America – land of the free, home of the brave, and headquarters of the frivolous lawsuit. We Americans will literally sue for anything and everything. Don’t believe me? Take Anton Purisima of Manhattan for example. In 2014, he filed a lawsuit naming New York City, an Au Bon Pain bakery, two local hospitals, Kmart, and a dog owner as the defendants. He sought damages for “civil rights violations, personal injury, discrimination on national origin, retaliation, harassment, fraud, attempted murder, intentional infliction of emotional distress, and conspiracy to defraud”.
He pretty much included any instance in which he felt wronged by someone, including an infected finger he suffered when he was bitten by a dog on a bus and a “Chinese couple” taking unauthorized pictures of him at a hospital. He said no money in the world could satisfy him because his damages are priceless. So he settled on an amount of two undecillion dollars, which apparently is a two followed by 36 zeros. The problem with this, is that this happens to be more money than there is on Earth. That means if he had won the lawsuit then presumably the global economy would collapse and we would all become indentured servants of Anton Purisima.
But this wasn’t even the worst lawsuit in recent years. In 2015, Jennifer Connell attended the 8th birthday party of her nephew, Sean Tarala. Apparently Tarala was so happy to see his beloved aunt that he leapt into her arms. The jump caused Connell to fall to the ground, breaking her wrist. So she did what every reasonable person would do and sued her 8-year old nephew. She claimed her injuries were caused by Tarala’s “negligence and carelessness,” arguing that the 8-year old birthday boy “should have known that a forceful greeting such as the one delivered by the defendant to the plaintiff could cause the harms and losses suffered by the plaintiff.”
This leads us to our question for today: what are the tax implications of winning a personal injury lawsuit? Would Anton Purisima have to pay taxes on his two undecillion dollar winnings?
General Rule for Personal Injury Awards
The general rule is that if you receive funds from a legal action or settlement that originates from physical injury or illness, then you don’t have to pay taxes on any of that income. This includes money received for pain and suffering, medical expenses, attorney’s fees and court costs, and even lost wages.
However, the IRS ruled that you must pay taxes on any money awarded for emotional distress unless the emotional distress is attributable to a physical injury.
Exceptions
But there are exceptions to this rule, and you must pay taxes in the following four circumstances:
Punitive damages. You must always include punitive damages as income, even if they are awarded due to physical injury or illness.
Prior medical deductions. If a damage award reimburses a previously deducted medical expense, then you must include in income that amount, but only to the extent you received a tax benefit from the deduction in the tax year you claimed the deduction.
Compensation for a voluntary act. If you receive a payment for pain and suffering from the voluntary performance of a contract, you can’t exclude that income.
Interest. Interest paid on an award, even if allocable to an excluded amount, is taxable.
Documentation is Important
The best documentation to claim the exclusion from taxable income is a court document or settlement agreement that specifically allocates your award between compensatory (this is the amount you don’t pay taxes on) and punitive damages (the amount you pay taxes on).
Give Your Retirement Funds a Super Boost with an HSA
You ever shell out cash for something and only fully realize how bad of a deal it is once you’re away from the situation. For example, maybe you’ve been to Chuck E. Cheese lately. I put out $30 so my kids can play arcade games while a giant mouse dances around the room. But my kids don’t care about the games; they just care about the tickets so they can get some prizes We’ve been there dozens of times and they still haven’t figured out that they get four tickets each game no matter what they do. In fact, the skeeball machine just gave up trying to pretend and gives you the tickets before you start playing. Finally, after an hour of torture, they are ready to trade in those tickets. For my kids, this is seemingly the biggest decision of their lives. I don’t think they would put in as much mental effort if they had to decide whether to live with Mommy or Daddy.
I’ve done the math and the ticket counter at Chuck E. Cheese definitely has the worst exchange rate in the global market. How is it that my $30 turned into a plastic frog, a bookmark (my kids don’t even use bookmarks), and a tattoo of a mouse? But to be fair, if you really save up those tickets a few times, you could afford some vampire fangs as well.
Well, the same thing goes for your retirement funds. Are you getting the most bang for your buck when you set aside funds for retirement? Most people just default to a traditional IRA, but is this always the best way to go? Maybe not.
You probably just think of a Health Savings Account (HSA) as simply an account to put aside money for medical expenses. After all, the name is Health Savings Account, so what else would it be for?
This article may have you looking at HSAs in a completely different light. The HSA is the Swiss Army knife of savings accounts. Not only does it provide big benefits for medical expenses, but it is also a powerful tool to supplement your retirement savings. In fact, you will probably benefit more by putting money aside in an HSA rather than a traditional IRA.
We’re going to compare three aspects of the HSA and traditional IRA to see which one wins. While there are other considerations, feel free to contact me with any questions at [email protected].
Qualify for an HSA
First you need to qualify for an HSA. To contribute to an HSA, you must have a high deductible health plan. For 2017, a high deductible health plan is a plan with an annual deductible of at least $1,300 for self-only coverage, or at least $2,600 for family coverage. Additionally, the maximum annual out-of-pocket expenses they require you to pay is $6,550 for self-only coverage, and $13,100 for family coverage.
Deduction for Contributions
The HSA and traditional IRA are similar in that you may qualify for a tax deduction when you contribute. But to qualify for the IRA deduction, you have to meet the following requirements: (1) you (and your spouse, if applicable) are not covered by an employer retirement plan, or
(2) if you are eligible for an employer retirement plan, then your modified adjusted gross income must not exceed $62,000 ($99,000 for joint filers) before the phase-out begins
So, you lose your tax deduction for IRA contributions if you are either eligible for a retirement plan at work or make too much money.
In contrast to the traditional IRA, your tax deduction for HSA contributions is never phased-out. It doesn’t matter if you earn $10 million; you always get this deduction. You fund the HSA tax-free whether you use pre-tax dollars from your paycheck to contribute or deduct the contributions on your tax return.
Advantage: HSA
Medical Expenses
But here’s the biggest advantage with the HSA—you may never pay taxes on the amount you withdraw. See, with an IRA, you get a deduction when you contribute, but you pay taxes on the backend when you withdraw funds upon retirement.
With an HSA, you can withdraw funds at any time tax-free to use for qualified medical expenses. When you reach Medicare-eligibility age (currently age 65), you can even use the HSA funds to cover your health insurance premiums, including Medicare Part B premiums and long-term care insurance premiums.
Additionally, if you are 65 or older, you can even withdraw HSA funds for non-medical expenses with zero penalty, and only pay income tax on the withdrawals.
So the HSA gives you a double tax benefit. You get a deduction when you contribute (benefit number one). Then when you use the funds for medical expenses or qualified health insurance premiums, it’s tax-free (benefit number two). Don’t forget the added benefit of these funds growing tax-free over years of investing.
Tax deduction going in, tax-free coming out!
Advantage: HSA
Withdrawals
With an HSA, you can withdraw funds at any time, tax free, to use for qualified medical expenses. When you reach Medicare-eligibility age (age 65), you qualify for an added benefit because you can use the HSA funds to cover your health insurance premiums, including Medicare Part B premiums and long-term care insurance premiums. These expenses are inevitable, so why not pay them with tax-free cash?
That’s not the case with an IRA. As soon as you turn 70 1/2, the IRS requires you to start taking some money out of your IRA accounts so they can start charging you tax on that income. You may know this as required minimum distributions (RMDs).
Advantage: HSA
Many people are looking to increase their retirement funds. Maybe you’ve maxed out your 401(k) contributions at work and wish you could put away more. Before you automatically assume that a traditional IRA is the only choice, you may want to see if the HSA gives you the boost you need.
When you start your own business, you have a plethora of options for the type of entity you would like to operate as. Just to name a few, you can be a sole proprietor, incorporate as an LLC, C corporation, or a partnership (if you have a business partner). All of these choices can make you more confused than a homeless man on house arrest.
