Tag: itemized deductions

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Income Tax Planning

New Tax Law – Don’t Let the Tax Tail Wag the Dog – Part 2 of 2

Part 1 of this post focused on the two investment-related tax areas of the new tax law that went into effect on January 1st – (a) the Medicare investment income tax and (b) long-term capital gains and qualified dividends. It made the point that while the amount of potential income tax liability resulting from exposure to one or both of these changes may be significant, neither one in and of itself, or in combination for that matter, should cause you to overhaul an otherwise appropriate retirement income planning investment strategy.

After preparing income tax projections using current vs. prior tax law, your CPA or other income tax professional will be able to determine two things: (a) the total amount of your additional projected income tax liability attributable to various changes in the law, and (b) the amount of your additional projected income tax liability attributable to specific changes in the law, including the Medicare investment income tax and 20% long-term capital gains and qualified dividends tax.

Once you determine the amount of your projected income tax liability attributable to specific changes in the law, the next step is to determine (a) the applicable income threshold type and amount that you have exceeded, and (b) the projected amount of excess income over the applicable threshold amount. In the case of the Medicare investment income tax, the threshold type is modified adjusted gross income (“MAGI”) and the amount is $200,000 if single or $250,000 if married filing joint. If your additional projected income tax liability is attributable to long-term capital gains and/or qualified dividends, the threshold type is taxable income and the amount is $400,000 if single or $450,000 if married filing joint.

Whether you’re affected by the Medicare investment income tax or the 20% (vs. 15%) tax on long-term capital gains and dividends, the next step is to determine the various components of income that comprise your gross income. Once you do this, you need to determine which specific non-investment related components can be reduced, as well as the amount of reductions for each component, in order to reduce the amount of your projected income tax liability attributable to changes in the tax law.

It’s important to keep in mind that some types of income can be reduced indirectly. An example of this is taxable salary which can be reduced significantly by various types of pre-tax deductions as available, including, but not limited to, 401(k) plan and cafeteria plan contributions. Another example is self-employment income which can be reduced by self-employment expenses.

In addition to determining which specific non-investment related components can be reduced, it’s also important to determine if any losses can be created or freed up as another means of reducing gross income. This can include capital losses to offset capital gains, net operating losses, as well as passive activity loss carryovers that can be freed up as a result of the sale of a rental property. The latter strategy can be a double-edged sword since this may also result in a capital gain that may increase exposure to the Medicare investment income tax and/or the 20% capital gains tax.

Since the starting point for determining exposure to both the Medicare investment income tax and 20% capital gains tax calculations is adjusted gross income (“AGI”), the next step is to determine potential deductions for AGI, or “above-the-line” deductions, that you may not be currently taking advantage of. This includes self-employed retirement plan contributions, self-employed health insurance premiums, and health savings account (“HSA”) contributions, to name a few.

If your issue is the 20% capital gains tax, in addition to reducing your AGI, there’s another way that you can potentially reduce your exposure to this tax and retain the 15% favorable capital gains tax. Keeping in mind that the threshold type in the case of the 20% capital gains tax is taxable income which is calculated by subtracting itemized deductions and personal exemptions from AGI, you may be able to increase your itemized deductions in order to reduce your taxable income.

As you can see, there are things you can do to reduce your exposure to the Medicare investment income tax and 20% capital gains tax without changing your investment strategy. If you have an otherwise appropriate retirement income planning investment strategy, don’t let the tax tail wag the dog.

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Income Tax Planning

The 2013 Tax Law Schizophrenic Definition of Income – Part 2 of 2

Per last week’s blog, as a result of President Obama’s signing on January 2nd of the American Taxpayer Relief Act of 2012 following changes legislated by the 2010 Health Care Reform Act effective beginning in 2013, there are now five different definitions of income affecting seven different tax areas. Exhibit 1, which was also included in last week’s post, summarizes 2013 individual federal income-based tax law changes, comparing each one with the law in effect in 2012.

