THE FOLLOWING IS JUST A BASIC OVERVIEW THAT REQUIRES ADDITIONAL
CONFIRMATION BY AN EXPERT BEFORE PROCEEDING FURTHER
Click to Buy it now!
These issues were identified in several classes in financial planning as
key items that consumers needed to know and/or were being confronted with
in their everyday lives. Always check with a professional on any area of
taxes. Further, recognize that the government is changing tax law as we speak
and you cannot depend on what was valid even just a few months (days) ago.
Taxes: the 1% of American households with the highest incomes -- those earning
an average of about $1 million a year -- pay about 31% of their income in
federal taxes, including payroll tax and income tax, according to the
Congressional Budget Office. The 20% of households with the lowest incomes
-- those earning an average of about $15,000 a year -- pay less than 5% of
their incomes in taxes.
In 1980, households in the bottom 20% of the income distribution earned 5.7%
of all income and paid 2% of all federal taxes; in 2003 -- the most recent
data available -- they earned 4.2% of all income and paid 1% of all taxes.
Meanwhile, the highest earning 20% of households earned 45.8% of income in
1980 and paid 56.3% of all taxes. In 2003 those high-income households earned
52.2% of income and paid 65.7% of taxes.
There are 66,498 pages of federal tax rules in the commonly used Standard
Federal Tax Reporter. In 1913, when the federal income tax was introduced,
there were 400 pages.
1. 1034 Rollover: Eliminated. Now couples get a $500,000
offset for appreciation upon selling a home and singles get $250,000 if you
own and live in it for two out of the last five years. The once in lifetime
$125,000 over age 55 exemption is repealed.
The exclusion does not apply to depreciation after 5/6/97 so using a home
office deduction may not be the best thing to do since depreciation is recaptured
A partial exclusion for the two year ruled is allowed for change in employment,
health reasons and and unforeseen circumstances. Then the amount is generally
For those going into a nursing home, the two year test is reduced to
just one year.
2. Basis- Original basis is what you bought something for
(gift basis not covered under this discussion). Current or existing basis
is original basis minus any depreciation plus any improvements (taxable
additions). Gain or profit is measured from existing basis. This is ABSOLUTELY
NECESSARY to understand in the use of investments and for estate planning.
I'll first discuss pension plans, IRA's, annuities and the life. Parts are
addressed later anyway. Remember again, that this cannot be the complete
treatise on all the intricacies, so be sure to contact an expert before
proceeding to do anything.
When you put money into a standard NON QUALIFIED annuity, you have taken
previously taxable money and put it into a tax sheltered account. That's
because the funds grow tax deferred until withdrawn. Once withdrawn, the
growth is taxable as (REMEMBER THIS) ordinary income on amounts above
Example. Assume you put $25,000 into an annuity. Since the $25,000 was already
taxed, it becomes your taxable basis. If your funds grew to $75,000
by age 65 and you withdrew everything, then $50,000 would be taxed ($75,000-
$25,000 basis) as ordinary income.
If you took out sporadic amounts of money, how would they be taxed? As ordinary
income first. Under the new tax laws, this process is called last in first
out (LIFO) The last money out is the first money taxed. So withdrawing $2,500
is taxed fully as ordinary income. Another $6,345 comes out as ordinary income.
Once you have used up all the growth and get down to where nothing is left
except your basis of $25,000, then any return of those funds is tax free.
(Prior to 1986, it was first in first out (FIFO) and the first distributions
were non taxable until the basis was used up and only then became taxable.)
The last method for taking money out is over your lifetime or five years
whichever is longer. Using made up numbers, assumed you were 65 and were
expected to live to 85. The total funds would be divided by 20 years (simplistic
method). As such, you might get $1,000 per month of which part was growth-
we'll say $750 as taxable- and the rest of $250 was a return of basis and
nontaxable. Once you had received enough of the payments where all the basis
is used up, all subsequent payments are fully taxable as ordinary income.
