Financial Topics Newsletter Archive
SBT Investment Services, Inc. through its relationship with Infinex Investments, Inc., member SIPC/FINRA, offers a range of educational resources to help customers achieve their life goals. These include the personal attention of our Advisors, registered representatives of Infinex Investments, Inc., periodic educational forums, and topical articles in our Financial Newsletter.
We publish this online newsletter monthly and maintain an archive of past issues. If you have any questions about or would like to discuss an article, please contact one of our Advisors.
September 2007
In This Issue:
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Tax Planning for Major Life Events
Most of life’s major financial decisions have tax ramifications. As you encounter those events, keep these tax-planning tips in mind:
- Marriage or divorce — Either event should prompt a thorough review of your tax situation. In both cases, your tax filing status will change, which may have an impact on your tax-planning situation. Your filing status is determined as of December 31, so if you are planning to get married or divorced around year-end, review the tax ramifications first. Consider these specifics:
- Check income tax withholdings. You may need to adjust your allowances for income tax withholding purposes or review any estimated taxes that are being paid.
- Review fringe benefits. In the case of marriage, you will want to coordinate your fringe benefits with your spouse’s benefits. In a divorce, you may have to find another source for fringe benefits you obtained from your spouse’s employer.
- Understand the tax ramifications of any divorce agreements. Determine who will claim minor children as dependents on tax returns. Determine whether any payments are classified as child support or alimony, which have significantly different tax ramifications. Review how the division of property will affect your gain or loss when you sell the asset.
Birth of a child — Each exemption on your tax return reduces your taxable income by $3,400 in 2007, although high-income taxpayers may find these exemptions reduced. Other tax items to review include:
- Plan for other tax benefits. A $1,000 child tax credit is available every year until your child is age 17, but the credit is phased out at higher income levels. You may also be eligible for a child care credit if you pay for child care so you can work. Check at your place of employment to find out if child care reimbursement accounts are available, which allow you to pay childcare expenses from pretax earnings.
- Start saving for college. It’s never too early to start saving for college. There are a variety of tax-advantaged ways to save for college, including section 529 plans and Coverdell education savings accounts. Once your child starts college, be aware of other ways to reduce the cost of college, including the Hope and lifetime learning credits, the above-the-line education deduction, and interest deductions for qualified higher education loans.
- Consider annual gifts to your child. In 2007, you can gift $12,000 ($24,000 if the gift is split with your spouse) to each child on a tax-free basis. This amount can increase annually for inflation in $1,000 increments. This reduces your taxable estate and you avoid paying taxes on any earnings on those assets. Be aware, however, of the “kiddie tax,” which refers to the way children’s investment income is taxed. In the past, it applied to children under age 14, but now applies to children under age 18. In 2007, the first $850 of investment income is tax free, the second $850 is taxed at the child’s marginal tax rate (typically 10%), and any remaining investment income is taxed at the parents’ marginal tax rate. Once the child is age 18 or older (previously age 14 or older), all investment income is taxed at his/her marginal tax rate. Thus, until your child turns age 18, you might want to select investments with lower tax burdens, such as municipal bonds.
- Think about individual retirement accounts (IRAs). Once your child starts earning income, consider setting up an IRA for him/her. If the child does not want to use his/her money for the IRA, you can gift the money to the child.
Purchasing or selling a home — The tax benefits of owning a home are significant. Consider these tax aspects of home ownership:
- Mortgage interest and property taxes can be deducted on your tax return, reducing the cost of owning a home. Mortgage interest is deductible on up to $1,000,000 of original debt incurred to purchase a principal residence. Additionally, interest paid on up to $100,000 of home-equity debt is deductible on your tax return. You may want to replace loans that generate personal interest, which is not tax deductible, with home-equity loan debt.
- When you sell your home, significant capital gains can be excluded from income. You can exclude $250,000 of gain if you are a single taxpayer and $500,000 of gain if you are married filing jointly, provided the home was your primary residence in at least two of the preceding five years. You no longer have to purchase another home to qualify for the exclusion. If you are forced to sell in less than two years due to employment changes, health reasons, or unforeseen circumstances, you can prorate the exclusion amount based on how long you lived in the home.
- Planning for retirement — With all the other demands on your income, it’s easy to forget about planning for retirement. However, you should take advantage of tax-advantaged ways to save for your retirement.
