Why You Should Consider Moving your Traditional IRA Into Your Current Employer’s 401(k)

Over the weekend I had a friend call for some tax advice – he was planning to purchase a duplex to occupy and rent and was considering taking a distribution from his IRA (ROTH & Traditional) and a loan from his 401(k) in addition to the cash funds he was going to use as a down-payment to avoid PMI. His proposal was this:

  • $25k loan from 401(k) – the max given his $50k vested balance
  • $10k early distribution from his Traditional or ROTH IRA
  • $35k in cash for the remainder for a total down-payment of $70k.

Long story short, I had recommended he roll his Traditional IRA into his employer’s 401(k), a little known maneuver, to increase the the amount of loan he’d be eligible for through his 401(k) (typically a maximum of 50% of the account balance or $50,000). This move saves him from draining his IRAs and their future earnings, as well as the tax on a $10,000 early Traditional IRA distribution. As an added bonus, he will now be able to contribute to his ROTH IRA in future years using the “back-door” ROTH strategy that many high earner’s utilize to navigate the contribution limits typically associated with ROTHs.

Reuters assembled an article detailing additional benefits that come with rolling your Traditional IRA into an employers 401(k), check it out here.

Disclaimer: This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

Ten Year-End Tax Moves To Minimize Your Tax Exposure

*Updated 12/28/17

With major tax reform looming, we compiled a list of year-end planning moves that can help you take advantage of the tax breaks that may be heading your way. While congress appears poised to enact tax reform this year, it’s by no means a sure bet. So keep a close eye on the news and don’t swing into action until the ink is dry on the President’s signature of the tax reform bill.

Both the tax bill passed the House of Representatives and the one before the Senate would reduce tax rates for many taxpayers, effective for the 2018 tax year. Additionally, businesses may see their tax bills cut, although the final form of the relief isn’t clear right now.

The general plan of action to take advantage of lower tax rates next year would be to defer income into next year. Here’s how:

  • If you are an employee who believes a bonus is coming your way before year end, consider asking your employer to delay payment of the bonus until next year.
  • If you are thinking of converting a regular IRA to a Roth IRA, consider postponing your ROTH conversion until next year. That way you’ll defer income from the conversion until next year and hopefully have it taxed at lower rates.
  • If you run a business that renders services and operates on the cash basis, the income you earn isn’t taxed until your clients or patients pay. So if you hold off on billings until next year—or until so late in the year that no payment can be received this year—you can defer income until next year.

Both the House-passed tax reform bill and the version before the Senate have provisions to repeal or reduce many popular tax deductions for 2018 in exchange for a larger standard deduction. You can maximize your tax benefit by accelerating these expenses. Here’s what you can do about this right now:

  • The House-passed tax reform bill would eliminate the deduction for nonbusiness state and local income or sales tax, but would allow an up-to-$10,000 deduction for real estate taxes on your home. The bill before the Senate would ban all nonbusiness deductions for state and local income, sales tax, and real estate tax. If you are an employee who expects to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding on those taxes. That way, additional amounts of state and local taxes withheld before the end of the year will be deductible in 2017. Similarly, pay the last installment of estimated state and local taxes for 2017 by Dec. 31 rather than on the 2018 due date, or prepay real estate taxes on your home.
  • Neither the House-passed bill nor the bill before the Senate would repeal the itemized deduction for charitable contributions. But because most other itemized deductions would be eliminated in exchange for a larger standard deduction (e.g., in both bills, $24,000 for joint filers), charitable contributions after 2017 may not yield a tax benefit for many. If you think you will fall in this category, consider accelerating some charitable giving into 2017.

Here are some other “last minute” moves that could wind up saving tax dollars in the event tax reform is passed:

