NOBODY EVER SAID TAXES WERE FAIR

Tax reform discussions rarely touch on the many inequities and basic “unfairness” in the US Tax Code.

Here are three examples of “unfairness” that still remain in the US Tax Code.  They were not addressed in the GOP Tax Act but should be in future tax reform legislation.  I have posted separately about these in the past – but here they are together in one post.

As an aside, many of the inequities in the pre-TCJA code involved or were made worse by the dreaded Alternative Minimum Tax.  But the Act makes the AMT no longer an issue in most cases.

(1) Taxation of Social Security and Railroad Retirement Benefits

As I am often telling clients each filing season, because of the way Social Security and Railroad Retirement benefits are taxed it is very possible that for every additional $1.00 of income you pay tax on $1.85.  So, income that falls within the new 22% bracket can be effectively taxed at 40.7% - almost 4% above the current top tax rate.

Social Security and Railroad Retirement benefits are taxed based on the extent of your other taxable income and tax-exempt interest.  You could pay tax on up to 50% or 85% of the gross benefits.  So, an additional $100 of dividends, or interest or capital gains or W-2 income can cause an additional $85 of your benefits to be taxed, so the $100 increase causes your AGI to increase by $185.

Because taxable Social Security and Railroad Retirement benefits increase AGI, increases could also reduce tax deductions and credits that are affected by AGI – increasing the effective tax rate of the increase.

As a side bit of unfairness, because increased SS or RR benefits increase AGI, the increase can potentially result in some qualified dividends and long-term capital gains, which have caused the increase in taxable SS or RR, being effectively taxed at more than the “advertised” 0% or 15% rate.

The Solution – tax Social Security benefits the same as any other pension with “after-tax” employee contributions, using the “Simplified Method”.  The taxable portion of the benefit would be calculated by SSA and reported as such on the SSA-1099 and RRB-1099, similar to the way partially taxable pension income is reported on the Form 1099-R.  Or perhaps treat Social Security and Railroad Retirement like a “ROTH” investment, as employee contributions are not deductible, and do not tax benefits at all.  These benefits were not taxed at all until 1984.

(2) Taxation of Gambling Winnings

Gross gambling winnings, reported on Form W-2G, are generally reported in full as income on Line 21 of Page 1 of the Form 1040, increasing AGI, while gambling losses, to the extent of reported winnings, are deductible as an Itemized Deduction.  So, it is possible for a taxpayer to pay additional federal income tax on net gambling losses.

John Q Taxpayer buys $10 in state lottery tickets each and every week.  One week he hits for $500.  He has no other gambling activity for the year.  He must report the $500 win in full as taxable income and, if he receives Social Security, potentially increase taxable SS benefits by $425.  So, his AGI could increase by $945.  If he is unable to itemize due to the increased Standard Deduction he does not get a tax benefit for his losses.  So, if he is in the 22% bracket he would pay from $110 up to $204 in federal income tax on $20 in gambling losses.

If the $500 win does cause his taxable SS benefits to increase by $425 but he can itemize and deduct $500 in losses on Schedule A he is still paying $94 in income tax in the 22% bracket.  And if he can deduct medical expenses the net taxable income is increased by $69 because the additional income reduces the allowable medical deduction.

Thankfully Tax Court decisions and IRS regulation revisions have corrected this problem for some casino gambling – but not for all gambling situations.

I have no problem with limiting the deduction for gambling losses to gambling winnings – just with where and how the losses are deducted.

The Solution – obviously, report only net gambling winnings, after deducting losses, but not less than 0, as income on Page 1 of Form 1040, as is done on the NJ-1040.

(3) The Marriage Tax Penalty

The Marriage Penalty manifests itself in many ways in the US Tax Code.  The result is that two married individuals, each with their own separate sources of income (i.e. W-2 or pension income), pay more income tax by filing as a married couple then by filing two separate returns as unmarried Single taxpayers merely living together.