- Participate in your 401(k) plan. Start contributing to a 401(k) plan as soon as you are eligible. In 2007, you can contribute a maximum of $15,500, plus individuals age 50 and older can make an additional catch-up contribution of $5,000, if permitted by their plan. These contributions reduce your current-year taxable income, although you still have to pay Social Security and Medicare taxes on the contributions. If your employer matches contributions, make sure to contribute at least enough to maximize the match.
- Review IRAs. Even if you are contributing to a 401(k) plan, take a look at IRAs as well. In 2007, you can contribute a maximum of $4,000 to an IRA, plus individuals age 50 and older can make an additional catch-up contribution of $1,000. Traditional deductible IRAs will reduce your current year taxable income. Roth IRAs do not reduce current year taxable income, but qualified distributions can be taken income-tax free. For those who are not eligible for traditional or Roth IRAs, consider contributing to a nondeductible IRA. Starting in 2010, all taxpayers, regardless of income level, can convert traditional IRAs to Roth IRAs.
- Check your options before retiring. The choices you make regarding distributions from your pension plans and IRAs will have a significant impact on your tax situation after retirement. Make sure you review all your options before deciding how to withdraw those funds.
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What Is Your Marginal Tax Rate?
If you answer that question by looking at the tax rate tables that show income tax rates of 10%, 15%, 25%, 28%, 33%, and 35%, you could be understating your real marginal tax rate. Your marginal tax rate could be higher due to numerous provisions that phase out or limit certain deductions, credits, and other tax benefits. Some of the more significant provisions include:
- Limitation on itemized deductions — Once adjusted gross income (AGI) exceeds $78,200 in 2007 for married couples filing separately and $156,400 for all other taxpayers, itemized deductions, with the exception of medical expenses, investment interest, and casualty losses, must be reduced by 3% of the excess over this AGI amount. The maximum reduction is 80% of itemized deductions. In addition, medical expenses can only be deducted to the extent they exceed 7.5% of AGI, while miscellaneous expenses must exceed 2% of AGI and casualty losses must exceed 10% of AGI.
- Phaseout of personal exemptions — The personal exemption amount of $3,400 in 2007 is reduced by two-thirds of 2% of each $2,500 of AGI over threshold amounts. Those amounts for 2007 are $234,600 for married taxpayers filing jointly, $195,500 for heads of household, $156,400 for single taxpayers, and $117,300 for married taxpayers filing separately.
- Exclusion of Social Security benefits from income tax — Up to 50% of benefits are taxed when AGI plus tax-free interest plus one-half of Social Security benefits is over $25,000 but less than $34,000 for single taxpayers and is over $32,000 but less than $44,000 for married couples filing jointly. Up to 85% of benefits is taxed once income exceeds $34,000 for single taxpayers and $44,000 for married couples filing jointly.
- Other phaseouts — Numerous credits, deductions, and other benefits are phased out once income exceeds prescribed limits, including the earned income credit, the child credit, the dependent care credit, traditional and Roth individual retirement account (IRA) contributions, Coverdell education savings account contributions, Hope scholarship and lifetime learning credits, the above-the-line higher education expense deduction, student loan interest deductions, rental real estate losses under passive loss rules, the adoption credit, and the elderly and disabled credit.
While these items aren’t called income taxes, the result is the same — an increase in your total income tax bill.
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Undoing a Roth Conversion
When converting a traditional individual retirement account (IRA) to a Roth IRA, transferred amounts must be included in income if taxable when withdrawn (e.g., contributions and earnings in traditional IRAs and earnings in nondeductible IRAs), but are exempt from the 10% federal income tax penalty. Your adjusted gross income (AGI) cannot exceed $100,000 in the conversion year, excluding any converted amounts.
To use this strategy effectively, you need to decide when to convert. Taxes are paid based on your investments’ values on the conversion date. If those values decline after you convert, you end up paying taxes on more than the current market value.
If you’re in that situation, consider recharacterizing your conversion. For conversions made in 2007, you can recharacterize until October 15, 2008, meaning you can convert back to your original traditional IRA. Just make sure not to take possession of the funds. The transfer from the Roth IRA to the traditional IRA should be a trustee-to-trustee transfer. After the recharacterization, it is as if you did not convert, so you owe no taxes. If you already filed your 2007 tax return and paid the taxes, you can file an amended return to get a refund. You can then reconvert at a later date, provided your AGI does not exceed $100,000 in the conversion year. (Keep in mind that starting in 2010 there is no income limitation for Roth IRA conversions.) The reconversion can be completed at the later of 30 days after the recharacterization or the beginning of the tax year following the first conversion.
