Thursday, July 31, 2014

Your Retirement: Navigating the Social Security ‘Tax Trap’

If you haven’t discovered it already, up to 85 percent of your Social Security benefits could be taxed.

As financial advisors, we are often surprised by the number of prospective retirees who come to us for planning and are shocked that they have to pay taxes on their Social Security when they retire.

In fact, in 2012, Social Security beneficiaries paid a total of $45.9 billion in income taxes on their benefits. That’s right!

Sadly, for many people this taxation could be avoided or at the very least, significantly reduced.  You have to plan ahead for it – and that means understanding how taxes work in retirement.

So here’s how it works: First, to determine the taxability of your Social Security, you must take into consideration your combined income, also known as provisional income, which is arrived at by taking 50 percent of your Social Security benefits and adding that figure to all the other taxable and tax-free interest income you receive in retirement. Yes, even municipal bonds are considered in this equation.

If you file as an individual and your combined income is below $25,000, your benefits won’t be taxed at all. If your income is between $25,000 and $34,000, up to 50 percent of your benefits may be subject to tax. For income of more than $34,000, up to 85 percent of your benefits may be considered taxable income.

If you and your spouse file a joint return with combined income below $32,000, your benefits are safe. For income between $32,000 and $44,000, up to 50 percent of benefits may be subject to taxation, and up to 85 percent if combined income exceeds $44,000.

It is possible to have income in excess of these thresholds while keeping your benefits out of the hands of Uncle Sam. Let’s look at a case to see how this plays out.

Case Study:

A married couple, Jerry and Linda, are both 62 and have recently decided to retire. They’re income need is $62,000 per year. As it stands currently, they have $38,000 of income. So they will have to make up the shortfall of $24,000 ($62,000 - $38,000 = $24,000) from their investment assets.

Jerry and Linda have done a good job accumulating assets to make up for the shortfall between their fixed income resources and their desired income need. However, we want to distribute the assets in the most tax-efficient manner. After all, a dollar paid out in taxes is a dollar that never returns!

Current Income:

Interest and Dividends Income..$2,000

Social Security Income.........$18,000

Pension Income.................$18,000

Total Income...................$38,000

Current Assets:

Bank Accounts....$150,000

Mutual Funds.....$300,000

IRA..............$250,000

401K.............$300,000

Total Assets.....$1,000,000

Jerry and Linda obviously could draw $24,000 from any one of the accounts listed above. However, what option would allow them to access it without causing their Social Security benefits to become taxable?  Through our analysis, we found that they could distribute $15,000 from the mutual funds of which only $2,942 is taxable as a gain. The remaining $12,058 would be consider principal and is not taxable.

They could also distribute $9,000 from their bank accounts, which again would be non-taxable. Any interest accrued on the bank accounts is taxed as interest and dividends and is already accounted for in the combined income above.

So as you can see, we devised an income plan that allows them to attain their $62,000 income goal.  But does it muster up to our “tax free” goal? Let’s work through the calculation:

Interest and Dividends Income..........$2,000

50 percent of Social Security Income...$9,000

Pension Income.........................$18,000

Mutual Funds capital gain..............$2,942

Bank Accounts..........................$0    

Combined Income Total..................$31,942

It sure does with $58 to spare! You see, with proper planning Jerry and Linda were able to produce an income of $62,000 without causing one cent of their Social Security to become taxable. Had they made a different choice they could have had a combined income of $53,000 rather than $31,942, causing 85 percent of their Social Security to become taxable.

A fundamental part of any financial plan is the need for a strategy to help prevent or minimize the effect of income taxes on your wealth. If you do not have such a plan, you can lose significant amounts of money that you may never be able to recapture. There are numerous income-tax savings concepts at your disposal. Unfortunately, most people don’t use any, and many use the wrong ones.

Your Retirement: Navigating the Social Security ‘Tax Trap’

If you haven’t discovered it already, up to 85 percent of your Social Security benefits could be taxed.

As financial advisors, we are often surprised by the number of prospective retirees who come to us for planning and are shocked that they have to pay taxes on their Social Security when they retire.

In fact, in 2012, Social Security beneficiaries paid a total of $45.9 billion in income taxes on their benefits. That’s right!

Sadly, for many people this taxation could be avoided or at the very least, significantly reduced.  You have to plan ahead for it – and that means understanding how taxes work in retirement.

