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Monthly Tax Ideas:
Feb 08, Sept 07, June 07, May 07, April 07
Feb 08 Bean Counter Tax Ideas
Section 162 Employee Benefit Program:
A married couple is entitled to deduct payments for health insurance and medical payments that are made under an employee benefit program. T.C. Memo. 2007-351
Ralph owns a sole proprietor business and he had one employee, his wife Erika. Erika performed actual business duties (key factor) for the family business. During the year Ralph obtained a health insurance policy that covered his employee(s). During the year, Ralph paid wages of $3,000.00 subject to Social Security and Medicare taxes to Erika.
Erika paid the insurance premiums from her own checking account as well as cancer insurance plus unreimbursed medical expenses. At a later date, Erika submitted invoices to her employer for repayment. The Schedule C business deducted the cost as an employee benefit program cost. Upon examination, the IRS rejected the deduction and billed for the additional tax liability.
The married couple argued that the items were paid as a reimbursement to Erika. Her policy covered Ralph as a spouse with Erika being the primary insured. The Tax Court held that the deduction is correct. Erika paid the medical items from her own bank account. Likewise, her spouse is allowed to be covered. Ralph’s business had a valid medical reimbursement plan which was allowed as an ordinary and necessary business expense.
If Ralph lost this one, he would have been allowed to deduct the family’s medical cost that exceeded 7 1/2% of their adjusted gross income. With proper planning a sole proprietor business can be very handy.
Section 1091- IRA Wash Sale Losses of Stock or Securities.
Rev Rule 2008-5 has addressed the deductibility of an individual IRA loss resulting from a Wash Sale. Here are the facts: An individual owned 100 shares of ABC Corporation in his IRA. The stock has a basis of $1,500.00. The stock was sold on December 17 for $700.00 resulting in a loss of $800.00. No problem so far, but watch what happens next.
Our investor purchased the same company stock in his Roth account on December 26. His Roth Account is for his benefit, same as the selling IRA account. The individual executed the sale and repurchase with a different retirement account. ( Also the individual is a not a dealer in the stock position. )
Code section 1091 (a) provides that any loss claimed to have been sustained from a sale cannot be repurchased within a 30 day period. A “substantially identical stock or securities” will result in any loss not being recognized for tax purposes.
The IRS ruled that the loss on the sale of stock is disallowed under section 1091. Because both accounts, IRA and Roth, benefit the same individual and beneficiaries, each account will not stand alone for Wash Sale purposes. The accounts are considered as being the same. The tax exempt or non exempt status does not apply. Therefore, our investor has a basis problem.
Common mistakes of the S Corporations and their shareholders
The IRS has identified several mistakes that are commonly made by S Corporations and their shareholders. The most common are as follows:
- Accrual of expenses due a shareholder – Pursuant to code section 267, an accrual corporation cannot accrue and deduct expenses payable to a shareholder until cash moves between the entity and taxpayer. The shareholder is 99% of the time a cash basis taxpayer. That is, expenses and income are recognized when actually received by the taxpayer. Therefore, the corporation cannot deduct a rent expense until actually paid.
- Fringe Benefits – Certain fringe benefits paid by the S Corporation on behalf of a shareholder, who owns more than 2% of the corporation (including family members), are taxable to the individual. Examples include health, accident and life insurance premiums, meals and lodging, and certain cafeteria plan benefits.
- Compensation to Shareholders – If the shareholder is a performing an earned income type service for the corporation’s benefit, do not improperly classify the service as rent or distribution. This mistake will be reclassified upon examination as wage subject to the employment taxes. Penalties etc would be added to the tax bill.
- Losses in excess of basis- Pursuant to code section 1366, a shareholder in a S Corporation, can deduct any pass thru losses up to the stock basis amount. Therefore, it is important to compute the annual stock basis for each shareholder. Any loans to the corporation by a shareholder will add to that individual’s basis.
Sept 07 Bean Counter Tax Ideas
Donating a Life Insurance Policy to Charity
A number of charities now ask their donors to consider donating life insurance policies rather than, or in addition to, cash, in order to make substantially larger gifts than would otherwise be possible. The advantage to donors is that they can make a sizable gift with relatively little up-front cash or even no cash if an existing policy is donated. The fact that a charity may have to wait many years before receiving a payoff from the gift is typically not a problem, because charities normally earmark such gifts for their endowment or long-term building funds.
