Welcome to the Tax Blog

News, information, and opinions about:

  • Federal, State, and Virginia Beach Taxes
  • The Tax Preparation Business
  • Tax Planning

If you have a question or comment, please drop me a line. Paul @ PIM Tax.

28 October 2015

I am very fortunate that I had a living Grandmother for so much of my life, but she passed away last week. She was withered and frail at the end, but her mind was still keen. She was widely revered in my family for her wit and wisdom. I am sure if I had ever asked her if she thought she was wise she would not admit to it. She would probably say she just had common sense. (Something that seems altogether less common in our society these days.)

I have been thinking of the things she used to do and say. Whatever you want to call it she taught me many life lessons, and one of them is to not be wasteful. She and my grandfather (who passed last year) lived comfortably on very little money. They knew how to stretch every nickel, and I learned from them how to do the same.

A penny saved is a penny earned is an old adage that I often heard growing up. I don't hear it as often these days, but I think it is just as valid as it ever was. Given the estimates on retirement savings rates I read about, it might be time to revive a penny saved is a penny earned. Saving & investing needs to be taught and encouraged with every generation of Americans.

Remarkably, some of my Grandmother's wisdom seems to have made it's way into the tax code. In some circumstances a penny saved can immediately be turned into more than a penny earned. To encourage individuals to save for retirement the government provides tax incentives. Certain types of saving can reduce your tax bill, resulting in an immediate gain on the amount you save.

Imagine that your top marginal rate is 25%. If you put $200/month into the retirement plan at work (or a traditional IRA) you would have $2400 saved at the end of one year. Since money put into an IRA comes off your taxes as an adjustment to income, you would also have reduced your tax bill by $600 (25% of $2400). That means it only cost you $1800 to save $2400. 180,000 pennies saved, 240,000 pennies earned. The guaranteed rate of return on your savings in that scenario is so incredibly high it boggles the mind. If an investment advisor promised you a 25% return on your investment I'd say run away as fast as you can, but in this case it's a certainty.

Let's not forget about state income taxes. In Virginia the top marginal rate is 5.75%. That saves you (if you're a Virginia resident) another $138 in taxes. That means it only cost you $1662 ($1800 - $138) to save $2400. Add to that total any matching contributions offered by your employer and you are in the investment return stratosphere right out of the gate.

To sweeten things even more for people at the lower end of the wage scale there is also a Saver's Credit. The Saver's Credit provides an additional retirement saving incentive in the form of a non-refundable tax credit of up to 50% of the amount saved. Income limitations and filing status impact the amount of the credit according to the table below. 

virginia beach tax preparation savers credit

Military members serving in a combat zone will often have an unusually low AGI because of the combat zone tax exclusion. What a great year to save that can be!

The federal government provides more incentives for paying for college than saving for college, but there are still some college savings tax benefits. These are found primarily in 529 college savings plans. 529 plans are sponsored by the various states and there is no federal tax benefits for your contributions to a 529 account. Most states, however, allow a state income tax deduction for your contributions. The Virginia 529 allows up to $4,000 to be deducted per account per year from your Virginia state income taxes. At a top marginal rate of 5.75% that is an immediate tax savings of $230 per $4,000 contributed. Or as I like to say, it only cost me $3,770 to save $4,000. 

Money in a 529 plan grows tax free and is exempt from both state and federal taxes if it is used to pay for a qualifying higher education expense (QHEE). If you saved $166.67/month for 15 years ($2,000/year) and it grew at a reasonable 0.5% compounded monthly (6.168% APY) you would have invested $30,000 and have $48,470.75. The tax benefit of having that $18,470.75 (the growth on your $30,000 investment) growing tax free is $5,679.76 (marginal rate of 25% federal and 5.75% Virginia). $5,679.76 will buy you a semester of tuition at James Madison University. (I know, I just paid for one!)

The bottom line to all of this is that my Grandmother was right. A penny saved is a penny earned. And if your saving also gets you additional tax benefits your saved penny turns into pennies very quickly. If you want to explore ways to increase your tax savings, please contact me.

21 October 2015

tax prep virginia beach virginia 529 loopholeHow much is your time worth? Would you fill out a couple of forms that might take you 20 - 30 minutes for $230? If you will be paying college expenses one day and you pay taxes in the state of Virginia you can get that $230 every year if you want it. If you're really motivated, you might be able to fill out some additional paperwork and collect an additional $230 every time you do.

