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Don’t Miss the Opportunity for a Spousal IRA

Article Highlights: 

  • Spousal IRA 
  • Compensation Requirements 
  • Maximum Contribution 
  • Traditional or Roth 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 their own IRA, otherwise known as a spousal IRA, as long as they have adequate compensation. 

The maximum amount that a non-working or low-earning spouse can contribute is the same as the limit for a working spouse, which is $6,000 for 2020. If the non-working spouse’s age is 50 or older, that spouse can also make “catch-up” contributions (limited to $1,000), raising the overall contribution limit to $7,000. These limits apply provided that the couple together has compensation equal to or greater than their combined IRA contributions. 

Example: Tony is employed, and his W-2 for 2020 is $100,000. His wife, Rosa, age 45, has a small income from a part-time job totaling $900. Since her compensation is less than the year’s contribution limit, she can base her contribution on their combined compensation of $100,900. Thus, Rosa can contribute up to $6,000 to an IRA for 2020. 

Both spouses’ contributions can be made either to a traditional or Roth IRA or split between them as long as the combined contributions don’t exceed the annual contribution limit. Caution: The deductibility of the traditional IRA and the ability to make a Roth IRA contribution are generally based on the taxpayer’s income: 

  • Traditional IRAs – There is no income limit restricting contributions to a traditional IRA. However, suppose the working spouse is an active participant in any other qualified retirement plan. In that case, a tax-deductible contribution can be made to the IRA of the non-participant spouse only if the couple’s adjusted gross income (AGI) doesn’t exceed $196,000 in 2020 (up from $193,000 in 2019). 
  • Roth IRAs – Roth IRA contributions are never tax-deductible. Contributions to Roth IRAs are allowed in full if the couple’s AGI doesn’t exceed $196,000 in 2020 (up from $193,000 in 2019). The contribution is ratebly phased out for AGIs between $196,000 and $206,000 (up from a range of $193,000 to $203,000 in 2019). Thus, no contribution is allowed to a Roth IRA once the AGI exceeds $206,000. 

Example: Rosa from the previous model can designate her IRA contribution as either a traditional deductible IRA or a nondeductible Roth IRA because the couple’s AGI is under $196,000. Had the couple’s AGI been 201,000, Rosa’s allowable contribution to a deductible traditional or Roth IRA would have been limited to $3,000 because of the phase-out. The other $3,000 could have been contributed to a conventional IRA and designated as nondeductible. 

Please contact us if you would like to discuss IRAs or need assistance with your retirement planning.

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

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 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 we can help you properly analyze your conversion options or develop a conversion plan that fits your particular circumstances.

Tax Reform Cracks Down on IRA Recharacterizations

Note: This is one of a series of articles explaining how the various tax changes in the GOP’s Tax Cuts & Jobs Act (referred to as “the Act” in this article), which passed in late December of 2017, could affect you and your family, both in 2018 and future years. This series offers strategies that you can employ to reduce your tax liability under the new law.

If you have been or are anticipating converting your traditional IRA to a Roth IRA, you should be aware of a tax trap that Congress built into the Act.

Background: There are two types of IRA accounts:

  • Traditional IRA – Is a retirement plan that generally provides a taxpayer with a tax deduction when a contribution is made to the account. Then when distributions are taken from the account they are fully taxable, including earnings.
  • Roth IRA – Is also a retirement plan, but unlike the traditional IRA, a Roth IRA does not provide a tax deduction for the contribution. Thus, once a taxpayer reaches retirement age, all of the distributions are totally tax-free.

The big benefit here is that all the Roth account earnings over the years end up being tax-free as opposed to those from the traditional IRA, which are taxable. For that reason, many taxpayers take advantage of a provision in the law that allows them to convert a traditional IRA to a Roth IRA. However, for the year that a traditional IRA is converted to a Roth IRA, the converted amounts are taxable. Therefore, most IRA owners carefully plan the amount and timing of the conversions to be done in a year when they are in lower-than-normal tax brackets.

Prior law included a provision that allowed taxpayers to change their minds and undo a conversion by recharacterizing the Roth converted amounts back to traditional IRAs and thus also undoing the tax liability. This was helpful for those who had underestimated the tax liability, did not have money available to pay the tax, saw the value of the converted IRA drop (which would mean they’d be paying tax on a phantom value) or just changed their mind.

