2018 Tax Reform May Result in State Windfall

Did our state representatives in Congress know all along that 2018 Tax Reform may result in a large shift of taxes from the Federal government to their respective state government coffers?

There is much information on the 2018 Tax Reform bill that is now signed into law and effective for 2018 but little about the effect on state taxes here in Virginia (and likely other states, too). Some taxpayers may find that Line 5 of Schedule A now capped at $10,000 will result in a reduction in itemized deductions for 2018 at the state level. The result of fewer itemized deductions at the state level of-course will increase your state taxes.

State income taxes withheld were never included on the state return but because real estate or property taxes may take you over the new $10,000 cap you may find a surprise when filing 2018 state tax returns.

More taxes due to the state.

Another, even more important, aspect of 2018 Tax Reform is that many more taxpayers will no longer being itemizing deductions because the Federal standard deduction has increased substantially.

If you are one of those who used to itemize and now find that in 2018 your itemized deductions are less than the standard deduction then, if you file using the standard deduction (still optional) you must, in Virginia, also file your state return using the standard deduction.

For singles this is only $3,000 and for married-joint returns it is only $6,000 in Virginia. Yikes! This also could result in large increases in your VA state taxes.

From what I have seen so far, the savings in taxes at the Federal level more than offset any increase in taxes at the state level but you have to run the numbers.

Proposed Tax Changes

I have not written in almost a year (February 2014 was my last post). There is always much to write about though and proposed tax changes are high on the list.

I recall reading Larry Burkett's book back in 1991 titled "The Coming Economic Earthquake" and remembering that he said that tax-deferred accounts only hold promises and not guarantees.

In President Obama's State of the Union address, he touched upon a few tax proposals but in his proposed budget there are even more changes than what he highlighted in his speech.

They are just that, though, "proposed" and unlikely to ever make it into law.

But as Michael Kitces recently writes in his blog "...nonetheless, the proposals provide important insight into what the White House considers..."

Just a few examples of proposals over the last few years, and recently, may give you pause:

(1) No RMD's (Required Minimum Distributions at age 70 and 1/2) if all of your IRA balances aggregated together are under $100,000 or you annuitize a portion of your IRA's to get you under the $100,000 limit. That sounds good.

(2) Eliminating the "back-door" ROTH. This is where you contribute to a Traditional IRA non-deductible contributions up to the limit ($5,500 or $6,500 for 2015 depending on age) and then convert those funds, after a reasonable time, to a ROTH IRA. For those whose income exceeds the ROTH contribution income limits (starting the phase-out at $183,000 of Adjusted Gross Income for 2015) this has been a way to get money into a ROTH. The proposal limits conversions to "pre-tax" dollars only, thereby eliminating any "after-tax" dollars from conversions.

(3) Require minimum distributions (RMDs) from ROTH IRAs. Though still not taxed, under current law, no RMDs are required from ROTH IRAs. They can continue to grow tax-deferred and tax-free with no limits until death and then the beneficiaries are required to take RMDS from inherited ROTH IRAs.

(4) Limit of $3.4 million that you can accumulate and hold in tax-deferred accounts.

(5) Value-add tax or consumption tax (which would, in effect, make ROTH IRAs taxable when withdrawn and spent on something).

That is just a sampling but it holds true that tax-deferral and tax-free accounts are promises from today's government and not necessarily true for the future. Diversify accounts by tax location.

ROTH Myth

Allan S. Roth writes in the February 2014 Financial-Planning.com magazine that "...a common myth is that the ROTH ... is better than the traditional [IRA] account if the assets are held for a certain number of years. This is false. The only things that matter are the marginal tax brackets in the year of the conversion and the year of withdrawal. If the marginal tax bracket ends up higher upon withdrawal, the conversion will have been beneficial..."

This is just  a number's thing. It is true. Other ROTH advantages, though, may entice someone to do ROTH conversions and/or start a ROTH. There is the 5-year rule for starters so beginning a ROTH sooner rather than later may still make sense to get the clock ticking in your favor. Another is that ROTH's do not have required minimum distributions. And, more importantly, withdrawals never show up on your tax return because it is not taxable income. 

Even if you are in the same tax bracket when you take money out, your social security may be taxed differently if you can minimize your taxable income and that may effect your true marginal tax rate.

Of-course, any money you put into a ROTH can be taken out without penalty or taxes and so this may be a good place to consider for some portion of your emergency fund.

Asset Locations

Where you hold your investments (tax-deferred or taxable accounts) can make a difference. For example, stocks and stock funds held in a tax-deferred retirement account (i.e. 401k or Traditional IRA, etc.) turn a capital gain into ordinary income.

If you are in the 15% tax bracket, the current capital gains tax rate is zero. Putting money into a Traditional IR or 401k will save on taxes right away but it is only a deferral until some later date.

