Potential tax law changes hang over year-end tax planning for individuals

As if another year of the COVID-19 pandemic wasn’t enough to produce an unusual landscape for year-end tax planning, Congress continues to negotiate the budget reconciliation bill. The proposed Build Back Better Act (BBBA) is certain to include some significant tax provisions, but much uncertainty remains about their impact. While we wait to see which tax provisions are ultimately included in the BBBA, here are some year-end tax planning strategies to consider to reduce your 2021 tax liability.

Accelerate and defer with care

One of the most reliable year-end tactics for reducing taxes has long been to accelerate your deductible expenses and defer your income. For example, self-employed individuals who use cash-basis accounting can delay invoices until late December and move up the planned purchase of equipment or the payment of estimated state income taxes from early next year to this year.

This technique has always carried the caveat that you generally shouldn’t pursue it if you expect to be in a higher tax bracket the following year. Potential provisions in the BBBA also may make it advisable for certain taxpayers to reverse the strategy for 2021 — that is, accelerate income and defer deductible expenses.

The current version of the BBBA would impose a new “surtax” of 5% on modified adjusted gross income (MAGI) that exceeds $10 million, with an additional 3% on income of more than $25 million. As a result, the highest earners could pay a 45% federal marginal income tax on wages and business income (the current 37% income tax rate plus 8%). It could be even higher when combined with the net investment income tax, which might be expanded to include active business income for pass-through entities.

In addition, there’s a proposal to temporarily increase the $10,000 cap on the state and local tax deduction to $80,000. Individuals in high-tax states should consider whether there may be an advantage to accelerating a 2022 property or estimated state income tax payment into 2021, or whether the deduction might be more valuable next year, particularly if they’ll face a higher effective tax rate.

Leverage your losses

Taxpayers with substantial capital gains in 2021 could benefit from “harvesting” their losses before year-end. Capital losses can be used to offset capital gains, and up to $3,000 ($1,500 for married persons filing separately) of excess losses (those that exceed the amount of gains for the year) can be applied against ordinary income. Any remaining losses can be carried forward indefinitely.

Beware, however, of the wash-sale rule. Generally, the rule prohibits the deduction of a loss if you acquire “substantially identical” investments within 30 days, before or after, of the date of the sale.

Taxpayers who itemize their deductions could compound their tax benefits by donating the proceeds from the sale of a depreciated investment to a charity. They can both offset realized gains and claim a charitable contribution deduction for the donation.

Satisfy your charitable inclinations

For 2021, charitable contributions can reduce taxes for both itemizers and non-itemizers. Taxpayers who take the standard deduction can claim an above-the-line deduction of $300 ($600 for married couples filing jointly) for cash contributions to qualified charitable organizations.

The adjusted gross income limit for cash donations is 100% for 2021; it’s scheduled to return to 60% for 2022. That means you could offset all of your taxable income with charitable contributions this year. (Donations to donor advised funds and private foundations don’t qualify, though.)

Taxpayers who don’t generally itemize can benefit by “bunching” their charitable contributions. In other words, delaying or accelerating contributions into a tax year to exceed the standard deduction and claim itemized deductions. For example, if you usually make your donations at the end of the year, you could bunch donations in alternative years — say, donate in January and December of 2022 and January and December of 2024.

Retired taxpayers who are age 70½ and older can reduce their taxable income by making qualified charitable contributions of up to $100,000 from their non-Roth IRAs. Retired or not, individuals age 72 and older can use such contributions to satisfy their annual required minimum distributions (RMDs). Note that RMDs were suspended for 2020 but are effective for 2021.

So long as the assets would be considered long-term if they were sold, donations of appreciated assets offer a double-barreled tax benefit. You avoid the capital gains tax on the appreciation and can deduct the asset’s fair market value as of the date of the gift.

Convert traditional IRAs to Roth IRAs

As in 2020, when many taxpayers saw lower than typical income, 2021 could be a smart time to convert funds in traditional pre-tax IRAs to an after-tax Roth IRA. Roth IRAs have no RMDs, and distributions are tax-free.

You’ll have to pay income tax on the converted funds, but it’s better to do so while subject to lower tax rates. Similarly, if you convert securities that have dropped in value, your tax may well be lower now than down the road — and any subsequent appreciation while in the Roth IRA will be tax-free.

It’s worth noting that President Biden had proposed including a provision in the BBBA that would limit the ability of wealthy individuals to engage in Roth conversions. There was a lot of back-and-forth with respect to these provisions, and the latest version of the House bill includes certain restrictions. Whether these provisions will make it past any Senate amendments remains to be seen, but the proposal could be a harbinger of future proposed restrictions.

Proceed with caution

The strategies outlined above always come with pros and cons, but perhaps never more so than now, when potentially significant tax legislation that would take effect next year is under negotiation. We can help you chart the best course in light of any developments.

© 2021

Working remotely from “out of state” can be taxing

The COVID-19 pandemic has required many people to work remotely, either from home or a temporary location. One potential consequence of remote work may surprise you: an increase in your state tax bill.

During the pandemic, it’s been fairly common for people to work remotely from another state — across state lines from the employer’s place of business or even across the nation. If that describes your situation, you may need to file tax returns in both states, potentially triggering additional state taxes. But the outcome depends on applicable law, which varies from state to state.

Watch out for double taxation

Generally, a state’s power to tax a person’s income is based on concepts such as domicile and residence. If you’re domiciled in a state — that is, you have your “true, fixed permanent home” there — the state has the power to tax your worldwide income. A state also may tax your income if you’re a “resident.” Usually, that means you have a dwelling in the state and spend a minimum amount of time there.

It’s possible to be domiciled in one state but a resident of another, which may require you to pay taxes to both states on the same income. Many states offer relief from such double taxation by providing credits for taxes paid to other states. But it’s still possible for remote work to result in higher taxes — for example, if the state where your employer is based, and where you usually live, has no income tax but you work remotely from a state with an income tax.

A state also may be able to tax your income if it’s derived from a source within the state, even if you aren’t a resident or domiciliary. Several states have so-called “convenience rules”: If you’re employed by an organization in the state, but live and work in another state for your convenience (not because the job requires it), then you owe income tax to the state where the employer is based.

If that happens, you also may owe tax to the state where you reside, which may or may not be reduced by credits for taxes paid to the other state. Some states have agreed not to impose their taxes on remote workers who are present in their state as a result of the pandemic. But in many other states there’s a risk of double taxation.

Know your options

If you’ve worked remotely from out of state in 2021, consult your tax advisor to determine whether you’re liable for taxes in both states. If so, ask if there are steps you can take to soften the blow.

©2021

5 tax planning tips for retirees

There’s a common misconception that, when you retire, your tax bills shrink, your tax returns become simpler and tax planning is a thing of the past. That may be true for some, but many people find that the combination of Social Security, pensions and withdrawals from retirement accounts increases their income in retirement and may even push them into a higher tax bracket.

If you’re retired or approaching retirement, consider these five tax-planning tips:

1.     Take inventory. Estimate how much money you’ll need in retirement for living expenses and inventory your income sources. These sources may include taxable assets, such as mutual funds and brokerage accounts; tax-deferred assets, such as IRAs, 401(k) plan accounts and pensions; and nontaxable assets, such as Roth IRAs, Roth 401(k) plans or tax-exempt municipal bonds. Social Security benefits may be nontaxable or partially taxable, depending on your other sources of income.

