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.

Somebody claimed my dependent! Now what?

March 12, 2015

Every year thousands of taxpayers attempt to e-file their return, only to get a nasty surprise–somebody else claimed one of their dependents. In the IRS e-file system, once a taxpayer appears as a dependent on a tax return, no other return will be accepted with that same person also claimed as a dependent. Unfortunately, some unscrupulous individuals will rush out and claim a dependent, usually a child, that they aren’t legally allowed to claim on a return filed very early in the tax filing season. Most commonly, this occurs among separated parents when a non-custodial parent with no permission to claim a dependent does so anyway.

So what does the person legally entitled to claim the dependent do? Well, while the authorized parent will wind up getting the tax breaks they’re entitled to from the dependent, unfortunately it may take some time.

In order to claim a dependent that has already been “claimed” in the e-file system, a taxpayer will have to file a paper return by mail. With that return, the taxpayer may want to include a brief letter explaining the situation, and include an item of evidence that the taxpayer actually has the right to claim the dependent in question. For example, a parent could include a copy of the child’s report card mailed to the parent’s address as proof of being the custodial parent. Most likely (although I am not aware of any fixed policy on this), the IRS will process the refund for the taxpayer based on claiming the dependent in question. Several months later, both individuals who claimed the dependent will likely get letters from the IRS demanding proof that the child may legally be claimed by the taxpayer. The unauthorized parent, as determined by the evidence provided to the IRS, will have to pay back the difference in taxes resulting from the dependent, and significant penalties as well.

Unfortunately, paper filing means waiting longer to get a refund. For many parents, this money may be urgently needed, and the extra weeks (or possibly months) involved in processing a paper return can cause financial difficulties. In this situation, there is one strategy that may offer some help. If the authorized parent is getting a refund even without the child that has been improperly claimed, then one strategy is to e-file a return claiming all dependents, deductions, and credits except for the dependent who is already claimed. This will result in the taxpayer getting part of the refund very quickly. The remaining refund can then be claimed by filing an amended return that includes the dependent in dispute. Filing the amendment will lead to the same process described above; both taxpayers claiming the dependent will be contacted and asked for evidence of their position.

Unfortunately, this situation is so common that nearly all tax preparers have seen it at some point, often multiple times. But rest assured the IRS will make sure that only individuals legally authorized to claim dependents will actually get the tax benefits from doing so.

More common mistakes to avoid

March 5, 2015

Just a quick add-on to last week’s post, here are a few more quick tips to keep in mind during tax season…

  1. Don’t miss out on the Retirement Savings Contribution Credit (or Saver’s Credit). If you’re single and make less than about $30,000/yr, or married w/ a combined income of less than $60,000/yr, you may be eligible for this credit. If you contribute to an employer-based retirement plan, or to an individual retirement plan such as a Roth IRA or Traditional IRA, you can receive a tax credit for up to 50% of the amount you contribute to the account. It’s the IRS giving you money for giving yourself money. And if your employer does matching contributions, you can really leverage your contributions. More information available from the IRS.
  2. If you want to check the status of your refund after you’ve filed your return, go to the source: The IRS. You can use the “Where’s My Refund?” tool from the IRS to check on the status of your return after it’s been transmitted to them by your tax software or tax preparer. (Also available in Spanish.) This will be the most up-to-date information available about the status of your refund.
  3. Use the best filing status. It’s very common for newly married couples to want to file separately at first since they don’t feel like they’ve “merged” their finances. In nearly all cases, using the Separate filing status will result in a worse result. There are a few exceptions to that, but in general avoiding the Married Filing Separate status will save you a lot of money.

That’s all for this week. If I run across more common errors, I’ll post them here.


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