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Be Careful When Converting

Conversion of St Paul

Conversion of St Paul (Photo credit: Lawrence OP)

When converting from a 401(k), traditional IRA, 403(b), SIMPLE IRA, SEP or 457(b) to a Roth IRA there are some important tax considerations to keep in mind.

First, converting from a tax deferred plan to a tax free plan it’s not always the best idea. Generally, it’s going to make sense to convert if the tax payer believes that he or she will be in a higher income tax bracket in retirement. For example, John, age 28 has a 401(k) and recently left his employer. He’s currently in the 15% bracket but expects to be in the 28% bracket or higher in retirement. It may make sense for John to convert his 401(k) to his Roth IRA.

This makes sense for John because when he converts from a pre-tax, employer sponsored plan like the 401(k) it’s money that has not yet been taxed. If he converts while in the 15% bracket, that money is now subject to tax at the 15% rate, and arguably a lower amount of money being taxed since he’s still young. If he decided to wait until retirement to convert (let’s assume he’s in the 28% bracket) then that money is going to be taxed at 28%, or almost twice the rate if he had converted when he was in the 15% bracket. John has also eliminated future RMDs as Roth IRAs have no such requirement.

Generally, it may make sense to not convert if you expect to be in a lower tax bracket at retirement. The reason is you’d convert at a higher tax bracket today, only to be in a lower bracket in retirement. Thus, you’ve paid a higher than necessary amount of tax on your money.

Second, when converting, pay close attention to you your age and how you choose to “pay” the tax. Let’s look at two examples.

Let’s say John in the example above decides to convert when he leaves his employer at age 28. He’s saved a nice sum of $100,000 in his 401(k). He decides to convert to a Roth IRA at the 15% bracket. He elects to pay the tax himself from outside of the 401(k), that is, he elects to not have any tax withheld from the conversion. He decides he’ll pay the tax from another source when tax time comes around. All is being equal, John owes $15,000 at tax time.

This turns out to be a very wise decision for John. Here’s why.

Let’s assume the same scenario above except that John decides to have the $15,000 withheld from his 401(k) to pay the taxes on the conversion. Remember how old John was? 28. He’s under age 59 1/2 and the $15,000 withheld for taxes is considered an early distribution, and, you guessed it, subject to the 10% early withdrawal penalty. So instead of paying $15,000 in taxes, John pays an additional $1,500 due to the 10% penalty or a total of $16,500.

It pays (either you or the IRS) to consider the tax ramifications of converting to a Roth IRA. Talk to an experienced financial planner and or tax advisor for help.

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Tax Time is Over. Maybe.

Tax

For most folks tomorrow marks the one week anniversary of filing their 2014 tax return. Not much needs to be done after they’ve filed except for deciding to have more withheld in 2014 for those folks who had to write a check to Uncle Sam or deciding what to do with the refund (hint: put it in an IRA) for those folks who got a refund.

What happens when the return may have been submitted with mistakes or perhaps costly errors? Generally, if the error is minor the IRS will correct errors or accept returns without certain forms or schedules attached.

For those returns that have a change in filing status, income, deductions, and credits then filing an amended return will most likely be appropriate. For those folks needing to file an amended return they are allowed to file using form 1040X. Form 1040X will allowing corrections to earlier filed returns that used 1040A, 1040EZ.

If a person needs to file for separate years then a separate 1040X must be filed for each tax year that’s being amended.

According to IRS topic 308 keep the following points in mind:

  • Attach copies of any forms or schedules that are being changed as a result of the amendment, including any Form(s) W-2 received after the original return was filed.
  • Tax forms can beobtained by calling 800-829-3676 or visiting www.irs.gov.
  • An amended tax return cannot be filed electronically under the e-file system.
  • Normal processing time for Forms 1040X is up to 12 weeks from the IRS receipt date.

Generally if a refund is to be claimed the amended return needs to be filed within 3 years after the due date of your original return or 3 years after the date you filed your return if you filed for an extension.

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Do Unto Others?

anonymousIn the financial services industry there has been considerable discussion on the application of the fiduciary standard of care for clients versus the suitability standard of care. There are generally two sides to the argument: on the fiduciary side the standard of care is to act in the best interests of the client (the standard that Jim and I are held to and embrace) and the other side which is a suitability standard of care in which the recommendation needs to be suitable, but not necessarily in the best interest of the client.

