Avoid these simple tax mistakes

February 26, 2015

This week, it’s just a mish-mash of various common mistakes or misconceptions I’ve run across that you would be wise to steer clear of.

  1. Are you a registered domestic partner in California? If one partner’s employer provides health insurance to the other partner, this is unfortunately taxed as income on the federal tax return. However, California provides a deduction on the state return for this amount, and other states that have same-sex spouses and registered domestic partners may allow it as well. Check your state law. In California, it’s a subtraction from wages (reported on Line 7 of Schedule CA). And depending on your income and the cost of health insurance, this can save you several hundred dollars on your tax bill. NOTE: Many tax professionals miss this little-known deduction, so even if you had a professional do your taxes, you should double-check that they caught this.
  2. Do you pay for your own health insurance and receive income as an independent contractor? Make sure you deduct that health insurance. In general, medical costs must exceed 10% of income to be deductible, so many people just ignore these costs on their tax return. But in the special case of health insurance and self-employment earnings, you can actually take a deduction for the entire cost of health insurance in most cases.
  3. Did you sell stock or other assets? Many people who don’t frequently sell stock or other assets, or who received it as a gift or inheritance, don’t know what their cost basis is in the asset. As a result, they pay much more tax on the sale than they should. Your cost basis is generally what you paid for the stock; plus the value of reinvested dividends. If you received stock from your employer, your cost basis is the amount that was reported as income on your W2. (Frequently this is the Fair Market Value of the stock, minus any amount you actually paid, on the exercise date.) If you received assets as a gift, your basis is whatever the donor’s basis was. And if you inherited assets, your basis is generally the Fair Market Value of the asset on the date of death of the decedent.
  4. Look closely for withholding on 1099 statements. Most people catch withholding on their W-2, but sometimes taxes are withheld on pension/IRA distributions (1099-R), unemployment (1099-G), Social Security payments (SSA-1099), and occasionally even interest payments or proceeds from stock sales (1099-INT and 1099-B). Don’t forget to take credit for these payments you’ve already made to the government! No need to pay the same tax twice.

These are just the most common mistakes I’ve seen in the last week or two. In my experience, the majority of self-prepared tax returns contain one or more mistakes. More often than not, they’re minor oversights like #4. These can be eliminated by simply carefully examining all of your tax documents, and carefully reading each screen if you’re using tax software. However, occasionally, there are deductions or credits that aren’t widely known and the software doesn’t do a great job of telling you about (like #1).  In these cases, a professional review is probably your best bet to uncover the mistake.

Income averaging for a lifetime of tax savings

February 19, 2015

Our income tax system is what’s known as a “progressive” income tax. Like every developed nation, the US taxes high incomes at a higher rate than lower incomes. Some may debate whether or not a progressive tax structure is fair or effective (although it’s interesting to note that there has never been a nation that can be considered prosperous by modern standards that did NOT use a progressive income tax system), but the fact is a progressive income tax system is here to stay. And in today’s economy, where job security is largely a thing of the past and young people of today can expect a lifetime of fluctuating income, this presents a possible tax trap for some, and a tax saving opportunity for those who plan ahead.

Over the course of a career, nearly all people will fall into multiple tax brackets. Most of us start out in the bottom brackets, many of us move up to the middle brackets at some point, and a few will have years in the top income brackets. Without proper planning, people with modest assets and only a few high earning years may wind up paying taxes at levels equal to, or higher than, the truly affluent. This is because the income tax system only looks at one year at a time. So even one good earnings year can put you in the highest bracket, even though over your career you don’t necessarily earn a lot of money relative to your peers.

Sales people are often a good example of this; real estate agents in particular. When working on commission, a person might make $500k one year, but then earn $20k each year for the next 5 years. This person would pay taxes at the highest rate (currently about 40%) on a significant portion of their income during this period. Meanwhile, somebody in a more stable profession might earn $100k each year for six years, resulting in the same before tax earnings of $600k during the six year period. However, $100k of annual income will probably put this person in no higher than the 25% tax bracket. As a result, the person with steady earnings might pay tens of thousands of dollars less in taxes on the exact same amount of income.

It might not seem fair, but that’s the way it works…and it’s awfully hard to imagine any alternative so that’s probably the way the system will be in the future. But this does present a tax savings opportunity. A savvy individual needs to consider their lifetime earning potential and plan accordingly.

Young people, who are likely still in relatively low tax brackets, should generally fund Roth IRA accounts and other investments that give no tax deduction right now, but offer tax savings in the future. Buying up stock and other assets likely to appreciate over the long run can also be a good move from a tax perspective at this point as well, as we’ll see later.

