Are You Paying The Right Income Taxes?

Combining Tax Planning With Financial Planning

It’s that time again! The mad rush to understand undecipherable tax forms, collect long-lost receipts, gather 1099s and decide how honest you or your accountant will be in your tax return preparation.

Ah, but is that really the best approach? Are you paying the right income taxes?

A few questions to start…Do you prepare your own tax returns? A recently aired TV ad from ol’ reliable H&R Block states that “people who do their own taxes lose $1 Billion a year”.

But let’s ask an even more annoying question. Do you have a professional prepare your taxes and your financial plans? If you don’t have a qualified professional work with you to plan your tax strategy as part of your financial plan you’re probably burning money.

Let’s start with a bold comment: Tax Planning for 2013 should have started years ago.

To maximize your wealth and reduce your anxiety, tax planning should consider opportunities/consequences related to the key financial planning events in your life, including some of the following:

• When should I claim Social Security?
• When/how should I sell major assets e.g. house, stocks?
• How do I remember/verify potential Itemized Deductions?
• Whether/when I should convert to Roth IRA?
• What is my best investment strategy?
• What Estate planning will I pursue?
• What is my primary residence?
• And a long list of Etc.s

Let’s look at 5 examples to see how tax planning and financial planning need to be coordinated.

Example 1: Social Security decisions affect tax options

Deciding when and how to claim Social Security can significantly affect your wealth. As an example, for my wife and I the “optimal” Social Security decision should result in a potential $400,000 windfall over the “standard” approach, per analysis by an SS expert[1]. (We’ll review the details of the “optimal” approach in another article.)

But, the “optimal” scenario means I must forego collecting most of my SS income until I’m 70 (this results in receiving 30+% higher SS amounts thereafter).

But, at 70 ½  years old I must start taking my mandatory IRA distribution. That means our taxes will soar since my higher SS income will be combined with a healthy IRA distribution.

So, that suggests another tax decision. Should I convert to Roth now while my tax rate is lower? And, how much can I convert each year to pay the lowest taxes while not busting my budget?

To say the least, these hundred thousand dollar questions deserve professional review.

Example 2: Manage Spending and Receipts to Optimize Itemized Deductions

Here’s an example that applies to most of us. Have you ever been troubled by the fact that you can’t find receipts for certain tax expenditures? Or, have you ever realized that spending money in one year vs. another could have reduced your taxes substantially?

Let’s look at itemized deductions. Ok, I recognize that some of you may think that you get a “free pass” on itemized, trying to claim as much as you can without getting caught. Now remember, I was an IRS Tax Auditor for several years, so I’ve had to audit to some of those “interesting” claims.

Here’s the law. There are 7 Itemized Deduction Categories: Medical & Dental, Taxes, Interest, Charities, Casualty & Theft Losses, Job and Certain Miscellaneous, Other Misc.

With each of these categories there are Pitfalls and Opportunities. Here are the two most frequent pitfalls:

• Failing to claim the total you actually spent
• Claiming too much without verification, which risks audit.[2]

There are some simple solutions to these pitfalls. There is great software available to automatically capture, categorize and manage expenses[3], as well as scanning  software to keep records for selected receipts. Don’t clog your mind trying to remember where your receipts are. Use the software!

And, realize that when you time expenditures is important. Can you prepay Real Estate taxes in a year where you need the deduction? Do you have a choice when to pay some medical expenses, since the 2013 deduction must now exceed 10% of your income (unless you are over 65), much higher than the 7.5% in prior years?

Example 3: When and How to Sell Major Assets: Sale of Residence

Even after the Great Recession for many of us our most valued asset is our residence.

Good  News: 2013 law still allows  up to $500,000 gain above “adjusted basis” without tax.

But (ah, yet another but), beware of pitfalls:

• Not meeting 2 primary tests: ownership and use.

–     If you haven’t lived in the house for at least 2 of the 5 years prior to sale you are not eligible for exclusion (e.g. living in Florida to avoid NYS taxes could affect sale of New York home)

–     Home office deduction, rentals affect use and taxability

• If contract provides for all or part of selling price to be paid in future, this may require an “Installment sale” report in lieu of the standard reporting method.
• Failing to reflect expenses of sale (commissions, lawyers, mortgage expenses)
• Failing to reflect additions to cost basis ($15,000 kitchen you installed 5 years ago)
• Foreclosure or short sale which has loan forgiveness will result in exclusion of most of  forgiven amount from taxable income (new 2013)

Admittedly, we don’t always have a choice in what tax year we can sell a residence. But, for those smart people who recognized the new capital gains impacts in 2013 selling in 2012 could have saved them a potential 3% penalty.

And, for you sports fans, you may have heard that Derek Jeter’s state taxes were being questioned as to whether he spent more days in New York (up to 9% rate) or Florida (tax  free). Jeter sold his NY City Trump Tower residence and now lives in a 32,700 square foot Tampa mansion. Jeter’s not only good with the bat, he did well in choosing a tax advisor.

Example 4: When and How to Sell Major Assets: Sale of Stocks

Just in case you needed to be convinced to not prepare your own tax return, look at the new Schedule D that is available in to report 2013 Sale of Stocks. In its infinite wisdom, the IRS designed a form that is now 20% longer than it was before, with wonderful new ways to confuse even a hardened IRS veteran.

