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09 July 2018
The word basis can have many different meanings in tax and finance. When it comes to your IRA it refers to the portion of your IRA on which you will NOT have to pay tax. That makes it a really good thing to know (unless you enjoy paying taxes!). Unfortunately, IRA basis is one of the rare areas of the tax code where nobody else is keeping track of it for you. The IRS doesn’t. Your bank or brokerage can’t. You have to do it for yourself - and if you aren’t then you could end out paying more taxes than you need to.
The Basics on IRA Basis
There are two types of IRAs. There’s the Traditional IRA, and there’s the Roth IRA. The primary difference between the two is the timing of when the money gets taxed. The concept of the Traditional IRA is that you don’t pay taxes on the money you contribute to the account, but you pay regular tax rates on the money when it comes out. The concept of the Roth IRA is that you pay tax on the money when it is contributed to the account, but then you don’t pay any taxes on the money coming out.
If those concepts were the only rules, then I wouldn’t be writing this article. If those were the only rules, the tax basis of a traditional IRA would be 0% of the account (none of it would be excluded from taxes) and the tax basis of the Roth IRA would be 100% of the account (all of it would be excluded from taxes). But, alas, nothing can ever be that simple in tax law. There are exceptions, and it’s those exceptions this article addresses.
Basis in Your Roth IRA
The IRS uses the term qualified when referencing IRA distributions (a.k.a. withdrawals). Qualified means the distribution/withdrawal meets all the rules to keep the tax benefits of the IRA. One of the things that makes a Roth IRA distribution qualified is the age of the account holder. If you are more than 59 ½ years old when you withdraw from the Roth IRA, then the distribution is deemed qualified (tax free).
Life happens to us all, though. For a variety of reasons people often need to tap into their retirement savings before the age of 59 ½. This can lead to non-qualified distributions from their Roth IRAs, and that means the distribution does not keep its tax-free characteristics. If you tap into your Roth IRA before the age of 59 ½ you’ll have to pay tax on the distribution. Maybe…
Because you received no tax benefits when you contributed money to your Roth IRA, you don’t have to pay tax on the contributed money when it comes out. This is similar to a bank account. I don’t get a tax break when I put money into my bank account, and I don’t pay taxes when I withdraw it from my bank account. It’s just my money. It is the same with the money you put into your Roth IRA.
The catch is this tax-free status is limited to the money you contribute to the account (which I am referring to as your tax basis). Any money that is in your Roth IRA due to growth (dividends, capital gains, interest, etc.) would be subject to taxes if withdrawn early. HOWEVER - when you make a withdrawal from your Roth IRA, the contributed money comes out first. So, you can take money out of your Roth IRA account up to the amount you contributed without a tax consequence. This can provide you with a valuable source of tax-free money if you need it in an emergency. Let’s look at an example.
Jimmy is 30 years old. Jimmy opens a Roth IRA and contributes $3,000 per year for 5 years. At the end of 5 years the Roth account has a value of $18,000. Jimmy contributed $15,000 and there is also $3,000 of growth in the account. Jimmy’s car was destroyed in a hurricane, and his insurance won’t pay for the loss. Jimmy needs a car, so he looks to his Roth IRA for money. Jimmy can take up to $15,000 out of his Roth IRA (the amount he contributed) and not have to pay any taxes on that withdrawal. If he takes more than $15,000 he will have to pay the taxes on the amount over $15,000, because that is from the growth of the investments in the account.
Knowing the amount of his basis in his Roth IRA was important to Jimmy. If he didn’t know how much he contributed he might have taken too large a distribution and given himself a tax problem for later. Or he may have been overly cautious and not withdrawn enough to buy reliable transportation, using a high-interest rate loan instead.
Jimmy’s basis was an easy number to know in my scenario. In real life it doesn’t normally work that way. In real life people are not quite as systematic. They put money in the Roth IRA when they can and don’t contribute when money is tight. After several years they aren’t really sure how much money they have contributed to their account. Which means they don’t know how much they can take out before they trigger a tax issue.
With a Roth IRA your bank or broker (whoever is holding your Roth IRA) may be able to help you determine your basis. If you’ve kept the account at the same bank or brokerage the entire time they may be able to provide you with a history of your contributions, as well as any previous withdrawals. If you’ve moved accounts, they may not have your full contribution history. It’s worth asking them, though.
I don’t advocate using your Roth IRA like a piggy bank. Just because you can take your contributed money out tax free does not mean you should. That account is designed to fund your retirement, and should not be used for anything else unless the need is great. But when the need is great, knowing your Roth IRA basis can be extremely useful knowledge.
Basis in Your Traditional IRA
The concept behind the Traditional IRA is you receive a tax benefit for contributing to the account, but you pay taxes on the money when it is withdrawn. This tax benefit is meant to encourage Americans to save for their retirement. Our government has decided, however, that not everyone needs to be provided with such an incentive. There are income limitations to claiming the tax benefits of contributing to a Traditional IRA. Those limitations change depending on whether your employer provides you with a retirement plan at work. If you have an employer-sponsored retirement plan (TSP, 401K, 403B, VRS, military pension, etc,) then you lose your right to claim the Traditional IRA tax benefit at a lower income level. If you do not have an employer-sponsored plan you are allowed to claim the Traditional IRA tax benefits until your income hits a higher level.
Note, these limitations are only on the tax break for contributing to the Traditional IRA. Regardless of your income level, you can always make contributions to your Traditional IRA, you just can’t always get the tax break for making the contribution. That’s how you start to form tax basis in your Traditional IRA - by making contributions that do not qualify for the tax break.
Just like the Roth IRA, any money you contribute to your Traditional IRA without getting a tax break for making the contribution can come out tax free. But - BIG DIFFERENCE ALERT - unlike the Roth IRA, your contributed money does not come out of your Traditional IRA first. Money distributed from your Traditional IRA comes out as a mix of qualified contributions, non-qualified contributions, and growth. You have to know the composition of that mix so you know how much of your withdrawal is taxable and how much is not taxable. Let’s look at another example.
