In a great blog post on the subject, Dave Schneider related the case of a business idea he had that went afoul because of the picky nature of his major client. Within this anecdote, there is a real lesson to be learned for small business owners, and that lesson is that, no matter how much they can potentially stand to gain from a client, if they are running their business into the ground trying to please them, then they should step back and compare the value the client has brought them to the negative value of their difficult nature.
Are you constantly going over your budget or time-frame in order to please your client? The profit that your client brings you is not actually profit if it is constantly being eaten into by extra hours and resources. There is a big difference between being nice to a major client by throwing in something extra from time to time in order to keep them satisfied and putting in extra work on every single project they give you because they are never satisfied.
Are they stopping you from working with other clients because of their demands? If the growth of your business is being stymied by the time it takes you to satisfy your one picky customer, you should think to yourself if it makes rational sense for you to continue bending over backwards. If in the time it takes you to work for them you could satisfy two or three other clients, then the money side of the argument for sticking with them may not hold water either.
Lastly, are they constantly asking you to change your product or processes to better suit them? If the product that you are offering is not lining up with the expectations and demands of your client and they are requesting that you modify it, then you should probably not be working with them, since what you offer and what they want are two different things. Simply because there is money to be made, that does not mean that the relationship has the potential to be profitable in the long term
Thursday, May 22, 2014
Friday, May 16, 2014
A Guide to the Tax Rules of Mortgage Refinancing
Recent drops in interest rates have prompted millions of households to refinance their mortgages. Borrowers who refinance need to familiarize themselves with tricky tax rules on what is or isn't deductible for interest payments. Here are some reminders on how the rules work.
Consider a client who owns a personal residence. It's worth more than the remaining principal balance on the mortgage. The lender is willing to allow a refinance for more than the balance of the existing mortgage. Tax rules allow the client to deduct interest payments on a refinancing loan as long as it's for the same amount as the existing balance. But is the client also entitled to deduct interest payments for the part of the refinancing that exceeds the existing balance? And does it matter that the client plans to use most of the excess refinancing proceeds to pay off credit card debts?
Whether borrowers are entitled to deduct interest on the excess amount depends upon how they use the proceeds from the refinancing and the amount of the proceeds. When borrowers use the amount in excess of the existing mortgage to buy, build or substantially improve principal residences, meaning year-round dwellings, or second homes such as vacation retreats, their interest payments come under the rules for home acquisition loans. Those rules allow them to deduct the entire interest as long as the excess plus all other home acquisition loans don't exceed $1 million ($500,000 for married couples filing separate returns).
However, when borrowers use the excess for any other purposes, another set of rules prohibits deductions for payments of interest on "consumer loans." This wide-ranging category includes credit card bills, auto loans, medical expenses and other personal debts such as overdue federal and state income taxes. There is, though, a limited exception for interest on student loans, one of those "above-the-line" subtractions to arrive at adjusted gross income.
But most borrowers are able to sidestep these restrictions on deductions for consumer interest, thanks to the rules for home equity loans. Those rules allow them to deduct the entire interest as long as the amount in excess of the existing mortgage plus all other home equity loans don't exceed $100,000, dropping to $50,000 for married couples filing separate returns. It makes no difference how borrowers use the proceeds.
When their refinanced loans are partly home acquisition loans and partly home equity loans, there's an overall limit of $1.1 million, which is a combination of $1 million from the home acquisition debt and $100,000 home equity debt. (That number drops to $550,000 for married couples filing separately.) When the loans exceed the ceiling of $1 million for home acquisition loans and $100,000 for home equity loans, the excess generally is categorized as nondeductible personal interest. The general disallowance is subject to exceptions for loan proceeds used for business or investment purposes.
Yet another restriction applies to the steadily growing number of borrowers burdened by the alternative minimum tax. The AMT allows deductions for interest payments on home acquisition loans of up to $1 million ($500,000 for married couples filing separately). But AMT rules deny any deductions for interest on home equity loans for first or second homes, unless the loan proceeds are used to buy, build, or substantially improve the dwellings.
Consider a client who owns a personal residence. It's worth more than the remaining principal balance on the mortgage. The lender is willing to allow a refinance for more than the balance of the existing mortgage. Tax rules allow the client to deduct interest payments on a refinancing loan as long as it's for the same amount as the existing balance. But is the client also entitled to deduct interest payments for the part of the refinancing that exceeds the existing balance? And does it matter that the client plans to use most of the excess refinancing proceeds to pay off credit card debts?
Whether borrowers are entitled to deduct interest on the excess amount depends upon how they use the proceeds from the refinancing and the amount of the proceeds. When borrowers use the amount in excess of the existing mortgage to buy, build or substantially improve principal residences, meaning year-round dwellings, or second homes such as vacation retreats, their interest payments come under the rules for home acquisition loans. Those rules allow them to deduct the entire interest as long as the excess plus all other home acquisition loans don't exceed $1 million ($500,000 for married couples filing separate returns).
However, when borrowers use the excess for any other purposes, another set of rules prohibits deductions for payments of interest on "consumer loans." This wide-ranging category includes credit card bills, auto loans, medical expenses and other personal debts such as overdue federal and state income taxes. There is, though, a limited exception for interest on student loans, one of those "above-the-line" subtractions to arrive at adjusted gross income.
