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As part of the recent CARES Act, Treasury has been directed to provide US taxpayers with an advanced tax credit (a.k.a. 'Stimulus Check"). Here is a brief explanation of how they work, who will get one, how much they will get, and some things you may want to consider to maximize your benefit.
Possibly the best kept secret in all this mess is that self-employed taxpayers who need to take sick leave or family leave as a result of the coronavirus / COVID-19 pandemic will now qualify for special new tax credits when they file their 2020 tax return. Learn how to qualify and how to calculate your credit in this short video.
In case you missed it, the tax filing and paying deadline is extended until July 15, 2020. To whom does this apply and what's the best way to take advantage of the situation? Learn from this short video!
March 21, 2020
A short video to explain the changes to the filing deadlines release by the IRS and Virginia, and how the COVID-19 pandemic is impacting operations at PIM Tax Services.
PIM Tax Services will donate 100% of our profit from tax returns generated during the postponed period (4/15/2020 - 7/15/2020) to the Hampton Roads Community Foundation.
19 January 2019
I did not expect to be posting a blog article today, but much to my surprise, the IRS released a proposed Revenue Procedure late yesterday, and I felt like I needed to provide some information and guidance. (Treasury (the IRS) releases Revenue Procedures as formal guidance to taxpayers on how to apply the tax law.) The proposed Revenue Procedure is designed to clear up the confusion as to whether or not rental real estate qualifies for the new Section 199a “Qualified Business Income” deduction. I wasn’t surprised by the content of the proposed Revenue Procedure. I was surprised we received guidance before the tax season was officially underway! Clear guidance isn't nearly as abundant as I would like during normal times. With the government shutdown and big chunks of the IRS out on furlough I figured there was no way they could issue coherent and timely guidance. I was pleasantly surprised they gave us both. Let me break it down for you.
As part of the December 2017 tax reform - the Tax Cuts and Jobs Act (TCJA) - there is now a tax deduction written into the tax code known as the Section 199a deduction (cleverly named after the paragraph in the Internal Revenue Code that describes it.) You might also see it referred to as the Qualifying Business Income deduction or QBI deduction because it is a deduction on Qualifying Business Income (QBI). It’s complicated, but in a nutshell, qualifying pass through business can deduct 20% of their income, essentially making that 20% insulated from federal income taxes. It is a REALLY good deduction. Landlords want to be able to claim it, but questions lingered as to whether residential rental real estate was considered a 'qualifying business'.
After interim regulations came out in August, most tax pros believed holding out real property for the purpose of generating rents (a.k.a. being a landlord) would qualify for the Section 199a deduction. Count me among them. It seemed like that was Treasury’s intent, but there was still room to interpret the new law in different ways.
Yesterday’s release of the new proposed Revenue Procedure finally put that to rest.
What the Proposed Revenue Procedure Says
The proposed Revenue Procedure establishes a Safe Harbor for landlords looking to claim the Section 199a deduction. By establishing a Safe Harbor, the IRS is essentially saying, “If you have residential rental property and you comply with the following guidelines, then you will qualify for the Section 199a deduction.”
There are just 4 guidelines:
A) You must maintain separate books and records for your rental business.
(Paul’s interpretation: Do not run your real estate activities through your personal bank account. The Section 199a deduction is for BUSINESSES. You are expected to treat your real estate enterprise like a business in order to get this deduction.)
(B)(1) For tax years 2018 - 2022 you must work at least 250 hours per year on ‘rental services’. (I’ll explain rental services later.)
(B)(2) Beginning in 2023 you must work at least 250 hours per year for 3 of the previous 5 years on ‘rental services’. (I’m just trying to make it through January 2019, and they are giving me guidance on 2023 and beyond? Oy!)
(C) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following:
(1) hours of all services performed
(2) description of all services performed
(3) dates on which such services were performed
(4) who performed the services
(Paul’s interpretation: You need to clock in and clock out when you are working on your rental property business.)
Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019. (Paul’s interpretation: You don’t need these records for 2018.)
(D) You must attach a signed statement to your tax return indicating you are claiming the Section 199a deduction, and you are compliant with the proposed Revenue Procedure. It must also contain the following language: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”
The proposed Revenue Procedure describes rental services as follows:
The proposed Revenue Procedure is also careful to specifically exclude the following activities from qualifying as rental services:
There was some additional guidance in the proposed Revenue Procedure about how to aggregate (or not aggregate) your properties for your business enterprise, as well as a prohibition on mixing residential and commercial properties in the same enterprise. Those are important to a few people, but I don’t want to get into that yet. For now I just want to make sure the majority of my landlords know there is concrete guidance on whether and how to claim the section 199a deduction.
