Sunday, July 27, 2014

Tax Planning Tips

Online publications typically circulate their tax planning tips at the end of the year.  But tax planning can take place all year long; it doesn't matter whether the April filing deadline is 12 months away or just around the corner.

Tax Planning Strategies

Planning strategies really come down to one simplified income tax formula:

Gross Income - Deductible Expenses = Net Taxable Income

Tax Deductions
The overall tax-planning objective is to minimize net taxable income.  The tactics involved with meeting that objective are twofold:  minimizing gross income, while maximizing deductible expenses.  The following paragraphs are going to look at each of these tactics separately.

Minimizing Gross Income

No doubt it's possible to minimize taxable income by taking some time off from work, but that's not going to help anyone's lifestyle in the long run.  The tax tips discussed in this section include tactics that allow a filer to exclude income from federal income taxes.  Therefore, the first tip has to do with retirement planning.

Tax Tip 1:  Lowering Gross Income using Retirement Plans

It's no accident this is the first item listed.  One of the most effective ways to lower gross income is to have it directed into a 401(k) or 403(b) plan.

The 401(k) rules are quite generous when it comes to lowering income, and they are mirrored by the 403(b) contribution rules.  On a pre-tax basis, it's possible to invest up to $17,500 in 2013 and 2014, and employee contributions are often matched by an employer.  In 2015 and beyond, these contribution amounts will rise with an index of inflation.  That means it's possible to lower taxable income by $17,500, get an instant return on investment, and save for retirement at the same time.  It's really a win-win.

Tax Tip 2:  Deferring Income

A second way to lower gross taxable income is by deferring it.  The objective here is to defer money, or income, to another tax year.  Perhaps the best example uses the tax laws to defer stock market gains.

Individuals that have shares of stock that have gone up since they were purchased can defer taking a capital gain and raising their gross income.  This is especially desirable if it's possible to offset that capital gain with a capital loss in later years.

Keep in mind the IRS disallows the loss on sales of securities if substantially identical securities are purchased within 30 days, which is called a wash sale.

Maximizing Deductible Expenses

Even though this section has been labeled as deductible expenses, it really includes two items: tax deductions and tax credits.  A tax deduction lowers taxable income, while a tax credit is just as the name implies; a credit that's applied to the total tax bill.  Tax credits are far more valuable on a dollar-for-dollar basis.

Tax Tip 3:  Tax Credits

Admittedly, the qualifying rules for tax credits are typically complex and very specific to each program.

Child Tax Credit:  provides a credit of $1,000 per qualifying child under the age of seventeen.  In 2013, this credit is phased-out for taxpayers with modified adjusted gross incomes (AGI) in excess of $110,000 for married-joint filers, $55,000 for married filing separately, and $75,000 for all other taxpayers.
Hope and Lifetime Learning Credit:  up to $2,500 in credits for each qualifying student enrolled in a qualifying institution of higher education are available through the Hope Credit and Lifetime Learning Credit programs.
Child and Dependent Care Credit:  individuals paying a childcare provider for a child under age 13 so they can work, may be able to claim the child and dependent care credit.  The credit may be lowered or eliminated for individuals with higher adjusted gross incomes.
Energy Saving Devices:  homeowners that install some of the newer energy saving devices such as air conditioners, water heaters, furnaces, boilers or solar panels may be eligible for a tax credit of up to $2,000.  Check with local electric or gas utilities to find out which energy saving devices provide tax credits or rebates.

Tax Tip 4:  Tax Deductions

This final set of planning tips has to do with tax deductions.  While it's certainly possible to buy a new home and deduct mortgage interest and property taxes; that's not the intention of this section.  These are actions a taxpayer can take to squeeze out more deductions.

IRA Accounts:  Roth IRAs do not provide immediate tax help, although the money removed from these accounts is not considered taxable income.  Individuals looking for immediate relief might want to consider funding a Traditional IRA, which can be tax deductible.  It's just another way the government provides incentives to save for retirement.
Medical Expenses:  no one plans to get sick, but there is one way to use those medical expenses to a taxpayer's advantage.  Only medical expenses in excess of 7.5% are allowed as tax deductions.  That's where the strategy of grouping medical expenses comes into play.  If a family has been hit hard with a lot of medical expenses in a given year, then it may be worthwhile to accelerate additional elective medical payments into the same tax year.  This way it's possible to get a tax break on medical expenses, even with the 7.5% threshold.
Homeowner Deductions:  it's also possible to accelerate mortgage and property tax deductions merely by changing the timing of certain payments.  By writing checks before December 31st, it's possible to claim the interest expense or property taxes in that same tax year.
Business and Personal Expenses:  this final tax planning tip has to do with accelerating personal or business-related expenses.  By charging some of these costs on a credit card, it's possible to claim the expense in one tax year, and pay for them in the following year.
Prepaying Taxes and Adjusting Withholding

One last suggestion doesn't involve a tax-lowering strategy, but rather the payment of income taxes themselves.  For some taxpayers, the April deadline can be financially difficult in terms of paying what is owed on a federal tax return.