But most borrowers are able to sidestep these restrictions on deductions for consumer interest, thanks to the rules for home equity loans. Those rules allow them to deduct the entire interest as long as the amount in excess of the existing mortgage plus all other home equity loans don't exceed $100,000, dropping to $50,000 for married couples filing separate returns. It makes no difference how borrowers use the proceeds.
When their refinanced loans are partly home acquisition loans and partly home equity loans, there's an overall limit of $1.1 million, which is a combination of $1 million from the home acquisition debt and $100,000 home equity debt. (That number drops to $550,000 for married couples filing separately.) When the loans exceed the ceiling of $1 million for home acquisition loans and $100,000 for home equity loans, the excess generally is categorized as nondeductible personal interest. The general disallowance is subject to exceptions for loan proceeds used for business or investment purposes.
Yet another restriction applies to the steadily growing number of borrowers burdened by the alternative minimum tax. The AMT allows deductions for interest payments on home acquisition loans of up to $1 million ($500,000 for married couples filing separately). But AMT rules deny any deductions for interest on home equity loans for first or second homes, unless the loan proceeds are used to buy, build, or substantially improve the dwellings.
Wednesday, May 14, 2014
How to Survive an IRS Audit
When responding to your audit notice, you should be thorough, but avoid sending the IRS superfluous information because that slows the process.
It's a scenario many taxpayers entertain: What would happen if I was audited?
With April 15 in the rear view mirror, some taxpayers are finding out. Still, the odds of being audited are slim: According to the Internal Revenue Service, less than 1 percent of individuals' returns were audited in 2013, and fewer audits are expected this year due to budget cuts.
High-income taxpayers and self-employed individuals have the highest chances of being audited, according to Robert McKenzie, a partner at the law firm Arnstein and Lehr LLP in Chicago who previously worked in the collection division of the IRS.
Bob Fodera, a partner with ParenteBeard, an accounting firm headquartered in Philadelphia, agrees, adding that taxpayers who have claimed inconsistent deductions over the years are more likely to be audited. And if your spouse has a small business, especially one the IRS considers more of a hobby, that, too, is often a trigger, Fodera says. "I've seen this come up with amateur photographers quite often," Fodera says.
So if you've recently received a letter or notice from the IRS informing you that you're being audited, what can you expect – and what should you do?
What to expect. If you're like Elizabeth Safran, 45, who owns a public relations company in New York City and files as a sole proprietor, you will probably feel "fear, later followed by shock," she says, when you receive the letter.
When Safran received hers in 2011, she reread it a couple of times. "It was a whole lot of text. I saw the years 2008 and 2009 and Schedule C," Safran recalls.
She struck out on her own as a public relations consultant in 2007 and the new, single mom was understandably petrified. But it was the spring of 2011, and she had until July to gather her paperwork and visit the IRS office in midtown Manhattan.
While some fear is understandable, don't let it consume you. "The first thing to do is not to be overwhelmed and shut down," says Mike Campbell, a tax partner at BDO USA LLP, a professional services organization headquartered in Chicago.
The process. According to McKenzie, there are three types of audits: correspondence, office exam and field exam.
The correspondence audit is conducted through the mail, and it’s common – McKenzie says 80 percent of individual audits are done this way.
The office exam requires face time at an IRS office, which is what Safran experienced. "It normally lasts four hours or less, and by necessity, the IRS only reviews limited issues on the return," McKenzie says.
The field exam is a comprehensive, thorough audit that strikes fear in the hearts of taxpayers. It's usually held at the taxpayer's place of business, and McKenzie says it involves "hours of intense review and verification by a revenue agent."
It’s important to be honest and respond as thoroughly as you can, Campbell says. But he adds: "It's not necessary to volunteer additional information outside of the scope of the audit, as that will only lead to new potential questions and possible expansion of the scope of the audit."
You could also end up slowing the process if you throw every bit of information and data you have at your IRS agent, he says.
With April 15 in the rear view mirror, some taxpayers are finding out. Still, the odds of being audited are slim: According to the Internal Revenue Service, less than 1 percent of individuals' returns were audited in 2013, and fewer audits are expected this year due to budget cuts.
High-income taxpayers and self-employed individuals have the highest chances of being audited, according to Robert McKenzie, a partner at the law firm Arnstein and Lehr LLP in Chicago who previously worked in the collection division of the IRS.
Bob Fodera, a partner with ParenteBeard, an accounting firm headquartered in Philadelphia, agrees, adding that taxpayers who have claimed inconsistent deductions over the years are more likely to be audited. And if your spouse has a small business, especially one the IRS considers more of a hobby, that, too, is often a trigger, Fodera says. "I've seen this come up with amateur photographers quite often," Fodera says.
So if you've recently received a letter or notice from the IRS informing you that you're being audited, what can you expect – and what should you do?
What to expect. If you're like Elizabeth Safran, 45, who owns a public relations company in New York City and files as a sole proprietor, you will probably feel "fear, later followed by shock," she says, when you receive the letter.
When Safran received hers in 2011, she reread it a couple of times. "It was a whole lot of text. I saw the years 2008 and 2009 and Schedule C," Safran recalls.