Unfortunately, the Act pulled the plug on recharacterizations, and beginning in 2018, taxpayers can no longer undo a conversion. Once a conversion is made, the IRA owner will have to live with the tax consequences. This rule applies for conversions from a traditional IRA, SEP or SIMPLE to a Roth IRA. The new law also prohibits recharacterizing amounts rolled over to a Roth IRA from other retirement plans, such as 401(k) or 403(b) plans.

However, for taxpayers who made a conversion to a Roth IRA in 2017, the IRS has announced the conversion may be recharacterized as a contribution to a traditional IRA if the recharacterization is made by October 15, 2018. A Roth IRA conversion made on or after January 1, 2018, cannot be recharacterized.

Recharacterization is still permitted with respect to other contributions. For example, an individual may make a contribution to a Roth IRA for a particular year and, before the due date for their income tax return for that year, recharacterize it as a contribution to a traditional IRA or vice versa.

If you have questions related to converting a traditional IRA to a Roth IRA, please give this office a call. If you would like to strategize on how to minimize the tax on a conversion, please contact us.

Important Facts to Know About IRAs

The individual retirement account (IRA) is one of the favored ways to save money for retirement. There are two types of IRAs: the traditional IRA and the Roth IRA. The annual maximum that an individual can be contributing between the two types of IRAs is $5,500, unless the individual is 50 years of age or older, and then the maximum is increased to $6,500. The basic contribution amount is inflation adjusted annually and the amount quoted is for 2017, while the additional amount for those 50 and older is fixed at $1,000. Contributions to an IRA may or may not be tax deductible depending on the type of IRA and, in some cases, the amount of the taxpayer’s income for the contribution year and whether the taxpayer participates in an employer’s retirement plan.

Compensation – In order to contribute to either type of IRA, the taxpayer must have compensation equal to the amount of the contribution. Compensation includes wages, tips, bonuses, professional fees, commissions and net income from self-employment. Alimony recipients may treat alimony as compensation for purposes of making IRA contributions. Also, members of the military receiving excludable combat pay may count the excluded amount as compensation for IRA purposes.

Active Participation in Another Retirement Plan – When an individual is an active participant in another retirement plan, such as an employer qualified pension, profit sharing or stock bonus plan, a qualified annuity, tax-sheltered annuity, government plan or simplified employee pension plan (SEP), the deductible IRA contribution is phased out for higher-income taxpayers. For 2017, the adjusted gross income (AGI) phaseout ranges are illustrated below.

Filing Status
Single and
Head of Household
Married Joint and
Surviving Spouse
Married Filing Separate
Phaseout Range
$62,000 to $72,000
$99,000 to $119,000
$0 to $10,000

There is a special rule for those who are married and filing jointly when one spouse is not an active participant in another retirement plan. That spouse’s phase-out range is increased to AGIs between $186,000 and $196,000.

Example: Sally, age 45 and single, is employed and her only income for 2017 is W-2 wages in the amount of $67,000. She is also an active participant in her employer’s 401(k) plan. She has no adjustments to her income, so her AGI for the year is also $67,000. Since she participates in her employer’s pension plan her IRA contribution is subject to the phaseout limitations. Her AGI is halfway through the phaseout range, so her deductible IRA contribution is limited to $2,750 (1/2 of $5,500). If Sally’s AGI had been $72,000 or more, she would not be able to make a deductible IRA contribution.

These phaseout limitations only apply to the deductible amount of a traditional IRA contribution. An individual can still contribute the full amount, limited by his or her compensation, but the excess amount is treated as a nondeductible contribution to the traditional IRA and establishes a basis. Then in the future, when an IRA distribution is taken, a prorated amount of the distribution will be nontaxable.

Nondeductible Contributions – In addition to making nondeductible contributions that are ineligible for IRA deductions due to active participation and income limits, an individual can also elect to treat otherwise deductible contributions as nondeductible. However, before making nondeductible IRA contributions, an individual should first consider a Roth IRA, discussed below, as an alternative.

Spousal IRA – An often-overlooked opportunity for maximizing IRA contributions is what is referred to as a “spousal IRA.” This allows a spouse with no or very little earned income to contribute to his or her IRA as long as the other spouse has sufficient earned income to cover them both.