Please see last week’s post for a discussion of the first three definitions of income. This week’s post examines the last two.

Adjusted Gross Income Exceeding $250,000 or $300,000

Once your adjusted gross income (AGI) exceeds $250,000 if single or $300,000 if married filing jointly, your income tax liability will increase as a result of two affected tax areas: (1) Itemized deductions limitation and (2) Personal exemption phaseout. Although neither of these provisions was effective in 2012, both have been part of prior years’ tax law.

Itemized Deductions Limitation

The limitation on itemized deductions, known as Pease after the congressman who helped create it, was originally part of the Economic Growth and Tax Relief Reconciliation Act of 2001, was phased out beginning in 2006, and was repealed in 2010.

Back in 2013, the itemized deductions limitation reduces most otherwise allowable itemized deductions by 3% of the amount by which AGI exceeds the specified threshold of $250,000 or $300,000, depending upon whether you’re filing as a single or married filing joint taxpayer. Itemized deductions can’t be reduced by more than 80%. In addition, the reduction doesn’t apply to deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses.

Personal Exemption Phaseout

The personal exemption phaseout is another reincarnation of prior tax legislation. Since 1990, the personal exemption has been phased out at higher income levels. The 2001 tax act phased out the phaseout beginning in 2006 with repeal in 2010.

Back in 2013, 2% of the personal exemption amount, projected to be $3,900, is eliminated for each $2,500 of AGI in excess of $250,000 for single filers and $300,000 for those using married filing joint tax filing status.

Taxable Income Exceeding $400,000 or $450,000

Welcome to 2013 tax law income definition #5 affecting two more income tax areas. If your taxable income exceeds $400,000 if single or $450,000 if married filing jointly, your income tax liability will be further increased by two different tax provisions: (1) Income tax bracket and (2) Long-term capital gains and qualified dividends.

Income Tax Bracket

The top tax bracket of 35%, which was in effect from 2003 through 2012, jumps by 4.6% to 39.6% beginning in 2013 for those individuals whose taxable income exceeds the single and married filing joint thresholds of $400,000 or $450,000, respectively. The last time that the 39.6% rate was part of the tax law and was also the top tax rate was in 2000.

Long-Term Capital Gains and Qualified Dividends

Beginning in 1982, tax rate reductions reduced the tax rate on long-term capital gains, i.e., capital gain income from assets held longer than one year, from 28% to a maximum of 20%. The rate was further reduced from 20% to 15% beginning in 2003 and also began applying to qualified dividends.

The 20% maximum rate on long-term capital gains and qualified dividends has returned in 2013 for those individuals whose taxable income exceeds the $400,000 or $450,000 threshold depending upon filing status.

Summary

With the exception of the Medicare Earned Income Tax and Medicare Investment Income Tax discussed in last week’s post, the other five affected tax areas resulting in higher federal income taxes in 2013 are reincarnations of prior tax law. Everyone with employment or self-employment income of any amount with limited exception will pay more tax in 2013 than they did in 2012, all else being equal. In addition, income tax liability will increase for anyone with certain types of income exceeding specified thresholds starting at $200,000 or $250,000 depending upon filing status. The cumulative effect of the various changes and associated increase in federal income tax liability will be significant for many people.

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Annuities Deferred Income Annuities Fixed Index Annuities

Invest in DIA to Fund LTCI Premiums When Retired – Part 4 of 4

The first three posts in this series discussed five differences between fixed index annuities (“FIA’s”) with income riders and deferred income annuities (“DIA’s”) that will influence which retirement income planning strategy is preferable for funding long-term care insurance (“LTCI”) premiums in a given situation. If you haven’t done so already, I would recommend that you read each of these posts.

This week’s post presents a sample case to illustrate the use of a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement.

