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What to do with $1,000

Jun 10th, 2013
by jblankenship.
1 comment
One Thousand Dollars!

One Thousand Dollars! (Photo credit: The Consumerist)

I occasionally get this question – especially around the time of tax refunds.  When someone comes up with an additional $1,000 dollars, they want to know how to best use that money to help out their overall financial condition.

Of course this question has different answers for different situations.  I’ll run through several different sets of conditions that a person might find him or herself in, and some suggestions for how you might use that $1,000 to best improve your financial standing.  It’s important to note that you don’t have to have an extra $1,000 lying around to use this advice – you could have an extra ten or twenty or fifty bucks a week and put it to work with the same principles.  The point is to find money that isn’t being spent on something critical, and put it to work for you!  Even small steps amount to wonders.

Debt

If you have consumer debt, including credit card debt, auto loans, student loans and the like, it makes the most sense to use this money to bring down your overall debt balance or eliminate it if you can.

If the interest rate on your debt (or a portion of your debt) is greater than about 3% or 4%, you aren’t likely to find a better way to “invest” than to eliminate some of your interest costs.  This is because debt is a negative investment – when you have debt that carries an interest rate of 8%, year over year while the debt balance is there, you are “earning” a –8% return on that money.

Some folks recommend eliminating all debt, but that’s a bit impractical in today’s world.  Low-cost mortgage debt and auto loans can be good uses of leverage – especially mortgage debt at the rates we’ve seen of late.  I suggest that you focus on the highest rate consumer debt first and foremost, eliminating this drag on your financial state.  Once you’ve eliminated every debt except for mortgage debt, you can move on to other pursuits.  Eliminating consumer debt at high interest rates is the best move you can make to  improve your financial self.

Emergency Fund

An emergency fund is an amount of money set aside that can be used to cover all of the unexpected expenses that come up and surprise you: new tires for the car, roof replacement, or medical expenses not covered by insurance, for example.  The other thing that an emergency fund is for is to give you some “cushion” if you find yourself unemployed for an extended period of time.  It’s for this reason that an emergency fund is typically referred to as a certain number of months’ worth of expenses – such as 3-6 months’ worth of expenses.  You should have an emergency fund of an amount that would provide for your living expenses for several months should you be unexpectedly laid off.

If you don’t have an emergency fund, or if your emergency fund is smaller than you should have set aside, this is another great place to put your extra $1,000.  Typically an emergency fund is in a place that’s a bit difficult to get at – such as a bank savings account without debit card or ATM access.  This way you’re not tempted to invade this money for non-emergency purposes.  Sometimes folks use a Roth IRA as a dual-purpose account until they can establish separate accounts for retirement and emergency funds.

A Roth IRA could be used as your emergency fund, since you can withdraw your contributions to your Roth IRA at any time for any purpose without tax or penalty.  I don’t recommend this option for your long-term use, because if you have to get at the funds for an emergency purpose and you’re not able to replace them in the account within 60 days, you’ll lose the Roth treatment of those contributions forever.  You can always put more into the Roth IRA at a later time, but once you’ve got the money in there, you shouldn’t take it out before retirement without a very, very good reason.

Knowledge

The most important tool for achieving financial success is knowledge.  For this reason, I suggest that you use some of your new-found riches to improve your financial knowledge.  There are many good books out there (I’ve reviewed quite a few of them, click this link for a list of financial books I’ve reviewed) that will help you to better understand your finances and how you can improve things.

I wouldn’t suggest spending all $1,000 on education – maybe as much as $50 or $100 for several good books.  This will help you to make good decisions with your remaining money.

Retirement Savings

If you haven’t maxed out all of your retirement savings for the year, such as 401(k) plans and IRAs, this is another good place to put your $1,000 to work.  For an IRA or Roth IRA (if you’re eligible by your income level) it’s simply a matter of making the contribution to the account and investing it appropriately.

If on the other hand you haven’t maxed out your 401(k) plan, you can defer this additional $1,000 by your paychecks throughout the remainder of the year and earmark this additional $1,000 to make up the difference in reduced take-home pay.  If you started in July and you have 13 more pays left in the year, you’d set aside around $75 per paycheck (if paid every two weeks) and your income will be reduced by a little less than that, since the money you deferred isn’t taxed.

Who Does Each Option Work Best For?

Folks who are just starting out in improving your financial situation quite often need to focus on all of the options I mentioned above – debt reduction, emergency fund, knowledge and retirement savings.   The list was put together in priority order, so you should focus on debt reduction first, then emergency funds, and so on.

If you’re a little farther down the timeline and have eliminated all consumer debt and have established an emergency fund, improve your knowledge first, and then add more to your retirement savings.  I mentioned before that the most important tool that you have is your knowledge.  The most important action you can take to improve your financial standing is to increase your bottom line.  We did this first when we eliminated all debt.  The next step is to add to savings.  Both moves will increase your net worth – your assets (savings and possessions) minus your liabilities (loans and other debts) equals your net worth.  The key to financial success is to make moves that will have a positive impact on your net worth.

Students who don’t have any debt accumulated should focus first on the emergency fund, and then on retirement savings.  In some cases it makes good sense here to put the money into a Roth IRA, since money in a Roth IRA won’t be counted on your financial aid forms, since it’s a retirement account.