So here’s how it works: First, to determine the taxability of your Social Security, you must take into consideration your combined income, also known as provisional income, which is arrived at by taking 50 percent of your Social Security benefits and adding that figure to all the other taxable and tax-free interest income you receive in retirement. Yes, even municipal bonds are considered in this equation.

If you file as an individual and your combined income is below $25,000, your benefits won’t be taxed at all. If your income is between $25,000 and $34,000, up to 50 percent of your benefits may be subject to tax. For income of more than $34,000, up to 85 percent of your benefits may be considered taxable income.

If you and your spouse file a joint return with combined income below $32,000, your benefits are safe. For income between $32,000 and $44,000, up to 50 percent of benefits may be subject to taxation, and up to 85 percent if combined income exceeds $44,000.

It is possible to have income in excess of these thresholds while keeping your benefits out of the hands of Uncle Sam. Let’s look at a case to see how this plays out.

Case Study:

A married couple, Jerry and Linda, are both 62 and have recently decided to retire. They’re income need is $62,000 per year. As it stands currently, they have $38,000 of income. So they will have to make up the shortfall of $24,000 ($62,000 - $38,000 = $24,000) from their investment assets.

Jerry and Linda have done a good job accumulating assets to make up for the shortfall between their fixed income resources and their desired income need. However, we want to distribute the assets in the most tax-efficient manner. After all, a dollar paid out in taxes is a dollar that never returns!

Current Income:

Interest and Dividends Income..$2,000

Social Security Income.........$18,000

Pension Income.................$18,000

Total Income...................$38,000

Current Assets:

Bank Accounts....$150,000

Mutual Funds.....$300,000

IRA..............$250,000

401K.............$300,000

Total Assets.....$1,000,000

Jerry and Linda obviously could draw $24,000 from any one of the accounts listed above. However, what option would allow them to access it without causing their Social Security benefits to become taxable?  Through our analysis, we found that they could distribute $15,000 from the mutual funds of which only $2,942 is taxable as a gain. The remaining $12,058 would be consider principal and is not taxable.

They could also distribute $9,000 from their bank accounts, which again would be non-taxable. Any interest accrued on the bank accounts is taxed as interest and dividends and is already accounted for in the combined income above.

So as you can see, we devised an income plan that allows them to attain their $62,000 income goal.  But does it muster up to our “tax free” goal? Let’s work through the calculation:

Interest and Dividends Income..........$2,000

50 percent of Social Security Income...$9,000

Pension Income.........................$18,000

Mutual Funds capital gain..............$2,942

Bank Accounts..........................$0    

Combined Income Total..................$31,942

It sure does with $58 to spare! You see, with proper planning Jerry and Linda were able to produce an income of $62,000 without causing one cent of their Social Security to become taxable. Had they made a different choice they could have had a combined income of $53,000 rather than $31,942, causing 85 percent of their Social Security to become taxable.

A fundamental part of any financial plan is the need for a strategy to help prevent or minimize the effect of income taxes on your wealth. If you do not have such a plan, you can lose significant amounts of money that you may never be able to recapture. There are numerous income-tax savings concepts at your disposal. Unfortunately, most people don’t use any, and many use the wrong ones.

Wednesday, July 30, 2014

Why tax planning is so important

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. Your choice.

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 under our beloved Internal Revenue Code.

While the federal income tax rules are now more complicated than ever, the benefits of good tax planning are arguably more valuable than ever before.

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 tax bills along the way.

How are tax planning and financial planning connected?

Financial planning is the art of implementing strategies that help you reach your financial goals, be they short-term or long-term. That sounds pretty simple. However, if the actual execution was simple, there would be a lot more rich folks.

Tax planning and financial planning are closely linked, because taxes are such a large expense item as you go through life. If you become really successful, 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 process.

Over the years as a tax pro, I have 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: Josephine is a 45-year-old unmarried professional person. She considers herself to be financially astute. However, she is not well-versed on taxes. One day, Josephine meets Joe, and they quickly decide to get married. Caught up in the excitement of a whole new life, Josephine impulsively sells her home shortly before the marriage. The property is in a great area and has appreciated by $500,000 since she bought it 15 years ago. She intends to move into Joe’s home, which is a dump, but Josephine is a proven genius at remodeling, and she plans to work her usual magic on Joe’s property.

Result without tax planning: For federal income tax purposes, Josephine has a whopping $250,000 gain on the sale of her home ($500,000 profit minus the $250,000 home sale gain exclusion allowed to unmarried sellers).

