taxgirl » retirement & pension

Deduct This: History of the IRA Deduction

Kelly — Mon, 27 Jun 2011 15:56:54 +0000

Remember Studebaker?

Studebaker was a manufacturing company that started in 1852 in South Bend, Indiana, making wagons for farmers, miners, and the military. Ten years after the first gasoline-powered car was tested in the U.S., Studebaker entered the car manufacturing business and it was, at one point, the largest automobile maker in the world. By the 1960s, however, the company was having financial and labor difficulties and the last Studebaker car rolled off the assembly line on March 16, 1966.

Studebaker had a legacy that was bigger than cars. In the 1960s, as Studebaker was shuttering its plants, the company realized that its pension plan was so poorly funded that it could not afford to pay all its employees their pensions. As a result, thousands of workers received no pension or only part of their pensions.

As a result of that story and others like it, the public began to put pressure on Congress to do something to protect pension plans. In 1974, Congress enacted the Employee Retirement Income Security Act, often referred to as ERISA.

ERISA was huge. It regulated pension plans, retirement plans and other benefits, including health care plans.

One of the key components of ERISA was the individual retirement account, or IRA. As originally contemplated, taxpayers could contribute up to $1,500 per year and reduce taxable income by the amount of the contributions. Additionally, the amount inside the IRA would grow without being immediately taxed, a concept referred to as “tax deferred.”

Since the point of ERISA was to protect workers with benefit plans, initially, IRAs were restricted to those workers who were not already covered by a qualified employment-based retirement plan. This all changed under Reagan’s 1981 Economic Recovery Tax Act (“ERTA”) which removed that restriction. Under ERTA, all taxpayers who were age 70½ or less could contribute to an IRA. Also under ERTA, taxpayers could contribute up to $2,000 for their own IRA and $250 for a nonworking spouse and receive a tax deduction.

IRAs did not survive Reagan’s next set of tax reforms unscathed. Under the Tax Reform Act of 1986 (“1986 TRA”), deductions were phased out for high-income taxpayers who were covered by an employment-based retirement plan or had a spouse covered under such a plan.

Ten years later, however, the Small Business Job Protection Act of 1996 (“SBJPA”) expanded the scope of the IRA. Under SBJPA, the limits for contributions for nonworking spouses were increased from $250 to $2,000. The following year, the Taxpayer Relief Act of 1997 (“1997 TRA”) made even more significant changes. The phase-out limits for high-income taxpayers were increased and the rules were tweaked to allow more taxpayers who were not covered by an employment-based retirement plan to make contributions.

The 1997 TRA also introduced the Roth IRA, named for Sen. William Roth (D-DE). Roth IRAs are a special type of retirement accounts that allow for contributions to be made out of after-tax assets. Since the tax is already paid on those assets, there’s no tax on the withdrawals. There is, however, also no corresponding distribution deduction on your tax return.

IRAs continued to expand under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA boosted contribution limits for IRAs to $5,000 per qualifying person per year. In addition, EGTRRA allowed for “catch-up” contributions of up to $1,000 for taxpayers aged 50 and above. EGTRRA was only temporary, however, and was slated to expire at the end of 2010.

Today, assuming you qualify, you can make an IRA contribution and take a deduction under §219 of the Tax Code:

In the case of an individual, there shall be allowed as a deduction an amount equal to the qualified retirement contributions of the individual for the taxable year.

Phase out and other limitations still apply. It’s always a good idea to check with your tax professional for all of the details.

You can generally make a contribution right up until Tax Day and have it count for the prior taxable year. So, for example, for 2011, you can make a contribution all the way up to April 17, 2012 (yes, Tax Day in 2012 falls on a weekend). The deduction is taken on the front page of your federal form 1040 (downloads as a pdf) at line 32 ,or line 28 for the self-employed though different rules apply.

Don’t let the term “deduction” throw you. The IRA deduction is available whether you claim the standard deduction or itemized your deductions on a Schedule A. Since the IRA deduction is taken on the front page, it’s considered an “above the line” deduction. “Above the line” deductions are also called adjustments to income since they reduce your taxable income.

