Business Entity Choosing the form of entity under which a business will operate is the first important decision a business owner will make. The three variables to help you determine which option is right for you are business control, owner liability, and tax implications.
Forms of business entity are:
- Sole Proprietorship
-Limited Liability Company
Sole Proprietorship. A sole proprietorship has a single owner and is the most simple entity type. The benefits of the sole proprietorship are its ease of implementation and lack of regulatory requirements. It allows complete business control to a single business owner (proprietor). It requires the business owner to file a Schedule C (profit or loss from a business or profession) with their personal income tax filing. The proprietor personally assumes all liability and business risk, which can often be "transferred" through the purchase of liability insurance.
Partnership. The main difference between the sole proprietorship and the partnership is the number of business owners. Although quite easy to establish, it is a good idea to begin a partnership with a formal arrangement known as the partnership agreement. The partnership agreement sets forth the intent of the business owners in the event of a wide variety of business events such as the sale of the entire business, the sale of a single individual's holdings or the disposition of ownership in the event of the death of a partner.
Like the sole proprietorship, the partnership represents a "flow-through entity" where both cash flows and tax liabilities flow through to the business owners. The partnership provides its owners minimal protection from business risk.
C-corporation. Though often costly and time-consuming to establish and maintain, the C-corporation provides the greatest amount of liability and business risk protection to the business owner(s). Strict governmental regulations outline company structure, reporting, and disclosure requirements.
Corporations have unlimited lives with ownership rights passing to designated heirs upon the death of an owner. The corporate entity also has a great deal of income tax flexibility and can offer the broadest array of tax deductible benefits, but may also trigger "double taxation" of some corporate profits as they are taxed at the corporate level as profits and again, potentially, at the individual level as taxable dividends are paid to shareholders.
S-Corporation. The "S Corp" functions as something of a hybrid, assuming many of the best features of several other entity types. The S Corporation is a legal entity that offers owners the benefits of greatly limited liability, while allowing company profits or losses to flow directly through to the business owners for income tax purposes, thus avoiding potential double taxation. The legal requirements and costs associated with starting an S Corporation are modest, as are the regulatory requirements. There are limitations on the number of owners within an S Corporation, and a C Corporation may not be an owner.
Limited Liability Company. Like the S Corporation, the Limited Liability Company (LLC) combines many of the benefits of other entity types. In contrast to the proprietorship and partnership, the LLC provides its owners (or members) with limited liability for the debt and business risk associated with ownership. The LLC also avoids the "double taxation" of the corporation by functioning as a "flow-through entity" for income tax purposes.
Protecting Against the Loss of Key Employee The vast majority of small-business owners accept the wisdom of insuring the firm against the loss of its property values. We take care to insure the physical assets against fire, tornados and other disasters. Yet, protection from the loss a key executive may be far more important.
First, the probability of losing a key employee is far greater than a loss due to fire. It has been estimated that the chances of death of a key executive is 14 times greater at age 45, 17 times greater at age 50, and 23 times greater at age 55 than a loss caused by fire. Further, about one out of every three individuals dies in the working period of life with a consequent loss to his or her business.
Second, the loss due to a fire is temporary. Plants and factories can be rebuilt. Inventory can be replaced. The new building is likely to be more useful and valuable than the old one. On the other hand, a new hire may need several months or even years to become as productive as her or his predecessor. In fact, the deceased employee may prove impossible to replace.
Who Is Key? Every corporation has at least one key executive or an employee who makes a substantial contribution to the operation, profitability and success of the business. Any individual who has critical intellectual information, sales relationships, bank relationships, product knowledge, and/or industry contacts that may adversely affect profits in the event of their absence, may be considered key.
The Role of Key Person Life Insurance Although life insurance cannot ever fully replace the value of a key employee, it can indemnify the business for the financial setbacks that can occur. The proceeds from the life insurance policy can help ensure a smooth transition following their passing. Life insurance can provide the business with needed funds to keep the business running, to assure creditors that their loans will be repaid, to assure customers that business will continue operations, to cover the special expenses of finding, hiring, and training a replacement.
How This Strategy Works There is no particular form of agreement or special contract needed by the business to obtain key employee insurance on an executive or owner. However, the board of directors should authorize the maintenance and payment of the policy.
The applicant is the company. The application is signed by an officer of the business other than the insured party. Generally, the premiums will be paid by the business on an after-tax basis and are not deductible as a business expense. The business will be designated as the beneficiary and the insurance proceeds received upon the death of a key executive are not subject to federal income tax.
Qualified Retirement Plans for Small Businesses For the small-business owner, attracting and retaining valuable employees can be a daunting challenge. One way to make working for your business more attractive to current and potential employees alike is to implement a qualified retirement plan for you and your employees. Besides greater appeal to your workers, qualified plans can also provide you with numerous tax advantages, including:
- Contributions for all participants are 100% tax-deductible to the business up to certain limits.
- Annual contributions by the business are not considered taxable income to the plan participants.
- Capital gains and interest earned are deferred from taxation during the accumulation years.
- Income taxes are payable upon withdrawal.
-At retirement, favorable tax treatments may apply such as spreading payments over the participant's lifetime and special averaging formulas.
Non-Tax Advantages In addition to the obvious tax and employee hiring/retention advantages, there are many other, equally important, reasons to implement a qualified plan. For example, plan assets are creditor-proof. The assets of the plan are not subject to malpractice lawsuits or bankruptcy rulings.
These and other advantages combine to help improve morale as the participants realize that their company provides the mechanism to help secure their retirement.
Types of Plans The two most common types of qualified retirement plans are pension and profit-sharing plans. A business can also sponsor an IRA or SEP (simplified employee pension plan).
Pension Plans. There are three major types of pension plans -- defined benefit, money purchase, and target benefit.
- A defined benefit plan is one where the retirement benefit is determined by a plan formula - usually based on years of service.
- A money purchase pension plan is one where the plan formula specifies the percentage of each participant's compensation that will be contributed each year.
- A target benefit plan is a hybrid. It starts out as a defined benefit plan, which determines the benefit. Once the benefit is calculated, the plan converts to a defined contribution or money purchase plan.
Profit-Sharing Plans. The most popular type of profit-sharing plans is 401(k) plans. Elective deferrals amount to these plans are limited based on age, including catch-up provisions. Annual contributions to a profit-sharing plan are generally not required; instead, they can be discretionary each year.
Implementing a Cafeteria Plan in Your Business Internal Revenue Code 125 allows an employer to implement an employee benefit plan, which allows employees to select the benefit programs they prefer.
The plan offers the employee to choose from the "menu" of benefits available. It's sort of like ordering lunch from the restaurant - which is why the plan is referred to as a "cafeteria plan"!
Cafeteria plans, along with 401(k)s, are among the most popular employee benefit plans of the past decade. The tax benefits to the employer and employees far exceed the minimal required government reporting.
Cafeteria Plan Benefit Options
In general, the IRS allows the following benefits to be present in a Section 125 plan:
- Group-term life insurance (up to $50,000; amounts above that level of death benefit may be subject to Social Security and Medicare taxation)
- Accident and health plans
- Long- and short-term disability benefits
- Flexible spending accounts to save for health, medical, and childcare expenses
- CODA [401(k) plans]
- Dependent group life, accident, and health insurance coverages
Employee Tax Aspects
The plan essentially allows expenses that normally would be paid by the employee on an after-tax basis to be paid via salary reductions on a pretax basis. This allocated income will not be subjected to FICA or income taxes. The result is that taxable dollars have been converted to nontaxable dollars - thereby increasing the employee's take-home pay.
Employer Tax Aspects
Generally, employer contributions to a plan are income tax deductible. In addition, contributions on behalf of the employees, if such contributions are not included in the employee's income, are not subject to FICA (Social Security) or FUTA (Federal Unemployment Tax Act). This can result in significant savings to the company's bottom line.
The employer must file an annual information return (IRS Form 5500) stating plan participation, cost and business type.
An important point for the employee to remember is that there can be no claim of any unused benefits or contributions from one plan year to the next. This is known as the "use it or lose it" rule.
Many employees steer clear of these plans because of this rule. You have to decide up front how much to put in the plan and if you don't spend it all within a year, you forfeit the leftover amount.
Sounds risky - at least until you consider that the tax breaks are so powerful that even if you wind up forfeiting 20% of what you put into a plan, you'll still come out ahead.
For example, let's say you set aside $5,000 for medical expenses in 2007 and wind up spending just $4,000. At face value, you've lost $1,000. But consider: If you're in the 25% federal tax bracket and face a 5% state income tax as well as the 7.65% Social Security and Medicare tax, the $5,000 you put in the plan will save you more than $1,800 in taxes, leaving you $800 ahead. Put another way, you'd have to earn almost $6,300 to have $4,000 left over to pay those bills. Even if you forfeit $1,000, you still come out ahead. That's why it's wise to be aggressive in using flexible spending accounts.
Deferred Compensation In addition to providing qualified plans to employees, many business owners implement nonqualified alternatives in order to supplement retirement benefits. These selective benefit plans are generally offered to key employees and owners. One popular nonqualified benefit is deferred compensation.
Basically, nonqualified deferred compensation refers to an arrangement between an employer and an employee in which compensation for current services is postponed until some future date or the occurrence of a future event. The effect is to postpone taxation for the employee until compensation is received - usually at retirement or disability.
