Eldercare Can Be a Medical Deduction

Article Highlights:

  • Nursing Homes
  • Meals and Lodging
  • Home Care
  • Nursing Services
  • Caregiver Agencies
  • Household Employees

Because people are living longer now than ever before, many individuals are serving as care providers for loved ones (such as parents or spouses) who cannot live independently. Such individuals often have questions regarding the tax ramifications associated with the cost of such care. For these individuals, the cost of such care may be deductible as a medical expense.

Incapable of Self-Care – For the cost of caring for another person to qualify as a deductible medical expense, the person being cared for must be incapable of self-care. A person is considered incapable of self-care if, as a result of a physical or mental defect, that person is incapable of fulfilling his or her own hygiene or nutritional needs or if that person requires full-time care to ensure his or her own safety or the safety of others.

Assisted-Living Facilities – Generally, the entire cost of care at a nursing home, home for the aged, or assisted-living facility is deductible as a medical expense, provided that the person who lives at the facility is primarily there for medical care or is incapable of self-care. This includes the entire cost of meals and lodging at the facility. On the other hand, if the person is living at the facility primarily for personal reasons, then only the expenses that are directly related to medical care are deductible; the cost of meals and lodging is not a deductible medical expense.

Home Care – A common alternative to nursing homes is in-home care, in which day helpers or live-in caregivers provide care within the home. The services that these caregivers provide must be allocated into (nondeductible) household chores and (deductible) nursing services. These nursing services need not actually be provided by a nurse; they simply must be the same services that a nurse would normally provide (e.g., administering medication, bathing, feeding, and dressing). If the caregivers also provide general housekeeping services, then the portion of their pay that is attributable to household chores is not deductible.

The emotional and financial aspects of caring for a loved one can be overwhelming, and as a result, caregivers often overlook their burdensome tax and labor-law obligations. Sadly, these laws provide for no special relief from these tasks.

Is the Caregiver an Employee? – Because of the way that labor laws are written, it is important to determine if an in-home caregiver is an employee. The answer to this question can be very subjective. Caregivers’ services can be obtained in a number of ways:

  • Agency-provided caregivers are employees of the agency, which handles all the responsibilities of an employer. Thus, loved ones do not have any employment-tax or payroll-reporting responsibilities; however, such caregivers generally come at a substantially higher cost than others.
  • Self-employed caregivers pay all their expenses, are responsible for their own income reporting and taxes, and are not considered employees under federal or state law. The IRS lists 20 factors that it uses to determine whether an individual is an employee; the main factors are financial control, behavioral control, and the relationship between the parties. The household workers are typically classified as employees.
  • Household employees are subject to Social Security and Medicare taxes. The employer is thus responsible for withholding the employee’s share of these taxes and paying the employer’s share of payroll taxes. Fortunately for these employers, the special rules for household employees greatly simplify the payroll-withholding and income-reporting requirements. Any resulting federal payroll taxes are paid annually in conjunction with the employer’s individual 1040 tax return. Federal income-tax withholding is not required unless both the employer and the employee agree to do so. However, the employer is still required to issue a W-2 to the employee and to file that form with the federal government. The employer also must obtain federal and state employer ID numbers for reporting purposes. Some states have special provisions for the annual reporting and payment of state payroll taxes; these may be similar to the federal requirements.The employer’s portion of all employment taxes (Social Security, Medicare, and both federal and state unemployment taxes) related to deductible medical expenses are also deductible as a medical expense.

You may be thinking, “Wait a minute – the household employers I know pay in cash and do not pay payroll taxes or issue W-2s to their household employees.” This observation may be accurate, but such behavior is illegal, and it is not right to ignore the law. Think about what could happen if one of your household employees is injured on your property or if you dismiss such an employee under less-than-amicable circumstances. In such circumstances, the household employee will often be eager to report you to the state labor board or to file for unemployment compensation.

Note, however, that gardeners, pool cleaners, and repair people generally work on their own schedules, invest in their own equipment, have special skills, manage their own businesses, and bear the responsibility for any profit or loss. Such workers are not considered household employees.

