What Is The True Cost Of An Early Withdrawal From Your 401(k)?

Tapping into your 401(k) as if it were a rainy day fund should always be a last resort. Many individuals are not aware of the negative tax implications of an early withdrawal from a retirement account. Before we go more in-depth, here are the key take-aways:

  • Borrowing or taking early withdrawals from your 401(k) can result in large tax burdens in addition to tax penalties
  • While exceptions exist, the most common withdrawals (education or buying a home) are still subject to tax penalties
  • If you borrow from a 401(k), loan funds will not grow in value and will automatically be converted to a withdrawal if you leave your employer, voluntarily or involuntary, while the loan is still outstanding.

401(k) Penalties

The penalties for early withdrawals from your 401(k) are assessed at a flat 10% rate on the total distribution. So, if you take a $50,000 distribution from your 401(k) before reaching 59 ½ years of age, you will owe a penalty of $5,000 before even paying any federal income tax on this amount. Remember, most 401(k) contributions are pre-tax deferrals, meaning you receive a deduction in the year you contribute, but you eventually pay tax on the withdrawals and earnings when you retire – hopefully in a lower tax bracket.

Exceptions to the Rules

There are exceptions to the 10% early withdrawal penalty mentioned above, but they are typically rare situations. Distributions made because of total and permanent disability and distributions made to cover medical expense that are deductible and exceed 10% of your adjusted gross income whether or not you itemize your deductions for the year. All exceptions can be found here.

401(k) Loans

Many employers and plan administrators offer the opportunity to borrow funds from your 401(k). Loans from your 401(k) can have some upside, such as low interest rates and not showing on your credit report, but there are also some downsides. Borrowed funds do not participate in the market or growth of your retirement account.

Quite possibly the biggest risk with loans is the immediate payback clause if you are laid off, quit, or are terminated as an employee. If you do not payback the full amount of the outstanding loan, the outstanding balance will be considered a distribution and no further repayment would be required. Not only does this subject you to the 10% early withdrawal penalty, but the withdrawal will be fully taxable at your marginal rate. Since this would be considered income, it can catapult you into a higher tax bracket, resulting in higher taxes on all your income.

Here’s a brief example of how this might look. Let’s say you are a married taxpayer with W-2 income of $150k. Based on 2017 estimated tax brackets, you would be in the 25% tax bracket. If you had a $50k loan from your 401(k) and were unexpectedly laid off, you would have to pay that loan back immediately. If you couldn’t afford to pay this loan back immediately, that $50k would become taxable in 2017, pushing you into the 28% bracket. The tax on that $50k distribution is now $14k PLUS the early withdrawal penalty of $5k, costing you a total of $19k. To summarize, a $50k early withdrawal would only leave you with $31,000!

Reminder: Donations this Giving Tuesday May Help Reduce Tax Bills

This Giving Tuesday, remember that donations to eligible organizations, cash or non-cash, are tax deductible and may reduce your tax liability come spring filing season.

Are you eligible to claim charitable donations on your taxes? Only taxpayers who itemize using Form 1040, Schedule A can claim deductions for charitable contributions. You will most likely be a Schedule A filer if you pay for items such as mortgage interest, property taxes, state & local taxes, and charitable contributions that in total, exceed the current year standard deduction. If your itemized deductions exceed this standard deduction for the tax year, you will likely receive a benefit from charitable contributions.

For example, in 2016 the standard deduction for married filing joint taxpayers is $12,600. If the total of your mortgage interest, property taxes, and charitable contributions is in excess of the standard deduction ($12,600), you are an itemized taxpayer.

Is the organization your are contributing to an eligible entity? You can check for eligible entities on the IRS website using their “Select Check” tool. Note that newer organizations may not be listed on the IRS website yet and churches, synagogues, temples, mosques, and government agencies are eligible to receive deductible donations even if they are not listed in the IRS database.