Types of Deferred Compensation
Deferred compensation plans can be categorized several different ways. Plans can be:
- Funded or unfunded
- Forfeitable or nonforfeitable
- Defined benefit or money purchase
- They can also provide one or a combination of death benefits, disability benefits and retirement benefits.
Funded plans generally involve a trust fund or escrow account where the employer transfers money at a later date for its "promise to pay" deferred compensation. These are not very popular as the participant may be deemed to have "constructive receipt" of such funds and therefore inherits a current tax liability when funded.
IRS Revenue Ruling 60-31, 1960-2 CB 174, states that an employee's right to receive deferred compensation, backed during the deferral period solely by an employer's "naked promise" to pay, produces no currently taxable income for the employee. A deferred compensation plan is not regarded as funded merely because the corporation purchased and owns a life insurance policy or annuity contract to make certain that funds will be available when needed.
One of the problems with a typical unfunded deferred compensation plan is that the employee has no guarantee that future payments will be made. If the employer defaults in making promised payments, becomes insolvent, or files bankruptcy, the employee simply becomes a general creditor waiting in line with all the other creditors hoping to recoup some of their receivables.
The rabbi trust protects an executive from an employer's future unwillingness or inability to pay promised benefits while retaining the benefits of deferred income taxation. The IRS has stated in a series of private letter rulings that an irrevocable trust or an escrow account can be established to fund a deferred compensation agreement as long as the assets placed into the rabbi trust remain subject to the claims of general creditors. If this condition is met, the employee will not be deemed to have "constructive receipt" of the assets, and, therefore, will not have received a current economic benefit. Hence, the employee will not be required to pay taxes until the payments are made at a future date.
The rabbi trust gives the employee security in knowing that the employer is, in fact, setting aside money to fulfill its obligation under a deferred compensation agreement.
Choosing the Right Continuation Plan for Your Business The death of a major shareholder in a closely held corporation can seriously interrupt the continuity and profitability of the business. Surviving shareholders must struggle with how to continue the company as a profitable business with the loss of a key player. Heirs must concern themselves with how to replace the income that the shareholder had earned and how to extract their inherited portion of the company value.
To reduce potential areas of conflict and realize a smooth transition, company owners should enter into an agreement while the parties are still living. This is called a buy-sell agreement. Stock purchase plans are generally arrangements through which shareholders agree to sell their stock interests in the event of specific triggering events such as death, disability, or retirement.
Stock purchase plans are generally classified into three categories: stock redemption plans, cross purchase plans, and hybrid plans.
Under a stock redemption plan, the corporation agrees to purchase all or part of the stock interest of a shareholder. There are three approaches to stock redemptions - full redemptions, partial redemptions, and Section 303 redemptions.
In a cross purchase agreement, the remaining shareholders buy the stock interest of a single shareholder. They can either distribute the shares proportionally to what they had before the triggering event occurred or non-proportionally according to what is outlined in the buy-sell agreement.
A hybrid plan, or wait-and-see approach, gives the corporation the first chance to buy. If the corporation does not buy in within a specified time frame (for example, 90 days), the other stockholders have the option to buy. If that option is not exercised, then the corporation must buy the shares.
Many factors need to be considered when determining the best type of stock purchase plan to implement, cost factors, psychological factors, ease of administration, tax implications, and transfer for value rules to name a few. You should seek the advice of financial and legal counsel to help implement your plan.
Planning for The "Golden Years" There's a saying that if you have your health, you have everything. Well, that's not exactly true - without adequate resources, you could enjoy a long, healthy retirement at a far lower standard of living than you'd prefer!
When preparing for retirement, it's vital to keep in mind the importance of money to your quality of life during your "golden years." And with retirements now stretching as long as 20 to 30 years - and beyond - ensuring your retirement dollars outlive you is a paramount concern.
Failing to Plan, or Planning to Fail?
It's been said that he who fails to plan, plans to fail. And nowhere is that concept illustrated more starkly than with retirement planning. A sound financial plan can be the difference between the retirement of your dreams and the nightmare of discovering you have too little money, too late to change financial course.
A disciplined retirement preparation plan, diligently followed, will help you develop realistic objectives ... assess progress toward your goals ... and make periodic adjustments to keep you on track.
How Much Retirement Income Will YOU Need?
Government research has determined that most Americans need between 60 and 80 percent of their pre-retirement income in order to maintain their standard of living during retirement. However, many financial experts have raised this figure to between 80 and 100 percent of pre-retirement income, citing skyrocketing healthcare costs, lengthening life spans, and the ever-present threat of inflation - which can rob a retirement portfolio of purchasing power over time.
Of course, how much you will need in retirement will be a function of your goals, time horizon, and spending habits. Those who want to purchase a second home and travel frequently will obviously need more than those who prefer to stay at home in their paid-off house. Consider these factors when estimating your future retirement income needs:
Your support of children who will be self-sufficient by the time you retire
Your current work-related expenses that will be dramatically reduced in retirement, such as commuting costs, daily meal expenses, dry cleaning bills, etc.
Whether your mortgage will be paid off prior to or early in retirement
Whether you will need to continue your monthly savings amount or begin to spend that amount for necessities
Your tax bill in retirement
Sources of Retirement Income
Once you have estimated your target retirement income, you can begin evaluating your potential sources of regular income. In general, your income sources will fall into one of these three categories:
1) Government sources. The Social Security system was inaugurated during the Great Depression to augment retirees' incomes. Most experts feel that the system will remain solvent throughout much of the 21st century. Even so, a rising retirement age and cuts in benefits could reduce your monthly Social Security check. Benefits are based on the amount you earned during your working years.
2) Employer-sponsored plans. Many employers offer company-sponsored retirement plans, which generally fall into two categories. Defined benefit plans, which are normally funded by the employer and guarantee a retirement benefit based on a formula comprising number of years on the job and employment earnings. For example, a traditional pension is a defined benefit plan. Defined contribution plans, on the other hand - such as 401(k), 403(b), and 457 - rely on funding from employees, matching funds from the employer, or a combination of the two. The employee owns an account balance (subject to company rules regarding vesting) of contributions and earnings. Upon changing jobs, an employee may be able to roll over assets into the new employer's plan or into an IRA. At retirement, the employee decides how to withdraw the balance he or she has accumulated.
3) Personal savings. This is perhaps the most overlooked aspect of retirement planning. Personal savings include, but aren't limited to, balances in savings accounts, directly held assets, home equity, shares in a partnership or business, and even collectibles such as artwork and coins.
How to Get - And Stay - On Course
How can you determine whether you're on track to reach your retirement goals, and to make adjustments if necessary? We can help you develop a sound financial plan based on your specific situation, monitor it regularly to ensure you're making progress toward your objectives, and recommend occasional adjustments to help you stay on course.
Can You Afford to Retire Early?
Historically, most Americans have considered 65 to be their target retirement age. This is likely the result of past Social Security laws, which provided full benefits beginning at age 65.
However, many workers today are retiring at an increasingly earlier age. In just the last few years, for example, the average retirement age has fallen to age 63. And many younger workers are planning to retire even earlier; in fact, according to a recent study by the Employee Benefit Research Institute, more than a third of today's workers plan to retire before age 64.
What You Give Up
An early retirement often comes at a cost. Here are a few of the financial results of early retirement that you must consider carefully:
Not only are Social Security benefits reduced for early retirement, but the age at which full benefits begin is being gradually raised to 67.
Retiring early often happens right at the peak of your earning years, meaning you not only forego that income, but also the resulting saving and investing that would have taken place in these years.
The annual benefit provided by employer-sponsored defined benefit pension plans is usually based on a combination of years of service and your ending salary. Both are reduced by early retirement.
Health care costs tend to increase for retired individuals. Benefits that were once paid for by employer-sponsored coverage often become the responsibility of the retiree.
Consider Your Options Carefully
Choosing when to retire is one of the most important financial decisions you will make. Consider your options carefully. Careful planning can help ensure you a comfortable and financially independent retirement.
1. "2006 Retirement Confidence Survey," Employee Benefit Research Institute and Mathew Greenwald & Associates, Inc.
How Living Expenses Change During Retirement
There are some upsides to being a retiree - senior discounts, lower taxes, subsidized healthcare, and regular Social Security checks among them. On the other hand, mature Americans must contend with worrisome issues such as rising costs for medical care, long-term care, prescription drugs, and even basic necessities such as food and energy.
To determine your monthly expenses during retirement, you might start by dividing costs into two categories: those you believe will change and those you believe will remain largely the same.
Costs You Believe Might Change
Housing expenses particularly if you plan to live in your paid-off home or plan to downsize to a smaller dwelling
Medical insurance which may shift from a premium for HMO coverage to a Medigap policy
Costs for dependents if you have children you believe will be self-sufficient by the time you retire
Entertainment and travel expenses for some people, these might decline precipitously; for others, they might be far higher
Taxes - most retirees find their combined tax burden is less than during their working years
Automobile-related costs - retirees generally drive less than workers who commute to their jobs every day, thus spending less on maintenance, tolls, gasoline, etc.
Monthly contributions toward retirement savings accounts - not only can you stop making this contribution, you might even consider spending it!
Costs You Think Will Remain the Same
Clothing - unless you previously spent large amounts of money on uniforms or other job-specific wardrobe items
Household expenses - such as telephone, utilities, cable, etc.
Determine Your Individual Needs
Once you analyze all this information, you can determine your estimated monthly income needs as well as how large of an emergency fund to establish. This fund should be held in a liquid form such as a money market account, which provides stability for your funds as well as ready access to them.