Develop a plan for drawing retirement income in a tax-efficient manner, being sure to keep state income tax, if applicable, in mind. For example, you might minimize current taxes by tapping nontaxable assets first, followed by assets that generate capital gains, and putting off withdrawals from tax-deferred accounts as long as possible.

On the other hand, if you’re approaching age 72 and will have substantial required minimum distributions (RMDs) from tax-deferred accounts when you reach that age (see No. 3 below), it may make sense to withdraw some of those funds earlier. Why? It can help you avoid having large RMDs that would push you into a higher tax bracket later.

For example, you might withdraw as much as you can from IRAs or 401(k) accounts each year without exceeding the lower tax brackets. That way, you keep current taxes on those funds at a reasonable level while reducing the size of your accounts and, in turn, the size of your RMDs down the road. You can obtain additional funds from nontaxable or capital gains assets, if needed.

2.     Consider the timing of Social Security benefits. You can begin receiving Social Security benefits as early as age 62 or as late as age 70. The later you start, the larger the benefit amount — so, if you don’t need the money right away, putting it off may be a good investment. Also, benefits are reduced if you start them before you reach full retirement age and continue to work.

Keep in mind that, if your income from other sources exceeds certain thresholds, your Social Security benefits will become partially taxable. For example, married couples filing jointly with combined income over $44,000 are taxed on up to 85% of their Social Security benefits. (Combined income is adjusted gross income plus nontaxable interest plus half of Social Security benefits.)

3.     Make qualified charitable distributions. You’re required to begin RMDs from tax-deferred retirement accounts once you reach age 72 (up from 70½ for people born before July1, 1949) though you’re able to defer your first distribution until April 1 of the year following the year you reach age 72. RMDs generally are taxed as ordinary income and you must take them regardless of whether you need the money. As noted in No. 1, a large RMD can push you into a higher tax bracket.

One strategy for reducing the amount of RMDs, at least if you’re charitably inclined, is to make a qualified charitable distribution (QCD). If you’re age 70½ or older (this age didn’t increase when the RMD age increased), a QCD allows you to distribute up to $100,000 tax-free directly from an IRA to a qualified charity and to apply that amount toward your RMDs.

The funds aren’t included in your income, so you avoid tax on the entire amount, regardless of whether you itemize. In addition, the income-based limits on charitable deductions don’t apply. Any amount excluded from your income by virtue of the QCD is similarly excluded from being treated as a charitable deduction.

4.     Pay estimated taxes. Your retirement income sources may or may not withhold income taxes. To avoid tax surprises and penalties, estimate whether your withholdings will be sufficient to pay your tax liability for the year and make quarterly estimated tax payments to cover any expected shortfall.

5.     Track your medical expenses. Currently, medical expenses are deductible only if you itemize and only to the extent they exceed 7.5% of your adjusted gross income. If you have significant medical expenses, track them carefully. Then if you exceed this threshold or are close to exceeding it, consider bunching elective expenses into the year to maximize potential deductions.

If you’re nearing retirement age and have questions on how your tax situation may change, contact your tax advisor.

© 2021

Rental real estate - Determining if a property is a business or an investment

If you own rental real estate, its classification as a trade or business rather than an investment can have a big impact on your tax bill. The distinction is especially important because of the 20% Section 199A deduction for certain sole proprietors and pass-through entity owners.

The 199A deduction is available for qualified business income (QBI), which can come from an eligible trade or business, but not from an investment. So, assuming you otherwise meet the requirements, qualifying your rental real estate activities as a trade or business may yield substantial tax savings. Fortunately, an IRS Revenue Procedure establishes a safe harbor.

A brief review

The 199A deduction is too complex to cover fully here. But, in general, it allows owners of sole proprietorships and pass-through entities — partnerships, S corporations and, generally limited liability companies (LLCs) — to deduct as much as 20% of their net business income, without the need to itemize.

Eligible owners are entitled to the full deduction so long as their taxable income doesn’t exceed an inflation-adjusted threshold (for tax year 2021, $164,900 for singles and heads of households; $329,800 for joint filers). Above the threshold, the deduction may be reduced or eliminated for businesses that perform certain services or lack sufficient W-2 wages or depreciable property.

Rental real estate guidance

According to the IRS, for purposes of the 199A deduction, an enterprise is a trade or business if it qualifies as such under Internal Revenue Code Section 162. That section doesn’t expressly define “trade or business” — it’s determined on a case-by-case basis based on various factors. Generally, a trade or business is an activity conducted “on a regular, continuous and substantial basis” with the aim of earning a profit.

Uncertainty over whether rental real estate qualifies, especially for taxpayers with one or two properties, prompted the IRS to issue Revenue Procedure 2019-38 to establish a safe harbor. Under the Revenue Procedure, a rental real estate enterprise (RREE) is deemed a trade or business if the taxpayer (you or a “relevant pass-through entity” in which you own an interest):

·      Maintains separate books and records for the enterprise,

·      Performs at least 250 hours of rental services per year (for an enterprise that’s at least four years old, this requirement is satisfied if you meet the 250-hour test in at least three of the last five years),

·      Keeps logs, time reports or other contemporaneous records detailing the services performed, and

·      Files a statement with his or her tax return.

The Revenue Procedure lists the types of services that count toward the 250-hour minimum and clarifies that they may be performed by the owner or by employees or contractors. It also defines an RREE as one or more rental properties held directly by the taxpayer or through disregarded entities (for example, a single-member LLC).

Generally, taxpayers must either treat each rental property as a separate enterprise or treat all similar properties as a single enterprise. Commercial and residential properties, for example, can’t be combined in the same enterprise.

Planning opportunities

There may be opportunities to restructure rental activities to take full advantage of the safe harbor. For example, Marilyn owns a rental residential building and a rental commercial building and performs 125 hours of rental services per year for each property. As noted, she can’t combine the properties into a single enterprise, so she doesn’t pass the 250-hour test.

But let’s say she exchanges the residential building for another commercial building for which she provides 125 hours of services. Then she can treat the two commercial buildings as a single enterprise and qualify for the safe harbor (provided the other requirements are met).

Don’t try this at home

The tax treatment of rental real estate is complex. To take advantage of the 199A deduction or other tax benefits for rental real estate, consult your tax advisor.

Sidebar: Are you a real estate professional?

Ordinarily, taxpayers who “materially participate” in a trade or business are entitled to deduct losses against wages or other ordinary income and to avoid net investment income tax on income from the business. The IRS uses several tests to measure material participation. For example, you materially participate in an activity if you devote more than 500 hours per year, or if you devote more than 100 hours and no one else participates more.

Rental real estate, however, is generally deemed to be a passive activity — that is, one in which you don’t materially participate — regardless of how much time you spend on it. There’s an exception, however, for “real estate professionals.”

To qualify for the exception, you must spend at least 750 hours per year — and more than half of your total working hours — on real estate businesses (such as development, construction, leasing, brokerage or management) in which you materially participate. (The hours you spend as an employee don’t count, unless you own at least 5% of the business.)

© 2021

Oops, you overfunded your 529 plan

Some might consider it a good problem to have: saving too much money for college. But if the money is held in a Section 529 college savings plan, there could be tax consequences to overfunding the account.