Lastly, be sure to document your contributions with bank statements or canceled checks. If you contribution is greater than $250, ask the receiving organization for a written statement or letter acknowledging your contribution.

Year-End Tax Moves – Speculating on President-Elect Trump’s Tax Cuts

President-Elect Trump declared in several interviews that lowering taxes is one of his top priorities. Those that are betting on him delivering this promise and passing reformation through a Republican controlled congress should consider deferring income to 2017 in an effort to take advantage of the possibility of lower tax rates.

The Trump tax plan, features only three brackets, down from the current seven, and reduces the maximum tax rate of 39.6% to 33%. The standard strategy for year-end planning has always been to defer income, wherever possible, into the coming year. Here are some ways to achieve this goal, and speculate on the possibility for change:

  1. An employee who believes a bonus may be coming his way may be able to request that his employer delay payment of any bonus until early in the following year. For example, if a bonus would normally be paid on Dec. 15, 2016, an employee may ask the employer before Dec. 15 to defer any bonus coming his way until Jan. 2, 2017. If the employee is successful in deferring the bonus, they will succeed in having it taxed in 2017 as opposed to 2016. But note that if an employee waits until a bonus is due and payable to request a deferral, the tax on the bonus will not be deferred.
  2. Income that a cash basis taxpayer earns by rendering services isn’t taxed until the client, patient, or customer pays. If the taxpayer holds off billing until next year, or bills late enough in the year that no payment can be received in 2016, income will not become taxable until next year.
  3. Defer a traditional IRA-to-Roth IRA conversion until 2017. Conversions are generally subject to tax as if it were distributed from the traditional IRA or qualified plan and not re-contributed to another IRA. A taxpayer who plans to make such a conversion should defer doing so if he believes the conversion will face a lower tax next year.
  4. Defer Property sales. The President-elect’s plan to repeal the Affordable Care Act (“Obamacare”) also would repeal the 3.8% surtax on net investment income. It may also be in best interest to set up an installment sale and recognize income over multiple tax periods.
  5. Trump’s tax plan also aims to increase the standard deduction ($30,000 for joint filers, up from the $12,600 allowed in 2016). Since most taxpayers may not receive the benefit for itemizing property taxes, mortgage interest, and charitable contributions under the proposed increased deduction, it may be wise to accelerate these expenses before year-end 2016. For example, property taxes may be due in January 2017 for the 2016 period, you can opt to pay early, prior to December 31, 2016, and accelerate this deduction.

While President-Elect Trump’s proposal has been listed as one of his top priorities, there is no telling what portions of this plan will ever make it into law. The five planning techniques above are just examples of scenarios that could reduce your overall tax burden in the event Mr. Trump follows through with his proposal.

 

When to File? Important Changes to Due Dates and more

As the 2016 tax year winds down, there is no better time than now to get your finances in order. Let’s face it, the last thing you want to think about during the holiday season is taxes. I compiled a list of the deadlines to follow after year-end. Please note that legislation during the year changed the due dates for many common forms. Below is a summary:

Individual Due Dates:

  • Individual Form 1040 – April 15th (no change)
  • FinCEN Form 114 (FBAR) – April 15th (previously due June 30th)

Business Due Dates:

  • Partnership Form 1065 – March 15th (previously due April 15th)
  • S-Corporation Form 1120S – March 15th (no change)
  • C-Corporation Form 1120 (calendar year) –  April 15th (previously March 15th)
  • Forms W-2 – January 31 (previously February 28 & March 31 if electronically filed)
  • Forms 1099-MISC – January 31* (previously February 28 & March 31 if electronically filed)

*This new due date is only for Forms 1099-MISC using Box 7 to report non-employee compensation.

For a complete list of all updated due dates, including Trust and Estate Forms 1041, and Form 990 for Exempt Organizations, the AICPA has compiled the changes into a PDF table.