The IRS was also quick to point out that you are not precluded from claiming the Section 199a deduction just because you don't qualify for the Safe Harbor. You may still qualify for the Section 199a deduction even if you violate the guidelines in the proposed Revenue Procedure. Your unique facts and circumstances would need to be analyzed when making that decision
Bottom Line: Separate books and bank accounts, start keeping records of your rental service activities, and enjoy your Section 199a deduction!
If you still have questions, ask! (757) 407-4189
02 January 2019
I don’t regret one minute of my Navy career, but if I had realized how much fun it is to be an entrepreneur and business owner, I would have done it a long time ago. Building this tax business (and now building Redeployment Wealth Strategies with Sean) has been, and continues to be, both fun and gratifying. One of the most enjoyable aspects of these new careers is the opportunity to meet other entrepreneurs/small business owners. We are a strange and interesting breed, and I like spending time with (and helping whenever possible) other members of my tribe.
A question I frequently receive from clients with their own start-up business is how to protect profits from taxation. This question typically comes in the second or third year of business operations. The first year is rarely profitable for a new business as the costs involved with starting the business usually take up all the available revenue. After two or three years, however, many new businesses start to show a profit and people start to wonder if they are being as efficient as possible with their taxes. (Managing taxes being an essential task of the small business owner.)
My favorite response for sole-proprietors is to establish a Solo 401K. Not only does it allow the entrepreneur to avoid a good chunk of state and federal income taxes, but it also serves another purpose - retirement planning. Starting a business tends to consume all of one’s mental resources for the first few years. That's how it was for me. It seems like all my waking time was spent thinking about the business. Who has time for retirement planning? Most of us either forget about it altogether, decide to think about it ‘later’, or just figure we like what we are doing so much we aren’t ever going to retire anyway! (A haphazard planning strategy that ruffles my financial planner's feathers!)
As the name implies, a Solo 401K is designed for one person. As with nearly all government regulations, however, there are exceptions to the rule. If both you and your spouse work for the business, you can have a Solo 401K. If you have formed a partnership where only the partners are working in the business, you may also have a Solo 401K. If you have common-law employees in your business, you cannot use a Solo 401K. (You would need to establish a different retirement plan in which your employees can also participate.)
Solo 401Ks are also surprisingly easy to establish. All the large online brokerages (Vanguard, Fidelity, Schwab, TD Ameritrade, etc.) have fast and simple online applications. They are also easy to maintain administratively compared to 'regular' 401K plans. While a regular 401K plan requires additional tax returns and compliance documents, the Solo 401K only takes filling in a few extra lines of your current tax return each year.
Solo 401K Contributions:
What makes the Solo 401K so powerful as a tax planning tool is the ability to make tax-free contributions to it. There are two categories of contributions to a Solo 401K if you are under 50 and three categories of contributions if you are 50 & over. Let’s take a look at each:
Elective Deferral: This is essentially the same contribution as the one you may have made as an employee. (If you were in the military and participated in the TSP retirement plan, your contributions were officially known as your elective deferrals.) In 2019 you can contribute up to $19,000 into your Solo 401K via elective deferral. The caveat is that you have to earn at least that much from the business in order to make the contribution. In other words, your elective deferrals are limited to the smaller of $19,000 or 100% of your profit/compensation from the business.
Employer Contribution: If you were an employee you used to call this ‘matching money’. That’s the part you can put into the 401K as an employer. In 2019 that amount is limited to $56,000. Before you get delirious about that number, there are some important limitations to discuss. The first is that for self-employed people you are essentially limited to 20% of your total compensation net of the deduction you take for paying self-employment taxes. (There is a fancy formula and IRS worksheets to determine this limit, but 20% is pretty darn close. See IRS pub 560 is you want to see the formula and worksheets.) You also have to reduce that $56,000 limit by the amount of your elective deferrals. So, the combination of elective deferral and employer contribution into your Solo 401K cannot exceed $56,000. Note: the employer contribution for W-2 employees is 25% of compensation. If you have elected S-Corp tax treatment for your business, you are paid on a W-2, and only your W-2 income counts toward the Solo 401K limit. (The amount reported on your K-1 does not count as compensation for the purposes of calculating your Solo 401K contribution limits.)
Catch-Up Contribution: If you are 50 years old or older, you can also contribute an extra $6,000 to your Solo 401K. When you add that to your combined limit of $56,000 from your elective deferral and employer contribution, you have the potential to shelter up to $62,000 from state and federal taxes in 2019.