Another possible challenge in retirement is that required minimum distributions will push you into a higher tax bracket when this could be managed by possibly using ROTH IRA's if you qualify or a taxable account.

Another disadvantage is that those tax-deferred retirement accounts do not get a step-up in basis at death but rather are passed on to beneficiaries who then will be taxed on withdrawals in their regular income tax bracket.

Bonds and bond funds held in non-taxable accounts will not grow as fast but interest income is taxed at the same rates as ordinary income.

Tax location diversification makes sense.

Tax-Loss Harvesting

Taking losses and offsetting them against gains is a typical tax-loss harvesting strategy. The savings potential is usually tax deferral. You have to remember that when you sell something at a loss, your next purchase has, in effect, reset the cost-basis. This sets you up for future taxable gains - sometimes.

If you are in the 15% Federal tax bracket, today's tax code provides up to a $3,000 loss annually against your income (15%). The resulting reset in your cost-basis may mean that the potential future capital gains will be taxed at 0%.

There is the potential for tax planning strategies if the right situation applies to you.

Will a family of four making less than $50,000 pay Federal taxes?

I am using $50,000 because this is close to the average national income of the U.S. for a family of four.

Let's see:

If you qualify to file Married-Jointly in 2014, then the following income is not taxed:

$12,400 is the standard deduction (forget about needing mortgage interest deductions or real estate tax deductions, they may not get you over this threshold though everyone's state taxes and charitable contributions will affect your total deductions possible)

$15,800 is the exemption for four at $3,950 per exemption in 2014

Two child tax credits of $1,000 each is $2,000 off the top, so if you make another $20,000 (rough numbers), then your Federal tax on that $20,000 is offset ( dollar-for-dollar) by these child tax credits. These may expire in 2017 if not extended so keep your eyes wide open.

Well, we are over $48,000 of income with no Federal tax and we have not yet considered whether there are other credits that may apply:

(1) Any interest on a qualified student loan? That is a deduction that offsets income, too, in part.
(2) Did you save for your retirement in a 401k or even a ROTH? That may qualify for a saver's credit of a few hundred dollars.
(3) Oh, and yes, you may even qualify for the EIC (Earned Income Credit) too. Not much, but something.

Yes, a family of four making less than $50,000 most likely is not paying much, if any, Federal taxes. Now the states are sure to get a piece of the action but not the Federal government.

Taxes and the Home Office Deduction

Starting in 2013, there is a new home office safe harbor “standard deduction” of up to $1,500 (it is $5 times the sq. ft. used for the office).

 

If you are using a part of your home for your home office, this may help simplify the calculation if it turns out to be more than using the old allocation method.

  
Here is the IRS link to the Revenue Procedure: http://www.irs.gov/pub/irs-drop/rp-13-13.pdf

 

Tax Law Changes for 2011

On December 17, 2010 several tax laws were extended for 2 more years but, in addition, there were a few new enhancements. Always seek a professional in these matters. Here are a few:

(1) Estate tax exemption is now portable for married couples. So, for the next two years everyone gets a $5 million exemption and, if married, the surviving spouse receives a $10 million exemption without creating any trusts. Be careful though since it is only temporary and also because these are Federal limits only - not states (MD is still $1 million, for example).

(2) Qualified dividends are taxed like long-term capital gains (15% bracket is zero and in higher tax brackets it is a maximum of 15%) but now the definition includes dividends from Real Estate Investment Trusts (REIT's). They used to be taxed at regular income rates.

(3) Some tax credits (like for education) and the phase outs of itemized deductions were also extended.

So, be sure to watch your tax calculations carefully and seek the advice of a tax professional or a certified financial planner before you take action.

New Tax Schedules for 2009 Returns

As you prepare your 2009 tax return, there are several changes. As an example, two new schedules should be reviewed in case they affect your return:

Schedule M - related to last year's Make Pay Work tax credit where many earners received a little extra in their paychecks to help stimulate the economy.

Schedule L - for those who do not itemize deductions allows some extra add-on deductions if you qualify.

There are many changes besides these examples so keep a watchful eye.

Tax Loss Harvesting

Financial advisors often suggest to their clients to "harvest tax lossess" - sell those stocks or funds that have lost money. It is true that losses can offset gains and also that up to $3,000 in losses can be offset against regular income. Nice.

As Dan Moisand in a February 2010 issue of Financial-Planning.com reminds us, though, "...the process of harvesting losses...reset[s]...cost basis to a much lower amount. [You], therefore...increased future taxable gains..."

Since the next purchase you make, assuming it is a successful investment and has a gain when later sold, resets the cost basis, then over a studied 10-year period you may find, as he did, that taxes paid on future investments offset, in part, the losses supposedly "harvested".