This is where things get sticky.

Acting in the best interest of the client is pretty cut and dry. After extensive questioning and gathering of information a recommendation is made to the client based on what is best for their situation. This means recommending keeping the current course of action, following a designed and carefully thought out plan, or recommending the client do business elsewhere.

Suitability on the other hand requires only finding an appropriate solution that suits the client. This may be a proprietary product that the advisor is only able to sell based on company and contract affiliation, licensing and compensation structure. In other words (and these are my words only) the advisor rationalizes the reason for the recommendation whether or not it’s in the client’s best interest.

Proponents of the suitability standard are normally compensated by commissions only or a combination of commission and fees. They are normally adamant about only adhering to the suitability standard. Why? The answer is simple: self-preservation. Think of it this way, if the only way you’re compensated is through the sales of a product then why would you want to be held to a standard that says what you’re selling has to be in the best interest of the client? What if you can only sell life insurance or annuities? As the saying goes, if you all you have is a hammer then everything looks like a nail.

Proponents of the fiduciary standard are dominantly compensated by fees directly from the client. What does this mean? This means the client pays the advisor for their advice, not a product sale. The relationship nor the compensation of the advisor isn’t tied to a sale it’s tied to the quality of advice. In other words, it’s very transparent. The client knows exactly what they’re paying for and can rest assured they’re getting advice regardless of a product sale. In this case the advisor has a tool box full of tools to utilize instead of just one tool.

Admittedly this type of system is not 100% perfect. There will still be a few bad apples and there will always be outliers, and there will be bad advice. However, from personal experience I have been able to witness both sides. Early in my financial career I worked for a firm that was commission only – one of those firms where I was told if the client wasn’t going to buy, send them to the 800 number. Really. Temptation to sell something, anything to make a living was high. I was arguably the worst salesperson they had. It’s extremely difficult to be a fiduciary in that situation – not impossible, but difficult.

Being able to work with a firm that is aligned with my own beliefs embracing the fiduciary standard there is zero temptation to recommend anything less than what’s best for the client. No sales pressure, no product pushing.

For those that would argue against the fiduciary standard let me ask this question. It’s a question I ask ask frequently of my students and colleagues that argue in favor of suitability.

“If roles were reversed and you were the client, what standard would you want applied to you?”

They answer almost always the fiduciary standard. The next question is rhetorical, but apt:

“They why should your clients get anything less than what you want for yourself?”

There’s usually silence.

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Obamacare and Your 2013 Tax Return

Taxation - Highlighted in the dictionary

Taxation – Highlighted in the dictionary (Photo credit: efile989)

So – you’re considering your income tax return (or maybe you’ve already filed) and you’re wondering if there are things you need to know with regard to Obamacare.  Fortunately, it’s not much (for most folks), for your 2013 return anyhow.  Next year will be a different story.

The IRS recently produced their Health Care Tax Tip HCTT-2014-10 which lists some tips about how the health care law impacts your 2013 tax return.  The actual text of the Tip is below:

What do I need to know about the Health Care Law for my 2013 Tax Return?

For most people, the Affordable Care Act has no effect on their 2013 federal income tax return.  For example, you will not report health care coverage under the individual shared responsibility provision or claim the premium tax credit until you file your 2014 return in 2015.

However, for some people, a few provisions may affect your 2013 tax return, such as increases in the itemized medical deduction threshold, the additional Medicare tax and the net investment income tax.

Here are some additional tips:

Filing Requirement: If you do not have a tax filing requirement, you do not need to file a 2013 federal tax return to establish eligibility or qualify for financial assistance, including advance payments of the premium tax credit to purchase health insurance coverage through a Health Insurance Marketplace. Learn more at www.Healthcare.gov.

W-2 Reporting of Employer Coverage:  The value of health care coverage reported by your employer in box 12 and identified by Code DD on your Form W-2 is not taxable.

Information available about other tax provisions in the health care law:  More information is available on www.IRS.gov regarding the following tax provisions: Premium Rebate for Medical Loss Ratio, Health Flexible Spending Arrangements, and Health Saving Accounts.