  • The exercise of an incentive stock option (ISO) can result in AMT complications. But both the Senate and House versions of the tax reform bill call for the AMT to be repealed next year. So if you hold any ISOs, it may be wise to hold off exercising them until next year.
  • If you’ve got your eye on a plug-in electric vehicle, buying one before year-end could yield you an up-to-$7,500 discount in the form of a tax credit. The House-passed bill, but not the one before the Senate, would eliminate this credit after 2017.
  • If you’re in the process of selling your principal residence, wrap up the sale before year end. Up to $250,000 of your profit ($500,000 for certain joint filers) will be tax-free if you owned and used the property as your main home for at least two of the five years before the sale. However, under the House-passed bill and the bill before the Senate, the $250,000/$500,000 tax free amounts (“Section 121 exclusion”) would apply to post-2017 sales only if you own and use the property as your main home for five out of the previous eight years.  This proposal did not make the final cut
  • Under current rules, alimony payments generally are an above-the line deduction for the payor and included in the income of the payee. Under the House-passed tax bill but not the version before the Senate, alimony payments would not be deductible by the payor or includible in the income of the payee, generally effective for any divorce decree or separation agreement executed after 2017. So if you’re in the middle of a divorce or separation agreement, and you’ll wind up on the paying end, it would be worth your while to wrap things up before year end if the House-passed bill carries the day. On the other hand, if you’ll wind up on the receiving end, it would be worth your while to wrap things up next year.
  • Both the House-passed bill and the version before the Senate would repeal the deduction for moving expenses after 2017 (except for certain members of the Armed Forces), so if you’re about to embark on a job-related move, try to incur your deductible moving expenses before year-end.

Please keep in mind that some of the year-end moves that should be considered in regard to the tax reform package currently before Congress—which, may or may not actually become law. If you would like more details about any aspect of how the proposed legislation may affect you, please feel free to contact our office.

Year-End Planning: Tax Strategies for Employee Stock Options

Stock options can be complex and costly if you don’t properly plan for taxes. Two common forms of non-cash employee incentives are Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). With tax reform on the horizon, hopefully this post will help you make a more informed decision about the opportunities that exist before the end of the year.

Incentive stock options: ISO’s are qualified stock options granted to an employee that allow the employee to buy stock or ownership in the employer at a specified price. Many ISO grants have vesting schedules that need to be met as a condition of receiving the options. With ISOs, there are no regular income tax consequences when granted or exercised. A taxable event does, however, occur if/when the employee sells the stock at a gain.

An ISO has certain requirements that must be met. For example, the option price cannot be less than the market value of the stock at the time of the grant, it must be exercised within ten years from the time of grant, and the market value of the stock for any ISOs exercisable in any year is limited to $100,000.

To avoid disqualified dispositions and lock in favorable capital gain treatment, ISO’s generally can’t be disposed of within two years after the option is granted or one year after the stock is transferred to the employee.

If there is a disqualifying disposition of a share of stock, you would recognize ordinary compensation income equal to the “bargain element”. This bargain element is the fair market value (FMV) of the stock on the date of sale less the exercise price.

For Alternative Minimum Tax (AMT) purposes, when an ISO is exercised, assuming the stock is fully vested on the exercise date, the amount of the bargain element is included as an adjustment for alternative minimum taxable income. If the stock is not substantially vested in the year of exercise (still subject to forfeiture), income is includible under the Code Sec. 83 rules for AMT purposes. In future years, a tax credit may be allowed against regular tax for AMT paid on account of the adjustment for ISO exercises.

Launch Consulting Insight: Since the Republican plan for tax reform has called for the AMT to be repealed, it may be worth holding off on exercising ISOs until 2018, if the current tax bill is passed.

Nonqualified stock options: NSOs, are taxable similar to an employee receiving compensation income equal to the FMV of the option. If a NSO isn’t tradeable and has no “ascertainable market value”, a taxable event would occur when stock is received upon exercise of the options rather than at the time of option receipt. The taxable amount would be the “bargain element”, the difference between the stock’s market price on the date of option exercise, less the exercise price under the option.

Launch Consulting Insight: NSOs pose a more difficult dilemma with year-end planning. If you have NSOs, you may want to consider waiting to exercise until 2018 if you believe tax reform will be enacted and lower tax rates will apply in 2018. I would recommend factoring in market conditions, since an increase in the stock value over the waiting period could increase the amount of income subject to taxation. Alternatively, if the bargain element now is small, and you think it could increase by next year, you may want to consider exercising in 2017 to minimize the amount of ordinary income recognized on your bargain element.

Third Quarter Tax Updates

Interested in what’s happened over the last three months this year?

I’ve summarized the key tax developments that may affect you, your family, your investments, and your livelihood.

President Trump reveals tax reform plan. The Trump Administration and select members of Congress have released a “unified framework” for tax reform. This documents details a number of tax reformation changes but leaves many specifics unaddressed.