The major consideration is of death. When you die,
the basis on the annuities held above does NOT change
for your beneficiaries. THERE IS NO STEP UP IN
BASIS.$75,000- $25,000 basis = $50,000 as ordinary income.
Now consider the standard mutual fund. Assume you bought one for $25,000.
Over a period of 10 years, your taxable basis WILL adjust (current or adjusted
basis) due to the distributions of dividends and capital gains (even though
you just simply checked off the boxes to reinvest dividends and capital gains
and never saw the money directly.) Since you could have gotten them (called
constructive receipt), they become taxable. You'll get a 1099 each year for
these distributions and you need/must adjust your basis upon a subsequent
sale. Let's say that your fund is worth $75,000 in ten years and the basis
increased over the years to $35,000 and you sold all shares. (The basis for
selling individual shares is basically determined by first in first out method
(IRS), Share identification (Preferred) and average cost method. There are
other methods however.) The gain of $40,000 is taxable as LONG TERM GAIN
which is traditionally much lower than ordinary income rates. Nice savings.
But the key is this. Assume you die and the $75,000 is passed to your son,
friend, me. The assets get a full step up in basis
to $75,000 upon death. Subtracting the value from current
basis ($75,000- $75,000= $0) leaves zero dollars to be taxed. Now, which
is better as a beneficiary? Ordinary income tax from the $50,000 in the annuity
or No tax on nothing?
There is one other type of asset to be considered. For personal or real property
used in a trade or business or held for the production of income, depreciation
is available along with some of the attributes listed above.
Assume you have a rental home worth $100,000. You may depreciate (covered
more fully in paragraph 3 below) the asset (EXCEPT FOR THE LAND) over a period
of time and deduct the amount from current taxes (many caveats apply. If
you want to know which ones contact a CPA or buy a book). Assume $25,000
was land and that the other $75,000 was used a tax deduction through depreciation
over the years. When you go sell your property you need to add back in the
land value and get $25,000. (If you hadn't taken all depreciation yet, the
basis is adjusted accordingly.) If the property was worth $100,000, then
you had a $75,000 long term capital gain ($100,000 minus adjusted/current
basis of $25,000). Better tax aspects than an annuity though it's like comparing
apples and oranges in other considerations. (And just so you know, the capital
gains rate is based on your income tax bracket and does not exceed 20%. But
depreciation is "recaptured" at a 25% rate.)
But you die again. Guess what? The basis is stepped
up to the full value at the date of death- $100,000. Your
beneficiaries then sell the property for $100,000 and have $0 tax. So, everything
else being equal (caveats can apply), which is better?. Long term capital
gains and a full step up in basis for many assets or ordinary income and
no step up in basis for pension plans, IRA's, Keogh's.
3. Depreciation- This is a tax deduction that represent
the wasting away of an asset. Business personal property is depreciated over
various schedules of 3, 5 and 7 years. Residential real estate is depreciated
over 27.5 years; commercial over 31.5 years (law changed to 39 years for
property placed in service after May 13, 1993- exceptions apply). Do not
depreciate land. Take out value of land, set aside and then add back in to
existing or current basis when property is sold.
Under the new laws, depreciation is recaptured at a 25% rate. This may preclude
the use of a home office deduction.
4. LTCG, LTCL, STCG, STCL-At the end of each tax year, an
investor looks at all the long term positions (assets held over one year)
and short term positions (held less than one year). If both positions are
gains, they are taxed according to the long term capital gain rates and ordinary
income as applicable. If there are long term gains and losses, they are offset
each year against each other. The same is done with short term capital gains
and losses- net them. If there are both long and short term positions when
finished and they are different (gains and losses), an investor
nets them together and whatever is left retains the characteristic of the
larger. If a loss however, only $3,000 net losses may be used per year. The
rest is carried over to subsequent years and netted again. The same criteria
applies if both the long and short term positions are both negative. In such
cases, only $3,000 is allowed as a deduction this year using the short term
first. Anything left over is carried forward to the following year and the
whole thing starts over.