The tax man giveth

529 plans are tax-advantaged accounts designed to help families save money for college education expenses. Savings grow on a tax-deferred basis, and withdrawals are made tax-free if the money is used to pay for qualified education expenses such as college tuition, fees, books, and, generally, room and board. Further, some states offer tax incentives for contributions to 529s.

The tax consequences come into play if 529 funds are used for anything other than qualified education expenses. Specifically, earnings on investments held in the account will be taxable and a 10% penalty will be assessed if the money is used for noneducation-related expenses.

Note that only the earnings portion of the account will be subject to taxes and penalties. Funds you’ve contributed to the account (or principal) won’t be taxed upon withdrawal regardless of what they’re used for, because contributions were made with after-tax dollars.

Your alternatives

So what should you do if your child graduates from college and there are funds left in your 529 account? Here are a few options to consider:

Change the beneficiary. The flexibility that characterizes 529 plans includes the ability to name someone else as the account’s beneficiary. So if you have other children in college now or who’re planning to attend college, you can simply make them the beneficiaries of the account.

You can even change the beneficiary to yourself. This would allow you to use the funds for qualified expenses for your own education.

Use the funds to pay for private school education. The Tax Cuts and Jobs Act changed the 529 plan rules so that up to $10,000 of funds per year can now be used for private K-12 tuition. Therefore, if you have younger children, you can potentially make beneficiary changes so you can use the 529 plan funds to send them to a private school. But beware that, depending on the state, there could be state tax consequences.

Investigate nonqualified 529 plan withdrawal options. The law specifies certain situations where nonqualified withdrawals can be made from 529 plans penalty-free. These include a child’s death or disability and a graduate’s attendance at a U.S. military academy.

Also, if your child is awarded an academic or athletic scholarship, you can use withdrawals up to the scholarship amount for expenses that aren’t education-related and avoid the 10% penalty on earnings. But you’ll still have to pay income tax on the earnings when you file your federal tax return.

There’s also a new provision that allows — subject to restrictions, of course — 529 plans to be used to repay student loans.

Leave the money alone. There’s no deadline for 529 account withdrawals, so you can leave funds in the account to pay for future education expenses. The money will continue to grow tax-deferred as long as it stays in the account.

So if your child decides later to attend graduate school, funds can be used to help cover these expenses. You can even keep funds in the account for the long term to help pay education expenses for your future grandchildren. This will give your children a good head start on college saving for their kids.

If all else fails

If none of these strategies are ideal for your situation, you may just have to withdraw excess 529 funds and pay the taxes and penalties due. Since they apply only to the earnings portion of the account, the tax hit may not be too severe.

© 2021

Are you liable for “nanny taxes”?

If you employ household workers — which may include nannies, babysitters, housekeepers, cooks, gardeners, health care workers and other employees — it’s important to understand your tax obligations, commonly referred to as “nanny taxes.” Here’s a quick review.

Which workers are covered?

Simply working in your home doesn’t necessarily make a worker a household employee. You’re not required to withhold or pay taxes for independent contractors — such as occasional babysitters who work for many different families.

But the rules for distinguishing between employees (who trigger nanny tax obligations) and independent contractors (who don’t) are complicated, So be sure to consult your tax advisor if you’re uncertain.

Which taxes must you pay?

Your nanny tax obligations vary depending on the type of tax:

Income tax. You’re not required to withhold federal income taxes (or, usually, state income taxes) from a household employee’s pay, unless the employee asks you to and you agree. In that case, you’ll need to have the employee complete Form W-4 and you’ll need to withhold income taxes on both cash and noncash wages (other than certain meals and lodging).

FICA taxes. You must withhold and pay FICA taxes (Social Security and Medicare) if your household employee’s cash wages reach a specified threshold ($2,300 for 2021). If you meet the threshold, you must pay the employer’s share of Social Security taxes (6.2%) and Medicare taxes (1.45%) on the employee’s cash wages (but not on meals, lodging or other noncash wages). In addition, you’re responsible for withholding the employee’s share of these taxes (also 6.2% and 1.45%, respectively), although you may opt to pay the employee’s share rather than withholding it.

Note: There’s no FICA tax liability for wages you pay to certain family members or to household employees under the age of 18 if working for you isn’t their principal occupation. A student who babysits on the side would be one example.

Unemployment taxes. You must pay federal unemployment tax (FUTA) if you pay total cash wages to household employees (other than certain family members) of $1,000 or more in any quarter in the current or preceding calendar year. The tax applies to the first $7,000 of an employee’s cash wages at a 6% rate, although credits reduce that rate to 0.6% in most cases.

How are taxes reported and paid?

Unlike businesses, you generally don’t need to file quarterly employment tax returns for household employees. Rather, you report household employment taxes on Schedule H of your personal income tax return. However, if you own a business as a sole proprietor, you may add the taxes for household employees to the deposits or payments you make for your business employees and include household employees on Forms 940 and 941.

Even if you report household employment taxes on Schedule H, you’re still responsible for paying the tax throughout the year, either through quarterly estimated tax payments or by increasing withholdings from your wages. Otherwise, you’ll have to pay the tax when you file your return and be subjected to penalties for underpayment of estimated tax.

You’ll also need to file Form W-2 if you’re required to withhold FICA taxes or agree to withhold income taxes for a household employee.

Know your obligations as an employer

In addition to the tax requirements discussed above, there may be other obligations that come with being an employer. These may include complying with minimum wage and overtime requirements, and documenting immigration status. Turn to your tax advisor for more information.

© 2021

Disasters and your taxes: What you need to know

Homeowners and businesses across the country have experienced weather-related disasters in recent months. From hurricanes, tornadoes and other severe storms to the wildfires again raging in the West, natural disasters have led to significant losses for a wide swath of taxpayers. If you’re among them, you may qualify for a federal income tax deduction, as well as other relief from the IRS.

Eligibility for the casualty loss deduction

Casualty losses can result from the damage, destruction or loss of property due to any sudden, unexpected or unusual event. Examples include floods, hurricanes, tornadoes, fires, earthquakes and volcanic eruptions. Normal wear and tear or progressive deterioration of property doesn’t constitute a deductible casualty loss. For example, drought generally doesn’t qualify.

The availability of the tax deduction for casualty losses varies depending on whether the losses relate to personal-use or business-use items. Generally, you can deduct casualty losses related to your home, household items and personal vehicles if they’re caused by a federally declared disaster — meaning a disaster that occurred in an area that the U.S. president declares eligible for federal assistance. Casualty losses related to business or income-producing property (for example, rental property) can be deducted regardless of whether they occur in a federally declared disaster area.

Casualty losses are deductible in the year of the loss, usually the year of the casualty event. If your loss stemmed from a federally declared disaster, you can opt to treat it as having occurred in the previous year. You may receive your refund more quickly if you amend the previous year’s return than if you wait until you file your return for the casualty year.

The role of reimbursements

If your casualty loss is covered by insurance, you must reduce the loss by the amount of any reimbursement or expected reimbursement. (You also must reduce the loss by any salvage value). Reimbursement also could lead to capital gains tax liability.

When the amount you receive from insurance or other reimbursements (less any expense you incurred to obtain reimbursement, such as the cost of an appraisal) exceeds the cost or adjusted basis of the property, you have a capital gain. You’ll need to include that gain as income unless you’re eligible to postpone reporting the gain.