Assumptions

As with all financial illustrations, assumptions are key. A change in any single assumption will affect the results. The following is a list of assumptions used in the sample case:

  1. 55-year old, single individual
  2. Planned retirement start age of 68
  3. Life expectancy to age 90
  4. Current annual LTCI premium of $4,000 payable for life
  5. Need to plan for infrequent, although potentially double-digit percentage increases in LTCI premium at unknown points in time
  6. Given assumptions #4 and #5, plan for annual pre-tax income withdrawals of approximately $6,000 beginning at retirement age
  7. Solve for single lump sum investment at age 55 that will provide needed income
  8. Investment will come from a nonqualified, i.e., nonretirement, investment account
  9. One investment option is a fixed index annuity (“FIA”) with an income rider with lifetime income withdrawals beginning at age 68.
  10. Second investment option is a deferred income annuity (“DIA”) with no death benefit and lifetime income payout beginning at age 68.
  11. FIA premium bonus of 10%
  12. FIA annual return of 3%
  13. FIA income rider charge of 0.95% of income rider value otherwise known as the guaranteed minimum withdrawal benefit (“GMWB”)
  14. No withdrawals are taken from the FIA other than the income withdrawals.
  15. All investments are purchased from highly-rated life insurance companies known for providing innovative and competitive retirement income planning solutions.

Investment Amount

The first thing that needs to be solved for is the amount of investment that must be made at the individual’s age 55 in order to produce lifetime annual income of approximately $6,000 beginning at age 68. The goal is to minimize the amount of funds needed for the investment while choosing a strategy from a highly-rated insurance company that’s known for providing innovative and competitive retirement income planning solutions.

It turns out that an investment of $50,000 to $65,000 is needed to produce lifetime annual income of approximately $6,000 beginning at age 68. Given the fact that my goal as a retirement income planner is to use the smallest amount of investment for a fixed income annuity to produce a targeted income stream in order to preserve the remainder of a client’s investment portfolio for my client’s other financial goals, the amount of the investment needed is $50,000.

Results

There are three items we will examine to compare the results between investing $50,000 in a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement. They are as follows:

  • Annual gross income
  • Annual taxable income
  • Value/death benefit

Annual Gross Income

Per the Exhibit, the annual payout, or gross income, from the FIA is $5,764, or $236 less than the annual gross income of $6,000 from the DIA. This equates to a total of $5,428 for the 23 years of payouts from age 68 through age 90.

Annual Taxable Income

If the investment was made in a retirement account like a traditional IRA and assuming there have been no nondeductible contributions made to the IRA, 100% of the income would be taxable. This would be the case for both the FIA or DIA.

As stated in assumption #8, the investment will come from a nonqualified, i.e., nonretirement, investment account. Per Part 2 of this series, this makes a difference when it comes to taxation of the withdrawals. Per the Exhibit, 100% of the annual FIA income of $5,764 is fully taxable vs. $3,066 of the DIA income. This is because the DIA, unlike the FIA, is being annuitized and approximately 50% of each income payment is nontaxable as a return of principal. Over the course of 23 years of payouts, this results in $62,054 of additional taxable income for the FIA vs. the DIA.

The amount of income tax liability resulting from the additional taxable income from the FIA will be dependent upon several factors that will vary each year, including (a) types, and amounts, of other income, (b) amount of Social Security income, (c) potential losses, (d) adjusted gross income, (e) itemized deductions, (f) marginal tax bracket, and (g) applicable state income tax law.

Value/Death Benefit

While the present value of the future income stream of a DIA represents an asset, you generally won’t receive an annual statement from the life insurance company showing you the value of your investment. In addition, while some DIA’s will pay a death benefit in the event that the annuitant dies prior to receiving income, per assumption #10, this isn’t the case in this situation. Consequently, the DIA column of the “Value/Death Benefit” section of the Exhibit is $0 for each year of the analysis.