The idea behind the IRA deduction, of course, is to encourage people to save. I’m not sure, in practice, if the deduction significantly adds to the appeal of the IRA since it’s been my experience that most taxpayers tend to make the contribution primarily for the deferral, not the deduction. It does, of course, make me curious: do you make contributions for the deferral, the deduction or some other reason?

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This is Part Four of my series on the history and evolution of popular tax deductions; you can read the first of the series here (student loan interest deduction); the second of the series here (medical expenses deduction); and the third of the series here (tax attorney’s fees deduction). The series will continue throughout the month of June.

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Budget Vote Shows Medicare Plan Vulnerable

Kelly — Wed, 25 May 2011 13:09:27 +0000

When presidential hopeful Newt Gingrich first objected to House Budget Committee Chair Paul Ryan’s (R-WI) Medicare proposal, there was a collective gasp in the political sphere. Until a few weeks ago, many Republicans thought the budget, which included a controversial provision to overhaul Medicare, was untouchable. The proposal, which appeared to be endorsed by most of Republican leadership, had been gaining support.

And then it happened: Gingrich criticized the proposal publicly. And almost overnight, Ryan’s plan looked vulnerable.

Granted, the fallout from Gingrich’s remarks has not been overwhelmingly positive for the former Speaker of the House. But Gingrich falling out of line with the remainder of the GOP seemed to signal to others in the party that not everyone was on board with the plan. Today, five Republican Senators publicly joined those ranks. In the final vote on the budget, Sen. Lisa Murkowski (R-AL), Sen. Rand Paul (R-KY), Sen. Scott Brown (R-MA), Sen. Olympia Snowe (R-ME) and Sen. Susan Collins (R-ME) voted against the proposal. Two other Republicans, Sen. Kay Bailey Hutchison (R-TX) and Sen. Pat Roberts (R-KY) did not vote. The lack of support from those seven Republicans contributed to failure of the proposal, which was voted down, 50-47 (in case you’re wondering who the other non-voting Senator was, it was Sen. Charles Schumer (D-NY)).

Senate Majority Leader Harry Reid (D-NV) was self-congratulatory after the vote, saying, “The Republican plan would kill Medicare.”

In response, the Republicans noted that the Democrats have yet to pass a budget for this year or the next.

Expect the drama to continue.

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Is Ryan’s Medicare Proposal the Right Kind of Change?

Kelly — Sun, 22 May 2011 12:47:47 +0000

It was one of those jaw dropping, rubbing your eyes, cleaning out your ears moments. Presidential hopeful Newt Gingrich, thought by many to be a frontrunner for the GOP nomination, went out on a limb and criticized his own party’s plans for Medicare reform. Speaking on Meet the Press, Gingrich said about the Republican plan:

I don’t think right-wing social engineering is any more desirable than left-wing social engineering. I don’t think imposing radical change from the right or the left is a very good way for a free society to operate.

Ouch.

Some may agree with Gingrich. Others, such as House Budget Committee Chairman Paul Ryan (R-WI), who crafted the plan, clearly disagree. But what is clear (beyond the fact that Gingrich has wounded his relationship with many conservatives) is that the future of Medicare is a politically charged topic that’s bound to attract a great deal of attention in the upcoming 2012 election. So what the heck is it all about?

Medicare is health insurance. The general idea is that you pay in to the system while you’re working so that you can benefit from Medicare later in life, most notably when you retire. In most cases, you are eligible for Medicare if you or your spouse worked for at least 10 years in Medicare-covered employment; you are 65 years or older; and you are a citizen or permanent resident of the U.S. If you aren’t yet 65, you might still qualify for coverage if you have a disability or with End-Stage Renal disease.

It is an enormous federal program. It’s been around for nearly fifty years, beginning when the Social Security Act of 1965, amending a former law, was signed into law by President Lyndon B. Johnson. Former President Harry S. Truman was the first Medicare beneficiary (he opted in for Part B coverage) and received the first Medicare card.