You may be able to postpone the reporting obligation if you purchase property that’s similar in service or use to the destroyed property within the specified replacement period. You also can postpone if you buy a controlling interest (at least 80%) in a corporation owning similar property or if you spend the reimbursement to restore the property.

Alternatively, you can offset casualty gains with casualty losses not attributable to a federally declared disaster. This is the only way you can deduct personal-use property casualty losses incurred in areas not declared disaster areas.

The loss amount vs. the deduction

For personal-use property, or business-use or income-producing property that isn’t completely destroyed, your casualty loss is the lesser of:

1. The adjusted basis of the property immediately before the loss (generally, your original cost, plus improvements and less depreciation), or

2. The drop in fair market value (FMV) of the property as a result of the casualty (that is, the difference between the FMV immediately before and immediately after the casualty).

For business-use or income-producing property that’s completely destroyed, the amount of the loss is the adjusted basis less any salvage value and reimbursements.

If a single casualty involves more than one piece of property, you must figure the loss on each separately. You then combine these losses to determine the casualty loss.

An exception applies to personal-use real property, such as a home. The entire property (including improvements such as landscaping) is treated as one item. The loss is the smaller of the decline in FMV of the entire property and the entire property’s adjusted basis.

Other limits may apply to the amount of the loss you may deduct, too. For personal-use property, you must reduce each casualty loss by $100 (after you’ve subtracted any salvage value and reimbursement).

If you suffer more than one casualty loss during the tax year, you must reduce each loss by $100 and report each on a separate IRS form. If two or more taxpayers have losses from the same casualty, the $100 rule applies separately to each taxpayer.

But that’s not all. For personal-use property, you also must reduce your total casualty losses by 10% of your adjusted gross income, after you’ve applied the $100 rule. As a result, smaller personal-use casualty losses often provide little or no tax benefit.

The requisite records

Documentation is critical to claim a casualty loss deduction. You’ll need to be able to show:

1. That you were the owner of the property or, if you leased it, that you were contractually liable to the owner for the damage,

2. The type of casualty and when it occurred,

3. That the loss was a direct result of the casualty, and

4. Whether a claim for reimbursement with a reasonable expectation of recovery exists.

You also must be able to establish your adjusted basis, reimbursements and, for personal-use property, pre- and post-casualty FMVs.

Additional relief

The IRS has granted tax relief this year to victims of numerous natural disasters, including “affected taxpayers” in Alabama, California, Kentucky, Louisiana, Michigan, Mississippi, New Jersey, New York, Oklahoma, Pennsylvania, Tennessee and Texas. The relief typically extends filing and other deadlines. (For detailed information for your state visit: https://bit.ly/3nzF2ui.)

Note that you can be an affected taxpayer even if you don’t live in a federally declared disaster area. You’re considered affected if records you need to meet a filing or payment deadline postponed during the applicable relief period are located in a covered disaster area. For example, if you don’t live in a disaster area, but your tax preparer does and is unable to pay or file on your behalf, you likely qualify for filing and payment relief.

A team effort

If you’ve incurred casualty losses this year, tax relief could mitigate some of the financial pain. We can help you maximize your tax benefits and ensure compliance with any extensions.

© 2021

IRS Creates Identity Protection PIN Opt-In Program for Taxpayers

The IRS has created Publication 5367, IP PIN Opt-In Program for Taxpayers. If you have concerns about identity fraud, consider utilizing this program.

Following are additional details about the IP PIN:

• it is a six-digit number known only to the taxpayer and the IRS;

• the opt-in program is voluntary;

• the IP PIN should be entered onto the electronic tax return when prompted by the software product or onto a paper return next to the signature line;

• the IP PIN is valid for one calendar year; taxpayers must obtain a new IP PIN each year;

• only dependents who can verify their identities may obtain an IP PIN; and

• IP PIN users should never share their number with anyone but the IRS and their trusted tax preparation provider.

Moreover, taxpayers may obtain an IP PIN through Get an IP PIN, the IRS online tool. Taxpayers must validate their identities through Secure Access authentication to access the tool and their IP PIN. Before attempting this rigorous process, taxpayers must see Secure Access: How to Register for Certain Online Self-Help Tools. However, the tool will be offline between November and January. Further, if taxpayers are unable to validate their identity online and their income is $72,000 or less, they may file Form 15227, Application for an Identity Protection Personal Identification Number. The IRS will call the telephone number provided on Form 15227 to validate your identity. However, for security reasons, the IRS will assign an IP PIN for the next filing season. The IP PIN cannot be used for the current filing season.

Taxpayers who cannot validate their identities online, or on the phone with an IRS employee after submitting a Form 15227, or who are ineligible to file a Form 15227 may call the IRS to make an appointment at a Taxpayer Assistance Center. They will need to bring one picture identification document and another identification document to prove their identity. Once verified, the taxpayer will receive an IP PIN via U.S. Postal Service within three weeks. Lastly, the IP PIN process for confirmed victims of identity theft would remain unchanged and they would automatically receive an IP PIN each year.

Hiring your minor children this summer? Reap tax and nontax benefits

If you’re a business owner and you hire your children this summer, you can obtain tax breaks and other nontax benefits. The kids can gain on-the-job experience, spend time with you, save for college and learn how to manage money. And you may be able to:

• Shift your high-taxed income into tax-free or low-taxed income,

• Realize payroll tax savings (depending on the child’s age and how your business is organized), and

• Enable retirement plan contributions for the children.

A legitimate job

If you hire your child, you get a business tax deduction for employee wage expenses. In turn, the deduction reduces your federal income tax bill, your self-employment tax bill (if applicable), and your state income tax bill (if applicable). However, in order for your business to deduct the wages as a business expense, the work performed by the child must be legitimate and the child’s salary must be reasonable.

For example, let’s say you operate as a sole proprietor and you’re in the 37% tax bracket. You hire your 16-year-old daughter to help with office work on a full-time basis during the summer and part-time into the fall. Your daughter earns $10,000 during 2021 and doesn’t have any other earnings.

You save $3,700 (37% of $10,000) in income taxes at no tax cost to your daughter, who can use her 2021 $12,550 standard deduction to completely shelter her earnings.

Your family’s taxes are cut even if your daughter’s earnings exceed her standard deduction. Why? The unsheltered earnings will be taxed to the daughter beginning at a rate of 10%, instead of being taxed at your higher rate. 

How payroll taxes might be saved

If your business isn’t incorporated, your child’s wages are exempt from Social Security, Medicare and FUTA taxes if certain conditions are met. Your child must be under age 18 for this to apply (or under age 21 in the case of the FUTA tax exemption). Contact us for how this works.

Be aware that there’s no FICA or FUTA exemption for employing a child if your business is incorporated or a partnership that includes nonparent partners. And payments for the services of your child are subject to income tax withholding, regardless of age, no matter what type of entity you operate.

Begin saving for retirement

Your business also may be able to provide your child with retirement benefits, depending on the type of plan you have and how it defines qualifying employees. And because your child has earnings from his or her job, he can contribute to a traditional IRA or Roth IRA and begin to build a nest egg. For the 2021 tax year, a working child can contribute the lesser of his or her earned income, or $6,000, to an IRA or a Roth.

