Friday, April 29, 2016

Avoid the Social Security Tax Trap


No one likes a tax surprise, yet retirees may be subject to shockingly high marginal rates because of the complex manner in which Social Security income is taxed. Joint filers with $40,000 of total Social Security benefits and as little as $28,000 of other income can find themselves paying up to 185% of the normal marginal tax rate for their income level. IRA distributions and even supposedly tax-free municipal bonds are counted as income in these calculations.
Many baby boomers will confront this tax trap. Unlike previous generations, they are mostly two-wage earner couples, meaning they will collect higher total Social Security benefits. Affluent boomers have accumulated significant assets in IRAs and 401(k)s, which will produce substantial taxable distributions starting after age 70-1/2. Both factors will likely force many boomers firmly into the tax trap.
While it will be difficult for these clients to completely avoid the trap, there is a window of opportunity before they reach age 70-1/2 to mitigate some of the bite. This means considering strategies to shift taxable income off of future years as much as possible. Strategies include moving assets into tax-free accounts, tax-efficient investing and expense management.
Start with Social Security itself. If your clients are waffling about whether to delay the receipt of those benefits until 70, give them another compelling reason. Explain that delaying their filing for benefits may also help them minimize the impact of the tax trap in two marked ways.
If they delay, they may need to draw down some qualified savings as an income bridge between retirement and age 70. These early draw-downs will reduce future RMDs, thereby lowering future taxable income. Secondly, delaying their filing can provide a window to do some other tax planning.
Roth conversions are an obvious choice, especially before your clients reach age 70, when they would start collecting Social Security (presuming they delay) and begin taking forced RMDs. During their pre-70s years, clients may have significant space in the 15% federal tax bracket in which to work. If they have non-qualified assets with which to pay income taxes, they should consider Roth conversions potentially up to the 15% bracket limit of $75,300 for joint filers. This would lower RMDs and taxable income in future years. It would also generally give them greater tax-planning flexibility, since retirement saving would be spread more equitably between tax-deferred and tax-free accounts.
Clients should maximize contributions to Healthcare Spending Accounts (HSAs) if they are still working and using a high-deductible health plan, further moving assets into tax-free vehicles.
Tax-efficient management of nonqualified investments is also important, as it can lower future AGI and, by extension, combined income. This includes investment strategies that minimize capital gains, interest and dividend payments, and focuses more on growth. Staggering gains by consolidating them in some years, and minimizing in others, may also help.
Even municipal bond strategies should be re-evaluated. Municipal bonds could lose much of their tax-savings value as the bond income pushes Social Security income into the tax trap, effectively creating a tax on the muni bond income.
If the client is realizing profits from rental income, review the pros and cons of real-estate investments. There may be ways to shift more income into the pre-RMD years before age 70 or, conversely, plan income-lowering costs for repairs and the like after the client reaches 70-1/2.
Managing expenses may be another useful approach. Higher expenses naturally require more income. If that income must come from tax-deferred savings, this only pushes more income into the tax trap. Lowering expenses can help.
Mortgages are an obvious expense-lowering target, as they often represent the largest financial burden in retirement. Paying off a mortgage before starting Social Security would dramatically lower income needs and could reduce the requirement for additional taxable distributions in excess of RMDs.