More Information

Find out more tax-related provisions of the health care law at www.IRS.gov/aca.

Find out more about the Health Insurance Marketplace at www.Healthcare.gov.

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Avoiding Mistakes on Your Tax Return

"YOU ARE ONE OF 50,000,000 AMERICANS WHO ...

“YOU ARE ONE OF 50,000,000 AMERICANS WHO MUST FILL OUT AN INCOME TAX RETURN BY MARCH 15. DO IT NOW^ AVOID THE RUSH…. – NARA – 516202 (Photo credit: Wikipedia)

When filing your tax return you want to make sure that you don’t make mistakes.  Mistakes can be costly in terms of additional tax and penalties, as well as the extra time and grief they can cause you.  Most of the time using e-filing software can help you to avoid these mistakes, but you should check over the return anyhow to make certain you haven’t fat-fingered something or if something didn’t go wrong with the software.

The IRS recently issued their Tax Tip 2014-46, which lists out 8 common mistakes that folks make on their tax return, and how to avoid them where possible.  The actual text of the Tip follows below:

Eight Common Tax Mistakes to Avoid

We all make mistakes.  But if you make a mistake on your tax return, the IRS may need to contact you to correct it.  That will delay your refund.

You can avoid most tax return errors by using IRS e-file.  People who do their taxes on paper are about 20 times more likely to make an error than e-filers.  IRS e-file is the most accurate way to file your tax return.

Here are eight common tax-filing errors to avoid:

  1. Wrong or missing Social Security numbers.  Be sure you enter all SSNs on your tax return exactly as they are on the Social Security cards.
  2. Wrong names.  Be sure that you spell the names of everyone on your tax return exactly as they are on the Social Security cards.
  3. Filing status errors.  Some people use the wrong filing status, such as Head of Household instead of Single.  The Interactive Tax Assistant on www.IRS.gov can help you choose the right one.  Tax software helps e-filers choose.
  4. Math mistakes.  Double-check your math.  For example, be careful when you add or subtract or figure items on a form or worksheet.  Tax preparation software does all the math for e-filers.
  5. Errors in figuring credits or deductions.  Many filers make mistakes figuring their Earned Income Credit, Child and Dependent Care Credit, and the standard deduction.  If you’re not e-filing, follow the instructions carefully when figuring credits and deductions.  For example, if you’re age 65 or older or blind, be sure you claim the correct, higher standard deduction.
  6. Wrong bank account numbers.  You should choose to get your refund by direct deposit.  But it’s important that you use the right bank and account numbers on your return.  The fastest and safest way to get a tax refund is to combine e-file with direct deposit.
  7. Forms not signed or dated.  An unsigned tax return is like an unsigned check – it’s not valid.  Remember that both spouses must sign a joint return.
  8. Electronic filing PIN errors.  When you e-file, you sign your return electronically with a Personal Identification Number.  If you know last year’s e-file PIN, you can use that.  If not, you’ll need to enter the Adjusted Gross Income from your originally-filed 2012 federal tax return.  Don’t use the AGI amount from an amended 2012 return or a 2012 return that the IRS corrected.
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Capital Gains and Losses and Your Tax Return

AlistairDarling

AlistairDarling (Photo credit: StCartmail)

When you own certain kinds of assets and you sell them, you may incur a capital gain or loss that is applicable to your income tax preparation.  If the original purchase price plus applicable expenses associated with the asset (known as the basis) is less than the proceeds that you receive from the sale of the asset, you have incurred a capital gain.  On the other hand, if the basis of your asset is greater than the proceeds from the sale, you have incurred a capital loss.

Capital gains are taxable to you, using a separate tax rate – and capital losses can be deducted from your capital gains for the year.  Excess capital losses (above your capital gains for the year) can be used to reduce your income by up to $3,000 per year, carried forward until used up (or for your lifetime).