Keep accurate records 

As you can see, hiring your child can be a tax-smart idea. Be sure to keep the same records as you would for other employees to substantiate the hours worked and duties performed (such as timesheets and job descriptions). Issue your child a Form W-2. Contact us if you have questions about how these rules apply to your situation.

© 2021

IRS Extends 2020 Tax Filing Deadline

The Internal Revenue Service announced Thursday, March 18 in the afternoon that the federal income tax filing due date for individuals for the 2020 tax year will be automatically extended from April 15, 2021, to May 17, 2021.  The State of Michigan has followed suit, but many states have not yet confirmed that they will do the same.

The IRS will be providing more formal guidance in the coming days/weeks.

• The postponement applies to individual taxpayers, including individuals who pay self-employment tax.

• The postponement does not apply to calendar year-end Trust Tax Returns (1041) or C-Corporation Tax Returns (1120). These are still due on April 15, 2021.

• Penalties, interest and additions to tax will begin to accrue on any remaining unpaid balances as of May 17, 2021.

• The postponement does not apply to 2021 estimated tax payments that are due on April 15, 2021. These payments are still due on April 15.

• In addition, earlier this year, the IRS announced relief for victims of the February winter storms in Texas, Oklahoma and Louisiana. These states have until June 15, 2021 to file various individual and business tax returns and make tax payments. This extension to May 17 does not affect the June deadline.

• FMD will continue to monitor the various states for further guidance.

Despite this extension, we strongly encourage our individual clients to continue to work closely with their tax advisors and push forward on their tax return preparation and filing.

Divorcing business owners need to pay attention to tax implications

If you’re getting a divorce, you know it’s a highly stressful time. But if you’re a business owner, tax issues can complicate matters even more. Your business ownership interest is one of your biggest personal assets and your marital property will include all or part of it.

Transferring property tax-free

You can generally divide most assets, including cash and business ownership interests, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. When an asset falls under this tax-free transfer rule, the spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).

For example, let’s say that, under the terms of your divorce agreement, you give your house to your spouse in exchange for keeping 100% of the stock in your business. That asset swap would be tax-free. And the existing basis and holding periods for the home and the stock would carry over to the person who receives them.

Tax-free transfers can occur before the divorce or at the time it becomes final. Tax-free treatment also applies to postdivorce transfers so long as they’re made “incident to divorce.” This means transfers that occur within:

• A year after the date the marriage ends, or

• Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.

Future tax implications

Eventually, there will be tax implications for assets received tax-free in a divorce settlement. The ex-spouse who winds up owning an appreciated asset — when the fair market value exceeds the tax basis — generally must recognize taxable gain when it’s sold (unless an exception applies).

What if your ex-spouse receives 49% of your highly appreciated small business stock? Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex will continue to apply the same tax rules as if you had continued to own the shares, including carryover basis and carryover holding period. When your ex-spouse ultimately sells the shares, he or she will owe any capital gains taxes. You will owe nothing.

Note that the person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven’t appreciated. That’s why you should always take taxes into account when negotiating your divorce agreement.

In addition, the IRS now extends the beneficial tax-free transfer rule to ordinary-income assets, not just to capital-gains assets. For example, if you transfer business receivables or inventory to your ex-spouse in divorce, these types of ordinary-income assets can also be transferred tax-free. When the asset is later sold, converted to cash or exercised (in the case of nonqualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.

Avoid adverse tax consequences

Like many major life events, divorce can have major tax implications. For example, you may receive an unexpected tax bill if you don’t carefully handle the splitting up of qualified retirement plan accounts (such as a 401(k) plan) and IRAs. And if you own a business, the stakes are higher. Your tax advisor can help you minimize the adverse tax consequences of settling your divorce under today’s laws.

© 2019

Powers of attorney can be vital documents

Most people realize the importance of a will to help direct the transfer of assets after death. During your lifetime, you also may want to have a power of attorney (POA) for convenience and asset protection.

            The person who creates a POA is known as the principal. In the POA, an agent (known as the attorney-in-fact) is given the authority to act on the principal’s behalf. POAs come in different forms with different purposes.

General POA

A general or regular POA gives the agent the broad ability to act for the principal. This type might be useful when the principal will be unable to act on his or her own behalf for some reason. Someone in the military, for example, might name an agent to handle financial affairs during the principal’s overseas assignment.

Limited POA

As the name suggests, these special POAs are not open-ended. There could be a specified time period when you’re unable to act on your own behalf. Alternatively, a limited POA could be effective only for a designated purpose, such as signing a contract when you can’t be present.

Durable POA

Regular or limited POAs may become void if the principal loses mental competence. Unfortunately, that can be the time when a POA is needed most: when assets could be squandered because of poor decisions.

            Therefore, a durable POA can be extremely valuable because it remains in effect if the principal becomes incompetent. The agent can make financial decisions, such as asset management and residential transactions. If a durable POA is not in place, the relatives of an individual deemed to be incompetent might have to go to court to request that a conservator be named, which can be a time-consuming and expensive process with an uncertain outcome.

Springing POA

Some people are not comfortable creating a POA while they are still competent, yet an individual who loses mental capability cannot legally create a POA. One solution is to use a springing POA, which takes effect only in certain circumstances, such as a doctor certifying that the principal cannot make financial decisions. Note that some states may not allow springing POAs, and some attorneys are skeptical about using them because the process of getting a physician’s timely certification might be challenging.

Health care POA

The POAs described previously empower an agent to make financial decisions. A health care POA is different because it names someone to make medical decisions if the patient cannot do so. The agent named on a financial POA could be someone trusted with money matters, whereas someone with other abilities and concerns could be appropriate for a health care POA.

Powerful thoughts

As indicated, the agent you name on any POA should be someone you trust absolutely with your wealth or your health. Married couples are best protected if both spouses have their own POAs.

In addition, you might have to check with the financial firms holding your assets before having a POA drafted. Some companies prefer to use their own forms, so a POA drafted by your attorney might not be readily accepted. Moreover, financial institutions might be reluctant to accept a very old POA, so periodic updating can be helpful.

            When creating a POA, you should make it clear that the power applies to retirement accounts such as IRAs. Your agent should have the ability to execute rollovers and designate beneficiaries, for example. An attorney who is experienced in estate planning can help you obtain a POA with the power to help you and your loved ones, if necessary.

It’s not too late: You can still set up a retirement plan for 2018

If most of your money is tied up in your business, retirement can be a challenge. So if you haven’t already set up a tax-advantaged retirement plan, consider doing so this year. There’s still time to set one up and make contributions that will be deductible on your 2018 tax return!

More benefits

Not only are contributions tax deductible, but retirement plan funds can grow tax-deferred. If you might be subject to the 3.8% net investment income tax (NIIT), setting up and contributing to a retirement plan may be particularly beneficial because retirement plan contributions can reduce your modified adjusted gross income and thus help you reduce or avoid the NIIT.

If you have employees, they generally must be allowed to participate in the plan, provided they meet the qualification requirements. But this can help you attract and retain good employees.

And if you have 100 or fewer employees, you may be eligible for a credit for setting up a plan. The credit is for 50% of start-up costs, up to $500. Remember, credits reduce your tax liability dollar-for-dollar, unlike deductions, which only reduce the amount of income subject to tax.