Here are some additional issues to consider:

Overtime – Under the Fair Labor Standards Act, domestic employees are nonexempt workers and are entitled to overtime pay for any work beyond 40 hours in a given week. However, live-in employees are an exception to this rule in most states.

Hourly Pay or Salary – It is illegal to treat nonexempt employees as if they are salaried.

Separate Payrolls – Business owners may be tempted to include their household employees on their companies’ payrolls. However, any payments to household employees are personal expenses and thus are not allowable as business deductions. Thus, business owners must maintain separate payrolls for household employees; in other words, personal funds (not business funds) must be used to pay household workers.

Eligibility to Work in the U.S. – It is illegal to knowingly hire or continue to employ an alien who is not legally eligible to work in the U.S. When a household employee is hired to work on a regular basis, the employer and employee each must complete Form I-9 (Employment Eligibility Verification). The employer must carefully examine the employee’s documents to establish his or her identity and employment eligibility.

If you have questions related to eldercare or about how your state deals with related employment issues – or if you would like assistance in setting up a household payroll system – please contact this office.

Tax Tips for IRA Owners

Article Highlights:

  • Early Withdrawals
  • Excess Contributions
  • Multiple Rollovers
  • No Traditional IRA Contributions in the Year Reaching age 70½
  • Failing to Take a Required Minimum Distribution (RMD)
  • Late Contributions
  • Switch the Type of IRA
  • Backdoor Roth IRA
  • Alimony as Compensation
  • Spousal IRA
  • Saver’s Credit
  • IRA-to-Charity Direct Transfers

There are both opportunities and pitfalls for IRA owners, and while you definitely don’t want to get caught up in a pitfall, you may want to take advantage of the opportunities. IRAs come in two varieties: the traditional and the Roth. The traditional generally provides a tax deduction for a contribution and tax-deferred accumulation, with distributions being taxable. On the other hand, there is no tax deduction for making a Roth contribution, but the distributions are tax-free.

So, it leaves taxpayers with a significant decision, with long-term consequences of whether to contribute to traditional or Roth IRA. If you can afford to make the contributions without a tax deduction, then the Roth IRA is probably the better choice in most circumstances. However, some high-income restrictions limit the deductibility of a traditional IRA and the ability to contribute to a Roth IRA.

Pitfalls – Here are some of the pitfalls that can be encountered with IRAs:

  • Early withdrawals – IRAs were designed by the government to be retirement resources, and to deter individuals from tapping these accounts before retirement they added what is called an early withdrawal penalty of 10% of the taxable amount of the IRA distribution. The penalty generally applies for distributions made before reaching age 59-½, but there are some exceptions to the penalty.
  • Excess contributions – The tax code sets the maximum amount that can be contributed to an IRA annually. Contributions in excess of those limits are subject to a nondeductible 6% excise tax penalty, and this penalty continues to apply each year until the over-contribution is corrected.
  • Multiple rollovers – A rollover is where you take possession of the IRA funds for a period of time (up to 60 days) and then redeposit the funds into the same or another IRA. Only one IRA rollover is allowed in a 12-month period and all IRAs are treated as one for purposes of this rule. If more than one rollover is made in a 12-month period, the additional distributions are treated as taxable distributions and the rollover is treated as an excess contribution, with both causing significant tax and penalties. Rollovers can be avoided by directly transferring assets between IRA trustees.
  • No Traditional IRA contributions in year reaching age 70½ – Individuals cannot make a Traditional IRA contribution in the year they reach the age 70½ or any year thereafter. This rule doesn’t apply to Roth IRAs. Contributions to a traditional IRA made in the year you turn 70½ (and for subsequent years) are treated as excess contributions and are subject to the nondeductible 6% excise tax penalty until corrected.
  • Failing to take a required minimum distribution (RMD) – Individuals who have traditional IRA accounts must begin taking RMDs in the year they turn 70½ and in each year thereafter. However, the distribution for the year when an individual reaches age 70½ can be delayed to the next year without penalty if the distribution is made by April 1 of the next year. Failing to take a distribution is subject to a penalty equal to 50% of the RMD. The IRS will generally waive the penalty for non-willful failures to take the RMD, provided the individual has a valid excuse and the under-distribution is corrected. The RMD rules don’t apply to Roth IRAs while the owner is alive.

