Why I prefer traditional IRAs to Roths (part 2)

June 5, 2014

Last time I explained the difference between pre-tax and after-tax contributions to retirement accounts. (These accounts are often called traditional IRAs and 401ks for pre-tax accounts, and Roth IRAs/401ks for after-tax accounts.) I also explained that if you’ve got a fixed amount of money to invest, and it’s less than the maximum amount you can contribute to your retirement account, then you’re typically going to be better off putting more money into a pre-tax account than an after-tax account. (If you’re not already fairly familiar with pre-tax and after-tax retirement accounts, as well as the concept of marginal tax rate vs. effective tax rate, it may be good to go back and read the first post.)

This time I want to look at the situation where the amount you’ve earned and have available to put in a retirement account exceeds the limits of what you’re allowed to contribute by law. For example, 401k’s limit most people to about $18,000 each year (adjusts for inflation annually) in contributions – but to make the math easy we’ll say the limit is $20,000. So what if you have $25,000 more income than you need and want to invest it?

In this case, the comparison isn’t as clear cut. If you put $20,000 into a pre-tax account, then you don’t pay tax on that $20,000, but you will pay tax on the other $5,000. For simplicity, let’s assume a marginal tax rate of 20%, meaning you pay $1,000 in tax and have $4,000 left to invest outside of any type of retirement account. We’ll call this Scenario 1.

If you instead put $20,000 into an after-tax account, then you pay tax on the full $25,000. Assuming the same 20% marginal tax rate, that means the remaining $5,000 all went to taxes. So you’ve got $20,000 in an after-tax account, and everything else went to taxes. We’ll call this Scenario 2.

So let’s follow what happens over the next 30 years if we assume your portfolio grows to 10 times its original value, and then everything is liquidated.

Scenario 1: You start with $20,000 in a retirement account and $4,000 in an ordinary investment account with no tax advantages. Over 30 years, the $20,000 becomes $200,000. The $4,000 becomes…well, that’s where things get tricky. Because taxes might have eaten away at some of the returns, you probably won’t get the same return on investment as you did with the money in the retirement account. So you’ve got $200,000 in a retirement account that you’ll have to pay tax on when you withdraw it. You also have whatever the $4,000 outside the retirement grew to after accounting for taxes paid along the way, or any growth you gave up for more tax-favored assets. (Some assets, most notably municipal bonds, provide largely tax-free earnings…but you typically pay for that tax status with lower yields on the investment.)

Summary: At the end of 30 years, you have $200,000 minus the tax you pay to withdraw the $200,000, plus $40,000 minus anything you lost along the way to either taxes or foregone gain in tax-favored investments.

Scenario 2: You start with $20,000 in a retirement account. It grows to $200,000. There’s no tax to withdraw it, so you have $200,000 at the end of 30 years.

Summary: At the end of 30 years, you have $200,000.

Note that I’ve assumed a particular rate of return…but the comparison doesn’t change if the actual rate of return is different. As long as your choice of investments in your portfolio is unaffected by whether your money is in a traditional or Roth account (which seems logical that would be the case), then we can take the rate of return as a given that has no affect on the comparison of which is better.

So…which scenario actually makes you better off?? Well, notice that Scenario 1 has two unknowns. The first is how much you’ll pay in tax when you withdraw the money from your retirement account. The second is how much you’ll lose on the money that’s outside of a tax-favored retirement account.

Well, let’s say for simplicity that your tax rate in retirement is still 20% on all income, so when you withdraw the $200,000, you’re left with only $160,000 after taxes. The remaining $4,000 almost certainly didn’t grow to $40,000, because you were paying taxes – or foregoing maximum growth in order to avoid taxes – along the way, so you wind up with less than $200,000. Since Scenario 2 leaves you with $200,000 in the end, you’re better off with Scenario 2, the after-tax contribution scenario. This is the argument people make when they advocate for contributing to after-tax Roth accounts.