Tuesday, April 26, 2016

You may be doing your taxes all wrong


After having just filed your 2015 return and possibly being shocked at how much you owed, you may be ready for some tax planning to reduce the pain from now on. While “tax planning” is a frequently used term, it’s not necessarily well-understood. Here’s the scoop:
What tax planning really means
Tax planning is the art of arranging your affairs in ways that postpone or avoid taxes. By employing effective tax planning strategies, you can have more money to save and invest or more money to spend. Or both!
Put another way, tax planning means deferring and flat-out avoiding taxes by taking advantage of beneficial tax-law provisions, increasing and accelerating tax deductions and tax credits, and generally making maximum use of all applicable breaks available to you under our beloved Internal Revenue Code.
While the federal income tax rules are now more complicated than ever, the benefits of tax planning are arguably more valuable than ever.
Of course, you should not change your financial behavior solely to avoid taxes. Truly effective tax planning strategies are those that permit you to do what you want while reducing your tax bills along the way.
Tax planning and financial planning are closely related
Financial planning is the art of implementing strategies that facilitate reaching your financial goals, be they short-term or long-term. Sounds pretty simple: However, if it actually was simple, there would be lots more rich folks out there (including yours truly).
Tax planning and financial planning are closely linked, because taxes are such a large expense item as you go through life. As your income goes up, taxes will probably be your single biggest expense over the long haul. So planning to reduce taxes is a critically important piece of the overall financial planning puzzle.
Horror stories when folks fail to make the connection
Over the years as a tax professional, I’ve been amazed at how many people fail to get the message about tax planning until they commit a grievous blunder that costs them a bundle in otherwise avoidable taxes. Then they finally get it. The trick is to make sure you don’t have to learn this lesson the hard way. To illustrate the point, consider the following example.
Example: Joe is a 45-year-old unmarried professional. He considers himself to be financially astute. However, he is not very knowledgeable about taxes. One day, Joe meets Joan, and they quickly decide to get married. Caught up in the excitement of a whole new life, Joe impulsively sells his home right before the marriage. The property is in a good area and has appreciated by $500,000 since he bought it 15 years ago. Joe and Joan intend to move into Joan’s home, which is, frankly, a dump. But Joe is an ace DIY remodeler, and he plans to work his magic on Joan’s property. Ignoring taxes, this a good plan.
Result without tax planning: For federal income tax purposes, Joe has a whopping $250,000 taxable gain on the sale of his home: $500,000 profit minus the $250,000 federal home sale gain exclusion allowed to an unmarried seller.
Result with tax planning: If Joe had kept his home and lived there with his new bride for two years before selling, he could have taken advantage of the more generous $500,000 home sale gain exclusion allowed to married couples. That way, he could have permanently avoided $250,000 of taxable gain. If necessary, the couple could have sold Joan’s home instead of Joe’s. Since her place is a dump, she could have sheltered any taxable gain with her separate $250,000 gain exclusion. Alternatively, the couple could keep Joan’s property and work on remodeling it while still living in Joe’s highly appreciated home for the requisite two years.
Moral of the story: By selling his home too soon without considering the tax-smart alternative, Joe cost himself $62,500 in taxes: completely avoidable $250,000 gain taxed at an assumed combined federal and state rate of 25%. In a higher tax bracket, the damage would be even worse. The whopping tax bill on the home sale is a permanent difference, not just a timing difference. The bill could have been zero. The point: You cannot ignore taxes when contemplating major transactions. If you do, bad things can happen, even with seemingly intelligent moves.
The last word
There are many other ways to commit expensive tax blunders. Examples include selling appreciated securities too soon when hanging on for just a little longer would have resulted in low-taxed long-term capital gain instead of high-taxed short-term gain, taking retirement account withdrawals before age 59½ and getting hit with the 10% early-withdrawal penalty tax, and failing to arrange for payments to an ex-spouse to qualify as deductible alimony. The list goes on and on.
The cure is to plan transactions with taxes in mind and avoid making impulsive moves. Seeking professional tax advice before pulling the trigger on significant transactions is usually money well spent. As the rest of this year unfolds, some of my future columns will focus on tax-planning strategies that many folks can benefit from. Hopefully, we can together do a better job of keeping your tax bill on the right side of reasonable from now on.

Monday, April 25, 2016

Filing may be complete, but tax planning is ongoing


The countdown for filing 2015 tax returns is finished, and the taxes are off to Washington. While some Americans have already cashed refund checks, other families had to grin and bear the burden of the marginal tax rate.
There are two tax systems at play in the U.S., and some politicians proclaim there is one system for the rich and another for the poor. But the reality is there is one tax code for the informed and one for the uninformed.
Start a conversation about taxes, and it quickly becomes clear that many people don’t understand their returns or how taxes work. Everyone with earned income (a job) pays into Social Security and Medicare. Those contributions are never returned nor deferred when you put money in a retirement plan like a 401(k) or IRA. This creates plenty of frustration when you hear that over half of Americans don’t pay any taxes. But that oft-quoted statement is wrong. What is true is that about half of U.S. tax returns use the marginal tax brackets.
Your tax return is similar to a symphony where instruments work in unison. Although I can’t tell you what musician is playing especially well, even my tone deaf ears can identify the instrument that is out of tune! Your tax return works the same way, in which one line works with the next. Just one bad financial decision during the year can create an input that creates negative consequences on the rest of your return.
Albert Einstein described insanity as doing the same thing over and over while expecting a different result. Every year individuals pick up their taxes from their CPA firms, and gasp at the amount owed. Then they complain, scribble their names on a check, file the return in a drawer and repeat the process the next year. Insanity!
Tax planning is a central part of financial planning and needs to be conducted before Dec. 31, not April of the following year. April is the season to tax report. The number of individuals who spend countless hours on investment statements but disregard their 1040 tax return is staggering. In my humble opinion, there is no entity that will separate most American families from their retirement more dramatically than the IRS. Markets go up and down but rarely does the IRS send a check back!
As we conduct financial planning in 2016, our objective is to be as tax savvy as possible. Pay attention to line 43 on your tax return and find out how much income was actually subject to taxation. Once you know that number, you can make some very important decisions including whether you should consider a Roth IRA or contribute to a college fund. The IRS provides us a rule book but it is our job to use those rules to create the best possible scenario during the year so that our accountants can provide savvy tax reporting next April.