Here's the deal - the Virginia 529 plan offers Virginia residents the opportunity to deduct up to $4,000 annually from their Virginia Adjusted Gross Income for each Virginia 529 plan they own and contribute to. You can deduct your contributions dollar-for-dollar up to $4,000 for each account you put money in, as long as you are also the owner of that account. The top marginal income tax rate in Virginia is 5.75%, meaning you can save $230 each time you deduct $4,000 from your Virginia AGI.

Virginia also allows a carryover of any unused deduction. If you contribute $10,000 to a single account in a year you can deduct $4,000 for that tax year, $4,000 in the next tax year and $2,000 in the tax year after that.

Virginia 529 plans are individual in nature, and can only have one owner. But beneficiaries - the person you intend to use the money - can have multiple accounts as long as the total of all accounts for one beneficiary remains below $350,000. Meaning...you can be the owner for an account for your child, and your spouse can be the owner of another Virginia 529 account for the same child. If you each contribute $4,000 to your respective accounts, then you can take $8,000 off the Virginia AGI on your joint state income tax return.  Have two children? If you and your spouse both open an account for each child and you put $4,000 in each of those four accounts, you can deduct $16,000 from your Virginia AGI in a single year. That's a tax savings of $920 that year!

Here's a nifty concept: there is no minimum time requirement for your money to be in the Virginia 529 account to qualify for the tax benefit. In other words, you can deposit the money into the Virginia 529 account, take it out a week later, and still qualify for the state income tax deduction. Just make sure you have qualifying higher education expenses (QHEE) in the amount of the 529 distribution and your tax deduction is yours to keep.

There are 4 Virginia 529 programs to choose from, but the best for a short time frame is called College Wealth. You essentially open a bank account at BB&T or Union Bank & Trust and deposit the money there. Make sure you get the right forms to characterize the account as being within the Virginia 529 program. Your money sits in the bank earning higher than normal bank savings interest (1% on savings last I checked - it varies) and it's FDIC insured. There are better plans for long term Virginia 529 investing, but if you're just doing a quick turnaround for the tax deduction the bank account is the lowest risk way to go.

There are several ways to get your money out of the College Wealth account, but I found the easiest is to have them send me a check. You request a withdrawal via your account on the Virginia 529 website and tell them where you want the check sent.  It's not lightening fast, but it is sufficient. I requested my most recent withdrawal on August 30 and I received the check in the mail on September 8. Plenty of time to pay my son's bills at James Madison University.

DO NOT take your money out of another 529 account and cycle it through a College Wealth account. That will count as 2 withdrawals for education. You will have to account for QHEE to cover both distributions or face the tax and penalties for an unqualified withdrawal.

529s are a great tax deduction, but if you qualify for the American Opportunity Credit or the Lifetime Learning Credit you will likely get a larger tax benefit using one of those tax credits. Make sure your use of the Virginia 529 does not interfere with your eligibility for those other more valuable tax credits for education. The good news is that unlike the AOC and LLC, you can use 529 money for room and board, so it is possible to take advantage of more than one tax break for education per student per year. You can get the AOC for the tuition expense and the 529 tax benefits for paying room and board. You just need to keep things organized and coordinated (and documented for tax purposes!). If you have any questions please contact me.

14 October 2015

Virginia beach tax preparation self employment taxesPayroll Taxes go by many names. Of the ones that are fit to print in a family blog you might know them better as social security taxes, medicare taxes, FICA, or self-employment taxes. These are all accurate to a degree, but payroll taxes covers all of them, so that's how I'll refer to them.

Payroll taxes are the federal taxes collected to support the Social Security and Medicare programs. The rate of taxation is 6.2% of wages up to $118,500 (in 2015) for Social Security (with a matching amount from your employer) and 1.45% of wages for Medicare (with a matching amount from your employer). There is no wage cap for the Medicare tax. There is, however, an additional Medicare tax of 0.9% on wages greater than $200,000 for single tax filers and $250,000 if you are married filing jointly. (Employers are not required to match the additional Medicare tax.)

Note that payroll taxes are paid only on wages, salary, or tips. Income from (real estate) rents or investments are not subject to payroll taxes. Although, the 3.8% Net Investment Income Tax to support Medicare definitely makes this a grey area.