Here’s a table showing the types of Solo 401K contributions and the 2019 limit for each:
Lesser of $19,000 or 100% of earned income.
Lesser of $56,000* or 25% of salary, or
20% of compensation if self-employed**.
Catch-Up Contribution if 50 or over:
Total of all Contributions Cannot Exceed:
Under age 50: $56,000
Age 50 and Over: $62,000
* Cannot exceed $56,000 when combined with Elective Deferral.
** Compensation does not include S-Corp shareholder payouts from K-1 (W-2 income only from S-Corp).
Debbie, age 40, is the sole proprietor of a schedule C business. She does not have any employees, and in 2019 her income net of the deduction for self-employment taxes is $50,000. Her 2019 Solo 401K contribution limit is $29,000.
She can contribute up to $19,000 as her elective deferral.
She can contribute $10,000 (20% of $50,000) as the employer contribution.
She is under 50 and cannot make the catch-up contribution.
Jerry, age 55, is a sole proprietor who has elected S-Corp treatment. He is the only employee of his S-Corp. In 2019 he pays himself $100,000 on his W-2 and takes another $200,000 as a shareholder distribution on his K-1. His 2019 Solo 401K contribution limit is $50,000.
He can contribute $19,000 as his elective deferral.
He can contribute $25,000 (25% of $100,000) as his employer contribution. (The money from the K-1 does not count toward the employer contribution limit.)
He can contribute an additional $6,000 for the catch-up contribution.
Monique, age 28, is an RN by day, but has a side business she works nights and weekends. She files on a schedule C and in 2019 her side business makes $300,000. She contributes $8,000 to the 401K at her nursing job, and receives a 50% match from her nursing employer for $4,000.
She can contribute up to $48,000 to her Solo 401K
She can contribute $11,000 via elective deferral ($19,000 - $8,000; the elective deferral limit is cumulative no matter how many jobs one has.)
She can contribute up to $37,000 ($56,000 - $19,000) for the employer contribution. (The employer contribution limit is separate for unrelated employers, so the $4,000 match she received from her nursing job does not reduce the amount she can contribute to her Solo 401K.)
That last example was tricky, as I snuck in a couple of concepts without much explanation. While Solo 401ks are much simpler than regular 401Ks, there are still quite a few details. Strategies can also be tricky, as you may want to determine the path giving you the most advantageous tax situation if you need to pay self-employment taxes. I find modeling these scenarios is the best way to ensure you are getting the best tax result consistent with your retirement planning strategy. If you’d like to discuss strategies or run through a few scenarios with Solo 401K planning, give me a call.
22 December 2018
There are a multitude of TV shows these days dedicated to real estate flipping. Flipping, if you don’t know, is where you purchase a property, fix it up, and then sell it for a profit. I watch these shows from time to time. I notice they never talk about the tax implications of flipping houses. Probably because I might be the only person watching who would find a tax discussion interesting. That’s unfortunate, because the tax implications of real estate flipping have a significant impact on the flipper’s profitability - and I have found that most beginning flippers do not understand them.
Here’s the biggest tax issue with flipping houses (there are others, but this is the most misunderstood, and causes the most problems for new flippers): When you are in the business of flipping houses, the properties you are flipping are considered inventory. Selling inventory generates income taxed at regular income tax rates - not capital gains.
I think it is easy to understand why some people are not aware of this when they first start flipping houses. All their previous transactions with houses and property were treated as investments that generated capital gains or losses. If you buy a house to live in and then sell it, you can exclude the capital gain from the sale from your income. When you have a rental property for a few years, then sell it, you would have a capital gain or loss. Most beginning flippers have dealt with these scenarios, but have never dealt with a scenario where the house was treated as inventory.
In addition to being taxed as ordinary income, selling inventory also has two other attributes flippers need to know:
Jimmy finds a sweet flipping deal. There’s a property available for $100,000. With about $20,000 in basic remodeling Jimmy figures he can sell it for $185,000. He buys the property in July 2018 with the intent to complete the remodel and flip it by October. As often happens, Jimmy runs into time and cost overruns. By February 2019 he has spent $40,000 on repairs and remodeling, and the house is still not ready to put on the market. Being over budget, his cash flow is tight. It’s time to file his 2018 tax return. A big refund would surely be helpful. At least he can deduct all that money he has spent on this flip property, right?
This is where I gently tell Jimmy he cannot deduct the expenses from this flip on his 2018 taxes. His inventory has not sold, so he cannot yet deduct the cost of it.
