Taking the Mystery Out of Alternative Minimum Tax

office pictures may 2012 002This year many taxpayers were faced with the unwelcome surprise of Alternative Minimum Tax on their income tax return. Alternative Minimum Tax (AMT) is a complex, parallel income tax system to the standard income tax calculation.  AMT was started in 1969 in an attempt to prevent very wealthy people from using large deductions and exemptions to avoid paying income tax.  At that time it was discovered that 155 households with income over $200,000 were able to avoid paying any income tax.  AMT was originally aimed at the very rich but over the years it has come to impact millions of middle and upper income taxpayers.

Until you are hit with AMT, you may be unaware that behind the scenes your tax software runs two sets of numbers to determine how much income tax you will owe.  Your return is calculated using the standard income tax rules and it is calculated using the AMT rules.

AMT recalculates your taxable income by adding back many commonly used deductions and exemptions.  Some of the most common AMT add-backs include state and local taxes including real estate taxes, miscellaneous itemized deductions, home equity loan interest that isn’t used to buy or improve a home, and medical expenses.  AMT also adds back exemptions for dependents and the standard deduction, if you don’t itemize.  Tax-exempt interest from most private activity bonds becomes taxable under AMT and if you exercise Incentive Stock Options, the gain becomes taxable upon exercise. Under the standard income tax calculation, tax is due when the stock is sold.

If there is a possibility you will be subject to AMT, I recommend having your taxes professionally prepared or using tax preparation software.  Your software will calculate AMT by adding the items listed above to your adjusted gross income to arrive at your Alternative Minimum Tax Income (AMTI).  You are allowed to exempt some of your income from AMTI.  For 2016 the exemption for single filers is $53,900 and for joint filers is $83,800, the exemption is reduced for higher income taxpayers.  AMT is calculated by subtracting your exemption from your AMTI and multiplying your first $186,300 by 26% and anything over $186,300 by 28%, these figures are adjusted every year.  Your total income tax for the year will be the higher of your standard income tax calculation or AMT.

Taxpayers who are most likely to fall into AMT are those who live in a state with high income taxes, those with high deductions and those with large families. While there are limited opportunities to reduce the likelihood of paying AMT, one option is to reduce your adjusted gross income by maximizing tax deferred retirement plans such as 401k and 403b plans.  You also may be able to reduce AMT by moving to a state with no or low income tax or by managing the timing on when you pay state and local taxes.

Tax Diversification Can Stretch Retirement Dollars

Jane Young, CFP, EA

Jane Young, CFP, EA

Most investors understand the importance of maintaining a well-diversified asset allocation consisting of a wide variety of stock mutual funds, fixed income investments and real estate.  But you may be less aware of the importance of building a portfolio that provides you with tax diversification.

Tax diversification is achieved by investing money in a variety of accounts that will be taxed differently in retirement.   With traditional retirement vehicles such as 401k plans and traditional IRAs, your contribution is currently deductible from your taxable income, your contribution will grow tax deferred and you will pay regular income taxes upon distribution in retirement.  Generally, you can’t access this money without a penalty before 59 ½ and you must take Required Minimum Distributions at 70 ½. This may be a good option during your peak earning years when your current tax bracket may be higher than it will be in retirement.

Another great vehicle for retirement savings is a Roth IRA or a Roth 401k which is not deductible from your current earnings.  Roth accounts grow tax free and can be withheld tax free in retirement, if held for at least five years. If possible everyone should contribute some money to a Roth and they are especially good for investors who are currently in their lower earning years.

A third common way to save for retirement is in a taxable account.  You invest in a taxable account with after tax money and pay taxes on interest and dividends as they are earned.  Capital gains are generally paid at a lower rate upon the sale of the investment.  In addition to liquidity, some benefits of a taxable account include the absence of limits on contributions, the absence of penalties for early withdrawals and absence of required minimum distributions.

Once you reach retirement it’s beneficial to have some flexibility in the type of account from which you pull retirement funds.  In some years you can minimize income taxes by pulling from a combination of 401k, Roth and taxable accounts to avoid going into a higher income tax bracket.  This may be especially helpful in years when you earn outside income, sell taxable property or take large withdrawals to cover big ticket items like a car.  Another way to save taxes is to spread large taxable distributions over two years.

Additionally, by strategically managing your taxable distributions you may be able to minimize tax on your Social Security benefit.   Your taxable income can also have an impact on deductions for medical expenses and miscellaneous itemized deductions, which must exceed a set percentage of your income to become deductible.  In years with large unreimbursed medical or dental expenses you may want to withdraw less from your taxable accounts.