She struck out on her own as a public relations consultant in 2007 and the new, single mom was understandably petrified. But it was the spring of 2011, and she had until July to gather her paperwork and visit the IRS office in midtown Manhattan.
While some fear is understandable, don't let it consume you. "The first thing to do is not to be overwhelmed and shut down," says Mike Campbell, a tax partner at BDO USA LLP, a professional services organization headquartered in Chicago.
The process. According to McKenzie, there are three types of audits: correspondence, office exam and field exam.
The correspondence audit is conducted through the mail, and it’s common – McKenzie says 80 percent of individual audits are done this way.
The office exam requires face time at an IRS office, which is what Safran experienced. "It normally lasts four hours or less, and by necessity, the IRS only reviews limited issues on the return," McKenzie says.
The field exam is a comprehensive, thorough audit that strikes fear in the hearts of taxpayers. It's usually held at the taxpayer's place of business, and McKenzie says it involves "hours of intense review and verification by a revenue agent."
It’s important to be honest and respond as thoroughly as you can, Campbell says. But he adds: "It's not necessary to volunteer additional information outside of the scope of the audit, as that will only lead to new potential questions and possible expansion of the scope of the audit."
You could also end up slowing the process if you throw every bit of information and data you have at your IRS agent, he says.
When Safran went to the IRS office, she says she was pleasant and professional and had a feeling the agent appreciated it. After she met her contact, they walked back to an office and passed another office where a taxpayer was shouting, "I paid cash! I didn't pay with receipts!"
Don't be that person, Safran suggests.
But you shouldn’t be a doormat, either. Richard Houston, a Los Angeles businessman who specializes in website development, says he was audited in 1975 for tuition and related education expenses. "Even though I didn't complete the rest of the courses required for a degree, I was in total compliance with the IRS code and the appropriate regulations," he says.
Houston went to his local IRS office armed with a reference book ("U.S. Master Tax Guide," published by CCH) and showed the agent why he believed the deduction was allowable.
The agent disagreed. Houston then asked to talk to the supervisor, and after a discussion, the deductions were allowed. "Be prepared and be armed with the truth, because they aren't pushovers," Houston says.
What’s the worst that could happen? That's what everyone wants to know. If you can't show the records requested, will you go to jail?
You're probably not going to the clink. "Generally, only in extreme cases of willful negligence and tax evasion does someone end up in jail," Campbell says.
But an audit experience could be expensive. "In most audits, the worst that can happen is that the IRS would adjust your return to remove deductions you claimed and can’t substantiate or include income you may have omitted," Campbell says. "Then you would pay the tax due, plus interest from the time that tax should have been paid."
That's assuming the IRS feels you’ve been cooperative, because as Campbell says, "The IRS can also choose to assert a 20 percent accuracy-related penalty under Section 6662 if it deems even your mistakes on the return to be egregious or to represent a substantial understatement of your tax liability."
And, of course, if you have to hire an attorney or accountant to help you organize paperwork or make your case, that will also require an outlay of funds.
Above all, if the IRS comes up with a figure that you owe, don’t neglect to pay. The agency can “garnish wages and put liens against your assets and other avenues to collect the tax, interest and penalty," Campbell says.
Advice for the hopelessly disorganized. Tax experts advise keeping good records in case of an audit, but what if you haven't done that?
Michael Raanan, a former IRS revenue officer and president of Landmark Tax Group in Santa Ana, California, says you might have luck gathering records from your employer or previous employers, your bank or financial institution, the IRS (if you've lost your old tax returns), your tax preparer or bookkeeper and your mortgage lender.
Types of paperwork to gather include "sales slips, credit card receipts and other proofs of payment, invoices, canceled checks, bank statements and, of course, mileage logs," Raanan says.
The logs are very important if you've deducted a lot of miles. "Without a mileage log or a GPS record of mileage incurred, it would be difficult for the IRS to accept all of the miles claimed," Raanan says.
And, sure, spending all this time on your taxes is, well, taxing, but it’s worth it to be as prepared as possible for your audit.
That’s what Safran found. Before her audit, she faced the possibility of owing the IRS $40,000. In the midst of running her business and adjusting to motherhood, she traveled the paper trail, gathered every document she could and asked for an extra month when she realized she needed more time (the IRS obliged). After the three-hour meeting, Safran's tax bill was whittled down to $5,000 since her paperwork supported the numbers on her return.
"I think if I had had better documentation, I could have gotten it down to $3,000," Safran adds.
Tuesday, May 13, 2014
IRS Warns Against Including SSNs in Form 990
As the May 15 deadline approaches for tax-exempt organizations to file the Form 990, 990-EZ and 990-PF, the Internal Revenue Service is warning them not to include Social Security numbers and other personally identifiable information in their tax forms.
Filing a 990-series return is important for many groups and they are at risk of losing their tax exemption if they fail to file for three years in a row. However, they should be careful not to include Social Security numbers on Form 990 when filing the form. The IRS also cautions not to include personally identifiable information. Including unnecessary SSNs or other unrequested personal information could lead to identity theft.