On the other hand, there’s a projected value for the FIA from age 55 through age 79. This value is also the amount that would be paid to the FIA’s beneficiaries in the event of death. There’s a projected increase in value each year during the accumulation stage between age 55 and 67 equal to the net difference between the assumed annual return of 3% and the income rider charge of 0.95% of the income rider value.

Per the Exhibit, the projected value/death benefit increases from $56,278 at age 55 to $68,510 at age 67. Although the assumed premium bonus of 10% is on the high side these days, this is reasonable given the fact that FIA values never decrease as a result of negative performance of underlying indexes, the assumed rate of return of 3% is reasonable in today’s low index cap rate environment, and the assumed income rider charge of 0.95% of the income rider value is on the upper end of what’s prevalent in the industry. The projected value/death benefit decreases each year from age 68 to age 79 until it reaches $0 beginning at age 80 as a result of the annual income withdrawals of $5,764.

Conclusion

As discussed in Parts 1 – 3 of this series, there are five important differences between FIA’s with income riders and DIA’s that will influence which retirement income planning strategy is preferable for funding LTCI premiums during retirement in a given situation. Two of the differences, income start date flexibility and income increase provision, haven’t been addressed in this post.

In addition to the five differences, the amount of the investment required to produce a targeted lifetime annual income amount to pay LTCI premiums, including potential increases, will differ depending upon the particular FIA or DIA strategy used. In the illustrated case, which isn’t uncommon today, an investment of $50,000 resulted in an almost identical lifetime income payout whether a FIA with an income rider or a DIA is used.

As illustrated, the taxable income associated with a DIA in a nonqualified environment is much less compared to a FIA. As previously discussed, the amount of tax savings resulting from the reduced taxable income will depend upon an analysis of several factors and will vary each year. Ignoring the potential income tax savings resulting from the tax-favored DIA payouts, the FIA with income rider would be the preferred investment choice for many individuals in this case given the presence, duration, and projected amount of, the investment value/death benefit.

The FIA edge is reinforced by the fact that, unlike most traditional DIA’s, the income start date and associated annual lifetime income payout amount for FIA’s is flexible. This would be an important consideration in the event that the year of retirement changes. Furthermore, this is quite possible given the fact that the individual is 13 years away from her projected retirement year.

As emphasized throughout this series, the purchase of LTCI needs to be a lifetime commitment. Planning for the potential purchase of a LTCI policy should be included as part of the retirement income planning process to determine the sources of income that will be used to pay for LTCI throughout retirement. Whether it’s a FIA with an income rider, a DIA, or some other planning strategy that’s used for this purpose will depend on the particular situation.

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Roth IRA Social Security

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 5 of 6

Retirement Income Center

Parts 3 and 4 of this series addressed the first two of three primary economic benefits associated with a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets and (2) elimination of exposure to required minimum distributions, with the first one being the most important and overriding reason in most cases for doing a conversion. This post discusses the third and final benefit – potential reduction in taxation of Social Security benefits.

Economic benefit #3 has intentionally been saved for last. Unlike the first two benefits which will occur provided there is an increase in the value of the Roth IRA after the conversion (benefit #1) and you live until at least age 70-1/2 and you haven’t depleted your traditional IRA (benefit #2), reduction in taxation of Social Security benefits is less certain. This is why this benefit is prefaced by the word, “potential.”

As we know from reading the two-part series, Say Goodbye to Up to 30% of Your Social Security Benefits that was published on January 10, 2011 and January 17, 2011, you can lose up to 30% of your Social Security benefits to federal income tax. Per the series, the amount of benefits subject to tax in a particular year is dependent upon four factors: (1) tax filing status, (2) total amount of Social Security benefits received, (3) adjusted gross income, and (4) tax-exempt income. Generally speaking, factor #3 is the most important one in determining the percentage of benefits that will be lost to federal income tax. The greater your adjusted gross income, or “AGI,” the more likely a larger portion of your Social Security will be eaten up by federal income tax.