For the majority of taxpayers - wage-earning employees earning less than $200,000 per year - payroll taxes are fairly straight-forward. You have 7.65% of your gross income withheld from every paycheck. That money is sent off to the government in exchange for the promise that when we are older there will be a retirement stipend and healthcare benefits waiting for us.

If you're not in that group of taxpayers working as employees for $200,000 or less, there are some additional complexities to the payroll tax system that you should probably know.

The Additional Medicare Tax

As previously stated, if you are single and earning more than $200,000 per year, or MFJ and earning over $250,000, you are required to pay an additional medicare tax of 0.9%. Your employer is required to withhold the additional tax from your salary and pay it to the trust fund for you. However, your employer might not be aware of all of your income. Let's look at some examples:

Stan is single and has two consulting jobs. ABC company pays him $140,000 per year and XYZ company pays him $175,000. Stan is required to pay the additional Medicare tax on $115,000 - the amount his combined $315,000 income exceeds the $200,000 threshold for single filers. But, neither ABC nor XYZ is withholding the additional Medicare tax from his salary. The companies' payroll departments are not aware that Stan's total income requires him to pay the additional Medicare tax.

Rita and Frank are married and file jointly. Rita makes $190,000 as a lawyer at the firm of Dewey, Cheatham & Howe. Frank also earns $190,000 per year as an engineer for Wobbles Construction.  When they file they will owe the 0.9% additional Medicare tax on $130,000, the amount their combined $380,000 exceeds the $250,000 threshold for MJF taxpayers. Again, neither employer is withholding the additional Medicare tax.

If your employer does not withhold the tax you are still required to pay it. Your options for this are to adjust your withholding on your W-4 to account for the additional Medicare tax, make quarterly payments to the IRS, or pay it at the end of the year when you file your taxes. Be aware, however, that if you wait until the end of the year to pay it you could find yourself subject to a penalty for the under withholding of tax.

Self-Employment Taxes

People who are self-employed are required to pay both the employee and employer share of payroll taxes. When combined these are known as self-employment taxes. There is a bit of a strange formula for calculating the self-employment tax. If you just left it at 2 X 7.65% = 15.3% to cover the 7.65% paid by the employer and employee you would end up paying at a higher rate than an employed wage-earner. Instead, you need to account for the fact the 7.65% paid by the employer is never part of the employee's gross wages. Therefore the self-employment tax rate is [15.3% X (1 - 0.0765)] = [15.3% X .9235] = 14.130%.

I have added a few slides that better explain this formula:

 

Half of self-employment taxes are also taken as an adjustment to income on the front page of form 1040. This makes sense (hard to believe sense sometimes makes it into the tax code, but in this case it did!). People who work as employees are not required to pay federal income taxes on the amount their employer pays in payroll taxes on their behalf, so it is only fair the self-employed are afforded that same allowance.

One final note on payroll taxes. If you are an employer and you withhold payroll taxes from your employees, make certain you are paying those taxes to the government as required. The government takes a very stern stance on the matter. If you fail to pay your regular taxes it is considered stealing from the government, and you will pay a small penalty for doing it. However, if you fail to pay payroll taxes withheld from your employees it is considered stealing from your workers. The penalty for doing that is 100% of the tax owed and can also land you in prison. Business people are frequently creative financiers, but I would strongly caution you against getting creative with payroll taxes. It is not worth it.

If you have any questions about payroll taxes, please contact me.

07 October 2015

No More IRS ProblemsThe IRS assigns a strange relationship between tax preparers and their clients. When preparing your taxes I am allowed to believe what you tell me about nearly anything related to your return. I am not required to make you prove what you tell me about your taxes is the truth. You can tell me you purchased a giraffe as a qualified higher education expense for college, and I don't need you to prove to me that it was a legitimate expense. I can put the giraffe on your tax return and file it. My only requirement is to inform you that if the IRS reviews your return and disallows the expense for the giraffe you will have to pay taxes plus penalties and interest.

Unfortunately, this IRS-allowed relationship between us could be a horrible disservice to you as a taxpayer and me as a tax professional. If I put a giraffe down as an education expense knowing the IRS is going to penalize you for it you would not be getting your money's worth out of me. You deserve the best advice possible, and to give the best advice I need to ask questions. If you tried to expense a giraffe, I would ask questions. I would ask a lot of questions.