Example: Assume $40,000 long term capital loss (LTCL) and a $60,000 long
term capital gain (LTCG) in 2002
Also during 2002, a $90,000 short term capital loss (STCL) and a $50,000
short term capital gain (STCG).
Net long term positions= $20,000 LTCG
Net short term positions= $40,000 STCL
Net together. Whatever is larger is what it is. $40,000 STCL- $20,000 LTCG=
$20,000 STCL. But an investor is allowed to use only $3,000 of a loss each
year. So there would be a $17,000 STCL carryover and the process is started
all over again.
The above numbers were developed as though everything was bought and sold
during the year without taking into account the end result. The point being
is that $17,000 of a Short term loss will need to be carried over to the
next year. Wasn't there are possibility that something else might have been
sold for a gain this year in order to absorb some of the excess loss?
The maximum capital gains rate is currently 15% bracket. Enjoy it while you
5. Expensing option-
6. Social Security and Medicare-
7. Business Use of Home- Must be principal place of business
and most of business income is attributable to activities there. Space must
be used exclusively for business. Physical separation from rest of home is
helpful. Taxpayer can deduct applicable percentage of maintenance and utilities
for space and can actually depreciate space over 31.5 or 39 years. But value
is lower of fair market value at time of business start or its basis. Deductions
cannot exceed net income from business.
SPECIAL NOTE: Remember that when the home is sold, there is a lower basis
overall and more appreciation and tax to pay. Additionally, any depreciation
MUST be recaptured at 25%.
Before you take the deduction, check with an expert. The IRS has been contesting
this. However, starting in both 1997, if you have inventory in a separate
room, you may count that as part of the room "space" so the policy is now
a little more liberal. And under the new 1998 tax rules, the office does
NOT have to be the exclusive place of business.
8. Social Security Benefit taxation- Workers add their AGI,
tax exempt interest income and one half of the social security benefits received
that year. If the amount exceeds $25,000 single; $32,000 married filing joint;
$0 if married filing separately, then the LESSER of the following is declared
as taxable income- one half of the social security benefits which the worker
received that year or one half the excess over the $25,000, $32,000 or $0
If AGI exceeds $34,000 single or $44,000 MFJ, then the taxpayer must include
in taxable income the LESSER of
1. 85% of social security benefits or
2. a fixed amount ($6,000 for MFJ or $4,500 for individuals) or the amount
included under present law whichever is less; PLUS 85% of income (includes
tax exempt interest) that exceeds $44,000 MFJ or $34,000 single.
In other words, the government is taxing the benefits received at 50% or
85% if there is too much money received from all sources- and that includes
municipal bond interest. This is different losing benefits if you make too
much money- item 6 above.
9. Deductible Interest- $0 for personal interest. All interest
on a residential loan of $1,000,000 or less. But to that can be added another
$100,000 of an HEL (Home Equity Line) and that is also fully deductible.
Obviously many many homeowners have converted non deductible personal, credit
card and car interest by taking out an HEL loan.
But consider this. Assume you had a $400,000 home paid in cash. When rates
were low, you refinanced for a $250,000 loan. How much of the interest is
deductible? Only the amount on $100,000. (Yes, there are issues regarding
acquisition debt, substantial improvements, etc. but that is why you would
need to contact a CPA.)
10. Kiddie Tax- Idea in past was to gift property to children
and have assets taxed at lower tax rate. Parents could act as trustees on
UGMA and UTMA's (Uniform Transfers to Minors).
SPECIAL NOTE: Parents may gift money to these accounts and put them into
growth funds that might appreciate well until the child turns 18. However,
the funds belong solely to the child at the age of majority and he/she may
do anything they want. Most parents do not want to take the risk. Further,
if the funds were to be used for college, college formulas look to take 35%
of a child's assets but only 6% of a parents. Therefore it might be cheaper
for a parent to pay the higher tax on any earnings, maintain control and
actually give less to the college.
