example: If you reach a point where you no longer can manage your own finances, your co-owner can easily tap a jointly owned checking account and see that your bills are paid. In addition, joint ownership might make sense when you are certain that there is only one person you would want to inherit a financial account. At one owner’s death, assets held as JTWROS will be transferred to the co-owner without the delay and expense of probate.
To see a disadvantage of joint ownership, consider this scenario where unnecessary estate tax is paid…
John Smith dies in 2008, when the federal estate tax exemption is $2 million. All of his assets are held jointly with his wife, Marge, so she inherits everything. Marge dies later in the year with a $5 million estate. Her estate is $3 million over the exemption so, at a 45% estate tax rate, $1.35 million is owed to the IRS.
Trap: Because John’s assets were held jointly, he had no assets to pass into a “credit shelter” trust (one structure to use the federal estate tax break), so his estate-tax exemption was wasted. The IRS collected an extra $900,000 in estate tax.
Better way: John could have left $2 million to a trust that would benefit Marge and then pass tax-free to their son, Bob, at Marge’s death (the trust would avoid estate tax because of John’s $2 million estate-tax exemption). Then Marge could have left Bob $3 million, of which $2 million would be sheltered by her estate-tax exemption. This plan would have generated only $450,000 in federal estate tax (45% of $1 million), not $1.35 million.
Strategy: If estate tax is a concern, be sure that both spouses have assets subject to probate (such as bank or brokerage accounts) that they can leave to a credit-shelter trust. This will help ensure that they take full advantage of their collective estate-tax exemptions ($4 million in 2008, $7 million in 2009).
Step Up to Tax Savings
As seen above, excess use of joint ownership by married couples can lead to problems. The same may be true for joint ownership with a nonspouse. The co-owner will inherit while would-be heirs will be shut out.
Strategy: Instead of a joint account, use a power of attorney or a trust to enable someone to handle your finances in case you become incapacitated. This won’t interfere with your plans to distribute your assets.
When would naming a nonspouse as co-owner make sense? If you trust that person absolutely and you want him/her to inherit that account.
Advantage: Naming a nonspouse as joint owner is a simple, cost-effective way to provide for possible incapacity. What’s more, a valuable tax break won’t be lost.
Example: Jane Jones has $400,000 worth of securities. Her basis is $100,000. If Jane dies as sole owner and leaves her portfolio to her daughter, Alice, in her will, Alice will inherit the securities with a stepped-up basis. After Jane’s death, Alice can sell the inherited securities and owe no capital gains tax on all the appreciation. (Note that this appreciation may be subject to estate tax.) Now suppose that Jane has named Alice as co-owner of the account. That basis step-up will not be lost. If two co-owners are not married to each other, the estate of the first owner to die will include a share of the property based on the portion of the original purchase price furnished by the decedent.
In our example, Jane had acquired all the securities before adding Alice to the account as a joint owner. Thus, 100% of the securities will be included in Jane’s estate and Alice will inherit with a full basis step-up to market value even though she had been named co-owner of the account.
Spousal treatment: What if, in the above example, Jane had instead named her husband, Dan, joint owner of her brokerage account? At Jane’s death, all of the assets in the account would have gone to Dan, but he would have received only half of a basis step-up.
Example: Assume Jane dies when the securities are worth $400,000. Only Jane’s half of the account ($200,000) gets a basis step-up.
Therefore, Dan’s basis in the inherited assets would be $200,000 (a basis step-up for Jane’s half) plus $50,000 (Dan’s half of the original $100,000 basis).
Exceptions: Generally, in community property states, such as California, Nevada, and Texas, Dan would get a full basis step-up. Also, joint tenancies created before 1977 by Jane get a full step-up for Dan.
Strategy: Learn the laws of your state. Assuming the basis step-up will be 50%, not 100%, it might make sense to hold highly appreciated assets in one name so the surviving spouse can inherit with a full step-up.
Gift Tax Trouble
Using joint ownership can lead to a gift-tax trap.
Example: Jane Jones has named her daughter, Alice, co-owner of her brokerage account, as above. Alice then withdraws cash or securities from this joint account.
Such a withdrawal may be treated as a taxable gift. If so, gift-tax returns may have to be filed and gift tax might have to be paid.
Acceptable: Alice can withdraw assets to pay for her mother’s expenses. That won’t trigger tax consequences.
Not acceptable: If Alice uses the withdrawn assets for any other purpose (besides Jane’s expenses), the withdrawal will be treated as a gift from Jane to Alice.
If such gifts this year top $12,000, a gift tax return will have to be filed. Once Jane has made a total of $1 million worth of taxable gifts to Alice and other recipients, gift tax will have to be paid if additional gifts are made.
Strategy: If the co-owner named to someone else’s account withdraws assets, document the fact that the assets were used on behalf of the original owner. A diary and cancelled checks can serve as proof.