Opportunities

Late contributions – If you forgot to make an IRA contribution or just decided to do so for the prior year, the tax law allows you to make a retroactive contribution in the subsequent year, provided you do so before the unextended April filing due date. As an example, you can make an IRA contribution for 2018 through April 15, 2019. This is also a benefit for taxpayers who were not previously sure they could afford to make a contribution.

Switch the type of IRA – If you make an IRA contribution for a year, tax law allows you to switch the designation of that contribution from a traditional IRA to a Roth IRA, or vice versa, provided you do so before the unextended April filing due date.

Backdoor Roth IRA – Contributing to a Roth IRA is not allowed if the individual’s modified adjusted gross income (AGI) exceeds a specified amount based on filing status. For example, the limits for 2019 are $203,000 if filing a joint return, $10,000 if filing married separate, or $137,000 for all others. If a high-income taxpayer would like to contribute to a Roth IRA but cannot because of the income limitation, there is a work-around that will allow the high-income individual to fund a Roth IRA. Here is how that backdoor Roth IRA works:

  1. First, a contribution is made to a traditional IRA. For higher-income taxpayers who participate in an employer-sponsored retirement plan, a traditional IRA is allowed but is not deductible. Even if all or some portion is deductible, the contribution can be designated as not deductible.
  2. Then, since the law allows an individual to convert a traditional IRA to a Roth IRA without any income limitations, the non-deductible traditional IRA can be converted to a Roth IRA. Since the traditional IRA was non-deductible, the only tax related to the conversion would be on any appreciation in value of the traditional IRA before the conversion is completed.One potential pitfall to the backdoor Roth IRA is often overlooked by investment counselors and taxpayers alike that could result in an unexpected taxable event upon conversion. For distribution or conversion purposes, all of your IRAs (except Roth IRAs) are considered one account, and any distribution or converted amounts are deemed taken ratably from the deductible and non-deductible portions of the traditional IRA, and the portion that comes from the deductible contributions would be taxable. So, the conversion tax implications should be considered before employing the backdoor Roth strategy.

Alimony as compensation – In order to contribute to an IRA, an individual must receive “compensation.” For IRA purposes, compensation includes taxable alimony received. Thus, for purposes of determining IRA contribution and deduction limits, individuals who receive taxable alimony and separate maintenance payments may treat the alimony as compensation, for purposes of making either a traditional or a Roth contribution, allowing alimony recipients to save for their retirement.

Spousal IRA – One frequently overlooked tax benefit is the “spousal IRA.” Generally, IRA contributions are only allowed for taxpayers who have compensation (the term “compensation” includes wages, tips, bonuses, professional fees, commissions, taxable alimony received, and net income from self-employment). Spousal IRAs are the exception to that rule and allow a non-working or low-earning spouse to contribute to his or her own IRA, otherwise known as a spousal IRA, based upon his or her spouse’s compensation (as long as it is enough to support the contribution).

Saver’s credit – The saver’s credit, for low- to moderate-income taxpayers, helps offset part of the first $2,000 an individual voluntarily contributes to an IRA or other retirement plans. The saver’s credit is available in addition to any other tax savings resulting from contributing to an IRA or retirement plans. Like other tax credits, the saver’s credit can increase a taxpayer’s refund or reduce the tax owed. The maximum saver’s credit is $1,000 ($2,000 for married couples if both spouses contribute to a plan). The application of this credit is very limited. Please call for additional details.

IRA-to-charity direct transfers – Individuals age 70½ or over must withdraw annual RMDs from their IRAs. These folks can take advantage of a tax provision allowing taxpayers to transfer up to $100,000 annually from their IRAs to qualified charities. This provision may provide significant tax benefits, especially if you would be making a large donation (although it also works for small amounts) to a charity anyway.

Here is how this provision, if utilized, plays out on a tax return:

(1) The IRA distribution is excluded from income;
(2) The distribution counts toward the taxpayer’s RMD for the year; and
(3) The distribution does NOT count as a charitable contribution.