11. Gifting up to $12,000 per person per year is allowable
without any reporting or tax consequences. Gifts over $12,000 per year up
to the lifetime exemption of $1,000,000 must be reported but no tax need
be paid. Gifts over $1,000,000 (excluding $12,000 amount available each year)
is subject to gift tax.
IMPORTANT: Read again the above. It is possible to use your $1,500,000
(2005) lifetime exemption during life. You do not have to wait till you die.
It may be very beneficial to take a highly appreciating asset out or your
estate well before anticipated death. (However, tax is only offset for the
One other item. When you gift something, the asset received will normally
carry the same basis as it had from the giftor. Sometimes it is not a good
idea to gift. For example, if you were 75 years of age and in ill health,
gifting an asset worth $10,000 with a $2,000 basis means the recipient, if
they sold the asset then, would have long term capital gains on the $8,000
of profit. However, if you died and they received it as a beneficiary, the
basis would have been stepped up to the value at the date of death. They
would incur NO tax upon a sale at that price. The issue, is of course, timing
and when you will die. But it's what you are supposed to think about in order
to do good estate planning.
Lastly, there are a couple exceptions to the general rules. If, say, a
grandparent pays your hospital expenses of $25,000 DIRECTLY to the hospital,
there is not gift per se. If a grandparent pays your son's tuition directly
to the University, there is not a gift, per se. Obviously, these are just
the main elements and you need to review each tax section carefully to assure
that you are not violating some section.
12. Real Estate losses- Most losses on real estate or other
activities where there is not active involvement are not (usually) currently
deductible against earned income. However, if an investor has an AGI under
$100,000 and can be shown to have some form of involvement in the management
of a property, then up to $25,000 of losses may be offset against the AGI.
The allowance is only available on real estate and is phased out between
AGI between $100,000 and $150,000.
Current law also says that passive losses may be deducted directly against
ordinary income as long as taxpayers spend at least 50% of their personal
services in real estate trades or businesses and spend more than 750 hours
during the year performing real property related personal services.
Tricky area- check with a professional
13. $125,000 exemption on home sale- Gone under new tax
law. See Number 1
minimum required retirement distribution rules.
15. IRA's: IRA
INHERITED IRAS –
16. Points on a loan. If the loan is for the purchase of
a home are deductible in the year of sale if:
1. The loan was for a purchase or improvement of and secured by your principal
2. The charging of points in your area is a normal practice
3. The amount is computed as a percentage of the stated principal amount
of the mortgage.
4. The amount must be paid directly by you and not from the mortgage funds
If these requirements are not met, the points are deducted rateably over
the period of the loan. If the property is sold before the mortgage is paid
off, the remaining points are a deduction that year.
17. Tax Credits
||Maximum Tax credit per year
18. Basis upon gift and death. Assume your grandmother had
stocks worth $1,000,000 and had a current basis of $200,000. If she were
to gift them to a nephew, the nephew would receive the assets
with a basis of $200,00 as well (basis may be adjusted if value has gone
down- check tax codes for further information) and would incur a substantial
tax when they were sold. However, if she were to die and bequeath the stock
to the nephew, there is a step up in basis at the date of death to the full
$1,000,000, The assets may then be sold for no taxable gain.
Note: This has essentially nothing to do with the issues of estate or gift
tax- that's a separate issue.
19. Gains on discounted bonds purchased after April 30,
1993 are taxed at ordinary income tax rates- as high as 39.6% federal instead
of the long term capital gain rate.
20. Pension plans payouts. Recognize that literally all
pension plan payments are taxed as ordinary income since none of the assets
had ever been taxed. But that's also true when the assets are given to
beneficiaries upon death. There is no step up in basis.
If you had $250,000 in a pension plan and died, your beneficiary will need
to pay ordinary income tax on the entire $250,000 (though various payout
schedules may be used).