Provisions that would impact individuals include:

  • A standard deduction increase to $24,000 for married taxpayers filing jointly, and $12,000 for single filers;
  • Elimination of the personal exemption
  • A reduction in the number of tax brackets from seven to three: 12%, 25%, and 35%;
  • An increase of the child tax credit;
  • Repeal the individual alternative minimum tax;
  • Largely eliminate itemized deductions, but retain the home mortgage interest and charitable contribution deductions; and
  • Repeal both the estate tax and the generation-skipping transfer tax

Plan provisions affecting businesses would:

  • Applying a maximum 25% tax rate for “small” and family-owned businesses conducted as sole proprietorships, partnerships and S corporations;
  • A reduction in the corporate tax rate to 20% (down from the current top rate of 35%);
  • Provisions for full expensing for five years;
  • Partial limitation of the net interest expense deduction for C corporations;
  • Repeal most deductions and credits, but retain the research and low-income housing credits;
  • Provide a 100% exemption for dividends from foreign subsidiaries; and
  • Tax the foreign profits of U.S. multinational corporations at a reduced rate and on a global basis.

 

For more information on other key tax updates and how they may impact you, feel free to contact our office.

The Smartest Way to Minimize Tax on a ROTH IRA Conversion

Considering converting your Traditional IRA into a Roth IRA? You’re not alone. Many of my clients are wondering if they should convert their IRA now and pay tax on the conversion this year, or wait till next year when tax rates may be lower.

If you are already sold on converting to a Roth IRA, you can convert this year without worrying about changes to the tax code! If tax rates turn out to be lower next year under tax reform, you can use the recharacterize-and-reconvert strategy to shift the conversion’s tax consequences from 2017 to 2018.

What are the benefits of a ROTH conversion? Roth IRAs have two major advantages over traditional IRAs:

  1. While distributions from a traditional IRAs are taxed as ordinary income (except to the extent they represent nondeductible contributions), Roth IRA distributions are tax-free if they are “qualified distributions”
  2. While Traditional IRAs are subject to the lifetime required minimum distribution (RMD) rules that generally require minimum annual distributions in the year following the year in which the IRA owner attains age 70 1/2, Roth IRAs aren’t subject to the lifetime RMD rules that apply to traditional IRAs (as well as individual account qualified plans).

There are other tax advantages. Since distributions from Roth IRAs are tax-free (if they are qualified distributions), they could keep you from being taxed in a higher tax bracket. Not only that, Qualified Distributions from Roth IRAs don’t enter into the calculation of tax owed on Social Security payments, and they have no effect on Adjusted Gross Income (AGI) based deductions!

Keep in mind that converting from a Traditional IRA to a Roth IRA, (or from another pre-tax qualified plan to Roth IRA) is not income-tax-free. Instead, it is subject to tax as if it were distributed from the traditional IRA (or qualified plan) and not rolled over into another plan of the same type, but it generally isn’t subject to the 10% premature distribution tax. A substantial conversion could move a taxpayer into a higher bracket and/or result in reduced tax breaks that have AGI-based phaseouts or “floors”.

If you convert your pre-tax retirement account to a Roth IRA during 2017, you have the ability to determine when to pay tax on the conversion—in the year of the conversion, or in the following year. This unique opportunity allows you to minimize your tax liability on the conversion, should significant changes to the tax code occur.

Here’s how it works: If congress fails to pass a tax code overhaul, or if the reform fails to lower your 2018 marginal tax rate, and you are making a Roth IRA conversion this year, simply report the transaction on your 2017 return. But if tax reform succeeds, and your marginal tax rate will be lower next year (in 2018) than this year, you can shift the conversion’s income from 2017 to 2018 through a 2-step process.

Step 1 – recharacterization. The conversion from a traditional IRA to a Roth IRA can be recharacterized (reversed or cancelled out).

The recharacterization is made via a trustee-to-trustee transfer directly between financial institutions or within the same financial institution. Any recharacterized conversion (or Roth IRA rollover from a traditional IRA) will be treated as though the conversion or rollover had not occurred. Any recharacterized contribution will be treated as having been originally contributed to the second IRA, not the first IRA. The amount transferred must include related earnings or be reduced by any loss.

Ideally, a recharacterization should be made by the due date (plus extensions) of the taxpayer’s return for the affected year, and reflected on the return for that year.

However, you can make a recharacterization even after you have filed your return for the year for which a conversion to a Roth IRA was made. Technically, you have six months from the unextended due date of the return to make a recharacterization of the amount you previously converted to a Roth IRA. For example, a conversion from a traditional IRA to a Roth IRA in 2017 may be recharacterized as a contribution to a traditional IRA as late as Oct. 15, 2018. If you want to make a recharacterization after having filed the return for the affected year, you simply file an amended return reflecting the transfer, and write “Filed pursuant to section 301.9100-2” on the amended return.