Recently Divorced or Seperated? Here’s What You Need to Know

While taxes may be the last thing on your mind when going through a divorce, these events can have a big impact on your income. Alimony and a name or address change are just a few items you may need to consider. Here are some key tax tips to keep in mind:

  • Child Support.  Child support payments are not deductible and if you received child support, it is not taxable.
  • Alimony Paid.  You can deduct alimony paid to or for a spouse or former spouse under a divorce or separation decree. Voluntary payments made outside a divorce or separation decree are not deductible. You must enter your spouse’s Social Security Number or Individual Taxpayer Identification Number on your Form 1040 when you file.
  • Alimony Received.  If you get alimony from your spouse or former spouse, it is taxable in the year you get it. Alimony is not subject to tax withholding so you may need to increase the tax you pay during the year to avoid a penalty.
  • Spousal IRA.  If you get a final decree of divorce or separate maintenance by the end of your tax year, you can’t deduct contributions you make to your former spouse’s traditional IRA. You may be able to deduct contributions you make to your own traditional IRA.
  • Name Changes.  If you change your name after your divorce, be sure to notify the Social Security Administration. File Form SS-5, Application for a Social Security Card. You can get the form on SSA.gov or call 800-772-1213 to order it. The name on your tax return must match SSA records. A name mismatch can cause problems in the processing of your return and may delay your refund.  Health Care Law Considerations.
  • Special Marketplace Enrollment Period.  If you lose health insurance coverage due to divorce, you are still required to have coverage for every month of the year for yourself and the dependents you can claim on your tax return. You may enroll in health coverage through the Health Insurance Marketplace during a Special Enrollment Period, if you lose coverage due to a divorce.

In addition to the above, changes in your health insurance policy or income and family size can impact any advance payments you may be receiving with the premium tax credit. It’s important to fully understand the tax implications that a divorce decree may have on your overall tax picture.

If you have any question, leave them in the comments below!

The Ultimate Guide to Estimated Taxes (Form 1040-ES)

A common question I receive from small business owners is “how do I calculate my quarterly tax payments?” At the heart of this question is the fear of ending up like Al Capone. I hope to alleviate those fears and provide you with this ultimate guide to estimated taxes.

First, what are estimated taxes? Estimated taxes are payments of tax on income that is not subject to withholding. The most common types of income that are not subject to withholding are self-employment income, business income, rental income, and investment income.

Am I required to make estimated tax payments? You may be required to make estimated tax payments if you expect to owe over $1,000 in federal taxes after subtracting out federal tax withholding and credits.

Is there a difference between “ES taxes” and “Estimated Taxes”? Nope! They are the same. Sometimes estimated taxes are referred to as “ES” taxes because individuals would send payment with Form 1040-ES.

When are estimated taxes due? Estimated taxes are due in four installments, usually on the following dates:

  • 1st Quarter – April 15
  • 2nd Quarter – June 15
  • 3rd Quarter – September 15
  • 4th Quarter – January 15

Does the IRS have to receive my payment by the due date if I mail my check with Form 1040-ES? Nope! The IRS will consider your payment timely if postmarked by the due date.

How do I calculate estimated taxes? I like to break estimated tax calculations into two categories – safe-harbor calculations or actual calculations. The safe harbor provision states that as long as you pay 100% of the prior year tax liability (110%, if your AGI was >$150,000 in the prior year) or 90% of the current year tax, you can likely avoid any penalty on potential under payment. While you may owe additional tax come April 15th, this makes ES calculations much more simple!

Where do I find my prior year Adjusted Gross Income (AGI)? Your adjusted gross income can be found on Form 1040, Line 37 (for 2015).

Where do I find the total tax paid last year? The total tax paid in the previous year can be found on Form 1040, Line 63 (for 2015)

I’m still confused about this safe-harbor non-sense, elaborate! If you expect income (and therefore taxes) to increase year after year, you can simply take last years total tax, subtract out any year-to-date withholding (your spouses withholding from their job as an employee, for instance), and divide by 4.

