Maximize your exclusion in the year you begin or end a period abroad

April 30, 2015

Americans working overseas are still responsible for filing US tax returns and paying US tax (despite what your fellow ex-pat at the bar may have told you!). Fortunately, the IRS allows a couple of ways to minimize or completely avoid US tax on income earned overseas: the foreign tax credit, and the foreign earned income exclusion (FEIE). If you’re working in a country with no income tax, or a very low income tax, you’re probably going to want to claim the FEIE.

The FEIE allows a taxpayer to exclude over $90,000 of income earned overseas and pay no tax on it. Plus you get to exclude an additional amount for housing costs. This additional amount starts at about $27,000, but can be well over $50,000 if you’re in a high-cost location. Most people who take foreign jobs hear about this exclusion and are happy to apply it. However, most people don’t get the full value they’re entitled to in the year they move overseas or the year they return.

One way to qualify for this exclusion is the Physical Presence Test. This means you’re simply present in a foreign country for 330 days in a one year period. It doesn’t have to be the same foreign country for all 330 days, and the one year period can start or end on any day of the year. Most people choose a 12-month period that starts on the day they arrive, or ends on the day they leave. This is logical, but it might be costing you money.

It’s important to pick the 12-month period that maximizes your exclusion (even the IRS says so!), because if your 12-month period only covers part of the year, you have to prorate your exclusion. So let’s say you move overseas on July 1, and you remain in the foreign country for the next 365 days. Most people would use the 12-month period from July 1 in the current year to June 30 in the next year. If you do that, you could be costing yourself thousands of dollars. If you stayed in a foreign country that whole time, you could actually start your 12-month period on May 26 and still have 330 days in a foreign country in a 1 year period.

Why is this so important?

The extra 35 days in your “qualifying period” get you a significantly larger exclusion amount when you pro-rate the annual exclusion. In this case, the extra days would result in you being able to exclude almost $9,000 more foreign income. The way the exclusion works, that could easily make a difference of over $2,000 in the tax you pay. So don’t short-change yourself! In the year you move to or from a foreign country for a job, it’s usually a good idea to use the Physical Presence Test and choose a 12-month period with as many days in the tax year as possible. IRS Publication 54 actually outlines the step by step process of how to do this in chapter 4, so I’m just going to include the instructions (from 2010) right here:

If you qualify for the foreign earned income exclusion under the physical presence test for part of a year, it is important to carefully choose the 12-month period that will allow the maximum exclusion for that year.

Example.

You are physically present and have your tax home in a foreign country for a 16-month period from June 1, 2009, through September 30, 2010, except for 16 days in December 2009 when you were on vacation in the United States. You figure the maximum exclusion for 2009 as follows.

  1. Beginning with June 1, 2009, count forward 330 full days. Do not count the 16 days you spent in the United States. The 330th day, May 12, 2010, is the last day of a 12-month period.
  2. Count backward 12 months from May 11, 2010, to find the first day of this 12-month period, May 12, 2009. This 12-month period runs from May 12, 2009, through May 11, 2010.
  3. Count the total days during 2009 that fall within this 12-month period. This is 234 days (May 12, 2009 – December 31, 2009).
  4. Multiply $91,400 (the maximum exclusion for 2009) by the fraction 234/365 to find your maximum exclusion for 2009 ($58,596).

You figure the maximum exclusion for 2010 in the opposite manner.

  1. Beginning with your last full day, September 30, 2010, count backward 330 full days. Do not count the 16 days you spent in the United States. That day, October 19, 2009, is the first day of a 12-month period.
  2. Count forward 12 months from October 19, 2009, to find the last day of this 12-month period, October 18, 2010. This 12-month period runs from October 19, 2009, through October 18, 2010.
  3. Count the total days during 2010 that fall within this 12-month period. This is 291 days (January 1, 2010 – October 18, 2010).
  4. Multiply $91,500, the maximum limit, by the fraction 291/365 to find your maximum exclusion for 2010 ($72,949).