Jane starts a Traditional IRA when she is 50 years old. She contributes $3,000 each year for 5 years, getting a tax break each year for those first 5 years. At age 55 Jane gets a promotion and a big pay raise at work. She increases her contributions to her Traditional IRA to $5,000 each year, but she is now unable to take the tax deduction for her contributions because her income is too high.
Jane is now 60 years old. Her Traditional IRA value is $60,000. Jane decides to take $10,000 from her Traditional IRA and go see New Zealand. How much of her withdrawal is taxable?
We know Jane’s taxable basis in her Traditional IRA is going to be the $25,000 (5 years times $5,000 per year) of contributions she made without getting a tax benefit. The $15,000 of qualified contributions and the $20,000 of growth in the account are all taxable. So, $25k/$60K (41.67%) is not taxable. $35,000/$60,000 (58.33%) of her $10,000 distribution (or $5,833) is taxable.
Again, my example is simple to make it easier to demonstrate the concept. Real life is rarely this clear. In real life people who have made contributions to their Traditional IRAs without receiving a tax break usually do not know what their tax basis is in their account.
What shocks many people is that their bank or brokerage can’t help them figure it out! Here’s why: whether or not you received a tax break for your Traditional IRA contribution is a function of whether your employer offers a retirement plan and your adjusted gross income - and your bank/brokerage doesn’t have that information! They don’t know which years your contributions received a tax benefit and which years they did not. When you take a distribution from a Traditional IRA the bank/brokerage will issue a form 1099-R, and they will check the box that says “Taxable Amount Not Determined”. It’s on you to determine the taxable amount and report it to the IRS when you file your tax return.
Figuring Your Traditional IRA Basis
Ideally, you’d be like Jane and track your Traditional IRA basis. But, what do you do if you’re like the 99.99% of Americans who have a basis in their Traditional IRA, but don’t know how much it is? If you’ve been filing your taxes correctly you can go back through your old tax returns and review your form 8606 submissions. You should have been reporting your non-deductible Traditional IRA contributions on this form each year.
If you don’t have all your old tax returns you can request tax return transcripts from the IRS. The transcripts are free, and you can use them to piece together the information you need to determine your Traditional IRA basis in that way.
If you want help determining your basis in your IRA come see me. I have a nifty tool that can pull all your IRS transcripts going back to 1990. We can pull all your transcripts at once and cull them for the information we need.
24 June 2018
With the thriving military bases in the region, Hampton Roads is blessed with many military retirees. (I find it ironic we are called ‘retirees’, since many of us work just as hard (or harder) after leaving the service as we did when we were on active duty!) Some interesting tax issues often arise in the year a member leaves military service. I lived a few of these issues, and see even more as a tax professional. Hopefully this article will help some of my newly retired (or about to retire) brothers and sisters in making transition to civilian life a little smoother.
That First State Tax Return Can Be a Doozy! Many of us took advantage of the Servicemembers Civil Relief Act (SCRA) to avoid paying state income taxes while we were on active duty. I sure did. At the beginning of my first duty station in Florida I marched down to the Duval County Courthouse and registered my domicile in Florida. Took that paper to my personnel office, and skipped out on paying state income taxes for the next 20 years.
Spouses weren’t covered by the SCRA back then, so my lovely wife Tade has been filing in Virginia since we moved here in 2001. I didn’t have to start filing here until I retired from the Navy in 2010. Even though many military spouses are now exempt from state taxes by the Military Spouse Residency Relief Act (MSRRA), I still see many couples in the situation Tade and I were in; one spouse is a Virginia resident, and the other is not.
In my opinion, Virginia handles this situation very sanely. Even if the married couple files their federal return jointly, Virginia allows them to file separately if one is a resident and the other is not. Not all states allow you to have a different filing status on your state return than you have on your federal return. Virginia makes it the only correct way to file if one of you is not a Virginia resident. I find that simple to comprehend. Unfortunately, most do-it-yourself tax software has a lot of trouble when you try to change filing status between your federal and state returns. I've had a few clients successfully figure out how to do this, but not many.
The more difficult situation arises in the year of retirement. We can continue to use my situation as an example. Tade was a Virginia resident all of 2010. Paul became a Virginia resident on December 1, 2010. How did we file our 2010 Virginia taxes?
Tade filed the same way she always did - her status was married filing separately, and she was a full-year resident (form 760). Paul also filed in Virginia as married filing separately, but on a Virginia part-year resident return (form 760PY). We had to use two different forms to file in Virginia! Good luck getting your do-it-yourself tax software to help you get to that conclusion.
Worse still are the state returns for folks whose transition meant they were part year a resident of one state, and part year a resident of another state. It can be quite challenging to get the interplay between the state returns to be right in these situations. I pay $1,200 annually for my tax software, and I’ve been known to throw my hands up (mutter some sailor-like words about the parents of the people who designed my software), download blank forms from a state website, and fill them out by hand to get the correct tax result.
The bottom line on this issue is that your state tax return(s) in the year of your transition out of the military can be more challenging to prepare than usual. Don't expect your off-the-shelf software solution to walk you to the right answer. They don't deal with this problem very often. (Fortunately, you don't either!)
Increased Income Means Increased Taxes. Many military retirees experience increased income when they leave the military. They get a job for as much as (or more than) they were making while on active duty. They also begin receiving their military retired pay. The increased stability of not having a military move looming in the future means spouses may also see a bump in pay as well. It is not uncommon for me to see a family’s income double within a year of a military retirement.
As I have previously written, there is an income zone (that I call ‘the crease’) where your income taxes will increase significantly faster than your income.* This zone sits just above the income level of many military families. When their income increases right after a military retirement, they can shoot into (or through) that zone, and the tax impact can be dramatic. One couple saw a 70% increase in income, but their tax bill more than tripled!
Higher incomes can (and probably should) lead to higher taxes, but there are ways to be proactive about managing the situation to keep your tax bill from exploding. The solutions are unique to the individual situation, but nearly all require advanced planning. Very little can be done to mitigate taxes after the tax year is over. You need to plan and act ahead. Please contact me if you want assistance developing your tax strategy.