Example: Tony is employed and his W-2 for 2017 is $100,000. His wife, Rosa, age 45, has a small income from a part-time job totaling $900. Since her own compensation is less than the contribution limits for the year, she can base her contribution on their combined compensation of $100,900. Thus, Rosa can contribute up to $5,500 to an IRA for 2017. Without this special rule, Rosa’s contribution would be limited to $900, the amount of her own compensation.

Roth IRA – An alternative to a traditional IRA is the Roth IRA. Whereas traditional IRAs provide a tax-deductible contribution and tax-deferred accumulation, Roth IRAs provide no tax deduction but have tax-free accumulation. Thus, when retirement distributions are taken from a Roth IRA, they are tax-free. On the other hand, those taken from a traditional IRA are fully taxable except for the non-deductible contributions discussed above.

However, contributions to Roth IRAs are never tax-deductible and the allowable contribution is phased out for higher income taxpayers, regardless of whether they actively participate in an employer’s retirement plan. For 2017, the adjusted gross income (AGI) phaseout ranges for Roth IRA contributions are illustrated below.

Filing Status
Single and
Head of Household
Married Joint
Married Filing Separate
Phaseout Range
$118,000 to $133,000
$186,000 to $196,000
$0 to $10,000

Example: Rosa, in the previous example, can designate her IRA contribution to be either a deductible traditional IRA or a nondeductible Roth IRA because the couple’s AGI is under $186,000. Had the couple’s AGI been $191,000, Rosa’s allowable contribution to a deductible traditional or Roth IRA would have been limited to $2,750 because of the phaseout. The other $2,750 could have been contributed to a nondeductible traditional IRA.

Back-Door Roth IRAs – Those individuals whose incomes are too high to qualify for a Roth IRA contribution can make a traditional IRA contribution and then convert the contribution to a Roth IRA using an IRA conversion process, discussed later in this article, available to all taxpayers of any income level.

Contribution Timing – Because income (AGI) limitations apply to IRAs, contributions can be made after the close of the year, giving taxpayers time to accurately determine their AGIs for the year and the correct amount of their IRA contributions. The contribution must be made no later than the unextended due date for filing a return, which is April 15. However, if the due date falls on a weekend or holiday, the due date is extended to the next business day. So, 2017 contributions must be made by April 17, 2018.

Penalties – There is a 6% penalty on amounts contributed to an IRA in excess of the allowable contribution amount. This penalty continues to apply annually until the excess is corrected. There is also a 10% early distribution penalty on the taxable amount withdrawn from an IRA before reaching age 59½. However, some or all of the 10% penalty is waived under certain circumstances, such as for first-time homebuyers, to pay for higher education expenses, to pay for medical insurance by some unemployed individuals or when a taxpayer becomes disabled. For those wishing to retire early, the penalty can also be waived if distributions are a series of substantially equal payments over the taxpayer’s life and continue until the taxpayer reaches age 59½ or for a minimum of five years, whichever is later.

Rollovers – From time to time a taxpayer may need to take funds from the IRA. If they are returned within 60 days, the distribution is not taxable and the 10% early withdrawal penalty will not apply. However, this is only allowed once in any 12-month period. This restriction does not apply to direct trustee-to-trustee transfers when the IRA owner is switching trustees or investments. CAUTION: All IRA accounts are considered one, so this rule applies collectively to all IRA accounts, meaning that an individual cannot make an IRA-to-IRA rollover if he or she has made such a rollover involving any of his or her IRAs in the preceding 12-month period.

Conversions – To take advantage of the tax-free benefits of a Roth IRA, an IRA owner can convert a traditional IRA to a Roth IRA any time, but taxes must be paid on the amount of the taxable traditional IRA funds converted to a Roth IRA. Timing is key when making a conversion, because one would want to do that in a low-income year or make a series of conversions so as to spread the income over a number of years. If contemplating a conversion, it should be accomplished as early in life as possible to provide a longer period of tax-free accumulation.