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The Qualified Terminable Interest Property (QTIP) Trust

Jun 5th, 2013
by jblankenship.
3 comments
Qtip

Qtip (Photo credit: miggslives)

Often we come up against situations in planning finances for folks where some special tools are necessary.  One of those situations, quite common these days, is when one or both members of a couple has children by a prior marriage.  The situation brings about some interesting questions when considering how the marital assets will be divided when one member of the couple has passed on.

Daryl has three children by a prior marriage, and his wife Toni also has three children by a prior marriage.  Both Daryl and Toni have considerable assets from before their marriage – each has a investments and retirement accounts in their own name: Toni’s accounts are worth $350,000, and Daryl’s accounts are worth $300,000.  Given their lifestyle, they will not be needing much of their accounts early in retirement – but it’s quite likely that later in life they may need the accounts for medical care and potentially for nursing facility care.

Under common circumstances, when Daryl passes away, he will leave his assets to Toni, so that she can continue to live the lifestyle that she’s been accustomed to, as well as to ensure that she can afford adequate medical care later in life.  But if he bequeaths his entire estate directly to Toni, what happens when she passes?  Again, under common circumstances, she would pass along her estate to her children.  The problem is, by doing this, Daryl’s children don’t get a share of the estate at all!  How can this be straightened out?

One thing would be for Daryl to designate in his will that his estate would be split among Toni and his children, either equally or in some formula.  This gives rise to another problem though: what if the portion that he leaves to Toni isn’t enough to cover her living expenses and medical care?  His desire to make sure his kids got their fair share has left his wife possibly in dire straits when there was plenty of money available.

Another way to handle this would be for Toni and Daryl to each specify in their wills that the final estate, whichever of the two it would be, would be split among all six of their combined offspring.  The problem with this is that after Toni has passed away, Daryl decides to remarry again – and then when re-doing his will he cuts out Toni’s kids, who he has always had a contentious relationship with.

Enter the QTIP

Investopedia defines a Qualified Terminable Interest Property trust as follows:

A type of trust that enables the grantor to provide for a surviving spouse and also to maintain control of how the trust’s assets are distributed once the surviving spouse has also died. Income, and sometimes principal, generated from the trust is given to the surviving spouse to ensure that he or she is taken care of for the rest of his or her life.

This type of trust does exactly what we’re looking for:  after Daryl’s death, his assets become the property of his QTIP trust, which provides for Toni to be able to take income (and principal as necessary) from the assets in order to maintain her lifestyle.  Upon Toni’s passing, Daryl has declared that his three children will then receive an inheritance of the remaining assets in the QTIP.  Toni set up a QTIP for her estate as well, in the event that she pre-deceased Daryl, so that her children could receive a portion of the remaining estate upon Daryl’s death.

QTIP trusts can hold any type of asset, such as investment accounts, farmland, homes, and collectibles.  IRAs can be owned by a QTIP trust, but special care needs to be taken when setting up the trust to ensure that the marital deduction is preserved and that the income can be distributed as appropriate to the surviving spouse.  It’s usually simpler to pass an IRA directly to beneficiaries, or use a see-through trust to assist with the distribution process.

An important factor to consider when setting up these QTIP trusts is that a qualified trustee should be appointed to oversee the distribution of the assets.  This trustee should be a disinterested third party who would be in a position to make good decisions about when and how much of the trust is distributed to the surviving spouse.  Without this type of oversight, the survivor could diminish the QTIP first, before his or her own assets, thereby effectively disinheriting the decedent’s children.

You’d think it’s unlikely that something like this would happen, but as I’ve often said – you never really know someone until you are dividing an estate with them.  Once the original owner has died, the interested parties often cease to act like relatives and revert to the basics of the transaction: they’re just people splitting up money (or other assets).  It pays to get this right, in order to reduce the possibility of one or more parties taking advantage of others.

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Book Review: How to Retire Happy

Jun 3rd, 2013
by jblankenship.
No comments yet
How to Retire Happy

“The 12 most important decisions you must make before you retire”

Author Stan Hinden, who is the former syndicated Washington Post “Retirement Journal” columnist, has just released his Fourth Edition of this book.  The book is Hinden’s commentary and advice, as well as a sort of journal, as he and his wife Sara entered into and have been living in retirement over the past 17 years.  Hinden retired in 1996 at the age of 69, at which time he began writing the “Retirement Journal” column.  He was nominated for a Pulitzer Prize in Commentary in 1998 for his work.

This book is an excellent read for folks who are planning toward retirement or have recently retired.  Hinden has organized the process into 12 decisions, some of which include: “Am I Ready to Retire?”, “What Should I Do with the Money in My Company Savings Plan?”, and “Where Do I Want to Live When I Retire?”. Mr. Hinden then walks through each of the 12 decisions with his own personal insights and choices, as well as with expert recommendations and commentary on the subjects.

The book is a fairly quick read at 250 pages, and the writing style is simple and conversational.  The decision-points that Mr. Hinden discusses are thought-provoking, and he has been diligent to provide sources for additional review at the end of each Decision/Chapter.  Topics covered include income taxes, pensions, retirement accounts, Social Security, Medicare, long-term care insurance, and many other categories pertinent to retirees.

The author’s wife, Sara, became afflicted by Alzheimer’s Disease in 2007, which has resulted her needing to be placed in a residential nursing facility as the disease has progressed.  This was a particularly difficult section for me as I very much empathized with Mr. Hinden as he was faced with the difficult decisions associated with his wife’s condition.  In a similar fashion, the author discusses the issues that he faced with his own health after learning that he needed a four-way heart bypass shortly after his retirement.  These insights that are brought forth are very helpful though, as we all must consider that such decisions may likely be a big part of our own lives.