Last year, a watchdog group, Public.Resource.org, found a database of tens of thousands of Social Security numbers from people who filed the tax returns for Section 527 campaign committees and other political organizations that the IRS had accidentally posted on the Internet (see IRS Accidentally Exposed Tens of Thousands of Social Security Numbers). The IRS quickly took down the database when the whistleblower group pointed out the error, but two subcommittee chairmen in Congress soon demanded information from the IRS about the security snafu (see Lawmakers Question IRS Chief about Release of Social Security Numbers).
Amid the continuing headlines about the IRS's extra scrutiny of Tea Party groups and other political organizations applying for tax exemptions, the IRS is being extra cautious this year in warning charities, not-for-profits, private foundations and other tax-exempt organizations that file Form 990-series returns to be careful about safeguarding their Social Security numbers and other personal information. The IRS has also released a video on YouTube from an IRS employee explaining the importance of keeping such information away from identity thieves, not to mention congressmen.
Filing a 990-series return is important for many groups and they are at risk of losing their tax exemption if they fail to file for three years in a row. However, they should be careful not to include Social Security numbers on Form 990 when filing the form. The IRS also cautions not to include personally identifiable information. Including unnecessary SSNs or other unrequested personal information could lead to identity theft.
Last year, a watchdog group, Public.Resource.org, found a database of tens of thousands of Social Security numbers from people who filed the tax returns for Section 527 campaign committees and other political organizations that the IRS had accidentally posted on the Internet (see IRS Accidentally Exposed Tens of Thousands of Social Security Numbers). The IRS quickly took down the database when the whistleblower group pointed out the error, but two subcommittee chairmen in Congress soon demanded information from the IRS about the security snafu (see Lawmakers Question IRS Chief about Release of Social Security Numbers).
Amid the continuing headlines about the IRS's extra scrutiny of Tea Party groups and other political organizations applying for tax exemptions, the IRS is being extra cautious this year in warning charities, not-for-profits, private foundations and other tax-exempt organizations that file Form 990-series returns to be careful about safeguarding their Social Security numbers and other personal information. The IRS has also released a video on YouTube from an IRS employee explaining the importance of keeping such information away from identity thieves, not to mention congressmen.
Monday, May 12, 2014
How to Amend Your Federal Tax Return
Here are some additional thoughts, based on reader questions and interviews with tax pros, on what to do when you discover mistakes—or even honest omissions—on a tax return you've filed. The answer varies depending on your situation and the size of the change.
Suppose you get a revised form from a brokerage house or some other financial institution changing the amount of dividend income reported for last year. Often, the change is just a few dollars. In such cases, tax pros say many clients routinely ignore it, even if the change would mean a slightly larger refund. It may not be worth the cost of paying your tax preparer to file amended returns.
But the answer would be different if you receive a notification involving a substantial amount. "You usually should file an amended tax return if you made an error claiming your filing status, income, deductions or credits on your original return," the IRS said in a "tax tip" in April. Use Form 1040X, and check on your state's rules, too. (Most states have their own income tax.)
When should you file an amended return? This can be tricky. "If you are due a refund from your original return, wait to receive that refund before filing Form 1040X to claim an additional refund," the IRS said. "Amended returns take up to 12 weeks to process." You may cash your original refund while awaiting the additional refund.
If you owe more tax because of something you just discovered, "file your Form 1040X and pay the tax as soon as possible," the IRS said. "This will reduce any interest and penalties."
How do you find out what's happening on your amended return? You can check three weeks after you file by clicking on "Where's My Amended Return?" on the IRS website (irs.gov). You can also call 866-464-2050. The IRS says you can use this to track an amended return for the current year and up to three years back.
Sunday, May 11, 2014
Why I Don’t Like Roth IRAs:
Tax planning for clients during tax season always generates new strategies and ideas, as unique situations tend to get my analytical wheels turning. From a risk/reward wealth management perspective, I like to look at tax planning with the actual cost to the client in mind, including what is the best cash flow option, because the most tax efficient savings strategy for each person’s situation is the ultimate wealth planning strategy. Here are a few thoughts that may also relate to your clients:
Negative Cash Flow Savings
I’ve never been a big proponent of the Roth IRA due to its drastic current negative cash flow. Here’s what I mean by negative cash flow savings: Let’s assume your client can put $6,000 in a Roth IRA, which costs them $7,800 in cash flow to save $6,000 (assuming a 25% federal and 5% state income tax bracket). Putting that same $6,000 in an IRA will only cost $4,200 in cash flow to save $6,000 - assuming the same tax rates above.
I’ve learned that most clients want to save money for retirement, while also living a little along the way, traveling and enjoying quality time with kids/family as they age. The IRA savings example above gives families an extra $3,600 of cash flow per year, which they could further save or spend. Of course, many of you will argue that the Roth IRA is tax-free for life, while the other is taxable when withdrawn. That’s true, based on the current tax laws. However, in my experience many clients live on less money in retirement, usually dropping them at least one tax bracket below where they saved/contributed the money while working.
