Some early 401(k) withdrawals are penalty-free

 

To encourage workers to set aside money for retirement, Congress modified the tax law in the late 1970s. The new provisions offered certain tax advantages to companies that established "defined contribution" plans. Unlike traditional pensions, such plans do not provide for specific pension payouts during retirement. Instead, they establish how much an employee can contribute. The most common of these plans, as defined by its subsection in the Internal Revenue Code, is the 401(k).
In an effort to keep employees from raiding their retirement accounts too soon, the tax code also assesses stiff penalties for early withdrawals. In general, if you're still working and pull money out of your employer-sponsored 401(k) account before age 59½, you'll be socked with a 10% penalty on the withdrawal, in addition to regular income taxes.
Nevertheless, some provisions of the tax code allow for penalty-free withdrawals from a 401(k) account before age 59½.
Think long and hard, however, before taking an early withdrawal. Presumably, the longer you contribute to a 401(k) account, the more savings will be available to meet your retirement needs. Considering the meager retirement savings of many Americans — one recent study found that the median retirement savings of households nearing retirement is $12,000 — the decision to make an early withdrawal should not be taken lightly.
Following are two ways your traditional 401(k) account can be tapped without incurring the 10% penalty. Note that different rules apply to distributions from Individual Retirement Accounts (IRAs) and Roth 401(k) plans.

• Age 50 withdrawals for public safety employees and reservists. If you're a police officer, firefighter, or medic working for a state or city government, you won't be subject to the 10% penalty on early withdrawals if you leave your job in or after the year you turn 50. This provision also applies to certain active-duty reservists.

• Age 55 withdrawals after separation from service. If you leave your employer in or after the year you reach age 55, you can take penalty-free distributions from your company's qualified 401(k) plan. Note, however, if you retire before that year and wait until you're 55 to take the distribution, you'll be subject to the 10% penalty.

In addition to these two provisions, the tax code provides additional limited exceptions to the 10% penalty rule. If you're considering an early withdrawal from your retirement accounts, give us a call at (949) 453-1521 $$

Should you choose LLC status for your business?

 

Are you thinking of making your new business a limited liability company? You've probably already learned that an LLC combines the limited liability protection of a corporation with a partnership's flexibility in allocating income and other items among owners. However, you may be wondering how that hybrid status affects your taxes. For instance, would you file as a corporation or a partnership — or something else?
The answer is: You get to choose. When you're the only owner, or member, of your LLC, the default entity for federal tax purposes is a sole proprietorship. You attach a Schedule C, E, or F to your individual return to report business activity and pay income and self-employment tax.

You can also opt to file as a corporation, either a "C," or an "S." To elect C corporation status, complete Form 8832, Entity Classification Election. To elect S corporation status, you must file Form 2553 by March 15 of the year you want S status to begin. At year-end, report your business income on Form 1120 or 1120S.

When your business has multiple members, it's considered a partnership, unless you elect corporate status by filing Form 8832 or Form 2553.

Deciding how to organize your business is not a one-size-fits-all process. While you can change your mind later, doing so may have tax consequences. Give us a call at (949) 453-1521. We're here to help you figure out the right fit. $$

Mutual Fund Tax Planning

Are mutual funds part of your portfolio? As you begin your late-summer investment review in preparation for year end, think about how your funds can affect your federal income taxes.
Here are two things to consider.

Dividend income. The dividends you receive from mutual funds held in nonretirement accounts are included in the calculation of net investment income. When your 2013 modified adjusted gross income exceeds $250,000 ($200,000 when you're single), a portion of your net investment income will be taxed at a rate of 3.8% over and above your ordinary tax liability.

Planning tip. The tax form the mutual fund company sends you at the beginning of 2014 may classify some dividends as "qualified" — meaning they meet the requirements for a lower tax rate. However, you have to own the mutual fund shares for more than 60 days to get the lower rate on your federal return.

Capital gains. Mutual funds generally distribute short-term and long-term capital gains from in-fund sales to shareholders. Even if you reinvest the distributions in additional shares instead of opting for cash, the gain remains taxable to you.

Short-term distributions, for sales of fund investments held one year or less, are taxable at your ordinary income tax rate. The tax rate for long-term capital gains may be as high as 20%, depending on your adjusted gross income.

 You might also have a capital gain or loss when you sell shares of a mutual fund. That's true even if you "exchange" one fund for another and receive no proceeds.

Planning tip. You have options for calculating the cost of mutual fund shares you sell during the year. Remember to include reinvested distributions in your basis.