Here’s an example: Last year, the total tax on Line 63 was $40,000. You work freelance and your spouse works as employee. Your spouse’s federal income tax withholding on their paycheck for the current year is $2,500/month or $30,000 for the year. Your business is growing, and just by looking at your financials on QuickBooks you see that you are on pace to increase net profit by 20% for the year! You know that you will owe more in tax, but you would prefer to hold on to the money for short-term capital needs or an equipment purchase, so you decide to make a safe harbor payment. Since your AGI was greater than $150,000 for the prior year, you will need to have a minimum of $44,000 ($40,000 x 110%) of federal taxes paid in for the current year to avoid penalty.  We subtract the amount your spouse will have in withholding, and arrive at $14,000 ($44,000 “safeharbor” tax that needs to be paid in at a minimum, less $30,000 estimated withholding from your spouses paycheck). We divide the $14,000 by 4, to arrive at $3,500. We will make four $3,500 tax deposits by each quarterly due date. Please note, this doesn’t necessarily mean you won’t owe any additional tax at the year of the year, but it does mean you will not owe any interest or penalty for underpayment of taxes.

I know it’s not that easy, do you have any other resources with examples? Okay, maybe your right, maybe estimated taxes are a little more complex than I am making them out to be. The IRS does try to simplify the process and put out instructions and resources on the topic. Estimated tax worksheets and instructions from the IRS website can be found here.

When should I use the safe-harbor provisions and when should I do an actual estimate? I recommend using the prior year tax safe-harbor calculation if you expect taxes to increase from the prior year. The current year safe harbor (90% of the current year tax) is ideal for individuals that may have had a high paying job prior to becoming a consultant or self-employed, and expect their tax liability to decrease significantly. Occasionally, we will calculate an actual tax due amount – if a client has a large unusual transaction, such as a investment property disposal, a large stock transaction, option exercise, or company exit OR if the individual prefers to not owe any tax at the end of the year.

What about Self-Employment taxes? Yikes! The dreaded self-employment tax. If you are subject to the self-employment tax, and want to use the current year safe harbor (paying 90% of the current year tax, as opposed to 100/110% of the prior year tax), refer to the worksheets on the IRS website previously mentioned.

How do I make estimated tax payments? You can make estimated tax payments by mailing Form 1040-ES with a check, using DirectPay on the IRS website, or EFTPS with the Treasury Department.

Do you have any other tips? That’s all I have for now – if you have questions, feel free to leave them in the comments!

If this post was helpful, feel free to share it with your friends! Since quarterlies are often overlooked, individuals sometimes end up paying penalties or interest that could have been easily avoided. Why give the IRS any more than you have to?

 

 

The Sharing Economy & How It Impacts You

The IRS recently launched a new resource center on IRS.gov aimed at providing tips for individuals that are taking part in the sharing economy. The past few years, the sharing economy has changed the way people travel, commute, and vacation. With new streams of revenue from assets that individuals already possess, come new requirements to ensure individuals file accurate tax returns.

The IRS, working in conjunction with the National Taxpayer Advocate, is taking steps to provide additional information to taxpayers, including the creation of the new Sharing Economy Resource Center on IRS.gov.

To help people meet their tax reporting responsibilities, the new Sharing Economy Resource Center offers tips and resources on a variety of topics ranging from filing requirements and making quarterly estimated tax payments to self-employment taxes and special rules for reporting vacation home rentals.