Watch out for phrases like "capture the equity" in your house and "harvest your losses". They are not the panacea they appear to be at times.

Defer, Defer, Defer

Deferring taxes may not be in your best interests. Do not assume that this is always the best alternative. Reasons:

(1) Today the tax brackets change based on inflation so more and more income may be taxed at low 10% and 15% rates when your income drops in retirement.

(2) Social security income may be taxed but the income limits at which they are taxed are NOT indexed to inflation. Income over only $44,000 (if married) makes 85% of social security taxable.

(3) If you have money in ROTH IRA's or taxable brokerage accounts, then using some of this money first in retirement may reduce your taxes later. Maybe.

(4) Deferring withdrawals from retirement accounts may result in a higher Required Minimum Distribution at age 70 and 1/2 that could have been avoided by taking some of that money early in retirement or not putting as much in there in the first place. Maybe.

(5) Don't forget estate taxes. ROTH's and taxable accounts may not be taxed to your heirs depending on "step-up-in-basis" laws (There is no estate tax but currently $1.3 million for 2010 and another $3 million pass tax free but these laws are expected to change).

Expats - Foreign Earned Income

If working outside the U.S. (physically located outside the U.S. that is) for 330 days during a 12-month consecutive period, then you are eligible for the Foreign Earned Income Exclusion obtained by filing IRS Form 2555. In 2009, the first $91,400 earned overseas is tax-free.

Expats may have to pay taxes in the country where they are working however, but even these taxes can be claimed as a credit (foreign tax credits are claimed on IRS Form 1116) if, indeed, they qualify.

According to Nick Hodges, president of NCH Wealth Advisors, in an article in the January 2010 issue of Financial-Advisor magazine by Jeff Schlegel, "...more developed countries such as the U.K. tend to have higher income taxes than the U.S..."

ROTH Conversions

You can learn about the advantages and disadvantages of converting Traditional IRA funds, paying the taxes and then allowing them to grow tax-free in a ROTH IRA from many websites.

I will not go into the details here, but it is not a slam-dunk and may, indeed, not be wise until you run the numbers for your specific situation.

Two points to consider:

(1) As the tax law is today, when you retire, your Traditional IRA may, indeed, NOT be taxable. That's right. For example, for a married couple in 2010, nearly the first $20,000 (rounding a bit) of income is in the zero tax bracket. These brackets are currently indexed to inflation, so if you plan to withdraw your Traditional IRA money out in increments around 20 years from now, you may be able to withdraw as much as $40,000 per year tax free.

(2) There are property rights in America that are respected. However, your right to tax-free income from the ROTH is not a protected right. Who knows what Congress will do to your ROTH value's tax-free right in 20 years? Convert to a ROTH in 2010, pay tax now and, maybe pay tax later, too. Run the numbers and you may surprise yourself (don't forget to calculate the future value of the taxes paid to convert - and, of-course, those funds would not come from the Traditional IRA but another source, for sure).

Thank you Congress for keeping financial planners in business. A good one can help you.

Tax Refund - oh boy!

Time to begin work on 2009 tax returns of-course was about a year ago. Yes, that is right. The planning should have been started at the beginning of the tax year and not at the end because you don't want to be under-withheld and potentially pay penalties. You also don't want to have paid the government too much during the year and get a large refund.

Why not a large refund?

The argument you always hear is that you have given the government an interest-free loan of your money that you could have earned the interest. Well, let's see, over a year a $2,400 refund for example would have probably saved you an additional $12 in interest (if kept in a safe money market) or could have cost you nearly $500 if you had dollar-cost averaged into a retirement stock fund. But that is only a 1-year return and not fair.

No, the real reason to avoid a large refund is that you think of it as a "windfall" and you may, indeed, spend it. You may end up neither saving it nor investing it and lose all around. Adjust your W4 form online at http://www.irs.gov/ or better yet see a financial planner to get an even more accurate picture of next year's tax liability.

2010 Tax Planning Limits

Reference: IRS ruling # IR-2009-94, Oct. 15, 2009, if you still are working and have earned income:

"...The limitations [i.e. 401k plan; 403(b); TSP] ... will remain unchanged for 2010. This is because the cost-of-living index for the quarter ended September 30, 2009, is less than the cost-of-living index for the quarter ended September 30, 2008, and, following the procedures under the Social Security Act for adjusting benefit amounts, any decline in the applicable index cannot result in a reduced limitation..."