Traditional IRA distributions are included in AGI. This includes both voluntary as well as required minimum distributions, or “RMD’s.” Roth IRA distributions, on the other hand, typically aren’t included in AGI since they generally aren’t taxable provided that certain rules are followed regarding the timing of distributions. Assuming that you’ve obeyed the rules, you will reduce your AGI in future years when you would have otherwise taken taxable traditional IRA distributions had you not done your Roth IRA conversion.

While a reduction in AGI doesn’t necessarily translate to a reduction in taxation of Social Security benefits, as illustrated in Exhibit 1 of Part 2 of Say Goodbye to Up to 30% of Your Social Security Benefits, there’s a very good chance that this will happen unless the total of your AGI, tax-exempt income, and 50% of your Social Security benefits exceeds several hundred thousand dollars. Per Part 1 of that series, the loss of 30% of Social Security benefits to taxation won’t occur unless you’re in the top 35% tax bracket. In 2011, the 35% bracket isn’t an issue until taxable income, i.e., AGI less itemized deductions and personal exemptions, exceeds $379,150.

Although reduction in taxation of Social Security benefits won’t occur in every situation, it should nonetheless be included as part of most Roth IRA conversion analyses.

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Income Tax Planning Social Security

Increase Your After-Tax Social Security Benefits – Part 4 of 4

Retirement Income Center

If you read Part 3 of this series last week, you should be familiar with my football analogy. Specifically, when it comes to winning the Social Security retirement benefit game once you start receiving benefits, you need to win two halves of the game: (1) reduce taxable benefits, and (2) reduce the tax attributable to your benefits. Parts 2 and 3 of this series discussed how to win the first half. Now that the halftime entertainment is over, we’re ready to start the second half.

In order to reduce the tax attributable to your Social Security retirement benefits, once you’ve employed appropriate strategies for reducing your taxable benefits, the focus should be on maximizing your itemized deductions – without increasing your exposure to alternative minimum tax (“AMT”). If the total amount of your itemized deductions is less than the standard deduction – game over. If you’re able to itemize your deductions, read on.

There are basically five categories of itemized deductions to pay attention to:

  1. Medical and dental expenses
  2. Taxes paid
  3. Interest paid
  4. Gifts to charity
  5. Job expenses and certain miscellaneous deductions

Here’s a brief overview of each category, two of which are only deductible if the total amount exceeds a specified percentage of adjusted gross income (“AGI”):

Medical and Dental Expenses

A deduction is allowed only for expenses paid primarily for the prevention or alleviation of a physical or mental defect or illness. You may only take a deduction for the amount of your total medical and dental expenses that exceeds 7.5% of your AGI.

Taxes Paid

Deductible taxes primarily include (1) the greater of state income taxes or general sales taxes, (2) real estate taxes, and (3) motor vehicle registration fees. You need to be careful about prepaying state income and real estate taxes at the end of the year to maximize these deductions since they can also increase your alternative minimum taxable income and your AMT liability.

Interest Paid

The most notable deduction in this area is home mortgage interest on first and second homes up to specified limits. Investment interest is also deductible to the extent of investment income.

Gifts to Charity

Charitable contributions made to qualified charitable organizations are deductible and include gifts made by cash or check as well as noncash contributions.

Job Expenses and Certain Miscellaneous Deductions

The most notable deduction in this area is unreimbursed employee expenses, including job travel, union dues, and job education. Other potential deductions include tax preparation and planning fees, investment management fees, and safe deposit box fees. You may only deduct the amount of your total job expenses and specified miscellaneous deductions that exceeds 2% of your AGI.

Based on my 25+ years of experience as a tax professional, including defending deductibility of itemized deductions on behalf of clients in IRS examinations, I can tell you unequivocally that consultation with a tax professional is crucial to maximizing, and defending, your itemized deductions – without increasing your exposure to AMT.