Sunday, April 24, 2016

Prince's death sets off estate planning quagmire


The death of the virtuoso music artist Prince Thursday set off a countdown until the tax man takes a bite out of the star's estate.

Relevant parties must determine just how big Uncle Sam's bite will be. In the case of a musical superstar like Prince, though, such a task is a real challenge — borderline impossible, even, some say — and could spark a lengthy feud between the government and the estate. And the stakes are high, given that more than half the estate's value could be forfeited in tax.

Richard Behrendt, director of estate planning at Annex Wealth Management, calls it a “quirky valuation challenge” that is more art than science. The difficulty comes down to placing a value on intangible assets, such as future royalties the artist may earn from a body of work.
“You're trying to look at present value of a future income stream,” said Charlie Douglas, board member of the National Association of Estate Planners and Councils and an Atlanta-based wealth adviser.

Prince reportedly amassed a fortune worth around $300 million. Yet the divide between how the Internal Revenue Service and the Prince estate view the present value of future royalties could be huge, because with the death of a popular artist comes the likelihood of ballooning popularity and hence a ballooning valuation.

“For an artist, whether it's Picasso or Prince, death has an impact on their body of work. It's undeniable,” said Mr. Behrendt, who worked for 12 years at the IRS as an estate tax attorney. “The IRS will factor that in and say his death will blow the royalties off the charts, but his attorneys will say, 'You can't do that.'”

The estate of the late entertainer Michael Jackson understands this point all too well. It's currently locked in a court battle with the IRS, which valued Jackson's name and image upon death at more than $434 million. The estate's estimate: $2,015.

Anecdotally, Mr. Behrendt says the IRS feels it got “burned” in the case of Elvis Presley's estate, because it didn't anticipate the phenomenon of a pop icon's increasingly popular catalog after death. Elvis generated $55 million in 2015 alone, second only to Michael Jackson's $115 million, according to Forbes' list of top-earning dead celebrities.

“Now their eyes are open and they'll be putting their best people on these unique cases,” Mr. Behrendt said.

And, as a New York Times article indicates, a “trove of Prince's recordings remains unreleased,” so any potential value derived from that remains a mystery.

Details on Prince's will and who will be executing his estate haven't yet emerged, but if he didn't have a will designating an executor (which is unlikely, given his reputation as being a good businessman, Mr. Douglas said) it would likely pass to his sister, Tyka Nelson. (Prince divorced twice and didn't have any surviving children.)

The estate has 15 months to file a federal estate tax return (nine months plus a six-month extension). The estimated federal estate tax is due on the nine-month date, though. (Because Prince was unmarried at death, he can't take advantage of the unlimited marital deduction, which would pass the estate to a spouse tax-free.)

The federal government assesses a 40% estate tax on estate values over $5.45 million. Minnesota, Prince's state of residence, is one of about 20 states that has a state estate tax as well — its top rate is 16%, likely making Prince's estate tax rate a whopping 56% total when including the federal rate.

Muddying the valuation challenge even more, however, are state rules governing an “inheritable right of publicity,” which protects individuals' identities from being used without permission. While California, for example, is a state that offers protections for both the living and deceased in this respect, Minnesota doesn't appear to offer a post-mortem right.

“That would lessen the [estate] value, because you don't have enforceable rights of publicity,” Mr. Douglas said.