I will recommend this book to any and all folks who are looking for insights as they approach retirement.  It will definitely give you additional insight as you take on this next step in your life – what Hinden mentions is likely the “final quarter” of your life.  He points out though, that this final quarter needn’t “sound grim.  In any football game, the last quarter is often the most exciting.  The same can be true of retirement.  It is one more chance to add points on the scoreboard of your life.”

The above book review is part of a series of reviews that I am doing in an arrangement with McGraw-Hill Professional Publishing, where MH sends me books with the only requirement being that I read the book and write a review – like it or not.  If you find the information in this review useful, let me (and McGraw-Hill) know!

Exceptions to the 10% Early Withdrawal Penalty from IRAs and 401(k)s

May 29th, 2013
by jblankenship.
6 comments
English: A clock made in Revolutionary France,...

English: A clock made in Revolutionary France, showing the 10-hour metric clock. (Photo credit: Wikipedia)

When you take money out of your IRA or 401(k) plan (or other qualified retirement plan, such as a 403(b) plan), if you’re under age 59½ in most cases your withdrawal will be subject to a penalty of 10%, in addition to any taxes owed on the distribution.  There are many exceptions to this rule though, and the exceptions are not the same for all types of plans.  IRAs have one set of rules, and 401(k)s have another set of rules.

The exceptions are always related to the purpose for which the money was withdrawn.  The exact same dollars withdrawn do not have to be used for the excepted purpose, just that the excepted expense was incurred.

IRA Exceptions

It is important to know that all distributions from your traditional IRA are subject to ordinary income tax, but some distributions are not subject to the early withdrawal penalty.  The list of exceptions for early withdrawals from IRAs is as follows:

Death of the owner of the IRA – if the owner of the IRA dies, the beneficiaries of the IRA can (in fact, must) take withdrawals from the plan without paying the 10% penalty.

Total and permanent disability of the owner of the IRA – if the owner of the IRA is deemed to be totally and permanently disabled.   You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

SOSEPP – With a Series of Substantially Equal Periodic Payments, lasting at least five years or until age 59½ (whichever is longer), there is no 10% penalty applied.

Medical Expenses – if you have medical expenses greater than 7.5% of your Adjusted Gross Income, a distribution from your IRA to cover these expenses (the excess above 7.5% of AGI) will not be subject to the penalty.  Any amounts paid by insurance toward the medical expenses reduces the overall expense counted toward the excepted expenses.

Health Insurance Premiums – if you’re unemployed, you can take a distribution from your IRA to cover your health insurance premiums without paying the penalty.

Qualified higher education expenses – amounts withdrawn from your IRA to pay for tuition, fees, books, supplies, and equipment needed for enrollment or attendance of a student at an eligible higher education institution are not subjected to the penalty.  In addition, if the student is at least a half-time student, room and board expenses paid for with an IRA distribution would not be subject to the penalty.  The amount of education expenses is reduced by any scholarships, grants, and qualified 529 plan distributions; any amount applied to an IRA penalty exception is also not eligible to be used toward education credits, such as the American Opportunity Credit or the Lifetime Learning Credit.

First-time home purchase – amounts withdrawn from your IRA up to $10,000 that are used toward a qualified first-time home purchase are an exception to the penalty.

Qualified reservist distributions – if a reservist who is called to active duty after September 11, 2001 for a period of 179 days or more takes a distribution from an IRA (after the start of active duty and before the end of active duty) the distribution will not be subject to the 10% penalty.

Rollovers – both direct, trustee-to-trustee transfers and 60-day indirect transfers are exempted from the penalty.

Excess contributions – if you have contributed too much to your IRA, you can take out the excess contribution without penalty.  However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

401(k) Exceptions

As with the IRA, most withdrawals from a 401(k) or other qualified retirement plan are subject to taxation.  Early withdrawals before age 59½ are also subject to a 10% penalty, with some exceptions.  The exceptions are as follows:

Death of the participant – this is the same as the exception for an IRA above.

Total and permanent disability of the participant – same as with an IRA.

SOSEPP – same as with an IRA.

Medical Expenses – same as with an IRA.

Qualified reservist distributions – same as with an IRA.

Rollovers – same as with an IRA.  However, an indirect 60-day rollover (not a trustee-to-trustee transfer) is subject to mandatory 20% withholding.  If the withheld 20% is not transferred within 60 days, this amount may be subject to both taxation and the 20% early withdrawal penalty.

Corrective distributions – just like with an IRA, if you have contributed too much to your 401(k), you can take out the excess contribution without penalty. However, any growth that is attributed to the amount that you over-contributed will be subject to the 10% penalty and taxes when withdrawn.

Separation from service after age 55 – if you leave employment after the age of 55, you are eligible to take distributions from your 401(k) or other QRP without penalty.  This is only valid while the funds are still in the 401(k) – if you rollover the funds to an IRA, this option is no longer available.  If the participant is a public safety employee (police, fire, or emergency medical technicians), the age is 50 or older.

Qualified Domestic Relations Order (QDRO) – in the event of a divorce, if the 401(k) is to be divided or distributed to the ex-spouse of the participant, withdrawals from the plan by the ex-spouse are not subject to the 10% penalty.