(* The revision of the federal tax laws that went into effect in 2018 (also known as the Tax Cuts and Jobs Act) made some changes that should help flatten out 'the crease' as described in my linked article from 2016. Notably, starting in 2018 the child tax credit does not begin phasing out for families until their adjusted gross income is more than $400,000.)
Your Military Pension is Taxable in Virginia. The Commonwealth offers some generous tax breaks to military personnel, but not much after you retire. Virginia will tax your military retired pay as regular income. The DoD will follow your instructions and/or the withholding tables provided to them by Virginia to determine how much to withhold for Virginia taxes. IT’S ALMOST NEVER ENOUGH.
Here’s how this scenario frequently plays out: You leave the military after 20+ years of service, having not paid state income taxes for decades. You get a civilian job. The pay is good, but there’s that new line on your pay stub/earnings statement for “Virginia Tax Withheld”. It isn’t much, but it’s a bit annoying since you never paid it before. You also start getting retirement pay (Woo hoo! Free money!) There’s that annoying line on your retiree statement for Virginia taxes, too. Then you file your first Virginia income tax return and find out you owe them thousands of dollars because neither your employer nor the DoD were withholding enough to cover your Virginia tax bill. It happened to me, and I’m pretty knowledgeable about taxes!
Setting up your tax withholding is another area that requires a little prior planning. It can be tricky. See me if you want some assistance with that. I learned my lessons on that one the hard way, but I learned them well!
If you bothered reading this article it’s probably because you are recently retired from the military, or you are about to retire. It’s an exciting time. I remember feeling a bit anxious about the future during the year of my transition. (Not about taxes, but life in general.) If I could do it over again I would relax a little bit and dream bigger from the start. I learned more in my decades of service than I knew. You probably did, too. Congratulations on getting to this next stage, and thank you for your service!
13 May 2018
I frequently encounter new landlords who are confused and/or frustrated by their tax situation. They decided to turn their house or condo into a rental business, but they didn't fully understand the tax implications of doing so. Now they are paying both financially and emotionally.
In an effort to save at least a few people from this fate, I am providing you with this quick “Top 5” list of tax issues you should consider before you decide to become a landlord.
1. Your Mortgage is Not Deductible. If life (or being a landlord) were simple, the mortgage on your rental property would be deductible. This would give you a simple formula to figure your rental income.
You take in $1200/month in rent;
You pay the bank $1,000/month for your mortgage
You make$200/month or $2,400 for the year
Boom - you’d be done!
In reality it’s not even close to being that simple!
A mortgage is typically paying 4 different things in one payment: (1) principal on the loan, (2) interest on the loan, (3) real estate taxes, and (4) insurance. You have to break out each of those expenses separately on your tax return. Interest, insurance, and real estate taxes are all deductible expenses as paid. The principal, however, is deducted through a cost recovery system that we typically refer to simply as ‘depreciation’. More on that later. For now just be aware you cannot directly deduct your mortgage payments on your tax return. It's not that simple.
2. You Must Track Everything. By renting your property you have opened a business. The IRS considers you to be operating a business. So does the Commonwealth of Virginia. If you aren’t treating it like a business, then you risk learning some expensive lessons down the road. Businesses need records, so get a record keeping system in place. (Hint: a box of receipts is NOT a record keeping system.) A spreadsheet will do if you just have 1 or 2 properties. More than that and you’re probably going to want some sort of accounting software.
Track all the expenses for the property. Once you’ve turned it into a business, everything you spend on the property is a business expense. Make sure it gets recorded in your spreadsheet (or bookkeeping system you adopt).
Get a separate bank account for your landlording activities. It’s a business, it deserves its own bank account. Don’t run personal expenses through the landlord account. Don’t run business expenses through your personal account. Keep them separate. It keeps the bookkeeping cleaner if you do, which makes it look like you’re treating your rental activities like a business.
3. You Can Be Creative with Expenses. Within reason, of course. You can’t take your kids to a Taylor Swift concert and then write it off as a business expense. There are, however, some reasonable ways to save on taxes and meet multiple goals. Here is one of my favorite examples.
The grass needs to be cut at the rental property. You have a 14-year-old son. Pay him $50/week to mow the grass. That’s what you’d pay a professional service to do it. Over the course of the mowing season your kid makes $1,200. You have to issue him a W-2. However, his income is below the threshold for paying federal or state income tax. Because he is your child and under the age of 18, he does not have to pay Social Security or Medicare taxes, either. (So you don't have to bother with withholding these taxes.) He now has $1,200 of earned income tax free. You have a $1,200 deductible expense against your rental property business.
Open a Roth IRA for him and put the $1,200 in it. He can contribute the entire amount of his earned income up to $1,200. When he is ready to go to college he can pull that $1,200 out and spend it on college with no tax consequences. Long story short - you just got a $1,200 tax deduction for saving money for your kid’s college.
If you think you have a creative idea on how to get the most out of the tax benefits of being a real estate investor, it’s probably best to get a professional opinion on them first. Creative is good, until it crosses the line into illegal. Nobody wants that.
4. If You Earn Over $150K, Your Losses are Suspended. Our beloved government has classified rental activity as passive activity. (Which I find ironic, because most landlords I know are working their tails off!) When you lose money at a passive activity it is known as passive activity losses (PAL). PAL are only deductible against passive incomes....UNLESS the PAL is from residential real estate and your modified adjusted gross income is less than $100,000. If that is the case, then you are able to deduct up to $25,000 of PAL against other income (like your wages from a job). If your income is above $100,000 then the amount of PAL you can deduct is reduced. At $150,000 of modified adjusted gross income you can not deduct any PAL against other (non-passive) sources of income. However...
The PAL isn’t lost if you can’t deduct it. It is suspended. Suspended passive losses are carried over to future years. You can use the suspended passive losses against future passive income, or you can use them when you sell the property. I’ve written about this extensively elsewhere, but for now just be aware that your passive losses are suspended if your modified adjusted gross income is greater than $150,000 and that you still need to track those losses so that you can use them in the future.