But wait a minute! As I showed last time, the tax rate you’ll pay on the distributions is nearly always going to be much closer to your marginal rate than your effective rate. (For a complete explanation, see the last post.) So you’re going to be paying lower taxes on the distribution…probably significantly lower. So let’s run the math on a tax rate of 10% on the distributions. (In my experience as a tax professional, an effective tax rate of roughly half your marginal rate is quite common.)

In this case, the $200,000 you have to pay tax on in Scenario 1 only reduces what you have left to $180,000 (not $160,000). This means the $4,000 outside of a retirement account only had to grow to $20,000, rather than $40,000, to get to break even. Well, I’m not a financial advisor, but I can tell you there are ways to invest for the long haul that actually involve very little tax bite. The easiest way to do this is you could invest in stocks that provide primarily price growth (which doesn’t get taxed until sold) with little to no dividends paid (since the dividends get taxed whenever paid) – so at the end of 30 years you might have close to $40,000, of which you’ll have to pay tax only on the gain over the original $4,000. Since the tax rate on long-term gains has been better than the ordinary tax rate through-out most of the 100-year history of income tax in this country…and your ordinary rate will already likely be lower when you sell the stock later…then it’s a good bet that the original $4,000 could be worth over $30,000 even after accounting for taxes. So now that we’ve added some real-world facts to this situation – most notably that you’ll probably pay a much lower tax rate on the distribution than the contribution – we see that Scenario 1, the pre-tax contribution, results in more money left at the end after everything is accounted for…over $210,000 compared to $200,000 in Scenario 2.

(Here’s an alternate possibility for the money outside the retirement account: You could invest in municipal bonds on which you pay no tax. You generally give up some yield when investing in safe, tax-favored investments like muni bonds. However, just about any financial advisor will tell you that some safe muni bond investments should be a part of any balanced portfolio. So if you’re going to hold some safe government bonds anyway, then you could hold them in a non-retirement account, where it will make little difference that you’re not receiving any special tax treatment.)

Of course, this has all involved predicting 30 years into the future, and nobody has a crystal ball. Some people will quibble with various assumptions I’ve made, and that’s certainly to be expected. If we’re going to compare, then we have to make some kind of assumption for the unknowns. And my reasonable assumptions may be somebody else’s fool’s beliefs. Only time will tell.

But to me this uncertainty is yet another argument for recognizing most tax savings now, when it’s a certainty, rather than waiting for much later when the benefit is only an educated guess at this point. I’ll never argue with a balanced approach to pre-tax and after-tax retirement account contributions, but in my mind the vast majority of the time that balance should be tilted strongly in favor of pre-tax accounts that provide an up-front tax benefit.

A caveat: Sometimes I have clients who owe no income tax at all. Far from being the free-loading 47% you may have heard about, they’re typically hard-working people, often with educations and good middle class incomes, who have a lot of deductions (usually a few kids). Or they’re self-employed and had a bad income year, or they went through a long period of unemployment. For a variety of reasons, large numbers of people wind up owing no federal income tax, but they still have some savings available and would like to set aside some money for retirement in a tax-favored account. (Usually they know this no-tax status won’t last for long.) In this case, a Roth contribution is definitely the way to go, hands down. Taking a deduction for a traditional IRA account provides no benefit in this case, and you now might be shifting income from a year where it won’t be taxed to a year where it could be. Bad move. Every time. If there are no tax savings from putting money in a Traditional IRA, then use a Roth.

Second caveat/personal note: My personal mix is about 80% of my retirement savings is in traditional IRAs and 401ks, with the remaining ~20% in a Roth IRA. I would probably put even more in a traditional IRA, but Roth IRAs do have one really nice benefit that’s not available with Traditional IRAs. I can withdraw the money I’ve contributed to a Roth at any time, penalty-free. If I withdraw the earnings, I get penalized, but there’s no penalty for withdrawing up to what I’ve contributed. So I put my low-risk, liquid investments in my Roth account, and my Roth effectively functions as an emergency savings account. If I unexpectedly needed to access a reserve of cash beyond my ordinary savings, I could liquidate the low-risk assets in my Roth and withdraw most of the money in my Roth without penalty. Just thought I’d throw those tips in there in favor of Roths since I’ve spent most of the last two posts beating up on Roths.