One last note I find interesting. The tax code itself actually states that “qualifying days” are days when the taxpayer meets one of the foreign residence tests (either Physical Presence or Bona Fide Residence) AND has a tax home in a foreign country. Since a “tax home” requires having a home and job overseas, my intuition would be that if your 12-month period starts before you arrive overseas, this would NOT increase your qualifying days, and therefore your pro-rated exclusion, because you don’t have a tax home until you arrive. Fortunately, the IRS has apparently in this case defied intuition in FAVOR of the taxpayer. If you’re one of those people who can save a few hundred, or a few thousand, dollars by using this trick, let’s hope the IRS continues to be so generous with this!


Favorable capital gains tax treatment (and statistics) provide a better investment vehicle than IRAs

April 23, 2015

The tax code offers a number of options to allow people to invest for retirement in ways that get friendly tax treatment. Individual Retirement Accounts (IRAs) and 401(k) plans are just a couple of the more common options, although there are many more. Unfortunately, these accounts come with a lot of restrictions and can sometimes cause severe penalties. And in most of these accounts, you’re not getting any special break on your tax rates, just a deferral on when you recognize the income. Plus many people aren’t able to participate at all due to high income.

Wouldn’t it be nice if the IRS allowed retirement savings options where you could get current year deductions, withdraw your money at any time without penalty, and then get favorable tax rates when you retire?

Well believe it or not, the tax code allows you to do just that. I’m not talking about a specific code section or any type of “plan” with a specific name. What I’m talking about is the rules for tax treatment of capital gains and losses.

You see, the tax code has numerous provisions to protect wealth. (You may have heard that it’s the other way around, but I won’t get into the politics of why that’s such a popular misconception.) One of the most important provisions is the treatment of gains on losses from capital investments. If you invest in stock or land or any of the numerous other categories of capital investments, you get different tax treatment depending on whether your bet is a “winner” or a “loser”.

If your asset goes down in value–it’s a loser–you can sell the asset and reduce your “ordinary income.” Ordinary income is basically all income other than capital gains and losses…and it all gets taxed at marginal rates that can go up to 35%. So if you lose money, you actually lose as little as 65 cents on the dollar, depending on your tax bracket. But if your asset goes up in value, and you hold it more than a year, then when you sell the asset you get taxed at a maximum rate of only 15%. So when you win, you win 85 cents, when you lose, you lose only 65 cents. (You won’t find those odds at any table in Vegas!) No matter what your tax bracket is, the tax you pay on the gain from these capital assets will be less than your tax on any other type of income (except qualified dividends, but I’m trying not to get too technical here).

This preferred treatment of capital gains has existed for almost the entire period since 1954. One could argue this has been a significant factor in the long-term run up of stock prices in the US. (For the rest of this article, whenever I refer to stock, I could mean any other capital asset. Stocks are just the most common example.) And this treatment, combined with the laws of probability, give rise to a way to save for retirement that in many ways makes better sense from a tax perspective than any of the traditional types of retirement accounts.

The approach is relatively simple, but first a quick look at the conventional approach. Let’s say you’re around 30, currently saving $5,000/yr for retirement, and plan to continue to do so for the next 20 years. The conventional wisdom would say a simple, tax-efficient approach is to put this money into an IRA and invest it in a low-fee mutual fund or ETF that provides broad coverage of the stock market. While that’s not a bad approach, here’s something not much more complicated and considerably more tax-efficient: Open an account with a discount broker and buy a dartboard.

OK, the dartboard is figurative. Countless studies have shown that mutual funds and similar instruments consistently under-perform the market. The reason is simple–annual fees, even low annual fees of 0.5% of your account value, will significantly erode the value of your account over time. An individual investor picking stocks at random and buying them for $5-10 per trade will get better results on average than the mutual fund because the trading fees plus the cost of a dart board are significantly less expensive than the fees charged by money managers, and a large basket of stocks will perform the same whether picked at random or by a “professional” money manager. Countless studies have verified that money managers do no better than what would be predicted by random selection of stocks, just google it.