There are two actions that can help take the pain out of tax time.  The first has to do with prepaying taxes.  This is as simple as filling out a tax form, and sending the IRS a check each quarter.

Correct Withholding

The second has to do with adjusting withholding.  Neither getting a large tax refund nor sending a large check to the IRS makes a lot of sense.  Anyone getting a large refund is lending the federal government money, interest free.

On the other hand, owing a lot of money to the IRS each year is not a good place to be either.  In fact, withholding too little in taxes could result in unnecessary penalties.

Anyone in either of these situations should adjust their withholding.  This process involves filling out a fairly simple tax form that can be downloaded from the IRS website or obtained from an employer.  The W-4 takes about ten minutes to complete and filling out the form now will avoid a big tax bill later on

Saturday, July 26, 2014

Compare traditional and Roth IRA when building your nest egg

Saving enough money for retirement is the first step toward building your nest egg, but just as important is where you invest that money.
When it comes to investing your retirement dollars, consider not only your asset allocation, but also asset location. Should you put your money in a taxable or nontaxable account? Should you set up a traditional or Roth IRA?

Millions of Americans use IRAs to save for retirement. While the majority of retirement savers have traditional IRAs, Roth IRAs — only available since 1998 — have grown in popularity. New research shows savers contribute more readily to Roth IRAs than traditional IRAs, with more than 7 in 10 new Roth IRAs opened exclusively with contributions.

In contrast, traditional IRAs are largely created through rollovers from employer-sponsored retirement plans, according to new data from the Investment Company Institute.

Still many Americans may not understand the differences between traditional and Roth IRAs to determine which accounts may be best for them. Here are some key points to keep in mind:

Differences between traditional and Roth IRAs

Traditional IRAs offer the benefit of tax deferred growth since contributions are generally made with before-tax dollars and you don't pay taxes on that money until you take it out. Contributions are deductible, unless you are covered under an employer-retirement-plan and your income exceeds certain limits, but anyone can make a nondeductible IRA contribution. You're taxed at your ordinary income tax rate on the money when you take the money out. Distributions of nondeductible contributions are not taxable.

Roth IRAs are another terrific way to save and invest for retirement. But they work a bit differently. The benefit to a Roth is tax-free growth. You make after-tax contributions and earnings grow tax-free. Unlike regular IRAs, your contributions can be withdrawn tax free at any time. Earnings from a Roth account can also be withdrawn tax-free after age 59½, as long as you have held a Roth IRA for five years. You an also withdraw up to $10,000 for a first time home purchase before age 59½.

Income and contribution limits

Contributions to traditional and Roth IRAs are the same: $5,500 this year or $6,500 for those 50 or older.

Anyone under age 70½ with eligible compensation, such as wages, can contribute to a traditional IRA, but there are income limits if you are covered under an employer retirement plan and you want to take a tax deduction on your contributions. For married couples filing jointly, the income limits for deductible IRA contributions start at $96,000 (for a fully deductible IRA) and ends at $116,000 (for a partial deduction); for single filers it's $60,000 to $70,000. The closer you get to the end of the range, the lower the amount you are able to deduct.

"There is no age limit on Roth IRA contributions. You can contribute as long as you have eligible compensation, and your income does not exceed certain amounts," notes retirement expert Denise Appleby. The income limits for Roth IRAs are much higher, making them attractive to many higher income savers. Individuals filing as single and making less than $114,000 this year and married couples who make less than $181,000 and file taxes jointly are eligible to contribute the full amount to a Roth IRA. "The eligible contribution is reduced as the income gets closer to $129,000 for single filers and $191,000 for married-filing jointly. No contribution is allowed if income exceeds these amounts," Appleby said.

Why contribute to a Roth IRA

If you're deciding between contributing to a deductible IRA and Roth IRA, there a several things to keep in mind.

Roth IRAs are a great location for the assets of many savers, particularly if you think you may need to tap into those funds at some point before retirement because you can withdraw contributions from a Roth IRA tax-free at any time.