If handled correctly, a life insurance policy donation can net the donor a charitable deduction. A charitable deduction is also available for any cash contributed in future years to continue paying the premiums on a policy that was not fully paid up when it was donated. However, if handled incorrectly, no deduction is allowed.
New Tax Law Benefits Small Business Owners
Congress recently passed and the President has signed yet another new tax law. This latest effort is called the Small Business and Work Opportunity Tax Act of 2007 (the1 Act). The stated purpose of the legislation was to provide small business owners with tax relief to help offset the cost of the newly increased federal minimum wage. Below some major provisions of the new law are listed.
Section 179 Rules. The Section 179 rules allow small business owners to immediately expense business equipment purchases versus -- depreciating them over several years. The Act extends the current taxpayer-friendly Section 179 deduction rules for one more year— through tax years beginning in 2010—and also makes them even more generous starting with tax years beginning in 2007. For 2007, the maximum Section 179 deduction is generally increased to $125,000 (from $112,000 before the Act). For 2008 through 2010, the $125,000 amount will be indexed for inflation.
Prior to the Act, the Section 179 benefit began phasing out on a dollar-for-dollar basis when eligible equipment purchased reached $450,000. For 2007, the Section 179 deduction phase-out threshold is generally increased to $500,000 of qualifying property. For 2008 through 2010, the $500,000 amount will be indexed for inflation.
In addition, the current rule allowing Section 179 deductions for the cost of off-the-shelf software is extended through tax years beginning in 2010. The current rule allowing Section 179 elections to be changed or revoked on amended returns is also extended through tax years beginning in 2010.
Spousal Joint Ventures Taxed as Partnerships.
A husband-wife joint venture that is treated as a partnership for federal tax purposes generally must file an annual Form 1065 (U.S. Return of Partnership Income) and issue each spouse a separate Schedule K-l (Partner's Share of income, Deductions, Credits, etc.) each year. This requirement can present a tax reporting hardship.
For tax years beginning after December 31, 2006, the Act allows some husband-wife joint ventures to “elect out" of the partnership rules for federal tax purposes when in compliance with specific requirements. After electing out, each spouse will report his or her share of the federal income tax items from the venture on the appropriate IRS form, Similarly, each spouse will report his or her share of net self-employment income from the venture and will receive credit for that income for Social Security benefit eligibility purposes.
While electing out won't change a married couple's total federal income tax liability or total self-employment tax liability, it will eliminate the need to prepare and file Form 1065 and the related Schedules K-l.
Work Opportunity Tax Credit (WOTC).
The WOTC is available to employers of persons who fall into one of the designated targeted groups (generally, economically or physically disadvantaged persons). Under exceedingly complicated rules, the WOTC provides employers with a federal income tax incentive to hire members of certain targeted groups. Before the Act, the WOTC was scheduled to expire for wages paid to employees who begin work after 2007. The Act extends the WOTC to cover wages paid to qualified employees who begin work before September 1, 2011. In addition, the Act expands the list of targeted groups and makes other favorable changes for wages paid to affected employees who begin work after May 25, 2007.
Retirement Savings Contributions for 2007
There is still ample time to plan for your 2007 retirement savings contributions. You can contribute up to $4,000 ($5,000 if you are age 50 or older by year-end) to your IRA in 2007 if certain conditions are met. For married couples, the combined contribution limites are $8,000 ($4,000 each) and $10,000 ($5,000 each if both are age 50 by year-end) when a joint return is filed, provided one or both spouses had at least that much earned income. Keep in mind that contributions to traditional IRAs may be tax-deductible subject to specific limitations.
When you establish and contribute to a Roth IRA, withdrawals are tax-free if specific requirements are satisfied. In addition, there are no mandatory distributions rules at age 70 1/2 if you meet the earned income requirement.