3 options to consider

Many types of retirement plans are available, but here are three of the most attractive to business owners trying to build up their own retirement savings:

1. Profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and flexibility in plan design. You can make deductible 2018 contributions as late as the due date of your 2018 tax return, including extensions — provided your plan exists on Dec. 31, 2018. For 2018, the maximum contribution is $55,000, or $61,000 if you are age 50 or older and your plan includes a 401(k) arrangement.

2. Simplified Employee Pension (SEP). This is also a defined contribution plan, and it provides benefits similar to those of a profit-sharing plan. But you can establish a SEP in 2019 and still make deductible 2018 contributions as late as the due date of your 2018 income tax return, including extensions. In addition, a SEP is easy to administer. For 2018, the maximum SEP contribution is $55,000.

3. Defined benefit plan. This plan sets a future pension benefit and then actuarially calculates the contributions needed to attain that benefit. The maximum annual benefit for 2018 is generally $220,000 or 100% of average earned income for the highest three consecutive years, if less. Because it’s actuarially driven, the contribution needed to attain the projected future annual benefit may exceed the maximum contributions allowed by other plans, depending on your age and the desired benefit.

You can make deductible 2018 defined benefit plan contributions until your tax return due date, including extensions, provided your plan exists on Dec. 31, 2018. Be aware that employer contributions generally are required.

Sound good?

If the benefits of setting up a retirement plan sound good, contact us. We can provide more information and help you choose the best retirement plan for your particular situation.

© 2018

Can you deduct business travel when it’s combined with a vacation?

At this time of year, a summer vacation is on many people’s minds. If you travel for business, combining a business trip with a vacation to offset some of the cost with a tax deduction can sound appealing. But tread carefully, or you might not be eligible for the deduction you’re expecting.

General rules

Business travel expenses are potentially deductible if the travel is within the United States and the expenses are “ordinary and necessary” and directly related to the business. (Foreign travel expenses may also be deductible, but stricter rules apply than are discussed here.)

Currently, business owners and the self-employed are potentially eligible to deduct business travel expenses. Under the Tax Cuts and Jobs Act, employees can no longer deduct such expenses. The potential deductions discussed below assume that you’re a business owner or self-employed.

Business vs. pleasure

Transportation costs to and from the location of your business activity may be 100% deductible if the primary reason for the trip is business rather than pleasure. But if vacation is the primary reason for your travel, generally none of those costs are deductible.

The number of days spent on business vs. pleasure is the key factor in determining whether the primary reason for domestic travel is business:

• Your travel days count as business days, as do weekends and holidays — if they fall between days devoted to business and it would be impractical to return home.

• Standby days (days when your physical presence is required) also count as business days, even if you aren’t called upon to work those days.

• Any other day principally devoted to business activities during normal business hours also counts as a business day.

You should be able to claim business was the primary reason for a domestic trip if business days exceed personal days.

Deductible expenses

What transportation costs can you deduct? Travel to and from your departure airport, airfare, baggage fees, tips, cabs, etc. Costs for rail travel or driving your personal car are also eligible.

Once at the destination, your out-of-pocket expenses for business days are fully deductible. Examples of these expenses include lodging, meals (subject to the 50% disallowance rule), seminar and convention fees, and cab fare. Expenses for personal days aren’t deductible.

Keep in mind that only expenses for yourself are deductible. You can’t deduct expenses for family members traveling with you — unless they’re employees of your business and traveling for a bona fide business purpose.

Substantiation is critical

Be sure to accumulate proof of the business nature of your trip and keep it with your tax records. For example, if your trip is made to attend client meetings, log everything on your daily planner and copy the pages for your tax file. If you attend a convention or seminar, keep the program and take notes to show you attended the sessions. You also must properly substantiate all of the expenses you’re deducting.

Additional rules and limits apply to the travel expense deduction. Please contact us if you have questions.

© 2018

The new tax law will change divorce tactics

When couples divorce, financial negotiations often involve alimony. The tax rules regarding alimony were dramatically changed by the Tax Cuts and Jobs Act (TCJA) of 2017, but existing agreements have been grandfathered. In addition, the old rules remain in effect for divorce and separation agreements executed during 2018. Next year, the rules will change, and the roles will be reversed.

Under divorce or separation agreements executed in 2018, and for many years in the past, alimony payments have been tax deductible. Moreover, these deductions reduce adjusted gross income, so they may have benefits elsewhere on a tax return. While the spouse or former spouse paying the alimony gets a tax deduction, the recipient reports alimony as taxable income.

Shifting into reverse

Beginning with agreements executed in 2019, there will be no tax deduction for alimony. As an offset, alimony recipients won’t include the payments in income.

Example 1: Joe and Kim Alexander get divorced in 2018. Joe expects to be in a 35% tax bracket in the future, whereas Kim anticipates being in a 22% bracket. Suppose that the proposed agreement has Joe paying $3,500 a month ($42,000 a year) in alimony.

Joe will save $14,700 in tax (35% times $42,000), but Kim will owe $9,240 (22% times $42,000). Net, the couple will save over $5,000 per year in taxes. This type of calculation will affect the negotiations, as it has in the past. Assuming the relevant rules are followed, it may make sense to tip the agreement toward Joe paying alimony to Kim, perhaps in return for other considerations.

Example 2: Assume that the Alexanders’ neighbors, Len and Marie Baker, have identical finances. They divorce in 2019. If Len pays $42,000 a year in alimony, he will get no deduction and won’t get the $14,700 in annual tax savings that Joe did in example 1. Marie, on the other hand, will pocket $42,000, tax-free, without the $9,240 tax bill faced by Kim in example 1.
    
Moving things along

Just as people shouldn’t “let the tax tail wag the investment dog,” so taxes shouldn’t dominate divorce or separation proceedings. However, it’s also true that taxes shouldn’t be ignored. If you are in such a situation, our office can help explain to both parties the possible savings available from executing an agreement during 2018, rather than in a future year.

The new rules will be in effect beginning in 2019. With no alimony deduction and a tax exemption for alimony income, it may be desirable to consider after-tax, rather than pre-tax, income when making decisions. Speaking very generally, there may be less cash for the couple to use after-tax.

Keep in mind that, as of 2019, not all states will have alimony tax laws that conform to the new federal rule. Your state may still offer tax deductions for alimony payments and impose income tax on alimony received. That’s all the more reason to look at after-tax results when calculating a divorce or separation agreement.

Getting personal

The impact of the new TCJA on spousal negotiations may go beyond the taxation of alimony. Among other provisions to consider, the TCJA abolishes personal exemptions. As a tradeoff, the standard deduction was almost doubled (see CPA Client Bulletin, April 2018). 

In some past instances, divorcing spouses would agree that the high bracket party would claim the children’s personal exemptions, which effectively were tax deductions, in return for some other consideration. Now those exemptions don’t exist, so they shouldn’t be part of divorce negotiations. If you previously entered into an agreement that included the treatment of children’s personal exemptions, you may want to consult with counsel to see about possible revisions.

Trusted advice

Defining alimony

Payments to a spouse or former spouse must meet several requirements to be treated as alimony for tax purposes. The following are some key tests:

• The payments are made under a divorce or separation agreement.

• There is no liability to continue the payments after the recipient’s death.

• The payments aren’t treated as child support or a property settlement.