But even if you plan to keep your money earmarked for retirement, there are several reasons why Roth IRAs make sense. If you think you'll be in a higher tax bracket when you retire, especially if you're a younger worker and have yet to reach your peak earning years, then a Roth IRA is better than a traditional IRA from a tax standpoint. Also, you don't have to take required minimum distributions from a Roth IRA at age 70½ like you do from a traditional IRA. A Roth IRA is also a great estate planning tool, since you can leave the account to your heirs and stretch out distributions tax free.

On the other hand, if you think your income tax bracket will be much lower when you retire than it is now, you may be better off taking the upfront tax deduction of a traditional IRA. If you think your income tax bracket will be the same when you retire, then it's almost a wash for income tax purposes. 

Friday, July 25, 2014

Mid-Year Tax Planning For College Grads

I am assuming here that the graduate did get a job or is about to start a job or could be under-employed waiting for the right job.
Once you get that new job, think about your retirement. I know it’s the last thing on your mind, but I promise you will be glad you did 40 years from now. Enroll in your employer’s retirement plan.
There is a tax credit, the Retirement Savings Contribution Credit that is available for low-income wage earners. If you decide to contribute to the 401(k) plan at work or open an IRA for $2,000, you could be eligible for up to $1,000 credit. Here the government is giving you an incentive to start saving for retirement.
This credit is in addition to whatever other tax benefits may result from the retirement contributions. For example, your contribution to a traditional IRA may be deductible. Contributions to a 401(k) plan are not subject to income tax until withdrawn from the plan.
Income limits apply; single individuals with incomes up to $30,000 and for married couples with incomes up to $60,000. You must also be at least age 18, not a full-time student. According to the IRS if you were in school for 5 months of the year you are considered a full-time student. So if you graduated from college in January you are golden. If you graduated in May you will not be eligible for the credit.
Next, your school loans. Payments won’t start until 6 months after graduation and you will be eligible for a deduction on the interest you pay.
You may be able to deduct up to $2,500 of the interest you paid on student loans on your federal individual income tax return. The deduction is not limited to government-sponsored loans, but does not apply to loans made to students by family members. And, as with most tax rules, if you make too much money the deduction will go away.

Thursday, July 24, 2014

Mid-Year Tax Planning For Your Retirement Plans

Mid-year is a good time to take stock of your retirement accounts. The contribution limits for this year for a 401(k), a 403(b) and a 457 plan is $17,500.

If you are 50, or reach that magic age this year, you can use the catch-up provision and contribute an additional $5,500 to your account. Not too many workers are able to contribute the max to their retirement and even less can use the catch-up provision.

If you are not contributing the maximum to your retirement account consider increasing your contribution level to at least what your employer may be matching.

Then consider increasing your contribution level every six months or share every raise with your retirement plan. If it’s not in your checking account, you are not apt to spend it.
There is a big tax advantage in using your employer’s retirement plan. There are no income taxes withheld from the dollars you contribute. You will still owe Social Security and Medicare taxes though on the amount contributed.

While those dollars are in your account, they are growing tax deferred. Tax deferred compounding is the Eighth Wonder of the world. And it truly is a wonderful thing for your dollars will hopefully continue to grow each year and you will not owe taxes on them until you begin withdrawals in retirement.

If there is no 401(k) where you work consider setting up an IRA, Individual Retirement Arrangement. For this year, all IRA contributions are limited to $5,500 and if you are over 50, you can add a catch-up contribution of another $1,000 to the account. That’s a standard IRA, Spousal IRA, Non-deductible IRA and the Roth IRA.

You must have earned income of at least the amount of the IRA contribution and if you have a retirement plan at work you may not be eligible for a deduction for the IRA.

Wednesday, July 23, 2014

Use A Roth Conversion to Achieve Lower Tax Bills

One of the planning options that most all folks have available to them is the Roth IRA Conversion.  For the uninitiated, a Roth IRA Conversion is a transaction where you move money from a Traditional IRA or a Qualified Retirement Plan (QRP) such as a 401(k) into a Roth IRA.  With this transaction, pre-tax amounts would be included in income as taxable in the year of the Conversion.

As you might expect, making a decision like this can result in a considerable tax impact, depending on the individual circumstances.  A Roth IRA Conversion may make a great deal of sense for one individual, while another may decide that the Conversion cost is too great for the result.  Detailed below is one specific circumstance that indicates a Roth IRA Conversion is a good move – although each individual needs to consider his or her situation carefully, because every situation is unique.