The idea behind Medicare was to provide taxpayer funded health insurance benefits for older Americans. This came about after concerns arose that many Americans could not afford coverage after retirement. In 1964, the Senate Special Aging, Health of the Elderly Subcommittee released a report which stated, among other things, that private health insurance was unable to provide the majority of older Americans with “adequate hospital protection at reasonable premium cost.” Shortly thereafter, with health insurance for older people a priority for many in Congress, Medicare was created.

Under today’s system, when you work, you pay into the Medicare system as part of your federal payroll taxes. You pay 1.45% of your pay and your employer pays in 1.45% for a total contribution of 2.9%. Unlike Social Security, there is no income cap, so all of your wages are subject to the tax; the cap on Medicare wages was removed beginning January 1, 1994.

With the new health care act, there are some changes to the way that taxes will be imposed for purposes of Medicare. Specifically, beginning in 2013, Medicare tax will be imposed at a higher rate of 3.8% on investment/unearned income for high income taxpayers. High income taxpayers means those individual taxpayers reporting income over $200,000 and married taxpayers filing jointly reporting income over $250,000. Investment income includes exactly what you’d think but excludes distributions from qualified retirement plans, including pensions and IRAs.

Additionally, also beginning in 2013, the health care act increases the Medicare tax on high income individuals by 0.9%, from 1.45% to 2.35% for wages over the income thresholds ($125,000 for married taxpayers filing separately, $200,000 for individual taxpayers and $250,000 for married taxpayers filing jointly). The employer contribution will remain the same at 1.45%. To be clear, the additional tax is imposed at the wages over those threshold amounts; amounts under the threshold will still be taxed at 1.45%. So, for example, if a single taxpayer earned $500,000, the first $200,000 would be taxed at 1.45% and the next $300,000 would be taxed at 2.35%. Self-employed taxpayers will have the same limitations; the additional 0.9% tax applies to self-employment income that totals more than the respective threshold.

At retirement, most taxpayers are eligible for “free” Medicare Part A coverage. I say “free” because technically, you have been paying for it all along. Other benefits under Parts B, C and D of Medicare are subject to eligibility restrictions and/or additional cost.

If you do the math – especially if you’re currently paying for your own health care insurance – you can see that these dollars don’t add up under these facts. Assuming a real median income of just under $50,000 for taxpayers, that means a total Medicare contribution of $1,450 per year. When you can find private insurance for those kinds of dollars, you let me know. And that, of course, is exactly the problem.

Medicare is a huge, expensive program. The scope and expense of the program is a problem for both parties. The Democrats tried to address the issue through the provisions in the new health care act. Most Republicans, however, including Gingrich and Ryan want to get rid of the new health care act altogether, saying that it doesn’t do enough to control costs, and replace it with another plan.

What Ryan has proposed – and Gingrich objected to – was to move Medicare to more of a defined contribution plan administered by the government but relying on private insurers. If you think you’ve heard the concept before, it is shades of the idea of privatization of Social Security proposed a decade or so ago.

In theory, opening up the market to competition should result in lower costs to consumers. Of course, that was the idea behind pieces of Obama’s health care plan, too. The problem is that doesn’t seem to happen with respect to private insurers. Costs for plans in the private sector have continue to climb since the new health care act was signed into law. This has alarmed many in D.C., forcing the Obama administration to investigate significant premium rate increases.

It’s not completely out of the question that the subsequent dialogue about increased premiums under the current health care act will further influence the direction of Ryan’s plan. The proposal has actually evolved over time with the most current version approximating the existing system for federal employees. Ryan has referred to it as a “premium-support model” where the government would pay the insurer directly, in effect subsidizing the cost of a plan chosen directly by the insured. What has taxpayers on edge about the plan, however, is that seniors will be responsible for the remaining share of their own medical costs. That means cost savings for the government but potential increases for taxpayers, depending on costs and benefits. The fear is that it might force seniors into choosing less desirable – but more affordable – plans.

