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Tuesday
Nov272012

2012 Year-End Tax Planning Overview

Every November, as part of my continuing professional education requirement, I attend an all-day tax seminar, where tax law changes and recent court decisions are explained and discussed.

Normally, this conference is about as exciting as a root canal, but this year, because of all the uncertainties surrounding the impending “fiscal cliff,” the mood was more like a convention of psychics discussing the impending Mayan apocalypse.

For the CURRENT 2012 tax year, the changes from 2011 are relatively minor, and shouldn’t affect most of you, with the singular exception of California Proposition 30 which RETROACTIVELY increased the highest marginal tax rates for individuals with taxable incomes in excess of $250,000 and couples with incomes in excess of $500,000 from one to three percent. Because this change was retroactive to the beginning of the year, you may have been under-withheld on your California income taxes (or paid in less than the required quarterly estimates). If you think you may be subject to this increase, contact me before the end of the year so that the shortfall can be calculated.

As far as the situation for 2013 and beyond is concerned, your guess is as good as mine. As of this writing, Congress has yet to act on proposals to prevent a “worst-case” scenario, but presumably some action will be taken before December 31. Nonetheless, the consensus view is that in all likelihood, EFFECTIVE tax rates will increase for MOST taxpayers, either from an increase in marginal tax rates, or the reduction or the elimination of certain credits, deductions and benefits.

For that reason, the normal tax planning strategy of deferring income until next year and accelerating deductions to the current tax year should probably be reversed.

For example, if you are sitting on investments with sizable gains, it might be a good idea to sell them before year end and take the gains in 2012. If these investments are still sound, you can repurchase the same shares and effectively “lock in” a higher basis. The “wash sale” rules that apply to losses do NOT apply to gains, so there will be no 30-day waiting period for the repurchase.

Similarly, you may want to prepay medical and educational expenses to take advantage of current tax provisions that may not be available next year.

If you have any questions about your own situation, please contact me before year end.

The following is a partial list of credits and deductions that have changed or expired in 2012: 

  • Educator expenses: $250 maximum deduction for professional educators is no longer available for 2012
  • Tuition deduction for those who itemize. The American Opportunity (“Hope”) Tax Credit is still available for 2012, however.
  • State and local general sales tax deduction for those who itemize
  • Deduction for mortgage insurance premiums
  • Nonrefundable credits can no longer be used to offset alternative minimum tax (AMT)
  • Temporary AMT exemption amounts in effect for the 2010 and 2011 are set to expire (unless Congress passes an “AMT Patch” before the end of the year)
  • Nonbusiness energy credits
  • IRA-to-Charity exclusion

For businesses and investors in income property, these include: 

  • Sec. 179 and 15-year depreciation allowances for certain real estate investments
  • Sec. 179 depreciation $500,000 maximum reduced to $139,000
  • 100% bonus depreciation allowed for certain assets reduced to 50% in 2012
  • Enhanced transportation fringe benefits
  • Reduced built-in gains holding period
  • Research credit
  • Enhanced charitable deductions for computer, book and food inventories
  • S corporation basis adjustment for charitable contributions
  • Work-Opportunity Credit (non-veterans only)
  • 100% exclusion for small business stock (Sec. 1202)
  • Sec. 181 expensing of film and television production costs
  • 7-year motorsports depreciation

If you think any of these might apply to you, contact me if you have any questions.

I anticipate sending out organizers to my returning clients before the end of January. When you receive yours, please take extra care in preparing it and providing all supporting documentation.  

Finally, if you want to file early because you’re expecting a sizable refund or for any other reason, please let me know before mid-January so I can schedule your return for filing before the usual March-April tsunami.

Thanks once again for letting me be your “tax guy,” and best wishes for the holidays.

Yours very truly,

Rick Zalon, CPA

Tuesday
Feb212012

Impact of Early Distributions

DIRECT FROM THE IRS:

Taxpayers may sometimes find themselves in situations when they need to withdraw money from their retirement plan early. What they may not realize is that that transaction may mean a tax impact when they file their return.

Here are 10 facts from the IRS about the tax implications of an early distribution from your retirement plan.

1. Payments you receive from your Individual Retirement Arrangement before you reach age 59 ½ are generally considered early or premature distributions.