Here's why - because even though you don't have to prove anything to me, if you are audited you have to prove everything to the IRS. The burden of proof is on you. If you can't substantiate your claim for a tax write-off it will be disallowed, your tax bill will be changed, and you will owe taxes, interest, and (probably) penalties on the amount they determine you have underpaid.

IRS: You deducted $2,000 for painting your rental home; where is the invoice?

IRS: You claimed 5,000 miles as a business expense; show me your vehicle logs.

IRS: You claimed a home office deduction; show me your office.

IRS: You deducted those clothes as a work expense; show me where your employer has required you to have those clothes (and that you can't use them for anything else).

If you can't prove your expenses to the satisfaction of the IRS the deductions will come off your tax return, and you will pay. I don't want you to be in that position. Not on my watch.

If you are my client and I am asking you questions it isn't because I don't believe you. It's because I know what the IRS expects and I want to make sure you are able to substantiate your deductions. I am not challenging you. I am not the IRS. I don't work for the IRS. I work for you. As your advisor I want to be certain the position we are taking on your tax return is defensible if it gets challenged by the IRS. I find that out by asking you questions about your tax claims. As long as there is a reasonable basis for your claims I am happy to put them on your tax return.

My Reputation as a Tax Preparer Matters

There's one more part to this story. I can represent my clients to the IRS in the event of an audit. You can authorize me to deal with the IRS on your behalf, and you never have to talk to them at all. Many clients prefer to let a knowledgeable, experienced professional represent them during an audit. It makes perfect sense.

The local IRS office is relatively small. Professional tax preparers in this region deal with the same IRS agents over and over. We get to know each other. Now let's suppose you are being audited and you want me to represent you. How would you want the IRS agent sitting across the table to perceive me? Would you prefer they knew me as a tax professional that dotted his i's and crossed his t's, or would you prefer my reputation among the auditors was that I'm a guy who lets his clients claim outlandish things on their tax returns without ever asking any questions? Clearly you'd want me to have a sterling reputation with the IRS while I was representing you.

To have that sterling reputation it is important for me to be thorough on every single tax return I prepare.  The IRS agents know if they are dealing with a true professional or some frivolous hack. If I am not thorough they know it, and I do a disservice to you and to all of my other clients who want the best representation they can get when the IRS comes knocking. IRS auditors are looking for tax cheaters and frauds. They don't want to waste their time looking at tax returns that are probably correct. If they know I am a guy who usually gets it right they don't look at too many of my returns. Conversely, if they know I am a guy who likes to "take chances" on the returns I prepare they are going to look at many more of the returns I file. I don't want that. You don't want that.

The IRS allows me to provide poor service to my clients by preparing tax returns with unsubstantiated claims. I won't do it, though. My reputation with the IRS is too valuable for me to put at risk. I will work hard to get you every single tax break we can get, but when I am representing clients to the IRS I want to be in a position to win. It matters.

30 September 2015

virginia beach tax preparation military tax break rentalI was on active duty with the US Navy for just under 24 years. During my service we relocated 7 times, finally ending up in Virginia Beach for my last three tours and retirement. (We like it here.) I was actually fortunate compared to many of my fellow service members. Most of my friends were moving more often than I was. Military families move a lot.

Moving that often makes home ownership a frightening prospect. You seem to just get settled and you're moving again. You have to put your house on the market and hope it sells for a price that doesn't wreck your family finances, or you have to deal with leasing it to someone that you hope takes decent care of your biggest investment. Then, when your house no longer qualifies as your primary residence, you end up owing capital gains taxes when you sell it. Many military families prefer to rent rather than buy just to limit the unknowns to their already strained family budget.

However - President Bush signed a law in 2003 that took some of the scariness out of home ownership for military personnel, If you haven't heard about it you may want to keep reading. It can be worth some decent money.

The Military Family Tax Relief Act, as it was called, suspends the primary residence use test rules for military personnel for up to 10 years. Under the use test rules, in order to qualify for the capital gain exclusion for the sale of your primary residence you must have lived in the house for at least 2 of the 5 years immediately prior to the sale. With the 10-year suspension under the Military Family Tax Relief Act you can meet the use test if you lived in the house for 2 of the 15 years immediately prior to the sale. To qualify for the suspension you must be on PCS orders more than 50 miles from your residence, or relocated to government provided housing.

I think an example is the best way to explain what all of that means. The couple pictured above are Duane and Lareese. I worked with Duane in 2011 when I was deployed as a civilian. I used their names and picture, but have completely manufactured the facts below in order to illustrate the specific tax benefit.