If an IRA conversion is made and then the IRA owner later regrets making the conversion, the Roth IRA can be recharacterized as a traditional IRA up to the extended due date of the return, which for a 2017 return would be October 15, 2018. Typical reasons for recharacterizing include not being able to pay the tax on the conversion or if the IRA has dropped in value after the conversion. Starting in 2018, this will no longer be permitted.

Retirement Distributions – For both traditional and Roth IRAs, distributions can begin once a taxpayer reaches age 59½ without penalty. For traditional IRA owners, once they reach age 70½ they must begin taking what is referred to as a minimum required distribution (RMD) each year. The minimum amount is based upon current age and the value of the IRA account. Roth IRAs are not subject to the RMD requirement. Failing to take a distribution of the required minimum amount may result in a 50% penalty of the amount that should have been withdrawn but wasn’t. However, the IRS will waive the penalty under certain conditions. TIP: In any post-retirement year when your income is below the taxable threshold, you have an opportunity to withdraw from the IRA tax-free. You should consider doing so even if you don’t need the income. You can put it away in a savings account until you do need it.

As you can see, the rules regarding IRAs are complex, and this article has only covered the most commonly encountered ones. Please give us a call if you would like to discuss how IRAs would apply to your particular circumstances or if you are in need of assistance planning for your retirement.

Converted Your Traditional IRA to a Roth IRA? Worried You May Have Done It Too Soon if Tax Reform Passes?

When you convert a traditional IRA to a Roth IRA, you have to pay the tax on the conversion. However, individuals frequently do this so they can take advantage of future tax-free accumulations. Distributions from Roth IRAs are generally tax free, including any earnings (accumulations) while the account is a Roth account.

Are you considering converting your traditional IRA to a Roth IRA in 2017? Are you hesitant to do so because of uncertainty about the timing and specifics of the Administration’s and Congress’ proposal to cut tax rates for individuals? Have no fear, because you can convert your traditional IRA to a Roth IRA this year, and if tax reform passes with lower tax rates effective next year, you can undo the conversion for 2017 and then re-convert for 2018.

Tax law allows individuals who convert in one year to undo that conversion by a procedure referred to as recharacterization. The procedure has been used for years, primarily by individuals whose IRA funds are invested in stocks and who converted from their traditional IRA funds to a Roth IRA only to see the value of their Roth IRA decline after the conversion due to stock market fluctuations. Recharacterizations are also used by individuals who converted their traditional IRA to a Roth IRA and then found they could not or did not want to pay the conversion tax.

This same process can be used by anyone for any purpose. So, for example, if you converted your regular IRA to a Roth IRA in 2017 and tax reform is enacted effective in 2018, you can recharacterize (undo) your 2017 conversion back to a traditional IRA. However, the recharacterization must be accomplished by the extended due date of your 2017 tax return, which is October 15, 2018. If you choose to, you then can then reconvert the traditional IRA to a Roth IRA in 2018 and take advantage of the new lower tax rates.

Generally, you must wait at least 30 days to make the reconversion. However, if you make the recharacterization of the Roth IRA back to your a traditional IRA in 2017, you may not reconvert that amount from the traditional IRA to a Roth IRA before the beginning of 2018 or, if it is later, the end of the 30-day period beginning on the day on which you transferred the amount from the Roth IRA back to a traditional IRA by means of a recharacterization.

Example: For years, Jack has been making deductible traditional IRA contributions. Then, during the summer of 2017, Jack decided to convert $25,000 of those traditional IRA funds into a Roth IRA. After the conversion is completed, late in 2017, Congress passes and the president signs a tax reform bill that reduces Jack’s marginal tax rate in 2018. To take advantage of the lower tax rate, Jack recharacterizes (undoes) the conversion back to a traditional IRA for 2017 and then reconverts it back to a Roth IRA in 2018. To do that, Jack first transfers the $25,000 (plus earnings or minus losses since the original conversion) back to a traditional IRA by way of a trustee-to-trustee transfer (it’s OK for the transfer to be with the same financial institution). He could make the recharacterization as late as October 15, 2018, but chooses to do so on January 15, 2018. Then, after making the transfer back to the traditional IRA, Jack reconverts the amount back to a Roth IRA on Feb. 20, 2018.

For more information on recharacterizations and conversions, and how they might fit into your tax planning, please give us a call.