At first glance, this may not appear to provide a tax benefit. However, by excluding the distribution, a taxpayer with itemized deductions will lower his or her AGI, which will help with other tax breaks (or punishments) that are pegged at AGI levels, such as medical expenses, passive losses, and taxable Social Security income. In addition, non-itemizers essentially receive the benefit of a charitable contribution to offset the IRA distribution.

Please call this office for further details or to schedule an appointment for some IRA planning unique to your circumstances.

It’s Not Too Late to Make a 2018 Retirement-Plan Contribution

Article Highlights:

  • Traditional IRAs
  • Roth IRAs
  • Spousal IRA Contributions
  • Simplified Employee Pension Plans
  • Solo 401(k) Plans
  • Health Savings Accounts
  • Saver’s Credit
  • Children with Earned Income

Have you been ignoring your future retirement needs? This tends to happen when people are young; because retirement is far in the future, they believe that they have plenty of time to save for it. Some people even ignore the issue until late in life, which causes them to scramble to fund their retirement. Others even ignore the issue altogether, assuming that they will qualify for Social Security and that the resulting income will take care of their retirement needs.

Did you know that you can make retirement savings contributions after the close of the tax year and that these contributions may be deductible? With the April tax deadline in the near future, the window of opportunity is closing to maximize contributions to retirement and special-purpose plans for 2018. Many of these retirement contributions will also deliver tax deductions or tax credits for the 2018 tax year.

Contribution Opportunities – Some 2018 retirement contributions are available after the close of the year.

  • Traditional IRAs – For 2018, the maximum traditional IRA contribution is $5,500 (or $6,500 if the taxpayer is at least 50 years old on December 31, 2018). A 2018 traditional IRA contribution can be made until April 15, 2019. However, for taxpayers who have other retirement plans, some or all of their IRA contributions may not be deductible. To be eligible to contribute to IRAs (of any type), taxpayers—or spouses if married and filing jointly—must have earned income such as wages or self-employment income.
  • Roth IRAs – A Roth IRA is a nondeductible retirement account, but its earnings are tax-free upon withdrawal—provided that the requirements for the holding period and age are met. Roth IRAs are a good option for many taxpayers who aren’t eligible for deductible contributions to a traditional IRA. For 2018, the contribution limits for a Roth IRA are the same as for a traditional IRA: $5,500 (or $6,500 if the taxpayer is at least 50 years old). A 2018 Roth IRA contribution can also be made until April 15, 2019.Caution: For those who have both traditional and Roth IRA contributions, the combined limit for 2018 is also $5,500 (or $6,500 if the taxpayer is at least 50 years old).
  • Spousal IRA Contributions – A nonworking spouse can open and contribute to a traditional or Roth IRA based on the working spouse’s earned income. The spouses are subject to the same contribution limits, and their combined contributions cannot exceed the working spouse’s earned income. Spousal IRA contributions for 2018 must also be made by April 15, 2019.
  • Simplified Employee Pension IRAs – Simplified Employee Pension IRAs are tax-deferred plans for sole proprietorships and small businesses. This is probably the easiest way to build retirement dollars, as it requires virtually no paperwork. The maximum contribution depends on a business’s net earnings. For 2018, the maximum contribution is the lesser of 25% of the employee’s compensation or $55,000. A 2018 contribution to such a plan can be made up to the return’s due date (including extensions). Thus, unlike a traditional or Roth IRA, a Simplified Employee Pension IRA can be established and funded for 2018 as late as October 15, 2019 (if an extension to file a 2018 Form 1040 has been granted).
  • Solo 401(k) Plans – A growing number of self-employed individuals are forsaking the Simplified Employee Pension IRA for a newer type of retirement plan called a Solo 401(k) or Self-Employed 401(k). This plan is available to self-employed individuals who do not have employees, and it is notable mostly for its high contribution levels.For 2018, Solo 401(k) contributions can equal 25% of compensation, plus a salary deferral of up to $18,500. The total contributions, however, can’t exceed $55,000 or 100% of compensation. Note that an individual must have established the Solo 401(k) account by December 31, 2018, to make 2018 contributions. However, contributions to an established account can then be made up to the return’s due date (which can be extended to October 15, 2019, for most taxpayers). Taxpayers who did not establish a Solo 401(k) account by the end of 2018 can still open one now for 2019 contributions.
  • Health Savings Accounts – Health savings accounts are only available for individuals who have high-deductible health plans. For 2018, this refers to plans with a deductible of at least $1,350 for individual coverage or $2,700 for family coverage. These accounts allow individuals to save money to pay for their medical expenses.Money that an individual does not spend on medical expenses stays in that person’s account and gains (tax-free) interest, just like in an IRA. Because unused amounts remain available for later years, health savings accounts can be used as additional retirement funds. The maximum contributions for 2018 are $3,450 for individual coverage and $6,900 for family coverage. The annual contribution limits are increased by $1,000 for individuals who are at least 55 years old. Contributions to a health savings account for 2018 can be made through April 15, 2019.