2. Early distributions are usually subject to an additional 10 percent tax.

3. Early distributions must also be reported to the IRS.

4. Distributions you roll over to another IRA or qualified retirement plan are not subject to the additional 10 percent tax. You must complete the rollover within 60 days after the day you received the distribution.

5. The amount you roll over is generally taxed when the new plan makes a distribution to you or your beneficiary.

6. If you made nondeductible contributions to an IRA and later take early distributions from your IRA, the portion of the distribution attributable to those nondeductible contributions is not taxed.

7. If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed.

8. If you received a distribution from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.

9. There are several exceptions to the additional 10 percent early distribution tax, such as when the distributions are used for the purchase of a first home (up to $10,000), for certain medical or educational expenses, or if you are totally and permanently disabled.

10. For more information about early distributions from retirement plans, the additional 10 percent tax and all the exceptions, see IRS Publication 575, Pension and Annuity Income and Publication 590, Individual Retirement Arrangements (IRAs). Both publications are available at www.irs.gov or by calling 800-TAX-FORM (800-829-3676).


Links:

  • Publication 575, Pensions and Annuities (PDF 227K)
  • Publication 590, Individual Retirement Arrangements (IRAs) (PDF 449K)
  • Form 5329, Additional Taxes on Qualified Plans (including IRAs) and Other Tax Favored Accounts (PDF 72K)
  • Form 5329 Instructions (PDF 40K)

Wednesday
Nov302011

Year-End Tax Letter

I hope that 2011 has, thus far, been a happy and prosperous one for you and your family.

 

In terms of legislation, 2011 was a quiet year on the tax front. Barring any last-minute retroactive congressional mischief, rates, deductions and credits are virtually unchanged from 2010.

 

This means that the usual year-end strategy of deferring gains and income, taking losses, and accelerating deductions holds true.

 

This doesn’t mean that the taxing agencies at the federal and state level have been idle, however. Both the IRS and the California Franchise Tax Board have new requirements and compliance programs, so here’s a “heads-up” for what to look out for this year.

 

Sales of stock and securities: If you sold stock or securities through a broker, the broker will issue you a revised form 1099-B. This form is intended to report all the details of each sale including the sales price and cost basis (usually what you paid for the stock) for determining capital gains and losses. This requirement is new, however, and the form provided by the broker will not yet capture all sales.

 

Most of you have provided excellent detail of your trading activities in the past, and in many cases you’ve been maintaining your own spreadsheets. Please continue to do so, but also please provide copies of any 1099-Bs and all other information provided by your broker that can help establish cost-basis.

 

Merchant charges, 1099-Ks: Those of you who are in business, rent property, or sell merchandise online will likely receive a new form – Form 1099-K. This form will report credit card or other merchant payments (PayPal for example) over specified amounts. Be on the lookout for this new form and please provide me with any 1099-Ks you receive.

 

This is no doubt part of a concerted effort by the taxing authorities to focus on the growing problem of unreported income. As this is the first year for this requirement, in all likelihood only PayPal vendors and Amazon affiliates will be affected, but if you maintain a website that serves as a portal for various forms of e-commerce, you will face this reporting requirement in 2012.

 

Beginning with your 2012 returns, you will have to report sales figures separately, on two separate lines: one for merchant cards and third party payments (generally, credit cards and remittances reported on Form 1099-K); and the other for cash and check payments. This requirement will apply to sole proprietorships (Schedule C) or rental properties (Schedule E), or other business returns (corporation, partnership, etc.).

 

You will therefore need to start tracking payments by type beginning in January, 2012. If you need any help setting up your accounting systems and procedures to separately track these amounts, please let me know.

 

Foreign accounts: The reporting requirements for assets held overseas are increasing convoluted, and the penalties for failure to report them are becoming increasingly draconian. Not all foreign holdings must be reported. If, for example you hold stock in a foreign company through a U.S. broker, foreign holdings are already reported. If you directly hold any other types of foreign assets, including bank accounts and securities accounts, please let me know, and if you have any doubt as to whether any of your assets are “foreign” for the purposes of compliance with current requirements, please contact me.