What makes matters worse is that this choice has huge consequences to your bottom line. Choosing the wrong entity can lead to dire consequences. One choice that should definitely be on your radar is the S Corporation.
You may be wondering what exactly an S Corporation is. Well, it’s basically a kind of entity that only exists for tax purposes. For all other purposes, it’s a different type of entity.
Confused yet? Allow me to explain: You know that annoying friend you have on Facebook that dominates your feed with annoying posts like, “I have the best wife. She’s my best friend and partner in crime <3 <3”. Or “Feeling blessed - my kids never fight and I never have to yell at them #soblessed #neverfight #neveryell #hashtag”.
You probably assume that this annoying friend is so happy, right? Think again. Recent psychological studies have shown that people who constantly post about how great their lives are on social media are actually quite insecure and unhappy. The reason they post this is because it’s easy to pretend everything is great in this fake, virtual world. Also, the comments people leave for them provides a boost to their self-esteem. So, things may not be great with Shmoopie at home, but by pretending that it is, they can feel better. You just didn’t see that person yelling at their kids to shut up, stop fighting, and look happy for the picture, so they can post #mylittleangels.
What’s my point with this nonsense? The S Corporation is similar to these annoying Facebook posters. These people create this virtual utopian life where they are completely happy and present it to the world to see. And for the most part it works – we believe it. An S Corporation is really just a tax concept. Your legal entity is really just an LLC or C Corporation, but you can elect something called “S Corporation status” with the IRS and state. They allow to pretend to be something that you’re really not, and it could save you thousands of dollars.
For tax purposes, the S Corporation is a pass-thru entity, meaning that the corporation’s income, deductions, and tax credits, are passed down to you, the shareholder, on a K-1. The huge advantage to an S Corporation is the ability to save on Social Security and Medicare taxes (aka self-employment taxes).
This is how you can save: Even though you are the owner of an S Corporation, you are also an employee. As an employee, you pay yourself a salary to compensate you for the work you do in the business. The wages are subject to Social Security and Medicare taxes. The rest of the profits can be taken out as distributions, which are not NOT subject to Social Security and Medicare taxes. These taxes are a whopping 15.3 percent!
If you operate as a sole proprietor (or LLC taxed as a sole proprietor) then you pay Social Security and Medicare taxes on your entire profit. Let’s look at a quick example to see how an S Corporation can save you big money.
Example. Let’s say you earn $150,000 net profit in your business in 2017.
If you operate as a sole proprietor, you pay $19,790 in Social Security and Medicare taxes
If you operate as an S Corporation and take a salary of $50,000, you will pay only $7,650 in Social Security and Medicare taxes. You can still take out the remaining $100,000 profit from the company, but without paying Social Security and Medicare taxes on it.
The S Corporation saves you $12,140 in self-employment taxes!!!
There are various considerations to account for before deciding if an S Corporation is right for your business, so speak to your accountant to see if it makes sense for you. You may just find yourself saving thousands in taxes with an S Corporation.
It doesn’t matter how old you are, we’ve all dreamed of the day we can retire. We can just imagine ourselves on the beach with no worries. Or playing shuffleboard in Del Boca Vista. Or maybe it’s just finally being able to yell at people and blame it on old age. Whatever it is, we imagine it will be delightful.
But to get to that point, you need money to retire. Unfortunately, this requires you to work now so you can save for later. Or as Homer Simpson says, “If you really want something in this life, you have to work for it. Now quiet! They’re about to announce the lottery numbers.”
When you work for someone else, saving for retirement is fairly straightforward. If your company has a 401(k) then you only need to decide how much to contribute each year. But when you operate your own business, there are several forms of retirement plans to choose from. The retirement plan that suits you best depends on your specific circumstances.
And your circumstances may change—the retirement plan that was most advantageous to you before isn’t necessarily the best for you now. You should constantly analyze your options to ensure you are using the plan that works best for you.
While there are many different retirement plans to choose from, I’ll discuss four of the most popular ones that could work for you. Note that this is quick rundown of these options so you should speak to your accountant or financial planner to decide which works best for you.
1. Traditional IRA: A traditional Individual Retirement Account (IRA) is very easy to set up. It allows you to sock away $5,500 ($6,500 if you’re age 50 or older) each year in a retirement account. If neither you nor your spouse are covered by a plan at work (i.e., 401(k), then you can deduct the amount you contributed. If your spouse is covered by a plan at work then your deduction starts being phased out when your modified adjusted gross income is above $184,000.
2. SEP IRA: The Simplified Employee Pension (SEP) lives up to its name—it’s truly a simple retirement plan that works for both self-employed individuals and small corporate owners. In fact, you can set one up in a matter of minutes. If you are self-employed as a sole proprietor, LLC member or partner, you can make a deductible contribution to a SEP of up to the lesser of: (1) 20% of self-employment income, or (2) $53,000.
The major advantage to a SEP plan is the ability to contribute a large amount to a retirement account with a simple plan with small administrative fees (usually less than $100). Another advantage is the ability to set up a SEP plan for the previous tax year as late as the due date (including extensions) of your tax return that you will file. That means for the 2016 tax year, you can set up a SEP account as late as October 15, 2017.
3. SIMPLE-IRA: The SIMPLE-IRA is another option. If you are self-employed as a sole proprietor, LLC member or partner, you can make a deductible contribution to a SIMPLE-IRA. You actually must make two types of contributions. The first type of contribution is the elective deferral contribution. For 2016, the maximum elective deferral contribution is the lesser of: (1) 100% of self-employment income, or (2) $12,500 ($15,500 if you are age 50 or older).
You then make another contribution called a matching contribution. The matching contribution is the lesser of: (1) 3% of your self-employment income, or (2) the amount of your elective deferral contribution. Because you may contribute 100% of your income up to $12,500 to a SIMPLE-IRA, when your income is lower you save more with this retirement plan than with a SEP.
4. Solo 401(k): The Solo 401(k) may be your best bet if you’re trying to put away as much cash for retirement as possible. Like the SIMPLE-IRA, there are two different types of contributions to a Solo 401(k). But unlike the SIMPLE-IRA, neither of these contributions are mandatory. The first contribution is the elective deferral contribution. For 2016, you can contribute up to $18,000 from your salary or self-employment income ($24,000 if age 50 or older).
The second contribution is the employer contribution, and this applies even if your business is a proprietorship. Tax law simply treats you as your own employer. The employer contribution is up to 20% of self-employment income.
The combined elective deferral and employer contributions may not exceed 100% of your salary or self-employment income.
The combined contributions may also not exceed a dollar cap, which for 2016 is $53,000 ($59,000 for those age 50 and older).
You have several options to choose from when saving for retirement if you run your own business. Know the differences between the various plans so you can choose the one that benefits you the most.
Take the time to reevaluate these plans every so often. While the SIMPLE-IRA may have been your best option at first, maybe a Solo 401(k) works better now. Or maybe the SEP plan allows you to maximize your contributions while keeping it simple and paying little admin fees.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether it’s tax returns, bookkeeping, payroll services or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
It seems like every day there’s a new fraudulent scam. And to be honest, many of them hover between ridiculous and just downright hilarious. I think most of us just shrug it off and think, “who would fall for this!?” But, there’s always people out there that fall for just about anything.
For example, I think we have all received emails from “Nigerian royalty” pleading for their help. All you need to do is help them funnel their millions of dollars out of Nigeria and into your bank account and you get to keep 30%. Wow, what a return on investment! All you have to do is to provide your bank account number (for "safekeeping" the funds of course) and you’re on your way to millions in cash.
For those that are unaware, this is actually a scam. While you may have considered this generous offer, at some point you probably became suspicious as to how this Nigerian prince got your email address in the first place. You probably assume everyone else has that same hesitation. You’d be wrong though. The top Nigerian scammer was recently arrested, and it’s estimated that he’s taken in over $60 million globally. He actually got over $15 million from one person alone. You would think that if someone has $15 million they would make better life decisions. Looks like someone’s financial planner really dropped the ball there.