Protecting Non-Taxation of Social Security

In this situation, the individual has a very low taxable income, low enough that she would not likely need to include Social Security benefits as taxable income once she begins receiving the benefits.  However, once she reaches age 70½ and Required Minimum Distributions (RMDs) are necessary, the amount of these distributions will increase her overall provisional income to a point where Social Security benefits will be taxable at the highest rate, 85%.  Converting a portion of the IRA to Roth IRA will help to keep the RMDs low enough that SS benefits can be taxed at a lower (or zero) amount.

For example, Jane is 60, single, and has retired.  She intends to begin receiving Social Security benefits of $24,000 at her full retirement age of 66.  She needs a total of $40,000 each year to live on.  She presently withdraws that amount from her IRA on an annual basis.  Her IRA balance at this point is $600,000.

If she did nothing about converting to Roth, when she reaches 70½ the amount of her RMD will be large enough to bump up her provisional income to a point where her Social Security benefits will be taxable at the maximum 85% rate. This comes about because her balance in the IRA (after withdrawals and annual increases averaging 5%) is roughly $557,000 at her age 70½.  Using IRS Table I to calculate her Required Minimum Distribution, we see that her RMD would be $20,328.47 for the year.

If, however, Jane began a process of converting a small portion of her IRA to Roth IRA each year between now and when she reaches age 70½, she could reduce the size of her traditional IRA and therefore reduce the size of her future RMDs to a point where the tax impact on her SS benefits is eliminated.  In our example, if Jane withdrew an additional $15,000 from her IRA and converted the after-tax portion to a Roth IRA, this would reduce her IRA balance to a point where the RMD (when required at age 70½) would be low enough that her SS benefits would no longer be subject to taxation at all.

This series of conversions brings her Traditional IRA balance down to approximately $359,000.  Now her RMD computes to $13,102.  At the same time, she has amassed a Roth IRA with a balance of approximately $148,000 – so her total of the two accounts is approximately $507,000.  The tax cost of the conversions and the lost income/appreciation on the money used for taxes makes up the difference.

This conversion would cost her an additional $3,750 in taxes per year for ten years, but the effect of non-taxation of her future SS benefits would be a reduction in future tax of $5,100 – for the rest of her life.  With this in mind, approximately 10 years later, at her age 80, this strategy would have paid off.  If she died prior to that age, the Roth Conversion would have cost more than the benefit.

Note: the figures used in the examples do not include inflation, and are purposely rounded for simplification.  Real-world results will differ, perhaps significantly, from this example.


There are many other situations when a Roth Conversion makes a lot of sense, the above is one example of a very good scenario for the conversion.  As I mentioned previously, each individual’s situation will be different and may or may not result in the same decision to convert or not.  Watch for more examples in future posts!

Tuesday, July 22, 2014

2014 Federal Income Tax Rates

As the close of the year draws near, taxpayers grow concerned about limiting their tax liability in 2014. By understanding their incremental federal income tax rates, individuals can appreciate the benefit received from a potential deduction.

2014 Income Tax Rate Schedules

Income tax rate tables, or brackets, are published each year by the federal government through the Internal Revenue Service or IRS. These tables outline the tax owed and incremental tax rates.  These schedules can also be used to estimate a potential income tax liability in 2014.  However, more accurate estimates can be achieved by completing Form 1040.

The American Taxpayer Relief Act of 2012 added a seventh bracket (39.6%) in 2013.  The remaining six rates were unchanged.  Reading a tax rate schedule is a fairly simple process.
The first step is to calculate an individual's total federal taxable income.  Again, IRS Form 1040 can help individuals determine that value more accurately.  Once the taxable income is known, the next step involves selecting the proper rate table.
There are four schedules, depending on the individual's filing status such as Single or Married, Filing Jointly.  The instructions for Form 1040 explain the process for selecting the correct status.

2014 Unmarried Individuals: Rate Schedule X

Taxable income is over -But not over -The tax is:Of the amount over -
$0$9,075$0 + 10%$0
9,07536,900907.50 + 15%9,075
36,90089,3505,081.25 + 25%36,900
89,350186,35018,193.75 + 28%89,350
186,350405,10045,353.75 + 33%186,350
405,100406,750117,541.25 + 35%405,100
406,750-118,118.75 + 39.6%406,750

2014 Married filing jointly or Surviving Spouses: Rate Schedule Y-1

Taxable income is over -But not over -The tax is:Of the amount over -
$0$18,150$0 + 10%$0
18,15073,8001,815.00 + 15%18,150
73,800148,85010,162.50 + 25%73,800
148,850223,05028,925.00 + 28%148,850
226,850405,10050,765.00 + 33%226,850
405,100457,600109,587.50 + 35%405,100
457,600 -127,962.50 + 39.6%457,600