5. Depreciation & Recapture. This is a very complicated topic, so I am just going to give you the two highest points in this article.
A. You must depreciate your rental property. I know you don’t want the value of your property to actually decrease, but that isn’t what depreciation means in this context. Depreciation is used to represent a method of recovery for the cost of your property. Instead of deducting the principal part of your mortgage, you deduct the cost of your property by taking a depreciation expense for it. Four things to remember about taking the depreciation expense:
(1) Only the building depreciates. The land does not depreciate. The land value must be removed from the overall value of the property when figuring your depreciation expense.
(2) If your building is residential rental property it depreciates in a straight line over 27.5 years. (Why 27.5 years? Because Congress says so.)
(3) If you make capital improvements to the building before it is placed in service as a rental property, the cost of those improvements is added to the basis of the building and depreciated over 27.5 years with the rest of the building.
(4) If you make capital improvements to the building after it is placed in service as a rental property, those costs are capitalized and depreciated separately over 27.5 years.
B. You must REPAY the depreciation expenses when you sell the property. Unless the property actually depreciated (which is rare). There are two things you should know about this:
(1) You can escape repaying the ‘depreciation recapture’ only if you die owning the property, or you do a 1031 exchange for another property.
(2) Even though repaying the depreciation is unpleasant in the year it is repaid, it is rare that taxpayers are net losers at the depreciation game. If you take the long view, even though you pay it back, you got an interest free loan from the IRS. How cool is that?
Despite number 5 having multiple parts to it, I am still going to call this my “Top 5” list. Being a landlord can be profitable. A big chunk of those profits is tied to the tax breaks you get for investing in real estate. Know what those tax breaks (and pitfalls) are before you blindly leap into landlording. If you have any questions or want some assistance in developing a real estate investing tax strategy, please contact me.
23 April 2018
Another tax season has officially come and gone. While I still have a couple dozen clients on extension to complete, I wanted to start blogging again. I like doing taxes, but only doing taxes for 12 hours a day, every day for weeks and weeks was starting to make me a little batty. I'm glad to mix it up a bit again.
I thought I’d kick things off with my annual tax season post mortem on the 5 biggest mistakes I saw taxpayers making during the tax season. These were either mistakes that were repeated often or mistakes that were so costly I want to ensure they remain very rare. Without further ado, let’s dig in!
1. Misunderstanding The Military Spouse Residency Relief Act
The military spouse residency relief act can be confusing, but I’m going to break down how Virginia implements it as simply as I can. If you are living in Virginia because your spouse is here on military orders, you have two options:
Several times this year I had clients tell me the military member (stationed in Virginia) was from (pick any state) Montana, but the spouse was a resident of (pick any other state) Ohio.
No. That isn’t how it works.
In this example, the non-military spouse can be from Montana or Virginia. To be from Montana the non-military spouse must have lived in Montana with the spouse and established residency in Montana before moving to Virginia.
There are dozens of details and permutations I have left out of this explanation, but that should cover 90% of the military families I see. Bottom line - as the spouse of a military member you don't have to pay taxes in Virginia if you are from the same state as the military member. Otherwise, you are paying taxes in Virginia.
2. Virginia Returns with the Non-Resident Military Member on Them
Nearly all married couples file their federal returns jointly. They will often get the most advantageous tax result by doing so. The do-it-yourselfers know this, so they prepare a joint federal return. Then it comes time to file their state taxes. He’s active duty and from Florida, and she is not. They know she has to pay taxes in Virginia, but he doesn’t. Let the battle with the software begin!
The states have a variety of ways to handle this situation. Virginia’s solution is that if one spouse is a VA resident and the other is not, then the resident spouse files separately in Virginia - even if they file jointly on their federal return. Most tax software hates that. It will try to steer you toward filing jointly in Virginia. Then his income shows up on the Virginia return and it doesn’t belong there. That’s when people come up with inventive ways to remove the non-Virginian's income from the Virginia return.
The fine folks in Richmond have no idea what your state of residency is. They only know that if you put somebody on the Virginia tax return and then invent some creative way to remove that person’s income, it’s wrong. They add it back on and send you a bill.
You have to remove the non-Virginian from the Virginia tax return. You can play with your software until you figure it out - a few people have cracked the code on that. (Don't ask me how they did it, though, I don't use that software.) Alternatively, you can paper-file your Virginia return. You can get downloadable forms for free from the Virginia Department of Revenue site.
3. Not Coordinating Withholding among Several Income Streams
Here is how this one normally goes: Martha earned $20,000 from her primary job during the year. She also started working a second job on nights and weekends, earning $20,000 from that. In addition, she receives $20,000 in pension benefits during the year. Altogether she has $60,000 of income. However, the HR folks at job 1, job 2. and the pension administrators don’t know about each other. As far as they know Martha is only earning the $20,000 per year they are paying her. They are withholding taxes as if her total tax bill is going to be based on $20,000 of income.
When Martha comes to see me and I figure her taxes based on the $60,000 she actually brought in, I am likely to find that she did not have enough taxes withheld and she is going to have to write checks to the IRS and VIrginia.
Getting your tax withholding right across multiple income streams can be tricky. The IRS online withholding calculator is pretty good at helping you figure it out. Just make sure you have pay stubs from all your income sources and your most recent tax return when you start. It will ask for a lot of data you won’t have at the ready in your memory banks.
4. Virginia Residents not Using VA529
I only saw this twice, but I hate to see any tax deductions go wasted, so I wanted to address it. Contributions to the Virginia 529 college savings plan are deductible from your Virginia income taxes. Despite this I noted 2 incidents where clients were paying taxes in Virginia and putting money into the 529 plan in another state.
There is no tax deduction for contributions to another state’s 529 plan. Virginia’s 529 plan has good choices, low fees, and can be used in other states, so I can’t think of a compelling reason not to use it if you are paying Virginia taxes. Unless, of course, you don’t like money. (Which would be a strange condition for somebody reading a tax blog!)