Consider reviewing your estimated needs at least annually, because circumstances can and do change in today's fast-moving world.
Bridging the Income Gap Social Security was never designed to be an individual's sole source of retirement income. Instead, it was meant to bridge the gap between people's income from pensions and savings and their monthly expenses.
Today, however, nearly two-thirds of all seniors rely on Social Security for at least 50% of their total monthly income. Nor are annual cost-of-living adjustments, or COLAs, keeping up with the spiraling costs of healthcare, housing, and energy in many areas across the country. Adjustments to extend the program's solvency have reduced benefits in real terms, as well as ratcheted up the age at which one can attain full benefits.
What's more, traditional company pension plans are fast going the way of the horse-and-buggy and the dodo bird. Instead, employers are moving toward "defined contribution plans" that put most of the responsibility for planning, funding, investing, and distributing plan funds squarely on the shoulders of individual employees.
Given these trends, one thing is clear: Each person must put increasingly greater emphasis on securing their own financial future in retirement. Your actions today and throughout your working career may make the difference between relying on government programs for a modest monthly income and enjoying a secure, independent "golden years."
The price of procrastination is steep and the cost of inadequate preparation too high for you to wait until later to start planning!
How Social Security Works
The Social Security program was signed into law in 1935 after the nation had endured more than a half-decade of the Great Depression. It was intended to provide a safety net of income for individuals too old or disabled to continue working.
Participation in the Social Security program is mandatory, with most wage earners contributing a percentage of their annual incomes to support the program. In return, participants, their spouses, and certain dependents are eligible for retirement, disability, and survivorship benefits.
Today, approximately 90% of people aged 65 and older receive a Social Security benefit check each month. For many, this benefit is their primary source of retirement income.
How Contributions are Made and Accounted For
Each year you work, you and your employer contribute to the Social Security program in equal amounts.
How Your Benefits Are Calculated Your benefits are based on a calculation that includes how many years you worked and how much you earned. These figures are used to determine the number of quarterly credits you accumulated toward benefits. If you were born prior to 1938, you may collect full Social Security benefits when you turn 65, or you may collect 80% of your benefit if you retire at 62. For people born after 1938, Normal Retirement Age (NRA), or the age at which you can receive full benefits, gradually increases from age 65 to age 67. To determine your NRA, visit http://www.ssa.gov. When you die, your surviving spouse is entitled to your benefits, unless he or she would collect more based on their own earnings history.
Your Social Security account opens once you receive a Social Security card. However, it is not activated until you begin earning income. Once your earnings begin, the amount you contribute each year is recorded.
The accuracy of this record is important. You can obtain a copy of your earnings record from the Social Security Administration by filling out and mailing Form 7004. Forms are available at your local Social Security office or by calling 800-772-1213 or online at www.ssa.gov/online/ssa-7004.html. If you discover errors in your record, you can ask that it be corrected, though you must supply evidence of such errors. The Social Security Administration encourages people to check their earnings records every three years or so, because the earlier a problem is found, the easier it is to correct.
How Your Benefits Are Taxed Once you begin receiving retirement benefits, you may have to include them as part of your taxable income reported to the IRS each year.
If your total income for the year, including half of your Social Security and your tax-exempt earnings, is greater than $32,000 ($25,000 for single taxpayers), you will owe federal income tax on a portion of your Social Security benefits. The IRS provides a worksheet to help you determine how much you must include in your taxable income each year.
Did you know that...
The Social Security Administration paid approximately $539 billion in benefits to nearly 49 million people in 2006
Social Security benefits were awarded to more than 4 million people
Among elderly Social Security beneficiaries, 54% of married couples and 74% of unmarried persons receive half or more of their income from Social Security.
Women accounted for 57% of adult Social Security beneficiaries
The average age of disabled-worker beneficiaries was 51
Disability and blindness were the reasons for paying 82% of Supplemental Security Income recipients
Saving for Retirement and a Child's Education at the Same Time You want to retire comfortably when the time comes. You also want to help your child go to college. So how do you juggle the two? The truth is, saving for your retirement and your child's education at the same time can be a challenge. But take heart--you may be able to reach both goals if you make some smart choices now.
Know what your financial needs are The first step is to determine what your financial needs are for each goal. Answering the following questions can help you get started:
· How many years until you retire?
· Does your company offer an employer-sponsored retirement plan or a pension plan? Do you participate? If so, what's your balance? Can you estimate what your balance will be when you retire?
· How much do you expect to receive in Social Security benefits? (You can estimate this amount by using your Personal Earnings and Benefit Statement, now mailed every year by the Social Security Administration.)
· What standard of living do you hope to have in retirement? For example, do you want to travel extensively, or will you be happy to stay in one place and live more simply?
· Do you or your spouse expect to work part-time in retirement?
· How many years until your child starts college?
· Will your child attend a public or private college? What's the expected cost?
· Do you have more than one child whom you'll be saving for?
· Does your child have any special academic, athletic, or artistic skills that could lead to a scholarship?
· Do you expect your child to qualify for financial aid?
Many on-line calculators are available to help you predict your retirement income needs and your child's college funding needs.
Figure out what you can afford to put aside each month After you know what your financial needs are, the next step is to determine what you can afford to put aside each month. To do so, you'll need to prepare a detailed family budget that lists all of your income and expenses. Keep in mind, though, that the amount you can afford may change from time to time as your circumstances change. Once you've come up with a dollar amount, you'll need to decide how to divvy up your funds.
Retirement takes priority Though college is certainly an important goal, you should probably focus on your retirement if you have limited funds. With generous corporate pensions mostly a thing of the past, the burden is primarily on you to fund your retirement. But if you wait until your child is in college to start saving, you'll miss out on years of tax-deferred growth and compounding of your money. Remember, your child can always attend college by taking out loans (or maybe even with scholarships), but there's no such thing as a retirement loan!
If possible, save for your retirement and your child's college at the same time Ideally, you'll want to try to pursue both goals at the same time. The more money you can squirrel away for college bills now, the less money you or your child will need to borrow later. Even if you can allocate only a small amount to your child's college fund, say $50 or $100 a month, you might be surprised at how much you can accumulate over many years. For example, if you saved $100 every month and earned 8 percent, you'd have $18,415 in your child's college fund after 10 years. (This example is for illustrative purposes only and does not represent a specific investment.)
If you're unsure how to allocate your funds between retirement and college, a professional financial planner may be able to help you. This person can also help you select the best investments for each goal. Remember, just because you're pursuing both goals at the same time doesn't necessarily mean that the same investments will be appropriate. Each goal should be treated independently.
Help! I can't meet both goals If the numbers say that you can't afford to educate your child or retire with the lifestyle you expected, you'll have to make some sacrifices. Here are some things you can do:
· Defer retirement: The longer you work, the more money you'll earn and the later you'll need to dip into your retirement savings.
· Work part-time during retirement.
· Reduce your standard of living now or in retirement: You might be able to adjust your spending habits now in order to have money later. Or, you may want to consider cutting back in retirement.
· Increase your earnings now: You might consider increasing your hours at your current job, finding another job with better pay, taking a second job, or having a previously stay-at-home spouse return to the workforce.
· Invest more aggressively: If you have several years until retirement or college, you might be able to earn more money by investing more aggressively (but remember that aggressive investments mean a greater risk of loss).
· Expect your child to contribute more money to college: Despite your best efforts, your child may need to take out student loans or work part-time to earn money for college.
· Send your child to a less expensive school: You may have dreamed your child would follow in your footsteps and attend an Ivy League school. However, unless your child is awarded a scholarship, you may need to lower your expectations. Don't feel guilty--a lesser-known liberal arts college or a state university may provide your child with a similar quality education at a far lower cost.
Think of other creative ways to reduce education costs: Your child could attend a local college and live at home to save on room and board, enroll in an accelerated program to graduate in three years instead for four, take advantage of a cooperative education where paid internships alternate with course work, or defer college for a year or two and work to earn money for college.
Can retirement accounts be used to save for college? Yes. Should they be? Probably not. Most financial planners discourage paying for college with funds from a retirement account; they also discourage using retirement funds for a child's college education if doing so will leave you with no funds in your retirement years. However, you can certainly tap your retirement accounts to help pay the college bills if you need to. With IRAs, you can withdraw money penalty free for college expenses, even if you're under age 59½ (though there may be income tax consequences for the money you withdraw). But with an employer-sponsored retirement plan like a 401(k) or 403(b), you'll generally pay a 10 percent penalty on any withdrawals made before you reach age 59½ (age 55 in some cases), even if the money is used for college expenses. You may also be subject to a six month suspension if you make a hardship withdrawal. There may be income tax consequences, as well. (Check with your plan administrator to see what withdrawal options are available to you in your employer-sponsored retirement plan.)
Understanding IRAs An individual retirement arrangement (IRA) is a personal savings plan that offers specific tax benefits. IRAs are one of the most powerful retirement savings tools available to you. Even if you're contributing to a 401(k) or other plan at work, you should also consider investing in an IRA.
What types of IRAs are available? The two major types of IRAs are traditional IRAs and Roth IRAs. Both allow you to contribute as much as $5,000 in 2010 and 2011. You must have at least as much taxable compensation as the amount of your IRA contribution. But if you are married filing jointly, your spouse can also contribute to an IRA, even if he or she does not have taxable compensation. The law also allows taxpayers age 50 and older to make additional "catch-up" contributions. These folks can contribute up to $6,000 in 2010 and 2011.