• The payments are made in cash (including checks or money orders).

TCJA changes to employee benefits tax breaks: 4 negatives and a positive

The Tax Cuts and Jobs Act (TCJA) includes many changes that affect tax breaks for employee benefits. Among the changes are four negatives and one positive that will impact not only employees but also the businesses providing the benefits.

4 breaks curtailed

Beginning with the 2018 tax year, the TCJA reduces or eliminates tax breaks in the following areas:

1. Transportation benefits. The TCJA eliminates business deductions for the cost of providing qualified employee transportation fringe benefits, such as parking allowances, mass transit passes and van pooling. (These benefits are still tax-free to recipient employees.) It also disallows business deductions for the cost of providing commuting transportation to an employee (such as hiring a car service), unless the transportation is necessary for the employee’s safety. And it suspends through 2025 the tax-free benefit of up to $20 a month for bicycle commuting.

2. On-premises meals. The TCJA reduces to 50% a business’s deduction for providing certain meals to employees on the business premises, such as when employees work late or if served in a company cafeteria. (The deduction is scheduled for elimination in 2025.) For employees, the value of these benefits continues to be tax-free.

3. Moving expense reimbursements. The TCJA suspends through 2025 the exclusion from employees’ taxable income of a business’s reimbursements of employees’ qualified moving expenses. However, businesses generally will still be able to deduct such reimbursements.

4. Achievement awards. The TCJA eliminates the business tax deduction and corresponding employee tax exclusion for employee achievement awards that are provided in the form of cash, gift coupons or certificates, vacations, meals, lodging, tickets to sporting or theater events, securities and “other similar items.” However, the tax breaks are still available for gift certificates that allow the recipient to select tangible property from a limited range of items preselected by the employer. The deduction/exclusion limits remain at up to $400 of the value of achievement awards for length of service or safety and $1,600 for awards under a written nondiscriminatory achievement plan.

1 new break

For 2018 and 2019, the TCJA creates a tax credit for wages paid to qualifying employees on family and medical leave. To qualify, a business must offer at least two weeks of annual paid family and medical leave, as described by the Family and Medical Leave Act (FMLA), to qualified employees. The paid leave must provide at least 50% of the employee’s wages. Leave required by state or local law or that was already part of the business’s employee benefits program generally doesn’t qualify.

The credit equals a minimum of 12.5% of the amount of wages paid during a leave period. The credit is increased gradually for payments above 50% of wages paid and tops out at 25%. No double-dipping: Employers can’t also deduct wages claimed for the credit.

More rules, limits and changes

Keep in mind that additional rules and limits apply to these breaks, and that the TCJA makes additional changes affecting employee benefits. Contact us for more details.

© 2018

Home Equity Hassle

A key component of the TCJA is the expansion of the standard deduction. The numbers for 2018 are $24,000 (married couples filing jointly), $18,000 (heads of household), and $12,000 (all others). These amounts are almost double the respective standard deductions in 2017. However, personal exemptions were eliminated.

As a give-and-take, the new tax law trims some itemized deductions. Taxpayers can either itemize or use the standard deduction, so some shift to the standard deduction is likely.

Down with debt deductions

Among the trimmed itemized deductions are those for mortgage interest. The new law caps deductions to interest on $750,000 worth of debt used to buy, build, or substantially improve a main or second home. For loans incurred before December 15, 2017, the old rules remain in place, so interest on up to $1 million of such debt is still deductible.

These rule changes affect only newer home loans in the $750,000–$1 million range. Of broader impact, interest on home equity loans or lines of credit are no longer deductible (unless the proceeds of these loans are used to purchase or improve the home that secures the loan). Previously, interest on home equity debt up to $100,000 generally could be deducted. (All of these home loan interest tax changes are scheduled to end after 2025, reverting to 2017 law.)

Therefore, home equity debt now looks like many other types of loans: the interest is nondeductible. Should you keep the one you have? That depends on your situation. If you wish to reduce your debt load, paying down home equity debt has become more attractive. Prepaying a nondeductible loan at, say, 5% is the equivalent of earning 5% on your money, after tax, with no market risk.

Another option is to update your existing home debt. A so-called cash out refinance might provide you with spending money, although the full interest deduction may not be available. Our office can help you crunch the numbers to see if the expense involved would make it worthwhile, and how it will impact the after-tax cost of residence related debt.

Yet another alternative is to use a personal loan to pay off the home equity debt. An unsecured personal loan might be preferable to a loan or line of credit that places your home at risk.

Are State and Local Taxes Reasons for Relocation?

As many people are all too aware, some states and localities impose higher income and property taxes than others. Residents of high tax areas may have taken some solace by itemizing deductions on their tax returns and reducing federal income tax obligations by deducting the taxes paid.     

Example: Jennifer Knight deducted $25,000 worth of state income tax and local property tax on her 2017 tax return. Assuming Jennifer was in a 25% tax bracket, she reduced her net outlay for those taxes with $6,250 in tax savings (her 25% tax rate times the $25,000 tax deductions).     In this scenario, Jennifer’s actual tax cost was $18,750, not $25,000, because she cut her federal tax bill by $6,250.

New rules

Under the TCJA, there is still an itemized deduction for taxes paid, but it is now capped at $10,000 a year, starting in 2018. Some people refer to this as the SALT deduction for state and local taxes. It mainly covers property and income taxes, although taxpayers can choose to include sales tax instead of income tax towards the $10,000 cap. (The $10,000 limit is the same for single filers and couples filing jointly, so there is a true “marriage penalty” here.)     

As might be expected, taxpayers and politicians in high tax states and localities have loudly protested the cutback in the deduction for taxes paid. Is this the final straw? The added burden that will drive people to move to areas where income and property tax (and perhaps estate tax) are less of a burden?     

Relocation may make sense, but such a decision should be made with care. Calculate how much extra you’ll be paying in tax now, considering the loss of the taxes paid deduction and all the other features of the TCJA. Don’t forget to include the alternative minimum tax (AMT), which still impacts many individuals. People who owe the AMT get no tax benefit from deducting state or local taxes. Our office can help with this computation.     

Then, find out how much you’d owe after a move to a different area. Include income taxes and, assuming you’ll be a homeowner, likely property tax. Find out if sales tax will be meaningful in the new area. Determine the state’s estate tax exemption and estate tax rates, if you expect to leave assets to loved ones.     

Typically, you’ll discover that relocating is a puzzle with many different parts of varying sizes. Effectively paying more in state and local tax under the TCJA may be a key piece of that puzzle, but it’s just one thing to consider before calling the movers.

Regard Roth Conversions Carefully

The article “Rethinking retirement contributions” explains why the new TCJA devalues putting money into traditional tax-deferred plans and favors Roth versions. Does the same reasoning apply to conversions from Roth to traditional accounts? From a tax viewpoint, the answer may be yes, but other factors indicate you should be cautious about such moves.

Example 1: Fred and Glenda Polk would have had $220,000 in taxable income in 2017 without contributing to their employers’ traditional 401(k) plans. However, they contributed a total of $40,000 to the plan, bringing their income down to $180,000. The couple was in the 28% bracket last year, so the income deferral saved a total of $11,200 in tax: 28% times $40,000.