5. Charity Receipts
Those flimsy, blank receipts you get for donating items to Goodwill, The Salvation Army, Samaritan House, CHKD, DAV, etc. I have a real love-hate relationship with those things. I am glad the government is encouraging re-use of items, that people can get a tax break for donating their items to charity, and that poor people have access to a lot of used items at good prices to help them make ends meet. On the other hand many taxpayers are quite confused as to how to properly claim this deduction. They hand me their blank receipt, but when I ask what they had donated they look downright bewildered. They look at me as if to say, I gave stuff to charity and they gave me this blank receipt. Do something with it!
I can see how some confusion might happen. I can’t think of any other place where they hand you a blank receipt and expect you to know what to do. The thrift shop never explains it, either. The guy who takes in your stuff isn’t giving tax advice any time soon. He just hands you the receipt and you’re on your own. (The Thrift Shop isn't allowed to fill it out for you, btw. That's your job!)
You should take a few minutes and fill that out as soon as it is handed to you. The store isn’t going to fill it out for you. You aren’t going to remember what you donated 6 or 8 months later when it’s time to do your taxes. Take a little time to manage your taxes throughout the year. It is worth it!
That's my top 5 for this year. I hope you enjoyed it and there were some useful knowledge nuggets in there for you to use. If you have any questions don't hesitate to contact me.
08 January 2018
My plan is to write a new article for this tax blog at least once a week. It doesn’t always work out that way. Some interruptions to this plan are predictable. For example, I anticipate my blogging schedule will get interrupted during tax filing season (mid-January to mid-April). But this year the interruptions came earlier than expected. One thing that happened is that all my children came home for Christmas – that was a happy interruption.
There were a few others, too, but the biggest interruption (disruption?) I encountered is that just before Christmas something happened I was not anticipating – our federal government accomplished something. Both houses of Congress passed tax reform bills, they worked out the differences in a joint conference, and put a bill in front of the President – who signed it! (It was almost as if there was no dysfunction in Washington for a few days.)
Time will tell if this something our government accomplished with the new tax laws was a good thing or a bad thing. There were quite a lot of changes in the tax law, and I suspect we will ultimately judge some to be good and some to be bad. But since these changes are in effect NOW, people (like me) who plan tax strategies aren’t too keen on waiting to see how things work out in the long run. We need answers now to be able to plan and make strategies.
I have been reading (and reading and reading…) about this new tax law. I have a reasonably good understanding of it now, but there are some things that are just not yet knowable. The IRS has not yet had time to develop rules, forms, and instructions for the implementation of the new laws Congress handed them. The manner in which the IRS implements the changes will have a significant impact on future strategy.
Knowing that more is yet to be revealed, I still want to get some practical information about the new changes in this blog. I have received enough phone calls in the past few weeks to know there is an appetite for it. Instead of trying to eat the entire elephant I am going to stick to the issues I think will be of most interest to my clients and readers. These are the topics with which my clients have dealt with, or may need to deal with in the future. So, without further ado, here is my take on the provisions in the new tax law that will likely have the greatest impact on my clients. Remember, these are new rules for 2018. These changes will not impact the tax return you are about to file for 2017.
That’s where I am going to stop. It’s already a lot to process, and I am just scratching the surface of the tax law changes. The actual document is 1097 pages long, so it will take a lot of smart people a long time to fully digest it.
Fortunately, we have a year to ease into the changes. If new strategies arise during the year you can expect to hear from me. If you have questions, please contact me or ask during your tax prep appointment. I look forward to seeing you this year!
17 December 2017
Tax reform is in the news lately, and I have fielded more than a few questions about the anticipated impacts of the current proposals. I usually try to side-step the question. While I spend a lot of time analyzing tax laws I try not to spend too much time analyzing tax bills. I can’t predict what our government is going to do, and I don’t find a lot of value in trying to figure it out in advance. Hopefully you aren’t too distressed by that. If you are, look at it this way - if I could accurately predict what the government was going to do with tax laws and how that would impact each individual tax situation, you could not afford me.
I will make one observation on the flurry of activity coming out of the beltway, however; I believe we are about to see increased chaos at the state income tax level. Here’s why:
There are two bills floating around, one passed by the House and the other by the Senate. Our legislators are reportedly working to reconcile the differences between the two bills, so they can get something for the President to sign into law. Both bills contain the following provisions:
• Standard deduction nearly doubles
• Personal exemptions are eliminated
Unless the states scramble to change their own laws, both of those changes at the federal level will have significant impacts on state income tax returns. Let’s look at the impacts they would have on a Virginia income tax return. If you’re in another state, you may be able to use this discussion to determine if it will apply to your state’s income taxes as well.
Virginia is what we call a ‘conformity state’, meaning many of the tax laws in Virginia conform to federal tax law. The first line on a Virginia income tax return is “Federal AGI”, which is line 38 from your federal form 1040. That means that everything the federal government counted as income, and everything the federal government counted as an adjustment to income is embedded in the first line of your Virginia income tax return. There may be subsequent additions or subtractions to your federal adjusted gross income to calculate your Virginia adjusted gross income, but they start from the same point because Virginia conforms to federal tax law unless the Virginia code expressly stipulates otherwise.
Let’s look at the personal exemptions issue. Virginia currently allows you to take a $930 personal exemption for each person listed on your tax return - you, your spouse, and your dependents. The Virginia definition of ‘dependent’ (for tax purposes) conforms to the federal definition of dependent. If the federal personal exemptions go away, how and where are dependents going to be defined for Virginia tax purposes? If you don’t need to enter dependent information for your federal return, is Turbo Tax going to ask you for that information for your state return? Will personal exemptions on Virginia tax returns also need to be eliminated if the federal personal exemptions are eliminated?
To compensate for the loss of personal exemptions, the federal bills double the standard deduction. There is no bill pending in Virginia to double the standard deduction. If the Virginia personal exemption goes away, Virginia taxable income goes up.