Alright, so I’ve just explained why you’re probably better off letting your dog pick stocks than paying a “professional,” but what does this have to do with taxes? Well here’s where the strategy comes in. Let’s say instead of putting $5000 into an IRA every year, you select 5 stocks at random and buy $1,000 worth of each stock. If you start this early in the first year, you might have some “losers” by the end of the first year, which you can sell by year-end and take a tax deduction. Over time, you’ll probably have numerous losers, which can be sold anytime you want to take a tax deduction to reduce your taxable income. Of course, you’ll also accrue winners, and these are the stocks you hang onto for retirement. When you’re ready to sell those, you’ll get reduced tax rates on the gain–something you won’t get on distributions from any retirement account that’s not a Roth. And at any point in your life, if you need to access your “retirement account”, you’re free to do so with no penalty. In fact, as long as you’ve held the stock more than a year, when you cash it in you’ll get favorable tax rates.

So there you have it–current deductions, penalty-free withdrawals, and favorable tax rates in retirement.

Now, to address a few criticisms that I’m sure some people might have.

Those who are very familiar with retirement accounts might point out a Roth is similar with less complexity. You pay no tax on the gains in a Roth, which is a better deal than even the capital gains rates. And you’re able to take a limited amount of penalty-free withdrawals. And though there’s no current deductions with a Roth, the current deductions under this approach are limited to $3,000 each year and will probably be less than that most years. Fair enough. If you have no interest in current deductions, AND your income is below the Roth limit (currently around $100k), then the Roth is probably a better option if you’re willing to accept the restrictions on Roth plans. But if your income is above the limit, or you just like the freedom of being able to access all of your money at any time without penalty, this approach offers some advantages over a Roth.

I’m sure some people also can’t imagine leaving their retirement savings to random chance. But realistically, that’s what we all do all the time. Nobody knows where any asset’s price is going to go, and the “professional” money managers have consistently demonstrated they’re no better than average…they just charge you for the privilege of mediocrity. As long as you’re committed to buying a large basket of stocks…like 100 or more…the odds of your random basket performing significantly different than the market average drop pretty close to zero. The more stocks you buy, the better your odds of this random sampling matching actual market returns. Of course, the more you buy, the more trading fees you pay. But even if you buy in lots of only $100 each and pay a $5 per trade fee, your costs over ten years would be less than the fees of a money manager charging 0.5% annually. And if you’re only buying stock $100 at a time, you can diversify a LOT.

Finally, there’s the problem of the tax code always changing. While it’s certainly true that the tax code will change significantly over the next few decades, it seems reasonable to assume that favorable treatment for capital gains will remain a feature of the tax code. This has existed for all but a couple of the last 55+ years. And given the reality of politics, does it seem likely to you that a tax break that favors the incredibly wealthy will go away? My opinion is it’s very unlikely, but you’ll have to consult your own crystal ball on that one.


Why I strongly prefer Traditional IRAs to Roths

April 9, 2015

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

April 6, 2015

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.


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

April 2, 2015

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.


Employer stock plans made simple

March 26, 2015

So your employer offers a stock plan that allows you to purchase shares in the company at a steep discount, or receive stock at no cost to you at all. Seems like a great deal–and usually is–but these plans are often a source of a lot of headaches and even costly mistakes at tax time. Well this post is not going to get into all the different types of stock plans out there or all the different ways they are handled (the title says “made simple”), but I do want to offer a simple approach that applies to the vast majority of employer stock plans and should help you avoid very costly mistakes.

Here’s the simple approach…read on to see if this applies to you: In most cases, when you exercise employer stock options, you’ll have proceeds from a sale reported to you at the end of the year. It may appear at first that you’re being double-taxed on the exercise of stock options. In fact, you simply need to report the sale with cost basis equal to proceeds (i.e. no gain from the sale). This eliminates any tax liability from the sale of stock and prevents double-taxation.

Now, read on to make sure this simple approach applies to your situation…in my experience, it usually does.

I find it helpful to classify employer stock plans as one of three types:

1) Incentive Stock Option (ISO) plans,

2)  Employee Stock Purchase Plans (ESPP) and

3) everything else.