Why I strongly prefer Traditional IRAs to Roths

May 6, 2014

As a tax professional, I’m often asked by clients whether they should contribute to an IRA or 401k on a pre-tax basis, or after tax. In other words, when putting money in a retirement account now, should they take the tax deduction now for the contribution (i.e. a “pre-tax” contribution), and pay tax when they withdraw the money later? Or should they forgo the deduction now so that withdrawing the money later is completely tax-free?

Of course every situation is unique, so the answer depends on each client’s unique situation. And I nearly always recommend some amount of diversification over time. (I.e. it’s rarely a good idea to put ALL retirement funds in either a pre-tax or post-tax account.)

But I do generally recommend that people put the large majority of their funds into a pre-tax account and take the deduction now.

This sometimes surprises people who don’t think of themselves as making a whole lot of money right now. Or it surprises people who’ve heard from a financial adviser, or a friend, or somebody else who thinks that Roth IRAs and Roth 401ks (the name for after tax accounts) are the greatest thing since sliced bread. (There’s a great example of this thinking in this article, which seems to say anybody who’s not contributing to a Roth 401k is a fool, and your taxes will almost certainly go up in retirement…which as I’m about to show is usually not a good assumption.)

But the reason for my advice is based largely on a fact that most people don’t think about. By and large, when you put money into a retirement account, you’re getting a deduction at your marginal tax rate. But when you withdraw money from a retirement account, you’re typically paying tax on the withdrawals at close to your effective tax rate. OK, there’s a lot to explain in those two sentences, so bear with me.

Let’s say you have $10,000 to put in a retirement account. You can invest the money in an asset that will return ten times the original investment over 30 years. If you have a choice between paying a 20% tax on the money now, or 20% later, the results will be the same regardless. Pay 20% tax now, and the remaining $8,000 becomes $80,000 over time. Or pay no tax now, the $10,000 grows to $100,000, and you’re left with $80,000 after paying a 20% tax.  The main variable in this equation is whether you’ll pay a higher rate of tax now or later. You should pay the tax when you get the lowest rate in order to have the most left over after paying the tax.

And that’s where the marginal tax rate vs. effective tax rate comes in. Your marginal tax rate is the top tax bracket you fall in…it’s what you pay on an additional dollar of income. A single person with no exemptions taking the standard deduction and earning $60,000 is in the 25% tax bracket, for example.

Your effective tax rate, however, is basically the average tax rate you pay on all of your income. So that single person with no exemptions making $60,000 will pay a little under $7,000 in tax, for an effective tax rate of a little over 11%. This is because the single person doesn’t pay tax on some income (because of the standard deduction and exemptions), pays tax at 10% on some income, 15% on other income, etc.

And because everybody benefits from some deductions, as well as graduated income tax brackets where they pay lower tax on some of their income, nearly everybody’s effective tax rate will be lower than their marginal tax rate.

So back to the example of the single person making $60,000, this person cuts their tax bill by 25% of any amount put into a pre-tax retirement account. Put another way, if this person has $10,000 to put in a retirement account, then choosing to contribute to this account on an after-tax basis will leave only $7,500 left to put in the account. Over time, that will grow to $75,000.

But if this person contributes to a pre-tax account, leaving all $10,000 to go into the account, that amount will grow to $100,000. But tax will have to be paid as the money is withdrawn. Let’s assume this person has set aside money so that they’ll withdraw $60,000 per year in retirement, and they have no other significant income.  In this case, the tax rate when the money is withdrawn will average only about 11%, leaving nearly $90,000 out of the $100,000 — a much better outcome than having only $75,000 left.

Of course, I’ve ignored the effects of inflation, but tax brackets and other items tend to rise with inflation, so this really doesn’t change the fundamental idea. Also, I’m assuming tax rates will remain the same, and of course nobody knows what tax rates will do in the future. However, tax rates will have to change by a pretty huge amount for the effective rate to go from 11% to 25%. And unless that happens, this hypothetical individual is much better off taking the deduction now. I’ve also ignored Social Security income, which makes things a bit more complicated, but for most people Social Security doesn’t change the dynamic very much.