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Avoid Awkwardness in the Afterlife–Confirm Your Beneficiary Designations

May 24th, 2013
by jblankenship.
1 comment
Withholding Water

This is a topic that I cover with all clients, and one that I recommend you for everyone with retirement plans and other accounts with beneficiary designations.  Too often we think we have the beneficiary designation form filled out just the way we want it, and then (once it’s too late) it is discovered that the form hadn’t been updated recently – and the designation is not what we hoped for.

I made this recommendation to a client not long ago.  He assured me that he had all of his designations set up just the way he wanted.  His wife, sitting next to him in our meeting, asked him to make sure – talk to the IRA custodian and get a copy of the designation as it stands today.  A bit miffed about it all, he agreed to do so, and did the next day.  Guess what he found – as it stood on that day, his IRA beneficiary designation form indicated 100% of his IRA would pass to his ex-wife from 15 years ago!  Plus, he had no secondary beneficiaries named, which meant that if the ex predeceased him, HER heirs would be the primaries.  Thankfully he had checked on this to avoid this awkward and possibly devastating situation.

Know what was fixed pretty much immediately?

Take the time

You owe it to yourself and your heirs to take the time to review your beneficiary designations and keep copies of them in your “dead file”.  This includes IRAs, Roth IRAs, 401(k)/403(b)/457 plans, and other pensions or retirement plans.  You also may have POD or TOD (Pay on Death or Transfer on Death) designations on non-retirement accounts – confirm these and keep copies as well.

For your standard retirement accounts, such as IRAs, 401(k)s and the like, you typically have the option of naming a primary beneficiary (or beneficiaries) and a secondary or contingent beneficiary or beneficiaries.  It makes a huge difference on these accounts that you name a specific person (or persons) as the primary beneficiary, and a specific person (or persons) as the contingent beneficiary.  With IRAs, if you leave the designation blank, you may be taking away important options for your heirs.

If you leave the primary beneficiary designation blank you are leaving the transfer of your IRA up to the custodian’s default designation.  Quick! What’s your IRA custodian’s default beneficiary designation??  I didn’t think you’d know.

Often this default is your spouse first, and then your “issue” – meaning your children and other descendants.  Other times, the default beneficiary is your estate.  In the event that the estate is the default beneficiary, any beneficiaries of the estate will receive the IRA, but they will not be able to utilize the “stretch” option of receiving payout of the account over their remaining lifetimes.  This is because the IRS rules state that a “named beneficiary” must be in place in order to use the stretch provision.  If no “named beneficiary” exists, the stretch option is not allowed.  If the default is your spouse and your issue, these can be treated as “named beneficiary” if they are alive.

Discuss with your heirs

At face value, even though you think your intent for your beneficiary designations is clear, it might not be clear to your heirs.  For example, you may have chosen to pass along half of your IRA to your youngest child and only a quarter to the older two children because you believe the youngest child can use the money more than the other two.  Or maybe you decided to leave the entire IRA to your oldest daughter, and you want to designate your three sons to split up the farmland – which you believe is an equitable division.

Whatever you’ve decided, especially if there are perceived inequities in your division plan, you should take the time to review your plan with your heirs.  If that makes you uncomfortable, there are a couple of things to consider: First, if you’re uncomfortable discussing it with them, imagine how uncomfortable your heirs may be when the time comes to distribute your estate.  Maybe it’s not such a good idea after all if it could cause contention among your heirs.  Second, if you still believe your split is the right way to go, you should explain your plan to someone – your designated executor would be a good choice. And the designated executor should be a disinterested separate party, someone who isn’t receiving benefit from your estate plan, in order to keep the process “clean”.  Otherwise, if one of the heirs is your executor and the executor is perceived to receive preferential treatment, again you’ll have some contention among your heirs.

If there are complex instructions involved, consider making an addendum to your will.  Instructions in your will would have no impact on the beneficiary designations on your IRAs and other plans (these pass outside of your estate as long as you’ve made specific designations) but other asset divisions aside from retirement accounts may require explanation for your heirs to understand your intent.  Don’t expect that everyone will understand or agree with your thought process when you’re gone.  Explaining your thought process in advance will likely help to ensure that your division plan doesn’t result in a family rift.

Take the time to review your beneficiary designations.  Make sure that you have the primary beneficiary or beneficiaries that you want, and the percentages that you’d like each to have.  Also make sure that you have named contingent beneficiary or beneficiaries in the event that your primaries have predeceased you.  Lastly, make sure that you note how division is done after the death of the beneficiaries: per stirpes or per capita.

Fixing an IRA With the “Wrong” Beneficiary

May 1st, 2013
by jblankenship.
3 comments
Wrong

Quite often, for many different reasons (often known only to the deceased original owner), the original owner of an IRA designates a beneficiary that the survivors don’t necessarily agree with. It might be that only one of several children is designated, or perhaps additional beneficiaries are designated along with a spouse.  In cases like these, there are ways to make changes to the outcome of the inheritance.  In this article we specifically deal with the case where only one of four children was designated as the primary beneficiary of the IRA.

To resolve the situation, let’s consider the following IRA: John, the decedent, designated April (his daughter) as the primary beneficiary of his IRA.  It isn’t known why John only designated April as the beneficiary, as he has three other children – Bill, Chuck, and Dale – and John had only his IRA as an asset to pass along to the children.  April could choose to take the entire IRA as her own and receive payments over her lifetime using the stretch rules, but she sees the inherent lack of fairness in the situation, so she wants to make the IRA available to her brothers as well.

