Monday, October 31, 2016

Taxation of Social Security Benefits

How are Social Security Benefits Taxed?

If you are approaching retirement you are probably wondering how your social security benefits will be taxed. Like most tax questions, the answer is depends on the taxpayer’s specific circumstances.

Depending on your income level, up to 85% of your social security benefits may be taxed. This doesn't mean you pay 85% of your benefits back to the government in taxes-merely that you would include 85% of the benefit in your income subject to your regular tax rates.

To determine how much of your benefits are taxed, you must first determine your other income, including certain items otherwise excluded for tax purposes (for example, tax-exempt interest). Add to that the income of your spouse, if you file jointly and half of the Social Security benefits you and your spouse received during the year. The figure you come up with is your total income plus half of your benefits. Now apply the following rules:
1.   If your income plus half your benefits is not above $32,000 [$25,000 for single taxpayers], none of your benefits are taxed.

2.   If your income plus half your benefits exceeds $32,000 but is below $44,000, you will be taxed on (1) one half of the excess over $32,000, or (2) one half of the benefits, whichever is lower.

For example (1): Sam and Catherine have $20,000 in taxable dividends, $2,400 of tax-exempt interest, and combined Social Security benefits of $21,000. Thus, their income plus half their benefits is $32,900 ($20,000 plus $2,400 plus 1/2 of $21,000). They must include $450 of the benefits in gross income (1/2 ($32,900 − $32,000)). (If their combined Social Security benefits were $5,000, and their income plus half their benefits were $40,000, they would include $2,500 of the benefits in income: 1/2 ($40,000 − $32,000) equals $4,000, but 1/2 the $5,000 of benefits ($2,500) is lower, and the lower figure is used.)

Single Taxpayers

The formula for single taxpayers is slightly different. Item 2 above is changed as follows when computing for a single taxpayer.

2.   If your income plus half your benefits exceeds $25,000 but is below $34,000, you will be taxed on (1) one half of the excess over $25,000, or (2) one half of the benefits, whichever is lower.

For example (1A): Sam has $20,000 in taxable dividends, $2,400 of tax-exempt interest, and Social Security benefits of $9,000. Thus, his income plus half his benefits is $26,900 ($20,000 plus $2,400 plus 1/2 of $9,000). He must include $950 of the benefits in gross income (1/2 ($26,900 − $25,000)). (If his Social Security benefits were $3,000, and his income plus half his benefits were $30,000, he would include $1,500 of the benefits in income: 1/2 ($30,000 − $25,000) equals $2,500, but 1/2 the $3,000 of benefits ($1,500) is lower, and the lower figure is used.)

When Your Income Plus ½ of Your Benefits Exceeds $44,000

When your income plus half your benefits exceeds $44,000 ($34,000 for single taxpayers), the computation in many cases grows far more complex. Generally, however, unless your income plus half your benefits is fairly close to $44,000 ($34,000 for single taxpayers), if you fall into this category, 85% of your Social Security benefits will be taxed.

Don’t Be Surprised With a Higher Tax Bill

If you aren't paying tax on your Social Security benefits now because your income is below the above floor, or are paying tax on only 50% of those benefits, an unplanned increase in your income can have a triple tax cost. You'll have to pay tax (of course) on the additional income, you'll also have to pay tax on more of your Social Security benefits (since the higher your income the more of your Social Security benefits that are taxed), and you may get pushed into a higher marginal tax bracket.

This situation might arise, for example, when you receive a large distribution from a retirement plan (such as an IRA) during the year or have large capital gains. Careful planning might be able to avoid this stiff tax result. For example, it may be possible to spread the additional income over more than one year, or liquidate assets other than an IRA account, such as stock showing only a small gain or stock whose gain can be offset by a capital loss on other shares. If you should need a large amount of cash for a specific purpose, contact your tax advisor before liquidating any assets to estimate what your additional tax cost will be.

We once had a client that took a large IRA distribution to pay medical bills. This client was surprised with the significant increase in taxes during that year resulting from the higher income level and the increase in the amount of his social security benefits that were taxed. It was even more difficult for the client to handle when he discovered that he was unable to itemize the most of the medical expenses that were paid with the IRA distribution due to the floor on medical expense deductions. A little planning in this situation could have saved our client taxes. Simply deferring the payment of the medical expenses until the following year would have allowed him to itemize most of the medical expenses.

If you know your social security benefits will be taxed, you can voluntarily arrange to have the tax withheld from the payments by filing a Form W-4V. Otherwise, you may have to make estimated tax payments.

Monday, October 24, 2016

Understanding the Home Office Deduction

Understanding the Home Office Deduction

  • Direct expenses include the costs of painting or repairing the home office, depreciation deductions for furniture and fixtures used in the home office, etc.
  • Indirect expenses of maintaining the home office include utility costs, depreciation, insurance, mortgage interest, real estate taxes, and casualty losses allocated based on the square footage.