Please note that the information provided above is abbreviated. Contact this office for specific details on how each option applies to your situation.

Saver’s Credit – Low- and moderate-income workers are eligible for a saver’s credit that helps them offset part of the first $2,000 that they contribute to an IRA or a qualified employer-based retirement plan. This credit helps individuals who don’t normally have the resources to set money aside for retirement, and it is available in addition to the other tax benefits that are associated with retirement-plan contributions.

This credit is provided to encourage taxpayers to save for retirement. To prevent taxpayers from taking distributions from existing retirement savings and then re-depositing them to claim this credit, the qualifying retirement contributions used to figure the credit are reduced by any retirement-plan distributions taken during a “testing period”: the prior two tax years, the current year, and the portion of the subsequent tax year up to the return’s due date (including extensions).

Children with Earned Income – Many children hold part-time jobs, and after the recent tax reform, the standard deduction allows these children to earn $12,000 tax-free. This earned income also qualifies children for IRA contributions. Although children may balk at contributing their hard-earned income to an IRA, their parents or grandparents can gift Roth IRA contributions to children. That Roth IRA will significantly increase in value by the time the child reaches retirement age, 45 or 50 years later.

Individuals’ financial resources, family obligations, health, life expectancy, and retirement expectations vary greatly, and there is no one-size-fits-all retirement strategy. Events such as purchasing a home or putting children through college can limit retirement contributions; these events must be accounted for in any retirement plan.

If you have questions about any of the retirement vehicles discussed above or if you would like to discuss how retirement contributions will affect your 2018 tax return, please give this office a call.

Making Two IRA Rollovers in One Year Can Be Costly

Article Highlights:

  • One Rollover per Year Rule
  • Exceptions
  • Tax Consequences
  • Disqualified Rollover
  • Early Withdrawal Penalty

Tax law permits you to take a distribution from your IRA account, and as long as you return the distribution to your IRA within 60 days, there are no tax ramifications. However, many taxpayers overlook that you are only allowed to do that once in a 12-month period, and violating this rule can have some nasty and unexpected tax ramifications.

The one-year period is measured based on the date a distribution is received. If the second distribution is received before the same date one year later, it is a disqualified rollover.

Example – Jack takes a distribution from his IRA on June 30 of year one and subsequently rolls over the distribution (puts the funds back into the IRA) within the 60-day rollover period. Jack must wait until June 30 of year two before another distribution is eligible for a rollover. Any additional distributions taken during the one-year waiting period would be taxable.

Example – A taxpayer received a distribution from his IRA with Chase bank in February, which he immediately rolled into a new IRA with Wells Fargo. Then, in May, he took a distribution from the Wells Fargo IRA and rolled it back into the IRA at Wells within 60 days. Even though he rolled the exact amount back into the same institution within 60 days, the distribution from Chase had started the running of the one-year waiting period. Thus, his second distribution was in violation of the one-year waiting period and was a taxable distribution. The redeposit of what he thought was a rollover was actually a contribution to the IRA.

Like everything taxes, there are exceptions to the one-year rule, including the following:

Direct Transfers – As long as IRA funds are transferred directly between trustees, the transaction is not considered a rollover. A taxpayer can make as many direct transfers in a year as he or she wants; in fact, utilizing direct transfers is the preferred way to move funds from one IRA to another because it eliminates certain tax-return reporting issues.