Unfortunately, the tax world mimics the rest of the world, and new IRS scams pop up daily. While some seem absolutely ridiculous, some may be quite believable if you’re unaware of some basic rules on how the IRS contacts you.
Here’s one you can throw in the ridiculous batch. There’s a recent scam whereby the caller pretends they are from the IRS and you owe a large sum of money that you must pay immediately to avoid legal action. But here’s the kicker…you have to pay with iTunes. That’s right, iTunes. Like the music. You’re told to go to a store, purchase an iTunes gift card, load money onto it and then provide the 16-digit code on the back of the card. This can be done by phone call, text or email. Sometimes, the caller even stays on the phone with you the entire time as you go to the store, purchase the card, and provide the code.
It sounds ridiculous, but there are plenty of people falling for this scam. I have a feeling that if you think you can pay the IRS with One Direction songs then you probably are a great candidate to lose a lot of money to a Nigerian prince as well.
Just to be clear, you cannot pay a tax bill with iTunes credit. Here’s some other forms of currency you may not use to pay your tax bill: credit card miles, mitzvah points, IOUs, a promise to donate to a charity of the IRS’s choosing, donuts, and cronuts. Note that this was not an all-inclusive list.
The latest scam this summer involves robocalls. Apparently, robocalls are not just for elections. Basically, you receive a prerecorded message from the “IRS”. It will use one of two approaches. The message may try to scare you, threatening you with prosecution, deportation, or revoking your driver’s license over unpaid taxes. Or it may tell you that you are eligible for a larger refund. Either way, the objective is the same. Their goal is for you to call back and give over your bank account or other sensitive information.
Here’s some basic guidelines about how the IRS interacts with taxpayers, so you won’t ever fall victim to one of these scams. (1) The IRS will always contact you first via snail mail with a tax bill. (2) The IRS will never call and demand immediate payment. (3) The IRS will not demand you pay your bill in a very specific manner, such as prepaid debit cards. (4) The IRS will not ask for sensitive information over the phone, such as bank information or credit card numbers. (5) The IRS does not threaten to bring in police or other agencies to arrest you for not paying.
Never give out sensitive information to a caller. If you think it’s a scam, then call the Treasury Inspector General for Tax Administration at 800-366-4484 to report the call. If you’re not sure if it’s a scam, then call the IRS at 800-829-1040 and speak to an agent to look at your account.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether its tax returns, bookkeeping, payroll services, or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
Mothers love discussing their children’s’ milestones. “How old was he when he walked?” “What were her first words?” To be honest, if you ask most fathers these questions you probably won’t get such an accurate answer. “I don’t know; he was probably about one or two when he walked. Definitely less than three. I remember him being pretty short, so less than three sounds right. Final answer.” “I believe her first words were gaga followed by a googoo.”
But if you ask that same man how old his child was when she got her first summer job, then he’ll know exactly. “She was fifteen years, three months and four days old.” This is the ultimate milestone for a parent. It’s not just the achievement of getting a job; it’s a complete reversal of fortunes—literally.
Think of your child as a vacuum cleaner. They are always sucking everything in—tuition expense, camp expense, spending money, etc. Then imagine someone flipped that switch that makes the vacuum blow air out now. Instead of sucking in all your cash, they’re actually spitting out dollar bills. So it’s not just that your child stops spending all of your money for this moment in time, but they’re actually contributing in a positive sense to your economic situation.
Before you get too excited, realize that this is short-lived. The summer is coming to an end before you know it and the vacuum will be turned back on. But in the meantime, it’s best to consider the tax implications of your child working.
Tip 1. Know Your Tax Filing Requirements: There’s a good chance your child won’t be required to file a tax return for his or her summer earnings. If your child is an employee, then they must earn more than $6,300 in 2016 to meet the filing requirements. If your child is considered self-employed then the threshold is only $400.
But that doesn’t mean your child shouldn’t file a tax return though. If the employer has been withholding income taxes, and the wages are below $6,300, then your child can file a tax return and get back all that money. However, the Social Security and Medicare tax is not available for refund.
Tip 2. Claiming the Working Child as a Dependent: Just because your child isn’t a deadbeat this summer doesn’t mean you can’t claim them as a dependent. Any child under 19 years old (or under 24 years old if a full time student) can be claimed as a dependent as long as you provide more than half of their support. Support includes food, shelter, clothing, entertainment, schooling expenses, etc.
Tip 3. Filling out Form W-4: Form W-4 instructs the employer how much tax to withhold from the paychecks. If your child will not be required to file a tax return, then consider not withholding income taxes. But if you’re not sure, you may want to error on the safe side.
Tip 4. Consider Hiring Your Child: Hiring your child not only provides them with some extra spending cash, but can also lower your tax bill. It’s a legal way of shifting taxable income away from your high tax bracket to your child’s low, or even zero, tax rate. Plus, if your child is under age 18 then there’s no need to pay Social Security, Medicare, and unemployment taxes.
Tip 5. Contribute to a Roth IRA: Now that your child is employed, they can contribute to a Roth IRA. Chances are, your teenager won’t be retiring anytime soon. But with a Roth IRA, all that money that’s socked away in the fund will grow completely tax-free. So that’s decades of growth at no cost. Additionally, they can even withdraw the contributed amounts tax-free and penalty-free at any time.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether its tax returns, bookkeeping, payroll services, or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
Sometimes it’s just downright depressing when you think about where we are as a society. I mean, have you ever thought about how little we have progressed? Take for instance the Jetsons. I think it’s safe to say that we all thought the Jetsons was the blueprint of our future society. Yet, here I am in the year 2016 and I’m still not driving around New Jersey in a flying car for some reason. I have exactly zero robot maids and there’s not moving walkways everywhere I go.
But there’s one thing that makes me think we’ve really made progress. And that’s when you have to make a payment to someone. In the old days, if you had to pay back a friend, your choices were to pay by cash or check. And to get said cash or check to them, it involved either getting in your vehicle and driving to their house to physically drop it off or licking a stamp and sending it by snail mail.
But all that’s changed now. Gone are the days that you need to actually see your friends or lick any stamps. Look at your options now—PayPal, Chase QuickPay, Venmo, Square Cash, Google Wallet, and the list goes on. And if your friend still wants a check for some reason then you can just have the bank send it for you with a click of your mouse. Goodbye social interaction, hello technology. That’s real progress.
OK, so we’ve made some serious progress in our payment options, but the question for us is whether this progress has extended to when we have to pay the IRS for a tax liability. Chances are that if you’ve ever paid the IRS then you paid by check or direct bank withdrawal. But you may be surprised to learn there are other options available.
I Owe How Much?!?: Have you ever been punched in the stomach? Well, that’s exactly the way it feels if you’ve been unpleasantly surprised by a monstrous tax liability. But you actually have a couple of options if you don’t have all of the funds to pay immediately.
Assuming you owe $50,000 or less, one option is to request an installment plan using Form 9465. The application fees for this plan range from $43 to $120. Just realize you will be charged interest and penalties, which continue to accrue until the balance is totally paid off. You can choose the day of the month and amount you will pay each month, as long as it’s paid off within 72 months. If your balance is less than $10,000 then the IRS will generally automatically grant you a 36-month payment plan with no questions asked.
If you can pay your debt within 120 days, then it’s even easier. You can simply request a short-term extension using the IRS’s Online Payment Agreement.
Rack Up Those Miles: If there’s two things that we love, it’s credit card miles. Luckily, the IRS has authorized several companies to accept tax payments by credit card. But it’s going to cost you a bit more in convenience fees, so you need to do the math beforehand to make sure it’s worth using your credit card. The fees are in the range of 2% depending on the provider.