As individuals move toward middle-age, and their prime earning years, that becomes the time to start reducing their income through the use of tax-deferred savings plans, such as 401k’s and Traditional IRAs. In addition, if this individual was smart enough earlier in life to invest in a diversified group of assets, this person will probably have some assets that have lost value over time. These assets can be sold at losses and used to offset income that would otherwise be taxed at a high rate. Appreciated assets should be held on to, as these items won’t be taxed until they are sold.

Finally, as careers wind down, individuals can start recognizing income that was deferred earlier in their lives. This can be in the form of taking distributions from IRAs and 401k’s, or it can mean selling assets that have been held for many decades and experienced significant appreciation.

In addition to offering overall tax savings over a lifetime, this approach also provides flexibility during the inevitable fluctuations throughout a career. If  a person has been setting aside money, then a period of unemployment, for instance, can more easily be navigated. A middle-aged person who becomes unemployed for  a long period may choose to withdraw some money from a Roth (which can be done totally tax-free as long as certain criteria are met), as well as other money from a Traditional IRA or 401k (which can conceivably be done with no penalty and very minimal tax through careful planning).

Through careful planning, an individual can easily save tens of thousands of dollars over their lifetime by setting aside money in a way that makes the most sense from a tax perspective. Young people should generally look to assets that offer no current deduction but can grow in value without being taxed. Middle-aged individuals in their prime earning years should seek to maximize the deferral of taxes. And retired individuals should recognize income that has been deferred in a balanced way that will minimize the taxes on this income. Through this approach, individuals can avoid some of the unintended side affects of a progressive tax system.

Simple Accounting Solutions for Small Businesses

February 12, 2015

As our workforce grows increasingly more “flexible”…some might even say “unstable”…many people are trying their luck at starting their own business, or at least taking on temporary “contract” jobs where they’re not technically considered an employee. (From a tax perspective, a worker on a contract job is is considered in business for him or herself.) Most people taking this plunge don’t really know where to start as far as permits, licenses, tax responsibilities, legal requirements…the list goes on and on, as any self-employed person can attest. Well in this post I want to mention a few convenient and inexpensive (or free!) tools I’ve found that are helpful to new businesses.

Many people starting out feel almost obligated to purchase QuickBooks to start keeping track of their income and expenses. While this certainly isn’t a bad move–QuickBooks is a great accounting solution for many small- to medium-sized businesses–it may be overkill at first for solo operations and other very small businesses. When first getting started, many people just want a way to keep track of their income and expenses. They want to be able to organize everything at year-end so they get the maximum tax deductions, and they want to have some idea how much is going out compared to how much is coming in. And while a full-featured solution like QuickBooks can certainly do the job, really anything that can get the income and expenses onto a spreadsheet should be adequate while you’re still pretty small. And if your tax accountant requires you to use QuickBooks, it’s time to consider switching accountants. Gleaning the necessary information to prepare a tax return from a spreadsheet is a pretty easy task for most small businesses.

One important thing to point out here is if you’re going to operate as a business, even just an independent contractor, you should definitely set up a bank account that you use for all your income and expenses. It’s SO much easier to figure out whether or not that $30 spent at Target was office supplies (and deductible!) or a toaster (sorry, probably not deductible) if you know that everything spent from your “business account” was a business expense. Of course, you have to have the discipline to only use the account for legitimate business reasons…because just paying for that night at the movies with your kids from your “business account” doesn’t make it a business expense. Nice try, though :-)

Many bank accounts now come with some handy reporting features that may be all you need at first to track expenses. Basically, all you need is the ability to categorize expenses, and add an optional memo in case you need to add some extra detail. The date, amount, and location/merchant should all be a standard part of the transaction record. If your bank allows you to keep track of this information, and export it to a spreadsheet, you might be all set as far as tracking expenses.

If your bank doesn’t allow you to add categories and notes, then you might want to consider a free on-line tool like Mint or Expensify. I’ve used Mint (mint.com) for awhile for my personal expenses, and find it’s a very convenient way to track spending and know where your spending is going. You basically link your Mint account to credit card and /or bank accounts, and it automatically updates with all your transactions on a regular basis. It “learns” what merchants go with what category of expenses, but you can always recategorize if it doesn’t make the right choice. It’s pretty low maintenance once you’ve linked it to any accounts you want to track. Just check it periodically to verify the categories it chooses and add notes to any transactions that need more detail (e.g. meal expenses need notes about who you ate with and what was the business purpose to be deductible).