Both traditional and Roth IRAs feature tax-sheltered growth of earnings. And both give you a wide range of investment choices. However, there are important differences between these two types of IRAs. You must understand these differences before you can choose the type of IRA that's best for you.
Learn the rules for traditional IRAs Practically anyone can open and contribute to a traditional IRA. The only requirements are that you must have taxable compensation and be under age 70½. You can contribute the maximum allowed each year as long as your taxable compensation for the year is at least that amount. If your taxable compensation for the year is below the maximum contribution allowed, you can contribute only up to the amount that you earned.
Your contributions to a traditional IRA may be tax deductible on your federal income tax return. This is important because tax-deductible (pretax) contributions lower your taxable income for the year, saving you money in taxes. If neither you nor your spouse is covered by a 401(k) or other employer-sponsored plan, you can generally deduct the full amount of your annual contribution. If one of you is covered by such a plan, your ability to deduct your contributions depends on your annual income (modified adjusted gross income, or MAGI) and your income tax filing status:
What happens when you start taking money from your traditional IRA? Any portion of a distribution that represents deductible contributions is subject to income tax because those contributions were not taxed when you made them. Any portion that represents investment earnings is also subject to income tax because those earnings were not previously taxed either. Only the portion that represents nondeductible, after-tax contributions (if any) is not subject to income tax. In addition to income tax, you may have to pay a 10 percent early withdrawal penalty if you're under age 59½, unless you meet one of the exceptions.
If you wish to defer taxes, you can leave your funds in the traditional IRA, but only until April 1 of the year following the year you reach age 70½. That's when you have to take your first required minimum distribution from the IRA. After that, you must take a distribution by the end of every calendar year until you die or your funds are exhausted. The annual distribution amounts are based on a standard life expectancy table. You can always withdraw more than you're required to in any year. However, if you withdraw less, you'll be hit with a 50 percent penalty on the difference between the required minimum and the amount you actually withdrew.
· You have reached age 59½ by the time of the withdrawal
· The withdrawal is made because of disability
· The withdrawal is made to pay first-time home-buyer expenses ($10,000 lifetime limit)
· The withdrawal is made by your beneficiary or estate after your death
Qualified distributions will also avoid the 10 percent early withdrawal penalty. This ability to withdraw your funds with no taxes or penalties is a key strength of the Roth IRA. And remember, even nonqualified distributions will be taxed (and possibly penalized) only on the investment earnings portion of the distribution, and then only to the extent that your distribution exceeds the total amount of all contributions that you have made.
Another advantage of the Roth IRA is that there are no required distributions after age 70½ or at any time during your life. You can put off taking distributions until you really need the income. Or, you can leave the entire balance to your beneficiary without ever taking a single distribution. Also, as long as you have taxable compensation and qualify, you can keep contributing to a Roth IRA after age 70½.
Choose the right IRA for you Assuming you qualify to use both, which type of IRA is best for you? Sometimes the choice is easy. The Roth IRA will probably be a more effective tool if you don't qualify for tax-deductible contributions to a traditional IRA. However, if you can deduct your traditional IRA contributions, the choice is more difficult. The Roth IRA may very well make more sense if you want to minimize taxes during retirement and preserve assets for your beneficiaries. But a traditional deductible IRA may be a better tool if you want to lower your yearly tax bill while you're still working (and probably in a higher tax bracket than you'll be in after you retire). A financial professional or tax advisor can help you pick the right type of IRA for you.
Note: You can have both a traditional IRA and a Roth IRA, but your total annual contribution to all of the IRAs that you own cannot be more than $5,000 for 2011 ($6,000 if you're age 50 or older).
Know your options for transferring your funds You can move funds from an IRA to the same type of IRA with a different institution (e.g., traditional to traditional, Roth to Roth). No taxes or penalty will be imposed if you arrange for the old IRA trustee to transfer your funds directly to the new IRA trustee. The other option is to have your funds distributed to you first and then roll them over to the new IRA trustee yourself. You'll still avoid taxes and penalty as long as you complete the rollover within 60 days from the date you receive the funds.
You may also be able to convert funds from a traditional IRA to a Roth IRA. This decision is complicated, however, so be sure to consult a tax advisor. He or she can help you weigh the benefits of shifting funds against the tax consequences and other drawbacks.
Note: The IRS has the authority to waive the 60-day rule for rollovers under certain limited circumstances, such as proven hardship.
Roth IRAs Not everyone can set up a Roth IRA. Even if you can, you may not qualify to take full advantage of it. The first requirement is that you must have taxable compensation. If your taxable compensation is at least $5,000 in 2012 (and 2011), you may be able to contribute the full amount. But it gets more complicated. Your ability to contribute to a Roth IRA in any year depends on your MAGI and your income tax filing status. Your allowable contribution may be less than the maximum possible, or nothing at all.
Your contributions to a Roth IRA are not tax deductible. You can invest only after-tax dollars in a Roth IRA. The good news is that, if you meet certain conditions, your withdrawals from a Roth IRA will be completely free from federal income tax, including both contributions and investment earnings. To be eligible for these qualifying distributions, you must meet a five-year holding period requirement.
Should I convert to a Roth IRA? The Roth IRA offers a number of advantages over its traditional counterpart. These include:
· Tax-free distributions at retirement
· Ability to continue making contributions beyond age 70-1/2
· No required minimum distributions beginning in the year you turn 70-1/2
· Leaving assets to survivors that are free from income taxes
Details on eligibility to convert a traditional IRA to a Roth IRA.
· For years before 2010, if your filing status is married filing separately, you don't qualify unless you lived apart from your spouse for the entire year.
· For years before 2010, if your modified adjusted gross income is greater than $100,000, you can't convert a traditional IRA to a Roth IRA.
· For years before 2008, direct conversions from an employer plan to a Roth IRA were not permitted. You can do that now, but in some situations it may be preferable to roll to a traditional IRA and then convert to a Roth IRA.
· If you inherited a traditional IRA from a person other than your spouse, you can't convert it to a Roth IRA.
· You can convert a traditional IRA to a Roth IRA even if you made a rollover within the previous 12 months.
· If you're otherwise eligible, you can convert part of a traditional IRA to a Roth IRA. But you can't convert only the nontaxable part.
Assets converted to a Roth IRA must remain in the account for at least five years before any distributions are taken. Otherwise, a significant tax penalty may apply.
You'll maximize the potential for tax-free income later if you pay conversion taxes out of pocket, rather than withdrawal them from your IRA. If you can't pay conversion taxes without using part of your IRA funds, you probably shouldn't convert unless you are certain you will be in a high tax bracket during retirement.
Choosing a Beneficiary for Your IRA or 401(k)
Selecting beneficiaries for retirement benefits is different from choosing beneficiaries for other assets such as life insurance. With retirement benefits, you need to know the impact of income tax and estate tax laws in order to select the right beneficiaries. Although taxes shouldn't be the sole determining factor in naming your beneficiaries, ignoring the impact of taxes could lead you to make an incorrect choice.
In addition, if you're married, beneficiary designations may affect the size of minimum required distributions to you from your IRAs and retirement plans while you're alive.
Paying income tax on most retirement distributions Most inherited assets such as bank accounts, stocks, and real estate pass to your beneficiaries without income tax being due. However, that's not usually the case with 401(k) plans and IRAs.
Beneficiaries pay ordinary income tax on distributions from 401(k) plans and traditional IRAs. With Roth IRAs and Roth 401(k)s, however, your beneficiaries can receive the benefits free from income tax if all of the tax requirements are met. That means you need to consider the impact of income taxes when designating beneficiaries for your 401(k) and IRA assets.
For example, if one of your children inherits $100,000 cash from you and another child receives your 401(k) account worth $100,000, they aren't receiving the same amount. The reason is that all distributions from the 401(k) plan will be subject to income tax at ordinary income tax rates, while the cash isn't subject to income tax when it passes to your child upon your death.
Similarly, if one of your children inherits your taxable traditional IRA and another child receives your income-tax-free Roth IRA, the bottom line is different for each of them.
Naming or changing beneficiaries When you open up an IRA or begin participating in a 401(k), you are given a form to complete in order to name your beneficiaries. Changes are made in the same way--you complete a new beneficiary designation form. A will or trust does not override your beneficiary designation form. However, spouses may have special rights under federal or state law.
It's a good idea to review your beneficiary designation form at least every two to three years. Also, be sure to update your form to reflect changes in financial circumstances. Beneficiary designations are important estate planning documents. Seek legal advice as needed.
Designating primary and secondary beneficiaries When it comes to beneficiary designation forms, you want to avoid gaps. If you don't have a named beneficiary who survives you, your estate may end up as the beneficiary, which is not always the best result.
Your primary beneficiary is your first choice to receive retirement benefits. You can name more than one person or entity as your primary beneficiary. If your primary beneficiary doesn't survive you or decides to decline the benefits (the tax term for this is a disclaimer), then your secondary (or "contingent") beneficiaries receive the benefits.
Having multiple beneficiaries You can name more than one beneficiary to share in the proceeds. You just need to specify the percentage each beneficiary will receive (the shares do not have to be equal). You should also state who will receive the proceeds should a beneficiary not survive you.
In some cases, you'll want to designate a different beneficiary for each account or have one account divided into subaccounts (with a beneficiary for each subaccount). You'd do this to allow each beneficiary to use his or her own life expectancy in calculating required distributions after your death. This, in turn, can permit greater tax deferral (delay) and flexibility for your beneficiaries in paying income tax on distributions.