I’ll Take a Slurpee and a $7,000 Tax Bill: In one of the most unlikely partnerships since I watched that chimpanzee hugging a kitten on YouTube, the IRS joined forces with 7-11 and you can now pay your tax bill in cash at your local convenient store. Simply go online to the IRS.gov payments page and select the cash option. You will then receive a confirmation email from Officialpayments.com with instructions so you can be on your merry way for some refreshments and tax payments.
No matter what your situation is, make sure you file your tax return on time, even if you don’t have the money to pay. Failing to file is the worst thing you can do and I guarantee it will just make it worse. The IRS will not simply go away if you ignore your taxes. Unlike that awkwardness when your friend owes you money but you feel too weird asking them about it so you just don’t say anything but feel a deep resentment every time you see them until they pay you and you pretend like you forgot about it also even though you know you were going to remember that debt until the day you die, the IRS does not feel awkward asking you for money. So you’re going to have to pay the IRS, but at least now you know there’s some options.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether its tax returns, bookkeeping, payroll services, or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
It seems like everywhere you look there’s another diet plan being advertised. Sure, we all know about Weight Watchers, Nutrisystem, and Medifast. But there’s also been some rather unusual ones. There’s the Cookie Diet where you eat several cookies a day and somehow lose weight. I have my doubts though. I once ate an entire package of Double Stuff Oreos and I don’t think I lost a single pound. Then there’s the Subway Diet which defies the laws of nature. Apparently, you can lose dozens of pounds by feasting on foot long hoagies every day. And let’s not forget the ever-popular tapeworm diet from the early 1900’s. People would actually ingest a tapeworm with the theory being that the worm would grow in your intestines and absorb the food. For some reason this last one has lost some of its luster in recent years. I suspect there must be some downside of having a worm that can grow to be 30 feet long lodged in your intestines.
The fact is, Americans spend over $65 billion on weight loss every single year. There’s gym fees, weight loss program fees, diet pills, meal replacements, and of course the cost of tapeworms. It’s easy to see how these costs add up. Considering we spend more on weight loss than the entire GDP of some countries, we must be the skinniest country, right? Well, not exactly. In fact, we’re the 9th most obese country in the world. I’m not sure why, but it may have something to do with the fact that the $65 billion we spend on weight loss is completely dwarfed by the $117 billion we spend on fast food.But the question that’s relevant for now is whether any of these costs are tax deductible?
In 2002, the IRS issued a landmark ruling that obesity is considered a medical condition, and therefore costs incurred for its treatment is a tax deductible medical expense. It should be noted that a physician must diagnose the patient with obesity; there’s no deductions if you simply decide you need to lose some weight.
So in short, if you begin a diet regiment to improve your health or appearance then no expenses are deductible, but if it’s to treat a specific disorder, such as obesity or hypertension, then some of the expenses may be deductible.
So let’s discuss what exactly can be deducted for those that qualify. The IRS allows you to deduct any fees paid to join a weight loss program. This includes the initial fee as well as additional fees to attend meetings. These meetings are typically used to develop diet plans, discuss menus and receive literature regarding the plan.
Unfortunately, the IRS is very adamant that any costs incurred to buy reduced-calorie diet foods (think Nutrisytem and Medifast) is not a deductible expense. The IRS views these foods as mere substitutes for regular food you would buy to satisfy your nutritional requirements, and therefore are considered non-deductible personal expenses.
The same goes for membership dues to a gym or health club. The IRS does not allow a deduction for these. And while accessories such as yoga mats, dumbbells, and running shoes are not deductible, items that are specifically prescribed by a physician, such as orthotics and knee braces are deductible.
While the qualified expenses above are technically tax deductible, in reality very few people are able to get this benefit. That’s because you can only deduct medical expenses that exceed 10% of your adjusted gross income. That’s quite a hurdle for most taxpayers, unless you already have a lot of other medical expenses.
But what you can do is get reimbursed by your flexible spending account for these expenses – whether it’s an HSA or FSA. Flexible spending accounts follow IRS guidelines for qualified medical expenses, so by the IRS ruling that weight loss programs are deductible expenses, you may now be reimbursed for these expenses. This enables you to use pre-tax dollars to cover the costs.
Another issue relevant to weight loss is if you become a consultant/health coach for one of the diet programs. This has become increasingly popular, especially for Medifast. Most likely you will receive a 1099-Misc at the end of the year as an independent contractor. The first thing you must realize so you can plan accordingly is that no taxes have been taken out all year. That means you need to be prepared to pay them with your tax return.
So let’s say you made $10,000 as a health coach this year. If you’re in the 25% tax bracket, then you must pay $2,500 in income taxes at year end. Unfortunately, it doesn’t stop there though. As an independent contractor you’ll have to kick in another 14.13% for self-employment taxes (Social Security and Medicare taxes). So on that $10,000 you made, you’ll owe $3,913 in federal taxes.
This is where tax planning becomes crucial to the process. The first strategy is to negate as much of the taxable income as possible with qualified business expenses. This could be business mileage, supplies, travel expenses, etc. Another thing you should consider is taking a home office deduction. The second strategy which may make sense when you begin making a considerable income from this business is incorporating as an S Corporation. While the details of this strategy is beyond the scope of this article, you can use the S Corporation to eliminate much of the self-employment taxes, saving you thousands each year.
Daniel Magence, CPA, Esq. is a principal at Pristine CPA Solutions, LLC (www.pristinecpa.com). Pristine CPA Solutions offers tax and accounting services to individuals and businesses of all sizes, whether its tax returns, bookkeeping, payroll services, or personal income budgeting. He can be reached at [email protected] or 201-326-6908 if you have any questions or comments, or are interested in using Pristine CPA’s services. Feel free to contact us for a free consultation.
Like it or not, tax season is about to begin. The IRS announced they will begin accepting tax returns on January 19th. How you feel about tax season is probably directly correlated to whether you expect a liability or a refund from the IRS. Or maybe you just really hate taxes. If that’s the case, then you wouldn’t be alone. Here’s some other people who really hate taxes:
In January this year, a Texas man was arrested while trying to pay his $600 property tax bill. Timothy Andrew Norris, arrived in person at the Wichita County Courthouse to pay his tax liability with individual dollar bills. What’s so bad about that you may ask? Well, apparently he folded each bill so tightly that it took employees six minutes to unfold each bill. So for those doing the math at home, 600 bills would take 3,600 minutes, or 60 hours, to unfold the bills. As it turned out, the county officials were not too happy about this and asked him to leave. Things got heated and he was eventually arrested for criminal trespass. What’s interesting is that besides for clearly being the greatest dollar-folder in the history of mankind, he stated that this was his form of protest against property taxes.
It turns out that Americans aren’t the only ones that hate taxes. A man in England apparently answered one of the questions incorrectly on his tax return. In response to the question “do you have anyone dependent on you?” The man answered: “2.1 million illegal immigrants, 1.1 million crack heads, 2.2 million unemployable scroungers, 900,000 criminals in over 85 prisons, plus 650 idiots in Parliament, and the whole of the European commission.” When the taxing authority let him know that this answer was not acceptable, he responded, “who did I miss out?”
But surprisingly, people with these feelings are in the overwhelming minority in this country. In a recent survey conducted by the U.S. Internal Revenue Service’s Oversight Board, 96 percent of those surveyed said they completely or mostly agreed that “it is every American’s civic duty to pay their fair share of taxes.” Only 8 percent gave the answer “as much as possible” to the question, “How much, if any, do you think is an acceptable amount to cheat on your income taxes?”
But in all honesty, the IRS couldn’t care less what your personal thoughts are on paying taxes. As long as they get their money you can have whatever opinion you want—just don’t pay with dollar bills that take six minutes to unfold.
So as the latest tax season is about to begin, whether you want it to or not, here are some things to expect this year:
1. Slower service from the IRS: This should be no surprise to anyone. The IRS’s budget is tighter than a teenage boy’s skinny jeans. They are overworked and undermanned. So how will this affect us? As the IRS puts it, “there will be an increase in self-service options”. That’s their way of saying if you have a problem, then good luck because we don’t have the time or resources to deal with it. It also means that if must call the IRS about an issue then you may want to have a book handy to keep you occupied while on hold. Something along the lines of War and Peace should do.