Result with tax planning: If Josephine had instead kept her home and lived there with Joe for two years before selling, she could have taken advantage of the larger $500,000 home sale gain exclusion available to married joint-filers and thereby permanently avoided $250,000 of taxable gain. If necessary, Joe’s home could have been sold instead of Josephine’s. Alternatively, Joe’s property could have been retained, and the couple could have worked on remodeling it while still living in Josephine’s home for the requisite two years.

Moral of the story? By selling her home without considering the tax-smart alternative, Josephine cost herself $62,500 in taxes (completely avoidable $250,000 gain taxed at an assumed combined federal and state rate of 25%). This is a permanent difference, not just a timing difference. The point is, you cannot ignore taxes. If you do, bad things can happen, even with a seemingly intelligent transaction.

The last word

There are many other ways to commit expensive tax blunders. Like selling appreciated securities too soon when hanging on for just a little longer would have resulted in lower-taxed long-term capital gains instead of higher-taxed short-term gains; taking retirement account withdrawals before age 59½ and getting hit with the 10% premature withdrawal penalty tax; or 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 we get closer to the end of the year, some of my columns will focus on tax planning strategies that many folks can benefit from. Please stay tuned.

Tuesday, July 29, 2014

IRS Releases Form 1023-EZ for Certain Nonprofit Organizations Applications

The IRS recently issued Form 1023-EZ for use by certain nonprofit organizations applying for tax-exempt status under Section 501(c)(3). With the IRS’ tax-exempt unit under recent political scrutiny, a nonprofit organization filing the regular Form 1023, Application for Tax-Exempt Recognition, can expect to wait for several months or even a year for approval. The goal of the Form 1023-EZ is to expedite the filing and approval process for smaller organizations, which should hopefully also reduce the application time for larger organizations given the resulting decrease in overall paperwork.
Form 1023-EZ can only be used by organizations with gross receipts of $50,000 or less, and assets of $250,000 or less. Additionally, churches, schools, and hospitals are prohibited from using Form 1023-EZ regardless of gross receipts or assets.
Form 1023-EZ is three pages long, as compared to the 26 page Form 1023. Form 1023-EZ must be filed online, and there is a $400 user fee due at the time of submission of the Form. There is also an eligibility worksheet that an organization must first complete to ensure that it is eligible to use Form 1023-EZ.
The IRS estimates that as many as 70% of all tax-exempt applicants will qualify to use the new Form 1023-EZ. Although this streamlined process has the potential to benefit many smaller organizations, the brevity of the Form also increases the risk of fraud and misuse by charities that do not really meet the requirements for tax-exempt status. Smaller organizations should still consult with an attorney to ensure that the organization’s documents and operations comply with these requirements

The Moves to Make Now So You Can Cut Taxes Later

In my work with financial planning clients, I can see that people understand the merits of having a diversified mix of securities in an investment portfolio. Investment advisers have done a good job of explaining how diversification can improve clients’ risk-adjusted returns.

What can be a little harder for advisers to explain and clients to understand, though, is the value of “tax diversification” — having investments in a mix of accounts with different tax treatments. By having some securities in taxable accounts, others in tax-deferred accounts, and still others in tax-free accounts, people can maintain the flexibility that makes it easier to minimize their taxes in retirement.
The benefits of traditional tax-deferred retirement accounts, such as IRAs and 401(k)s, are easy for participants to see. Contributions reduce people’s current tax bills. And the benefits continue to compound over the course of the investors’ careers, since none of the income is taxable until withdrawals are made.

Yet what clients don’t often grasp is the price they’ll wind up paying for this tax benefit later in life. Distributions from tax-deferred accounts are treated as ordinary income. It can be more expensive to spend money from a traditional IRA than from a taxable account, since dividends and long-term capital gains in taxable accounts are taxed at more favorable rates. And IRS-mandated required minimum distributions from traditional retirement accounts can force a retiree to generate taxable income at times when he or she wouldn’t want to.

So how do you get clients to understand that traditional IRAs and 401(k)s may cost them more than they think? Sometimes it’s a matter of being blunt — saying that the $1 million they see on their account statement isn’t worth $1 million; they may only have $700,000 or less to spend after paying taxes.

Once clients understand that, they also understand the appeal of Roth IRA and Roth 401(k) accounts, since current income and qualified distributions are never taxable. Another advantage: The IRS also does not require distributions from Roth IRAs the way it does for traditional retirement accounts. For many high income taxpayers, $700,000 in a Roth IRA is more valuable than $1 million in a traditional IRA.