Consequences of Filing Married Separate

If you are married and thinking about not filing a joint return with your spouse, you will most likely use the married filing separate (MFS) filing status. If you are considering filing MFS, then you should be aware that the tax code is laced with special restrictions so that married individuals cannot benefit by filing MFS. This article describes some of the more frequently encountered issues when making the choice of filing status. Note: dollar amounts are those for 2017.

Joint & Several Liability – When married taxpayers file joint returns, both spouses are responsible for the tax on that return. What this means is that one spouse may be held liable for all the tax due on a return, even if the other spouse earned all the income on that return. In some marriages, this becomes an issue and causes the spouses to decide to file separately. In other cases, especially second marriages, the couple may want to keep their finances separate. Unless all the income, exemptions, credits and deductions are divided equally, which usually happens in community property states, this generally causes the incomes to be distorted and could easily push one of the spouses into a higher tax bracket and create a greater combined tax than filing jointly. Being in a separate property state, where each spouse claims their own earnings, can also create an uneven allocation of income and a higher tax bracket for one of the spouses.

Exemptions – Taxpayers are allowed a $4,050 tax exemption for each of their dependents. However, the $4,050 allowance cannot be divided between the MFS filers, so only one of the filers can claim a dependent’s exemption, and where there are multiple dependents, the spouses would need to allocate the exemptions between them.

Itemizing Deductions – To prevent taxpayers from filing MFS and one spouse taking advantage of itemized deductions and the other utilizing the standard deduction, the tax regulations require both to itemize if one of them does.

Social Security Income – When filing a joint return, Social Security (SS) income is not taxable until the modified AGI (MAGI) – which is regular AGI (without Social Security income) plus 50% of the couple’s Social Security income plus tax-exempt interest income and plus certain other infrequently encountered additions – exceeds a taxable threshold of $32,000. However, for married taxpayers who have lived together at any time during the year and are filing married separate, the threshold is zero, generally making more of the Social Security income taxable.

Section 179 Deduction – Businesses can elect to expense, instead of depreciate, up to $510,000 of business purchases, generally including equipment, certain qualified leasehold property and off-the-shelf computer software. The $510,000 cap is reduced by $1 for every $1 that the qualifying purchases exceed $2,030,000 for the year. Married taxpayers are treated as one taxpayer for purposes of the Section 179 expense limit. Thus, they generally must split the limit equally unless they can agree upon and elect an unequal split.

Special Passive Loss Allowance – Passive losses are generally losses from business and rental activities in which a taxpayer does not materially participate. Those losses are not allowed except to offset income from other passive activities. Rental property is an example of a passive activity, and for lower-income taxpayers, a special allowance permits taxpayers who are actively involved in the rental activity to currently deduct a loss of up to $25,000 if their AGI does not exceed $100,000. That $25,000 special loss allowance phases out by 50 cents for each $1 of AGI over $100,000 and is completely eliminated when the AGI reaches $150,000. When filing separately, this special allowance is not allowed unless the spouses live apart the entire year, and then the allowance is reduced to $12,500 each.

Traditional IRA Deduction Phase-Out – If a married taxpayer filing jointly is participating in a qualified employer pension plan, the deductibility of a traditional IRA contribution is phased out ratably for an AGI between $99,000 and $119,000. If the taxpayers file married separate, the phase-out begins at $0 if the taxpayer participates in their employer’s plan, and when the AGI reaches $10,000, no traditional IRA deduction is allowed. So little, if any, IRA deduction will be available to such an MFS filer.

Roth IRA Contribution Phase-Out – Taxpayers may choose to contribute to a non-deductible Roth IRA. However, Roth IRA contributions are ratably phased out for higher-income married filing jointly taxpayers with an AGI between $186,000 and $196,000. For a married taxpayer filing MFS status, that AGI phase-out range drops to $0 through $9,999, virtually eliminating the possibility of a Roth contribution.

Coverdell Education Accounts – Taxpayers are allowed to contribute up to $2,000 per beneficiary to a Coverdell education savings account annually. However for joint filers, the amount that can be contributed ratably phases out for AGIs between $190,000 and $220,000. For married filing separate taxpayers, the phase-out is half that amount, from $95,000 to $110,000.