(1) 401k (403b and TSP) plan contribution limit remains at $16,500 (if under age 50 anytime in 2010)

(2) 401k (403b and TSP) plan contribution limit remains at $22,000 (includes the $5,500 catch-up provision if age 50 or older anytime in 2010)

Other information related to limitations are:

(3) Highly compensated employee remains unchanged at $110,000 (Used to determine anti-discrimination qualifications for some plans, like FSA's)

(4) The definition of key employee in a top-heavy plan remains unchanged at $160,000 (which could limit your ability to contribute the maximum)

For personal ROTH IRA's, here is some additional information:

The adjusted gross income limitation...for determining the maximum Roth IRA contribution for married taxpayers filing a joint return or for taxpayers filing as a qualifying widow(er) is increased from $166,000 to $167,000 (start of the phase-out).

The adjusted gross income limitation ... for all other taxpayers (other than married taxpayers filing separate returns) remains unchanged at $105,000 (Start of the phase-out).

Making contributions is different from converting so...

for married couples, the the income limitation increased slightly but the $100,000 income limitation to convert Traditional IRA's to ROTH IRA's has been suspended in 2010.

This makes for some interesting planning opportunities since the tax due can be paid over years 2011 and 2012 but you have to "run the numbers".

Making Work Pay Tax Credit 2009 and 2010

Employers were required to start using new withholding tables by April 1 that affected some workers based on income.

The Making Work Pay credit is phased out for a married couple filing a joint return whose modified adjusted gross income (AGI) is between $150,000 and $190,000 and other taxpayers whose modified AGI is between $75,000 and $95,000.

The tables, however, don't take into account situations like the following so if you find yourself in one of these categories you may want to revisit your withholdings and complete a new W4 form and change the amount withheld from your paycheck.

For example:

-A single worker with two jobs will get a $400 boost in take-home pay at each of them, for a total of $800. That worker, however, may only be eligible for a maximum credit of $400 (if income is too high and is phased-out), so the remaining $400 may have to be paid back at tax time - either through a smaller refund or a payment to the IRS.

- A married couple with a combined income under the phase-out amount is eligible for an $800 credit. However, if both spouses work and make too much, the new withholding tables may give them each a $600 boost (not $400) - for a total of $1,200, which may be too little withheld.

- A single college student with a part-time job may get a $400 boost in pay. However, if that student is claimed as a dependent on a parent's tax return, the student doesn't qualify for the credit and would have to repay it when filing next year.

Many people will not have to make any changes. More information at the IRS site:

http://www.irs.gov/newsroom/article/0,,id=204521,00.html

Mileage Rates Increase Effective July 1, 2008

The mileage rate for expense reports (if your company follows the IRS guideline for use of your car for business purposes) has been increased to .585 from .505 per mile. And the mileage rate for moving and medical care has also increased 8 cents to .27 from .19 per mile. Go to:

For details: http://www.irs.gov/pub/irs-drop/a-08-63.pdf

Rates effective July 1, 2008 will be a little help if you can use these types of deductions on your tax returns or expense reports.

AMT - what will 2007's exemption be?

Here is a link to keep track of the AMT (Alternative Minimum Tax) if you are interested:

http://waysandmeans.house.gov/hearings.asp?formmode=all&comm=6

The House Ways and Means Committee is where this activity starts and they are planning to meet in September. Most likely, there will be a one year patch for 2007 (keeping the exemption amount the same as 2006 and keeping you from the extra tax possibility).

The Byrd Rule and Taxes

Return of the Estate Tax in 2011 ??? UNLIKELY but read on:

The amount of property that passes free of the Federal Estate Tax will increase from $2,000,000 during 2007 and 2008, to $3,500,000 during 2009, and to an unlimited amount during 2010 when the tax is repealed. The tax then returns in 2011.

The tax not only returns in 2011, it returns to the amount that existed in 2000 to allow "just" $1,000,000 to pass tax free.

The return of the Federal Estate Tax in 2011 is due to a "sunset provision" in EGTRRA, the law that created these changes to the tax.A sunset provision is part of a law that requires the automatic termination of that law on a specific date.

The sunset provision that is a part of EGTRRA was used to avoid the "Byrd Rule."Named for its creator, Sen. Robert Byrd, the Byrd Rule allows the objection of just one U.S. Senator to defeat the passage of any law that will affect revenue for more than ten years.

Although any such objection may be overridden with the support of 3/5 of the Senate, it was not believed that 3/5 of the Senate would support EGTRRA when it was proposed.In order to avoid the Byrd Rule, a sunset provision was included that automatically terminates the law within ten years. By ending within ten years, EGTRRA does not effect revenue for greater than ten years and could not be overridden by just one Senator.

(from the site: http://www.mystatewill.com/)

Taxes and Congress (May 2007)

The Senate's budget resolution leaves room to extend permanently a number of existing tax measures, including the 10% tax bracket; "marriage penalty" relief; a higher earned-income tax credit; an adoption credit; a higher child-care tax credit and a lower estate-tax rate and higher exemptions.