Under Virginia law, if you claim the standard deduction on your federal return, you must claim the standard deduction on your Virginia return. If you itemize deductions on the federal return you must itemize deductions on your Virginia return. With the doubling of the federal standard deduction, many more taxpayers will elect to use the standard deduction on their federal return. That means they will be forced to use the standard deduction on their Virginia return.
The Virginia standard deduction is $3,000 for single filers and $6,000 for married couples filing jointly. Not much. In this situation, it might be better for someone to use the federal standard deduction on the federal return, but significantly better to itemize deductions on their Virginia tax return. This puts taxpayers in the position of needing to figure their taxes both ways (using the standard and itemized deductions) to determine which gives the best overall result. Is it best for your wallet to pay a high federal tax bill and a low Virginia tax bill, OR is it better for your wallet to pay a low federal tax bill and a high Virginia tax bill. Good luck getting Turbo Tax to help you through that. (I’m not trying to knock TT, but they would literally have to program the software to calculate this using the tax laws in the 43 states that have an income tax. That’s a tall order.)
One of the stated intentions of tax reform is to simplify filing for Americans. I don’t see that happening in the short term if you are required to file a state income tax return. State legislators will undoubtedly move to adjust their state tax laws once the federal tax law is settled. That strikes me as something that will likely take a few years to sort out. That means we are likely looking at a few years of changes before things settle down again and people know the most advantageous way to file.
If greater income tax simplicity becomes a reality down the road, then it may be worth the temporary increase in chaos, but I think temporary increase in chaos is inevitable with this iteration of tax reform. There are too many moving parts and interactions between Virginia law and federal law, and the impact to state returns does not seem to have been fully analyzed.
I am not advocating for or against the federal income tax proposals currently making headlines. I just wanted to point out that tax simplification is not a simple process. All tax software, including my rather expensive professional version, starts with the federal tax return and then uses the data from the federal return to populate the state tax return. If there is a disconnect between federal and state law I expect to see more people in my office this year who have completed and filed their federal tax return, but need help with their state return(s). Hopefully I am wrong. Time will tell.
If you need help with your taxes, please contact me.
10 December 2017
If you worked under a job covered by Social Security, but were then injured and unable to work for a year or more you may qualify for Social Security Disability payments. These payments can sometimes be the difference between solvency and insolvency for those who need them, but they can also cause tax complications. Nothing is easy when it comes to government programs, right? Social Security Disability Benefits are sometimes taxable, but sometimes not taxable. To further complicate things, there is such a backlog of claims your first payment might cover more than one year of benefits. If you were injured and applied for benefits in 2017 you might not receive any benefits until 2018, at which time you could receive a lump sum payment for benefits going back to the date you were injured. Under the tax code you generally pay taxes on money when it is received, so you could have a tax problem in the year you receive a large lump sum.
There is a way to fix a tax problem created by Social Security lump sum payments, but you must know the fix exists and how to use it. There is a provision known as Section 86(e) allowing you to elect to have the portion of the Social Security Benefit received for a prior year to be taxed as it would have been if it had been received in that prior year. You don't have to go back and amend that prior year return, you just have to calculate the tax as it would have been calculated on that return. This can provide a very nice tax benefit when it's needed. Let’s look at an example situation to take a closer look at how the problem develops and how it gets resolved.
John works in a job covered by social security. His wife Jenny is a school teacher, but their financial plan is for Jenny to take a few years off work to stay at home with their infant son. She may even stay out of work longer to have more children. Then life happens...in January 2016 John is injured. His doctor says he will not be able to work for at least a year, possibly longer. John applies for Social Security Disability Benefits.
Throughout 2016 John is unable to work. He is also unable to provide adequate care for their son on his own. Jenny stays at home to care for them both. They burn through their savings, but they make it. By early 2017 John is strong enough to look after their son, so Jenny goes back to work as a teacher, earning $48,000 for the year.
In July 2017 the Social Security Administration approves John’s application for disability benefits and pays him $15,000 to cover the period back to the time of his injury. $10,000 of this amount is for 2016, and $5,000 is for 2017. For the remainder of 2017 John receives disability benefits totaling an additional $5,000.
John receives a 1099-SSA from the Social Security Administration in January 2018 stating he received $20,000 in benefits from the SSA in 2016. While this is true, it is also a bit misleading, and poses a big tax disadvantage for John and Jenny. Social Security benefits are taxable based on the amount of other income you make. Up to 85% of the benefits can be taxed if you make more than $44,000 and file a joint return. ($34,000 if you file individually.)
In 2016 John was recovering and Jenny was taking care of her husband and son. They had very little income that year. If they had received $10,000 of the Social Security disability benefits during 2016 as they should have, they would not have to pay income taxes on any of it. But they didn’t receive it in 2016, they received it in 2017. In 2017 Jenny earned $48,000, so now 85% of the $20,000 Social Security benefit received in 2017 ($17,000) could be exposed to taxation.
Section 86(e) to the Rescue
There is a fix for this in Section 86(e) of the Internal Revenue Code, commonly called the “Lump Sum Election”. This allows the taxpayer to calculate the tax on the Social Security as it would have been calculated had it been received in a timely fashion. In our example, if John and Jenny had timely received the $10,000 of 2016 Social Security Disability benefits, that $10,000 would have been taxed at 0% (or, rather, it would not be included in taxable income). Therefore, they can claim a Lump Sum Social Security Payment Election under Section 86(e), and get the 2016 tax treatment on that amount on their 2017 tax return.
On their joint tax return John and Jenny will put the full amount ($20,000) from the 1099-SSA on line 20A. On line 20b (the taxable amount of their Social Security benefits) they will put $8,500. They arrived at $8,500 using worksheets in IRS Pub. 915. Essentially, they take the 2016 rate times the 2016 amount and add it to the 2017 rate times the 2017 amount. The 2016 rate was 0% times $10,000, plus the 2017 rate of 85% times $10,000.
The IRS has never issued guidance on how to formally make the Lump Sum Election, so taxpayers are advised to include a statement with their tax return indicating they have chosen the Lump Sum Social Security Benefit Payment Election Under Section 86(e). You may even want to show the math used to come up with the amount taxable you include on line 20b.