The 2007 annual deferral limit for qualified retirement plans is $15,500. If you are at least age 50 by year-end, you can contribute an additional $5,000 to 401(k), 403(b), and 457 plans in 2007. These contributions will generally decrease your taxable income.
June 07 Bean Counter Tax Ideas
Medicare Part B Premiums Increase
As individuals age 65 and older may already know, Medicare Part B (Part B) premiums have gone up. Part B covers doctor bills, lab tests, and other outpatient services. Prior to 2007, the Federal government paid 75% of the monthly Part B premium ($374 in 2007) and the covered individual paid the remaining 25% ($93.50 in 2007). However, starting this year, premiums are based on your income—higher income equals higher premiums.
Taxpayers at the higher income levels, starting with modified adjusted gross income of $80,000 for single filers and $160,000 for joint filers, will now have less of their premiums subsidized by the government. Since your 2006 income tax information was not available in January, the Federal government used your 2005 tax information to compute your 2007 Part B premiums. So, higher income individuals have seen their premiums increase to one of four new levels (starting at $105.80 and ending at $161.40 per month or from 28% to 43% of the total monthly premium) in 2007.
This is the first year of a three-year program to increase Part B premiums for higher income individuals. In 2009, these taxpayers will be required to pay up to 80% of the monthly Part B premium. At the 2007 monthly Part B premium rate of $374, that's $299.20 per month compared to the standard 25% rate of $93.50 in 2007; and that's without adjusting for inflation.
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Potential Double Benefit from a Tax Deduction
For most taxpayers, the amount of federal income tax they pay each year often depends upon where they fall in the federal income tax brackets and on the breakdown of their taxable income between ordinary (e.g., wages) and capital gains from the sale of assets (e.g., common stock). Taxpayers eligible for the lower federal income tax brackets (those under 25%) on their ordinary income can generally expect to be taxed at a rate of only 5% (exceptions apply) on their long-term capital gains. Taxpayers finding themselves in the 25% or higher federal income tax brackets can generally expect to be taxed at a 15% rate (again, exceptions apply) on at least a portion of their long-term capital gains.
So, if it is inevitable that as our federal taxable income increases the rate of tax we pay on at least a portion of that income also increases, the converse should and does apply. That is, as our federal taxable income decreases the rate of tax we pay on at least a portion of that income will decrease. In addition, if a taxpayer has a long-term capital gain that, after considering ordinary income, is partially taxed at the 15% rate, any additional deduction that decreases ordinary income will simultaneously diminish the taxation of a comparable amount of long-term capital gain from the 15% bracket to the 5% bracket. This has the effect of producing a double benefit for that deduction.
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Basics of the Dependent Care Credit
Many taxpayers are eligible for the Dependent Care Tax Credit. This credit has been in an evolutionary state for more than two decades, being tweaked over the years by various pieces of legislation. So, we thought it might be a good time to review some of the basics of this beneficial credit.
Depending on the taxpayer's income, the credit ranges from 20% to 35% of the dependent care expenses (limitations apply) paid and incurred while the taxpayer and spouse, if married, are gainfully employed. The care must be for a qualifying individual.
As the taxpayer's income increases, the nonrefundable credit is gradually reduced from 35% to 20% of the lesser of the qualifying expenses or earned income of the taxpayer and spouse, if married. There is also an overall limitation of $3,000 for one qualifying person or $6,000 for two or more qualifying persons. A qualifying individual is either a qualifying child under age 13, or a dependent or spouse who is physically or mentally incapable of self-care and has the same principal place of abode as the taxpayer for at least half of the year. The credit is allowed to married taxpayers only if they file a joint return.
To claim the credit, child and dependent care expenses provided for the well-being and protection of a qualifying individual must be incurred to enable the taxpayer (and spouse, if married) to work. This means if the expenses were for household services, part of the services must have been for the care of a qualifying individual. Thus, expenses for ordinary household services (such as a housekeeper, maid, or cook) that are necessary to run the home qualify for the credit if part of the expenses relate to the care of a qualifying individual.
Examples:
Expenses for care outside the taxpayer's home qualify for the credit if incurred to allow the taxpayer(s) to work, and the main reasons for the expenses are the well-being and protection of the qualifying person.