Please call us at (949) 453-1521 for more information. We're happy to help you manage your investments with an eye toward tax savings. $$

Work-related education expenses can be deductible

 

Are you going to school this fall to earn an advanced degree or to brush up on your work skills? If so, you might be able to deduct what you pay for tuition, books, and other supplies.
In general, when you're self-employed or working for someone else, you can claim a deduction for out-of-pocket educational costs if the training is necessary to maintain your skills or is required by your employer.
A caution: Even when the education meets those two tests, if you're qualified to work in a new trade or business when you've completed the course, your expenses are personal and nondeductible. That's true even if you do not get a job in the new trade or business.
Because it's often difficult to determine whether some degrees, such as an MBA, qualify you for a new trade or business, you'll need to look at your specific situation to decide if you can claim a deduction. One useful test is to compare the work you were able to perform before the education to what you are qualified to perform afterward.
Work-related education expenses are an itemized deduction when you're an employee and a business expense when you're self-employed. You may also be eligible for other tax benefits, including the lifetime learning credit or the tuition and fees deduction.
To learn more, please call us at (949) 453-1521. $$

Track your IRA basis

 

What's your definition of basis? When it comes to your taxes, you might think of the amount you paid for an asset, such as your home or a security, less certain adjustments. But you may also have basis in your traditional IRA — and tracking that basis can save you tax dollars.
You get basis in a traditional IRA when you make contributions that are not deductible on your federal income tax return. Later — the save-you-money part — when you take distributions or convert your traditional IRA to a Roth, the basis reduces the amount you report as taxable income.
Does that mean you can withdraw or convert only your basis and owe no tax at all? Unfortunately, no. The reason is a pro-rata rule. It works like this: You figure the taxable portion of distributions by dividing your basis by the total year-end balance of all your IRAs. Each distribution is partly taxable and partly tax-free.
Knowing your basis can help heirs, too. When your beneficiaries inherit your IRA, they also inherit your basis.
Track your nondeductible contributions on IRS Form 8606. The form does not need to be filed every year, so be sure to keep a copy of the latest one.
If you need help constructing IRA basis from prior years, please give us a call at (949) 453-1521. $$

 

Check out Coverdell ESAs for college savings

You're probably familiar with 529 college savings plans. Named for Section 529 of the Internal Revenue Code, they're also known as qualified tuition programs, and they offer tax benefits when you save for college expenses.

But are you aware of a lesser known cousin, established under Section 530 of the code? It's called a Coverdell Education Savings Account and it's been available since 1998.

The general idea of Coverdell accounts is similar to 529 plans — providing tax incentives to encourage you to set money aside for education. However, one big difference between the two is this: Amounts you contribute to a Coverdell can be used to pay for educational costs from kindergarten through college.

Generally, you can establish a Coverdell for an under-age-18 child — yours or someone else's. Once the Coverdell is set up, you can make contributions of as much as $2,000 each year. That maximum is reduced when you're married filing jointly and your modified adjusted gross income reaches $190,000 ($95,000 when you're single).

Anyone, including trusts and corporations, can contribute to the account until the child turns 18. There are no age restrictions when the Coverdell is established for someone with special needs.

While your contribution is not tax-deductible, earnings within the account are tax-free as long as you use them for educational expenses or qualify for an exception. In addition, you can make a tax-free transfer of the account balance to another eligible beneficiary, to a different custodian, or to a 529 plan.

Qualified distributions from a Coverdell are tax-free when you use the money to pay for costs such as tuition, room and board, books, and computers.

Please call us at (949) 453-1521 for information about other rules that apply to Coverdell accounts. We'll be happy to help you decide whether establishing one makes sense for you$$

A tax credit is available for adoptions

Together you make a family.

Is this the year you'll become an adoptive parent? In addition to the benefits of family togetherness, you might also qualify for a special break on your income tax return. The federal credit for qualified adoption expenses became permanent in January.

As you know, tax credits save you money by reducing the amount you owe dollar-for-dollar. In the case of the adoption credit, you may be able to save up to $12,970 on your 2013 federal income tax return for expenses you pay during the process of adopting a child.

Be aware the credit is subject to a phase-out — that is, the amount you can claim is reduced once your 2013 modified adjusted gross income (MAGI) reaches $194,580. No credit is available when your MAGI is $234,580 or more.

In general, the credit is based on total out-of-pocket expenses including adoption fees, amounts you paid your attorney, court costs, and your meals and lodging while away from home. However, when you adopt a special needs child and qualify for the credit, you can claim the full $12,970, regardless of how much you spent during the adoption process. In addition, you may also be able to exclude from income certain adoption benefits provided by your employer.

The credit is typically available for both foreign and U.S. adoptions. For domestic adoptions, you can claim it even if your attempt to adopt was unsuccessful.

Other tax breaks are available for new parents. Please call us at (949) 453-1521 if you would like details$$

Happy 4th of July!

Many tax planning questions arise after Supreme Court's DOMA decision

On June 26, the U.S. Supreme Court held that Section 3 of the federal Defense of Marriage Act (DOMA) is unconstitutional (E.S. Windsor, SCt., June 26, 2013). Immediately after the decision, President Obama directed all federal agencies, including the IRS, to revise their regulations to reflect the Court's order. How the IRS will revise its tax regulations - and when - remains to be seen; but in the meantime, the Court's decision opens a number of planning tax opportunities for same-sex couples.