Tests for Home Office Deductions

Home office expenses are deductible if you meet any of the three tests described below:

·         The management or administrative activities test is met if you use your home office for administrative or management activities of your business, and if you meet certain other requirements.

·         The relative importance test is met if your home office is the most important place where you conduct your business, in comparison with all the other locations where you conduct that business.

Place for Meeting Patients, Clients or Customers Test - You're entitled to home office deductions if you use your home office, exclusively and on a regular basis, to meet or deal with patients, clients, or customers. The patients, clients or customers must be physically present in the home office.

Separate Structures - You're entitled to home office deductions for a home office, used exclusively and on a regular basis for business, that's located in a separate unattached structure on the same property as your home—for example, an unattached garage, artist's studio, workshop, or office building.

Alternative Simplified Method – Some taxpayers may choose to forgo tracking home office expenses and choose the Simplified Method for computing the home office deduction. Under this method, the deduction equals $5 (for 2015) multiplied by the home’s square footage used for qualified business use (up to 300 square feet).

Employees Working From Home – Employees working from home may take a home office deduction on Schedule A subject to the 2% of AGI limit if they meet the tests above and the business use of the home is for the convenience of the employer.


Monday, October 17, 2016

How Do the Dependent Care Credit and Dependent Care Flexible Spending Accounts Work?

How Do the Dependent Care Credit and Dependent Care Flexible Spending Accounts Work?
Occasionally we are asked about how the dependent care credit works and if it is better for a taxpayer to use a dependent care flexible spending account or FSA to pay for dependent care. This summary explains how both the credit and the FSA work to benefit the taxpayer.

Dependent Care Credit

First, for an expense to qualify for the credit, it must be an "employment-related" expense, i.e., it must enable you and your spouse to work, and it must be for the care of your of a qualified dependent under the age of 13. It can also be for the care of your spouse or dependent who is handicapped and lives with you for over half the year. Domestic help expenses, can also qualify if at least in part goes towards the care of the individual.

The typical expenses that qualify for the credit are payments to a day-care center, nanny or nursery school. Sleep-away camp doesn't qualify. The cost of first grade or above doesn't qualify because it's primarily an education expense. Surprisingly, the rules on kindergartens aren't clearly defined. Apparently, if the school offers a program similar to a nursery school's (more play than education) it can qualify. If it offers more of an educational program, it may not.

To claim the credit, you and your spouse must file a joint return. You’ll include the care-giver's name, address, and social security number (or tax ID number if it's a day-care center or nursery school) on form 2441 as part of your federal tax return. 

Qualifying expenses cannot exceed the lesser income you or your spouse earns from work. If one of you has no earned income, you won't be entitled to any credit unless the nonworking individual is a full-time student or disabled. In that case, that spouse is considered to have monthly income of $250 per qualified child up to 2 qualifying children.

A second limitation is that qualifying expenses can't exceed $3,000 per year for the first qualifying child, or $6,000 per year for two or more qualifying children. If your employer has a dependent care assistance program under which you receive benefits excluded from gross income, the dollar limits ($3,000 or $6,000) are reduced by the excludable amounts you receive.

The credit is computed as a percentage of your qualifying expenses-in most cases, 20%. (If your joint adjusted gross income [AGI] is $43,000 or less, the percentage will be higher, but never to exceed 35%).

For example a couple with AGI of over $43,000 paying $6,000 or more for childcare receive dependent care credits of $1,200 on their federal tax return.

Dependent Care Flexible Spending Accounts

Many large and even mid-sized employers offer flexible spending accounts with the dependent care option. Taxpayers participating in a dependent care FSA may contribute up to $5,000 per year to the FSA. These contributions are made on a pretax basis. The taxpayer then submits dependent care expenses to the FSA plan administrator for reimbursement from the FSA.

For taxpayers with marginal tax rates of 15% or higher, participating in the FSA is more advantageous than taking the dependent care credit. This is because the exclusion from income under the FSA gives a tax benefit at your highest tax rate, while the credit rate for taxpayers with AGI over $43,000 is limited to 20%.

For example let’s assume a couple with two children in daycare and a marginal tax rate of 25% take advantage of the FSA offered by one of their employers. The tax savings of making the $5,000 contribution to the FSA would be $1,250 ($5,000 X 25%), a $50 savings over the dependent care credit.

In addition to a federal income tax savings, participating in a dependent care FSA will result in savings on FICA (social security) taxes, because the amount contributed to the FSA isn't included in wages for FICA purposes. Consequently, you may save up to 7.65% of the amount contributed to the dependent care FSA, depending upon your income and the FICA tax wage base for the year in which the contribution is made.