Scenario: Duane and Lareese are married. Duane is active duty military, stationed in Virginia Beach. They purchase a house for $250,000 and live in it for nearly 3 years and then Duane receives PCS orders to the west coast. They could sell their house for $250,000 and (more or less) break even, or they could rent it. Duane and Lareese decide to become landlords and lease their home to another family. Duane stays on the west coast for several tours. After being out of their Virginia Beach home for 12 years Duane and Lareese decide to sell it. The house has had some time to appreciate in value and sells for $350,000.

Tax implications:

1. Depreciation - net gain $17,455. As landlords, Duane and Lareese take a business deduction for depreciation on their house. When the house was placed in service as a rental unit their basis in it was $250,000 minus the value of the land. Only the building can be depreciated. The value of the land does not depreciate. The land was worth $90,000, so Duane and Lareese's basis in the house (for depreciation purposes) is $160,000. Residential rental properties depreciate over a period of 27.5 years. Over the 12 years it was a rental property the total depreciation was $69,818. In the 25% top marginal rate Duane and Lareese pocket $17,455 in tax savings over the 12 year period the house was rented.

2. Capital Gains Taxes - net gain $15,000. Using the 10-year suspension of the use test rules, the house still qualifies as Duane and Lareese's primary residence (they lived in it 3 of the previous 15 years). This allows up to $500,000 in capital gains to be excluded from capital gains taxes. They purchased the house and the land for $250,000 and depreciated the house by $69,818, so their basis at the time of sale was $180,182.  They sold the home for $350,000 for a gain of $169,818. The portion of gain attributable to recapturing the depreciation is NOT excludable from taxes1, but the rest of the the gain is.  Duane and Lareese would normally pay capital gains at 15%, but due to his military service they can avoid paying capital gains taxes on $100,000 of this sale. This results in a tax benefit of $15,000.

Add the depreciation and capital gains tax savings together and Duane and Lareese netted $32,445 in additional tax benefits for Duane's active duty service. That averages to over $2,700 per year they can keep in their pockets. That would have been darn good money to work into our family budget when I was on active duty. (It still would be!)

There are many additional factors when considering whether to convert your house to a rental property, but don't overlook this tremendous tax benefit available to military personnel. It might tip the scales. Everyone's specific situation is a different. If you have questions, please contact me.

1Some or all of the unrecaptured gain from the depreciation of the house while it was a rental property might be excludable from taxes, depending on your taxable income. A year you received a combat zone exclusion for your military pay might be the best year to sell to take advantage of some additional tax benefits.

 

23 September 2015

Surface Transportation and Veterans Health Care Choice Improvement Act of 2015

Virginia beach tax preparation new Tax LawThat's a mouthful, eh? That's the name of a law President Obama signed on 31 July 2015. Even if you heard about it, I am willing to bet you didn't know there are some changes to the tax law in there, did you? There were quite a few changes, actually, but since they don't impact every American it didn't get a lot of attention from the media. Strangely, tax law changes are not mentioned anywhere in the title of the new law!

Here's the short version of the changes:

Change of Due Date for Partnership Returns (Form 1065). Beginning in tax year 2016 Partnership Returns will need to be filed by the 15th day of the third month after the tax year. For nearly everyone that means March 15, 2017. If your partnership's tax year is different from the calendar year it's going to be different. Form1065 (Partnership Return) will still be due on April 15, 2016 for tax year 2015.

C Corp Returns Due Date. Just the opposite of the partnership return. The due date was previously March 15, but has been moved to April 15. For corporations that do not use the calendar year as their tax year the due date is the 15th day of the 4th month after the tax year concludes. This change also takes effect for the tax FILING season in 2017.

Additional Information on Mortgage Interest Statements. Also beginning in 2017, mortgage lenders will be required to include the address of the property securing the loan, the loan origination date, and the principal balance at the beginning of the calendar year on Form 1098 Mortgage Interest Statement. I am happy about this change. There has been some confusion in the past.

Consistent Basis Reporting Between Estates and Beneficiaries. Beneficiaries receive a stepped-up basis in inherited property (such as a house). This means if the house is valued at $300,000 on the date of death, the beneficiary's basis in the property (for sale purposes) will be $300,000. For a while there has been a conflict between the estate administrator trying to keep property valuations low in order to keep estate taxes low, and the beneficiary trying to keep the valuation high so that his basis is high. The new law requires the estate administrator to include the valuation of each individual property with the estate tax return - with copies to the beneficiaries.