There is one comparatively big tax benefit to getting inventory tax treatment of your real properties. Unfortunately, you have to lose a lot of money on your deal(s) to use it. Capital losses are limited to $3,000 per year. Capital losses in excess of $3,000 must be carried over to future tax years. But losses on inventory aren’t capital losses. Whatever you lose on the house in the year of the sale can be completely deducted from your taxes in that year.
You Probably do not Need an S-Corp.
Many flippers read somewhere they can save on taxes by electing taxation as an S-Corp, so they make that election prior to making their first flip. They’ve nearly always wasted more money than they’ve saved by doing so. Electing S-Corp tax treatment generates additional expenses for your business - payroll, additional tax filings, legal assistance, etc.. Unless your tax savings are more than those additional expenses, you’re wasting money.
The amount of flipping income you need to be earning each year to make having an S-Corp worthwhile varies. Tax pros use rules of thumb based on regional factors. Here in Virginia Beach I tell people they should be grossing no less than $40,000 annually from their flipping business before they elect S-Corp tax treatment. If you’re making less than that every year the additional cost of maintaining the S-Corp outweighs the tax benefits and you are wasting money. (Much of that wasted money would be going into my pocket, so you know I'm telling the truth!)
I Meant to Rent, but then I Flipped - Am I a Flipper Now?
Unexpected events happen to people. (They seem to happen to real estate investors at an alarmingly high rate!) Sometimes you get into a deal thinking you’re going to hold the property for a rental, but you end up selling it right after you fix it up. You make a bit of money on the deal. Is it taxed like a capital gain or as regular income? When you’re not sure if your activity makes you a flipper or a long-term investor, you should look at something called the Winthrop Factors.
The Internal Revenue Code does not specifically define when someone is a real estate investor (landlord) or when they are a dealer (flipper) in the trade or business of selling real estate. The courts have had to address this issue, and they have developed a set of guidelines known as the Winthrop Factors. These are the things to consider when determining the tax treatment of the activity:
A review of the Winthrop Factors indicates the courts are most interested in the intent of the taxpayer when the property was purchased. Absent any other proof of your intent, the courts are going to look at your prior real estate activities and will likely conclude that the sale in question fit the prior pattern. If you’ve been a landlord, they are likely to assume you intended the property as a rental. If you’ve been a flipper, they are likely to assume you intended to flip this property all along.
There are several ways to be profitable in real estate. Whatever your preferred approach to real estate investing, be clear on the tax implications of buying and holding rental properties vs. flipping. Do not let an unanticipated tax surprise ruin your margins. Educate yourself or hire a tax professional who can help guide you through the process. If you have any questions, please feel free to contact me.
13 October 2018
The Tax Cuts and Jobs Act (TCJA) is the official name for the tax law changes enacted at the end of 2017 and became effective for 2018. Among the many changes within the TCJA there are two in particular that I want to focus on for this article:
I have been doing some modeling of the impacts of those two changes, and something I discovered is those changes have created situations in which tax payers filing Virginia tax returns have the potential to needlessly pay higher taxes than necessary. I want Virginia taxpayers to be aware of those potential risks so they can avoid them. My problem was figuring out how to communicate some relatively complex tax topics into something that can be understood before it puts the reader into a tax-knowledge-induced coma. My solution was to make a presentation, narrate it, and turn it into a video that can be viewed. Here it is:
While the video specifically addresses Virginia tax issues, taxpayers filing tax returns in other states may face similar potential risks. I have not analyzed the impacts of the new tax laws on other states. Taxpayers filing in other states should consult a tax professional if they have concerns.
If you have some questions after watching the video 3 times, please contact me. If you understood it the first time, let me know that, too, so I know how much effort I need to put into making my videos comprehensible. Thanks!
30 September 2018
The Virginia ABLE-Now program allows you to deduct up to $2,000 of contributions per year from your Virginia income taxes. Or you could exploit a simple trick created by the Tax Cuts and Jobs Act to increase the amount you are able to deduct from your Virginia tax return!
I have made no secret over the years of my fondness for the Virginia 529 program. They provide a valuable product at a good price. The investment selections in the College Invest program are top notch index funds with low fees and expenses. On top of that, they manage to be one of the few government agencies I find less than dreadful to work with. It’s actually pretty slick. You can do almost everything online with very few hassles, and I never sign off angry. If only the Virginia 529 team could take over the DMV!