Ultimately, if the IRS determines the tax amount paid by the estate was undervalued after receiving the tax return, the IRS proposes a valuation increase, which parties could then attempt to negotiate, Mr. Behrendt said. If they can't agree, the issue goes the way of the Michael Jackson estate — that is, to tax court.

Saturday, April 23, 2016

Retirement Planning: Make a Plan for Your Contributions

Income tax returns were due April 18 this year — also the deadline to make IRA and many other retirement plan contributions for last year. So naturally, it’s too late to make any last-minute contributions for 2015 … but it’s a fine time to start planning for 2016.

You still have the better part of nine months to max out your 401k plan for the year, and nearly 12 months to max out your IRA, Roth IRA, SEP or HSA, among other vehicles. But the sooner you start, the more likely you are to actually meet your goals. What could be a very doable monthly savings goal if started today might be a lot less doable if you wait until the summer.
So with all of this said, let’s map out a game plan for maxing out your contribution.

Where Will Your Contributions Go?

The first step is figure out what your options are. If you work for a company, the government or a non-profit, chances are very good that you have access to a 401k plan, 457b plan or 403b plan. For the vast majority of Americans, these are going to be the best options, and saving for them should be the No. 1 priority. So let’s dig into it.
The maximum salary deferral for all of these employer-provided options is $18,000*, or $24,000 for those 50 and older. For now, let’s just focus on the $18,000.
Let’s say you’ve been remiss and haven’t allocated a single dollar to your 401k plan yet for tax year 2016. You now have a little over eight months — or 16 paychecks — to get to $18,000. So, doing the math, you need to put save $2,250 per month, or $1,125 per paycheck, to max out your contribution for the year.
Now, that might sound like a lot, but it’s doable for most American families earning $80,000 or more. And if maxing out your 401k plan means that you have to dip into your regular savings account for a few months to pay your bills, that might be perfectly fine. It’s definitely worth it to take advantage of the tax savings and employer matching benefits.
In looking at some of the other retirement options, we have a little more timing flexibility, and the numbers get a lot smaller.
The contribution limits for IRAs and Roth IRAs this year are $5,500 for those younger than age 50, and $6,500 if you’re age 50 or older; you have until next April to contribute. Well, $5,500 spread out across 12 months is a very reasonable $458 per month, or less than many car payments these days. My monthly electric bills in Texas are higher than that, at least in the summer months. There is absolutely no justifiable reason why you cannot meet a contribution schedule like this. If you can’t save $458 per month, you need to take a long look in the mirror and an longer look at your monthly credit card statements and figure out what you’re doing wrong.
For the more ambitious savers, HSAs offer nice “spillover” savings options once you’ve already maxed out any employer retirement plans or IRAs that you qualify for. In 2016, you can contribute as much as $6,750 ($7,750 for those 55 and older) to an HSA investment account if you have a high-deductible health plan for your family.
The contributions are ostensibly for health expenses, but no one ever said you have to spend the funds on health expenses today. You can use HSA funds tax- and penalty-free at any time for health-related expenses. But you can also save the funds indefinitely and withdraw them penalty-free for non-health expenses once you reach age 65. (You’d pay taxes, of course, but you’d avoid the 20% penalty for non-health-related withdrawals.)
So, so long as you don’t plan on touching the funds until age 65, an HSA plan can be thought of as an extra, supplemental IRA. You have until the tax deadline to contribute, so maxing out the full $6,750 would amount to $562 per month. This is less of a priority than an IRA or your 401(k) plan. But if you’re an ambitious saver, it certainly makes the cut.