However, I’ve been using Expensify (expensify.com) to keep track of my receipts for a few years now. My favorite feature in Expensify is the ability to take a picture of a receipt on a smartphone, and then upload it to your account. Expensify will scan in the details (date, amount, merchant), and categorize it using rules it “learns” from your previous entries. I love this approach because now I have my receipts digitally stored. The IRS generally requires receipts for expenses greater than $75, or for meals, entertainment, and travel expenses of any amount, so keeping a digital copy of my receipts stored with my records is incredibly convenient. Expensify is free for up to three users in one company.

With Mint or Expensify, you get a lot of functionality for free, and you can export the results to a spreadsheet that can easily be sorted by categories at tax time. Expensify can also export to QuickBooks format.

Keeping track of income is often very easy for new businesses…because there isn’t much to keep track of! Maybe you just have one client, or a few clients, as you’re getting started, so keeping track of income isn’t really something you need help with. Or maybe you do mostly credit card billing, so your credit card statements already keep a record of your income.

But if you need an invoicing solution, there are again several free or inexpensive solutions. Freshbooks is becoming increasingly popular, and can be used for free if you only need to track one client at a time. However, the price jumps to $20/mth once you exceed that limit, then $30/mth when you go over 25 clients (but then it’s unlimited). Depending on what type of business you operate, you might hit that limit very quickly…like if you run a tax practice! On the plus side, though, Freshbooks also does expense tracking and allows you to take pictures of receipts and save them with the expense. I find Freshbooks isn’t quite as good with expenses as Expensify, but the good news is Freshbooks and Expensify can work together by using Expensify as a plug-in within Freshbooks.

There are undoubtedly many more options available for these tasks. But for a new business just getting started, it’s important to know that bookkeeping doesn’t have to mean a major software purchase and a steep learning curve. Start with a dedicated bank account and find a free tool to track income and expenses. As long as it can export to a spreadsheet, which is nearly universal in financial tools these days, then it should be fine for getting started.

If you find yourself overwhelmed with spreadsheet maintenance, then maybe it’s time to switch to a more powerful tool like QuickBooks. But hopefully by the time you get to that point, the investment in software and training will be a cost you can more easily stomach!

More on education and retirement account penalties

February 5, 2015

In an earlier article, I discussed some of the ways to avoid the 10% early distribution penalty for certain retirement account withdrawals. A reader had this followup question:

Hello, I was reading your article about using room and board costs as an education expense to reduce the 10% penalty on an early distribution from an IRA – if the student rents an apt not run by or affiliated with the college can these expenses be used as qualifying education costs to reduce the 10% penalty or does the student have to live and eat on campus?

Short answer: Yes, the costs for the off-campus apartment are allowable for this penalty exception.

There is a limitation on these costs. They cannot exceed the “allowance for room and board (…) that was included in the cost of attendance (for federal financial aid purposes) for a particular academic period (…).” (See IRS Publication 970, page 58)

In other words, you should check with your educational institution to determine what is their official “allowance for room and board.” This shouldn’t be too hard to find. For instance, I checked the website at CSU East Bay, where I got my Masters Degree in Taxation, and it took less than a minute to find this page outlining the costs of attendance. (“Costs of attendance” is a good term to use when searching or inquiring with a representative of the school.) At the bottom, they explicitly state the estimated cost of room and board for off-campus housing is $12,414 (at the time I checked). Nearly any school eligible for federal financial aid should be able to provide this number. It goes into the equation that federal aid programs use in determining how much aid students are eligible to receive at a given institution, so institutions may actually be required to provide it. (I’m not 100% sure if they’re required to provide it, but I do know it’s very common.) So in my case, since I’m enrolled at least part-time at the University, I could use up to $12,414 in room/board costs during an academic year to offset any penalties related to an IRA withdrawal. (Of course, I must actually have those costs. If my actual costs are less, I could only take the lower amount.)

Publication 970 makes it clear that off-campus costs are allowed in how they describe the amount eligible for this 10% penalty exception. The second limit on the exception (in addition to the exception I just quoted above), is the “actual amount charged if the student is residing in housing owned or operated by the eligible educational institution.” Clearly, if this exception were limited to only housing costs paid to the university, there would be no need to provide both limits.

So check with the educational institution to find out what their official “allowance” is for room/board, and then you can deduct that amount or the actual costs, whichever is lower. (And do your best to find those grocery/restaurant receipts…the rent will be easy, but you might miss some expenses in the food area. Still a lot better than no exception!)