The IRS recently produced their Tax Tip 2014-27 which lists ten facts about capital gains and losses that you may find useful as you prepare your tax return.  The text of the actual Tip is below:

Ten Facts about Capital Gains and Losses

When you sell a ‘capital asset,’ the sale usually results in a capital gain or loss.  A ‘capital asset’ includes most property you own and use for personal or investment purposes.  Here are 10 facts from the IRS on capital gains and losses:

  1. Capital assets include property such as your home or car.  They also include investment property such as stocks and bonds.
  2. A capital gain or loss is the difference between your basis and the amount you get when you sell an asset.  Your basis is usually what you paid for the asset.
  3. You must include all capital gains in your income.  Beginning in 2013, you may be subject to the Net Investment Income Tax.  The NIIT applies at a rate of 3.8% to certain net investment income of individuals, estates, and trusts that have income above statutory threshold amounts.  For details see www.IRS.gov/aca.
  4. You can deduct capital losses on the sale of investment property.  You can’t deduct losses on the sale of personal-use property.
  5. Capital gains and losses are either long-term or short-term, depending on how long you held the property.  If you held the property for more than one year, your gain or loss is long-term.  If you held it one year or less, the gain or loss is short-term.
  6. If your long-term gains are more than your long-term losses, the difference between the two is a net long-term capital gain.  If your net long-term capital gain is more than your short-term capital loss, you have a ‘net capital gain’.
  7. The tax rates that apply to net capital gains will usually depend on your income.  For lower-income individuals, the rate may be zero percent on some or all of their net capital gains.  In 2013, the maximum net capital gain tax rate increased from 15 to 20 percent.  A 25 or 28 percent tax rate can also apply to special types of net capital gains.
  8. If your capital losses are more than your capital gains, you can deduct the difference as a loss on your tax return.  This loss is limited to $3,000 per year, or $1,500 if you are married and file a separate tax return.
  9. If your total net capital loss is more than the limit you can deduct, you can carry over the losses you are not able to deduct to next year’s tax return.  You will treat those losses as if they happened that year.
  10. You must file Form 8949, Sales and Other Dispositions of Capital Assets, with your federal tax return to report your gains and losses.  You also need to file Schedule D, Capital Gains and Losses with your return.

For more information about this topic, see the Schedule D instructions and Publication 550, Investment Income and Expenses.  They’re both available on www.IRS.gov or by calling 800-TAX-FORM (800-829-3676).

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Simplified Home-Office Deduction Available

home office

home office (Photo credit: Sean MacEntee)

Beginning with your 2013 tax return you have a new option available for calculating the Home-Office deduction – based solely on the square footage of the dedicated space used for the home office.

Instead of having to maintain records that are directly and indirectly associated with your home office, you can use the simplified method, which applies a flat $5 rate per square foot to the home office space, up to a maximum of $1,500.

The record-keeping and tax preparation simplification is very beneficial: Form 8829 (the usual home-office deduction form) can cause a lot of headaches to prepare, especially if you have more than one home office and you itemize your home mortgage interest and real estate taxes.  For a single home office your tax preparation software will do much of the work for you, but complications like a second home office (not that uncommon in these days of officing-at-home) it can be complex.

Unfortunately, in my experience working with tax returns so far this season, it seems that the simplified method often results in a smaller home-office deduction than the old method.  With the simplified method you get the option to deduct your full real estate taxes and home mortgage interest above and beyond the home office deduction, whereas the old method required you to apportion these expenses between business and personal.  If the new method appeals to you, it is much simpler than gathering all the records and figuring out how to correctly fill out the forms.

The IRS recently issued their a news release, IR-2014-24, which details information about the simplified deduction.

Reminder To Home-Based Businesses: Simplified Option for Claiming Home Office Deduction Now Available; May Deduct up to $1,500; Saves 1.6 Million Hours A Year

Washington – The Internal Revenue Service today reminded people with home-based businesses that this year for the first time they can choose a new simplified option for claiming the deduction for business use of a home.

In tax year 2011, the most recent year for which figures are available, some 3.3 million taxpayers claimed deductions for business use of a home (commonly referred to as the home office deduction) totaling nearly $10 million.

The new optional deduction, capped at $1,500 per year based on $5 a square foot for up to 300 square feet, will reduce the paperwork and recordkeeping burden on small businesses by an estimated 1.6 million hours annually.