Step 2 – reconversion. After you convert an amount from a traditional IRA to a Roth IRA, not only may you transfer that amount back to a traditional IRA in a recharacterization, but may later reconvert that amount from the traditional IRA to a Roth IRA. If you take these steps, your resulting income will be fixed at the time of the reconversion.

It’s important to keep in mind that a reconversion cannot be made before the later of:

  • The beginning of the tax year following the tax year in which the amount was converted to a Roth IRA; or
  • The end of the 30-day period beginning on the day on which the IRA owner transfers the amount from the Roth IRA back to a traditional IRA by way of a recharacterization.

This timing rule applies regardless of whether the recharacterization occurs during the tax year in which the amount was converted to a Roth IRA or the following tax year.

If you have questions on ROTH conversions, feel free to contact us for assistance!

3 Myths About Real Estate Taxation

As an active CPA, I often stumble across forums and blogs on the internet with a plethora of misinformation that makes me want to bang my head against the wall. While this blog isn’t intended to be a PSA, the tax code is complex and you should always consult with a tax professional before acting on advice of a friend, colleague, or stranger on the web.

I assembled a list of the top  3 myths about real estate taxation with the intention of setting the record straight. Here’s the top offenders:

Myth #1: You need a real estate license to be a real estate professional

While you may need a license to hold yourself out to the public as a “real estate professional”, to qualify for real estate professional tax status the IRS only requires that you meet certain annual time thresholds.

The rules are pretty simple, the IRS defines a real estate professional as a taxpayer that materially participates in real estate. Qualifications? Work 750 hours in a real estate capacity and spend more than half your time in a real estate trade or business.

So what is a real estate business or trade? The IRS lists the following: renting and leasing of realty, construction, development, buying, operating, and managing realty, as well as realty brokerage businesses.

Simple enough, right? The full text can be found in full under Code Sec. 469(c)(7)(B).

Myth #2: Flipping income qualifies as capital gain

The IRS says “real estate dealers”, individuals or business involved in the buying, improving, and selling real property (“flipping”), cannot qualify for capital gains – regardless of whether you hold the property for 1 year or longer!

Court cases have made this pretty clear – real estate dealers should treat the business of flipping property similar to any other inventory based business. Meaning, sole proprietors involved in flipping activities would also be subject to self-employment taxes. You should also be aware that “real estate dealer” status could also subject your rentals to “self-employment”.

There are several strategies a knowledgeable CPA can help employ to reduce exposure to some of the negative implications.

Don’t believe me? There are plenty of court cases that support this – email me for a list!

Myth #3: Passive losses disallowed in one year are lost forever

The IRS has rules related to “passive losses”. These rules often limit the amount of loss that can be taken in a given year for a rental property.

The good news is that if your rental shows a passive loss, no taxes are being paid on the rental income you received for the year! Hopefully, that loss being generated is just “tax loss” rather than a hard loss.

So what happens to the losses in excessive of your rents received? When you have a passive loss from your rental activities and cannot use the loss because of your income level or the passive loss rules, they become suspended until they can be used to offset future passive income or offset any gain in the year that property is disposed of in a sale.

While the key to effective tax strategy usually involves obtaining the largest benefit now, the passive loss rules can work out quite nicely in the future.

Oh, and you can and should always write off depreciation. If you don’t write off depreciation, you will run into quite a mess when you go to sell the property.

Any questions? Feel free to email me at paul@launchconsultinginc.com or leave a message in the comment section below.

 

Worried About Owing Taxes at Year-End?

Individuals should review their withholding and avoid having too little (or too much!) federal income taxes withheld from their paychecks. Nobody likes a surprise in April, so it’s best to review your withholding for the year now and take into consideration any life changes; such as marriage, changes in dependents, or changes in income. Having the correct amount taken out helps to move taxpayers closer to a zero balance at the end of the year when they file their tax return, which means no taxes owed or refund due.

What to do if you have any life changes such as changes in marital status, dependents, income, or credit eligibility:

  1. Use the IRS withholding calculator to help determine the correct amount of tax to withhold.
  2. Give your employer a new Form W-4, Employee’s Withholding Allowance Certificate, to change their withholding status or number of allowances. Employers use the form to figure the amount of federal income tax to be withheld from pay. Making these changes in the late summer or early fall can give taxpayers enough time to adjust their withholdings before the tax year ends in December.