If your marginal rate is 15% or less, taking the credit may be more advantageous than participating in the FSA. In making the choice, you must consider the effect of the earned income credit, the refundable child tax credit, and Social Security tax.

Depending on where you reside, some states also have a dependent care credit based on the federal dependent care credit. As well, the pretax FSA deduction can reduce you state income taxes.

Before you sign up for an FSA you need to ask you employer about some of the possible drawbacks to dependent care FSAs. First, money may be deposited in an FSA on a "use it or lose it" basis. If you don't incur dependent care expenses that equal or exceed the amount you deposit in the FSA, you forfeit the surplus. In addition, once you elect to participate in an FSA, and elect the amount withheld, with limited exceptions, you may not change your election. Finally, it may takes several weeks to receive reimbursement for the expenses submitted.

The dependent care credit and the dependent care FSA are both good options for taxpayers with dependent care expenses. Before making a decision to utilize an FSA in lieu of the dependent care credit, consult a qualified tax advisor.

Monday, October 10, 2016

The Tax Benefits of Employing a Child

Employing Children under the age of 18 (and full-time students age 19 to 23):

If you are self-employed, paying wages to a child can be an effective income-shifting tax strategy:

·         Earned income can be sheltered by the child's standard and other deductions.

·         Earnings in excess of allowable deductions will be taxed at the child's low rates.

·         You will most likely need to withhold taxes on the child’s income, but your child will most likely get a refund for part of all of the withholding when filing a tax return.

·         Save on Social Security taxes - services performed by a child under the age of 18 while employed by a parent isn't considered employment for FICA tax purposes.

·         Save on Federal Unemployment - earnings paid to a child under age 21 while employed by his or her parent are exempted from FUTA (unemployment) tax.

·         Start saving for your child’s retirement – If your business has a retirement plan such as a SEP, you can contribute up to 25% of their earnings.

·         Continue saving for your child’s retirement - your child's participation a SEP does not prevent the child from making tax-deductible IRA contributions.

Wages paid to a child are only deductible by the parent-employer if:

·         The work is done in connection with the parent’s business or income producing property, and

·         The child actually renders the services, and

·         The payments are actually made. Payments must be reasonable for the services provided and the parent must keep records supporting the services performed and wages paid.

For example, let's say a sole proprietor pays $5,700 to her 17-year-old child. The sole proprietor's self-employment income would be reduced by $5,700, saving her over $800 in self-employment taxes. The parent also saves on income taxes by shifting the $5,700 from her higher income tax bracket by moving the $5,700 to the child’s return taxed at a low or possibly 0% tax rate. This could be as much as another $2,000 in tax savings.

Keep in mind that some of the rules about employing children (such as the maximum amount they can earn tax-free) change from year to year, and may require your income-shifting strategy to change, too. Before employing a child seek advice from a qualified tax professional.


Monday, October 3, 2016

Trade-in or Sale a Vehicle Used for Business

Trade-in or Sale Vehicle Used for Business

Here's an overview of the complex rules that apply to what appears to be a simple transaction, and some pointers on how to achieve the best tax results.
For business vehicles that have been depreciated:
·         The sale of a vehicle yields a taxable gain or loss while trading vehicles qualifies as a tax free exchange.

·         In a tax free exchange, the basis of the new vehicle is equal to the basis of the trade-in vehicle plus any cash paid in the trade.

·         As a general rule, it is better to trade-in vehicles that have been used exclusively for business and that have been substantially depreciated.

·         Conversely, it is generally better to sell a vehicle used exclusively for business when the basis depreciation has been limited by annual limitations and the vehicle has a relatively high basis as compared to the fair market value.

When you have used the standard mileage rate

      ·         Generally you are better off selling the old vehicle rather than trading it in.

·         The standard mileage rates have a built-in allowance for depreciation that reduce the basis of the car. (24¢ per mile in 2016).

·         Using the standard mileage rate usually means lower depreciation on the vehicle and may allow you to recognize a loss on the sale.

For vehicles used partially for business and partially for personal use the rules are more complicated. This may occur if you are self-employed, or an employee required to supply a car for business use.

  • If you sell the part-business, part-personal-use car, cost and depreciation must be allocated between the business and personal portions. Gain or loss on the business part is recognized; gain, but not loss, is recognized on the personal part.
  • If you trade in the part-business, part-personal-use car, the basis of the new car as computed under the normal trade-in rules is reduced by any difference between (1) the depreciation that would have been allowable had the old car been used 100% for business driving, and (2) the depreciation claimed for its actual business use.
Some business owners choose to lease a vehicle due to the simplicity of deducting the business/investment use portion of annual lease costs.
If you pay an additional sum up-front, it should be amortized over the life of the lease.
  • Any refundable deposit required as part of the lease deal can't be deducted at all.
  • Be aware that the IRS requires you add back to income each year an income inclusion amount derived from IRS tables for “luxury” vehicles.