The latest and greatest addition to Virginia 529 is the ABLE-Now account. It isn’t for college savings, but rather a vehicle for persons with disabilities to be able to contribute to their own maintenance and care without jeopardizing their access to public support programs (MEDICAID). It’s a great program for people with disabilities, so if you know someone with a disability and you don’t know about the 529 ABLE program - go find out more! (The ABLE programs are state specific, so if you are not a Virginia resident, find the ABLE program for your state.)
Congress authorized the ABLE accounts under section 529 of the Internal Revenue Code, the same section of the code that authorizes states to implement college savings programs. In a rare moment of clarity, the Commonwealth of Virginia General Assembly determined section 529 linkage was sufficient to have the highly successful Virginia 529 college savings plan folks also take on implementation and management of the Virginia 529 ABLE program. Virginia calls their 529 ABLE program the Virginia 529 ABLE-Now program.
One of the provisions of the Tax Cuts and Jobs Act (TCJA) - the federal tax reform for 2018 - allows taxpayers to roll 529 college savings plan money into 529 ABLE accounts. This opens up some possibilities and opportunities because there are differences between the tax benefits of the Virginia 529 college savings program and the Virginia 529 ABLE-Now program. Let me list the salient ones for this tax tip I am about to share:
This sets up an opportunity to make contributions to a Virginia 529 college savings plan, take the larger tax deduction for making the contribution, and then rolling the money over to the Virginia 529 ABLE-Now program to be used for a person with disabilities. Let’s look at an example of how this would work.
Helen and Dale have a son, Tim, with a qualifying disability for the Virginia 529 ABLE-Now program. They assist Tim with opening a Virginia 529 ABLE-Now account. They want to contribute $8,000 to it, but they know if they do they will only be able to deduct $2,000 of that contribution from this year’s Virginia tax return. The other $6,000 will be carried over to future years, but they are planning to put $8,000 per year into the account. At that contribution rate they’ll never be able to get the tax deduction for all their contributions. Instead, Helen opens a Virginia 529 College Invest account with Tim as the beneficiary and Dale opens a Virginia 529 College Invest account with Tim as the beneficiary. Helen puts $4,000 into the account she opened and Dale puts $4,000 into the account he opened. They can now deduct all $8,000 from this year’s Virginia taxes. Later they can roll the money from the two Virginia 529 College Invest accounts into Tim’s Virginia 529 ABLE-Now account. Helen and Dale can deduct their entire contribution, and Tim has money he can use for his own support without impacting his ability to access MEDICAID if he needs it.
What Helen and Dale want to watch out for here is this pesky thing called the Step Transaction Doctrine. In the event they were audited (by Virginia), the Commissioner could determine that putting the money in the the Virginia 529 college savings plan was only done to serve the second step of rolling the money over to the Virginia 529 ABLE-Now account - and therefore the entire process materially constitutes a contribution to the Virginia 529 ABLE-Now account, with it’s lower deduction limits.
Such a ruling would be easy to avoid by leaving the money in the Virginia 529 College Invest program for a year or two. The investment choices within the College Invest program are quite good, and you could build a portfolio to mirror the same investments available in the Virginia 529-ABLE-Now account. You’d get the same return for the same risk and eliminate the possibility of losing the deduction to the Step Transaction Doctrine.
Virginia’s income tax rate is essentially 5.75%. By deducting $8,000 vice $2,000 each year from their Virginia taxes Helen and Dale would decrease their Virginia income tax bill by $345. Is that life altering money? Probably not. It is, however, a great guaranteed return on an investment of 20 or 30 minutes of your time to set up the accounts and execute the plan each year.
You'd probably also want to think twice before using the College America verson of the Virginia 529 college savings plan for this maneuver. College America is implemented through financial advisers, so there may be additional fees charged that reduce the value of the tax savings.
If you would like more information or to discuss the tax benefits of the Virginia 529 plans in greater detail, please contact me for a free initial consultation.
19 August 2018
In most aspects Virginia laws conform to federal income tax laws. This is somewhat evident when you notice the first line on your Virginia tax return is your federal adjusted gross income. In essence, Virginia is just saying, “We accept all the federal definitions of income and adjustments as our opening argument.”
That said, there are distinct differences between the Virginia tax system and the federal tax system. These are sometimes confusing and I find myself frequently answering questions with the phrase, “That’s true on your federal tax return, but not on your virginia tax return.”
Here are twelve examples of the differences between Virginia tax law and federal tax law:
A Virginia income tax return is more like the federal return than it is different from it. The differences, however, can make a real impact on your bottom line. Hopefully this article shed some light on those differences. If you still have questions, don't hesitate to contact me!
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.
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.