ISO and ESPP plans have their own unique rules. Because these plans are far less common, I’m not going to address them here. Your employer should tell you if your plan is considered an ESPP or ISO plan. If so, stay tuned and I may get around to posting something on those. For now, I’m just going to address the “everything else” plans.

The way most employer stock plans work is as follows: You’re “granted” the right to “exercise” options to buy stock in a company once certain criteria are met. Often the criteria involve a certain amount of time with the company, sometimes they’re based on performance goals, usually you pay very little or nothing for the stock out of pocket. The point is when you’re initially “granted” the stock options, you generally do nothing from a tax standpoint. (Of course, you could make what’s called an 83(b) election which will change the tax treatment, but that’s fairly uncommon and beyond the scope of this article.)

However, once you meet the conditions necessary to “exercise” the stock option, and generally you must then make a decision to actually “exercise” the option and purchase the stock, your rights are considered to have “vested.” This means you now have full, unrestricted ownership of shares of the company stock which you may do with what you wish. And you also have income for tax purposes when this occurs…which is where things tend to get confusing.

The first thing to know is the “income” is the difference between what you pay out of pocket for the stock (often nothing), and the Fair Market Value of the stock on the exercise date. This amount is generally reported as wages to you by your company, and the amount will be included in your wages reported on your W2 at the end of the year. And anytime you have wages, your employer is required to withhold taxes on that amount, and this is where the confusion often originates.

The second thing to know about exercising employer stock options is how the withholding is handled. Normally when you get paid, your employer just withholds some of the money you’ve earned and pays it to the government to cover the tax liability generated by that income. But when your income is in the form of stocks, not cash, your employer can’t simply give the government some of the stock to pay the tax debt. Instead, your company must sell part of the stock you’re exercising and use the proceeds to pay the withholding tax. So even though you may just hold on to the stock you receive, you’ve still got a sale of stock that needs to be reported.

And that brings us to the third thing to know when exercising employer stock…how to report the stock sale. Since some of the stock you exercised was immediately sold, you’ll usually receive a 1099-B reporting the stock sale. And this is where it’s very common for people doing their own taxes (or occasionally people having their taxes done by an inexperienced preparer at one of the tax chain stores) to pay double-taxes on the income from exercising employer stock options. The “income” from the stock that was exercised and sold on the same day gets reported on both your W2 and a 1099-B, so how do you avoid paying tax twice on this amount since it’s reported twice? The answer lies in knowing your cost basis for the stock.

Cost basis is usually the amount you pay for stock, which is why some people mistakenly think they have no basis in the stock they exercised…resulting in double-taxation when they report the sale as 100% gain even though it’s already income on their W2.

In fact, cost basis also includes the amount of income recognized (and taxed) on your W2. Since the amount included on your W2 is the Fair Market Value (minus any out of pocket price you paid) of the stock on the exercise date, and the stock was sold on the exercise date, then the proceeds from the sale and the cost basis will almost always be exactly the same. Typically the only difference will be a small amount to cover broker fees, so you’ll actually have a slight loss when you report the sale. As a result, you have no gain, and therefore no taxable income, from the sale reported on 1099-B. Double-taxation avoided.

Reporting cost basis equal to proceeds, and therefore no gain, is quite simple really. So why do so many people get it wrong? Well, this is because most people use software, and software has to account for all the less common situations. If you know that your only stock sale is a same-day sale of exercised stock (and it’s not an ISO or ESPP), you can skip all the fancy guidance in whatever tax software you’re using. Just report the proceeds with a cost basis equal to proceeds and you’re done. That’s pretty simple…and it’s the most common situation.  (You might be able to add a little bit to your basis due to the transaction fees from the sale, but missing this will usually only result in a few extra dollars of tax liability, so it’s nothing to worry about.)