For example: Assuming the same tax rates above (25% federal and 5% state – for a total of 30%) for a client contributing to an IRA, in most cases, that client withdraws money out of an IRA during retirement at a total 15% bracket (15% federal with little or no state income tax on retirement assets, depending on the state of residency). This example provides long-term tax-free savings comparable to a Roth IRA when also considering the overall total cost of the long-term differing cash flow effects mentioned earlier. For further clarification on this point, you may want to read a past article of mine entitled: The Gamble of a Lifetime.
Income Qualifying Limits & Low Contribution Limits
The second reason I’m not a fan is the Roth IRA’s low income qualifying restrictions and the IRA’s low contribution limits. If an investor is not part of a 401(k) or covered pension plan where they work, the odds are pretty much stacked against them for retirement savings. In 2014, Roth IRA income limits for single filers are $114,000 to $129,000, and for joint filers it’s $181,000 to $191,000, with both IRA & Roth IRA contribution limits maxed out at $5,500 each unless over age 50.Therefore, if we still assume a 25% federal and 5% state tax bracket, plus a prudent low-end savings of 15% of income per year to fund a client’s retirement, the single filer can only invest $11,000 between both an IRA ($5,500) and a Roth IRA ($5,500) in retirement specific accounts, unless over age 50.
As such, a single filer is already short $6,100 (15% of $114,000 - $11,000) in retirement savings, if effectively using both an IRA and Roth IRA. If you compare the actual cash flow cost to saving 15% annually, it would roughly cost the non-401(k) covered single filer $18,930 (130% of $11,600 + 70% of $5,500) to save 15% of their $114,000 income or $17,100.
A covered 401(k) plan employee has contribution limits of up to $17,500, not including company matching contributions. The same single filer saving $17,100 in a 401(k) plan would have cash flow costs of only $11,970 (70% of $17,100) to save 15% of the $114,000 income or $17,100. The earlier contribution limits indirectly force a huge cash flow difference of $6,960 per year between the two examples. Joint filers are no different in like-kind comparisons, prompting the need to help clients decide where, how much and what works best to tax efficiently save 15% to 25% of income annually for retirement, and enjoy life along the way.
Despite the fact that most clients want to save money, very few can tax efficiently save for retirement while optimizing their current lifestyle. They either save a lot, thereby significantly sacrificing their family’s ability to enjoy life along the way, or save too little, enabling them to experience more with their families, but leaving them on the job till 67 or 70 because they haven’t saved enough.
Negative Cash Flow Savings
I’ve never been a big proponent of the Roth IRA due to its drastic current negative cash flow. Here’s what I mean by negative cash flow savings: Let’s assume your client can put $6,000 in a Roth IRA, which costs them $7,800 in cash flow to save $6,000 (assuming a 25% federal and 5% state income tax bracket). Putting that same $6,000 in an IRA will only cost $4,200 in cash flow to save $6,000 - assuming the same tax rates above.
I’ve learned that most clients want to save money for retirement, while also living a little along the way, traveling and enjoying quality time with kids/family as they age. The IRA savings example above gives families an extra $3,600 of cash flow per year, which they could further save or spend. Of course, many of you will argue that the Roth IRA is tax-free for life, while the other is taxable when withdrawn. That’s true, based on the current tax laws. However, in my experience many clients live on less money in retirement, usually dropping them at least one tax bracket below where they saved/contributed the money while working.
For example: Assuming the same tax rates above (25% federal and 5% state – for a total of 30%) for a client contributing to an IRA, in most cases, that client withdraws money out of an IRA during retirement at a total 15% bracket (15% federal with little or no state income tax on retirement assets, depending on the state of residency). This example provides long-term tax-free savings comparable to a Roth IRA when also considering the overall total cost of the long-term differing cash flow effects mentioned earlier. For further clarification on this point, you may want to read a past article of mine entitled: The Gamble of a Lifetime.
Income Qualifying Limits & Low Contribution Limits
The second reason I’m not a fan is the Roth IRA’s low income qualifying restrictions and the IRA’s low contribution limits. If an investor is not part of a 401(k) or covered pension plan where they work, the odds are pretty much stacked against them for retirement savings. In 2014, Roth IRA income limits for single filers are $114,000 to $129,000, and for joint filers it’s $181,000 to $191,000, with both IRA & Roth IRA contribution limits maxed out at $5,500 each unless over age 50.Therefore, if we still assume a 25% federal and 5% state tax bracket, plus a prudent low-end savings of 15% of income per year to fund a client’s retirement, the single filer can only invest $11,000 between both an IRA ($5,500) and a Roth IRA ($5,500) in retirement specific accounts, unless over age 50.
As such, a single filer is already short $6,100 (15% of $114,000 - $11,000) in retirement savings, if effectively using both an IRA and Roth IRA. If you compare the actual cash flow cost to saving 15% annually, it would roughly cost the non-401(k) covered single filer $18,930 (130% of $11,600 + 70% of $5,500) to save 15% of their $114,000 income or $17,100.
A covered 401(k) plan employee has contribution limits of up to $17,500, not including company matching contributions. The same single filer saving $17,100 in a 401(k) plan would have cash flow costs of only $11,970 (70% of $17,100) to save 15% of the $114,000 income or $17,100. The earlier contribution limits indirectly force a huge cash flow difference of $6,960 per year between the two examples. Joint filers are no different in like-kind comparisons, prompting the need to help clients decide where, how much and what works best to tax efficiently save 15% to 25% of income annually for retirement, and enjoy life along the way.
