Ask the Experts: CD inheritance not taxable, but interest is

This week, state Franchise Tax Board expert Daniel Tahara answers readers' questions on California taxes.

He's one of our online "Ask the Experts" writers who answer questions on taxes, investing, personal finances and wills/trusts.

To see more advice or to ask your own questions, go to: www.sacbee.com/personalfinanceblog. (Note: If you've previously submitted a question, the answer will be posted there, too.)

I have four CDs, payable upon death to each of my four sons. When the CDs are redeemed after my death, will each son pay taxes on the inherited amount? (I know they must pay tax on any earned interest.) Would it be better to make my sons co-owners on the CDs?

You are correct. The interest earned on CDs is considered taxable income to each of your sons. The bank will send a federal 1099-INT when taxable interest of at least $10 is paid during the year.

However, the certificate of deposit itself is not taxable to the beneficiary, since an inheritance is generally not subject to federal income tax.

For more details, go to www.irs.gov and search for IRS Publication 17 and IRS Publication 550.

I am entering a graduate program not related to my current job. Are there any tax deductions for the large expense I will be incurring?

There is money in my IRA from my 2008 retirement. Or should I get a student loan?

The short answer is no. There are no tax deductions for your non-work-related graduate program.

California does not have tax credits similar to the federal American Opportunity, Hope and Lifetime Learning credits.

However, a California taxpayer may be eligible to claim his/her qualifying tuition and fees as an itemized deduction, for amounts exceeding 2 percent of federal adjusted gross income (AGI).

The amount paid must qualify as a work-related education expense to be eligible for an itemized deduction.

To qualify, the education expenses must:

• Be required by an employer (or law) to keep your present salary, status or job

• Be needed to maintain or improve skills in current work

• Not be to meet a job's minimum education requirements

• Not qualify the taxpayer for a new trade or industry

Since you do not meet all of those requirements above, your education expenses would not qualify as itemized deductions.

With respect to withdrawals from your IRA, California has a tax on early distributions – those made before age 59 1/2 – from IRAs, qualified retirement plans, annuities and modified endowment contracts.

This early withdrawal penalty tax in California is generally 2.5 percent; there's also a federal penalty that is higher. See details in FTB Publication 1005.

The penalty tax is in addition to any regular California income tax on the distribution.

Thus, when tapping your IRA, you should consider both the tax cost of obtaining funds, as well as the diversion of funds from your future retirement.

You may want to consult with a financial planner for help in determining how to handle your graduate program costs. Best wishes in your continuing education.

– Compiled by Claudia Buck

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