But Roth IRAs and 401(k)s aren’t perfect and shouldn’t be a client’s only savings vehicle either. Participants don’t receive any upfront tax benefit. And it’s conceivable that future legislation may decrease or eliminate the benefits of Roth accounts. If the U.S. or certain states shift to a consumption-based tax system, for example, a Roth IRA will have been a poor choice compared to a traditional IRA.

And it’s useful to have money in taxable accounts, too. People need to have enough in these accounts to meet their pre-retirement spending needs. In addition, holding some stock investments in taxable accounts allows people to take advantage of a market downturn by realizing capital losses and securing a tax benefit. You can’t do this with a retirement account.

Given that each type of investment account has advantages and disadvantages, advisers should encourage all their clients to keep at least some assets in each retirement bucket. That way, retirees have the flexibility to choose the source of their spending based on the tax consequences in a particular year.

In a low-income year, retirees may want to pull some money from their traditional IRAs to benefit from that year’s low tax bracket. Depending on the retiree’s income level, some traditional IRA distributions could escape either federal or state income tax entirely. In a high-income year, when investments in a taxable account have a lot of appreciation, it may make sense for the retiree to spend from a Roth account instead.

Since we don’t know what a client’s tax situation will look like each year in the future, diversification of account types is just as prudent as investment diversification.

Monday, July 28, 2014

5 Smart Mid-Year Tax Moves for Right Now

During the summer months, your personal income taxes may be far from your mind as you contemplate possible travel, vacation time, and lots of outdoor fun. But right now is actually an excellent opportunity to spend time planning ahead for tax season in 2015.
Some people meet with their accountants each January to go over their annual taxes. Before 2014 ends, however, there are several key financial strategies you can use to save money on taxes.
Use the following tax wisdom, and implement these five smart mid-year tax moves to reduce the amount of money you’ll pay Uncle Sam come next April. In fact, by checking these tax moves off your “to do” list, you may even wind up getting a bigger tax refund.
1. Plan your annual donations
During the upcoming back-to-school season—and later, during the holidays—you’ll likely be solicited by co-workers for all kinds of donations, including gifts to their charities, cookies for their kids’ school drives, and money for various fundraisers.
After a while, all these solicitations can really add up. Sometimes, if you don’t have the extra money to donate, it’s best to politely decline. But other times, when you can afford to make a donation, you should make sure you get receipts for your generosity—to help document the tax deduction your contribution will bring.
According to the Association of Fund-Raising Distributors and Suppliers, schools, church groups and sports leagues raise about $1.4 billion annually in merchandise sales. So if someone hits you up for a donation, use the IRS online search tool to double-check that it’s a bona fide 501c3 charity. It’s fine to give to a worthy cause, but you should also be financially savvy about your giving. Only IRS-approved charities are eligible for a tax deduction.
2. Accelerate your expenses
Entrepreneurs should make business purchases, for things like copy machines, printers, faxes or office equipment before December 31 to get a tax deduction for business expenses.
But even if you’re not a business owner, you can accelerate other deductions, like donations you might make to charity or any property taxes you might plan to pay in January. The same is true for things like mortgage interest on your home; by making extra payments now, or anytime before year-end, you can write off the mortgage interest paid and increase your itemized deductions.
3. Delay your income
If your boss or a client is planning to make a fat year-end payment or bonus to you, when possible, try to get that payment on or after January 1, 2015. Delaying payment in this way will reduce your 2014 tax liability.
And does it really matter to your monthly budget if you get a sales bonus or a commission check on December 30 instead of January 1? Probably not. So do yourself a tax favor and get that check next year. By taking the payment in early 2015, the taxes won’t be due until tax season 2016.
4. Dump your losers
Have you been a victim of the lousy stock market? Now’s the time to take your losses. Write off investment losses on your 2014 taxes by selling depreciated shares of individual stocks or mutual funds before January 1, 2015.
5. Contribute to your retirement plan
Socking away more money into your retirement plan, such as a 401k or a 403b plan, can also net you significant savings come tax time.
When you contribute to a qualified retirement plan, you’re putting that money away on a pre-tax basis, thereby lowering your taxable income. So if you haven’t started making those contributions, stop procrastinating and head to your human resources department to get signed up immediately.
If you’re already contributing to your employer-sponsored retirement savings plan, consider boosting your annual contribution levels. Not only will you be doing a smart thing by saving more for your “golden years,” you may also net an additional financial benefit if your employer offers a matching contribution.
By putting these five smart mid-year tax moves into effect now, you’ll help make tax season a lot less taxing next year.


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.

Conclusion


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.