The planning that one may consider therefore is if there were other assets
that were being used during retirement that might be better left alone. Consider
some real estate rentals that the retiree was selling off to fund retirement
with the hopes of leaving as much of the IRA and pension plans to beneficiaries.
Wrong idea. Better to take payments at full tax from the pensions and leave
the real estate to the beneficiaries where the could get a full step up in
basis and incur NO tax.
21. Five year and ten year averaging from a pension plan.
Depending on your age, you may elect to "average out" the tax on a lump sum
payment from a pension at retirement rather than having it taxed in full.
Worthwhile? Well, recognize that you can roll the funds to an IRA- as most
people do- and keep deferring tax on any growth. However, in doing so you
will lose the ability to do the averaging at a later date. Further, all IRA
funds are taxed only as ordinary income. Needs a lot of review before you
commit including how old are you, what would you invest the money in and
at what rate, do you need money now, how long will you live, what other asset
do you have, etc. Five year averaging terminated at year end 1999.
22 Premature distributions from a pension plan. If you leave
a company- quit, laid off, etc.- most will require you terminate their pension
plan. If you take the money and do a transfer to an IRA, you can defer any
tax on the funds. But if you did a supposedly standard ROLLOVER, you could
get hit with a big tax.
Under normal methods, you are allowed to take money from an IRA, use it for
whatever, and then pay it back within 60 days and incur no tax.
But if you take money from a pension plan- even with the intent to roll it
to an IRA, congress requires your employer to WITHHOLD 20% of the amount
form the distribution. So if you were to get $100,000 normally, you'd get
only $80,000. But then you'd have to pay an IRA the full $100,000 back- which
means taking an extra $20,000 out of your pocket. If you don't do that, you
will be taxed on the $20,000 as ordinary income plus an additional 10% penalty
if you are under 59 1/2.
You can avoid the problem by doing a trustee to trustee
transfer. In such case, the money is NEVER received by the employee
and no 20% "holdback" occurs.
23. Long Term Care: Proceeds on long
term care insurance is tax free if you buy the special policies. A portion
of the premiums for a policy may be deductible- but only against the 7.5%
AGI. This means that perhaps only 5% of recipients will be able to get the
If your Tax Qualified policy pays "benefits", they are not taxable. But taxable
benefits from Non Qualified policies are a medical deduction against
7.5% of AGI. After all said and done, the Non TQ policy may provide
more and faster benefits for an acceptable cost.
24. Comparison of Coverdell account with Section 529 plan
25. Shorting Against the Box: This used to be a method
of insulating a stock holding that was losing value by going short the stock
at the same time. Gain is now recognized when you sell the borrowed shares.
26. Capital Gains:
27. Estimated Taxes:
ALTERNATIVE MINIMUM TAX: "Millions more taxpayers
will become subject to the alternative minimum tax..."
ALTERNATIVE MINIMUM TAX LINK:
The Alternative Minimum Tax for individuals is subjecting more and more
Americans to complex tax rules and higher income taxes than they would otherwise
pay. Here is the pdf report by the Joint Economic Committee, "The Alternative
Minimum Tax for Individuals: A Growing Burden"
ASSET PROTECTION LINK:
As many as 80% of Web advice-givers are also advocating tax fraud.
Here is some straightforward advice covering family limited partnerships,
selecting a foreign trustee, foreign bank accounts, avoiding scams and much
AUDIT STATISTICS: Want to know the odds for
being audited? Of course you don't, but here they are anyway.
CALCULATOR LINK: This calculator uses supplemental tax rates to
calculate withholding on special wage payments such as bonuses. If your state
does not have a special supplemental rate, you will be forwarded to the aggregate
bonus calculator. This is state-by state compliant for those states who allow
the aggregate method or percent method of bonus calculations.
DEFERRED COMPENSATION AND IRA BENEFITS LINK: Intense material on distribution
prepared by an attorney. Once in awhile I will designate how distributions
are made on IRA's- but only if it is SIMPLE. Most of the time it gets to
be VERY convoluted and you need a specialist. I am not kidding here. Never
do this at home!! Very scary material.