One way to accomplish this would be for April to withdraw 75% of the IRA and split that amount with her brothers.  She would then be able to stretch out the payments on the remaining 25% over her lifetime.  Mission accomplished, right?

The problem with this option is that April would have to pay tax on the 75% distribution – and since the IRA is sizeable, this is a significant cost.  Naturally she could just pass along this tax cost to her brothers in the form of a reduced payment, but this isn’t a very efficient way to distribute the money.

On the other hand, April could maintain the account in her name and stretch out payments over her lifetime, splitting each payment (after tax) among herself and her brothers.  Again, this accomplishes what she had set out to do, but she’s still paying tax on the entire amount and since our tax system works on a graduated scale, the tax on 100% received by one person is likely to be much higher than the tax would be for four persons each receiving 25% from the account.  In addition, the three brothers would be required to wait until April decides to take a distribution before they would have access to the account.  Bill for example, would prefer to withdraw a large sum right away as he’s building a home and could use the funds for the construction.  This would be very inefficient (tax-wise) if April had to make the withdrawal for him and pay the tax at her higher rate.

So – what else could be done?  It would be great if there was a way for April to re-write the beneficiary designation so that all four children were considered to be the beneficiaries, but that’s not possible.  What is possible is to re-direct a portion of the inheritance, by way of a method called disclaiming.

It’s important to know how to properly disclaim the inheritance of an IRA.  The person disclaiming all or a portion of an IRA must not be an eventual beneficiary as a result of the disclaimer.   Plus, the person disclaiming must not be in a position to direct who are the new beneficiaries; the natural course of the law must be followed.  If either of these rules is broken, the disclaimer is considered to be nonqualified, and any distribution would be considered to have been done by April.  Any amount transferred to her brothers would be considered a gift, subject to gift taxes.

So, if April disclaims the entire IRA, the new beneficiary would be John’s estate.  Since John’s will dictates that the four children will split all of his assets equally, this would accomplish the desired result, right?  No, not really.

The problem is that, when April disclaims the entire IRA, she is still an eventual beneficiary of the IRA since the estate becomes the de facto beneficiary, breaking the first rule above.  In addition, since the estate isn’t a “person”, the stretch rules can’t be used for this IRA at all.  When there is no real person as a beneficiary of an IRA, the entire account must be paid out within five years, rather than stretched out over a beneficiary’s lifetime.

What April should do is to disclaim 75% of the IRA, and also disclaim rights to the IRA portion of the estate that results from her first disclaimer.  This gives her 25% of the original IRA with the stretch benefits still intact.  In addition, since she’s disclaimed her right to the estate portion of the IRA asset, her brothers each have right to 25% of the IRA – 1/3 each of the 75% that April disclaimed.  This portion passes through the estate to the brothers.

The brothers will not be allowed to stretch out their payments from the account for more than five years – this is one unfortunate circumstance that can’t be avoided.  But otherwise, the eventual distribution is much more “fair” – even if it’s not what John had planned.  And each brother has control over his portion of the funds, at least for distribution purposes.  Bill can take the large distribution right away, and Chuck and Dale can delay up to five years before taking a distribution.  And each of the four siblings will only pay tax on the distribution that he or she takes.

Last-Minute Tax Tips

Apr 15th, 2013
by jblankenship.
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Deadline

Since today is D-Day for income tax filing, I’ve pulled together a few recent tips that the IRS published.  These tips cover a few of the areas that you may find interesting, including how to get a six-month extension for your filing (but not for payment of tax), errors to avoid as you complete your tax return, how to make IRA contributions, and tips for the self-employed at tax time.  This is a much longer post than I normally write, but I think it has a lot of very good and very timely information that will be useful today.

The actual text of these tips are listed below, with the reference number of each tip.

 

IRS Newswire IR-2013-38

Can’t File by April 15? Use Free File to Get a Six-Month Extension; E-Pay and Payment Agreement Options Available to People Who Owe Tax

WASHINGTON – The Internal Revenue Service today reminded taxpayers that quick and easy solutions are available if they can’t file their returns on time, and they can even request relief online.

The IRS says don’t panic.  Tax-filing extensions are available to taxpayers who need more time to finish their returns.  Remember, this is an extension of time to file; not an extension of time to pay.  However, taxpayers who are having trouble paying what they owe may qualify for payment plans and other relief.

Either way, taxpayers will avoid stiff penalties if they file either a regular income tax return or a request for a tax-filing extension by this year’s April 15 deadline.  Taxpayers should file, even if they can’t pay the full amount due.  Here are further details on the options available.

More Time to File

People who haven’t finished filling out their return can get an automatic six-month extension.  The fastest and easiest way to get the extra time is through the Free File link on IRS.gov.  In a matter of minutes, anyone, regardless of income, can use this free service to electronically request an automatic tax-filing extension on form 4868.

Filing this form gives taxpayers until Oct. 15 to file a return.  To get the extension, taxpayers must estimate their tax liability on this form and should also pay any amount due.

By properly filing this form, a taxpayer will avoid the late-filing penalty, normally five percent per month based on the unpaid balance, that applies to returns filed after the deadline.  In addition, any payment made with an extension request will reduce or eliminate interest and late-payment penalties that apply to payments made after April 15.  The current interest rate is three percent per year, compounded daily, and the late-payment penalty is normally 0.5 percent per month.