The new options is available starting with the 2013 return taxpayers are filing now.  Normally, home-based businesses are required to fill out a 43-line form (Form 8829) often with complex calculations of allocated expenses, depreciation and carryovers of unused deductions.  Instead, taxpayers claiming the optional deduction need only complete a short worksheet in the tax instructions and enter the result on their return.  Self-employed individuals claim eht home office deduction on Schedule C Line 30, farmers claim it on Schedule F Line 32, and eligible employees claim it on Schedule A Line 21.

Though some homeowners using the new option cannot depreciate the portion of their home used in a trade or business, they can claim allowable mortgage interest, real estate taxes and casualty losses on the home as itemized deductions on Schedule A.  These deductions need not be allocated between personal and business use, as is required under the regular method.

Business expenses unrelated to the home, such as advertising, supplies and wages paid to employees, are still fully deductible.

Long-standing restrictions on the home office deduction, such as the requirement that a home office be used regularly and exclusively for business and the limit tied to the income derived from the particular business, still apply under the new option.

Further details on the home office deduction and the new option can be found in Publication 587, posted on www.IRS.gov.

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Should You Pay Off Your Mortgage Early?

Ojibwe wigwam, from a 1846 painting by Paul Kane

As individuals pursue the American Dream of buying their first or next home the question may arise on whether or not it’s a good idea to pay down the mortgage and have no mortgage debt or pay the normal monthly payment and invest the extra money that would have gone to pay down the mortgage early in a place (the stock market) that offers the potential for higher returns over the long run.

There are many fierce advocates for paying off debt, any debt early. While this is a wise choice regarding high interest debts such as credit cards, student loans and other high interest loans it may not necessarily be the case for home mortgage debt.

Here’s a situation where for some folks it may make sense to pay down early and for others they may wish to consider invested the extra money elsewhere.

Generally, the younger a person or couple is when owning the home and the lower the interest rate on the mortgage it may make sense to forgo the extra payments to the mortgage and invest the money for potential greater returns on the market. With lower interest rates and the potential deductibility of the home mortgage interest the return on paying down the mortgage early may not be as great as long term gains in the market.

On the other hand, for an older couple nearing retirement they may consider paying down the mortgage early and owning their home free and clear when entering retirement. The emotional satisfaction of not having that expense in retirement and being able to take their former house payment and use that money elsewhere can bring great satisfaction. Since the couple has less time to accumulate wealth via the market, they can possibly achieve a greater return by paying off their home.

Another situation to consider is if there’s a need or a want for a safe, guaranteed return on someone’s money. Paying off debt early is an excellent way to achieve these types of returns. For example, if a couple has a 3.5% interest rate on their home and they have 15 years left on their mortgage, by paying off the home mortgage early they can achieve 3.5% returns, guaranteed, by eliminating that debt as soon as possible.

The trade-off here is they may miss out on potential gains in the market that may supersede the 3.5% return on paying off the debt. Again, this is a judgment call based on someone’s desire to get a guaranteed return or completely eliminate their debt.

So the answer is that it really depends on a person’s goals, situation and appetite for debt and risk. Home debt isn’t bad (we are not considering being upside down on a mortgage or buying a home that can’t be afforded). It’s simply a way to own a piece of the American Dream and the choice to pay down the mortgage early is a matter of judgment.

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Further Guidance on the One-Rollover-Per-Year Rule for IRAs


As a follow-up to the recent post on this blog The One-Rollover-Per-Year Rule: Revised, the IRS has recently released some additional guidance on the subject, via Announcement 2014-15.

As previously mentioned, the IRS has determined to begin using the one-rollover-per-year rule applied to ALL IRAs that the taxpayer owns, rather than only the affected IRAs that have been involved in a rollover.

According to the Announcement, the IRS fully acknowledges that the previous understanding of the rule was that it applied on an IRA-by-IRA basis.  In fact, there was a Proposed Regulation § 1.408-4(b)(4)(ii) on the books that was to further define the rule as applied only to the involved IRAs.  Ever since the Tax Court decided otherwise in the case Bobrow v. Commissioner (TC Memo 2014-21), the rule has been changed.

According to the recent announcement though, this will not take affect across the board until January 1, 2015.  Prior to that date, presumably, the old interpretation will be used, except, apparently, for Mr. Bobrow’s case (and any further cases that might be tried by the Tax Court).

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