The cost of a day camp or similar programs may be for the care of a qualifying individual and an employment-related expense, even if the day camp specializes in a particular activity.
One final point: a tax credit offsets your tax liability on a dollar-for-dollar basis. So, we want to ensure that you benefit from this and any other available credit. Please call us with any questions you might have on the Dependent Care Tax Credit or any other individual or business tax issue.
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May 07
May 07 Bean Counter Tax Ideas:
New Charitable Contributions Rules
For cash contributions, it's not unusual to give small amounts without expecting a receipt. Previously, if these donations were less than $250, you could either keep cancelled checks or reliable records, such as a list showing the dates, amounts donated, and charity name as proof of the donation. Under the new rules effective this year, however, it's no longer sufficient to simply keep good records of these donations to claim them as charitable contributions. Instead, cash contributions of less than $250 given in a single donation are only deductible if you keep a bank record (most likely a cancelled check, wire transfer acknowledgement, or credit card record) or written acknowledgement from the charity showing the name of the charitable organization, the date of the contribution, and the amount of the contribution.
So, if you are likely to itemize deductions on your income tax return and typically make cash contributions of less than $250, you should make donations by check rather than cash, because that will easily satisfy the documentation requirements. Simply keeping good records of the donations will no longer be enough to claim the deduction.
Substantiation rules for larger contributions of cash or other property (those that are more than $250) were not changed by the new rules, but, as a reminder, they require a little more effort to substantiate. A written acknowledgement from the charity must be obtained, showing the description of the property or amount of cash donated and a statement as to whether the donor received any goods or services in return for the property donated. If goods or services were received, a good faith estimate of their value should be obtained. A cancelled check or other reliable records are not sufficient proof. (You can obtain one written acknowledgement for multiple gifts of $250 or more to the same charity.) The acknowledgement must be received contemporaneously; that is, it must be obtained no later than the due date (or extended due date, if applicable) of the tax return for the year the contribution was made.
If you typically donate used clothing or household items to charities, such as Goodwill, the items must be in "good condition or better" unless the items were worth more than $500 and a qualified appraisal report is attached to your tax return. The IRS has not yet defined what is meant by "good condition or better." Thus, you might consider keeping a detailed list and photos of contributed items (unless the property is appraised). No new documentation is required, but to protect yourself in case of an IRS audit, you should, at a minimum, document that the donations were in good condition.
For any amount (even if it's less than $250) of contributions made by payroll withholding, you're now required to keep an official pledge card from the charity and documents from your employer (for example, a pay stub or Form W-2) showing the amount donated.
If you're planning to contribute property (other than publicly traded securities) for which a deduction of more than $5,000 will be claimed ($10,000 for closely held stock), please discuss these plans with us as soon as possible. Although the rules for substantiating this type of property haven't changed, there are now stricter rules for what is considered a "qualified appraisal" and who is considered a "qualified appraiser." You must have the appraisal done not earlier than 60 days before the donation and received by the due date (including extensions) of your tax return.
We hope this information is helpful as you plan for your charitable contributions. It's important to follow these recordkeeping requirements if you hope to claim the deduction for your donations because the IRS can and will disallow charitable deductions if these requirements aren't met. If you would like more details about these or any other aspect of the new rules, please don't hesitate to call us.
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Don't Overlook Nondeductible IRAs
The chances are good that if you participate in an employer-sponsored retirement plan, you may not qualify to make tax deductible contributions to an individual retirement account (IRA). Although you can always make a contribution to a nondeductible IRA (assuming that you or your spouse have earned income at least equal to the contribution), most people don't bother doing this. Such a contribution doesn't yield a tax deduction and although the earnings inside the account build up tax deferred, they're fully taxable as ordinary income when they're distributed.
Instead, people who want to maximize their retirement savings beyond what they're saving at work typically use a Roth IRA account if they qualify (the Roth IRA doesn't provide an upfront deduction, either, but it does allow earnings to build up tax-free, rather than tax-deferred) or invest in a taxable account such as a tax-efficient mutual fund that will yield mostly lightly taxed capital gain income.