Assuming you’ve implemented strategies to reduce your taxable benefits and maximize your itemized deductions without increasing your exposure to AMT, you’ve won both halves of the game since you will have (1) reduced your marginal income tax rate, (2) reduced the income tax attributable to your taxable Social Security benefits, and (3) increased your after-tax Social Security benefits. Congratulations – let the celebration begin!

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Income Tax Planning Social Security

Increase Your After-Tax Social Security Benefits – Part 3 of 4

Retirement Income Center

Since it’s Super Bowl Sunday as I write this post, let’s discuss strategy as it pertains to winning the Social Security benefit game. If you want to be successful at increasing your after-tax Social Security benefits, you need to have a winning strategy. Hopefully you read Part 1 of this post and if you’re not yet receiving benefits, you’ve begun to implement your pre-benefit receipt game plan.

Once you’ve begun receiving your retirement benefits, there are two halves to winning the game when it comes to increasing after-tax benefits: (1) reduce taxable benefits, and (2) reduce the tax attributable to your benefits. If you’ve read Parts 1 and 2 and/or the previous two-part Say Goodbye to Up to 30% of Your Social Security Benefits series, you know that reduction of taxable benefits is all about minimizing the three components of “combined income,” i.e., (1) 50% of Social Security benefits, (2) adjusted gross income, and (3) tax-exempt income. Components #1 and #3 were addressed in Part 2.

Let’s turn our attention to component #2 – adjusted gross income, or “AGI.” As defined in Retirement Income Visions‘ Glossary, “adjusted gross income” is equal to gross income from taxable sources less deductions from gross income that are allowable even if you don’t itemize deductions. To the extent that you’re able to (a) reduce your gross income from taxable sources and/or (b) increase your deductions from gross income, you will reduce the amount of your adjusted gross income and, in turn, reduce your “combined income.”

Reduce Gross Income From Taxable Sources

Even though you can reduce your taxable Social Security benefits by reducing your gross income, why would you want to do this? After all, don’t you want to maximize your salary, self-employment income, pension income, rental income, partnership income, interest and dividend income, capital gains, etc.? Absolutely — with a caveat. Your goal should always be to maximize cash flow while minimizing taxable income. For those of you who receive annual Schedule K-1’s from entities in which you are a partner, shareholder, or limited liability company member, you know that quite often there’s a difference between what shows up on your K-1 as taxable income vs. the cash distributions you receive.

How do you reduce your gross income when you’re receiving Social Security benefits without negatively impacting your cash flow? Here are six ways to do this:

  • For taxable investments, i.e., nonretirement accounts, invest in immediate and/or deferred income annuities since a portion (sometimes substantial) of the distributions will be nontaxable.
  • Sell assets with unrealized losses to offset capital gains recognized earlier in the year.
  • Minimize distributions in excess of required minimum distributions (“RMD’s”) from self-managed non-Roth IRA retirement plans.
  • Minimize taxable Roth IRA conversions.
  • If you have net rental income from your rental property(ies), transfer mortgage balances from your home to one or more of your rental properties to increase your rental property interest deduction up to the amount of your net rental income. Even though your overall mortgage interest deduction may be unchanged, you may be able to reduce your taxable Social Security benefits.
  • Look for opportunities to sell properties that have passive activity loss carry forwards in order to recognize the losses.

Increase Deductions From Gross Income

When we think of tax deductions, what comes to mind most often are “itemized deductions,” including mortgage interest, real estate taxes, charitable contributions, etc. While these types of deductions reduce taxable income, they don’t reduce adjusted gross income. Although the opportunities in this area are limited, and assuming you’re not paying alimony, here’s three possibilities:

  • If you’re less than 70-1/2, maximize your IRA deduction.
  • If you’re self-employed, maximize your self-employed pension plan, i.e., SEP-IRA deduction.
  • If you’re not eligible for Medicare, establish and maximize contributions to a health savings account (“HSA”).