Filing as Married Filing Separately does not always remove or reduce the Marriage Penalty.  Some deductions are “per return” and not “per spouse”.  And many tax benefits allowed on a Single return are reduced or just plain not allowed on a Married Filing Separate return – such as the Credit for Child and Dependent Care Expenses, the Earned Income Credit, the Credit for the Elderly or Disabled, or the HOPE or Lifetime Learning Education Credit.  A couple filing separately can pay more tax than if they filed a joint return.

The maximum amount of combined income or sales and property taxes that can be deducted on Schedule A is $10,000 – but only $5,000 if Married Filing Separate.  Two unmarried individuals living together can each deduct $10,000, for a total of $20,000.  If the 22% bracket applies, the marriage tax penalty for this item alone is up to $2,200. 

A married couple can deduct up to $3,000 in net capital losses per year – but only $1,500 if Married Filing Separate.  Two unmarried individuals each with capital losses for the year, or carried forward, in excess of $3,000 can each deduct $3,000, for a total of $6,000.  You do the math.

There is also a Marriage Tax Benefit – for households with only one earning spouse.  Because of the doubling of many tax benefits on a joint return the couple pays less tax than the earning spouse would pay on a Single return (if one spouse has no taxable income and was not married there is no need to file a return and the Standard Deduction is not claimed if filing as single – but twice the Standard Deduction is allowed on a joint return reporting the same total income; granted the earning taxpayer could claim the non-earning taxpayer as a dependent on the one Single return and possibly get additional tax benefits – but not as much as Married Filing Joint).

In my opinion there should be neither a tax penalty or tax benefit for marriage.

The solution – allow a two-income married couple to file separately as if they were each filing a Single return, with all the benefits and the same tax table and rate schedule as a Single filer.  I deal with this in more detail in “The Tax Code Must Be Destroyed”.  This at least does away with the marriage penalty.  I am not quite sure how to remove the marriage benefit, or if it actually should be removed.

There are many other inequities in the current US Tax Code.  I will discuss more in future posts.

Do you have any examples to share.

TTFN

TAXES AIN'T FAIR!

Tax reform has become a hot political topic.  Reduce taxes on the middle class, or increase taxes on the “wealthy” simply because they can afford it.

 

I see a great need for substantive tax reform not to reduce, or for some taxpayers increase, the actual amount of taxes paid – but to simplify the Tax Code and make it more fair.

 

Nobody ever said taxes are fair.  There are many inequities in the US Tax Code, some purposeful and some unintended.

 

Among the biggest inequities concerns how the Code treats some aspects of “gross income” and expenses related to generating this income.  I speak specifically of the taxation of gambling winnings and legal settlements.

 

If you have gambling winnings you must report, in most cases (how to report some winnings is a topic for another post), the gross winnings as income on Page 1 of the Form 1040.  This is the amount that is reported on Form W-2G.  So gross winnings are included in Adjusted Gross Income (AGI).  But gambling losses, to the extent of winnings reported, are deducted as a Miscellaneous Deduction on Schedule A if you are able to itemize (although not subject to the 2% of AGI exclusion).

 

Similarly, the gross amount of legal settlements, except for settlements for physical injuries or sickness (any damages or settlement you receive to compensate you for your medical expenses, lost wages, and pain, suffering, and emotional distress is not included in income), is included as income on Page 1 of Form 1040.  The legal fees, often as much as 1/3 of the settlement, and other related are also deducted as a Miscellaneous Deduction on Schedule A if you are able to itemize (in this case the deduction is subject to the 2% of AGI exclusion).

 

A taxpayer can have $5,000 in gross winnings from gambling activities for the year, but $6,000 in gambling losses.  So, the taxpayer’s gambling activity for the year has resulted in a loss.  The taxpayer ended up with no money “in pocket’ from gambling. 