2. More identity theft: During last tax season, the IRS identified 163,087 tax returns with more than $908.3 million claimed in fraudulent refunds. And that’s only the ones they identified. While the IRS has stepped up security measures for this year’s tax season, you shouldn’t expect this issue to go away. There’s always new scams, so keep your eye out for this and always be careful who you give your information out to. Always be on alert for phishing and phone scams. The IRS will never cold-call you or email you about a tax issue. If there’s a legitimate issue, then they will contact you through snail mail. Unfortunately, as the IRS increases its security measures, the inevitable side effect is that it’s likely we’ll see a boost in tax refund delays.
3. The Affordable Care Act: If you were not covered by health insurance all year, then expect to pay a penalty. The penalty this year will be the greater of 2% of the household income above the filing threshold or a flat dollar amount of $325 per adult.
The state of New Jersey gets a bad rep. People from other states (mainly New York) love to make New Jersey the butt of their jokes, whether it pollution, corrupt politicians, dumb residents, or mobsters.
“Why is New Jersey called the Garden State? Because oil, petroleum, land fill, and toxic waste dump didn’t fit on a license plate.”
“What’s the only thing that grows in Newark? The crime rate.”
“What happens when a blonde moves from New York to New Jersey? Both states get smarter.”
These are just some of the things you say hear people say in regards to my adopted hometown. Well, I’m here to set the record straight. I think this is an unfair characterization of this fine state (except the part about the toxic dumps, that’s true. Oh, and also the crime rate in Newark isn’t all that great. But I take great offense to the blonde joke). With all these lies going around about New Jersey, these out-of-towners are missing the one thing that’s actually true about New Jersey: its tax rules are pretty bad.
This article will go through some of the differences between federal and New Jersey laws, but please don’t share this information with any New Yorkers. It’s bad enough being called smelly and stupid, I don’t think we need to be known as the “unfavorable to taxpayers state” also.
You know how the money you save in an IRA account or Keough plan is excluded from taxable income on your Federal return? This is because the government wants to incentivize you to save for your retirement. New Jersey has a slightly different outlook on it. Its feelings are that it could care less about you and your subsequent retirement and you must include that contributed money in your taxable income. On the positive side, though, you can still exclude money contributed to your 401(k).
Another difference concerns charitable donations. Good ole’ Uncle Sam wants us to be generous to others and offers taxpayers a tax deduction for charitable donations. However, New Jersey comes in like Uncle Scrooge and disallows you to write off these contributions, leading again to higher taxable wages. It’s the same situation with moving expenses. On your federal return you are allowed to deduct moving expenses if your relocation relates to starting a new job or a transfer to a new location for your present employer. But don’t expect a deduction for moving expenses on your New Jersey return. You can move here, but don’t expect the state to care. Oh, and by the way, once you’re here, you can forget about deducting home mortgage interest as well. What about those high property taxes you may ask? The good news is that you can deduct up to $10,000 of property taxes on your New Jersey tax return. The bad news is that the average property tax bill in Bergen County last year was $10,826 (Teaneck was $11,529), so there’s a pretty good chance your bill is higher than $10,000.
So, enough of the bad news already. There is a deduction in which New Jerseyans have a major advantage over most states. One of the most commonly missed deductions on New Jersey tax returns is for medical expenses. On your federal tax return, you can deduct out-of-pocket medical expenses that are above 10% of your adjusted gross income. So, if for example you have adjusted gross income of $100,000 and medical expenses of $12,000, then you can only deduct $2,000 since that is the amount over that 10% threshold. People often assume that New Jersey has that same 10% threshold and do not even bother to accumulate their medical expenses for their accountant. However, New Jersey only has a 2% threshold, so in our scenario above the taxpayer would be allowed a deduction of $10,000 on his New Jersey tax return. With the cost of medical expenses rising every year, this can be very beneficial for New Jersey taxpayers.
According to the Bureau of Labor Statistics, the average American family spends $1,700 a year on clothes. That seems a bit low to me. Another telling statistic is that in 1930 the average woman had nine outfits. Today, that figure is 30 outfits — one for every day of the month. Now that sounds more accurate to me.
Here’s a freebie tip to all the husbands out there: when your wife says she’s going to the mall to do returns, she’ll come back with more bags than she left with. If you’re like I used to be, you probably thought that returns merely meant returning purchased items to the store. But apparently there’s an extra step involved, which is purchasing new items afterwards so you can keep the return-purchase-return cycle alive and kicking.
But whether your family spends $1,700 or $17,000 a year on clothes, chances are you have a ton of clothes in your house taking up much-needed space. Instead of just throwing it in some oversized donation bins you should be maximizing your tax deductions by donating it properly. But before you claim the deduction you need to know: (1) how to calculate the amount of the deduction and (2) what records you need to keep to prove the deduction to the IRS if needed.
Here’s another freebie tip. As of 2006, you can no longer donate used socks or underwear and get a tax deduction. You’re probably thinking, “What kind of disgusting human being would donate used underwear?”. Not surprisingly, the answer is Bill Clinton. That’s right; the POTUS himself deducted $6 for three pairs of used underwear on his 1986 tax return and now we’re all paying the price. Bottom line: if you were planning on donating used underwear then you may have bigger issues than not getting a tax deduction anyway.
Calculate Your Tax Deduction: First, you’ll need to figure out how much to deduct on your tax return. If you’re like most people, you have a bunch of garbage bags full of stuff which you know you spent thousands of dollars on but have no idea how much you can actually deduct for them. The tax law says you can deduct the fair market value for the items. But even though you paid $300 for that suit, that doesn’t mean the fair market value is anywhere close to that figure. Fair market value is essentially what it would sell for in a thrift store. So one method is to actually do your own research and place a value on each item based on what it would sell in a thrift store. That’s all and good if you’re donating one or two expensive designer suits, but if you have ten bags of clothes you won’t want to do your own research for every single item.
Luckily, there are several resources available online that estimate the fair market of clothing. The Salvation Army provides a free guide on their website. Not to be outdone, Goodwill also has a free guide on their website. Itsdeductible by TurboTax also provides a free guide as long as you provide them your email address. Finally, www.charitydeductions.com has a guide for $24.95, but this will provide more accurate quotes for specific clothing items since it researches the sales prices on eBay. Charitydeductions.com is worth shelling out the extra $25 if you have some expensive designer clothing to unload.
Records to Keep: Now the question is what documentation do you need to prove the amount of the deduction. When you donate clothing, the records you need depend on the value of your deductions. The IRS has four categories: (1) Less than $250 (2) Between $250 and $500 (3) Between $501 and $5,000 and (4) Over $5,000.
Less than $250: Ideally, the receipt you get from the charity should contain the name of the charity, the date and location of your contribution, and a description of the property. This sounds easy enough, but in practice most receipts you get will not have a detailed description of the property. The charity will simply give you a blank receipt with their information on it for you to fill out. This is why I recommend one extra step—every time you donate clothes you simply lay them out and take a few pictures of them and simply stick the pictures in a file. Should the IRS question the value of your donation, the pictures will provide proof as to what you donated.
Between $250 and $500: The record keeping requirement is the same as if it was less than $250 except the charity should also have a statement on the receipt that they did not provide any goods or services in return for your donation. Again, this is the ideal. In practice, if your receipt doesn’t have this statement on it, I would not expect the IRS to deny your tax deduction.
Between $501 and $5,000: You record-keeping requirements will depend on the value of individual items. If there is no single item valued over $500, but merely the aggregate value is over $500 then you have the same record-keeping requirements as the group just above. However, if you valued one or more single items over $500 then you must provide (1) the approximate date you acquired the item (2) how you acquired the item (i.e. purchase, gift), and (3) what the cost you paid or someone else paid for the item originally. If you valued an item over $500 that is not in “good condition” or better, then you will also need to get a qualified appraisal for the item and include it with your tax return.