By the time you read this post, Super Bowl Sunday will be a memory. If you’re receiving Social Security benefits, your game and associated battle to reduce the taxation of your benefits is ongoing. Do you have a winning strategy in place to maximize your after-tax Social Security benefits?

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Income Tax Planning Social Security

Say Goodbye to Up to 30% of Your Social Security Benefits – Part 1 of 2

Retirement Income Center

Retirement Income Visions™ began a series of posts on the topic of Social Security on September 27th, focusing on various little-known strategies for maximizing Social Security benefits. In addition to the strategies not receiving a lot of publicity, when they are discussed, income taxation is often overlooked. Given the fact that a large portion of Social Security benefits can be subject to income tax, maximization of after-tax Social Security benefits should be your goal with each strategy.

Prior to 1984, Social Security benefits were nontaxable. Beginning in 1984, up to 50% of Social Security benefits became subject to taxation. The percentage was increased from 50% to up to 85% beginning in 1994. Since 1994, up to 85% of Social Security benefits are taxable, depending upon the total of two individual calculations: (1) 50% of Social Security benefits plus (2) adjusted gross income increased by tax-exempt income. While tax-exempt income generally isn’t taxable, it comes into play when calculating the taxable amount of one’s Social Security benefits. Whenever the total of these two amounts, otherwise referred to as “combined income,” exceeds a specified threshold, a portion of Social Security benefits is taxable.

The amount of the threshold is dependent upon your tax filing status. If your status is single, head of household, or married filing separate, the threshold is $25,000. If, on the other hand, your status is married filing joint, then your threshold is $32,000. The greater the excess of “combined income” over the specified threshold, the greater the amount of taxable Social Security benefits.

The $25,000 and $32,000 thresholds are the floor amounts for calculating taxable Social Security benefits. Up to 50% of Social Security benefits are taxable if your combined income is between $25,000 and $34,000 if you use single, head of household, or married filing separate filing status. The combined income level for married filing joint status for taxation of up to 50% of Social Security benefits is between $32,000 and $44,000. Once the upper limits of these respective thresholds are exceeded, up to 85% of Social Security benefits are taxable.

So, if up to 85% of Social Security benefits are taxable, why is the title of this post, Say Goodbye to Up to 30% of Your Social Security Benefits? As with taxation of all income, the amount of income tax that you pay is dependent upon the amount of your taxable income. Taxable income is calculated by subtracting itemized deductions or the standard deduction and personal exemptions from adjusted gross income. Once you determine your taxable income, income tax rates are applied to specified ranges of taxable income that are dependent upon your tax filing status. Federal income tax rates currently range from a low of 15% to a high of 35%.

Assuming that your situation is such that 85% of your Social Security benefits are taxable and assuming that you’re in the top tax bracket of 35%, then you will lose 29.75% (85% x 35%), or approximately 30%, of your Social Security benefits to federal income tax. Conversely, you will retain 70.25% (100% – 29.75%), or approximately 70%, of your benefits after paying the income tax attributable to them.

In an effort to help you better understand taxation of Social Security benefits, next week’s post will include calculations of taxable Social Security benefits, federal income tax attributable to taxable benefits, and Social Security benefits net of federal income tax for various income levels. All of you analyticals will love this one!

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Roth IRA

Considering a Partial 72(t) Roth IRA Conversion? – Tread Lightly

Retirement Income Center

The topic of this week’s blog post is one which, quite frankly, doesn’t pertain to very many people. You may be wondering why I’m writing about it if this is the case. Besides bringing the topic to the attention of those who may be affected by it, the main reason I’m writing this post is to provide interested readers with an example of a tax planning strategy that, while it doesn’t run afoul of any IRS rules, hasn’t been officially blessed by IRS.

As with many of my blog posts, this one was inspired by one of my clients. Mr. and Mrs. R., who are retired, aren’t yet receiving Social Security benefits, and derive the majority of their income from Mrs. R.’s 72(t) IRA and two nonqualified term certain annuities, a sizeable portion of which is nontaxable.