Avoiding gaps or naming your estate as a beneficiary There are two ways your retirement benefits could end up in your probate estate. Probate is the court process by which assets are transferred from someone who has died to the heirs or beneficiaries entitled to those assets.
First, you might name your estate as the beneficiary. Second, if no named beneficiary survives you, your probate estate may end up as the beneficiary by default. If your probate estate is your beneficiary, several problems can arise.
If your estate receives your retirement benefits, the opportunity to maximize tax deferral by spreading out distributions may be lost. In addition, probate can mean paying attorney's and executor's fees and delaying the distribution of benefits.
Naming your spouse as a beneficiary When it comes to taxes, your spouse is usually the best choice for a primary beneficiary.
A spousal beneficiary has the greatest flexibility for delaying distributions that are subject to income tax. In addition to rolling over your 401(k) or IRA to his or her IRA, a surviving spouse can generally decide to treat your IRA as his or her own IRA. This can provide more tax and planning options.
If your spouse is more than 10 years younger than you, then naming your spouse can also reduce the size of any required taxable distributions to you from retirement assets while you're alive. This can allow more assets to stay in the retirement account longer and delay the payment of income tax on distributions.
Although naming a surviving spouse can produce the best income tax result, that isn't necessarily the case with death taxes. One possible downside to naming your spouse as the primary beneficiary is that it will increase the size of your spouse's estate for death tax purposes. That's because at your death, your spouse can inherit an unlimited amount of assets and defer federal death tax until both of you are deceased (note: special tax rules and requirements apply for a surviving spouse who is not a U.S. citizen). However, this may result in death tax or increased death tax when your spouse dies.
If your spouse's taxable estate for federal tax purposes at his or her death exceeds the applicable exclusion amount (formerly known as the unified credit), then federal death tax may be due at his or her death. The applicable exclusion amount is $5 million in 2011.
Naming other individuals as beneficiaries You may have some limits on choosing beneficiaries other than your spouse. No matter where you live, federal law dictates that your surviving spouse be the primary beneficiary of your 401(k) plan benefit unless your spouse signs a timely, effective written waiver. And if you live in one of the community property states, your spouse may have rights related to your IRA regardless of whether he or she is named as the primary beneficiary.
Keep in mind that a nonspouse beneficiary cannot roll over your 401(k) or IRA to his or her own IRA. However, a nonspouse beneficiary can roll over all or part of your 401(k) benefits to an inherited IRA.
Naming a trust as a beneficiary You must follow special tax rules when naming a trust as a beneficiary, and there may be income tax complications. Seek legal advice before designating a trust as a beneficiary.
Naming a charity as a beneficiary In general, naming a charity as the primary beneficiary will not affect required distributions to you during your lifetime. However, after your death, having a charity named with other beneficiaries on the same asset could affect the tax-deferral possibilities of the noncharitable beneficiaries, depending on how soon after your death the charity receives its share of the benefits.
Retirement Plans for Small Businesses As a business owner, you should carefully consider the advantages of establishing an employer-sponsored retirement plan. Generally, you're allowed a deduction for contributions you make to an employer-sponsored retirement plan. In return, however, you're required to include certain employees in the plan, and to give a portion of the contributions you make to those participating employees. Nevertheless, a retirement plan can provide you with a tax-advantaged method to save funds for your own retirement, while providing your employees with a powerful and appreciated benefit.
Types of plans There are several types of retirement plans to choose from, and each type of plan has advantages and disadvantages. This discussion covers the most popular plans. You should also know that the law may permit you to have more than one retirement plan, and with sophisticated planning, a combination of plans might best suit your business's needs.
Profit-sharing plans Profit-sharing plans are among the most popular employer-sponsored retirement plans. These straightforward plans allow you, as an employer, to make a contribution that is spread among the plan participants. You are not required to make an annual contribution in any given year. However, contributions must be made on a regular basis.
With a profit-sharing plan, a separate account is established for each plan participant, and contributions are allocated to each participant based on the plan's formula (this formula can be amended from time to time). As with all retirement plans, the contributions must be prudently invested. Each participant's account must also be credited with his or her share of investment income (or loss).
For 2011, no individual is allowed to receive contributions for his or her account that exceed the lesser of 100 percent of his or her earnings for that year or $49,000. Your total deductible contributions to a profit-sharing plan may not exceed 25 percent of the total compensation of all the plan participants in that year. So, if there were four plan participants each earning $50,000, your total deductible contribution to the plan could not exceed $50,000 ($50,000 x 4 = $200,000; $200,000 x 25 percent = $50,000). (When calculating your deductible contribution, you can only count compensation up to $245,000 (in 2011) for any individual employee.)
401(k) plans A type of deferred compensation plan, and now the most popular type of plan by far, the 401(k) plan allows contributions to be funded by the participants themselves, rather than by the employer. Employees elect to forgo a portion of their salary and have it put in the plan instead. These plans can be expensive to administer, but the employer's contribution cost is generally very small (employers often offer to match employee deferrals as an incentive for employees to participate). Thus, in the long run, 401(k) plans tend to be relatively inexpensive for the employer.
The requirements for 401(k) plans are complicated, and several tests must be met for the plan to remain in force. For example, the higher paid employees' deferral percentage cannot be disproportionate to the rank-and-file's percentage of compensation deferred.
However, you don't have to perform discrimination testing if you adopt a "safe harbor" 401(k) plan. With a safe harbor 401(k) plan, you generally have to either match your employees' contributions (100 percent of employee deferrals up to 3 percent of compensation, and 50 percent of deferrals between 3 and 5 percent of compensation), or make a fixed contribution of 3 percent of compensation for all eligible employees, regardless of whether they contribute to the plan. Your contributions must be fully vested. Another way to avoid discrimination testing is by adopting a SIMPLE 401(k) plan. These plans are similar to SIMPLE IRAs (see below), but can also allow loans and Roth contributions. Because they're still qualified plans (and therefore more complicated than SIMPLE IRAs), and allow less deferrals than traditional 401(k)s, SIMPLE 401(k)s haven't become a popular option.
If you don't have any employees (or your spouse is your only employee) a 401(k) plan (an "individual 401(k)" or "solo 401(k)" plan) may be especially attractive, Because you have no employees, you won't need to perform discrimination testing, and your plan will be exempt from the requirements of the Employee Retirement Income Security Act of 1974 (ERISA). You can make a deductible profit-sharing contribution of up to 25 percent of pay (to $245,000) on your own behalf in 2011, and in addition you can make deductible pretax contributions of up to $16,500 in 2011 (plus an additional $5,500 of pre-tax catch-up contributions if you're age 50 or older). However, total annual additions to your account in 2011 can't exceed $49,000 (plus any age-50 catch-up contributions).
Note: A 401(k) plan can let employees designate all or part of their elective deferrals as Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a 401(k) plan, there's no up-front tax benefit--contributions are deducted from pay and transferred to the plan after taxes are calculated. Because taxes have already been paid on these amounts, a distribution of Roth 401(k) contributions is always free from federal income tax. And all earnings on Roth 401(k) contributions are free from federal income tax if received in a "qualified distribution."
Note: 401(k) plans are generally established as part of a profit-sharing plan.
Money purchase pension plans Money purchase pension plans are similar to profit-sharing plans, but employers are required to make an annual contribution. Participants receive their respective share according to the plan document's formula.
As with profit-sharing plans, money purchase pension plans cap individual contributions at 100 percent of earnings or $49,000 annually (in 2011), while employers are allowed to make deductible contributions up to 25 percent of the total compensation of all plan participants. (To go back to the previous example, the total deductible contribution would again be $50,000: ($50,000 x 4) x 25 percent = $50,000.)
Like profit-sharing plans, money purchase pension plans are relatively straightforward and inexpensive to maintain. However, they are less popular than profit-sharing or 401(k) plans because of the annual contribution requirement.
Defined benefit plans By far the most sophisticated type of retirement plan, a defined benefit program sets out a formula that defines how much each participant will receive annually after retirement if he or she works until retirement age. This is generally stated as a percentage of pay, and can be as much as 100 percent of final average pay at retirement.
An actuary certifies how much will be required each year to fund the projected retirement payments for all employees. The employer then must make the contribution based on the actuarial determination. In 2011, the maximum annual retirement benefit an individual may receive is $195,000 or 100 percent of final average pay at retirement.
Unlike defined contribution plans, there is no limit on the contribution. The employer's total contribution is based on the projected benefits. Therefore, defined benefit plans potentially offer the largest contribution deduction and the highest retirement benefits to business owners.
SIMPLE IRA retirement plans Actually a sophisticated type of individual retirement account (IRA), the SIMPLE (Savings Incentive Match Plan for Employees) IRA plan allows employees to defer up to $11,500 (for 2011) of annual compensation by contributing it to an IRA. In addition, employees age 50 and over may make an extra "catch-up" contribution of $2,500 for 2011. Employers are required to match deferrals, up to 3 percent of the contributing employee's wages (or make a fixed contribution of 2 percent to the accounts of all participating employees whether or not they defer to the SIMPLE plan).
SIMPLE plans work much like 401(k) plans, but do not have all the testing requirements. So, they're cheaper to maintain. There are several drawbacks, however. First, all contributions are immediately vested, meaning any money contributed by the employer immediately belongs to the employee (employer contributions are usually "earned" over a period of years in other retirement plans). Second, the amount of contributions the highly paid employees (usually the owners) can receive is severely limited compared to other plans. Finally, the employer cannot maintain any other retirement plans. SIMPLE plans cannot be utilized by employers with more than 100 employees.