 

Property tax statements: California’s Franchise Tax Board has stated that they will require parcel numbers and other information pertaining to property taxes for any taxpayer who deducts property tax. Although this requirement isn’t slated to take effect in 2012, I would like you to provide me with copies of your property tax statements this year so I can do a preliminary review of them in preparation for the new requirement.

 

Use tax: California has long required payment of use tax if you purchase goods out-of-state that are used, consumed or stored in California, when no sales tax is collected on the purchase. Most such purchases are currently made over the internet or by mail order from out-of-state sellers. Taxpayers who don’t hold a California seller’s permit have the option of reporting the use tax on their California income tax returns , and in the past, reporting had been “voluntary,” and therefore ineffective. 

 

This is no longer the case. You now will have two options. You can total all untaxed out-of-state purchases and I will compute the use tax, or I can use  an official “lookup table” and report an amount due based on your California adjusted gross income. For example, if your adjusted gross income is $75,000, your use tax “due” will be $49. If your purchases are both over and under $1,000, you may elect to total just the purchases that are over $1,000 and I can compute the use tax on those and use the lookup tables for the small purchases.

 

New tax benefits

 

Not all the news is bad. There are a number of tax benefits that I can use to reduce your tax liability for this year and the future. There are new tax credits for employers providing health insurance, for small businesses increasing the number of employees, and an amnesty for payroll taxes, which has some major flaws, but could benefit your company.

 

Roth IRA conversions are still available and can be a useful way to reduce the tax you’ll pay later when you need the money.

 

Other changes

 

There are a number of other changes that might affect your tax return this year, including new rules for those who do not wish to file electronically, and a mandatory electronic payment requirement for higher income California individuals.

 

I anticipate sending out organizers to my returning clients before the end of January. When you receive yours, please take extra care in preparing it and providing all supporting documentation.  

 

Finally, if you want to file early because you’re expecting a sizable refund or for any other reason, please let me know before mid-January so I can schedule your return for filing before the March-April tsunami.

 

Thanks once again for letting me be your “tax guy,” and best wishes for the holidays.

 

Yours very truly,

 

Rick Zalon, CPA

 

Wednesday
Oct122011

The Higher Education Bubble

Wednesday
Feb022011

The Compleat Guide to Roth Conversions

Roth conversions have been getting a lot of publicity this year, for two reasons. First, 2010 is the first year that anyone can do them without being restricted by income limitations. Second, if you do a Roth conversion in 2010, you may report the income in 2010 or defer and spread it 50/50 in 2011 and 2012. 2010 is the only year this special defer/spread provision is available.

Briefly, when you make a contribution to a “traditional” IRA, you get a deduction but when you take a distribution, the amount is taxable. When you contribute to a Roth IRA you don’t get a deduction but distributions are tax free.

When you do a Roth conversion, it’s treated as if you take a distribution from your traditional IRA (taxable) and contribute it to a Roth. As such, the amount converted is taxable but it and any earnings after the conversion are tax-free when distributed.

In other words, do a conversion if your tax bracket will be low in 2010 or if you believe it will be low in 2011 and/or 2012, but recognize that despite their publicity, Roth conversions aren’t for everyone. Don’t do one if your tax rate is higher now than you believe it will be when you take distributions (generally, during retirement when you may have little other income). And remember the time value of money: paying tax now versus paying it later — or not at all — if you pass on the income to your children upon death.

 

CONVERSIONS – POST 2009

 

In taxable years beginning after December 31, 2009, the AGI limitation that prevented many taxpayers from converting traditional IRS is eliminated.

In addition, there is a one-time bonus in the law regarding income recognition. The taxpayer who makes a conversion in 2010 may recognize all the income in 2010 or spread the income over the next two years. The wording of the law is a bit odd: “. . . shall be so included ratably over the two-taxable-year period beginning with the first taxable year beginning in 2011.”

What this means is that if a taxpayer makes the conversion in 2010, he or she recognizes half the income in 2011 and half in 2012. Alternatively, the taxpayer may elect to recognize all of the income in the 2010 year of conversion.

One-time opportunity: If making a conversion in a year after 2010, the taxpayer recognizes all the income in the year of conversion.