You can read the complete details of Ryan’s plan here (downloads as a pdf).

It is, as Gingrich has articulated, a complete change from the existing system. But is it a welcome change? I get Gingrich’s comments, even as he is backing away from them. The proposal that Ryan is suggesting has many of the same system-based flaws evident in the current health care act.

The idea of handing over control of health care choices to Americans isn’t a bad one. But we’re asking seniors to make choices about health care providers and plans when they’re elderly, when they’re sick and when they’re concerned about how they’re going to pay for the rest of their retirement. It’s not the best of circumstances. And I don’t know about you, but I can’t make sense of those darn charts and brochures from insurance companies under the best of circumstances.

While there’s a lot of loud pushing and shoving about the 2012 plan, it’s important to note that there would be no real changes in Medicare under the proposal until 2022. That would allow for taxpayers under the age of 55 to adjust to the new changes. The eligibility age would bump to 67 by 2033. Another dramatic change.

Of course, change isn’t always bad. Winston Churchill once remarked, “There is nothing wrong with change, if it is in the right direction.” So, I ask you, is this the right direction?

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Taxes from A to Z: Z is for Code Z

Kelly — Sun, 03 Apr 2011 15:46:56 +0000

The last of the Taxes from A to Z series is Z for Code Z.

Code Z is a relatively recent addition to the tax world. It made its debut on the 2005 federal form W-2 (and the related federal form 1099-MISC) as part of the American Jobs Creation Act of 2004. The purpose of the code was to report income that didn’t meet certain criteria for nonqualified deferred compensation plans under the section 409A of the Tax Code.

A little historical context is always helpful and is especially true in this case. For years, there had been a fairly weak interpretation of the idea of constructive receipt with respect to retirement plans and elective deferrals of income. In law school, we learned (more or less) that income becomes taxable when you could take it, whether or not you actually did. The courts didn’t always agree with this premise and abuse with respect to deferred compensation plans was pretty rampant. Enter Enron, whose executives further abused the system, by ramping up their own retirement distributions before the company went bankrupt; in terms of timing, Enron officials appeared before Congress beginning in December 2001 and the new rules went into effective January 1, 2005.

The rule doesn’t affect a lot of taxpayers but when it does, man, it’s pretty gruesome. If a plan doesn’t comply with the rules under section 409A, the penalties are severe: all of the deferred amounts become immediately taxable and subject to a 20% penalty. Some exceptions apply.

Under section 409A, distributions from these kind of plans can only be made to an employee upon the occurrence of one of these events:

separation from the company;
disability;
death;
a fixed time or schedule specified under the plan;
change in ownership or effective control of the corporation, or a change in the ownership of a substantial portion of the assets of the corporation; or
the occurrence of an “unforeseeable emergency” which is defined as, among other things, a severe financial hardship because of an illness or accident to the taxpayer, spouse or dependent, a casualty loss, or “other similar extraordinary and unforeseeable circumstances arising as a result of events” beyond the taxpayer’s control.

The rules that govern deferred comp plans can be tricky but there are generally reasons for the complexity. Congress often finds itself on side of trying to curb abuse – as in this case – from folks trying to game the system. Section 409A (and the resulting Code Z) is an excellent example of trying to set things right.Similar Posts:

Taxes from A to Z: R is for Roth IRA

Kelly — Mon, 21 Mar 2011 01:08:24 +0000

Every now and again, I write a piece knowing that there will be a backlash of some sort. This is one of those pieces.

You’d think something like a retirement plan would be easy, with little to no controversy. But since its inception under the Taxpayer Relief Act of 1997, the Roth IRA has drawn a mixture of accolades and criticisms. And practically, without fail, whenever I’ve written anything less than a full on embrace of the Roth, I’ve received a barrage of emails and comments telling me how very foolish I am for suggesting that you take a moment to (gasp) consider whether a Roth IRA is the best option for you rather than simply sign up. But I’m going to do it again anyway…

The Roth IRA is a retirement plan named after Senator William Roth (D-DE), who was the bill’s chief sponsor. The Roth IRA differs from a traditional IRA in that you pay the tax on the money going into the retirement account where it then grows tax free – when you take it out, you don’t pay federal income tax on the distributions. In a traditional IRA, you defer the federal income tax on the money going into the retirement account – when you take it out, you pay tax on the distributions.