And of course, all this assumes a person’s income doesn’t go down at all in retirement, which is rarely the case. If income goes down, this further tilts the balance in favor of taking the deduction now.

So in my mind, it’s clear that it’s generally more advantageous to take the deduction now for most retirement account contributions. However, there’s an alternative scenario that I’ll look at next time where it’s not quite as clear cut…though as we’ll see it still tends to favor (though not by as much) contributing more money on a pre-tax basis than on an after-tax basis.


Good news for tax cheats…

April 26, 2014

OK, just a little end-of-season rant before returning to good, sound tax advice.

So for those who cheat on their taxes, I saw this bit of encouraging news recently:

IRS Audit Rates Hit New All-Time Low

While it may be tempting to view this as good news — after all, who like IRS audits? — the fact is a significant amount of people cheat on their taxes, and ever-increasing complexity in the tax law makes it harder and harder for the IRS to detect cheating without a certain amount of random audits. So while there are some tools the IRS has at it’s disposal to carefully target which 0.9% of taxpayers get selected for audit, it’s absurd to think that only 0.9% of taxpayers are deliberately cheating. And it’s also absurd to think that ALL of the 0.9% who are audited actually did anything wrong. (In fact, probably a minority of that group did anything wrong…the IRS still relies heavily on random audits, which is the only threat they’ve got against countless types of fraud that are impossible to ferret out by any other means.)

So while I’m not advocating for being dishonest on your taxes, it’s simply becoming more and more irrational to be honest. When the odds of getting caught are really, really low, even the threat of large fines does little to incentive honesty.

I sometimes encounter people who believe society could function with government funded entirely by voluntary donations…that people could contribute only what they wanted toward streets, police, schools, military, etc. While I highly doubt such a system could work, even if it could it would simply be a generosity tax. Those who choose to be generous would bear the burden while those who stingily refuse to give a dime would collect the benefits that everybody else pays for. I can not imagine a system that so heavily disincentives generosity could possibly work at any significant scale or for any significant length of time.

Well, folks, we seem to be moving rapidly toward an honesty tax. If you’re honest on your tax return, you get to bear all the cost of government services — or at least a greater share of it. But if you’re dishonest, you get a free (or greatly reduced price) ride on the backs of the rest of us naive schmucks.

So while some factions in Congress love to vilify the IRS and cut its budget at every opportunity (all while accomplishing nothing in terms of simplifying the tax code to make it easier to administer), can we just call out what they’re really doing? They’re pushing an Honesty tax. They want honest people to bear the costs of society and give the dishonest folks (presumably like themselves) a free ride.

OK, rant over, back to real tax advice (for honest folks just trying to pay their fair share but no more) next time…


Worried about late tax filing? Don’t sweat it.

April 8, 2014

It’s getting to that point in the year when many tax filing procrastinators start to panic about the looming deadline. And if they think about just giving up and taking everything to a professional, they’ll find many professionals have to tell clients who haven’t submitted all of their info yet that their return won’t be completed before the April deadline. This leaves people with the choices of…

  1. do their best to do their own taxes and hope everything comes out OK,
  2. take their taxes to one of the “McDonalds’” of tax preparation…the big national chains with plenty of minimally-trained, low-paid part-timers who will enter everything in a computer for you and hope it comes out OK, OR
  3. file their taxes LATE and risk being carted off to federal prison!

Well this post is to let people know that filing your taxes late is not a one-way ticket to the slammer. In fact, in many cases simply filing an extension (more on that later, or skip to it now), and making sure you get your taxes right–even if a little late–is the wisest choice to make.

People make mistakes when they hurry and they’re rushed. It’s human nature. Whether you prepare your own taxes, or pay somebody to do it for you, chances are whoever is working on your return in early April may feel a little pressure to get things done by the deadline. I’m unaware of any studies addressing this issue, but I would consider it almost a certainty that tax returns filed in the first half of April are more likely to contain mistakes than returns filed at other times. And fixing those mistakes later can be costly and time-consuming.