California Conformity:

California conforms to these provisions. However, a taxpayer may make a separate election on when to report the conversion. The taxpayer may elect to report all the income to California in 2010 or ratably in 2011 and 2012, independent of the federal election.

Example of 2010 conversion:

In 2010, Irene converts her traditional IRA worth $10,000 to a Roth (she has no basis in her IRA). She may recognize $5,000 in 2011 and $5,000 in 2012. She may, however, elect to recognize the full $10,000 in 2010. If she makes the conversion in 2011, she must recognize the entire $10,000 in 2011.

MFS now eligible: Another change beginning in 2010 is that married taxpayers filing separate returns may now do Roth conversions.

Two-year deferral is the default:

Income recognition from a 2010 conversion will take place in 2011 and 2012 unless the taxpayer elects to report all of the income in 2010.

Can I amend?

Wouldn’t it be nice if we could choose one or the other – report the conversion in 2011 and 2012 or report it all in 2010 – and amend later when we know the client’s tax situation for each of those three years? After all, the general statute of limitations is three years, which would mean we’d have until April 15, 2013, to make our final decision. Unfortunately, we don’t have that option. IRC Sec 408A(d)(3)(A) provides in plain language:

Any election under clause (iii) for any distributions during a taxable year may not be changed after the due date for such taxable year.

Thus, it would appear that you can amend, but no later than the extended due date of the return (10/15/11).

Can I do both?

Can you elect to report some of the conversion in 2010 and spread the rest over 2011 and 2012? Generally, no. Both the two-year spread and the election are contained in IRC Sec 408A(d)(3)(A)(iii), which states, “unless the taxpayer elects not to have this clause apply . . .” As such, the choice is all or nothing.

It would seem that a taxpayer could not get around that result by converting multiple accounts. First, the IRC makes it clear that the taxpayer has a choice to make the relevant clause apply or not. Second, the IRS did not allow splitting treatment when 1998 conversions were allowed a four-year spread with an election out.

Joint return strategy: In the case of a joint return, there is nothing to prevent once spouse from converting his or her IRA and electing 2010 treatment, and the other from spreading over 2011 and 2012.

Taxpayer dies

If the taxpayer does a conversion and dies, the entire unreported amount is reported in the year of death. As such, if a taxpayer does a conversion in 2010 and dies in 2011, the entire amount of the conversion is recognized in 2011 (assuming the taxpayer did not elect to report income in 2010).

Important caveat

Before implementing this strategy, keep in mind the following: Under distribution rules, all of the taxpayer’s IRAs are combined. This can lead to undesirable results for a high income taxpayer.

Example: Steve makes nondeductible contributions totaling $22,000 in the years 2006 through 2009. He has no other IRA accounts. In 2010, when Steve’s IRA has a value of $26,000, he converts it to a Roth. Unless he elects otherwise, Steve will report no income in 2010, $2,000 in 2011, and the remaining $2,000 in 2012. Or, he may elect to recognize the entire $4,000 “gain” in 2010.

However, suppose in his younger years, he had made deductible IRA contributions. Those accounts now have a combined value of $74,000, bringing the total value of his IRA accounts to $100,000 ($74,000 + $26,000). He converts the account that holds the $26,000 in 2010. In this case, he may only use 22% of his IRA basis ($22,000 divided by $100,000). As such, he uses basis of $4,840 (22% X $22,000). His taxable amount is $21,160 ($26,000 - $4,840).

Conversion Planning—Generally

Contributing to a Roth IRA can be a no-brainer for an individual nearing retirement age with a few extra dollars to save. But does that same taxpayer benefit from a Roth conversion? Sometimes, yes, and sometimes, no. Consider such issues as tax bracket, income fluctuation, and estate tax when making the decision to convert a traditional IRA to a Roth IRA.

Individuals nearing retirement are often in the top tax bracket. If an individual will drop to a lower bracket in the next few years, paying the tax on the Roth conversion now may not compensate for tax-free income later.

But, if a taxpayer currently has a low income year, consider converting the traditional IRA to a Roth. Taxpayers with large business losses, net operating losses (NOLs), or large itemized deductions combined with low income are also good candidates.