A lot of folks (especially in the investment world) feel that you don’t need to look any further. They say: Tax free growth? Always a win! Thus, everyone needs a Roth.

Um, not so fast.

Yes, in theory, the potential for tax savings with a Roth is impressive. But as a good friend of mine is fond of saying, “But we don’t live in theory.”

There are a few circumstances when contributing to a Roth deserves some thoughtfulness:

You’re looking for a tax deduction. Contributions to a traditional IRA may be eligible for an immediate federal income tax deduction while contributions to a Roth IRA are not eligible for a tax deduction.
You’re expecting to be in a considerably lesser tax bracket when you will withdraw your IRA funds. One of the most appealing aspects of the Roth is the ability to make withdrawals tax free. But it’s important to consider the time value of money… If you pay tax at 35% now to not pay 10% in, say, five years, is it worth it? You have to bet on the fact that your money will grow fast enough to make up the difference. Consider the length of time of the investment and your respective tax brackets now and at retirement.
You anticipate needing your IRA funds. One of the advantages of the Roth is that you are not required to make required minimum distributions (RMDs) at age 70-1/2 as you are required to do for a traditional IRA. If you don’t need the money, this can be a terrific estate planning technique since you can pass the money to your beneficiaries with a federal income tax savings. However, if you anticipate using the funds, the savings might not be as dramatic, depending on your circumstances (see #2 above).

Next, consider the mechanics. Even though the Roth has been around for awhile, it’s been modified a couple of times. In particular, for 2010 and 2011, the following rules and restrictions are important.

For 2010, your Roth IRA contribution limit begins to phase out if:

Your filing status is married filing jointly or qualifying widow(er) and your MAGI is at least $167,000 (you cannot make a Roth IRA contribution if your MAGI, or modified adjusted gross income, is $177,000 or more).
Your filing status is single, head of household, or married filing separate and you did not live with your spouse at any time in 2010 and your MAGI is at least $105,000 (you cannot make a Roth IRA contribution if your MAGI is $120,000 or more).
Your filing status is married filing separate and you lived with your spouse at any time during the year (you cannot make a Roth IRA contribution if your MAGI is $10,000 or more).

For 2011, your Roth IRA contribution begins to phase out if:

Your filing status is married filing jointly or qualifying widow(er) and your MAGI is at least $169,000 (you cannot make a Roth IRA contribution if your MAGI is $179,000 or more).
Your filing status is single, head of household, or married filing separate and you did not live with your spouse at any time in 2010 and your MAGI is at least $107,000 (you cannot make a Roth IRA contribution if your MAGI is $122,000 or more).
Your filing status is married filing separate and you lived with your spouse at any time during the year (you cannot make a Roth IRA contribution if your MAGI is $10,000 or more).

So long as you’re not phased out (see those AGI limits above), if you only make contributions to a Roth IRA, your contribution limit generally is the lesser of $5,000 ($6,000 if you are age 50 or older), or your taxable compensation.

It’s also important to remember that, for 2010, the MAGI and filing status requirements for converting a traditional IRA or rolling over an employer plan to a Roth IRA were eliminated. If you made a conversion or rollover to a Roth in 2010, you can choose to include the amount in income for 2010 or include the income in equal amounts in 2011 and 2012.

Other details to keep in mind… There’s no age limit and no time limit for contributing to a Roth IRA. You have to designate your IRA as a Roth IRA when you open the IRA. And since you don’t get a deduction for your contribution, you do not report Roth IRA contributions on your federal income tax return.