If you have investments, it’s very common to receive “corrected” statements regarding your income in March or April, and sometimes even later. If you have complex investments–particularly if you receive investment income reported on a Schedule K-1–you might not want to rush out and file because there may be corrected statements coming your way.

Also, if you pay somebody to do your return, you’re probably more likely to get that person’s undivided attention, and maybe even a little bit better rate, if you’re willing to work with them outside of the busy part of tax filing season.

But what about penalties and keeping the IRS off your back? Well these are certainly legitimate concerns, but let me explain what the actual consequences of filing late are so you can make an informed choice.

Penalties for filing late are based on your tax due. If you have no tax due because you’re getting a refund, then there’s no penalty. I’ve known clients who wait a few years and then file several years all at once. (I don’t recommend that approach, but some people are comfortable with it.)

If you do owe tax, the penalties are actually fairly minor as long as you file an extension. You can avoid the penalty completely by filing an extension and making a payment with that extension. Of course, if you don’t have your return done, how are you supposed to know how much to pay, right? Well, there are tools you can use to estimate your tax liability (TaxCaster is a pretty user-friendly, free tool to use for this purpose). Aim high with your estimate, and then when you file you’ll get the excess back–often with interest!

If your estimate comes in low, but you filed the extension, the late payment penalty is only 0.5% of the amount of underpayment, per month the payment is late. So if you owe an extra $5000, and you file and pay only one month late, then your late payment penalty is a whopping $25. Two months late…$50. So even for a fairly significant tax liability, the late payment penalty is often less than the cost of a parking ticket. There’s interest as well. But at 3% annually, this is almost too low to worry about.

One other consideration is whether filing late raises “red flags” or guarantees an audit. I’ve never seen any evidence that people who file extensions and file a few months late face a higher audit risk. The only possible downside is the IRS has 3 years to audit your return from the filing deadline or when you actually file, whichever is later. So filing after the April deadline can extend the time the IRS has to review your return. But if the IRS hasn’t selected your return for audit in 3 years, I wouldn’t worry much about the chance they’ll choose you in that extra month or two.

Of course, if you owe taxes and fail to file an extension by the filing deadline, then the situation is very different. If you owe money and haven’t filed a return or extension, the late filing penalty is 5% per month…ten times the rate for simply paying late. This can add up fast. So if you don’t think you’re going to be able to file by the deadline, then just follow these instructions and get that extension filed (it’s easy).

Step by Step Instructions for Extension filing

If you’re not using software that offers free extensions, you can still easily file an extension for free. Unfortunately, the IRS does not offer e-filing of extensions directly, and instead relies on private companies to supply this service. As a result, there are too many e-filing options for any rational person to sift through, so paper-filing is generally much simpler and easier (and free except for the stamp). The only drawback is you’ll have to mail a check if you’re making a payment.

With that caveat, here’s how to file an extension in 10 very simple steps: (OK, one or two aren’t “very simple,” but we promise they’re not bad.)

  1. First, print out Form 4868 with instructions.
  2. Cut off the Form 4868 at the bottom of page 1.
  3. Fill in Lines 1-3 with your name, address, and Social Security Number(s).
  4. Estimate your tax liability in Line 4. OK, this one can be tricky. We recommend TaxCaster from TurboTax as a pretty user-friendly tool for doing this. Alternately, you can base your estimate on last year’s tax return. When all else fails, there’s no penalty for making a wild guess and being way wrong. (Although there is a very small penalty for underpayment, so guess high.)
  5. Enter your 2013 payment in Line 5. For most people, this means add up the amount in Box 2 of all W2′s you received. This may underestimate your payments, but it’s a reasonable start.
  6. Subtract Line 4 from Line 5 and enter it in Line 6…just like it says on the form :-)
  7. Enter any amount you’re paying on Line 7. This is optional. You don’t have to include a payment.
  8. Check the boxes on lines 8 & 9 if they apply to you. (Line 9 only applies to non-US citizens.)
  9. Put the form, along with a check if you’re making a payment, in an envelope.
  10. Use the table on the back page of the 4868 instructions to determine which address to use (based on your state of residence and whether you’re making a payment).Put a stamp on that envelope, seal it, and drop it in the mail. You’re done.