Other plans The above sections are not exhaustive, but represent the most popular plans in use today. Recent tax law changes have given retirement plan professionals new and creative ways to write plan formulas and combine different types of plans, in order to maximize contributions and benefits for higher paid employees.
Finding a plan that's right for you If you are considering a retirement plan for your business, ask a plan professional to help you determine what works best for you and your business needs. The rules regarding employer-sponsored retirement plans are very complex and easy to misinterpret. In addition, even after you've decided on a specific type of plan, you will often have a number of options in terms of how the plan is designed and operated. These options can have a significant and direct impact on the number of employees that have to be covered, the amount of contributions that have to be made, and the way those contributions are allocated (for example, the amount that is allocated to you, as an owner).
How Capital Gains from the Sale of a Home Are Taxed For most of us, our home represents our largest asset. Over time, the management of this asset can make a big difference in our overall financial outlook. One of the largest planning opportunities home ownership brings is the favorable tax treatment afforded the sale of a primary residence.
The gain on the sale of a home is considered a gain on the sale of a capital asset. Any taxable profit you make is subject to a maximum long-term capital gain rate of 15% (down to 5% for taxpayers in the 10-15% federal income tax bracket) if you owned the house for more than 12 months. Gain on the sale of a home may be taxable only if they exceed $250,000 for single filers ($500,000 for joint filers) if certain conditions discussed below are met.
Determining Your Net Gain
To determine your profit (gain), you subtract your basis from the sale price minus all costs and commissions. For instance, if you sell a house for $250,000, and must pay your broker 6% of the sale price -- or $15,000 -- your sale price for determining capital gain tax is $235,000 ($250,000 minus $15,000).
Say you bought that house 20 years ago for $35,000. You have since redone the kitchen and bathrooms, put in new windows, added a bedroom, and a new roof. Your basis in the house is $35,000 plus the cost of all of the capital improvements you have made, providing you have documentation verifying the costs. Let's assume the total cost of those improvements over the 20 years you owned the home is $40,000. In such a case, your basis would be $75,000. Your capital gain would be $235,000 minus $75,000, or $160,000. If you are in the 28% federal tax bracket or higher, your capital gain tax on your home sale would be $24,000 unless you use the principal residence exclusion.
The Primary Residence Exclusion
Here's where the favorable tax treatment of capital gains from a residence come in. A $250,000 exclusion for single filers ($500,000 for joint filers) is now available to all taxpayers. You can claim the exclusion once every two years. To be eligible, you must have owned the residence and occupied it as a principal residence for at least two of the five years prior to the sale or exchange. If you fail to meet these requirements due to health reasons, a change in place of employment, or other unforeseen circumstances, you can exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of two years that these requirements are met. For example, let's say you were forced to move for employment reasons after only living in a home for 12 months. Without the qualified exclusion, your full tax would have been $20,000. Instead, you would pay just half, since you lived in the home 12 of the 24 months required, or 0.5 of the period. The tax of $20,000 multiplied by 0.5 would yield a tax bill of just $10,000.
For many Americans at or nearing retirement age, their home represents a terrific opportunity to "cash out," pad their retirement portfolio with tax-free gains, and help ensure their "golden years" truly live up to the name. Feel free to ask us for guidance in making this important decision.
Tax Issues with Capital Gains and Dividends
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, generating long-term capital gains or investing for dividend income could be two of your big opportunities to save on taxes. Be aware that the Act of 2003 created "sunset provisions," however, meaning that the tax rates on both capital gains and dividends may go up again unless congress acts to extend the rates. The lower rates are currently only legislated through 2008, although many observers believe these rates will eventually be made permanent.
Rates: The maximum tax rate on net capital gains from assets held 12 months or more has been reduced to 15% (from 20%) for most taxpayers and reduced to 5% (from 10%) for taxpayers in the 10% and 15% tax rate brackets for property sold or otherwise disposed of after May 5, 2003 (and installment sale payments received after that date). The reduced rate applies for both the regular tax and the alternative minimum tax.
(Note: The higher rates that apply to unrecaptured section 1250 gain, collectibles gain, and section 1202 gain have not changed.)
Tax Treatment of Capital Losses: If you incur losses from the sale of a capital asset, you can deduct those losses to the extent they offset capital gains from the sale of other assets. If your losses exceed your gains, you can only deduct up to $3,000 ($1,500 if you are married and filing separately) of capital losses in a tax year against other income on Form 1040. You can carry losses forward and continue to deduct $3,000 ($1,500 if filing separately) annually against other income until your losses are used up.
Other Issues: A long-term gain generally applies to assets held for a minimum of one year or more. Short-term capital gains are considered as part of your Adjusted Gross Income (AGI) and taxed at your ordinary income tax rate. Investors must avoid "wash sales" (selling and repurchasing the same or virtually the same asset), and you should also be aware of potential Alternative Minimum Tax (AMT) implications of taking large capital gains.
Changes Create Tax Savings Opportunities: In the past, dividend income was treated as just another source of ordinary income, and taxed at your normal tax rate. Now, the same 15% (or 5%) maximum tax rate that applies to net capital gain also applies to dividends paid by most domestic and foreign corporations after December 31, 2002.
For taxpayers in higher brackets, this represents a significant reduction. Certain dividends from regulated investment companies such as mutual funds, real estate investment trusts, and certain foreign corporations do not qualify for the reduced rates. There are also some holding requirements, consult your tax professional for more details.
As with capital gains, the Tax Relief Act of 2003 also created "sunset provisions" for dividend rates, so tax rates may go up again unless Congress acts to extend the rate reductions. The lower rates are currently only legislated through 2008.
Gift Tax Basics The federal government imposes a substantial tax on gifts of money or property above certain levels. Without such a tax, someone with a sizable estate could give away a large portion of their property before death and escape estate taxes altogether. For this reason, the gift tax acts more or less as a backstop to the estate tax. Yet few people actually pay a gift tax during their lifetime. A gift program can substantially reduce overall transfer taxes; however, it requires good planning and a commitment to proceed with the gifts.
Advantages of Gift Giving
You may have many reasons for making gifts - some people have personal motives, others are motivated by tax considerations. Many want their gift-giving program to meet both personal and tax-planning objectives. Reasons for considering a gift-giving plan include:
• Assisting someone in immediate financial need
• Providing financial security for the recipient
• Giving the recipient experience in handling money
• Seeing the recipient enjoy the gift
• Taking advantage of the annual exclusion
• Paying a gift tax now to reduce overall taxes
• Giving tax-advantaged gifts to minors
Gift Tax Annual Exclusion
Perhaps the easiest way to reduce the size of your taxable estate is to make regular use of the gift tax annual exclusion. You may give up to $12,000 each year to as many persons as you want without incurring any gift tax. (Congress has now indexed this gift level to inflation; however, the figure will rise only in increments of $1,000.) If your spouse joins in making the gift (by consenting on a gift tax return), you may (as a couple) give $24,000 to each person annually without any gift tax liability.
Unlimited Gift Tax Exclusion
In addition to the $12,000 exclusion, there is an unlimited gift tax exclusion available to pay someone's medical or educational expenses. The beneficiary does not have to be your dependent or even related to you, although payment of a grandchild's expenses is a common use of the exclusion. You must make the payment directly to the institution providing the service -- the beneficiary himself or herself must not receive the payment.
Gift Programs and Your Estate
Use of the gift tax exclusion in a single year may not affect your estate tax situation significantly, but you can reduce your taxable estate substantially through a planned annual program of $12,000 gifts ($24,000 if you are married). All gifts within the exclusion limits are protected from federal estate taxes.
In addition to reducing the size of your estate, another major tax advantage of making a gift is the removal of future appreciation in the property's value from your estate. Suppose that you give stocks worth $50,000 to your children now. If you die in 10 years and the stock is worth $130,000, your estate will escape tax on the $80,000 appreciation even though you pay a gift tax on your next tax return.
To learn more about gifting strategies and how they can play a role in your tax and estate planning, contact us to schedule a consultation. We'll be happy to help.
Home Work: Deducting Your Home Office
With the rise of cell phones and the Internet - not to mention a growing fluidity to employment situations - more Americans are choosing to telecommute and work from home.
The tax deduction for home-office expenses is among the most misunderstood and misused (if not unused) tax questions faced by those who work from home. One of the enduring myths is that the deduction is a good way to trigger an IRS audit. This article seeks to clarify the deduction and put those fears to rest for whom the home-office tax deduction is a legitimate business expense.
When Can Home Office Expenses Be Deducted?
The costs associated with maintaining a home office can be deducted only if strict IRS guidelines are met - generally that the office is used exclusively for business purposes. A spare bedroom where your mother-in-law stays while visiting from out of town, a corner of your downstairs family room, the nook in your master bedroom ... these types of home-office spaces rarely qualify under IRS rules.
The Taxpayer Relief Act of 1997 has eased the requirements for determining if the costs associated with a home office can be deducted. The new law states that a home office qualifies as a "principal place of business" if (1) the taxpayer uses the office to conduct administrative or management activities of a trade or business and (2) there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business.
Deductions will continue to be allowed for a home office meeting the above two-part test only if the taxpayer uses the office exclusively on a regular basis as a place of business and, in the case of an employee, only if such exclusive use is for the employer's convenience.