Education Tax Credits – Taxpayers are allowed a tax credit, called the American Opportunity Tax Credit, of up to $2,500 per family member enrolled at least half-time in college for the cost of tuition and qualified expenses. This credit phases out ratably for higher-income married taxpayers filing jointly with an AGI between $160,000 and $180,000. There is a second higher-education credit called the Lifetime Learning Credit, which provides a credit of up to $2,000 per family. This credit also phases out ratably for higher-income married taxpayers filing jointly with an AGI between $112,000 and $132,000.

However, neither credit is allowed for married filing separate taxpayers.

Higher Education Interest – Taxpayers can take a deduction of up to $2,500 for student loan interest paid on higher-education loans. Like other benefits, it is phased out for higher-income married taxpayers filing jointly, in this instance when the AGI is between $135,000 and $165,000. It is not allowed at all for taxpayers filing as married separate.

Education Exclusion For U.S. Savings Bond Interest – Although not frequently encountered, interest from certain U.S. Savings Bonds can be excluded if used to pay higher-education expenses for the taxpayers and their dependents. The exclusion phases out for married taxpayers with an AGI between $117,250 and $147,250. This deduction is not allowed at all when filing married separate.

Premium Tax Credit – For married taxpayers who qualify for the PTC (health insurance subsidy) under Obamacare, if they file married separate, they may be required to repay the subsidy.

Earned Income Tax Credit – This is a refundable tax credit that rewards lower-income taxpayers for working and can be as much $6,318 for families with three or more qualifying children. Taxpayers filing as married separate are not qualified for this credit.

Child Care Credit – If both spouses work and incur child care expenses, they qualify for the child care credit. However, for those married filing separate, the credit is not allowed.

Halved Deductions & Credits – Many of the deductions and credits allowed to a married couple filing jointly are cut in half for the married filing separate filing status. They include:

  • Standard Deduction
  • Standard Deduction Phase-Out
  • Alternative Minimum Tax Exemptions
  • Alternative Minimum Tax Exemptions Phase-Outs
  • Child Tax Credit Phase-Out

Head of Household Filing Status – Where a married couple is not filing jointly, one or both spouses may qualify for the more beneficial Head of Household (HH) filing status rather than having to file using the MFS status. A married individual may use the HH status if they lived apart from their spouse for at least the last six months of the year and paid more than one-half of the cost of maintaining his or her home as a principal place of abode for more than one-half the year of a child, stepchild or eligible foster child for whom the taxpayer may claim a dependency exemption. (A nondependent child only qualifies if the custodial parent gave written consent to allow the dependency to the non-custodial parent or if the non-custodial parent has the right to claim the dependency under a pre-’85 divorce agreement.)

As you can see, there are a significant number of issues that need to be considered when making the decision to use the married filing separate status. And these are not all of them, but only the more significant ones. The filing status decision should not be made nonchalantly, as it can have significant impact on your taxes. Please contact this office for assistance in making that crucial decision.

Having a Low Taxable Income Year? Ways to Take Advantage of It

Being unemployed, having had an accident that’s kept you from earning income, incurring a net operating loss (NOL) from a business, having an NOL carryover from a prior year, suffering a casualty loss or other incidents that result in abnormally low taxable income for the year can actually give rise to some interesting tax planning strategies.

But, before we consider actual strategies, let’s look at key elements that govern tax rates and taxable income.

Taxable Income – First, of all, to be simplistic, taxable income is your adjusted gross income (AGI) less the sum of your personal exemptions and the greater of the standard deduction for your filing status or your itemized deductions:

AGI                  XXXX
Exemptions
Deductions
Taxable Income XXXX

If the exemptions and deductions exceed the AGI, you can end up with a negative taxable income, which means to the extent it is negative you can actually add income or reduce deductions without incurring any tax.

Graduated Individual Tax Rates – Ordinary individual tax rates are graduated. So as the taxable income increases, so do the tax rates. Thus, the lower your taxable income, the lower your tax rate will be. Individual ordinary tax rates range from 10% to as high 39.6%. The taxable income amounts for 10% to 25% tax rates are:

Filing Status (2016) Single Married Filing Jointly Head of Household Married Filing Separate
10% 9,275 18,550 13,250 9,275
15% 37,650 75,300 50,400 37,650
25% 91,150 151,900 130,150 75,950

So for instance if you are single, your first $9,275 of taxable income is taxed at 10%. The next $28,375 ($37,650 – $9,275) is taxed at 15% and the next $53,500 ($91,150 – $37,650) is taxed at 25%. Here are some strategies you can employ for your tax benefit. However, these strategies may be interdependent on one another and your particular tax circumstances.