2014 Married filing separately: Rate Schedule Y-2

Taxable income is over -But not over -The tax is:Of the amount over -
$0$9,075$0 + 10%$0
9,07536,900907.50 + 15%9,075
36,90074,4255,081.25 + 25%36,900
74,425113,42514,462.50 + 28%74,425
113,425202,55025,382.50 + 33%113,425
202,550228,80054,793.75 + 35%202,550
228,800 -63,981.25 + 39.6%228,800

2014 Head of Household: Rate Schedule Z

Taxable income is over -But not over -The tax is:Of the amount over -
$0$12,950$0 + 10%$0
12,95049,4001,295.00 + 15%12,950
49,400127,5506,762.50 + 25%49,400
127,550206,60026,300.00 + 28%127,550
206,600405,10048,434.00 + 33%206,600
405,100432,200113,939.00 + 35%405,100
432,200-123,434.00 + 39.6%432,200

Tax Rate Example Calculation

We're going to run through a quick example to illustrate how the above tables are used to determine a taxpayer's incremental tax bracket in 2014.  In this example, let's say that Bill's filing status is Married Filing Jointly.  That means he will be using Schedule Y-1 above.  If Bill's federally taxable income in 2014 is $100,000, then the tax owed is calculated as follows:
Bill is going to use the third row of the Y-1 schedule because his income falls between $73,800 and $148,800.  That puts Bill in the 25% tax bracket.  Calculating the tax liability from that table:
$10,162.50 + 25% x ($100,000 - $73,800)
$10,162.50 + 0.25 x $26,200
$10,162.50 + $6,550.00 = $16,712.50

Marginal Tax Rates

Anyone that understands how to use these tables also understands why they are referred to as marginal tax rates.  Within each rate schedule it's possible to find the taxpayer's incremental tax rate, or marginal rate of tax.  This is the rate at which each incremental dollar earned is taxed.  In the above example, the marginal tax rate was 25%.

One of the more common misconceptions is that if someone earns more money, then all of the income is taxed at the higher rate.  The above tables demonstrate this is simply not true.  Individuals are taxed at an incremental rate on marginal income.  That means an individual might be taking home less pay for each additional hour worked, but they are certainly bringing home more money.

Monday, July 21, 2014

Tax planning moves to consider for your new child

Now obviously, everybody’s situation is different, but below are 3 tax-planning moves you should  plan to make as soon as possible once you become a father. Perhaps one or more of them is relevant for you and your planning.
  1. Fund a 529 Plan – 529 plans are great way to save money for a child’s education. These accounts, like IRAs, allow you to accumulate funds on a tax-favored basis. Although there is no federal income tax deduction for contributions to a 529 plan, funds grow tax-deferred while in a 529 account and, if distributions are used to pay qualified higher education costs, those distributions are tax-free. Plus, although there is no federal income tax deduction available, many states offer a state income tax break for contributions made by its residents to its own plan. Just like IRAs, the earlier one starts saving in a 529 plan, the better off they will be. With higher education costs continuing to sky rocket, I’m going to start as early as I can! 
  2. Attempt to Establish a Roth IRA as Soon as Possible – There are no minimum age requirements to open a Roth IRA. In theory, even a newborn can have one. The key, however, is that a person, regardless of age, needs some sort of “compensation” to make a Roth IRA contribution. Usually, that compensation is some sort of earned income. Now you might ask, “How can a newborn have earned income?” Well, there are a number of ways. Perhaps you own a business and you use your child’s likeness on marketing material. You could pay them for that, legitimately of course. Then, an amount equal to that earned income could be contributed to their Roth IRA (provided they meet the other requirements). I personally have no idea when my child will generate earned income. Maybe it will be soon. Maybe not for 20 or more years. That said, whenever the time comes, I am going to do everything in my power to start his tax-free retirement savings off as early as possible, even if it means I have to make a contribution to his Roth IRA with my own money.
  3. Update my Beneficiary Forms – Updating one’s beneficiary forms doesn’t sound like a tax-planning move, but instead, simply an estate planning move. In reality, it is both. Designated beneficiaries – generally living, breathing people named on the beneficiary form – are able to stretch distributions over their life expectancy. This helps an account grow tax-deferred as long as possible and minimize the tax impact on any distributions.
If something were to happen to me in the near future and my children were to inherit my retirement funds, they would be able to distribute those funds over more than an 80-year period.