  • Roth Conversions – Traditional IRA to Roth IRA conversions are not considered rollovers for purposes of the one-year rule.
  • Distributions to and from Qualified Plans – Since the one-year rule only applies to IRA-to-IRA rollovers, rollovers to and from other types of retirement plans are not governed by the one-year rule. However, SEPS and SIMPLE plans are treated as an IRA for purposes of the one-year waiting period.
  • Failed Financial Institutions – An IRA distribution made from a failed financial institution by the Federal Deposit Insurance Corporation is generally disregarded for purposes of applying the one-rollover-per-year limitation.

Tax Consequences – When the one-year rule is violated, any distribution after the first made within the one-year waiting period will not be treated as a rollover, with the following tax consequences:

  • Traditional IRA – In the case of a traditional IRA, the entire distribution will be taxable, and if the taxpayer is under age 59½ at the time of the distribution, the 10% early distribution penalty will apply to the taxable portion.
  • Roth IRA – In the case of a Roth IRA that is a:o Non-Qualified Distribution – A non-qualified distribution is one where the Roth IRA has not met the five-year aging requirements. Five-year aging generally means the Roth IRA has been in existence for a continuous period of five years, although the first and last years do not need to be full years. A distribution from a Roth IRA that has not met the five-year aging requirements would be a non-qualified distribution, and the earnings would be taxable. Of course, the original contributions are never taxable based on a specific distribution sequence: contributions, then conversions from traditional IRAs or rollovers from qualified plans (first the part that was taxed when the funds went into the Roth and then the nontaxable part), and lastly earnings. A 10% early distribution penalty applies to any amount attributable to the part of the conversion or rollover amount that had to be included in income at the time of the conversion or rollover (the recapture amount).

    o Qualified Distribution – No tax or penalty applies if a distribution from a Roth IRA is a “qualified distribution,” which is a distribution made after the five-year aging period is met if the taxpayer:

    – Is age 59½ or older,
    – Is disabled,
    – Is deceased, or
    – Qualifies for the first-time homebuyer exception (maximum $10,000).

Disqualified Rollover – An additional problem arises because the disqualified rollover amount will be treated as an IRA contribution, subject to the normal annual contribution and AGI limitations. Tax law includes a penalty when someone contributes more than is allowed (excess contribution). Thus, an excess contribution (except for on the year of the distribution) would be subject, annually, to a 6% excess contribution penalty.

There are a couple of possible remedies available for a disqualified rollover:

  • Corrective Distribution – The excess contribution and the interest attributable to it can be withdrawn by the extended due date of the return for the year the distribution was made, thus undoing the rollover. The distribution that resulted in a disqualified rollover will be subject to tax, as outlined earlier, depending upon whether it was a traditional or Roth IRA. The earnings attributable to withdrawn funds are taxable. However, the annual 6% excess contribution penalty is avoided.
  • Contributions in Future Years – The excess contribution could be left in the IRA and can be treated as an IRA contribution for a later year. However, until the excess contribution is fully absorbed as eligible future contributions, the annual 6% excess contribution penalty will apply.

Early Withdrawal Penalty – If the disallowed rollover occurs before reaching age 59½, an early distribution penalty of 10% of the taxable amount will apply and is in addition to the normal tax.

Although there are a number of exceptions to the under-age-59½ early distribution penalty, the following might be used to avoid or mitigate an early withdrawal penalty associated with a disqualified rollover:

  • Contributions Returned before the Due Date – If the taxpayer already made an IRA contribution for the tax year, the amount of that contribution can be withdrawn tax-free by the extended due date of the tax return, provided:
1. The taxpayer did not take a deduction for the contributions withdrawn, and
2. The taxpayer also withdraws any interest or other income earned on the contributions, and
3. The taxpayer includes in income, for the year during which the withdrawal was made, any earnings on the contributions withdrawn.
  • Medical Insurance Exception – The amount that is exempt from the penalty is the amount the taxpayer paid during the year for medical insurance for the taxpayer and his or her spouse and dependents. To qualify for this exception, the taxpayer must have:
1. Lost his/her job,
2. Received unemployment compensation for 12 consecutive weeks,
3. Made IRA withdrawals during the year he/she received unemployment or in the following year, and
4. Made the withdrawals no later than 60 days after being reemployed.