Based on a recent law change, the use of a nondeductible IRA now looks more appealing for taxpayers who can't qualify to make a Roth IRA contribution (because their income is too high). The new provision allows taxpayers, beginning in 2010, to convert traditional IRAs (such as a nondeductible IRA) to a Roth IRA regardless of the taxpayer's income level. Currently only taxpayers with modified adjusted gross income of no more than $100,000 can convert a traditional IRA to a Roth IRA. At the time of the conversion, ordinary income tax is due on the income portion of the IRA, but future earnings accrue tax-free. In addition, for conversions in 2010, the new law allows the resulting tax to be paid over two years—2011 and 2012.
Why are we bringing this to your attention more than two years before 2010? Because, if you're not yet age 70½ and want to maximize the funds that can go in a Roth IRA in 2010 or later, you should be funding nondeductible IRAs now—up to the lesser of your earned income or $4,000 (or $5,000, if you are age 50 or older by the end of the year for which you're making the contribution). It's not too early to fund for 2007 provided you know you'll have at least $4,000 (or $5,000) of earned income for the year.
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Section 199 Revisited
When you hear the term Section 199, one of several things might come to mind: an area of a department store near the back of the building, a new perfume or cologne, a portion of the latest cookbook, or a section of the Internal Revenue Code. In this case, you would be correct if you picked "a section of the Internal Revenue Code."
Section 199 was established by the American Jobs Creation Act of 2004 and gave us the Domestic Production Activities Deduction, also known as the "Producer Deduction." The Producer Deduction is just that, a business tax deduction based on income attributable to certain manufacturing and production activities conducted in the U.S.
We are revisiting this topic because the Producer Deduction doubles for tax years beginning in 2007 when compared with 2005 and 2006. For 2007 tax years, the deduction is 6% of qualified domestic production activities, or a 100% increase from the 3% allowed in 2005 and 2006. So, if you qualified for this deduction in prior years, your federal tax bill should decrease a little in 2007 if you continue to qualify. If you did not qualify in prior years or you did qualify, but the benefit was minimal, you might want to reanalyze your financials in light of the increased deduction available. Incidentally, the producer deduction rate will increase once again to 9% for tax years beginning in 2010.
The definition of qualified production activities is very broad. These activities include, but are not limited to, traditional manufacturing of tangible personal property; domestic construction, civil engineering and architectural services for U.S. projects; production of electricity, gas, and potable water; software production; film and videotape production and licensing; growing of agricultural products and food (farming); and processing agricultural products for food.
This Producer Deduction is available to individual business owners as well as C corporations, S corporations, and partnerships, among other entities.
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Apr 07
April 07 Bean Counter Tax Ideas:
Social Security Number Verification Process
The Social Security Number Verification Service (SSNVS), set up by the Social Security Administration, allows employers to use the internet to match their records of employee names and social security numbers with the Government’s data file before submitting W-2 Forms. You can access the SSNVS at www.socialsecurity.gov/bso/bsowelcome.html. this is faster and easier method to use than the submitting request to SSA by other means, including the telephone verification option.
Verification of data is important for both the employer and its employees. Correct names and numbers are critical to successful processing of wage reports, and unmatched records can cause additional processing cost for the employer. From the employees’ standpoint, verified names and numbers allow Government to properly credit employees’ earnings records. Any uncredited earnings can adversely affect future eligibility for Social Security retirement, disability, and survivors programs.
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New 401(k) Investment Option
As of January 1, 2006, employers are able to offer a new retirement savings program entitled the Roth 401(k). The new account will follow the features of a Roth IRA to be incorporated into the setting of a 401(k) account. But there are no income restrictions as with the Roth IRA. Contributions can be made with after-tax dollars, but the account will grow tax free. Withdrawals can also be tax free, providing the owner is over 591/2 years old.
Key Point: The plan must be inexistence or held for 5 years.