DISTRIBUTIONS LINK: Section 72(c) and its recent revisions.
IRA LINK 1: The IRS bulletin
on Employee Stock Purchase Plans
on IRA Accounts
on Lump Sum Distributions
on Pension Plans
on Profit Sharing Plans
on Roth IRAs
on SEP IRAs
on Simple IRAs
on Social Security Benefits
EARLY CALCULATOR LINK: If you retire before 59 1/2, you can take
out portions based on your actuarial lifetime and current rates. This calculator
requires a Java browser.
REVENUE BULLETINS LINK: (PDF format) Weekly bulletins. Just the thing
to discuss at family dinner.
IRA LINK: IRS pdf
LINK From Morningstar.
INHERITED 401KS AND IRAS LINK Kathleen
Pender San Francisco Chronicle article in full. Good stuff on complicated
DISTRIBUTION LINK: VERY extensive information on all . Hot Topics
and Recent developments in plan distribution By Noel C. Ice
IRS FORMS LINK:
SALES TAX DEDUCTION CALCULATOR LINK:
RULING LINK: IRS's private letter rulings and technical memoranda by
their most recent publication number.
IRS TAX LINK: Gets you directly
to the forms you might need. You can get to their other sites from there.
NANNY TAX LINK:
This site lets you estimate payroll taxes and calculates your Nanny's
take home pay for any state.
ROTH IRA: By George Chamberlain
ROTH IRA LINK 1: Many people wonder
about this non taxable IRA. Here is a page with tons of articles on the
value, some software applications, etc.
LINK 2: The site provides a calculator, case studies, examples
on why IRA calculations differ depending on tax and funding assumptions and
LINK 3: Various example showing how a ROTH IRA works and whether it will
be beneficial. Believe it or not, some ROTH IRA's will actually hurt a retiree.
S CORPORATION LINK: Knock yourself out with the U.S.Code.
TAX ON EARLY DISTRIBUTIONS
FROM A RETIREMENT PLAN IRS Code 558
ESTIMATOR LINK: A Quicken tool that allows to estimate your
taxes as the year goes on
TAX GLOSSARY LINK: Over 2000
entires including some esoteric issues as well.
TAX LINKS 1: A major link
to many tax pages.
TAX LINKS 2: A large sites with links
to government, commercial, and academic sites related to taxes.
TAX LINKS 3: An extensive site that
includes the potential changes in 2001 and more.
TAX LINK 4: Huge listing of all sorts
of tax issues in the United States. You can go to their home page and do
the same thing for other countries.
TAX GUIDE FOR ALIENS LINK:
Tough stuff- good info
TAX GUIDES: Investment
Income and Expenses ...IRS Publication 550
Tax Guide for Investors ...Fairmark
and Other Corporate Distributions ...IRS Publication 17, Chapter 9
Gains and Losses Topic Page
Income ...IRS Publication 17, Chapter 8
Mutual Fund Distributions
...IRS Publication 564
Passive Activity and At-Risk
Rules ...IRS Publication 925
Personal Finance & Investing
Wash Sale Rule
TAX PENALTY LINK: Having problems
with penalties regarding noncompliance with income and payroll taxes withheld
for paychecks that were not being quickly turned over to the government?
But how much really are the penalties?? This site "enters your information
and then automatically tries over 250 ways to reduce the penalty." Worth
RATE COMPARISON LINK A Quicken site that lets you compare adjusted
gross income ranges to see how your return stacks up against others with
TAX STATISTICS LINK:
The Statistics of Income (SOI) program produces data files on individuals,
corporations, estates, employee plans and much, much more. Great for
GUIDELINES ON LIFE INSURANCE AND ANNUITIES LINK You have no idea
how difficult this material can be.
U.S. TAX CODE LINK:
The entire code. Go for it!
WORLDWIDE TAXATION LINK: Extensive
listings and information to many countries around the world.