Assume they kept their $11,200 of tax savings in the bank. If their employers have a 401(k) plan that offers designated Roth accounts, they could convert the $40,000 they contributed in 2017 to the Roth side if the plans allow such moves. Alternatively, depending on the plan terms and the Polks’ circumstances, they might be able to rollover the $40,000 to a Roth IRA. Yet another possibility, the Polks might leave the $40,000 in their 401(k)s but convert $40,000 of pretax money in their traditional IRAs to Roth IRAs.

With any of these strategies, the couple would generate a $9,600 tax bill (24% of $40,000) on the Roth conversion, because their joint income falls into the 24% tax bracket in 2018, in this example. The Polks could pay that $9,600 from their $11,200 of tax savings in 2017 and wind up ahead by $1,600.

Therefore, people who move into a lower tax bracket this year might be able to come out ahead with Roth conversions of income that had been deferred at a higher tax rate. Going forward, the money transferred to the Roth side may generate tax free rather than taxable distributions.

One-way street

Nevertheless, there are reasons to be cautious about Roth conversions now. For instance, U.S. stocks are trading at lofty levels. Roth conversions could be highly taxed at today’s equity values.

Example 2: Heidi Morris has $300,000 in her traditional IRA, all of which is pre-tax. Investing heavily in stocks, Heidi has seen her contributions grow sharply over the years. With an estimated $100,000 in taxable income this year, Heidi calculates she can convert $50,000 of her traditional IRA to a Roth IRA in 2018 and still remain in the 24% tax bracket.

However, stocks could fall heavily, as they have in previous bear markets. The $50,000 that Heidi moves to a Roth IRA could drop to $40,000, $30,000, or even $25,000. Heidi would not want to owe tax on a $50,000 Roth conversion if she holds only $25,000 worth of assets in the account.

Under previous law, Heidi had a hedge against such pullbacks, at least for Roth IRA conversions. These conversions could be recharacterized (reversed) to her traditional IRA, in part or in full, until October 15 of the following calendar year. In our example, Heidi could have recharacterized after a market setback, avoided a tax bill, and subsequently re-converted at the lower value. (Timing restrictions applied.)

Such tactics are no longer possible because the TCJA has abolished recharacterizations of Roth IRA conversions. (Conversions to employer-sponsored Roth accounts could never be recharacterized.) Now moving pre-tax money to the Roth side is permanent, so the resulting tax bill is locked in.

In the new environment, it may make sense to take it slowly on Roth conversions in 2018. If stocks rise, boosting the value of your traditional retirement accounts that hold equities, you won’t be sorry about the increase in your net worth; you can convert late in the year at today’s lower tax rate. On the other hand, if periodic corrections occur, they could be an opportunity for executing a Roth conversion at a lower value and a lower tax cost.

Rethinking Retirement Contributions

The TCJA generally lowered federal income tax rates, with some exceptions. Among the ways in which lower rates impact tax planning, they make unmatched contributions to traditional employer retirement plans less attractive.

Example 1: Chet Taylor has around $100,000 in taxable income a year. Chet contributed $12,000 to his company’s traditional 401(k) in 2017, reducing his taxable income. He was in the 28% tax bracket last year, so his federal tax savings were $3,360 (28% of $12,000). An identical contribution this year will save Chet only $2,880, because the same income would put him in a lower 24% bracket. Not everyone will be in this situation.

Example 2: Denise Sawyer has around $200,000 taxable income a year. Denise contributed $12,000 to her company’s traditional 401(k) in 2017, reducing her taxable income. She was in the 33% tax bracket last year, so her federal tax savings were $3,960 (33% of $12,000). An identical contribution this year will save her $4,200 because the same income would put her in a higher 35% bracket.

Planning pointers

Considering the changes in tax rates, participants in employer sponsored retirement plans should review their contribution plans. If your company offers a match, be sure to contribute at least enough to get the full amount. Otherwise, you’re giving up a portion of your compensation package.

Beyond that level, decide whether you wish to make unmatched tax-deferred contributions to your traditional 401(k) or similar plans. The value here is tax deferral and the ability to compound potential investment earnings without paying current income tax. Deferring tax at, say, 12%, 22%, or 24% in 2018 will be less desirable than similar deferrals were last year, when tax rates were 15%, 25%, or 28%.

On the Roth Side

If you decide to cut back on tax-deferred salary contributions, spending the increased current income won’t help you plan for your future retirement. Other savings tactics may be appealing.

For instance, your employer might offer a designated Roth account in its 401(k) plan. These accounts offer no upfront tax benefit because they’re funded with after-tax dollars. The advantage is all withdrawals, including distributions of investment income, will avoid income tax after age 59½, if you have had the Roth account for at least five years. (Other conditions can also qualify distributions from a Roth account for full tax avoidance.)

Generally, the lower your current tax bracket and the higher your expected tax bracket in retirement, the more attractive Roth contributions can be.

Example 3: Ed Roberts, age 30, expects his taxable income (after deductions) to be around $50,000 this year, putting him in the 22% tax bracket. Ed hopes to have a successful career, so he might face a higher tax rate on distributions in the future. Therefore, Ed contributes $6,000 ($500 a month) to his company’s traditional 401(k) to get some current tax relief, and $6,000 to the Roth 401(k) for tax free distributions after age 59½.

Some advisers suggest going into retirement with funds in a regular taxable account, funds in a tax-deferred traditional retirement account, and funds in a potentially tax-free Roth account. Then, you may have considerable flexibility in choosing tax-efficient ways to draw down retirement cash flow.

Other Options

What if Ed’s employer’s 401(k) plan does not offer designated Roth accounts? A possible solution for Ed would be to contribute to a Roth IRA instead. In 2018, he can contribute up to $5,500 ($6,500 for those 50 and older). Roth IRAs also offer completely tax-free distributions after five years and age 59½.

Example 4: Assume that Ed’s employer will match up to $4,500 of his 401(k) this year and that Ed plans to save $12,000 for his retirement. Ed could contribute $5,500 to a Roth IRA and $6,500 to his traditional 401(k).

With higher incomes ($120,000 or more of modified adjusted gross income for single filers in 2018, $189,000 for couples filing jointly), Roth IRA contributions are limited or prohibited. People facing this barrier may able to fund a nondeductible traditional IRA, up to $5,500 or $6,500 this year, then convert those dollars to a Roth IRA with little or no tax at this year’s tax rates. (IRA contributions for 2017, with slightly different income limits, are possible until April 17, 2018.)

Ultimately, the choice between traditional and Roth retirement accounts will largely depend on expectations of future tax rates. Deferring tax in a traditional plan this year and saving 24% in tax may not turn out to be a good deal if future withdrawals are taxed at 28%, 30%, or 35%. The fact that the TCJA rates are among the Act’s provisions that are due to sunset in 2026, reverting to 2017 rates, may tilt the scales a bit towards the Roth side, where distributions eventually may escape tax altogether.

Trusted Advice

Retirement rules

• Participants in 401(k) and similar employer sponsored retirement plans can contribute up to $18,500 this year, or $24,500 if they’ve reached age 50.

• If your company’s 401(k) plan offers a designated Roth account, contributions to the plan can be divided in any manner you choose between a pre-tax account and a designated Roth account, but the total can’t exceed the $18,500 or $24,500 ceilings.

• Any employer match usually goes into the traditional 401(k), even if the contribution is to the Roth version, so income tax on the matching money is deferred.