Roth 401(k) accounts will be subject to the same contribution limits as regular 401(k) plans. In 2006, this means a contribution limit of $15,000 or $20,000 for individuals age 50 and over. The contribution limits apply to regular and Roth 401(k) plans combined. That is, an individual could not put $15,000 into a regular 401(k) and a Roth 401(k) plan. Only one total $15,000 (or $20,000) as the case maybe. Still the opportunity is there to put money into a plan that will have tax-free withdrawal ability. In 2006, the contribution limit for a regular Roth IRA is $4,000 or $5,000 if 50 and older. If the employer matches the employee’s contribution to a Roth 401(k), the match will be made with pre-tax dollars in a regular 401(k) account. Withdrawals will be as ordinary income
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Failure to make an Election Results in Inclusion of IRA into Estate.
An IRA from which a decedent received payments until his death, became includable in his estate because an irrevocable election was not completed. Here are the facts:
Walter M. retired and he opted to receive a lump-sum settlement from his retirement plan. The funds were transferred into an IRA-Rollover account. From January 1983 until his April 1999 death, the IRA paid out $1,000.00 per month to Walter. The IRA agreement did not indicate Walter’s election to receive the monthly annuity on an irrevocable basis. As such the agreement stated that Walter was to reserve to himself sole management of the custodial account.
Walter’s Estate Tax Return initially included the IRA and paid to the IRS $33,632. The executrix later filed an amended return excluding the IRA and asked for the $33,632 to be refunded. The IRS denied the request saying the IRA was created from a rollover of funds from a pension plan and does not qualify for exclusion from the estate. This dispute moved into the court system.
The estate put forth the position that the annuity value receivable is excluded from the estate. In addition, the estate argued that it was Congress’s intent to treat everyone fairly by enacting the tax Reform Acts of 1984 and 1986. The IRS position said that if Walter had retained the funds in a qualified plan, the funds would then be excluded; however, the funds were rolled into a IRA.
The Court held the funds were includable within the estate. The Court also said the TRA 86 transition rule applied only to qualified plans and not to a IRA. For the benefit not to be includible within the estate, Walter had to make an irrevocable election to the form of the benefit. The election was not done; therefore, it is part of the estate.
Sherrill v. United States, No. 2:04-CV-509
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Want to Swap Something: Code Section 1031 & 1035
Question, How can you sell something and not encounter any immediate capital gains tax? Section 1031 will allow taxpayers to use net proceeds from the sale of business property to buy like-kind property of equal or greater value. The deferred recognition of tax is pushed off further down stream. The deferment will not work for the sale of your personal residence or vacation home. But the swap would work for other real or personal property like rental houses, farm land, commercial property, jet planes plus many more. Keep in mind, that real property may not be exchanged for personal property. There needs to be similar kind relationship between the types of property. All property has to be for business or investment purpose. Stocks and bonds are not included.
The most common kind of exchange is called a delayed exchange. You sell your property and temporarily give the proceeds to a qualified intermediary, generally called an accommodator. The accommodator, who works for a fee, will set up and handle both sides of the exchange. If you want to do the complete transaction on your on, be aware of the rules and do not make a mistake. Any error will turn the deferment into a current tax collection situation. You have 45 days of selling your property to identify in writing the like-kind asset you intend to buy. Then you have 135 days to complete the transaction. No tax is due until you either sell the replacement property or do another 1031 exchange. Just remember, the IRS will carefully count the days to upset your transaction.
Here is how it works:
Facts: You own vacant land with a cost basis of $200,000 and have received a sale offer for $500,000.
Sale Price $500,000
Cost -200,000
Selling Cost - 30,000
Taxable Gain 270,000
15% Fed Tax 40,500
7% State Tax 18,900
Total Tax 59,400
A 1031 Exchange will defer the tax and allow you to push the tax downstream.
How about a 1035 Exchange of insurance policies? With proper planning, selected policies can likewise be utilized to push tax burdens into another time frame.
Here is what the Tax Code has to say in general terms: (You really need to have a tax consultant working with you!)
Internal Revenue Code:
Section 1031 Exchange of Property Held for Productive Use or Investment
Donating IRA Distributions to Charity
Under the Pension Protection Act of 2006 a favorable provision related to IRA distributions has been established. Under the new rule, qualified taxpayers can donate up to 5100,000 per year to an eligible charity without first being taxed on the distributions. However, unless Congress extends this provision, it will expire at the end of 2007. In addition, any unused portion of 2006's $100,000 limitation does not carry over to 2007. So, there's an incentive to take advantage of the new rule before year-end.