Obviously, there’s a lot here to consider (and clearly, some info I had to leave out). I highly recommend chatting with your financial advisor or your tax pro – or both – to see what works best for you. Which I guess leads me back to my point in the first place: think about it before you act. A Roth IRA can be a great choice for many taxpayers but it’s not a one size fits all fix (and emailing me won’t change my mind, just saying).

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Taxes from A to Z: E is for Early Distributions

Kelly — Mon, 07 Mar 2011 22:01:44 +0000

Let’s face it… It’s been a tough couple of years for a lot of taxpayers. More and more taxpayers have reached into their savings, including their retirement savings, in order to pay bills and otherwise make ends meet. Unfortunately, pulling that money out before retirement may feel like a good idea at the time but come Tax Day, it can cause a little bit of a headache. This is because the amounts you withdraw from a traditional IRA or other qualified retirement plan before reaching age 59½ are referred to ”early” or ”premature” distributions and are, in most cases, subject to an additional 10% early withdrawal tax in addition to the income tax payable on that amount.

Fortunately, there are some exceptions to this rule. You may not have to pay the early withdrawal penalty if any of the following apply:

The funds are considered a distribution from a retirement plan other than an IRA as a result of leaving your job and you are over age 55 (age 50 for qualified public safety employees);
You have unreimbursed medical expenses which total more 7.5% of your AGI;
Your distributions are less than the cost of your medical insurance or your qualified higher education expenses (IRAs only);
You are disabled;
You are a beneficiary of a deceased plan participant or IRA owner;
You are receiving distributions in the form of an annuity;
You use the distributions to buy, build or rebuild a first home (IRAs only and limited to $10,000);
Your distribution is due to an IRS levy (though that stinks);
Your distribution is a qualified reservist distribution;
Your distribution is made to an alternate payee under a QDRO;
The distribution was timely made to reduce excess contributions made under a 401(k) plan, employee or matching employer contributions or elective deferrals (see my related piece on corrective distributions); or
You are receiving a permissible withdrawal from an EACA (eligible automatic contribution arrangement).

If you don’t meet an exception, you’ll generally report and pay the 10% tax on line 58 of your federal form 1040:

You may also need to file federal form 5329, Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts (downloads as a pdf) if you’re claiming an exception. You don’t need to file form 5329 if your federal form 1099-R shows distribution code “1″ or “J” in Box 7 and you don’t qualify for an exception.

Keep in mind that you will also be treated as having made an early distribution or withdrawal if you don’t make your tax-free rollovers in a timely fashion. The safest bet when making a rollover, when possible, is to make an administrative rollover – in other words, let your administrator/trustee roll the plan directly to another administrator/trustee. Having a check made payable to you opens the door for timing and other issues if you’re not careful (and sadly, occasionally, even when you are).

Retirement plans can be tricky so check with a tax or investment advisor before you start pulling or rearranging accounts even if you think you know what you’re doing. If you make an early distribution/withdrawal, even if you don’t qualify for an exception, be sure and document the transaction well and check with your tax professional so that your paperwork accurately reflects what actually happened. You’d be surprised how many times the paperwork doesn’t really show what happened – that keeps folks like me in business.Similar Posts:

Taxes from A to Z: C is for Corrective Distributions

Kelly — Sat, 05 Mar 2011 20:11:47 +0000

Retirement plans can be great vehicles for tax deferrals – but they can also be giant headaches when it comes to reporting for tax reasons. This is because there are so many technical rules that the potential for making a mistake is fairly high if you don’t know what you’re doing (taxgirl PSA: your plan administrator is there for a reason, use him or her).

A common mistake in the world of retirement plans is, believe it or not, contributing too much in any year. Again, you should retain the services of a professional if you’re not sure what your limits are (or, at the very least, ring up your HR person).

If you’ve contributed too much in any year, the excess is taxable to you. To correct this mistake, your retirement plan may distribute the excess back to you (along with any associated income earned). Like most other distributions from a retirement account, a corrective distribution will be reported on a federal form 1099-R. However, a corrective distribution is not treated as a nonperiodic distribution from the plan and is not subject to the allocation rules. On the plus side, it’s not subject to an additional tax for early distributions but, on the downside, that money can’t be rolled over into another retirement plan. Be sure and familiarize yourself with the rules (or use the services of someone in the know).