 

If the taxpayer is able to itemize without taking into effect the allowed gambling losses, the Schedule A deduction for $5,000 in gambling losses results in net taxable income of 0 – so, in effect but not necessarily in reality, he/she does not pay federal income tax on the winnings.  But if the taxpayer is not able to itemize, even with the gambling loss deduction, or if he/she is only able to itemize because of the gambling loss deduction (without the deduction his itemizable deductions do not exceed the applicable Standard Deduction), he/she will be paying federal income tax on up to $5,000 of income that was not actually received – in the 25% tax bracket $0 in net gambling income could cost the taxpayer at least $1,250.

 

Similarly, with a taxable legal settlement, the need to deduct legal fees as a miscellaneous itemized deduction subject to the 2% of AGI exclusion could result in federal income tax being paid on more than the actual “in pocket” amount.

 

Of course, a large portion of the inequity comes from the fact that various items of income are increased and deductions and credits are reduced or eliminated based on one’s AGI.  And the fact that most itemized miscellaneous deductions are not allowed in calculating the dreaded Alternative Minimum Tax (AMT).

 

While a taxpayer may be able to wipe out gambling winnings with fully deductible gambling losses, the fact that gross winnings are included in AGI could result in more of the taxpayer’s Social Security or Railroad Retirement benefits (the amount of benefits taxed is determined by a formula that is based on AGI) being taxed – many frequent gamblers in the casinos of Atlantic City for example are senior citizens – or could reduce or totally eliminate allowable tax deductions or credits.  So again, the taxpayer is in reality paying federal income tax on $0 in net income.

 

The same is possible with a taxable legal settlement – except for settlements for discrimination claims, the related legal fees allowed as an “adjustment to income” which reduces AGI.  And, while there may be no excess tax under “regular” income tax rules there may be AMT.  Allowable gambling losses from Schedule A are fully deductible in calculating the dreaded AMT – but because legal fees are a miscellaneous deduction subject to the 2% of AGI limitation they are not deductible in calculating AMT.  So, tax is paid on the full amount of the gross settlement at a flat 26% or 28%.  When adding the federal and state tax to the legal fees the taxpayer may end up with only 1/3 or less of the actual award “in pocket”.

 

And while in many cases net and not gross gambling winnings are taxed under AMT, the fact that gross winnings are included in AGI, and therefore Alternative Minimum Taxable Income (AMTI), could reduce the AMT exemption, resulting in AMT tax on gambling winnings even if the net is 0.  $5,000 in gross winnings can reduce the AMT exemption by $1,250 and result in an additional $325 or $350 in AMT.

 

The AMT issue would go away if tax legislation repeals this tax.  And changing the way Social Security and Railroad Retirement benefits are taxed and no longer allowing AMT to affect tax deductions and credits would also help to remove inequities.  But the best way to do away with the unfairness of the tax treatment of these two types of income would be allowing taxpayers to net gambling losses against gambling wins (still not allowing the deduction of more losses than wins) and net legal fees against gross settlements – either directly by entering the net amount on Page 1 or by allowing the deductions as an adjustment to income reducing AGI – would certainly fix the problem.

 

So, what do you think?

 

FYI – I will post on other inequities in the current Tax Code in future posts.

 

TTFN

 

 

 

 

 

 

HOW THE US TAX CODE SCREWED SOME OF MY CLIENTS WHO RECEIVE SOCIAL SECURITY OR RAILROAD RETIREMENT BENEFITS THIS TAX SEASON

This past tax filing season I had to explain to one taxpayer in the 15% federal tax bracket why $8,000 in additional qualified dividends and long-term capital gains, which the IRS tells us is taxed at the rate of 0%, cost $1,097 in federal income tax (13.7%).   

And to another, in the 25% bracket, why $10,000 in additional rental income cost $4,625 in federal income tax (46.25%).

The reason lies in the way Social Security and Railroad Retirement benefits are taxed. 

This could also cause a taxpayer in the 15% bracket to pay $638 in federal income tax on $5,000 in tax-exempt municipal bond interest (12.75%).