If  you sold some employer stock after holding it for awhile, then you’ll probably want to use the guidance offered by your tax software. However, it’s always a good idea to check the results at the end and look at the cost basis reported on Schedule D before you submit your return. The cost basis should almost always be at least equal to the Fair Market Value of the stock on the date you exercised it. This is easy to determine using any number of online tools that allow you to look up historical stock prices. And don’t forget to multiply the Fair Market Value of one share by the total number of shares sold!! I’ve seen a few returns where individuals following the guidance for their software reported their basis as the share price of a single share…even though they’d sold hundreds, or even thousands, of shares.

If the cost basis reported by your tax software differs significantly from what you think it should be by simply looking up the historical price on the exercise date, it’s time to have a professional review your work. There are many, many ways this could happen, and the explanations are anything but “simple.”


Adjustments, Credits, and Deductions…what’s the difference and why it matters

March 19, 2015

Pop quiz: Given the choice between a $4000 deduction or a $2500 credit, which would you take?

If you don’t know the answer (and why), you might wind up making a very costly bad decision at tax time.

This post is inspired by a recent question a client asked me (details altered slightly to protect the innocent…):

I have stock I’ve held for many years that has appreciated about $100,000. I’m considering selling it because I’ve heard capital gains rates are at an all time low and may soon rise, plus I expect my own income to rise in coming years. I’ve heard the tax rate is 15%, which would be $15,000. I also may need a minor operation soon, which I’ve been told will probably also cost around $15,000. Can I just deduct the medical costs against the tax so I don’t pay any tax from selling the stock?

The first part of this question is actually very savvy. Indeed, long-term capital gains rates (the tax rate you pay on the gain from selling assets you’ve held more than a year) are the lowest they’ve been in nearly a century, and almost certainly will rise in the fairly near future. So selling now while capital gains rates are so low can be a good move in many cases. However, the actual question at the end demonstrates a very common and fundamental misunderstanding about tax credits and deductions.

This article attempts to clear up the confusion surrounding adjustments, credits, and deductions. These three words refer to similar concepts, and they all have the net effect of lowering your tax bill. However, they each lower your tax bill in slightly different way. So it can often be the case that $1 of one is worth more than $2 of another.

Tax credits are the best kind of tax reduction. A credit reduces your tax liability dollar for dollar in the amount of the credit. A popular new credit is the American Opportunity Credit. This credit reduces your tax liability dollar for dollar on up to $2,000 of qualified educational expenses. For example, if you have a $5,000 tax liability before considering education expenses, but then you include the $2,000 of qualified expenses on your return, you just reduced your tax liability to $3,000.

Most credits aren’t worth 100% of the expenses that qualify for the credit.  In fact, the American Opportunity Credit becomes a 25% credit on qualified expenses above $2,000 but less than $4,000. So if you had $3,000 in qualified expenses, you’d get a $2,250 credit — $2,000 plus $250 on the amount over $2,000 (25% of $1000 = $250).

The important thing to realize is that once you know the amount of a credit, you know that it will reduce your tax bill by that same amount.

(Most credits are limited by your total tax liability, meaning if you only have a $1000 tax liability, a credit of more than $1000 will still only reduce your bill to $0. But there are a few credits that are “refundable” and can result in negative tax liability where the IRS actually pays you money. For more info, see this bankrate.com explanation)

Deductions reduce your taxable income. While people most often ask “What can I deduct?” when looking for ways to reduce their tax bill, deductions are actually the least valuable form of tax reduction. There are two main reason for this.

First, deductions don’t reduce your tax directly, but only the amount of income that is used to calculate your tax. In other words, they only reduce your tax by a percentage of their value. And that percentage is determined by your marginal tax bracket. Most taxpayers fall into either the 10% or 15% tax brackets, meaning that’s the percent of tax they pay on each additional dollar earned. So a $1,000 deduction for a person in the 15% tax bracket is actually worth $150 in tax savings. For somebody in the 25% tax bracket, the next largest bracket, that $1,000 deduction would be worth $250.