You can recharacterize just a portion of the conversion. However, if you have several investments in the IRA, you can’t simply choose the ones with the largest losses. In that situation, a pro-rata portion of all the investments in the account will be considered in the recharacterization. You can bypass this rule by setting up separate Roth IRAs for each investment. Then, if one declines substantially, you can recharacterize that one Roth IRA account, leaving the other accounts intact.
There are other situations where you might want to recharacterize. You might have converted to a Roth IRA, thinking your income for the year would be less than $100,000. If you later find out that your income is over that threshold, you can recharacterize the conversion. Otherwise, in addition to the income taxes due, you would also have to pay a 10% federal income tax penalty and a 6% excise tax.
You can also recharacterize annual IRA contributions. Perhaps you contributed to a traditional IRA, but find your income is over the thresholds. You could recharacterize to a Roth or nondeductible IRA contribution.
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Selling Your Home at a Loss
With the real estate market slowing, more taxpayers may find themselves in a situation where the sale of their home results in a tax loss or their net sale’s price is less than the amount of their outstanding mortgage.
When selling a home, the basic tax rule is you can exclude gains of up to $250,000 if you are a single taxpayer and up to $500,000 if you are married filing jointly, provided the home was your primary residence in at least two of the preceding five years. But what happens if you have a loss on the sale? Since your primary home is not considered investment property, you cannot deduct a loss on your income tax return.
Although not a short-term solution, one way around this is to convert your home to rental property. Then, when the property is sold, the loss can be deducted as a capital loss, as long as you can prove the home was permanently converted to income-producing property. Your basis for calculating the loss is the lesser of your actual cost or the property’s fair market value when it was converted to rental property.
When calculating your gain or loss on the sale of your home, don’t confuse your mortgage balance with the basis in your home. Your basis is the amount you paid for the home plus any improvements. It is possible for your mortgage and equity loans to exceed the sales price. If you sell the home for less than your mortgage amount, then you will owe more than you received but it is still possible to have a gain for tax purposes.
Due to the home sale gain exclusion, you can exclude up to $250,000 if you are a single taxpayer and $500,000 if you are married filing jointly, provided the home was your primary residence in at least two of the preceding five years. If you move out of the house and it takes longer than three years to sell your home, your gain could be taxable. Please call if you’d like to discuss this in more detail.
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Your Parents and Their Estate Plans
Estate planning can be a difficult subject to discuss with your parents. You don’t want to seem concerned about how much money they may eventually leave you, while they may fear you are interfering with their finances. But to help ensure their estate is settled quickly according to their wishes, family members should have some basic information. You don’t need to know the specifics about who will receive what, but you should find out:
- Where important estate planning documents are located. Don’t ask for specifics, just make sure documents are in place so their wishes will be carried out. Find out if they have a durable power of attorney and a health care proxy. With a durable power of attorney, they designate someone to control their financial affairs if they become incapacitated. If your parents are concerned that this person may assume control prematurely, suggest leaving the document with their attorney, who can deliver it to the appropriate person when necessary. A health care proxy delegates health care decisions to a third person when your parent is unable to make those decisions. Usually, this document also outlines procedures to be used to prolong life.
- How to contact their advisors. Ask for a list of names, addresses, and phone numbers of lawyers, accountants, and financial advisors.
- Their rationale for distributing their estate. Often, when heirs understand why an estate is being distributed in a particular manner, it can prevent problems among those heirs. If your parents are reluctant to discuss these things now, suggest they leave a personal letter with their estate planning documents explaining their rationale for distributions. This is a good place to explain unequal bequests or large charitable contributions.
- Preferences for the future. Find out where your parents would like to live if they’re not physically able to live in their current home. Do they want to move in with relatives or live in an assisted-living facility? Discuss in detail what procedures they want performed to prolong life in the event of a terminal illness. Determine their preferences for funeral arrangements.
While these topics are sometimes not easy to discuss, they are important to know to ensure that your parents’ estate is properly handled.
Copyright © 2008. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
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Copyright © 2008. This newsletter intends to offer factual and up-to-date information on the subjects discussed, but should not be regarded as a complete analysis of these subjects. The appropriate professional advisers should be consulted before implementing any options presented. No party assumes liability for any loss or damage resulting from errors or omissions or reliance on or use of this material.
FR2007-0420-0124
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