Home Office Deduction Limits
The home office deduction is limited to the gross income from the activity, reduced by expenses that would otherwise be deductible (such as mortgage interest and taxes) and all other expenses related to the activities that are not house-related. A deduction isn't allowed to the extent that it creates or increases a net loss from the activity. Any disallowed deduction may be carried over to future years.
As part of its stated mission to be "kinder and gentler" to taxpayers, the IRS has eased guidelines somewhat on those taking deductions for their home offices. However, it's a good idea to solicit the advice of a knowledgeable professional to ensure you meet all the requirements before taking this deduction. We can help.
Tax Benefits of Home Ownership
In tax lingo, your principal residence is the place where you legally reside. It's typically the place where you spend most of your time, but several other factors are also relevant in determining your principal residence. Many of the tax benefits associated with home ownership apply mainly to your principal residence--different rules apply to second homes and investment properties. Here's what you need to know to make owning a home really pay off at tax time.
Deducting mortgage interest One of the most important tax benefits that comes with owning a home is the fact that you may be able to deduct any mortgage interest that you pay. If you itemize deductions on Schedule A of your federal income tax return, you can generally deduct the interest that you pay on debt resulting from a loan used to buy, build, or improve your home, provided that the loan is secured by your home. In tax terms, this is referred to as "home acquisition debt." You're able to deduct home acquisition debt on a second home as well as your main home (note, however, that when it comes to second homes, special rules apply if you rent the home out for part of the year).
Up to $1 million of home acquisition debt ($500,000 if you're married and file separately) qualifies for the interest deduction. (Different rules apply if you incurred the debt before October 14, 1987.) If your mortgage loan exceeds $1 million, some of the interest that you pay on the loan may not be deductible.
You're also generally able to deduct interest you pay on certain home equity loans or lines of credit secured by your home, but the rules are different. Home equity debt typically involves a loan secured by your main or second home, not used to buy, build, or improve your home. Deductible home equity debt is limited to the lesser of:
· The fair market value of the home minus the total home acquisition debt on that home, or
· $100,000 (or $50,000 if your filing status is married filing separately) for main and second homes combined
The interest that you pay on a qualifying home equity loan or line of credit is generally deductible regardless of how you use the loan proceeds. For more information, see IRS Publication 936.
Mortgage insurance For 2011, you can treat qualified mortgage insurance as home mortgage interest, provided that the insurance is associated with home acquisition debt, and is being paid on an insurance contract issued after 2006. Qualified mortgage insurance is mortgage insurance provided by the Department of Veterans Affairs, the Federal Housing Administration, the Rural Housing Service, and qualified private mortgage insurance (PMI) providers. The deduction is phased out, though, if your adjusted gross income is more than $100,000 ($50,000 if you're married and file separately).
Deducting real estate property taxes If you itemize deductions on Schedule A, you can also generally deduct real estate taxes that you've paid on your property in the year that they're paid to the taxing authority. If you pay your real estate taxes through an escrow account, you can only deduct the real estate taxes actually paid by your lender from the escrow account during the year. Only the legal property owner can deduct real estate taxes. You cannot deduct homeowner association assessments, since they are not imposed by a state or local government.
AMT considerations If you're subject to the alternative minimum tax (AMT) in a given year, your ability to deduct mortgage interest and real estate taxes may be limited. That's because, under the AMT calculation, no deduction is allowed for state and local taxes, including real estate tax. And, under the AMT rules, only interest on mortgage and home equity debt used to buy, build, or improve your home is deductible. So, if you use a home equity loan to purchase a car, the interest on the loan may be deductible for regular income tax purposes, but not for AMT.
Deducting points and closing costs Buying a home is confusing enough without wondering how to handle the settlement charges at tax time. When you take out a loan to buy a home, or when you refinance an existing loan on your home, you'll probably be charged closing costs. These may include points, as well as attorney's fees, recording fees, title search fees, appraisal fees, and loan or document preparation and processing fees. You'll need to know whether you can deduct these fees (in part or in full) on your federal income tax return, or whether they're simply added to the cost basis of your home.
Before we get to that, let's define one term. Points are certain charges paid when you obtain a home mortgage. They are sometimes called loan origination fees. One point typically equals one percent of the loan amount borrowed. When you buy your main home, you may be able to deduct points in full in the year that you pay them if you itemize deductions and meet certain requirements. You may even be able to deduct points that the seller pays for you. More information about these requirements is available in IRS Publication 936.
Refinanced loans are treated differently. Generally, points that you pay on a refinanced loan are not deductible in full in the year that you pay them. Instead, they're deducted ratably over the life of the loan. In other words, you can deduct a certain portion of the points each year. If the loan is used to make improvements to your principal residence, however, you may be able to deduct the points in full in the year paid.
What about other settlement fees and closing costs? Generally, you cannot deduct these costs on your tax return. Instead, you must adjust your tax basis (the cost, plus or minus certain factors) in your home. For example, you'd increase your basis to reflect certain closing costs, including:
· Abstract fees
· Charges for installing utility services
· Legal fees
· Recording fees
· Transfer or stamp taxes
· Owner's title insurance
For more information, see IRS Publication 530.
Tax treatment of home improvements and repairs Home improvements and repairs are generally nondeductible. Improvements, though, can increase the tax basis of your home (which in turn can lower your tax bite when you sell your home). Improvements add value to your home, prolong its life, or adapt it to a new use. For example, the installation of a deck, a built-in swimming pool, or a second bathroom would be considered an improvement. In contrast, a repair simply keeps your home in good operating condition. Regular repairs and maintenance (e.g., repainting your house and fixing your gutters) are not considered improvements and are not included in the tax basis of your home. However, if repairs are performed as part of an extensive remodeling of your home, the entire job may be considered an improvement.
If you make certain improvements to your home that improve your home's energy efficiency, you may be eligible for a federal income tax credit.
Energy tax credit A credit is available to individuals who make energy-efficient improvements to their homes. You may be entitled to a 10% credit for the purchase of qualified energy-efficient improvements including a roof, windows, skylights, exterior doors, and insulation materials. Specific credit amounts may also be available for the purchase of specified energy-efficient property: $50 for an advanced main air circulating fan; $150 for a qualified furnace or hot water boiler; and $300 for other items, including qualified electric heat pump water heaters and central air conditioning units.
There's a lifetime credit cap of $500 ($200 for windows), however. So, if you've claimed the credit in the past--in one or more tax years after 2005--you're only entitled to the difference between the current cap, and the total amount that you've claimed in the past. That includes any credit that you claimed in 2009 and 2010, when the aggregate limit on the credit was $1,500.
Exclusion of capital gain when your house is sold
If you sell your principal residence at a loss, you generally can't deduct the loss on your tax return. If you sell your principal residence at a gain you may be able to exclude some or all of the gain from federal income tax.
Generally speaking, capital gain (or loss) on the sale of your principal residence equals the sale price of your home less your adjusted basis in the property. Your adjusted basis is the cost of the property (i.e., what you paid for it initially), plus amounts paid for capital improvements, less any depreciation and casualty losses claimed for tax purposes.
If you meet all requirements, you can exclude from federal income tax up to $250,000 ($500,000 if you're married and file a joint return) of any capital gain that results from the sale of your principal residence. In general this exclusion can be used only once every two years. To qualify for the exclusion, you must have owned and used the home as your principal residence for a total of two out of the five years before the sale.
For example, you and your spouse bought your home in 1981 for $200,000. You've lived in it ever since and file joint federal income tax returns. You sold the house yesterday for $350,000. Your entire $150,000 gain ($350,000 - $200,000) is excludable. That means that you don't have to report your home sale on your federal income tax return.
What if you fail to meet the two-out-of-five-year rule? Or what if you used the capital gain exclusion within the past two years with respect to a different principal residence? You may still be able to exclude part of your gain if your home sale was due to a change in place of employment, health reasons, or certain other unforeseen circumstances. In such a case, exclusion of the gain may be prorated.
Additionally, special rules may apply in the following cases:
· If your principal residence contained a home office or was otherwise used partially for business purposes
· If you sell vacant land adjacent to your principal residence
· If your principal residence is owned by a trust
· If you rented part of your principal residence to tenants, or used it as a vacation or second home
· If you owned your principal residence jointly with an unmarried individual
Note: Members of the uniformed services, foreign services, and intelligence community, as well as certain Peace Corps volunteers and employees may elect to suspend the running of the two-out-of-five-year requirement during any period of qualified official extended duty up to a maximum of ten years.
Consult a tax professional for details.
Tax-Deferred Annuities: Are They Right for You?
Tax-deferred annuities can be a valuable tool, particularly for retirement savings. However, they are not appropriate for everyone.
Five questions to consider Think about each of the following questions. If you can answer yes to all of them, an annuity may be a good choice for you.
1. Are you making the maximum allowable pretax contribution to employer-sponsored retirement plans (a 401(k) or 403(b) plan through your employer, or a Keogh plan or SEP-IRA if you are self-employed), or to a deductible traditional IRA? These are tax-advantaged vehicles that should be fully utilized before you contribute to an annuity.
2. Are you making the maximum allowable contribution to a Roth IRA, Roth 401(k), or Roth 403(b), which provide additional tax benefits not available in a nonqualified annuity?
3. Will you need more retirement income than your current retirement plan(s) will provide? If you begin making the maximum allowable contributions to both a qualified plan and an IRA in your 30s or early 40s, you may have enough retirement income without an annuity.