Note: Due to the (currently) large estate tax exclusion ($5.43 million) estate returns are only required to be filed on the relatively small number of estates exceeding that value. There are, however, some reasons to file an estate return even if it isn't required. Consistent reporting of basis between estate and beneficiary is now another reason to consider filing an estate return even if the estate value is below the requirement threshold.

Foreign Bank Account Reporting (FBAR) Dates. If you have more than $10,000 total in overseas banks you have to report it on FinCen Form114. The due date was formerly June 30, but has been moved back to April 15. While that seems like it raises the burden on the taxpayer to get the Form 114 filed, the new law adds (for the first time) the possibility of getting a 6-month extension to file. Like the other laws, it takes effect in 2016 for the 2017 tax filing.

There were a few other tax items in this new law, but those are the main points. What any of the new tax provisions have to do with surface transportation or veteran's health care is beyond me. I strongly suspect I would not enjoy a front row seat to see how the legislative sausage gets made in Washington. I prefer things simpler - like putting new tax laws in a bill called The New Tax Laws for 2015 Act. Direct and to the point!

16 September 2015

Those of us who work in the tax field tend to throw words and terms around that most people don't use on a regular basis. One such term is 'Top Marginal Rate'. I thought I'd take a little time to explain what this term means, and why it is important.

Our federal tax code is progressive, meaning as income increases it gets taxed at a progressively higher rate. These different rates are known as the marginal rates (or tax brackets), and they change every few years as the Congress and the President come to an agreement on who should be paying what, and how much.There are different marginal rate schedules for each filing status. The current marginal rate schedules for Single, MFJ, and HoH are shown in the table below.

tax preparation virginia beach marginal rates3

As you can see, we currently have 7 different marginal rates ranging from 10% to 39.6%, and the different filing statuses pass through them at different levels of taxable income. Note this is TAXABLE income, not your gross income or your AGI. This is the income you are taxed on after all adjustments, deductions, and exemptions are taken into consideration. (Taxable income is found on Line 43 of form 1040)

The table is good, but I think a chart does a better job of demonstrating the comparison between marginal tax rates.

tax preparation virginia beach marginal rates

At the lower income levels (where the vast majority of us live) the comparison is fairly dramatic. A single person zips through the lower marginal rates and has income exposed to the 25% and 28% rates much earlier than the MFJ and HoH filers. A single filer with $100,000 of taxable income will pay significantly more income tax than an MFJ filer with $100,000 of taxable income.

Your top marginal rate is the highest marginal rate at which your income is taxed. It is an important number to know because any tax savings you can generate are saved at your top marginal rate. Once again, I think a graphic will be useful. Let's take a look at a single filer and give her a fairly high taxable income of $300,000 to make it interesting.

military discount tax prep virginia beach

This taxpayer's taxable income level exposes her income to 5 different tax rates, the highest being the 33% rate. The amounts of income exposed to each different rate are shown, as well as the tax generated at each rate and the total tax (of $82,607*). If this taxpayer's gross income (before deductions and exemptions) is $340,000 then her effective tax rate is $82,607/$340,000 = 24.3%.

Effective tax rates, while useful, can be misleading. Say, for example, this taxpayer was thinking about increasing her contribution to her 401K plan by $10,000. If she was analyzing her situation using her effective rate she would conclude this increased contribution would save her $2,430 (24.3% of $10,000) in taxes per year. However, this analysis is incorrect. Her top marginal rate is 33%. Any reduction in income exposed to taxes comes at that rate. Looking at the graph it comes off the top of the stack. Instead of saving $2,430 in taxes she would be saving $3,300 (33% of $10,000). Nearly $900 more in tax benefits than she originally believed.

Some quick math shows that her $10,000 contribution to her 401K results in an immediate tax savings of $3,300 - an instantaneous return on investment of 33%. If an investment advisor was promising you that kind of return I'd tell you it was a scam - too good to be true, but in this case the numbers are very, very real. You can create your own stellar ROI just by saving taxes at your top marginal rate.

The most important thing to remember from this post is that any tax savings you come up with are at your top marginal rate. If you have any questions or concerns, please contact me.

 

*For this example I have discounted that this taxpayer would also likely be exposed to Alternative Minimum Tax, the Medicare Surtax, and possibly the Net Investment Income Tax.