Besides Free File, taxpayers can choose to request an extension through a paid tax preparer, using tax-preparation software or by filing a paper Form 4868, available on IRS.gov.  Of the nearly 10.7 million extension forms received by the IRS last year, almost 5.8 million were filed electronically.

Some taxpayers get more time to file without having to ask for it.  These include:

  • Taxpayers abroad.  US citizens and resident aliens who live and work abroad, as well as members of the military on duty outside the US, have until June 17 to file.  Tax payments are still due April 15.
  • Members of the military and others serving in Afghanistan or combat zone localities.  Typically, taxpayers can wait until at least 180 days after they leave the combat zone to file returns and pay any taxes due.  For details, see Extensions of Deadlines in Publication 3, Armed Forces Tax Guide.
  • People affected by certain tornadoes, severe storms, floods and other recent natural disasters.  Currently, parts of Mississippi are covered by a federal disaster declaration, and affected individuals and businesses in these areas have until April 30 to file and pay.

Easy Ways to E-Pay

Taxpayers with a balance due now have several quick and easy ways to electronically pay what they owe.  They include:

  • Electronic Federal Tax Payment System (EFTPS).  This free service gives taxpayers a safe and convenient way to pay individual and business taxes by phone or online.  To enroll or for more information, call 800-316-6541 or visit www.eftps.gov.
  • Electronic funds withdrawal.  E-file and e-pay in a single step.
  • Credit or debit card.  Both paper and electronic filers can pay their taxes by phone or online through any of several authorized credit and debit card processors.  Though the IRS does not charge a fee for this service, the card processors do.  For taxpayers who itemize their deductions, these convenience fees can be claimed on Schedule A Line 23.

Taxpayers who choose to pay by check or money order should make the payment out to the “United States Treasury”.  Write “2012 Form 1040”, name, address, daytime phone number and Social Security number on the front of the check or money order.  To help insure that the payment is credited promptly, also enclose a Form 1040-V payment voucher.

More Time to Pay

Taxpayers who have finished their returns should file by the regular April 15 deadline, even if they can’t pay the full amount due.  In many cases, those struggling with unpaid taxes qualify for one of several relief programs, including the following:

  • Most people can set up a payment agreement with the IRS on line in a matter of minutes.  Those who owe $50,000 or less in combined tax, penalties and interest can use the Online Payment Agreement to set up a monthly payment agreement for up to 72 months.  Taxpayers can choose this option even if they have not yet received a bill or notice from the IRS.  With the Online Payment Agreement, no paperwork is required, there is no need to call, write or visit the IRS and qualified taxpayers can avoid the filing of a Notice of Federal Tax Lien if one was not previously filed.  Alternatively, taxpayers can request a payment agreement by filing Form 9465.  This form can be downloaded from IRS.gov and mailed along with a tax return, bill or notice.
  • Some struggling taxpayers may qualify for an offer-in-compromise.  This is an agreement between a taxpayer and the IRS that settles the taxpayer’s tax liabilities for less than the full amount owed.  The IRS looks at the taxpayer’s income and assets to make a determination regarding the taxpayer’s ability to pay.  To help determine eligibility, use the Offer In Compromise Pre-Qualifier, a free online tool available on IRS.gov.

 

IRS Tax Tip 2013-52

Five Things to Know if You Need More Time to File

The April 15 tax-filing deadline is fast approaching.  Some taxpayers may find that they need more time to file their tax returns.  If you need extra time, you can get an automatic six-month extension from the IRS.

Here are five important things you need to know about filing an extension:

  1. Extra time fo file is not extra time to pay.  You may request an extension of time to file your federal tax return to get an extra six months to file, until Oct. 15.  Although an extension will give you an extra six months to get your tax return to the IRS, it does not extend the time you have to pay any tax you owe.  You will owe interest on any amount not paid by the April 15 deadline.  You may also owe a penalty for failing to pay on time.
  2. File on time even if you can’t pay.  If you complete your return but you can’t pay the full amount due, do not request an extension.  File your return on time and pay as much as you can.  You should pay the balance as soon as possible to minimize penalty and interest charges.  If you need more time to pay, you can apply for a payment plan using the Online Payment Agreement tool on IRS.gov.  You can also send Form 9465,Installment Agreement Request, with your return.  If you are unable to make payments because of a financial hardship, the IRS will work with you.  Call the IRS at 800-829-1040 to discuss your options.
  3. Use Free File to request an extension.  Everyone can use IRS Free File to e-file their extension request.  Free File is available exclusively through the IRS.gov website.  You must e-file the request by midnight on April 15.  If you e-file your extension request, the IRS will acknowledge receipt of your request.
  4. Use Form 4868 if you file a paper form.  You can request an extension of time to file by submitting Form 4868, Application for Automatic Extension of Time to File US Individual Income Tax Return.  You must submit this form to the IRS by April 15.  Form 4868 is available on IRS.gov.
  5. Electronic funds withdrawal.  If you e-file an extension request, you can also pay any balance due by authorizing an electronic funds withdrawal from a checking or savings account.  To do this you will need your bank routing and account numbers.

 

IRS Tax Tip 2013-51

Eight Tax-Time Errors to Avoid

If you make a mistake on your tax return, it usually takes the IRS longer to process it.  The IRS may have to contact you about that mistake before your return is processed. This will delay the receipt of your tax refund.