Corrective distributions are coded on a federal form 1099-R as “8,” “B,” “D,” “P,” or “E” in box 7. If you made a corrective distribution during the year, make sure that you advise your tax pro accordingly. Sometimes mistakes happen and your form 1099-R might not properly reflect your corrective distribution – or the form might not be clear. This isn’t one of those things that you want to try and fix after the fact (although it can be done) so it’s best to make sure your tax pro has all of the pertinent info upfront.Similar Posts:

Taxes from A to Z: A is for Applicable Federal Rates

Kelly — Thu, 03 Mar 2011 13:59:30 +0000

First in the series: A is for Applicable Federal Rates, or AFRs.

Each month, the IRS provides various prescribed rates for federal income tax purposes; those rates are regularly published as revenue rulings. You can see the latest list of rates as a revenue ruling here (downloads as a pdf).

If you browse the list, you’ll note a few different versions of the AFR:

Current Short Term AFRs for terms of three (3) years or less;
Current Mid Term AFRs for terms in excess of three (3) years but no greater than nine (9) years;
Current Long Term AFRs for terms in excess of nine (9) years;
Current Adjusted Long Term Rates for determining the Long Term Tax-Exempt Rate, used to compute the annual net operating loss carryover utilization limitation following a change in ownership; and
Current Section 7520 Rate, used to value annuities, life interests or interests for terms of years and remainder or reversionary interests.

So, what in the world does all of this mean?

The easiest way to think of AFRs is that they’re guidelines that the IRS uses to determine interest rates for certain transactions. Commonly, these numbers are used to determine imputed interest (for family loans, for example).

Planners and other tax professionals watch these rates fairly closely because they can present some interesting opportunities. This is especially true when dealing with deferred or split interest gifts; examples of those include a charitable trust when part of the gift is going to a charity and part of the gift is going to a non-charitable beneficiary. Under the statute, the person making the gift can choose the most favorable AFR (that section 7520 rate alluded to above) over a period of about three months. That can be helpful because with something like a charitable remainder trust, you’d want to choose a high number, and for charitable lead trusts and remainder interests, you’d generally want to choose a low number.

The AFR is also used to calculate withdrawal amounts from IRAs. The IRS requires the use of AFRs for purposes of amortization calculation (stay with me) for figuring certain IRA withdrawals since the interest rate must be “reasonable” (and that’s based on the AFR). You might not actually plug those numbers in yourself but someone does when figuring how much your IRA withdrawals (using the amortization and annuity factor methods).

If your eyes glaze over while looking at the tables, you’re not alone. While many tax pros swear by the tables (my former law professor still calculates split interest gifts by hand using the tables), others opt to skip the tables altogether and go straight for the software. There is software available now that does all of these split interest, imputed interest and other calculations that rely on the AFR.

Chances are that you won’t ever have to use an AFR to make a calculation yourself (unless you’re a tax pro). But now you know what it is which is good to know if you have to deal with loans, IRAs or gifts. If nothing else, it makes good cocktail party chatter…Similar Posts:

Medicare and Self-Employed Taxpayers

Kelly — Mon, 28 Feb 2011 13:43:35 +0000

See folks, this is why you should always read the comments in the blog. We’ve been having a discussion about whether Medicare Part B is deductible as a self employed health insurance premium in the comments at this post: The A, B, C and Ds of Medicare.

The old Pub 535 said no. And the old instructions for the form 1040 said no. This year, the instructions for the 1040 said yes. And there is no updated Pub 535. So, which is correct?

In 2010, self-employed people may deduct their Medicare Part B health insurance premiums.

The IRS did not announce the change and I can’t find it anywhere on the IRS web site except on the form 1040 instructions. However, it’s been confirmed all over the place, including, apparently by the IRS to Bloomberg, as reported by Insurance & Financial Advisor. A similar report was posted by SFGate, also quoting IRS sources and noting that:

The IRS has long held that Medicare premiums are not eligible for the deduction because Medicare cannot be established by a taxpayer under a business.