You now have until mid-October to file your return without any late filing penalties.


Self-Employed People Might Want to Avoid Getting Subsidies for Their Health Insurance

March 28, 2014

We’re just about at another deadline for people to sign up for qualifying health insurance, or face a penalty for being uninsured when they file their tax return for 2014. So hopefully this doesn’t come too late for you, but I’ve been thinking about a particular aspect of the law that applies to self-employed people.

Self-employed people are able to deduct the cost they pay for health insurance and reduce their Adjusted Gross Income (AGI). To determine if people qualify for subsidized health insurance (aka “premium assistance”) based on their income level, the government uses Modified Adjusted Gross Income (MAGI), which in this case is defined as Adjusted Gross Income, plus excluded foreign income, non-taxable Social Security benefits, and tax exempt interest. So we run into circular logic here, because the amount you pay for health insurance depends on your MAGI, but your MAGI in turn depends on how much you pay for health insurance.

I’ve seen a few discussions of this problem, some of which propose rather complicated iterative mathematical solutions, but I think the solution is fairly simple and presents a clear planning opportunity for self-employed individuals who potentially qualify for health insurance subsidies under the Affordable Care Act. And depending on your household size, you could potentially qualify with a MAGI of well over $100,000. For example, a family of 5 qualifies for subsidies with a MAGI of $110,280 or less.

Based on a plain reading of IRC 162(l) (“allowed as a deduction (…) the amount paid during the taxable year for insurance (…)”), it appears that if you choose to pay full-price for your health insurance then you can deduct the full cost you pay during the taxable year, thus reducing your MAGI as low as possible. When you file your tax return at the end of the year, you’ll fill out whatever form the IRS provides to determine what amount of subsidy you’re actually eligible for based on 2014 MAGI, and claim the subsidy as a tax credit on your return. Using this method, you could potentially qualify for a significantly larger amount of premium assistance than if you applied for the subsidized premium amount up front and paid less for insurance during the year (thus increasing your MAGI).

Of course, it’s not a totally free lunch. Under the principle that if you deduct something that’s later refunded/reimbursed, then you simply claim the subsidy as income on the following year’s taxes. This is actually quite common when it comes to medical expenses. We sometimes see in the tax world that somebody will have to pay for major medical expenses out of pocket, and then they take a tax deduction for those expenses. Later, when they finally get the insurance company to reimburse them for their costs, they have to include the reimbursement as taxable income. So getting reimbursed for part of your health care costs after year end really isn’t even a new concept.

Here’s a simple example of how this might benefit you: In 2014, imagine I’m married no kids and make $65k/yr. If I don’t take the advance subsidy, we’ll say my insurance costs are $5k/year, making my MAGI $60k/yr. So I claim a credit for (let’s say) $3k. Since that’s a refund of premiums I deducted, I report the $3k as income in 2015.

If I do take the subsidy, we’ll say I pay only $2k/year for insurance. (The cut-off for the subsidy for 2 people is ~$62k/yr.) By paying only $2k/yr, my MAGI is $63k/yr and I no longer qualify for the subsidy…so now I have to PAY BACK the $3k/yr advance subsidy that I don’t actually qualify for.

In the first scenario, I paid $5000, got $3000 refunded, but have to pay tax on that $3000. At that income level for a married filing joint taxpayer, I’m probably paying 15% on that $3k, so overall I’m out about $2500.

In the second scenario, I pay $2000 during the year and another $3000 at year-end, so I’m out $5000. Overall, I’m $2500 better off paying full price up front and then taking the subsidy at year-end when I file my taxes!

Moral of the story: If you’re self-employed and potentially eligible for a subsidy, do not take the subsidy during the year.