Despite the fact that most clients want to save money, very few can tax efficiently save for retirement while optimizing their current lifestyle. They either save a lot, thereby significantly sacrificing their family’s ability to enjoy life along the way, or save too little, enabling them to experience more with their families, but leaving them on the job till 67 or 70 because they haven’t saved enough.
Thursday, May 8, 2014
Clients' higher tax bills prompt Investment advisers to brush up on taxes
After a particularly brutal 2013 filing season, look for income tax planning to emerge as a specialty among financial advisers.
A combination of factors is elevating the importance of income tax planning with respect to high-net-worth clients. First, there's the fallout from the American Taxpayer Relief Act of 2012, which took effect on Jan. 1, 2013.
Essentially, ATRA hit the top earners the hardest. Single filers with taxable income exceeding $400,000, as well as those who are married and filing jointly with taxable income over $450,000, now face a top marginal income tax rate of 39.6%. They also are subject to a top marginal tax rate of 20% on long-term capital gains.
Beginning at the $250,000 income level for singles and $300,000 level for married-filing-jointly taxpayers, there's a tax bite in the form of the phaseout of personal exemptions and itemized deductions.
Meanwhile, those with $200,000 in income (single) and $250,000 (married, filing jointly) are subject to the 3.8% surtax on the lesser of income over those thresholds or net investment income, and the 0.9% Medicare tax on wages over those thresholds.
Though ATRA was particularly harsh on the income and capital gains side, it was a little more forgiving on the estate tax side. There, the individual exclusion for estate and gift taxes is now at $5.34 million and the tax rate at 40%.
Clients' post-ATRA income tax chickens have come home to roost in the form of higher tax bills. That, combined with the relatively high exemption for estate and gift taxes, means income tax planning is now on the front burner.
“There's a big paradigm shift,” said Charles Douglas, editor of the National Association of Estate Planners and Council's Journal of Estate and Tax Planning. “When you look at the federal, state and the 3.8% surtax on the income tax side, those can outweigh the gift transfer tax.”
That means analyzing and minimizing income taxes becomes the focal point in a number of planning scenarios. “This is about advising people on where to live for income tax purposes, where to die for estate tax purposes, as well as having trusts in other estates,” Mr. Douglas said.
It's important to remember that trusts' income in excess of $11,950 is taxed at the 39.6% rate — the highest income tax bracket. Advisers ought to guide clients to think about tax-efficient assets to hold, such as municipal bonds and life insurance, Mr. Douglas said.
With trusts, clients can also add a “sprinkle provision” to make distributions out of the trust to children and grandchildren who are in lower income tax brackets, as opposed to having the trust face the highest income tax rates, he added.
Outside of trusts, advisers can point clients to other tax-exempt investments. “There's a big opportunity in deferring the income taxes by using non-qualified annuities or cash value life insurance,” said J. Christopher Raulston, a wealth strategist at Raymond James Financial Inc. He expected he would see more individuals use annuities and save in them, with the expectation that by the time they tap them for income, they'll be retired and in a lower bracket. “You're in your earning years and making a good living — that's when you want to defer income,” Mr. Raulston said. “You're using that annuity to leapfrog the higher tax years and push income toward later years in retirement.”
There are also other vehicles to consider, such as a life insurance retirement plan, which is essentially a formalized strategy of socking money away into a life insurance policy with the intention of building cash value, according to Mr. Raulston. The cash value becomes an asset the client can tap free of taxes. But be sure to monitor the policy throughout its life: Universal life written 20 to 30 years ago has been experiencing pressure due to low interest rates.
Finally, have your clients get their charitable giving in order for the 2014 tax year. Charitable giving not only allows clients to offload highly appreciated assets, it also nets them a deduction that they can use to reduce their income taxes. Gavin Morrissey, senior vice president of wealth management at Commonwealth, notes that clients are getting a twofer deal by combining a gift of highly appreciated low basis stock to a donor-advised fund or to a charity and then using the income tax deduction to offset the taxes they'd pay on a Roth conversion.
In the long run, this also helps clients diversify the tax treatment of their pool of assets when they prepare to retire. They now have an array of accounts with different tax treatments, and they can plan their income withdrawal strategy with taxes in mind.
“One of the biggest puzzles is where do you get the income from,” Mr. Morrissey said. “If you have a Roth IRA, a non-qualified account and a traditional IRA, you'll want to control taxes. Where are you getting your withdrawals from so that you don't unintentionally run into a higher tax bracket?”
A combination of factors is elevating the importance of income tax planning with respect to high-net-worth clients. First, there's the fallout from the American Taxpayer Relief Act of 2012, which took effect on Jan. 1, 2013.
Essentially, ATRA hit the top earners the hardest. Single filers with taxable income exceeding $400,000, as well as those who are married and filing jointly with taxable income over $450,000, now face a top marginal income tax rate of 39.6%. They also are subject to a top marginal tax rate of 20% on long-term capital gains.
Beginning at the $250,000 income level for singles and $300,000 level for married-filing-jointly taxpayers, there's a tax bite in the form of the phaseout of personal exemptions and itemized deductions.