But let’s look at Stock Capital Gains and Losses from a financial planning perspective. Here are some questions that you, your family and your financial/tax advisor should consider:

• Is there any capital loss carryover? The 2008 stock market collapse had a major impact on many investors. However, since the net capital loss available each tax year remains at $3,000, some investors still have a capital loss carryover. How should this enter into your current (and future) year planning?
• Are there short-term and/or long-term gains or losses? Tax treatment can be impacted based on whether a loss or gain is short-term or long-term. In some instances you can decide to sell early or hold-on longer, considering tax and financial impact.
• What tax rate bracket will you be in, since that determines rate at which capital gain that is taxed? Remember Example 1 with Social Security and the IRA Required Minimum Distribution (RMD)? All that non-taxed stock appreciation for the last few years suddenly become taxable when the RMD occurs. This is an area where tax and financial planning can have a major impact on bank balances and life style.
• What will the tax rate be on stocks sold this year vs next year?
• Are there details that impact the taxability? We won’t delve into them here, but there are stock sale nuances that need to be considered by your tax expert>

–     Wash Sales

–     Multiple purchase lots

–     Gift

–     Etc.

Example 5: Not All Income is taxed the same

Yeah, you probably know that not all income received is taxed the same way. To clarify this idea and its potential tax impact for 2013, consider following “given” for Mr. & Mrs. Taxpayer. They have:

• $10,000 Interest and $10,000 Dividends
• $30,000 of Social Security
• $10,000 Pension and $10,000 IRA distribution, no wages
• $20,000 stock Capital Gains, $550,000 gain on sale of residence,
• $15,000 of Itemized Deductions

These different income categories have potentially different tax rates (or no tax at all)

•  Interest: Only $5,000 of $10,000 is taxable, since it was from Tax Free accounts
• Dividends: Only $5,000 (Ordinary Dividends) is taxable, $5,000 of Qualified Dividends is not. (There’s a “but” here as well, but generally not taxable.)
• Capital Gains: $500,000 of house gain not taxable as long as they comply with the rules listed in Example 3. Only $50,000 only taxable if the rules are followed.
• Capital Gains: Short-term and Long-term gains are taxed same way, but Example 4 highlights some differences you may encounter.
• Pension and IRA: Same high taxable rate here, but IRA conversion to Roth is option.
• Social Security: $25,500 of $30,000 is taxable, due to nuances of the law.
• Itemized: This couple actually had $25,000 of expenses, but $11,000 of Medical did not exceed new 10% rule and are “lost”. The remaining $14,000 of itemized exceed $12,200 Standard Deduction.

For this couple the total Adjusted Gross Income for tax purposes was $125,500, even though they had over $515,000 of real income in the year.

Their taxes: they had $102,700 of Taxable income for Federal tax purposes, resulting in a $9,463 Federal Tax. The New York State tax is $4,160, and there were no Alternative Minimum Tax (AMT) implications. Total taxes about 13% of taxable income but only a fraction of the total income they received.

Good tax planning, combined with good financial planning, can help reduce the tax burden.

Summary

• Pay the right amount of taxes by:

–     Supporting your financial planning with tax planning

–     Finding the appropriate professional Financial/Tax Planner

–     Engaging the entire family in better financial/tax planning

–     Making it easier to keep appropriate tax records,

–     Avoiding tax audits

Exhibit 1: Important Federal Tax Rule Changes 2013

• 10%, 15%, 25%, 28%, 33% and 35% tax brackets “permanent”
• 0% tax rate on capital gains and qualified dividends if taxable income is below regular 25% bracket, 15% rate for other taxpayers. Adds 20% rate for gains falling in the new 39.6% bracket.
• Medical expense deductions have 10% deduction floor—up from 7.5%. The 7.5% floor exists if either taxpayer has reached age 65 before end of year.
• Option to claim itemized deduction for state and local sales taxes in lieu of state and local income taxes extended
• Over $250,000 Modified AGI (for Married Filing Jointly): 3.8% surcharge on taxable interest, dividends, and investment income
• Over $300,000 MAGI (Married Filing Joint) Phase Out
  • Itemized by % over theshhold
  • Exemption phase-out (2% per $2500)
• Over $450,000 MAGI (Married Filing Jointly) top tax bracket increase from 35% to 39.6%
• Schedule D has 20% more questions
• AMT exemptions $51,900 for singles, $80,800 for Married Filing Jointly and $40,400 for Married Filing Separately
• Estate tax $5 million exemption, but $1 million for New York State (but Governor Cuomo is considering increase this year) $14,000 Gift limit per person  you give to, but you can give to many people.

Exhibit 2: “12 Red Flags That May Get You Audited By the IRS”*

You make too much money. The IRS will target those with incomes above $200,000.

Not reporting taxable income. You must report all 1099s and W-2s

You give a lot of money to charity.

Claiming a home office deduction.

Claiming rental losses.

Deducting business meals, travel and entertainment.

Claiming 100% business use of a vehicle.

Writing off a loss for a hobby.

Running a business where almost all money is in cash.

Not reporting a foreign bank account.

Engaging in currency transactions.

Taking excessive deductions. Again, the IRS knows what is outside normal bounds based on your income

*Kiplinger Personal Finance Magazine February 2012

Exhibit 3: 2013 IRS Tax Tables

Married Taxpayers Filing Jointly