If you are collecting Social Security or Railroad Retirement for every $1.00 of additional taxable income you could be paying tax on $1.50 to $1.85.  And for every $1.00 of tax-exempt municipal bond income you could be paying tax on 50 to 85 cents.

The amount of Social Security or Railroad Retirement benefits that are taxed by Uncle Sam depends on the amount of your other taxable and tax-exempt income.  The maximum amount of benefits that are taxed is 85%.  If your gross Social Security benefits, before deducting Medicare Part B and Part D premiums, is $18,000 the most you will be taxed on is $15.300. 

If, based on your other income, the maximum 85% of your benefits are already being taxed then every additional $1.00 in taxable income is taxed as $1.00, and every additional $1.00 in tax-exempt municipal income is totally tax free (unless you are a victim of the dreaded Alternative Minimum Tax and you have income from private activity bonds).  

It is important for Social Security and Railroad Retirement beneficiaries to know where they stand regarding the taxability of their benefits so that they can understand how much additional taxable and tax-exempt income will cost in terms of federal income tax.

And so that their tax preparer does not put them in shock at tax time if they did well in the market or had additional income from another source during the year.

So here is how Social Security and Railroad Retirement benefits are taxed –

Start with one-half (50%) of your gross Social Security or Railroad benefits (from Box 5 of Form SSA-1099 or RRB-1099) – combined if filing a joint return.

To this number you add all other taxable income (Form 1040 Lines 7, 8a, 9a, 10-14, 15b, 16b, 17-19, 21).

Next you add the amount of tax-exempt interest reported on Box 8b of Form 1040.  While municipal bond interest is exempt from federal income taxation, it is included in the calculation of taxable SS or RR benefits – so in reality up to 85% of tax-exempt municipal interest could be subject to federal income tax.

From the total of these three amounts you subtract the total “adjustments to income” from Form 1040 line 23 – 32 plus any write-in adjustments included in Line 36.  Deductions for student loan interest, tuition and fees, and domestic production activities, the adjustments reported on Form 1040 lines 33, 34, and 35, are not allowed in calculating taxable benefits.

If this amount (50% of benefits + other taxable income + tax-exempt interest – most adjustments to income) is more than $25,000 (but not more than $34,000) if you file as Single, Head of Household, or Qualifying Widow(er) or $32,000 (but not more than $44,000) if you are Married Filing Joint than you will pay federal income tax on up to 50% of your total gross benefits.

If the amount is more than $34,000 if Single, Head of Household, or Qualifying Widow(er) or $44,000 is Married Filing Joint you will pay federal income tax on up to 85% of your total gross benefits.

If you are filing as Married Filing Separately and you lived with your spouse at any time during the year you will pay tax on 85% of your Social Security or Railroad Retirement benefits.  If you file separately and you and your spouse lived apart for the entire year you calculate the taxable benefit as if you are a Single individual.

Click here to download the IRS Social Security Benefits Worksheet. 

Here is another example of how this method of taxing benefits screws taxpayers. Let’s say you itemized in 2013 and claimed a deduction for the full amount of state income taxes withheld or paid in via estimated tax during the year.  When you prepared your state return you find you are getting a $300 refund.  When you prepare your 2014 Form 1040 you will report this $300 refund as taxable income Line 10. If you are receiving Social Security this could cost an additional $255 of your benefits to be taxed. 

If you are in the 15% bracket for both 2013 and 2014 this $300 provided a tax benefit of $45 on your 2013 return, but will cost you $83 in federal income taxes in 2014.  The solution is to claim the exact amount of your state tax liability as a deduction on Schedule A instead of the total amount paid, or to claim a deduction for state and local sales tax.      

If we are going to tax Social Security and Railroad Retirement benefits how should they be taxed?  I have suggested we tax these benefits the same as any other retirement benefit with after-tax employee contributions. Use the “simplified method” to allocate a portion of each monthly benefit payment to the total employee Social Security withholdings, or for a self-employed taxpayer the Social Security share of self-employment tax, as a “return of contribution”. So a portion of each monthly payment would be tax free.

TTFN