The IRS reminds filers that e-filing their tax return greatly lowers the chance of errors.  In fact, taxpayers are about twenty times more likely to make a mistake on their return if they file a paper return instead of e-filing their return.

Here are eight common errors to avoid.

  1. Wrong or missing Social Security numbers.  Be sure you enter SSNs for yourself and others on your tax return exactly as they are on the Social Security cards.
  2. Names wrong or misspelled.  Be sure you enter names of all individuals on your tax return exactly as they are on their Social Security cards.
  3. Filing status errors.  Choose the right filing status.  There are five filing statuses:  Single, Married Filing Jointly, Married Filing Separately, Head of Household and Qualifying Widow(er) With Dependent Child.  See Publication 501, Exemptions, Standard Deduction and Filing Information, to help you choose the right one.  E-filing your tax return will also help you choose the right filing status.
  4. Math mistakes.  If you file a paper tax return, double check the math.  If you e-file, the software does the math for you.  For example, if your Social Security benefits are taxable, check to ensure you figured the taxable portion correctly.
  5. Errors in figuring credits, deductions.  Take your time and read the instructions in your tax booklet carefully.  Many filers make mistakes figuring their Earned Income Tax Credit, Child and Dependent Care Credit and the standard deduction.  For example, if you are age 65 or older or blind check to make sure you claim the correct, larger standard deduction amount.
  6. Wrong bank account numbers.  Direct deposit is the fast, easy and safe way to receive your tax refund.  Make sure you enter your bank routing and account numbers correctly.
  7. Forms not signed, dated.  An unsigned tax return is like an unsigned check – it’s invalid.  Remember both spouses must sign a joint return.
  8. Electronic signature errors.  If you e-file your tax return, you will sign the return electronically using a Personal Identification Number.  For Security purposes, the software will ask you to enter the Adjusted Gross Income from your originally-filed 2011 federal tax return.  Do not use the AGI amount from an amended 2011 return or an AGI provided to you if the IRS corrected your return.  You may also use last year’s PIN if you e-filed last year and remember your PIN.

 

IRS Tax Tip 2013-50

Top Ten Tips on Making IRA Contributions

The IRS has 10 important tips for you about setting aside money for your retirement in an Individual Retirement Arrangement.

  1. You must be under age 70½ at the end of the tax year in order to contribute to a traditional IRA.
  2. You must have taxable compensation to contribute to an IRA.  This includes income from wages, salaries, tips, commissions and bonuses.  It also includes net income from self-employment.  If you file a joint return, generally only one spouse needs to have taxable compensation.
  3. You can contribute to your traditional IRA at any time during the year.  You must make all contributions by the de date for filing your tax return.  This due date does not include extensions.  For most people this means you must contribute for 2012 by April 15, 2013.  If you contribute between Jan. 1 and April 15, you should contact your IRA plan sponsor to make sure they apply it to the right year.
  4. For 2012, the most you can contribute to your IRA is the smaller of either your taxable compensation for the year or $5,000.  If you were 50 or older at the end of 2012 the maximum amount increases to $6,000.
  5. Generally, you will not pay income tax on the funds in your traditional IRA until you begin taking distributions from it.
  6. You may be able to deduct some or all of your contributions to your traditional IRA.
  7. Use the worksheets in the instructions for either Form 1040A or Form 1040 to figure the amount of your contributions that you can deduct.
  8. You may also qualify for the Savers Credit, formally known as the Retirement Savings Contributions Credit.  The credit can reduce your taxes up to $1,000 (up to $2,000 if filing jointly).  Use Form 8880, Credit for Qualified Retirement Savings Contributions, to claim the Saver’s Credit.
  9. You must file either Form 1040A or Form 1040 to deduct your IRA contribution or to claim the Saver’s Credit.
  10. See Publication 590, Individual Retirement Arrangements, for more about IRA contributions.

 

IRS Tax Tip 2013-46

Top Six Tax Tips for the Self-Employed

When your are self-employed, it typically means you work for yourself, as an independent contractor, or own your own business.  Here are six key points the IRS would like you to know about self-employment and self-employment taxes:

  1. Self-employment income can include pay that you receive for part-time work you do out of your home.  This could include income you earn in addition to your regular job.
  2. Self-employed individuals file a Schedule C, Profit or Loss from Business, or Schedule C-EZ, Net Profit from Business, with their Form 1040.
  3. If you are self-employed, you generally have to pay self-employment tax as well as income tax.  Self-employment ax includes Social Security and Medicare taxes.  You figure this tax using Schedule SE, Self-Employment tax.
  4. If you are self-employed you may have to make estimated tax payments.  People typically make estimated tax payments to pay taxes on income that is not subject to withholding.  If you do not make estimated tax payments, you may have to pay a penalty when you file your income tax return.  The underpayment of estimated tax penalty applies if you do not pay enough taxes during the year.
  5. When you file your tax return, you can deduct some business expenses for the costs you paid to run your trade or business.  You can deduct most business expenses in full, but some costs must be ‘capitalized’.  This means you can deduct a portion of the expense each year over a period of years.
  6. You may deduct only the costs that are both ordinary and necessary.  An ordinary expense is one that is common and accepted in your industry.  A necessary expense is one that is helpful and appropriate for your trade or business.