  • Higher Education Expense Exception – The part not subject to the penalty is generally the amount that is not more than the qualified higher education expenses for the taxpayer and his or her spouse, children, or grandchildren for the year at an eligible educational institution.

Bottom line, make sure you don’t have more than one IRA rollover in a year. However, if you inadvertently do, please call this office as soon as you realize the error so we can determine what actions can be taken to mitigate the resulting taxes and penalties.

Understanding Tax-Deferred Investing

Article Highlights:

  • Income Deferral
  • Earnings Deferral
  • Individual Retirement Accounts
  • Retirement Accounts
  • Bank Savings
  • Short- and Long-Term Capital Gains
  • Education Savings Accounts
  • Health Savings Accounts

When you are attempting to save money for your children’s future education or your retirement, you may do so in a number of ways, including investing in the stock market, buying real estate for income and appreciation, or simply putting money away in education savings accounts or retirement plans.

Knowing how these various savings vehicles are taxed is important for choosing the ones best suited to your particular circumstances. Let’s begin by examining the tax nuances of IRA accounts.

Individual Retirement Account (IRA) – There are two types of IRA accounts—the traditional and the Roth—and even though they are both IRAs, there is a huge difference in their tax treatment.

  • Traditional IRA – Contributions to a traditional IRA are generally tax-deductible unless you have a retirement plan at work, and then the IRA contribution may not be deductible if you are a higher-income taxpayer. All of the earnings from a traditional IRA are tax-deferred, meaning they are not taxable currently but will be when funds from the account are withdrawn; since the contributions were tax-deductible, everything you withdraw from the traditional IRA will be taxable. An exception to that last statement is when you didn’t claim a deduction for money that you contributed to the IRA, either by choice or when the law didn’t allow a deduction. In this case, withdrawals from a traditional IRA would be prorated as partly taxable and partly tax-free.
  • Roth IRA – Roth IRA contributions are never tax-deductible, but the earnings are never taxable if the account meets a 5-year aging rule and the distributions begin after you reach age 59.5.

So, which is best? Well, that depends upon your particular circumstances. If you need the tax deduction to fund the IRA, then by all means use the traditional IRA. However, if you can afford to the make a contribution without the deduction, then the Roth IRA will be the best because everything is tax-free when withdrawn, usually at retirement.

Retirement Plans – The tax code provides for a variety of retirement plans, both for employees and for self-employed individuals. These include: 401(k) deferred compensation plans, Keogh self-employed retirement plans, simplified employee plans (SEP), tax-sheltered annuity (403(b)) plans – most commonly for teachers and employees of nonprofits), and government employee plans (457) plans. For the most part, the consequences of these arrangements are the same as for a traditional IRA, allowing the amount contributed to be excluded from income (deferred), and then the distributions are fully taxable when they are taken. However, 401(k) and 457 plans may have a Roth option, under which there is no income exclusion for the contributions but the distributions at retirement are tax-free. If individuals have used both methods, the non-Roth contributions are deferred, and the earnings are fully taxable.

Bank Savings – When money is put away into a bank savings account or CD, the earnings are fully taxable in the year earned. However, after the tax on the annual earnings is paid, the full balance in the account is available, without any further tax.

Short- and Long-Term Capital Gains – Capital gains refers to the gain from the sale of capital assets – typically stocks, bonds, and real estate. Short-term capital gains are taxed at ordinary tax rates, while long-term capital gains enjoy special lower rates. For lower-income taxpayers, there is actually no tax on capital gains; for very high-income taxpayers, the capital gains rate maxes out at 20%, whereas the top regular tax rate for high-income taxpayers is 37%. However, for the average taxpayer, the capital gains rate is 15%, which provides a significant savings over the regular tax rates. To qualify for long-term treatment, the capital asset must be held for a year and a day.