This year, it’s different. Nobody knows why the change happened, where it’s been recorded (it wasn’t in the new tax law) or why the IRS has been so slow to get the word out. Mind boggling.Similar Posts:

The A, B, C and Ds of Medicare

Kelly — Tue, 25 Jan 2011 21:35:11 +0000

Here’s your big disclaimer upfront: I’m not a Medicare guru. I don’t work for Medicare. I don’t receive Medicare. But I do know enough to see that there’s some pretty awful information floating around which has lead to some confusion on the tax side. Let me see if I can help sort some of it out.

When you work, you pay into the Medicare system as part of your federal payroll taxes. You pay 1.45% and your employer pays in 1.45% of your pay. Unlike Social Security, there is no cap, so all of your wages are subject to the tax.

You pay in so that you can benefit from Medicare later. Generally, you are eligible for Medicare if you or your spouse worked for at least 10 years in Medicare-covered employment; you are 65 years or older; and you are a citizen or permanent resident of the U.S. If you aren’t yet 65, you might also qualify for coverage if you have a disability or with End-Stage Renal disease.

There are several parts to Medicare:

Medicare Part A helps cover inpatient care in hospitals, skilled nursing facility, hospice, and home health care. For most taxpayers, Medicare Part A is considered “premium free” – that’s because you (or your spouse) paid in while you (or your spouse) were working. If you aren’t one of those “premium free” folks, you can opt to buy Part A coverage – the rate depends on how many quarters you (or your spouse) paid into the system. If you pay out of pocket for Part A, the premiums would be considered medical expenses for purposes of the medical deduction. If you receive Part A because of your age or disability without paying out of pocket, you may not claim the premiums as medical expenses.
Medicare Part B is considered medical insurance. It’s optional coverage and you have to pay for it if you want it. For 2011, the monthly premium is $115.40. In most cases, this amount is deducted from your Social Security, RRB or Civil Service Retirement check. If you don’t get one of those checks, you’ll be billed for coverage every 3 months. If you pay for Part B, the premiums would be considered medical expenses for purposes of the medical deduction. It doesn’t matter whether the premiums are paid out of your checks or if you pay every three months.
Medicare Part C (sometimes called a Medicare Advantage Plan) is basically a private insurance plan approved by Medicare. Most plans cover Parts A and B, and often Part D. The plan might also offer extra benefits such as vision and dental. Most also include Medicare prescription drug coverage (Part D). Medicare pays the insurer directly for some of the costs and you are responsible for paying the additional costs (the costs and benefits under the plans are heavily regulated). If you pay for Part C, your costs would be considered medical expenses for purposes of the medical deduction. Costs paid by Medicare for your plan are not deductible.
Medicare Part D is prescription drug coverage. The costs and benefits of the plan vary according to a number of factors, including the amount of your modified adjusted income (MAGI). If you pay for Part D, your costs would be considered medical expenses for purposes of the medical deduction. Costs paid by your employer or other third party for your plan are not deductible.

That’s the quick and dirty summary. There are lots of specific facts and circumstances that might affect what kind of coverage you receive or are eligible to receive. If you have questions, call the nice folks at Medicare (1.800.MEDICARE) and ask them directly. I’m sure they’ll be happy to help.

But since the point of this blog is to talk about tax, here’s what I want you to take away from this article: if you pay for coverage, no matter what part/plan, AND if you itemize, then you may include your costs for coverage as part of your medical expenses for purposes of the medical deduction.

That said, remember this: seniors and the blind receive an additional amount as a standard deduction, making that threshold fairly high. There’s no need to add up your coverages if you’re not near that amount. Additionally, there is a “floor” for medical deductions which means those expenses are only deductible to the extent that they exceed 7.5% of your adjusted gross income.

If you have questions about whether you should itemize or whether other medical expenses would qualify for medical deduction, check with your tax professional.

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