Disclaimer: The above advice is based on a plain reading of the Internal Revenue Code and the application of logic and common tax principles. This does not mean the IRS will necessarily use logic, common tax principles, or a plain reading of the Internal Revenue Code when they create the forms and instructions to handle the premium subsidies/tax credit. (Though to be fair, as popular as it is to knock the IRS, I find that the vast majority of the time the IRS’ interpretation of the tax code is consistent with how most intelligent tax practitioners — not to mention most of the legal community — interpret it.) I’ve heard other theories of how the IRS may interpret this law, but to be honest none of the other interpretations I’ve read seem consistent. Regardless, I’m in no way guaranteeing the IRS will interpret the law this way. But the worst that can happen if you reject the subsidy now is that through some convoluted interpretation of the law the IRS determines you still don’t qualify even though you paid premiums that put your MAGI in the qualifying range. And of course you wouldn’t have qualified anyway, so you have nothing to lose by trying.


Avoiding Penalties on Retirement Account Distributions

March 20, 2014

If you had to take money out of a retirement account last year, the IRS provides some tips and general info on retirement account distributions that I’ve included below.

However, if you’re under age 59 1/2* and had to take a pension or IRA distribution last year, make sure to look carefully for all the possible exceptions to the early distribution penalty. There are several ways to get money out of an IRA or pension without penalty even if you’re under age 59. I’ll give you a few of the more common exceptions, but to find a complete list, start with page 3 of the Form 5329 instructions or consult with a well-qualified professional.

[*If you have an employer-based plan and you're separated from service, you can start taking distributions penalty-free at age 55 instead of 59 1/2.]

First, make sure you have a taxable withdrawal. If you’ve contributed to a Roth IRA, or made non-deductible contributions to a Traditional IRA (or the equivalent employer-based plans), then part or all of your contribution might be tax-free. With Roth IRA distributions, all of your distributions are tax- and penalty-free until you’ve distributed an amount equal to your contributions to the plan. (If you’ve converted Traditional IRA money to a Roth, you’ll have to wait five years before withdrawing these funds without a penalty.) With Traditional IRAs, the formula is more complicated…basically a portion of your distribution is non-taxable based on the portion of your IRA value that comes from non-deductible contributions. See Form 8606 for the details of that calculation. The amount of your distribution that is tax-free will also be penalty-free.

Once you’ve determined some or all of your distribution is taxable, you’ll want to start looking for exceptions to the early withdrawal penalty. Some of the most common ways we find to avoid these penalties relate to education and medical expenses. Unemployed individuals are generally able to avoid the penalty for amounts equal to what they pay for health insurance. And if you had major medical expenses (greater than 7.5% of your income), you may be able to exclude part of these costs from penalty as well.

Students are able to avoid the penalty for amounts equal to what they pay for qualified education expenses. And here’s a little known twist on education…if you’re at least a half-time student, you can include an allowance for room and board in your “qualified education expenses”–even though room and board is usually not considered an education expense for most purposes. Your school’s financial aid department should be able to help you determine the official room and board allowance for your school. (Note that these apply whether the student is you, your spouse, or a dependent.)

If you’re considering a withdrawal, and considering a home purchase, be aware that there’s a $10,000 exception for qualified “first-time home buyers” (which includes taxpayers who haven’t owned their home in the last two years). This exception can be used by both spouses, so it can be used to exclude $20,000 from penalty on a joint return. This exception can be used once in your lifetime. Of you might be able to take advantage of an exception that applies to a series of substantially equal payments made over a series of years. The payments must last at least 5 years or until you reach age 59 1/2, whichever is later, so this requires careful planning.

Be aware that some of these exceptions apply to individual retirement accounts like IRAs, some to employer plans like 401k’s, and some apply to both types of plans. Before applying any of these exceptions, or taking any action based on the intent of applying any of these exceptions, make sure you do your homework or consult a professional.

And without further ado, here’s what the IRS had to say on the topic:

Some taxpayers may have needed to take an early distribution from their retirement plan last year. The IRS wants individuals who took an early distribution to know that there can be a tax impact to tapping your retirement fund.  Here are ten facts about early distributions.