There are also a few other resources on the IRS website, such as this article on tax withholding.

Self-employed taxpayers, including those involved in the sharing economy, can use the Form 1040-ES worksheet to correctly figure their estimated tax payments. If they also work for an employer, they can often forgo making these quarterly payments by instead having more tax taken out of their pay.

Feel free to reach out if you have any questions about withholding.

How to Handle an IRS Letter

The IRS mails millions of letters every year to taxpayers for a variety of reasons. Many of these letters are computer generated. It’s important to keep the following tips in mind if you are ever the recipient of a letter or notice from the IRS:

  1. Don’t panic. Most notices can be resolved with a simple response providing the requested information.
  2. While you shouldn’t panic, you should certainly not ignore the letter. The majority of IRS notices are sent in respect to federal tax returns or tax accounts. Since every notice is different, be sure to read the notice carefully. Most will require a response in 30 days.
  3. Respond timely. Most notices ask for more information about a specific issue or item on a tax return. Not only will a timely response minimize additional interest and penalty charges (if, any), but it will also prevent the IRS from automatically making adjustments for lack of a response from you.
  4. Some notices will come from the Automated Under Reporting Service Center. These notices will typically indicate a changed or corrected tax return. The most common occurrence is when the IRS has information from another source that was missing on your return, such as stock sales reported by your broker, but not included on your return. Review the information and changes on the notice and compare it with your original return. If you agree with the changes, you should note the corrections on your copy of the tax return for you records. There is usually no need to reply to a notice like this when you agree to the changes unless specifically instructed to do so, or to make a payment.
  5. Respond promptly to a notice you do not agree with. You should mail a letter explaining why you disagree to the address on the contact stub at the bottom of the notice. Include information and documents for the IRS to consider and allow at least 30 days for a response.
  6. There is no need to call the IRS or make an appointment at a taxpayer assistance center for most notices. If a call seems necessary, use the phone number in the upper right-hand corner of the notice. Be sure to have a copy of the related tax return and notice when calling.
  7. Always keep copies of any notices received with tax records.
  8.  The IRS and its authorized private collection agency will send letters and notices by mail. The IRS will not demand payment a certain way, such as prepaid debit or credit card.

For more more information on notices, or for notice resolution, please contact Paul at Launch Consulting, Inc for assistance resolving any IRS issues.

 


Child Related Tax Benefits For Reducing Your Tax Burden

Being a parent can have its benefits. This is especially so during tax time. No, your kids will probably not help you sort through your tax receipts, but you can certainly claim some child-related tax benefits when you file your federal tax returns.

Some of these benefits include:

  • Claiming the Child as a Dependent: Parents can deduct $4,050 (2016/2017) for each qualified dependent. However, if your income is over a specific limit, the amount that you can deduct will decrease.
  • Child Tax Credit: For each qualifying child below the age of 17 years, you can claim the Child Tax Credit. The maximum credit you can claim is $1,000 per child. Individuals in lower income tax brackets might qualify for the Additional Child Tax Credit (ACTC).
  • Child and Dependent Care Credit: To claim this credit, you must have paid for the care of one of more qualifying people. Paying for care must have enabled you to work or to look for work. The list of qualifying people also includes dependent children below 13 years of age.
  • Adoption Credit: If you paid certain expenses for adopting a child, you could claim a tax credit for the amount paid. Form 8839, Qualified Adoption Expenses provides more details on this.
  • Education Tax Credits: The tax authorities provide education tax credits to reduce your tax liability. These credits are comprised of the American Opportunity Tax Credit and the Lifetime Learning Credit. Even parents who owe no tax can qualify for claiming these credits. In some cases, these credits are phased out (high income earners) or have reduced the amount of tax owed to less than zero. The latter situation invariably results in a refund.
  • Student Loan Interest: Parents might be able to deduct the interest paid on a qualified student loan. They can claim this even if they do not itemize the deductions. Use this Interactive Tax Assistant for determining if the interest you paid on a student or educational loan is deductible.
  • Self-Employed Health Insurance Deduction: The authorities permit taxpayers to deduct the premiums paid during the year. Self-employed taxpayers who paid for health insurance can avail this deduction.
  • Earned Income Tax Credit (EITC): You could get a credit of as much as $6,269 in EITC (2016) if you worked but earned less than $53,505 last year. In addition, you could qualify with or without kids. Refer to the EITC Assistant tool for more information.

If you have any further questions, feel free to contact me at paul@launchconsultinginc.com

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!