Be advised the election is not required. It is permissible to treat the entire lump sum as received in the current year if that is more advantageous to you. For example, if Jenny was still working in 2016, but not working in 2017, it would be more advantageous for them to pay the 2017 rate on the entire lump sum. In this situation, they would NOT elect to use Section 86(e) to apply the 2016 tax rate to part of the lump sum payment from Social Security.
Section 86(e) is one of those strange aspects of tax law that is highly useful, but not widely known. Most people never have to use it and virtually no one ever uses it more than once. It can save you quite a bit at tax time, though, if you can apply the Lump Sum Social Security Benefit Payment Exclusion to your advantage. If you find yourself in that position and you’re stuck, give me a call. If you know someone who received a large Social Security Disability payment covering multiple years, send them a link to this article. It might be very valuable to them!
03 December 2017
As I have written before, I am a fanboy of 529 plans in general and the Virginia 529 plan in particular. The Commonwealth has done an uncommonly good job at taking the federal guidelines for 529 plans and creating an efficient, effective, and user-friendly program. I like any program that gives us a tax break for education. What I particularly like about the 529 plans is that:
1. 529s are one of the few tax-advantaged higher education programs in which room & board is a qualified higher education expense. That’s good news if your child might eat or sleep at some point during their time at the university. I don’t know what planet our lawmakers are from when they don’t consider room and board necessary expenses for other college tax breaks. It was a significant chunk of what we spent on our children’s college educations, and we were glad we had the 529 plans in place to help us cover it.
2. Anyone can use the 529 plan. Most of the other tax breaks available for college have income limitations. Earn too much and you can’t take advantage of the program. Not so with the 529 plans. There is a limit to how much you can contribute, but there is no income barrier to participation.
3. Even if you don't plan far enough ahead to take advantage of the tax-deferred growth in a 529 plan, you can still get a tax break for your contribution by using the Virginia College Wealth program and running your education funds through a Virginia 529 account in the same year you make the payments. It's a nifty little loophole anyone can use.
As easy as Virginia 529 makes it to save for college, some mistakes can be made when you withdraw that will negate the great advantages you received for using a Virginia 529 plan. You can end up with a tax penalty if you aren’t careful. You can even wreck your eligibility for other (more valuable) college benefits. Here are 4 mistakes I see, and how to avoid them.
1. Using a 529 from a non-parent early in the student’s education. This is how this scenario frequently unwinds: Grandparents have a 529 for the student they started when they initially became proud grandparents. Now it's time for freshman year and Grandma and Grandpa take money out of the 529 and give it to the family to help with college expenses. That is unbelievably thoughtful and sounds wonderful, but it can have somewhat dire unintended consequences. Why? Because needs-based federal student aid is concerned with parent’s money and student’s money – and student’s money counts nearly 4 times as much as parent’s money when calculating eligibility for student aid. When Grandparents take money out of a 529 for a student, that counts as student money for federal student aid purposes. The grandparent’s helpfulness could get overshadowed by the student aid that gets lost as a result.
The solution here is to wait until the student’s junior year to tap into grandma and grandpa’s 529 money. There’s a built-in lag in income reporting to student aid. By the time the student aid folks are told about the grandparents 529 money, the student should be through their senior year.
2. Withdrawing money too early from the account. Here’s the scenario: You know the school is going to bill you on January 10th, so you withdraw money from your 529 plan on December 22nd so the money is ready and available when the bill arrives. Makes perfect sense, and you should be rewarded for being so prepared and organized. Except the IRS isn’t always concerned with what makes sense, or how this fits your personal method of organizing. Money withdrawn from a 529 in 2017 must be used to pay for college expenses in 2017. January is in 2018, so you can’t apply that 2017 withdrawn money against the 2018 college bill and keep it tax free.
The solution here is to wait until January to make the withdrawal for the January bill. You could also elect to do what we did, and withdraw from the 529 plan on a reimbursement basis. We would pay the college bills from current operating monies and then reimburse ourselves from the 529 after the fact. This had the added benefit of making our withdrawals more precise. We knew exactly how much we had spent on room and board by the time we made the withdrawal.
3. Withdrawing money to cover travel, commuting, and parking. As generous as the 529 plan is, there are still things that just aren’t covered. Travel, commuting, and parking are common expenses that are not allowable as qualified higher education expenses for the 529 program.
There is no solution for this. Plan ahead for these expenses, but not with your 529 money!
4. Assuming the 529 is only good for room and board if the student lives on campus. Every once in a while, I’ll find someone who believes you can only use the 529 money on dorm fees and pre-paid meal plans. It just isn’t so. You can use your 529 money for room and board off campus. The limitation is that you cannot claim a greater expense than what it would cost to put them in the dorms and buy the meal plan. If you want to put your son or daughter in the Ritz Carlton for a semester and let them eat caviar, knock yourself out. But...the most you can claim as a qualified higher education expense on your tax return is the same as it would cost to house and feed them on campus.
There isn’t a solution needed for this. Just be aware the student can live off campus and still use the 529 money. Also, be aware that it’s usually easier for me to take the posted on-campus rates from the university when I am calculating education expenses than it is for me to look at actual expenses.
The Virginia 529 plan is a great way tosave for college expenses. This is especially true if you know your student is going to be living on or near the campus. The important thing to remember is that you can accidentally make things worse with your 529 account if you aren't careful. When in doubt you should call me first.
26 November 2017
Readers should be aware the tax law signed buy the President on 22 December 2017 made this article obsolete. I leave it here for continuity and posterity.
As advertised last week, this week’s blog is about the ‘certain’ miscellaneous deductions you can take on Schedule A if you itemize your tax return. 'Certain’ miscellaneous deductions are subject to a “2% limitation” – meaning your deductions in this category must exceed 2% of your adjusted gross income (AGI) before they start to actually influence your taxes. Unreimbursed Employee Expenses are also subject to the 2% rule. Fortunately, Unreimbursed Employee Expenses and ‘Certain’ miscellaneous deductions are added together, so it makes it a bit easier to get above that 2% threshold to be able to get a deduction.