Over $5,000: For a deduction over $5,000 you’ll need to get a qualified appraisal for the clothing and include it with your tax return.
The kiddie tax – could anything sound more adorable? You can just imagine an IRS agent asking, “Would you like the big boy tax or the teenie weenie, ‘wittle, snuggly kiddie tax?” It sounds like something you’d love to just take and pinch its cheeks or have a photoshoot of it sleeping next to stuffed animals. But don’t be fooled, there’s nothing sweet and cuddly going on here. Much like Lots-o'-Huggin' Bear from Toy Story 3, the cute name is just smoke and mirrors. In reality it is the preverbal evil teddy bear with a sweet sounding name. The best way to avoid this tax is through knowledge. The more you understand about the kiddie tax, you will not only see it can be avoided, but you can actually benefit from it.
First, a little background on the kiddie tax. Previously, a widely-used tax-saving strategy for high-income families was to funnel unearned income through their children to reduce their overall taxes (unearned income refers to investments, such as interest, dividends and capital gains). Since the child’s tax rate in almost every case was much lower than the parents, the parents could earn money while paying very little tax. As you can imagine the IRS was not a huge fan of this and in 1986 Congress stepped in and enacted the kiddie tax. The purpose was to limit this funneling strategy by taxing certain amounts of children's unearned income at a very high rate. Later on the kiddie tax was expanded so that it's now applicable to the unearned income of much older children (it used to apply to children under 14 but now it applies to children under 19 or even older, if your child is in school).
Under the kiddie tax, children pay tax at their own income tax rate on unearned income they receive up to a threshold amount ($2,100 in 2015). However, all unearned income they receive above the threshold amount is taxed at their parent's income tax rate. As a result, the children’s income could be taxed as high as 35%, compared to the 10% rate that most children would be paying. Any unearned income below the standard deduction amount ($1,050 in 2015) is not taxed or reported to the IRS at all.
The resulting effect is that you get the benefit of the child's lower tax rate only for unearned income over the standard deduction amount ($1,050) and below the threshold amount ($2,100). Everything else above the threshold amount is taxed at the parent's rate.
It should be noted that the kiddie tax applies only to unearned income a child receives from income-producing property, such as cash, stocks, bonds, mutual funds, and real estate. Any salary or wages that a child earns through full or part-time employment are not subject to the kiddie tax rules; rather that income is taxed at the child's tax rate.
So now that I know what the kiddie tax is, how can I actually benefit from these rules? First, you should realize that although a $2,100 threshold does not sound like a lot, it’s actually a fair amount of unearned income for a child. For example, a child whose investments earn 5% per year would have to have over $42,000 in cash or property investments to earn at least $2,100. Now just for the sake of comparison, I just checked my daughter’s piggy bank and she had only $8.23. So I think she will be safe from the kiddie tax for the near future. As you can see, this tax really tends to be relevant to high-income taxpayers.
In cases where the kiddie tax doesn't apply to your children (they do not have a sizable amount of unearned income), you can give them all the money or property you want and their unearned income will be taxed at their rate so long as it’s below the $2,100 threshold. Even better, if this results in producing less than $1,050 in unearned income then it’s not even taxed at all. So this shift in property can be a huge tax savings. (On second thought, maybe it can actually be cute and cuddly after all.)
But how can someone benefit even in cases where their children are already subject to the kiddie tax? If you give your child investments that appreciate in value over time but don't generate much income until they're sold (which can be at age 24 when the child pays tax at their own rate and the kiddie tax is no longer applicable) then there is no need to be concerned with the kiddie tax. Examples of these investments include Treasury bills, US savings bonds, municipal bonds, and tax-managed mutual funds.
As you can see, by knowing the ins and outs of the kiddie tax, you can actually benefit from this evil little tax.
The most common form of charity is cash donations. Assuming you have proper documentation of the donation from a valid 501c3 organization, the IRS allows you to deduct as much as 50% of your adjusted gross income. But make sure you maintain records of that donation in case you’re questioned. Here’s a pop quiz: if you have adjusted gross income of $100,000 for example, and you have a deduction for charitable donations of $50,000, the IRS will assume (a) you are an extremely generous human being; or (b) you are lying and you will be audited. This is not to say you should not be overly generous in your donations if you can, just make sure to obtain the proper documentation.
Another popular form of charity is donating used clothing. A deduction cannot be claimed unless the items are in “good used condition or better”. Do not expect the charity to provide you with an assessed value of your donation. You are responsible for assessing the value of the donated items, whereas the charity merely confirms that you made the donation. Any non-money contribution in excess of $500 requires the taxpayer to attach Form 8823 to their return which essentially itemizes each item donated with a description, value, cost of the item, etc. There are various tools to help determine the value of the items with the most popular one published by the Salvation Army (salvationarmyusa.org). Due to this burden of assessing the value of each article of clothing, most people just find it easier to deduct $500 even if in reality the assessed value could be a bit more.
You may have seen ads from nonprofits asking for donations of your old cars, or maybe even heard a certain commercial with a jingle containing its phone number that you will never be able to get out of your head. Most people erroneously assume that your donation will automatically trigger a $500 deduction no matter the value. The reason why many people just deduct $500 is because it’s simple and you do not need to provide any documentation with the return if its $500 or less. However, in cases where the value is over $500, the amount that you can ultimately deduct will be furnished to you on a Form 1098-C from the organization that you must attach to your return. If the organization immediately sells the vehicle for more than $500 than your deduction will be limited to the sale proceeds. If it’s sold for less than $500 but is valued at more than $500 than the taxpayer can actually choose to deduct based on the fair market value, but cannot exceed $500. However, this is where you can really benefit: if the organization intends to use the vehicle for its business operations, to significantly improve the car before sale, to give to a needy person, or sell to a needy person for less than market value then you may take a deduction equal to the fair market value, which may be well over $500. Ensuring that your vehicle donation is being utilized for one of these uses may be extremely beneficial to both you and the organization.
Another great way to maximize your deduction while benefitting your favorite charity is by donating stocks. Assuming that the stocks have been held for at least one year, then not only will the taxpayer not have to pay capital gains tax on the gain, but he can deduct the full market value on the date of the donation instead of just what you paid. For example, you bought 100 shares of stock years ago for $2,000 that is now worth $10,000. If you donate that stock, then you will be able to deduct $10,000. Even more than that, you don’t have to pay capital gains tax on that $8,000 gain.
Roth IRA Part II: Forget Your Kid - How to Make Yourself a Millionaire
Daniel Magence
In my last article, I wrote about how you can get make your kid a millionaire with the help of a Roth IRA. Some of you thought it was a great idea; and for the rest of you…the feeling I got was that I had you at ‘millionaire’ and lost you at ‘kid’. After all, you did support them for the first two decades of their lives so I think that will do. So for this article we’re going to focus on making your own millions with a Roth IRA.
Before delving into the subject, we should understand the basic differences between a Roth IRA and a traditional IRA. With a traditional IRA, the contributions may be tax deductible on your federal and state tax returns if you qualify (whether you can deduct it depends on various factors such as income limits and whether your work offers a 401k). So you may get a deduction in the years you contribute but when you retire and start withdrawing you’ll pay taxes on all those funds that’s been growing for decades. Even if you don’t qualify for a deduction for the contributions you’ll still pay taxes on all the earnings. So in short, there’s a fair amount of tax implications with a traditional IRA.