09 September 2015

There are 79 numbered lines on a (2014) form 1040, and 3 of them are about getting a tax break for college education. Line 34 is the Tuition and Fees Deduction (which is actually an adjustment). Line 50 is for education credits from form 8863 - the American Opportunity Credit (AOC) and Lifetime Learning Credit (LLC). Line 68 is for the refundable portion of the AOC.

You can only use ONE of those credits for any given qualifying higher education expense (QHEE). So, what we all want to know is - which is the best?

The AOC is the best tax benefit for education available. If you qualify for it, you should use it. Unfortunately, the AOC is also the most restrictive. Not everyone qualifies to use it. It can only be used four times per individual, and is only for undergraduate education expenses. If a student is pursuing a graduate degree or is taking longer than four years to get an undergraduate degree you will run out of eligibility for AOC before you run out of college expenses. When that happens you need to choose between the Lifetime Learning Credit and the Tuition and Fees Deduction.

In most cases the Lifetime Learning Credit will provide the greatest tax advantage - but not always. There are times when the Tuition and Fees Deduction will be better. I made the flowchart below that gives some guidance on when LLC is always better, and when Tuition and Fees Deduction is always better. Unfortunately, that leaves some grey area where it might be one or the other, so I left that to "come see me". Any flow chart that covered all of the variables involved would be half eyesore and half comic mess. The flow chart I built is complex enough that I also built a slideshow (bottom of page) you can use to go step-by-step through the flowchart.

tax prep virginia beach education credits flowchart

The value of the Tuition and Fees Deduction depends on your top marginal tax rate. Deductions reduce the amount of your income that is subject to taxes. If you had $4,000 worth of qualifying expenses and your top marginal tax rate was 25%, the benefit to you would be $1,000. But if your top marginal tax rate was 15%, those same $4,000 worth of qualifying expenses would only be worth $600.

Because the Tuition and Fees Deduction is completely phased out for MFJ taxpayers with modified adjusted gross income over $160,000 ($80,000 for single and HoH), the maximum top marginal rate you can be in and still qualify for the Tuition and Fees Deduction is 25%. The cap on qualifying expenses under the Tuition and Fees Deduction is $4,000. Therefore the largest possible benefit of the Tuition and Fees Deduction is $1,000 - the highest qualifying top marginal tax rate (25%) times the highest amount of qualifying expenses ($4,000).

By comparison, the LLC can be worth up to $2,000. It is a tax credit given at the fixed rate of 20% on the first $10,000 of QHEE. If you have the maximum qualifying expenses ($10,000) you can take a tax credit for 20% of that amount, or $2,000. Therefore, anytime your qualifying expenses exceed $5,000, you will always take the LLC, because your credit will be over $1,000 and eclipse the highest possible benefit of the Tuition and Fees Deduction which tops out at $1,000.

The Lifetime Learning Credit is phased out at a lower income threshold than the Tuition and Fees Deduction. If you're MFJ with an MAGI over $128,000 you cannot claim the LLC. $64,000 for single and HoH filers. (A reduction of the LLC benefit begins at $108,000 and $54,000 respectively.) If your income gets you completely phased out of LLC, you may still qualify for the Tuition and Fees Deduction.

The different phaseout ranges, different tax rates, and differing levels of qualifying expenses add too many variables to construct a flowchart covering ALL of the possibilities. If you don't fall into either the obviously Lifetime Learning Credit category (over $5,000 of qualifying expenses), or the obviously Tuition and Fees Deduction category (income too high for LLC) then you should come see me. I'll help you figure out the most advantageous tax benefit for your situation. With two children in college, tax credits for education are near and dear to my heart. They can be a bit complex, but I don't mind spending extra time discussing them. If you have questions, just ask.

 

02 September 2015

The Net Investment Income Tax (NIIT) has been in effect since 2013. It provides for an additional surtax on investment income for taxpayers with MAGI over a threshold specific to their tax filing status. I have found that most people do not understand the NIIT. Probably because it is new and because the IRS description is written like this:

For the Net Investment Income Tax, modified adjusted gross income is adjusted gross income (Form 1040, Line 37) increased by the difference between amounts excluded from gross income under section 911(a)(1) and the amount of any deductions (taken into account in computing adjusted gross income) or exclusions disallowed under section 911(d)(6) for amounts described in section 911(a)(1). In the case of taxpayers with income from controlled foreign corporations (CFCs) and passive foreign investment companies (PFICs), they may have additional adjustments to their AGI. See section 1.1411-10(e) of the final regulations.