Finally, there may be major changes to tax rates or the tax code in the future.  A Tax diversified portfolio can provide a hedge against major changes from future tax legislation.

Tax Implications of Gifting to Children

 

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Many of you have worked hard and have saved all your life to achieve financial security and a comfortable nest egg.  However, due to current economic conditions your children may be struggling to pay their bills, buy their first home, or start saving for retirement.  You may want to help them right now, when they really need it, but you aren’t sure about the tax consequences.  There is good news! Over the last few years, the tax consequences to gifting have become much less onerous.  

Taxation on gifts is regulated as part of a combined gift and estate tax.  In 2014 everyone has a lifetime combined estate and gift tax exemption of $5.34 million.  If you are married, you have a combined exemption of $10.68 million dollars.  

Additionally, you can annually gift up to $14,000 to any number of recipients without chipping away at your lifetime exclusion of $5.34 million.  Generally, gifts to your spouse or a qualified charity are not subject to gift and estate tax.  If you exceed the annual gift limit of $14,000 to a single individual, you are required to file a gift tax return (Form 709) to report your gift.  However, you will not owe any taxes until you exceed your lifetime exclusion of $5.34 million.  Once the combined exclusion of $5.34 is exceeded, tax is imposed on the person gifting or transferring the assets, not the recipient.

You may want to make gifts to various friends or family members to help them through a rough patch or you may want to reduce your net worth to avoid or minimize estate tax.  By gifting up to $14,000 per year to several different individuals, you can reduce the amount of money that may ultimately be subject to estate tax.  For example, if you are married and have married children with a total of five children, both you and your spouse can each give $14,000 to each child, $14,000 to their spouses and $14,000 to each one of your grandchildren – every year.   This comes to a total of $252,000 in gifts per year that can be legally removed from you estate and avoid estate taxation.

According John Buckley, a nationally recognized Estate and Business Planning Attorney, gifts that are used for most education and medical expenses are not subject to the $14,000 annual gift tax limit.  Direct payment must be made to the educational institution or medical provider and not to the recipient. This is a huge benefit since many gifts are given to cover education expenses. 

Gifting can be a great way to minimize estate tax if you have a large net worth.  However, most of us save just enough to cover our retirement needs.  The desire to help family and friends is very natural, but avoid the temptation to gift money, especially to children, at the expense of your own financial security and retirement.

Saving for College with a 529 Plan

office pictures may 2012 002

Jane M. Young CFP,EA

A 529 Savings Plan is a tax advantaged college savings plan sponsored by a state or educational institution. The plan is named after section 529 of the Internal Revenue Code, created in 1996. Every state offers at least one 529 plan. Investment in a 529 plan enables the owner to save money, tax free, for future college expenses on behalf of a student or “beneficiary”. Although 529 plans are generally sponsored by specific states, they may be used at any eligible college, university, or trade school throughout the country.
Funds invested in 529 plans grow tax free if they are used for qualified education expenses. Qualified education expenses include tuition, required fees, room and board, required books, and required supplies. Although contributions are made with after tax dollars, residents of Colorado can deduct contributions made to the Colorado plan from their state income taxes.
The owner of a 529 plan has full control over the account. The owner has the freedom to select or change the beneficiary and select from the investment choices. Many find 529 plans preferable over custodial accounts for minors where the assets are held in the child’s name, and are irrevocable. Once funds are transferred to a custodial account, the funds must be used for the benefit of the minor. This can have unintended consequences. Here is an example, your daughter reaches the age of majority and decides she would rather have a corvette than a college education. Unfortunately, the money is hers to spend however she pleases.
Additionally, gains on custodial accounts are fully taxable. Custodial accounts can also be detrimental to financial aid because they are viewed as assets of the student. In comparison to a custodial account, a 529 plan has less impact on a student’s eligibility for need-based financial aid. A 529 plan is viewed as an asset of the parent rather than an asset of the student.
A common concern with 529 savings plans is your child may not need the funds for college expenses. Fortunately, if your designated beneficiary gets a scholarship or decides against a college education, you can change the beneficiary to another family member or to yourself. If you don’t need the money for college expenses, you can withdraw the money from the 529 plan. However, if the funds are not used for qualified education expenses you will have to pay a 10% penalty and taxes on the gains. This in not entirely bad, you have a lump sum of money that may have been spent years ago, if you weren’t saving for college.
Investing in most 529 plans is simplified by using age weighted portfolios. These portfolios gradually transition into less risky investments as the beneficiary reaches college age.
When purchasing a 529 plan, be aware of high fees and commissions. Most states offer direct programs that don’t charge sales commissions. Colorado offers the choice of an inexpensive program directly through Vanguard, without a sales load.

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