The Roth IRA is just the opposite – there’s absolutely no tax implications. You fund it with post-tax dollars so you don’t get that deduction when you contribute but you also pay zero taxes when you eventually withdraw the funds. Now, whether it’s better to pay taxes now (in the form of using post-tax dollars with the Roth IRA) or later (in the case of the traditional IRA) really depends on many factors. On one hand, you’ll most likely be in a lower tax bracket when you start withdrawing the funds (advantage traditional IRA), but on the other hand you have a lot less deductions that can offset some of your income later in life (advantage Roth IRA). Just think about it, you may have paid off your mortgage by then so you won’t be able to deduct the interest, you (hopefully) won’t qualify for the child care tax credit, and if you’re not working then you won’t be able to deduct state income taxes that come out of your paycheck now. (Thankfully, those of us residing in Bergen County can always count on ridiculously high property taxes that we’ll be able to deduct.) So even though your tax bracket may be lower later on life, you still could end up paying more taxes anyway due to less deductions. But the most important factor in this decision may be how long you have to grow these funds before you need them. If you won’t need to touch your IRA for another twenty to thirty years and it can grow 11% on average each year (the average rate of return for the S&P 500 for the past fifty years) then getting all these earnings tax-free can save you tens of thousands of dollars in taxes.
But here’s the kicker – you may be making too much money to contribute to a Roth IRA. If you file married filing joint and your modified adjusted gross income is over $193,000 ($131,000 for those that file single) then you’re not eligible to contribute because the IRS decided you’re too rich. While $193,000 is a very nice salary, raising a family on the East Coast can be very costly. This may seem like a familiar predicament you’re in – everyone seems to think you’re rich. The school seems to think you’re rich and wants your money, the shul thinks you’re rich and wants your money, your kids think your rich and want your money. You may even think you’re rich. That is until you look at your bank account at the end of the month and then realize maybe you’re not so rich. Well, now you can add the IRS to this list.
Lucky for you, there’s a way to get around this restriction by rolling over your traditional IRA to a Roth IRA. In 2010 Congress removed the income restriction for rollovers so now everyone is eligible to rollover their traditional IRA to a Roth IRA. But when you rollover these funds you will pay taxes now, and if you don’t know what you’re doing you can get clobbered with a hefty tax bill. In short, all the contributions you received a deduction for and all the earnings you haven’t paid taxes on yet will be included in your taxable income in the year you rollover. So you need a strategy so you won’t feel the sting of those taxes when you make this election.
There are a number of strategies you can implement but I will go over two in this article. The first strategy is the gradual conversion. Using this method, you would gradually convert a portion of the traditional IRA funds over several years. This allows you to have complete control over your tax bill. You can convert $100 or $100,000, do it over two years or twenty years. If you find that you have extra cash on hand one year then you can convert more funds that year. If you have less cash one year then you can convert less funds. This allows you to convert your retirement fund to a Roth IRA without getting hit with a massive tax bill at one time.
Another strategy is the charitable contribution method. If you plan on making a large donation to a charity one year then by timing your rollover to coincide with this donation you can completely wipeout the taxes you would pay when rolling over your IRA. For example, let’ say by rolling over your IRA you would have to include an additional $60,000 in your taxable income. But why pay the IRS when you can help out a charity instead? So you make a donation of $60,000 to charity that year as well. This donation will negate the additional income from the rollover and your tax bill will be zero.
Although the law says you can’t contribute to a Roth IRA if your income is too high, that doesn’t mean you can’t convert your traditional IRA to a Roth IRA. This is a great way to grow those earnings in your fund without having to pay any taxes whatsoever when you withdraw upon retirement. But when you rollover those funds to a Roth IRA, Uncle Sam is going to want his piece of the pie—and that piece of pie may be larger than you care to hand over. However, with a bit of tax planning you can minimize those taxes and even eliminate them altogether sometimes.
Roth IRA Part I: How to Make Your Kid a Millionaire
Daniel Magence
How many times have you been sitting down to a nice family dinner, surrounded by your beautiful children, and just thought, “Wow, these kids cost me a ton of money!”? Or maybe you noticed your 8 year-old watching Spongebob Squarepants and was thinking, “When are you gonna get a job already!?” I mean they eat your food, they don’t pay rent, and you need to pay for their schooling. But lucky for you, with the help of a Roth IRA you can turn those freeloaders into millionaires and then it’s your turn to show them how to freeload like a champ.
A Roth IRA is an extremely effective method to save for retirement. Unlike a traditional IRA, you fund a Roth IRA with post-tax dollars but you can then take everything out tax-free. This means everything – not just the principal that you contributed but all the earnings as well. This is what makes this such an attractive option, especially for younger people that have another thirty to forty years to grow this fund tax-free before they need it. With forty years of growth this little investment can turn out be quite a large nest egg.
In order to turn that kid into a millionaire you need to follow these steps:
Step 1: The kid needs a job since the IRA can only be funded with earned income. You may think this sounds crazy because there’s probably not much demand in the job market with someone with “extensive coloring experience” or a “vast knowledge of the ABC’s”. But the truth is, the absolute best way is if you have your own business and you hire them to do some small tasks (i.e. cleaning the office, filing papers). Hiring your own child is the ultimate win-win since not only is your child receiving money, but you get some nice tax breaks as well. The wages you pay to your child are deductible as a valid business expense so it shifts some of your taxable income away from you, plus unlike a normal employee, you don’t have to pay unemployment taxes for your child/employee under 21 years old or even FICA taxes if the child/employee is under 18 years old. But what if you don’t have your own business so you can’t just hire him yourself? Try to farm out Junior to a friend, neighbor, or maybe even your own employer and see if they would hire him to do some small tasks around the office. I’m sure if you look hard enough then someone can use a kid to do some filing or organizing around the office every so often or even in the summers.
Step 2: Setup a Roth IRA for your child. Most major financial institutions allow you to setup an account in your child’s name. It will most likely need to be a custodial or guardian account which prevents the child from withdrawing from the account before turning 18 without your consent.
Step 3: Fund the Roth IRA account with the child’s earnings and watch it grow.
To see how effective this strategy is let’s look at an example. First, let’s assume you have your own business and hire your own child. As stated earlier, this can be extremely beneficial to both you and your child. Let’s say you pay your child $5,500 a year (the maximum yearly IRA contribution) to do various tasks around your office starting at age 10 for ten years. Firstly, you have legally shifted $5,500 of taxable income away from you which amounts to $1,540 in taxes each year if you’re in the 28% tax bracket. Secondly, you have funded $55,000 into your child’s retirement fund by the time they are 20 years old. Even if we assume not a single penny more will be deposited into that account, there is still forty years for that $55,000 principal to grow. Now, the average rate of return for the S&P 500 for the past fifty years has been just over 11%. So assuming the same rate of return then that little $55,000 nest egg will be worth over $3.5 million by the time the little rugrat can begin withdrawing at age 59½! Even if you assume an 8% return it would still be over $1 million.
But let’s now assume you don’t have your own business and you can’t find someone that will realistically pay your child $5,500 a year. Between summer jobs and babysitting they manage to earn a total of $15,000 in that same ten-year span. That $15,000 investment would be worth more than $1 million by age 59½ assuming the 11% rate of return. Obviously these numbers grow exponentially if the child continues to fund the Roth IRA as time goes on.
You may look at your child a little differently now. Instead of just seeing an allowance-sucking garbage disposal, you may just see the sweet, sweet image of dollar signs now. When he has over $3 million extra in his pockets because of you, be sure to remind him how he got that money. You may want to also remind him how much he cost you. While you’re at it you can remind him that you can use a new car.
AMT Tax Part 2: How You Can Benefit From the AMT Tax
Daniel Magence
Last article I explained how horrible the AMT tax is. However, for this article I’ll explain how, in specific circumstances, you may actually be able to save money because of it. Before I get into the details, I was asked by a couple of people if I could further explain how the AMT tax works. This time I’ll use real-life experiences to try and make sense of this tax calculation.
When I was growing up our school used to hand out boxes of candy bars to the students to sell and raise money. But not just any student could sell the candy bars. You couldn’t get your hands on one of those boxes until you were at least in 3rd grade.