Background

The Supreme Court agreed in 2012 to hear an appeal of a federal estate tax case. Due to DOMA, the surviving spouse of a same-sex married couple was ineligible for the federal unlimited marital deduction under Code Sec. 2056(a). The survivor sued for a refund of estate taxes. A federal district court and the Second Circuit Court of Appeals found unconstitutional Section 3 of DOMA, which defines marriage for federal purposes as only a legal union between one man and one woman as husband and wife.

Supreme Court's decision

In a 5 to 4 decision, the Supreme Court held that Section 3 of DOMA is unconstitutional as a deprivation of the equal liberty of persons that is protected by the Fifth Amendment. Writing for the five-justice majority, Justice Anthony Kennedy said that "DOMA rejects the long-established precept that the incidents, benefits, and obligations of marriage are uniform for all married couples within each State, though they may vary, subject to constitutional guarantees, from one State to the next." Kennedy explained that "by creating two contradictory marriage regimes within the same State, DOMA forces same-sex couples to live as married for the purpose of state law but unmarried for the purpose of federal law, thus diminishing the stability and predictability of basic personal relations the State has found it proper to acknowledge and protect."

Chief Justice John Roberts, who would have upheld DOMA, cautioned that "the Supreme Court did not decide if states could continue to utilize the traditional definition of marriage." Roberts noted that the majority held that the decision and its holding "are confined to those lawful marriages-referring to same-sex marriages that a State has already recognized."

Tax planning

The Supreme Court's decision impacts countless provisions in the Tax Code, covering all life events, such as marriage, employment, retirement and death. The affect on the Tax Code cannot be overstated. It is expected that the IRS will move quickly to clarify how the decision impacts many of the more far-reaching provisions, such as filing status and employee benefits. Other provisions, especially the complex estate and gift tax provisions, will likely require more time from the IRS to issue guidance.

For federal tax purposes, only married individuals can file their returns as married filing jointly or married filing separately. Because of DOMA, the IRS limited these married filing statuses to opposite-sex married couples. The IRS is expected to issue guidance. Same-sex couples who filed separate returns may want to explore the benefits of filing amended returns (as married filing jointly), if applicable. Our office will keep you posted of developments.

Among the other provisions in the Tax Code affected by the Supreme Court's decision are:

• Adoption benefits
• Child tax credit
• Education tax credits and deductions
• Estate tax marital deduction
• Estate tax portability between spouses
• Gifts made by spouses
• Retirement plans

Looking ahead

Will the federal government look to where the same-sex couple was married (state of celebration) or where the same-sex couple reside (state of residence) for purposes of federal benefits? The Supreme Court did not rule on Section 2 of DOMA, which provides that no state is required to recognize a same-sex marriage performed in another state. At the time of the Supreme Court's decision, 12 states and the District of Columbia recognize same-sex marriage.

In some cases, the rules for marital status are determined by federal regulations, which can be changed without action by Congress. In other cases, the rules are set by statute, which would require Congressional action. Sometimes, a federal agency follows one rule for some purposes but another rule for other purposes. Generally, the IRS has used place of domicile for determining marital status. Our office will keep you posted of developments.

If you have any questions about the Supreme Court's decision and its impact on tax planning, please contact our office at (949) 453-1521 $$

Estate executors have tax filing responsibilities

Part of your responsibility as the executor or personal administrator of an estate involves making sure the necessary tax returns are filed — and there might be more of those than you expect. Here's an overview.

Personal income tax. You may need to file a federal income tax return for the decedent for the prior year as well as the year of death. Both are due by the following-year April 15 due date, even if the amount of time covered is less than a full year. You can request a six-month extension if you need additional time to gather information.

Gift tax. If the individual whose estate you're administering made gifts in excess of the annual exclusion ($14,000 for 2013), a gift tax return may be required. Form 709 is due April 15 of the year following the gift. The filing date can be extended six months. Estate income tax. Income earned after death, such as interest on estate assets, is reported on Form 1041, "Income Tax Return for Estates and Trusts." You'll generally need to file if the estate's gross income is $600 or more, or if any beneficiary is a nonresident alien. For estates with a December 31 year-end, Form 1041 is due April 15 of the following year.

Estate tax. An estate tax return, Form 706, is required when the fair market value of all estate assets exceeds $5,250,000 (for estates created in 2013). One thing to watch for: Spouses can transfer unused portions of the $5,250,000 exemption to each other. This is called the "portability" election. To benefit, you will need to file Form 706 when the total value of the estate is lower than the exemption.

Form 706 is due nine months after the date of death. You can request a six-month extension of time to file.

Give us a call at (949) 453-1521 for checklists and information about administering an estate. We're here to help make your task less stressful $$