For those of you unfamiliar with a 72(t) IRA, some brief background. Generally you must wait until age 59-1/2 to begin taking distributions from an IRA, otherwise you’re subject to a 10% premature distribution penalty in addition to any income tax liability on your distributions. IRS has carved out an exception to this rule whereby you won’t be subject to the 10% penalty if you receive a series of substantially equal periodic payments, or “SOSEPP,” from your IRA for the greater of five years or until you reach 59-1/2. A 72(t) IRA account is a traditional or a Roth IRA account from which a SOSEPP is being made.

While Mrs. R has been taking her SOSEPP for five years, she’s still about a year and a half from turning 59-1/2. If Mrs. R. discontinues her SOSEPP before she turns 59-1/2, IRS would consider this to be a modification of her SOSEPP. As such, Mrs. R. would be subject to a 10% premature distribution penalty on future distributions from her IRA. Furthermore, the 10% penalty would also be applied retroactively to all of the distributions she has already taken from her 72(t) IRA.

In addition to their 72(t) IRA and nonqualified annuity distributions, my clients recently sold a rental property at a loss of $26,000. After reducing their adjusted gross income by various itemized deductions, they were projected to have a 2010 taxable loss of approximately $25,000. While this would result in no income tax liability, without further income tax planning, this would be a potentially wasted opportunity to recognize additional income and still pay no income taxes.

How could my clients recognize additional income? While they could potentially sell securities at a gain in their nonretirement account, this would be offset by a sizeable capital loss carryover. The other option was to do a Roth IRA conversion of Mrs. R.’s 72(t) IRA. IRS regulations permit a full Roth IRA conversion of a 72(t) IRA provided that the IRA owner continues his/her 72(t) distributions from the Roth IRA account following conversion.

Since the value of Mrs. R’s. 72(t) IRA was approximately $280,000, the potential income tax liability attributable to a full 2010 conversion of Mrs. R.’s 72(t) IRA to a Roth IRA couldn’t be justified based on my client’s current and projected multi-year income tax planning even with splitting the reporting of Mrs. R.’s conversion income between 2011 and 2012. I calculated that Mrs. R. could do a partial conversion of $50,000 without incurring any income tax liability due to my client’s ability to use a net operating loss carryover that they couldn’t otherwise use in 2010. Furthermore, Mrs. R.’s conversion amount could be as much as $70,000 before my client’s marginal income tax rate would exceed 15%.

Since IRS has endorsed the full conversion of a 72(t) IRA to a Roth IRA, it would seem that there should be no issue with a partial conversion so long as the 72(t) payments continue following the conversion. Logically, the post-conversion 72(t) payment amount should be paid from both the original 72(t) IRA and the new Roth IRA accounts based on the allocation of the relative values of the two accounts. The problem is that IRS has provided no guidance on partial Roth IRA conversions of 72(t) IRA accounts, including the allocation of post-conversion 72(t) payment amounts.

Given this situation, while it isn’t logical, IRS could potentially challenge a partial Roth IRA conversion of a 72(t) IRA. If IRS were to prevail on this issue, as previously stated, future, as well as retroactive, 72(t) distributions would be assessed a 10% premature distribution penalty. IRS would also assess interest on any assessed penalties.

After consulting with Natalie Choate, a well-known attorney who specializes in estate planning for retirement benefits, I recommended to my clients that they consider doing a partial Roth IRA conversion of Mrs. R.’s 72(t) IRA in 2010, file a 2010 income tax extension application, and plan on recharacterizing, or undoing, Mrs. R.’s partial Roth IRA conversion by October 15, 2011, the extended due date of Mr. and Mrs. R.’s 2010 income tax returns, in the event that IRS doesn’t provide definitive guidance on partial Roth IRA conversions of 72(t) IRA’s by this date. (For an explanation of the recharacterization process, please see Recharacterization – Your Roth IRA Conversion Insurance Policy.)