NO INCOME IS TAXED ALONE

Fellow tax blogger Trish McIntire, of OUR TAXING TIMES, recently gave us an excellent post titled “No Income is Taxed Alone”.

Trish was talking about withholding – and the problem that arises when there are multiple sources of income or couples who both work.

As Trish points out in her post –

“Withholding is based on that particular income source; paycheck, IRA distribution or other income.”

If a spouse fills out a Form W-4 with her employer claiming “Married – 1” the withholding will be based on the often false assumption that the wages from which the tax is being withheld is the only source of taxable income. 

If the other spouse does not work, and the couple does not have substantial other income, the withholding should be sufficient to cover the tax cost of the wage income.

But what happens if the other spouse also works, and makes more money, and/or one or both of the spouses is collecting Social Security or Railroad Retirement, and/or is self-employed, and/or the couple has a substantial capital gain or substantial interest and dividend income?  Then the “Married – 1” withholding on the wages will be nowhere near enough to cover the tax cost of that particular source of income, and the couple could end up with a huge balance due to Uncle Sam and their resident state.

But if the couple also has substantial itemized deductions – state income and real estate taxes, mortgage interest, charitable contributions, etc – the balance due will be less.

You must take all sources of income, and all deductions, into consideration when deciding what to claim on a federal and state W-4 (while the federal W-2 usually also covers state income tax withholding - you can often file a separate federal W-2 and state W-4).

As a general rule I advise my two-income couples to have the spouse with the smaller wage income claim “Married, but withheld at the higher Single rate – 0”.

Just what is the tax cost of a particular source of income?  You might think it is your marginal tax rate.  If you are in the 25% tax bracket you would expect that $10,000 of additional income would cost $2,500 in federal income tax.  Or $1,500 if the income is qualified dividends or long-term capital gains. 

But this is very often not necessarily the case.  Why?  Because additional taxable income will increase your Adjusted Gross Income (AGI), and many tax deductions and credits are reduced or totally eliminated based on one’s Adjusted Gross Income or a “Modified” Adjusted Gross Income (MAGI).

Here are just some of the tax items that are affected by AGI or MAGI –

 

·      losses from rental real estate activities,

·      traditional IRA contributions,

·      the ability to contribute to a ROTH IRA

·      student loan interest,

·      qualified tuition and fees,

·      medical and dental expenses,

·      casualty and theft losses,

·      miscellaneous deductions,

·      the Credit for Child and Dependent Care Expenses,

·      the American Opportunity and Lifetime Learning credits,

·      the Retirement Savings Contributions Credit, and

·      the Child Tax Credit

And additional taxable income could increase the amount of Social Security or Railroad Retirement benefits that are taxed.  An additional $1,000 could increase your taxable income by as much as $1,850!

And additional taxable income will increase Alternative Minimum Taxable Income, which could in turn reduce the exemption allowed under the dreaded AMT.  $1,000 in additional income could add $1,250 to income subject to the dreaded AMT.

Even though we are told that the maximum tax on qualified dividends and long-term capital gains is 0%, 15%, or 20%, under both the regular tax and the dreaded AMT, the actual tax cost of additional qualified dividends and long-term capital gains, under both the regular tax and the dreaded AMT, could be much more than 0%, 15%, or 20%. 

We certainly know that investment income could be subject to the 3.8% Net Investment Income Tax (NIIT).  SInce qualified dividends and long-term capital gain are included in investment income, additional qualified dividends and long-term capital gains could be taxed at 18.8% or 23.8%.

So not only is no income taxed alone, but no income is taxed separately, or in a vacuum. 

This is just more proof of the complexity of the US Tax Code.  And of the need for careful year-round tax planning with the help of a tax professional.

TTFN

TRUE TAX TIME TALES - IRA WITHDRAWALS

Here are two instances from the recent tax-filing season that concern excess withdrawals from an IRA and the tax consequences, federal and state (NJ), thereof.

Both taxpayers are retired and over age 70½, so they are receiving annual RMDs (Required Minimum Distribution) from their traditional IRA investments.

Client A is a widow with income from Social Security, her IRA, a state pension, and interest, dividends and capital gains.

Client B, who is married, has income from Social Security, his IRA, a small corporate pension, taxable interest, dividends and capital gains, and a large investment in tax-exempt municipal bonds that generate substantial supposedly tax-free income.

Normally Client A would take the RMDs from her various IRA accounts, and Client B would take a distribution of the earnings from his IRA investments, which was slightly more than his RMD.