Here are a few key points people involved in the sharing economy should keep in mind:

  • Taxes. Income received is generally taxable, even if the recipient does not receive a Form 1099, W-2 or some other income statement. This is true if the sharing economy activity is only part-time or a sideline business and even if the recipient is paid in cash. On the other hand, depending upon the circumstances, some or all business expenses may be deductible.
  • Deductions. There are some simplified options available for deducting many business expenses for those who qualify. For example, a person who uses his or her car for business often qualifies to claim the standard mileage rate, currently 54 cents a mile for 2016.
  • Rentals. Special rules generally apply to the rental of a home, apartment or other dwelling unit that is used by the taxpayer as a residence during the taxable year. Usually, rental income must be reported in full, any expenses need to be divided between personal and business purposes and special deduction limits apply. But if the dwelling unit is rented out fewer than 15 days during the year, none of the rental income is reportable and none of the rental expenses are deductible.
  • Estimated Payments. The U.S. tax system is pay-as-you-go, based on the wherewithal to pay. This means that people involved in the sharing economy often need to make estimated tax payments during the year to cover their tax obligation. These payments are due on April 15, June 15, Sept. 15 and Jan. 15. Use Form 1040-ES to figure these payments.
  • Payment Options. The fastest and easiest way to make estimated tax payments is to do so electronically using IRS Direct Pay or the Treasury Department’s Electronic Federal Tax Payment System (EFTPS).
  • Withholding. Alternatively, people involved in the sharing economy who are employees at another job can often avoid needing to make estimated tax payments by having more tax withheld from their paychecks. File Form W-4 with the employer to request additional withholding. The Withholding Calculator on IRS.gov can also be a helpful resource.

If you have any questions about how the sharing economy may impact your taxes, feel free to contact our office.

 

Proposed Increases to the Social Security wage base

The Social Security Administration’s Office of the Chief Actuary (OCA) has projected an increase in the current Social Security wage base from $118,500 (2015 & 2016) to $126,000 for 2017.

This is bad news for those who are self-employed, operating as either a sole-proprietorship or a single-member LLC (SMLLC). Based on this estimate, each self-employed person with at least $126,000 in net self-employment earnings will pay $15,624 in Social Security taxes alone for 2017. This tax will be in addition to medicare taxes and income taxes at the taxpayer’s ordinary marginal rate.

Below are the social security wage base projections for 2017 on:

  • 2017 — $126,000
  • 2018 — $129,900
  • 2019 — $135,900
  • 2020 — $142,500
  • 2021 — $148,800
  • 2022 — $155,100
  • 2023 — $161,700
  • 2024 — $168,300
  • 2025 — $175,200

The OCA is projecting that the Social Security trust fund will become insolvent in 2034. As an entrepreneur, what steps are you taking towards minimizing your exposure to the Social Security Tax?

 

 

Accelerated Due Date for FinCEN Form 114

FinCEN Form 114, formerly referred to as “FBAR”, Report of Foreign Bank and Financial Accounts, is used to report a financial interest in or signature authority over a foreign financial account. The “FBAR” is due June 30 this year to report 2015 accounts, with no extensions allowed.

As part of the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015, tax years beginning after December 31, 2015 (beginning Jan 1, 2016), will be due April 15 with a maximum extension of 6 months.

The IRS has done a pretty good job with assuming this role on behalf of the Financial Crimes Enforcement Network and the Department of the Treasury. The first step they took was the electronic filing mandate a few years ago, and now, matching the deadline to the individual taxpayer deadline and adding an extension makes for a smoother filing season.

For more information on whether you may be required to file FinCEN Form 114, contact Paul Glantz, CPA at paul@launchconsultinginc.com

Due Date for Forms 1099 Quickly Approaching

Form 1099-MISC along with many other informational returns are due to recipients at the end of this month. Last year, I gave a brief outline of who may be be required to file.

Penalties for late filing range from $30-100 per late or incorrectly filed return. The maximum penalty is $250,000 per year. ($75,000 for small businesses).

These are pretty steep penalties for an informational return, and they are set to increase for the 2016 filing period ($50 for the minimum and up to $175,000 for small businesses).

 

For instructions on how to prepare Form 1099-MISC for the 2015 reporting tax year, visit the IRS website.

For information on due dates, and when and where to file, check out this IRS Publication.

If you have any questions about Form 1099-MISC contact Paul Glantz, CPA at paul@launchconsultinginc.com