Second, and more important, deductions offer no tax savings at all in many situations. Nearly everybody gets a “standard deduction” they can use to reduce their taxable income automatically (in 2014, this amount was $6,200 for Single filers, $12,400 if Married Filing Joint).  If your total deductions are less than the “standard” amount, you receive no benefit at all from them because you simply take the standard deduction (with a few rare and minor exceptions). Only when the total of your deductions exceeds the standard deduction do you benefit from “itemizing” your individual deductions and taking that value instead of the standard amount. For most people who don’t have a mortgage, this means they don’t benefit from these deductions–unless they have a lot of other deductions. Furthermore, many deductions are only allowed if they exceed a certain percent of your Adjusted Gross Income (AGI). For medical expenses, only expenses that exceed 7.5% of your AGI can be deducted. For work-related expenses, investment expenses, and most miscellaneous deductions, only expenses that exceed 2% of your AGI can be deducted. (Expenses in the 2% category can be added together before the 2% reduction, they don’t have to individually exceed 2% of AGI.)

As a result, many people who think they’re going to benefit from a substantial deduction receive no benefit at all, or the benefit is significantly less than they expected.

Adjustments are reductions in your Adjusted Gross Income. These are often referred to by accountants as “above the line” reductions. In this case, “the line” refers to your AGI–aka Line 37 on recent year 1040 Forms. Adjustments reduce your taxable income, much like deductions, but unlike deductions they are not subject to any limitations based on percentage of AGI. Plus you can still take the standard deduction and receive the benefit from adjustments. Because adjustments reduce your AGI, they have some additional benefits as well.

Your AGI determines a number of things. Most importantly, your AGI determines your eligibility for most tax credits and deductions. (And, paradoxically, your AGI can determine your eligibility for adjustments and income reductions–such as Social Security not being treated as taxable–even though these items affect your AGI. It sounds circular, but it’s accomplished through the use of Modified AGI which would require a separate article.) As a result, adjustments can not only reduce your taxable income, but increase other credits and deductions as well.

One relatively common example I’ve seen is reducing your AGI to benefit from the Saver’s Credit, a credit that can be worth 10%, 20%, or even 50% of any amount you contribute to qualified retirement accounts. This credit can be claimed by individuals with AGI below $26,500 and married filing joint couples with AGI below $53,000, so a fairly large number of taxpayers potentially qualify. If you’re just above one of the thresholds for this credit, a reduction in your AGI by, for example, taking an adjustment for qualified tuition and fees might result in a few hundred dollars in savings as a result of the Saver’s Credit now that your AGI is below the threshold–plus the savings from reducing your taxable income.

Adjustments are less restricted than deductions, and they can have added benefits by reducing your AGI. (In fact, in rare cases, I’ve seen adjustments result in tax savings larger than the actual amount of adjustment thanks to this domino effect.) Generally speaking, adjustments are more valuable than deductions and less valuable than credits.

Answer(s). So to answer the original pop-quiz question, which is better: $4000 deduction or $2500 credit? Because the top marginal tax rate is 35%, this means a $4000 deduction can’t be worth more than $1400 (=4000 x .35), and for most taxpayers who are in lower tax brackets, it would be worth even less. A $2500 credit, on the other hand, is worth $2500. So the choice is clear: the credit is better.

Notice I didn’t ask to compare to an adjustment, because due to the possible domino effect of reducing AGI, it’s impossible to say how much an adjustment will be worth without knowing many details about the tax return.

And regarding my client’s question about medical deductions, here are the two main considerations:

  1. Deductions reduce your taxable income, not your tax liability directly, so $15,000 in deductions won’t directly offset $15,000 in income tax. It can only reduce the income that is used to calculate that tax liability. (In other words, he was confusing deductions with credits.) And…
  2. …A $15,000 medical deduction still has to be reduced by 10% of AGI (which based on $100,000 in income from the stock sale must be at least $10,000). And if the remaining deductible expenses plus other itemized deductions don’t exceed the standard deduction, then there’s no tax benefit at all from the medical expenses.

After considering all the factors, I advised this particular client to avoid selling the stock and doing the surgery in the same year if practical, because the income recognized from the large stock sale would wipe out nearly all the benefit from the medical deduction. This turned out to be quite the opposite from his original assumption (do surgery in the same year to get big tax savings), and he was very glad he’d paid for the advice before making his decision.


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