Thursday, April 21, 2016

Seriously, the best time to start on 2016 taxes is now


Now that tax year 2015 is in the rearview mirror, it's time to turn your attention to the return you'll be filing next year.
Experts say most consumers' efforts to minimize their bill are too little, too late.
"Tax planning is more about whittling over time than grand gestures at the last minute," said certified financial planner Lynn Ballou, a regional director with EP Wealth Advisors. "It's a very complicated dance."
By IRS estimates, the average Form 1040 filer spends just two hours per season on tax planning. To put this in perspective, they expect you'll spend four times that on record keeping (i.e., sorting through that shoebox full of receipts) and twice that to actually prepare and submit your return.
One of the first places to mine for tax moves is your latest return, said Melissa Labant, director of tax advocacy for the American Institute of Certified Public Accountants. Start with the big picture – did you have an outsize refund or bill? Consider adjusting your tax withholding or estimated tax payments.
"The idea is to come close to breaking even," she said.
A more detailed line-by-line review on your own or with the help of your tax preparer can help highlight other action items, Ballou said. Maybe you didn't get the full value of certain credits or deductions, for example, or could have pushed yourself into a lower bracket by contributing a little more to your 401(k) plan.
Consumers subject to the alternative minimum tax might see red flags in retrospect, like high state and local taxes or capital gains that exceed your earned income, said Greg Rosica, contributing author to Ernst & Young's EY Tax Guide 2016. "If you're subject to it, make sure you understand why you're subject to it," he said – which can help you decide the best ways to avoid or minimize AMT impact in future years.
Once you've combed through last year's return, turn an eye to this year's possibilities. Many strategies take time to think through or are best acted on early.
"I would do [tax-loss harvesting] sooner rather than later," Ballou said.
Taxpayers can use that strategy to zero out any capital gains incurred, and can then deduct up to an additional $3,000 in capital losses against other income for that year. But it's better for your portfolio to start looking for and weeding out losers before the end of the year is looming, she said.
Early tracking of deductible expenses can help ensure you're making the most of certain tax breaks, especially those that have thresholds or are limited based on your adjusted gross income, said Rosica.
For example, knowing how close you are to the 10 percent threshold on medical and dental expenses (7.5 percent if you or your spouse is 65 or older) might influence whether you defer or accelerate treatments at the end of the year.
Pre-planning also allows for easier bunching of deductible expenses like charitable donations or real estate taxes. "That can bridge two different tax years," Rosica explained.
The net effect is that you could alternate claiming the standard deductions and itemized deductions, netting bigger breaks. Or if you are subject to the AMT, he said, bunching might mean you only have to face it every other year.
While you're thinking ahead to next year, cut some of your tax prep pain by getting more organized. "Have one spot for all of your tax records," said Labant. Make a note of deductible expenses, charitable donations and other relevant tax info so you aren't combing through receipts and credit card statements next year when the details aren't as fresh.

Wednesday, April 20, 2016

Time to talk about end-of-life issues is now

They say the only two things in life that are certain are death and taxes.

So it’s fitting that National Healthcare Decisions Day, which was Saturday, falls the day after Tax Day.
Now in its ninth year, National Healthcare Decisions Day encourages the young and old to talk about their end-of-life wishes and put those wishes in writing.

An advance directive for health care is a document that outlines what life-prolonging treatments, if any, you desire in case you are unable to speak for yourself. These treatments may include cardiopulmonary resuscitation, artificial respirators, feeding tubes and intravenous rehydration.
The document also appoints someone you trust as your proxy to speak on your behalf if you are incapacitated. This person will be able to make health-care decisions based on how well they know you with regard to anything not covered in your advance directive. Further, you can nominate a person to be appointed your legal guardian should a court ever determine you are in need of one.

Advance directives also may address issues including organ donation, whole-body donation to medical schools, funeral and burial arrangements.

According to a recent article in the American Journal of Preventive Medicine, only 26 percent of people have advance directives for health care.

The study found that most people who did not have an advance directive did not know that they existed, which highlights the importance of National Healthcare Decisions Day. The study found that older people or people with chronic diseases were more likely to have an advance directive, which illustrates the tendency for people to consider this option as death approaches.

Another recent study published in the American Journal of Public Health found that more than 60 percent of individuals age 18 years and older want their end-of-life wishes to be respected. But only about a third of them had completed advance directives.

The study found that while people had given thought to the question of end-of-life care, a majority had not completed the forms. Similar to the study in the American Journal of Preventive Medicine, about a quarter of those who did not have advance directives said they did not know about them. Others felt they were too young or healthy to complete them.

However, as the theme of this year’s National Healthcare Decisions Day points out, "It always seems too early, until it’s too late." Death or an incapacitating illness is unpredictable and could come at any time.
Finally, we would like to highlight that some people in the American Journal of Public Health study did not have advance directives because they were concerned about the cost, complexity or time that might be required to create one. As with many things in life, the cost, complexity and time of not having an advance directive far outweigh the relatively little cost and time of setting one up.

A qualified estate-planning attorney can help you set up your own advance directive. These documents do not expire, but it is recommended that you update them every couple of years for peace of mind. You will want to make sure that the person whom you designated as your proxy is still the best choice, and your family will want to know that your directive still reflects your current wishes.