Education Savings Accounts – The tax code provides two tax-advantaged plans that allow taxpayers to save for the cost of college for each eligible student: the Coverdell Education Savings Account and the Qualified Tuition Plan (frequently referred to as a Sec. 529 Plan). Neither provides tax-deductible contributions, but both plans’ earnings are tax-deferred and are tax-free if used for allowable expenses, such as tuition. Therefore, with either plan, the greatest benefit is derived by making contributions to the plan as soon as possible—even the day after a child is born—to accumulate years of investment earnings and maximize the benefits.

However, there are different limitations for the two plans, in that only $2,000 per year per student can be contributed to a Coverdell account, while huge amounts can be contributed to Sec. 529 plans, limited only by the estate-planning issues of each contributor and each state’s cap on account contributions, which goes into six figures.

Health Savings Accounts – A health savings account (HSA) can generally be established by taxpayers only if they have high-deductible health plans. The contributions are tax-deductible, the earnings accumulate tax-free, and the distributions are tax-free if used for qualified medical expenses. When part of an employer-sponsored plan, HSA contributions are excluded from the employee’s wages. Once the account owner reaches age 65, taxable but penalty-free distributions can be taken, even if they are not used to pay for medical expenses or to reimburse the taxpayer for medical expenses previously paid for out-of-pocket. Thus, these plans can serve as a combination tax-free medical reimbursement plan and taxable retirement savings arrangement. The maximum annual contribution is inflation adjusted; for 2018, it is $3,450 for self-only coverage and $6,900 for family coverage. Like other tax-advantaged plans, the key is to allow the account to grow through tax-deductible contributions and the accumulated earnings.

Unqualified Withdrawals – Be careful about making unqualified withdrawals – those that are taken before reaching retirement age, in the case of retirement plans, and those taken for unqualified expenses, in the case of education savings accounts and health savings accounts. Doing so can result in costly tax ramifications and potential penalties.

Like all things tax, nothing is simple, and a myriad of rules apply to the foregoing arrangements, so please contact this office for more information or a planning appointment.

Is a Roth Conversion Right for You? But Be Careful, They Can No Longer Be Undone!

Article Highlights:

  • Conversion Timing
  • Why Convert?
  • When to Convert?
  • Issues to Consider Before Making the Decision

Roth IRA accounts provide the benefits of tax-free accumulation and, once you reach retirement age, tax-free distributions. This is the reason why so many taxpayers are converting their traditional IRA account to a Roth IRA. However, to do so, you must generally pay tax on the on the converted amount. After making a conversion, your circumstances may change, and you may find yourself wishing you had not made the conversion. In the past, you could change your mind later and undo the conversion. But that option is no longer available under tax reform. So, be careful: once a conversion is made, there is no going back.

Timing is everything, and a favorable time to make a traditional IRA to Roth IRA conversion is a year when your income is abnormally low or the value of your traditional IRA has declined. You can also convert portions of your traditional IRA over a number of years, thereby gradually converting the traditional IRA to a Roth IRA, spreading the tax liability over a number of years, and keeping it in a lower tax bracket. If you previously made non-deductible contributions to a traditional IRA, those amounts can be converted tax-free but must be converted ratably with the other funds in the traditional IRA.

Many taxpayers overlook some great opportunities to make conversions, such as years when your income is abnormally low or a year when your income might even be negative due to abnormal deductions or business losses. Even the new higher standard deductions may offer a taxpayer the opportunity to convert some or all of their traditional IRA to a Roth IRA without any conversion tax.

Everyone’s financial circumstances are unique, and issues to consider include:

  • Will there be enough years before retirement to recoup the conversion tax dollars through tax-free accumulation?
  • Is your income low enough or are your deductions high enough to enable a tax-free or minimal tax conversion?
  • Will you be in a lower or higher tax bracket in the future?
  • Where would the money to pay the conversion tax come from? Generally, it must be from separate funds. If it is taken from the IRA being converted, for individuals under age 59½, the funds withdrawn to pay the tax will also be subject to the 10% early distribution penalty, in addition to being taxed.
  • It might be appropriate for you to design your own custom conversion plan over a number of years, rather than converting everything at once.

Conversions can be tricky, and once made, they can no longer be undone. If you are considering a conversion, it might be appropriate to call for an appointment so that this office can help you properly analyze your conversion options or develop a conversion plan that fits your particular circumstances.