Meanwhile, those with $200,000 in income (single) and $250,000 (married, filing jointly) are subject to the 3.8% surtax on the lesser of income over those thresholds or net investment income, and the 0.9% Medicare tax on wages over those thresholds.
Though ATRA was particularly harsh on the income and capital gains side, it was a little more forgiving on the estate tax side. There, the individual exclusion for estate and gift taxes is now at $5.34 million and the tax rate at 40%.
Clients' post-ATRA income tax chickens have come home to roost in the form of higher tax bills. That, combined with the relatively high exemption for estate and gift taxes, means income tax planning is now on the front burner.
“There's a big paradigm shift,” said Charles Douglas, editor of the National Association of Estate Planners and Council's Journal of Estate and Tax Planning. “When you look at the federal, state and the 3.8% surtax on the income tax side, those can outweigh the gift transfer tax.”
That means analyzing and minimizing income taxes becomes the focal point in a number of planning scenarios. “This is about advising people on where to live for income tax purposes, where to die for estate tax purposes, as well as having trusts in other estates,” Mr. Douglas said.
It's important to remember that trusts' income in excess of $11,950 is taxed at the 39.6% rate — the highest income tax bracket. Advisers ought to guide clients to think about tax-efficient assets to hold, such as municipal bonds and life insurance, Mr. Douglas said.
With trusts, clients can also add a “sprinkle provision” to make distributions out of the trust to children and grandchildren who are in lower income tax brackets, as opposed to having the trust face the highest income tax rates, he added.
Outside of trusts, advisers can point clients to other tax-exempt investments. “There's a big opportunity in deferring the income taxes by using non-qualified annuities or cash value life insurance,” said J. Christopher Raulston, a wealth strategist at Raymond James Financial Inc. He expected he would see more individuals use annuities and save in them, with the expectation that by the time they tap them for income, they'll be retired and in a lower bracket. “You're in your earning years and making a good living — that's when you want to defer income,” Mr. Raulston said. “You're using that annuity to leapfrog the higher tax years and push income toward later years in retirement.”
There are also other vehicles to consider, such as a life insurance retirement plan, which is essentially a formalized strategy of socking money away into a life insurance policy with the intention of building cash value, according to Mr. Raulston. The cash value becomes an asset the client can tap free of taxes. But be sure to monitor the policy throughout its life: Universal life written 20 to 30 years ago has been experiencing pressure due to low interest rates.
Finally, have your clients get their charitable giving in order for the 2014 tax year. Charitable giving not only allows clients to offload highly appreciated assets, it also nets them a deduction that they can use to reduce their income taxes. Gavin Morrissey, senior vice president of wealth management at Commonwealth, notes that clients are getting a twofer deal by combining a gift of highly appreciated low basis stock to a donor-advised fund or to a charity and then using the income tax deduction to offset the taxes they'd pay on a Roth conversion.
In the long run, this also helps clients diversify the tax treatment of their pool of assets when they prepare to retire. They now have an array of accounts with different tax treatments, and they can plan their income withdrawal strategy with taxes in mind.
“One of the biggest puzzles is where do you get the income from,” Mr. Morrissey said. “If you have a Roth IRA, a non-qualified account and a traditional IRA, you'll want to control taxes. Where are you getting your withdrawals from so that you don't unintentionally run into a higher tax bracket?”
Wednesday, May 7, 2014
Time to Think About Taxes, Again!
Yes, I know we're just past last year's tax season, but good tax planning works only if we start early enough for the current year. Having last year's tax return still fresh in memory gives us a great start for next year's tax planning.
Understand how your income is being taxedDo you know what your effective tax rate is? Do you have more than one income source? Do you know how each of your income sources is taxed? Income can be broadly classified as:
For example, if you had dependents and paid for child care, have you looked at your employer's benefits to see if they offer a dependent care account? A lot of employers also offer discounts toward a variety of businesses. One of my past employers offered a discount and extended hours at a nearby day care, but no one knew about it because it was only mentioned in an online benefits brochure which didn't get many views.
Did you contribute at least enough to your retirement plan to get the employer match?
Can you optimize your deductions?Did you itemize or take the standard deduction? What is the difference in your return when choosing between itemized and standard deduction? If you donated to charity and the difference between your standard and itemized deductions was small, you might want to consider donating every other year. Here is an example to explain this better:
Let's say you donated $12,000 to charity in 2012 and again in 2013. Let's additionally assume that both years you opted to take itemized deductions. The total deduction for 2012 and 2013 is $24,000.
Now, instead, let's assume you set aside $1,000 each month in 2012 and donated the entire $24,000 in 2013. You take the standard deduction for 2012 ($11,900 if you are married and filing jointly) and itemized deduction for 2013 ($24,000). This makes the total deductions for 2012 and 2013 a whopping $35,900. You can deduct an extra $11,900, which, depending on your tax bracket, can be a substantial saving.
Of course, this is an over-simplified illustration; there are other deductions like state taxes and property taxes to consider. These cannot be skipped every other year, but it is definitely worth doing the calculations both ways to determine which is more beneficial.