I had older siblings who would come home with these massive boxes filled with chocolate and I couldn’t wait until I was old enough to take one of those boxes home. I finally entered 3rd grade and when it was candy bar time I couldn’t have been more excited. Not only was I finally able to sell candy bars, but I found out that there’s also a competition to sell the most candy bars with the winner taking home a five pound Hershey’s bar. Life was good for this 3rd grader. I came up with this whole strategy of who I was going to sell to and how many boxes I would sell so I can get my hands on those five pounds of sweet, sweet, milk chocolate heaven.
Long story short, I knocked on my next door neighbor’s home the second I got home and asked if they would like to buy a candy bar. The neighbor said no (apparently other people have access to Hershey’s bars as well), yada yada yada, I gave up on selling and ended up eating half the box over the next two weeks. So this pretty much became my ritual each year—I come home with a box of candy, eat half of it, and return the other half. I have to say though, knowing that I probably ate five pounds of candy from the box I was supposed to sell definitely took the sting out of losing out on the five pound grand prize.
The point is, there were two kids in my class, let’s call them Jane and Jill, that somehow were able to sell hundreds of candy bars. For the rest of my elementary school career, Jane and Jill were always competing with each other with the most sold. Some years Jane won and some years Jill won. But one of them always won, and they always both sold over 500 candy bars.
As a side, I always suspected foul play. There were only three options as to how they were able to sell that much candy—(a) they were the greatest nine-year old salesmen in the history of mankind, (b) they found some remote village that had never tasted a Hershey’s bar before, or (c) their parents bought hundreds of candy from them so they could win.
So what does this have to do with the AMT tax? Jane is your regular income tax calculation. She’s working hard to sell the most amount of candy bars. She’s using her own set of calculations and strategy to reach that number. Jill is the AMT tax. She uses a whole different set of calculations and strategy to get to that high number. But just like in the dog-eat-dog world of elementary school candy selling, there can only be one winner. Whoever has the highest amount wins.
This is exactly how the AMT tax works. If the regular income tax has a higher amount of tax calculated then the AMT won’t be applicable to you. But if the AMT tax has the higher tax calculated then that will be the winner. So as you can now clearly see, the comparison between the tax system and Jane/Jill is actually quite uncanny…besides for the fact that Jane and Jill were huge cheaters and I hope they were engulfed in guilt as they snacked on that massive candy bar of shame. Other than that, the same.
So now that we know what the AMT tax is, how can we take advantage of it? It may sound like a radical approach because all we hear about is how everyone wants to avoid the AMT tax. The problem is sometimes you just can’t. You may make too much money one year and not enough items that are exempt from the AMT tax. In that case, instead of trying to avoid it, embrace it and make it work in your favor.
For example, let’s say you’re a real estate broker and you’re having a killer year. You know when it tax time comes you’re gonna get hit with the AMT tax. However, maybe you don’t necessarily expect to have such a great year next year, so you the AMT won’t be applicable next year. Remember what I said in the previous article—the maximum tax rate for the AMT is 28%, whereas the regular tax rate can be as high as 39.6%. If the AMT tax is going to be the winner this year that means any additional income will only be taxed at a maximum rate of 28%. So if you have a bonus or a commission that is supposed to be paid in the beginning of January next year, if you’re able to accelerate that payment to the end of this year instead then it will only be taxed at 28% instead of 35% or 39.6% next year when the AMT tax won’t be applicable to you.
So in short, if you anticipate getting hit with the AMT tax this year and not next year, and you have the ability to accelerate pending income, then paying taxes now at the AMT rate will actually save you money.
The bottom line is this—there can only be one winner; either the AMT tax or regular tax. Unfortunately, their gain is your loss as you have to foot the bill for whoever wins. But with a bit of tax planning, you may be able to mitigate some of the damage.
Recently, I found myself in the middle of an unusual conversation with my daughter. I use the word “unusual” because it’s definitely not what I’m used to. As a parent, I’ve spent years responding to softball questions that I don’t have to think anymore. “Can I punch my sister? No”. “Can I stay up late? No.” “Can I punch my sister and then stay up late? No.” In fact, I’ve gotten to the point that I can literally answer 99% of my kids’ questions while in a deep sleep, and often do. My method is simple. I just answer “No” most of the time and throw in a sporadic “Yes” once in a while to keep everyone on their toes. So I was completely unprepared when out of nowhere my daughter asked me, “Why do bad things happen to people sometimes?”
This is not what I was trained for. Before this, the most challenging question I’ve dealt with involved the permissibility of snacks, and now I found myself in a philosophical discussion on the manifestation of evil in the universe. I began to panic. My initial response was, “Don’t hit your sister” but that turned out to make no sense at all. All my training failed me and I was left to fend for myself. Eventually, I replied that there are just some bad things in life that we can’t control and don’t always understand. This is exactly how most people feel about the AMT tax as well – it’s awful, it seems to make little sense, and there’s very little we can do about it besides accepting our fate.
The AMT tax, which is short for alternative minimum tax, is basically a separate, parallel tax calculation that you are required to calculate in addition to your regular income tax calculation. You may not have heard of it, even if you pay it, because it’s really just another calculation that your accountant does on the regular tax form. So you have two tax calculations—the regular income tax and the AMT—and then you pay whichever one is higher. The alternative minimum tax on line 45 of your 1040 is really just the difference between what you would owe under the regular tax calculation and what you would owe under the AMT. If the regular tax bill is higher, that line is zero. If the AMT tax bill is higher, then line 45 is the difference between your tax bills under the two systems. (If you fell asleep four sentences ago, don’t worry, your accountant will do the calculation anyway).
Lawmakers implemented the AMT in 1969 because 155 high income taxpayers that claimed a lot of (legal) deductions owed no tax that year. So just to get this perfectly straight—the government didn’t get money from 155 people out of hundreds of millions of taxpayers one year and did what every rational human being would do and started a whole new tax system that now effects over 15% of the U.S. population and will cost taxpayers $385 billion over the next decade. Thank you Congress and thank you 155 taxpayers in 1969 for ruining it for everyone.
The problem is while the AMT tax was designed to make things fair by taxing the rich that were able to get away with a relatively small tax bill, it turns out that the demographic most-often hit with this tax is the middle class. That’s because high income taxpayers often pay income tax at the highest tax rate already (39.6% in 2015), so computing the tax under the AMT calculation (highest AMT rate is 28%), will often result in a smaller tax liability than their regular tax. However, this is not always the case with middle class taxpayers that pay at a lower tax rate.
So you may not be able to do much to avoid the AMT tax, but who tends to be most susceptible to this tax? Besides for your income being high enough (say $250,000 or more), there are some other critical factors, of which I will mention a few:
Large families: Under the regular tax calculation, you get a generous tax break for each member of your family. For every family member you claim on your tax return you get to exclude up to $4,000 of income from your taxable income. So if you have five, six, or a baker’s dozen of kids then that can be a nice tax break. However, the AMT doesn’t allow for this tax break so while your regular tax calculation may result in a minimal tax liability, your AMT tax calculation can result in a hefty tax bill. As I said, there’s not much you can do about this—if your tuition bills haven’t stopped you from having kids at this point then I doubt the AMT tax will.
High Property Taxes: The only good thing about paying high property taxes in New Jersey is that you can deduct it on your tax return. However, for AMT purposes you can’t deduct any property taxes or even the state and local income taxes you pay each paycheck.
Employee Business Expenses: If your job requires you to incur a fair amount of expenses that your employer does not reimburse you for, then you can deduct these as Miscellaneous Itemized Deductions. This is very helpful to certain professionals, such as real estate brokers and those in sales. However, the AMT strikes again and disallows Miscellaneous Itemized Deductions to be deducted in the calculation.
So why does the AMT tax happen to good people? There are just some things in life we don’t understand…but it may have something to do with the billions of dollars the government rakes in every year.
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