In 2013 both had investments in their traditional IRA come due - a CD for Client A and a corporate bond for Client B - resulting in excessive cash in the IRA.  Both took significant cash withdrawals from their traditional IRAs that were in excess of their RMDs for specific reasons.  For Client A the excess amount was $43,000+ and for Client B the excess amount was $35,900.

Here is what I explained to Client A –

“Oi vey!

The $43,413.00 extra IRA withdrawal increased your AGI, so it decreased the amount of your medical and miscellaneous expense deductions. The $43,413.00 added $47,547.00 to your net taxable income.

Plus it pushed you well into the 25% tax bracket, and caused your long-term capital gains and qualified dividends to be taxed at 15%. Without this additional income they would have been taxed at 0%.

It cost $12,164.00 in additional federal taxes, but only $4,341.00 (10%) was withheld - leaving a shortage of $7,823.00.

It also reduced the amount of medical expenses I could deduct on the NJ return - the $43,413.00 added $44,281.00 to your net NJ taxable income. It cost $1,121.00 in NJ state income taxes, and nothing was withheld for NJ.

So the total tax cost of this withdrawal was $13,285.00 - or about 31%.”

But there was more –

“Plus it kicked your actual gross income to over $100,000 – much more than the $80,000 income threshold to qualify for the Property Tax Reimbursement (PTR) {A special NJ state program that reimburses seniors and the disabled each year for the increase in property taxes – rdf} for 2012 AND 2013 (you need two consecutive years of under $80,000 to qualify). You will not get a PTR check for 2012 or 2013.”

So the actual cost of the excess IRA withdrawal was increased by over $1,000.

Client B’s additional IRA withdrawal also reduced his deductible medical expenses – so the additional taxable income went from $35,900 to approximately $38,600.  In the past he did not have to worry about the dreaded Alternative Minimum Tax, so his portfolio included a substantial amount of interest from “private activity bonds”.  As a result, the increased IRA withdrawal caused B to become a victim of AMT.  The bottom line was about $6,300 more in federal income tax. 

Luckily Client B lives in a state that does not have an income tax.

Because neither client had a “tax basis” in their IRA investments the amount of the IRA withdrawals were fully taxable as ordinary income.

Neither A nor B had to take the money from their traditional IRA accounts.  Both could have come up with the same amount of cash by selling available current investments – mutual fund shares for Client A and tax-exempt bonds for Client B.  At most there could have been a capital gain on the sale – which would have been taxed at the 0% rate on the federal level.

Both taxpayers were already being taxed on the full 85% of their Social Security benefits.  But for those who are not - for each additional unnecessary $1,000 IRA withdrawal they could be taxed on $1,850, making an unnecessary IRA withdrawal even more costly.

Obviously neither A nor B consulted me before taking the additional IRA withdrawals.

What can we learn from the experience of these two clients? 

For one, do not take money in excess of your RMD out of an IRA when you have an alternate source in “current” investments.

And, of course, do not take a substantial excess withdrawal from your IRA without first talking to your tax professional.  If A or B had called me before withdrawing the money I could have worked up a projection and showed them just how much the IRA withdrawal would cost.

TTFN

CASE IN POINT

I am constantly reminding you that the Adjusted Gross Income (AGI) is the most important number on your tax return.

By reducing one’s AGI one can often increase a multitude of deductions and credits and reduce taxable Social Security or Railroad Retirement benefits. Here is an excellent case in point.

This past week-end was dedicated to figuring out “Where the Fakawi” and to catching up on lots of little 1040-related tasks – such as amending returns.

With one client additional information regarding annual dividend reinvestment sent to me after April 15th allowed me to properly calculate the cost basis of mutual fund shares sold in 2009. As a result a net capital loss claimed on the 2009 Schedule D, and carried over to Page 1 of the 1040, was increased by $545.00.

By increasing the capital loss I reduced the Adjusted Gross Income. And by reducing AGI I increased -

• the allowable Miscellaneous deductions from Schedule A (re: the 2% of AGI exclusion),

• total Itemized Deductions (re: the 1% “read my lips” reduction of total deductions, aka PEASE),

• the Making Work Pay Credit (the credit was reduced via AGI “phase-out”), and

• the American Opportunity Credit (the credit was reduced via AGI “phase-out”)

By reducing the AGI by $545.00 I got the client an additional refund of $219.00 on the Form 1040X (hey – better in the client’s pocket). The client was in the 25% tax bracket, but the reduced AGI yielded a “return” of a little over 40%!

So now do you believe that one’s Adjusted Gross Income is the most important number on the tax return?

TTFN