4. Are you sure you won't need the money until at least age 59½? Withdrawals from an annuity made before this age are usually subject to a 10 percent early withdrawal penalty tax on earnings levied by the IRS.
5. Will you take distributions from your annuity on an ongoing basis throughout your retirement? You typically have the option of making a lump-sum withdrawal from an annuity, but this is almost always a bad idea. If you do, you'll have to pay taxes on all of the earnings that have built up over the years. If you take gradual distributions, you pay taxes a little at a time, allowing the rest of the money to continue growing tax deferred. In addition, if the annuity is nonqualified and you elect to receive an annuity payout, you will enjoy an exclusion allowance on each payment, in which a portion of each payment is considered a return of principal and is not taxable.
Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.
Tax Planning for Annuities
Favorable tax treatment is one of the main reasons for buying an annuity. But what exactly are the tax benefits? And are there any drawbacks? It's important to know the answers to these questions before deciding whether to purchase an annuity.
Of course, any information pertaining to taxes is complex, full of exceptions, and subject to change. This discussion deals with the general rules for taxation of annuities--you should consult a tax advisor for more specific information before you take any action.
Taxation of premiums Annuities are typically funded with after-tax dollars. So, the money you pay into an annuity (in the form of premiums) is nondeductible. By placing funds in an annuity, you will not realize any current income tax savings, unlike putting money into a traditional IRA, 401(k) plan, or other employer-sponsored retirement plan.
Tax-deferred growth Unlike most investments, an increase in the value of an annuity from interest is not currently taxable. Generally, annuity funds are allowed to grow tax deferred until they're distributed, at which time the owner will pay ordinary income tax on all gains.
Taxation of premature withdrawals Withdrawals taken before age 59½ may be subject to a 10 percent IRS penalty tax unless an exception applies. When you make a withdrawal from an annuity, the IRS assumes that earnings are withdrawn first. The 10 percent penalty applies to the earnings portion of a withdrawal. So, early withdrawals are costly from a tax standpoint.
For example, if your annuity has grown by $1,000 since you purchased it, a $500 withdrawal would be considered 100 percent interest and would be subject to the 10 percent penalty--in this case, $50. In addition, because the entire withdrawal represents earnings, it would be subject to ordinary income tax. If you are in the 25 percent tax bracket, your income tax liability on the withdrawal would be $125. Adding this to the early withdrawal penalty, $175 of your $500 withdrawal would end up in the IRS's pocket.
Taxation of scheduled distributions If you choose an annuitization option, you will begin receiving regular distributions from your annuity over a predetermined period of time. Each distribution consists of two components: principal (a return of the money you paid into the annuity) and earnings. The percentages of principal and earnings of each distribution will depend on the annuitization option chosen. Again, the earnings portion of each distribution will be treated as ordinary income. Also, depending on the annuitization option chosen, the 10 percent penalty rule may not apply.
Note: Annuity guarantees are subject to the claims-paying ability of the annuity issuer.
Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.
Taxation of lump-sum distributions Taking a lump-sum distribution of your annuity funds can have many consequences. If you make this election within the first few years after purchasing your annuity, you may be subject to surrender charges imposed by the issuer. In any case, the earnings portion of the distribution will be treated as ordinary income in the year you take the distribution. Also, keep in mind that a large lump-sum distribution could actually push you into a higher tax bracket, dramatically increasing your tax liability.
Tax Planning for Income The goal of income tax planning is to minimize your federal income tax liability. You can achieve this in different ways. Typically, though, you'd look at ways to reduce your taxable income, perhaps by deferring your income or shifting income to family members. You should also consider deduction planning, investment tax planning, and year-end planning strategies to lower your overall income tax burden.
Postpone your income to minimize your current income tax liability By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you'd otherwise use to pay income taxes. And when you eventually report the income, you may be in a lower income tax bracket.
Certain retirement plans can help you to postpone the payment of taxes on your earned income. With a 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty). This allows you to postpone the taxation of part of your salary and take advantage of the tax-deferred growth in your investment earnings.
There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.
Shift income to your family members to lower the overall family tax burden You can also minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces a great deal of dividend income, consider gifting the stock to your children. After you've made the gift, the dividends will represent income to them rather than to you. This may lower your tax burden. Keep in mind that you can make a tax-free gift of up to $13,000 per year per recipient without incurring federal gift tax.
However, look out for the kiddie tax rules. Under these rules, for children (1) under age 18, or (2) under age 19 or full-time students under age 24 who don't earn more than one-half of their financial support, any unearned income over $1,900 is taxed at the parent's marginal tax rate. Also, be sure to check the laws of your state before giving securities to minors.
Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options before making a decision.
Deduction planning involves proper timing and control over your income Lowering your federal income tax liability through deductions is the goal of deduction planning. You should take all deductions to which you are entitled, and time them in the most efficient manner.
As a starting point, you'll have to decide whether to itemize your deductions or take the standard deduction. Generally, you'll choose whichever method lowers your taxes the most. If you itemize, be aware that some of your deductions may be disallowed if your adjusted gross income (AGI) reaches a certain threshold figure. If you expect that your AGI might limit your itemized deductions, try to lower your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.
Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you're in a higher federal income tax bracket this year than you expect to be in next year, you'll want to accelerate your deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.
Investment tax planning uses timing strategies and focuses on your after-tax return Investment tax planning seeks to minimize your overall income tax burden through tax-conscious investment choices. Several potential strategies may be considered. These include the possible use of tax-exempt securities and intentionally timing the sale of capital assets for maximum tax benefit.
Although income is generally taxable, certain investments generate income that's exempt from tax at the federal or state level. For example, if you meet specific requirements and income limits, the interest on certain Series EE bonds (these may also be called Patriot bonds) used for education may be exempt from federal, state, and local income taxes. Also, you can exclude the interest on certain municipal bonds from your federal income (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like gain or loss from any other bond for federal tax purposes). And if you earn interest on tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. Keep in mind that although the interest on municipal bonds is generally tax exempt, certain municipal bond income may be subject to the federal alternative minimum tax. When comparing taxable and tax-exempt investment options, you'll want to focus on those choices that maximize your after-tax return.
In most cases, long-term capital gain tax rates are lower than ordinary income tax rates. That means that the amount of time you hold an asset before selling it can make a big tax difference. Since long-term capital gain rates generally apply when an asset has been held for more than a year, you may find it makes good tax-sense to hold off a little longer on selling an asset that you've held for only 11 months. Timing the sale of a capital asset (such as stock) can help in other ways as well. For example, if you expect to be in a lower income tax bracket next year, you might consider waiting until then to sell your stock. You might want to accelerate income into this year by selling assets, though, if you have capital losses this year that you can use to offset the resulting gain.
Note:You should not decide which investment options are appropriate for you based on tax considerations alone. Nor should you decide when (or if) to sell an asset solely based on the tax consequence. A financial or tax professional can help you decide what choices are right for your specific situation.
Year-end planning focuses on your marginal income tax bracket Year-end tax planning, as you might expect, typically takes place in October, November, and December. At its most basic level, year-end tax planning generally looks at ways to time income and deductions to give you the best possible tax result. This may mean trying to postpone income to the following year (thus postponing the payment of tax on that income) and accelerate deductions into the current year. For example, assume it's December and you know that you're in a higher tax bracket this year than you will be in next year. If you're able to postpone the receipt of income until the following year, you may be able to pay less overall tax on that income. Similarly, if you have major dental work scheduled for the beginning of next year, you might consider trying to reschedule for December to take advantage of the deduction this year. The right year-end tax planning moves for you will depend on your individual circumstances.
Taxation of Investments It's nice to own stocks, bonds, and other investments. Nice, that is, until it's time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?
Is it ordinary income or a capital gain? To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate income, such as interest? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won't get into that here.)
If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. Currently, dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. These rates are 15 percent for an individual in a marginal tax rate bracket that is greater than 15 percent, or 0 percent for an individual in the 10 or 15 percent marginal tax rate bracket. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.
The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.
Categorizing your ordinary income Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments--including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock--can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.
But not all ordinary income is taxable--and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt, or tax deferred.
· Taxable income: This is income that's not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you'll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
· Tax-exempt income: This is income that's free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
· Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.
A quick word about ordinary losses: It's possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.
Understanding what basis means Let's move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term--basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.
First, initial basis. Usually, your initial basis equals your cost--what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.
Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.
Calculating your capital gain or loss If you sell stocks, bonds, or other capital assets, you'll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.
Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.
Schedule D of your income tax return is where you'll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You'll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your marginal income tax bracket, and the type of asset(s) involved. See IRS Publication 544 for details.
·Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
· Marginal income tax bracket: Marginal income tax brackets are expressed by their marginal tax rate (e.g., 15 percent, 25 percent). Your marginal tax bracket depends on your filing status and the level of your taxable income. When you sell an asset, the capital gains tax rate that applies to the gain will depend on your marginal income tax bracket. Generally, a 0 percent long-term capital gains tax rate applies to individuals in the 10 or 15 percent tax bracket, while the long-term capital gains of individuals in the other tax brackets are currently subject to a maximum rate of 15 percent.
Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.
Using capital losses to reduce your tax liability You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.
Getting help when things get too complicated The sale of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional.
Starting in 2013 -- new Medicare contribution tax on unearned income may apply Beginning in 2013, high-income individuals may be subject to a new 3.8 percent Medicare contribution tax on unearned income (the new tax is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:
· Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
· The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return)
So, effectively, you're subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above. It's worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.