Clear as mud.

Let me try to break this down to make it understandable. There are 4 elements to the NIIT:

  • Statutory MAGI Thresholds
  • Calculating your MAGI
  • Definition of Net Investment Income
  • Determining the lesser amount to be taxed

First let's look at the statutory MAGI thresholds:

Federal Filing Status  MAGI Threshold Amount
 MFJ and QW  $250,000
 Single and HoH  $200,000
 MFS  $125,000

If your MAGI is above the applicable threshold amount for your filing status, you will owe the Net Investment Income Tax on Net Investment Income. Note: these threshold amounts are not indexed for inflation, so each year more and more taxpayers will find themselves paying NIIT.

Calculating MAGI. MAGI for the NIIT is your AGI plus any amounts excluded as foreign earned income, income from controlled foreign corporations, or income from passive foreign investment companies. Most taxpayers do not have income from foreign sources, so in most cases the NIIT MAGI will just be the same as AGI.

Definition of Net Investment Income. Net Investment Income includes interest, dividends, capital gains, rental income, non-qualified annuities, trust income, and passive business income (i.e. limited partnerships). There are a few others listed on form 8960, but the sources of income listed above will cover 98% of taxpayers. If you have other forms of investment income you are probably sophisticated enough to know what they are and their impact on your NIIT.

Last, but not least, you have to determine which is the lesser amount - your Net Investment Income, or the amount by which you exceed your MAGI threshold. Let's look at a few scenarios.

Don is single and his only source of income is the rents he collects on the dozen houses he owns. He collected $93,000 in rental income in 2014. He had no adjustments to income. His MAGI for NIIT purposes is $93,000. This is below Don's statutory MAGI threshold. He does not owe NIIT.

Janice is single and earned $190,000 in salary in 2014. She also had interest income, capital gains, and dividends totaling $36,000. She had no adjustments to income. Her MAGI for NIIT purposes is $226,000. The threshold for her filing status is $200,000, which she exceeds by $26,000. We need to compare that amount ($26,000) to her Net Investment Income, which is $36,000. Janice will have to pay NIIT on the lesser of those two amounts - $26,000.

Thomas and Traci are married and file jointly. Thomas earned $140,000 in salary in 2014. Traci earned $155,000 in salary. They also has $1,600 in CD interest. They took a $2,500 adjustment for student loan interest paid. Their MAGI for NIIT purposes is $294,100 [$140,000 + $155,000 + $1,600 - $2,500]. They exceed the NIIT threshold for their filing status by $44,100. Their Net Investment Income was $1,600. They will owe NIIT on the lesser amount of $1,600.

Jeff is single. When his father passed he left Jeff a trust that generated $310,000 of income to Jeff in 2014. Jeff had no other sources of income and no adjustments to income. His MAGI exceeds the threshold for his filing status by $110,000. He has $310,000 of Net Investment Income. He will pay NIIT on the lesser amount of $110,000.

The Net Investment Income Tax is another reason to get as much of your investment portfolio as possible into tax-qualified accounts where it does not count as income. If you would like some advice on how to do that, come see me.

 

Disclaimer

Information in the Tax Blog is current as of the day it was posted. Tax laws change frequently, and it is likely that as time passes acts of Government will make some of the older blog content out of date.

The information provided is for education purposes only. It is general in nature and may not pertain to the Reader's situation. Every taxpayer's circumstances are unique. Reader's are urged to do some research or talk to a tax professional before acting on any of the information posted in this blog.

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.

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Common Acronyms

ACTC - Additional Child Tax Credit

AGI - Adjusted Gross Income

AMT - Alternative Minimum Tax

APTC - Advanced Premium Tax Credit

AOC - American Opportunity Credit

CTC- Child Tax Credit

EIC - Earned Income Credit

HoH - Head of Household

LLC - Lifetime Learning Credit

MFJ - Married Filing Jointly

MFS - Married Filing Separately

MAGI - Modified Adjusted Gross Income

PIM - Plan of Intended Movement

PTC - Premium Tax Credit

QC - Qualifying Child

QHEE - Qualifying Higher Education Expenses

QR - Qualifying Relative

QW - Qualifying Widow(er)

 

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