This new provision is available to taxpayers age 70 ½ or older who have one or more IRAs and a desire to make charitable contributions. It allows eligible taxpayers to make charitable contributions directly from their IRAs for up to $100,000 for each year (2006 and 2007) to an eligible charity. These direct charitable distributions, which can replace otherwise required minimum distributions, are tax-free to the IRA owner.
Although these distributions can't be deducted as charitable contributions, they potentially provide the following benefits to taxpayers:
• For taxpayers who don't itemize their deductions (their itemized deductions are less than the standard deduction), making charitable contributions directly from an IRA effectively provides an indirect charitable deduction (because the distribution is excluded from income).
• The negative impact of the phase-out of deductions for personal exemptions and itemized deductions for higher-income taxpayers may be reduced if what would otherwise be taxable IRA distributions are replaced with the IRA contributions to charity.
• The overall limitation on deducting charitable contributions can be ignored for these distributions due to this new provision
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Examining the Unexpected Consequences with Employer Retirement Plan Loans
It's not unusual for retirement plan participants to have the opportunity to borrow a portion of their vested balance from the plan. That can be a plus because it gives plan participants access to a source of funds in the event of a financial emergency or perhaps to use as a down payment on a home purchase. However, there's also at least one downside to borrowing from a retirement plan. When you retire or otherwise leave your employer, most plans require that any outstanding plan loan must be immediately paid back in full. How you accomplish the loan payoff can have an Impact on your tax liability for the year.
The most tax efficient way to pay off the loan is to use funds from another source and simply pay off the loan. If you do that, the payoff doesn't have any tax consequences. Assuming you don't have available funds for a direct payoff, the other option for immediately paying back the loan is to allow the plan administrator to net the loan against your vested account balance. This has a much less favorable tax result because the amount of the loan is treated as a taxable distribution to you (subject to regular income tax, 20% withholding, and, if you're under age 59%, potentially a 10% penalty).
What if you want to pay off the loan with other available funds when you retire or leave but the plan administrator automatically nets the loan against your vested balance? There is still a way to avoid the adverse tax consequences if you use funds equal to the amount of the loan from another source. You use those funds to set up a rollover IRA account within 60 days of when the loan netting occurred, which will allow you to avoid having to pay tax currently on the loan payoff.
The following example illustrates some unexpected consequences of employer plan loans:
Lisa, age 53, is planning early retirement and wants to roll over her entire 401(k) plan proceeds to a traditional IRA in a tax-free lump sum distribution. Her 40l(k) balance is $60,000 and she has a $20,000 plan loan. Here are two options available to Lisa.
The preferable way to facilitate the rollover is
to repay the $20,000 loan before the
distribution. Lisa can then
request a direct rollover
of the entire $60,000 to an
IRA- Here, no taxes will
be due and she will avoid
the 10% early withdrawal
penalty. However, this
option does require that
Lisa have $20,000
available from a source
other than her 401(k) plan
to repay her loan. But this
is better than option two.
Lisa can also accomplish a tax-deferred rollover without first repaying the loan, but this procedure is more cumbersome. Here, her employer will offset the $20,000 loan and deduct $4,000 for federal income tax withholding from her $60,000 vested account balance. This will leave $36,000 in the account, which Lisa can have directly rolled over to an IRA. If this ($36,000) is all that Lisa rolls over, she will have to include $24,000 ($20,000 loan and $4,000 withholding) in her taxable gross income. In addition, she will be assessed a 10% early withdrawal penalty of $2,400 ($24,000 x 10%) since she is under age 59 ½ (unless an exception applies).
To accomplish a totally tax-free rollover in the second scenario, Lisa must transfer S60,000 (her total vested balance) to her IRA. Therefore, she will have to obtain $24,000 ($60,000-$36,000) from a source other than her 401(k) plan. (In option one she only had to come up with $20,000.) The transfer will be totally tax-free if Lisa transfers the additional $24,000 to her IRA within 60 days of the original $36,000 transfer, but, Lisa will still have to wait until she files her tax return to get back the $4,000 in withholding taxes.
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