Are you placing your investments in a tax-smart vehicle?Taxes should not be the only concern for any investment; you should evaluate your risk tolerance and do careful asset allocation. After you have made your investment decision, it is essential to choose the right vehicle to make it tax efficient. Should you invest in a taxable account or a tax-sheltered account? For example, if you are going to hold a stock for a very long time, it can be in a taxable account as it will be taxed as capital gains; but if you are going to be generating a lot of short-term gains, it might be better to place it in a tax-sheltered account.
Have a strategy in placeAfter going over your tax return with the goal of planning for next year, is there anything you can do now to make next year's return more efficient and less time-consuming? Think of all the potential expenses this year and figure out if any of them are deductible. For example, if you are planning to send your kids to summer camp, it might be a deductible expense. Knowing what you are going to deduct this year will make it easier to save the receipts and will also make sure you won't miss it due to last-minute lapses in memory.
Set up a system for next year's deductionsReceipts, receipts and more receipts. Anything that can be deducted, file it. Set up a system that works for you whether it's a folder for each month or a folder for each category or alternatively scanning the receipt and recording it in Excel. Pick a system and work on it throughout the year.
Get helpI wanted to have an accountant prepare my taxes for 2013; but I procrastinated and, by the time I contacted potential accountants, they were all too busy to take new clients. This year, I am looking for an accountant right now. Finding the right person can also be a time-consuming process. I want to get referrals, talk to the accountant, and develop a relationship. Doing it now, when the accountant is not drowning in client files, will help me find the best accountant for my situation.
What is your tax-planning strategy?
Understand how your income is being taxedDo you know what your effective tax rate is? Do you have more than one income source? Do you know how each of your income sources is taxed? Income can be broadly classified as:
- Ordinary — Income from a regular job, self-employment and freelancing; interest income and non-qualified dividends.
- Capital — Qualified dividends, income from the sale of an asset (stock, real estate, etc.)
- Passive — Income from sources like real estate and business investments where participation is not required.
- If you have a large amount of money sitting in a savings account that you won't require for at least 5 years, can you move it to dividend-paying stocks?
- If you paid the higher rate for selling a stock too soon, can you plan better on when you buy and sell stocks to pay the capital gains rate instead of the ordinary rate?
- If you don't have more than one source of income, especially if your job is your only source of income, consider diversifying by earning income on the side.
For example, if you had dependents and paid for child care, have you looked at your employer's benefits to see if they offer a dependent care account? A lot of employers also offer discounts toward a variety of businesses. One of my past employers offered a discount and extended hours at a nearby day care, but no one knew about it because it was only mentioned in an online benefits brochure which didn't get many views.
Did you contribute at least enough to your retirement plan to get the employer match?
Can you optimize your deductions?Did you itemize or take the standard deduction? What is the difference in your return when choosing between itemized and standard deduction? If you donated to charity and the difference between your standard and itemized deductions was small, you might want to consider donating every other year. Here is an example to explain this better:
Let's say you donated $12,000 to charity in 2012 and again in 2013. Let's additionally assume that both years you opted to take itemized deductions. The total deduction for 2012 and 2013 is $24,000.
Now, instead, let's assume you set aside $1,000 each month in 2012 and donated the entire $24,000 in 2013. You take the standard deduction for 2012 ($11,900 if you are married and filing jointly) and itemized deduction for 2013 ($24,000). This makes the total deductions for 2012 and 2013 a whopping $35,900. You can deduct an extra $11,900, which, depending on your tax bracket, can be a substantial saving.
Of course, this is an over-simplified illustration; there are other deductions like state taxes and property taxes to consider. These cannot be skipped every other year, but it is definitely worth doing the calculations both ways to determine which is more beneficial.
Are you placing your investments in a tax-smart vehicle?Taxes should not be the only concern for any investment; you should evaluate your risk tolerance and do careful asset allocation. After you have made your investment decision, it is essential to choose the right vehicle to make it tax efficient. Should you invest in a taxable account or a tax-sheltered account? For example, if you are going to hold a stock for a very long time, it can be in a taxable account as it will be taxed as capital gains; but if you are going to be generating a lot of short-term gains, it might be better to place it in a tax-sheltered account.
Have a strategy in placeAfter going over your tax return with the goal of planning for next year, is there anything you can do now to make next year's return more efficient and less time-consuming? Think of all the potential expenses this year and figure out if any of them are deductible. For example, if you are planning to send your kids to summer camp, it might be a deductible expense. Knowing what you are going to deduct this year will make it easier to save the receipts and will also make sure you won't miss it due to last-minute lapses in memory.
Set up a system for next year's deductionsReceipts, receipts and more receipts. Anything that can be deducted, file it. Set up a system that works for you whether it's a folder for each month or a folder for each category or alternatively scanning the receipt and recording it in Excel. Pick a system and work on it throughout the year.
Get helpI wanted to have an accountant prepare my taxes for 2013; but I procrastinated and, by the time I contacted potential accountants, they were all too busy to take new clients. This year, I am looking for an accountant right now. Finding the right person can also be a time-consuming process. I want to get referrals, talk to the accountant, and develop a relationship. Doing it now, when the accountant is not drowning in client files, will help me find the best accountant for my situation.
What is your tax-planning strategy?
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