For more information, visit the Small Business and Self-Employed Tax Center on the IRS website.  There are three IRS publications that will also help you.  See Publications 334, Tax Guide for Small Business; 535, Business Expenses and 505, Tax Withholding and Estimated Tax.  All tax forms and publications are available on IRS.gov or by calling 800-TAX-FORM (800-829-3676).

A Few Facts to Know About Retirement Plan Contributions

Apr 5th, 2013
by jblankenship.
No comments yet
Deadline

As we near the tax filing deadline, there are a few things you need to be aware of as you consider your retirement plan contributions for tax year 2012 (or whatever the prior tax year is, if you’re reading this sometime later).

Regular IRA contributions are due by the filing deadline, with no extensions. That means April 15, 2013 for the 2012 tax year. Your contribution for 2012 is considered made “on time” if your payment is postmarked by midnight on April 15, 2013.

Perhaps you wish to make a more substantial contribution to a retirement plan – in 2012, you can contribute up to $50,000 to a Keogh plan. That amount is limited to 20% of the net self-employment income, or 25% of wage income if the individual is an employee of the business. Keogh plan contributions can be made by the extended due date of your return – in most cases this is October 15, 2013 (for tax year 2012). The downside is that you must have established the Keogh plan by December 31, 2012 in order to make contributions for the 2012 tax year. If you have not established your Keogh plan yet, it’s too late for tax year 2012.

However, you still have another option if you want to make significant retirement plan contributions (above and beyond the $5,000/$6,000 limit on traditional IRAs) – and this is to establish and fund a SEP-IRA. The funding limit for SEP-IRAs is the same as for Keogh plans, but you can establish the SEP-IRA as late as the extended filing date (October 15) and fund it for the prior tax year.

Happy saving!

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How an IRA is Treated When a Beneficiary Dies

Mar 27th, 2013
by jblankenship.
2 comments
Treats Truck

When an IRA owner dies while the IRA still has funds in it, the primary beneficiary(ies) have the opportunity to transfer the account to an inherited IRA and begin taking the Required Minimum Distributions (RMDs) over his or her lifetime. When this primary beneficiary dies, it can be difficult to figure out who the money goes to. This is known as the successor beneficiary.

It’s important to know the difference between a successor beneficiary and a contingent beneficiary. A contingent beneficiary takes the place of the primary beneficiary in the event that the primary beneficiary dies before the original owner does. A successor, on the other hand, takes the place of the primary beneficiary when the primary beneficiary outlives the original owner. So it’s a matter of timing. What we’re interested in is the successor beneficiary.

There are four main ways that a successor beneficiary is determined:

  • Successor is named by the primary beneficiary. When the inherited IRA is established, the primary beneficiary has the opportunity to name one or more beneficiaries of the inherited IRA, along with contingent beneficiaries if desired.
  • Successor is the primary beneficiary’s estate. If the primary beneficiary hasn’t designated a beneficiary of the inherited IRA, the primary beneficiary’s estate becomes the successor beneficiary of the IRA.
  • Custodial documents name a successor beneficiary. Some IRA custodians provide for the designation of a successor beneficiary in the original plan documents. This is relatively rare, and even more rare that a successor is actually named.
  • Original owner names a successor beneficiary. Sometimes the original owner has had the foresight to utilize a trust document of some variety to control succession among beneficiaries. In a case like this, the trust is the primary beneficiary, and the trust has a primary beneficiary and successor beneficiary(ies).

Below is a flowchart which describes how the ownership of an IRA flows to different beneficiaries. (click on the chart to see a larger view)

ira transition flowchart

Distribution for the Successor Beneficiary

So, having sorted out that we are working with the appropriate successor beneficiary, we need to determine what is the proper distribution period for the successor beneficiary. As we know, if the IRA is an inherited IRA, it is subject to Required Minimum Distributions, over a period determined by the beneficiary’s age at the time of the death of the original owner. This figure is determined from Table I in the first year of distribution (the year after the death of the original owner), and is a set period of time. The factor from Table I is used in the first year, and each subsequent year one is subtracted from the first factor and the IRA is distributed based on that amount.

So, for example, if the beneficiary is 71 years of age in the first year of distribution, according to Table I the factor is 16.3. The IRA value is divided by 16.3 to come up with the RMD for the first year. Each subsequent year 1 is subtracted from the Table I factor, so that the IRA is distributed over 16.3 years. This is known as the Applicable Distribution Period, or ADP.

When a successor beneficiary takes over to receive distributions from the inherited IRA, the original ADP is still in effect, and the IRA must be distributed over that remaining period to the successor beneficiary(ies).

Complications

Several factors can add a considerable degree of complication to the process – such as if there are multiple primary beneficiaries and/or multiple successor beneficiaries.

Each primary beneficiary is treated separately, and the successors for each (unless determined by the original plan as mentioned above) are determined by the individual beneficiary. When there are multiple successors, each one is treated separately and the original ADP for the applicable primary beneficiary applies to all successors pro rata for the successor’s share.

Another complication is when one or more beneficiaries disclaims the inheritance. In a case like that, first it is determined whether the original beneficiary designation had pre-determined the successor for each primary beneficiary (such as “per stirpes”, meaning that the heirs of the original beneficiary are bequeathed the disclaimed share). In the absence of this sort of designation, the other beneficiaries in the primary class take over the disclaimed share.

Of course in the real world there are many, many more complications, but this should give you a place to start. Use the comments section below to bring in your more complex situations and we’ll work them out.

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