For example, Shawn is employed as an auto mechanic, and his 2017 AGI is $50,000. Like most auto mechanics he must bring his own tools to the job. Shawn spends $800 on tools in 2017. Shawn also has $900 of ‘certain’ miscellaneous deductions in 2017. Shawn’s combined Unreimbursed Employee Expenses and ‘Certain’ miscellaneous deductions is $1,700. 2% of Shawn’s AGI is $1,000 (.02 X $50,000). Therefore, Shawn can deduct $700 – the amount by which his combined Unreimbursed Employee Expenses and ‘Certain’ Miscellaneous Deductions exceeds 2% of his AGI.
Without further ado, here are the ‘Certain’ Miscellaneous Deductions:
Appraisal fees for a casualty loss or charitable contribution. Self-explanatory. If you have something appraised to claim it as a tax deduction, you can deduct the fee paid for the appraisal.
Casualty and theft losses from property used in performing services as an employee. While casualty and theft losses are deductible elsewhere on Schedule A, it may be more beneficial to take the deduction here if it was property used in the production of income. It can be added to other ‘certain’ miscellaneous deductions (and unreimbursed employee expenses) to help propel you over the 2% threshold. There is also a $100 per incident subtraction if the loss is claimed on the regular casualty and loss form - form 4684.
Clerical help and office rent in caring for investments. If you have investments generating taxable income and you need to rent office space or pay for clerical help to manage them, you can deduct those expenses.
Credit or Debit Card Convenience Fees for Paying Your Tax Bill. Both the IRS and Virginia will charge you a ‘convenience fee’ for using your debit or credit card to pay a tax bill. That fee can be deducted from your taxes.
Depreciation on home computers used for investments. If your home computer is helping you earn taxable income, you can claim a depreciation expense for it as a ‘certain’ miscellaneous deduction.
Excess deductions (including administrative expenses) allowed a beneficiary on termination of an estate or trust. If an estate’s total deduction in it’s final year exceed its income, the beneficiaries can deduct the excess losses on their individual returns.
Fees to collect interest and dividends. If you pay a broker or similar agent to collect interest or stock dividends for you, it can be deducted here. Note, this does not include the fee to buy or sell securities. That fee is used to adjust your capital gain or loss.
Hobby expenses, but generally not more than hobby income. If you have a hobby that generates income you can deduct the expenses of that hobby up to the amount of income it generates.
Indirect miscellaneous deductions from pass-through entities. If you are a member of a partnership, S-corporation, or a non-publicly traded mutual fund, you can deduct any passed-through deductions as miscellaneous deductions subject to the 2% limit.
Investment fees and expenses. You can deduct investment, custodial, and trust administration fees you pay for managing your investments that produce taxable income.
Legal fees related to producing or collecting taxable income or getting tax advice. If your legal fees are for income from your business, real estate investments, or farm, then it is better to deduct those as business expenses on the appropriate Schedule C, E, or F. However, if you received legal tax advice on a personal matter, such as your divorce, you can deduct it here.
Loss on deposits in an insolvent or bankrupt financial institution. If your bank or credit union becomes insolvent or bankrupt, you can deduct any lost deposits here. (Losses insured by FDIC are not deductible.)
Loss on traditional IRAs or Roth IRAs, when all amounts have been distributed to you. If you take a full distribution from your IRA and the amount you have recovered is less than the amount you contributed, you can deduct the losses on Schedule A.
Repayments of income. Repayments of taxable income received in a previous year of up to $3,000 are deductible, but subject to the 2% limit.
Repayments of social security benefits. If your repayments to SS in a tax year exceed the benefits received, you can deduct the net repayment from your taxes.
Safe deposit box rental, except for storing jewelry and other personal effects. The rental of a safe deposit box is only tax deductible if you are using it to store documents related to the production of income.
Service charges on dividend reinvestment plans. If you are a subscriber to a dividend reinvestment plan, you can deduct the service charges you pay to the plan for holding shares, reinvesting dividends, and keeping your records.
Tax advice fees. Ahem….AHEM! (But if you receive this advice for your business, real estate investments, or farm, then is it more efficiently deducted on the appropriate Schedule C, E, or F.)
Trustee's fees for your IRA, if separately billed and paid. The ordinary and necessary fees you pay to an IRA trustee are deductible if they are billed separately. This would normally apply to someone using a self-directed IRA.
That’s a rather long list, but if you worked your way through it you may have noticed a theme. These deductions are nearly all related to the production of income. The tax code our government has implemented would like to generously provide you with a tax break if you are trying to produce additional taxable income. As long as you exceed the 2% of AGI threshold, of course.
That 2% of AGI threshold is why I rarely get excited about ‘certain’ miscellaneous deductions (or unreimbursed employee expenses). A common scenario I deal with each year is a tax client asking me if they can deduct the $60 they spent on investment fees. The technical answer is ‘yes’, but in reality that $60 is never going to get over the 2% of AGI threshold, so even though we can record it as a deduction on your tax return, you are not receiving any benefit for it.
When I do get excited is when the deductions have exceeded the 2% threshold. That’s when clients probably feel like they are getting the third degree from me as I start asking additional questions, trying to unearth some additional ‘certain’ miscellaneous deductions. Hopefully, I explain everything sufficiently, so nobody thinks I am just sticking my beak into their business!
I’ll finish this ponderous post as I frequently do – with a reminder that taxes can be complex and confusing. Whenever you have any questions you can contact me. Don’t overpay your taxes because you are afraid to ask for help!
Paul D. Allen is a proud member of the National Association of Enrolled Agents, the National Association of Tax Professionals the Financial Planning Association of Hampton Roads, the National Association of Personal Financial Advisors (NAPFA), and The Tidewater Real Estate Investors Group. You can read more about Paul's background here.
Bought some software and then started having second thoughts? Stuck on a particular issue? Give me a call and ask about a consultation. I might be able to get you back on the path to finishing your own return.