NOL opportunity

When a taxpayer has a NOL, itemized deductions and personal exemptions often go unused. This is the perfect opportunity to convert all or a portion of a traditional IRA to a Roth IRA. Estimate how much can be converted without creating taxable income. Converting too much will result in taxable income at the lowest tax bracket. Converting too little will waste those personal deductions

Example of NOL

Terry has a $100,000 NOL carried forward from the prior year. His current AGI is $5,000 after applying the NOL. Terry’s itemized deductions and personal exemptions will be $20,000. Terry should convert at least $15,000 from traditional IRA to a Roth. This will bring his taxable income to zero.

Using charitable contributions

The charitable contribution deduction is limited by federal AGI. For most contributions, the law limits your deduction for charitable contributions to no more than 50% of AGI. Unused contributions may be carried over for five years before they expire. If a taxpayer is in danger of losing charitable contribution carryovers, doing a Roth conversion will

  • ·         Increase AGI;
  • ·         Increase charitable contributions by 50% of the AGI increase; and
  • ·         Increase taxable income by only 50% of the amount of the conversion.

The net effect of this plan is to cut the tax on the Roth conversion in half.

Effects of increased AGI on passive losses and Social Security taxability

The increase in AGI caused by Roth conversions can have negative tax consequences due to the phase-out of the $25,000 passive loss allowance on AGIs in excess of $100,000, and on the taxability of Social Security benefits for AGIs in excess of certain thresholds.

Cash outside the IRA to pay for the tax obligation

Assuming that you don’t have an NOL or other tax break to completely wipe out the income on the conversion, the taxpayer is going to need cash outside the IRA to pay tax on the conversion.

Conversion Planning—Recharacterization (the “Mulligan”)

If having excess deductions is the number one reason to do a conversion, the other number one reason to do a conversion is the “mulligan,” or the “do-over.” In the world or Roth conversions, the mulligan is the “recharacterization.” You make a conversion that you regret, so you recharacterize the conversion. Now you get to pretend that the conversion never happened.

What makes the IRA mulligan so inviting is that the deadline for making it isn’t until the extended due date of the return for the year of the conversion. This is true even if you don’t extend the return.

This means that if you do the conversion on January 1, 2010, you have until October 15, 2011 to decide if you really meant it.

Recharacterizing a high-value conversion to a Roth

When the taxpayer’s IRA consists of stocks and mutual funds, the lowest tax cost to the taxpayer is when a conversion is made at the time the market is at its lowest point since the taxable amount of the conversion is based on fair market value.

A taxpayer who converts from a traditional IRA to a Roth when the market is high will have an artificially high tax bill. If the market drops, the taxpayer may treat the conversion as if it had never been made by recharacterizing it. The taxpayer may later do the traditional-to-Roth conversion when the market is lower and therefore so is the tax cost.

Break into multiple Roths

Most account owners hold their IRAs with diversified portfolios in order to smooth out gains and losses. De-diversifying accomplishes the opposite—it accentuates gains and losses.

If you hold five stocks in your IRA, the probability that at least one of them will gain more than the average of the five is 100% (unless all five gain exactly the same). Thankfully, you can break out the five stocks in the single IRA and do five separate conversions into five separate Roth IRAs. If just one of the five appreciates substantially by the extended due date and the other four remain flat or decline, you can allow that one conversion to go through and recharacterize the other four.

Keep in mind that if you roll funds from a traditional IRA into an existing Roth that has a balance, then you must aggregate the gains and losses on all the assets in the account for the current year. This could diminish the tax benefits of recharacterizing. For the same reason, gains and losses will have to be aggregated if multiple assets are rolled into or acquired within a single Roth, even if the Roth is new.

Example of multiple accounts: Michelle converts $100,000 from her traditional IRA into a Roth. She uses the funds to buy $50,000 of Generic Stock and $50,000 of Plain Stock. By her extended deadline, Generic has gone up in value to $100,000 and Plain has gone down in value to $0. Michelle will have to recognize $100,000 of income if she allows the conversion to go through.

Kat does the same as Michelle, except she uses two separate Roths for the two stocks. Kat can let the conversion holding the Generic stock go through and recharacterize the Roth holding the Plain stock. She will recognize $50,000 of income.

Kat only has to recognize half as much income as Michelle even though their Roth IRAs have equal value.