Take IRA Distributions – Depending upon your projected taxable income, you might consider taking an IRA distribution to add income for the year. For instance, if the projected taxable income is negative, you can actually take a withdrawal of up to the negative amount without incurring any tax. Even if projected taxable income is not negative and your normal taxable income would put you in the 25% or higher bracket, you might want to take out just enough to be taxed at the 10% or even the 15% tax rates. Of course, those are retirement dollars; consider moving them into a regular financial account set aside for your retirement. Also be aware that distributions before age 59½ are subject to a 10% early withdrawal penalty.

Defer Deductions – When you itemize your deductions, you may claim only the deductions you actually pay during the tax year (the calendar year for most folks). If your projected taxable income is going to be negative and you are planning on itemizing your deductions, you might consider putting off some of those year-end deductible payments until after the first of the year and preserving the deductions for next year. Such payments might include house of worship tithing, year-end charitable giving, tax payments (but not those incurring late payment penalties), estimated state income tax payments, medical expenses, etc.

Convert Traditional IRA Funds into a Roth IRA – To the extent of the negative taxable income or even just the lower tax rates, you may wish to consider converting some or all of your traditional IRA into a Roth IRA. The lower income results in a lower tax rate, which provides you with an opportunity to convert to a Roth IRA at a lower tax amount.

Zero Capital Gains Rate – There is a zero long-term capital gains rate for those taxpayers whose regular tax brackets are 15% or less (see table above). This may allow you to sell some appreciated securities that you have owned for more than a year and pay no or very little tax on the gain.

Business Expenses – The tax code has some very liberal provisions that allow a business to currently expense, rather than capitalize and slowly depreciate, the purchase cost of certain property. In a low-income year it may be appropriate to capitalize rather than expense these current year purchases and preserve the depreciation deduction for higher income years. This is especially true where there is a negative taxable income in the current year.

If you have obtained your medical insurance through a government marketplace, employing any of the strategies mentioned could impact the amount of your allowable premium tax credit.

If you would like to discuss how these strategies might provide you tax benefit based upon your particular tax circumstances or would like to schedule a tax planning appointment, please give our office a call.

Taking Advantage of Back-Door Roth IRAs

If you are a high-income taxpayer who cannot contribute to a Roth IRA due to income limitations, there is a work-around that will allow you to fund a Roth IRA.

High-income taxpayers are limited in the annual amount they can contribute to a Roth IRA. In 2016, the allowable contribution phases out for joint-filing taxpayers with an AGI between $184,000 and $194,000 (or an AGI between $0 and $9,999 for married taxpayers filing separately). For unmarried taxpayers, the phaseout is between $117,000 and $132,000. Once the upper end of the range is reached, no contribution is allowed for the year.

However, those AGI limitations can be circumvented by what is frequently referred to as a back-door Roth IRA. Here’s how it works:

  1. First, you contribute 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, you now convert the non-deductible Traditional IRA 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.

Potential Pitfall — There is a potential pitfall to the back-door Roth IRA that is often overlooked, that could result in an unexpected taxable event upon conversion. For distribution or conversion purposes, all of your IRAs (except Roth IRAs) are considered as 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.

This may or not may affect your decision to use the back-door method but does need to be considered prior to making the conversion.

There is a possible, although complicated, solution. Taxpayers are allowed to roll over or make a trustee-to-trustee transfer of IRA funds into employer qualified plans if the employer’s plan permits. When permitted, such rollovers or transfers are limited to the taxable portion of the IRA account, leaving behind the non-taxable contributions, which can then be converted to a Roth IRA without any taxability.

Please call this office if you need assistance with your Roth IRA strategies or in planning traditional-to-Roth IRA conversions.

Grandchild IRA Gift Idea

If you have a young grandchild, we have a gift suggestion for you that can provide a lasting legacy between you and your grandchild.