  1. Payments you receive from your Individual Retirement Arrangement before you reach age 59 ½ are generally considered early or premature distributions.
  2. Early distributions are usually subject to an additional 10 percent tax.
  3. Early distributions must also be reported to the IRS.
  4. Distributions you rollover to another IRA or qualified retirement plan are not subject to the additional 10 percent tax. You must complete the rollover within 60 days after the day you received the distribution.
  5. The amount you roll over is generally taxed when the new plan makes a distribution to you or your beneficiary.
  6. If you made nondeductible contributions to an IRA and later take early distributions from your IRA, the portion of the distribution attributable to those nondeductible contributions is not taxed.
  7. If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed.
  8. If you received a distribution from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.
  9. There are several exceptions to the additional 10 percent early distribution tax, such as when the distributions are used for the purchase of a first home, for certain medical or educational expenses, or if you are disabled.
  10. For more information about early distributions from retirement plans, the additional 10 percent tax and all the exceptions see IRS Publication 575, Pension and Annuity Income and Publication 590, Individual Retirement Arrangements (IRAs). Both publications are available at IRS.gov or by calling  800-TAX-FORM (800-829-3676).

Is the “simplified” home office deduction right for you?

March 6, 2014

One of the more complicated pieces of the tax code that people commonly encounter is the home office deduction.

But last year the IRS announced it will offer a very simplified option for taking the home office deduction. As I’ll explain, this option will be very beneficial for most home-owners, especially in low cost areas. On the other hand, most renters, especially renters in expensive areas, will want to pass on this option. (Fortunately, the simplified option is just that, an option. You can still calculate your home office deduction under the old rules if you prefer.)

First, a quick background. The home office deduction is available to anybody who uses a portion of their home regularly and exclusively for business purposes. This part hasn’t changed.

Under the old method, the amount of the deduction was calculated by finding the ratio of the square footage of the home office to the entire square footage of the home. This ratio was then multiplied by various expenses related to maintaining a home such as utilities, insurance, mortgage interest, rent, etc. In addition, there are various instructions related to which expenses are always deductible, which expenses are only deductible to the extent of business profits, and so forth.

Under the new method, any area that meets the definition of a home office is eligible for a deduction of $5 per square foot, up to a maximum of 300 square feet (or $1500). So, for example, if you use a 200 square foot room as a home office during the tax year, you can deduct $1000 as a home office expense. This rule takes effect for tax year 2013.

Homeowners can still deduct the full amount they pay for mortgage interest and real estate taxes on Schedule A. Homeowners no longer deduct depreciation, which means no longer having to track depreciation over time and add that depreciation to income when the home is later sold. For these reasons, many homeowners will likely benefit from using this simplified method. In addition to fewer record-keeping hassles, many homeowners will actually get a larger deduction overall when considering that mortgage interest and real estate taxes will still be fully deductible. This won’t be true in every case, particularly if you pay a lot for utilities, home insurance, or other expenses that aren’t otherwise deductible. But as a general rule, if you own your home, you might want to consider using the simplified method.

For renters, on the other hand, you’ll probably want to continue tracking what you pay in rent and other costs so you can keep using the standard method. The reason for this is simple — you usually can’t deduct rent unless it’s a home office expense. So, let’s say you rent in even a low-cost area where you pay only 50 cents per square foot in monthly rent (this works out to $750 per month for a 1500 square foot home, just to give you an idea). Even at this rate, you’re paying $6 per square foot each year in rent alone. Plus you’re probably paying utilities on top of that, and maybe even insurance and some other costs as well. So being able to deduct $5 per square foot isn’t a particularly good deal for you. And if you’re in a high-rent area, like the SF Bay Area, you’re probably paying at least $1 per square foot each month, or $12 per year, so taking a deduction of only $5 per square foot doesn’t make much sense.

It’s a common trade-off in the tax world. Everybody claims to want simplification. But the downside to simplification is some people pay more and some pay less. And not many people like simplification if it means they pay more in tax. Fortunately in this case, every taxpayer has the choice. If taking the simplified option will mean a much smaller deduction for you, then keep doing things under the old method. But if you can save money, or even come out close to even, then your tax return will be getting a little simpler in 2013.


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