Many teens and young adults work during the summer months, and the wages they earn qualify them to make a contribution to either a traditional or Roth IRA. However, most young people are reluctant to fund an IRA account with their hard-earned summer income, and few are concerned with retirement, which is probably the last thing on their minds at their age.

This is incentive for a grandparent, or anyone for that matter, to gift the child money to fund an IRA. The maximum that can be contributed to an IRA is the lesser of the child’s earned income or $5,500 (the 2016 limit for an individual under age 50). Although that is the maximum amount, a lesser amount can be contributed.

If you take our suggestion, you will also need to decide whether the IRA should be a traditional or Roth IRA. Traditional IRA contributions are tax deductible, but the withdrawals at retirement are taxable. Most youngsters working during the summer months or part time year-round may not earn enough to even have any taxable income, and even if they do, the income is likely to be in the lowest tax brackets, so an IRA deduction would provide little if any tax benefit.

On the other hand, a ROTH contribution is not tax deductible and the distributions, including earnings, are tax-free at retirement, making it the best option in most cases.

Accomplishing this gifting will require cooperation from the child, as he or she will need to actually set up the IRA account so you can fund it. This may entail getting the child’s parents involved as well. What you don’t want to do is just make a check out to the child, who could then cash the check without actually putting the money into the IRA.

Your contribution to the IRA would be treated as a gift for gift tax purposes, but since the contribution amount would be below the annual $14,000 (2016) gifting exemption, it would not be subject to any gift tax reporting unless additional reportable gifts were given to the child during the year.

Unfortunately, you won’t get any benefit on your own income tax return for your generosity, but knowing you’ve made a long-term investment in your grandchild’s future will probably be benefit enough. If you need assistance determining the contribution amount or the type of IRA, please give this office a call.

Retirement Savings: the Earlier, the Better

Generally, teenagers and young adults do not consider the long-term benefits of retirement savings. Their priorities for their earnings are more for today than that distant and rarely considered retirement. Yet contributions to a retirement plan early in life can enjoy years of growth and provide a substantial nest egg at retirement.

Due to its long-term benefits of tax-free accumulation, a nondeductible Roth IRA may be the best option. During most individuals’ early working years, their income is usually at its lowest, allowing them to qualify for a Roth IRA at a time where the need for a tax deduction offered by other retirement plans is not important.

Because retirement will not be their focus at that age, young adults may balk at having to give up their earnings. Parents, grandparents, or other individuals might consider funding all or part of the child’s Roth contribution. It could even be in the form of a birthday or holiday gift. Take, for example, a 17-year-old who has a summer job and earns $1,500. Although the child is not likely to make the contribution from his or her earnings, a parent could contribute any amount up to $1,500 to a Roth IRA for the child.*

But keep in mind that young adults, like anyone else, must have earned income to establish a Roth IRA. Generally, earned income is income received from working, not through an investment vehicle. It can include income from full-time employment, income from a part-time job while attending school, summer employment, or even babysitting or yard work. The amount that can be contributed annually to an IRA is limited to the lesser of earned income or the current maximum of $5,500.

Parents or other individuals who contribute the funds need to keep in mind that once the funds are in the child’s IRA account, the funds belong to the child. The child will be free to withdraw part or all of the funds at any time. If the child withdraws funds from the Roth IRA, the child will be liable for any early withdrawal tax liability.

Consider what the value of a Roth IRA at age 65 would be for a 17-year-old who has funds contributed to his or her IRA every year through age 26 (a period of 10 years). The table below shows what the value will be at age 65 at various investment rates of return.

 

Value of a Roth IRA—Annual Contributions of $1,000
for 10 years beginning at age 17
Investment Rate of Return
2%
4%
6%
8%
Value at Age 65
$23,703
$55,449
$127,900
$291,401

 

What may seem insignificant now can mean a lot at retirement. Individuals who are financially able to do so should consider making a gift that will last a lifetime. It could mean a comfortable retirement for your child, grandchild, favorite niece or nephew, or even an unrelated person who deserves the kind gesture.

*Amounts contributed to an IRA on behalf of another person are nondeductible gifts by the donor and are counted toward the donor’s annual $14,000 (2014 and 2015 gift exclusion per done).

If you would like more information about Roth IRAs or gifting contributions to a Roth on behalf of someone else, please contact this office.