Tax Tips Blog

Edwards writes:

I took approx $5000 out of a Roth Ira that I funded in 2005. I took the money out in 2006 to invest in a startup business (which is going along fairly well). This Roth was funded with a one time contribution.

I miscalculated the amount of funds that would be needed to get this off the ground so I had to hit the Roth.

I received a letter from the IRS asking for me to pay them. I replied to the letter that this IRA was a Roth IRA and because I used after tax dollars AND I had no earnings, that I owed them nothing. I received another IRS letter today that asks me to sign a consent but does not specify what they want. I am not going to sign this.

Question: Did a taxable event occur when I took money out of the roth Ira?

My reply:
Hello Edward.

In general, distributions from Roth IRAs are tax-free until you’ve withdrawn all your regular contributions. After that you’ll withdraw your conversion contributions, if any. When you’ve withdrawn all your contributions (regular and conversion), any subsequent withdrawals come from earnings.

Withdrawals of earnings are tax-free if you’re over age 59½ and at least five years have expired since you established your Roth IRA. Otherwise (with limited exceptions) they’re taxable and potentially subject to the early withdrawal penalty.

You didn’t tell me how old you were when you made the withdrawal or the amount of the withdrawal, just that you “funded” it with $5,000 and had “no earnings”. My guess is that you were under age 59-1/2 when you withdrew the money, prior to it being in the Roth for 5 years, and you did not properly disclose on your tax return the reason for your withdrawal.

If my guess is correct then a taxable event did occur. However, you may not owe any tax if you can satisfy one of the exceptions and/or properly inform the IRS that you had no earnings. It sounds like you did this with your first response to the letter they sent you.

As to their request for “consent” without seeing all the notices that they sent you and your return I would have no idea what they are requesting consent for. It would make sense to me that they wish to verify that you did not have any earnings in your Roth and that is what their content is for, but it’s just a guess and may be incorrect.

I wish you success in your business!

Best wishes,
Gina

Tom writes:

My dad is age 57, and will be retiring in 3 months. He will be eligible to take a lump sum distribution from his company’s pension plan. If he does a direct rollover of the pension plan moneys into an IRA, will he be able to make withdraws from the IRA without the 10% penalty, i.e., separating from service after age 55? Or does he have to take withdraws from the IRA subject to Section 72(t) rules to avoid the 10% penalty?

My reply:

Hello Tom!  Congratulations to your father!

As you know if he were to take the lump sum distribution from a qualified retirement plan upon retirement, since he is 57 that distribution would avoid the 10% penalty.

In general, if he were to rollover his pension, instead of taking a distribution, then he would have to abide by the rules of the rollover.  If after he has established an IRA from his pension he wanted to take a distribution, in order to avoid the 10% early withdrawal penalty he would have to find another exception.  Some of those exceptions include:

• Distributions made as part of a series of substantially equal periodic payments for life (as you referred to)
• Distributions made to unemployed individuals for health insurance premiums
• Distributions due to total and permanent disability

Since I have not seen your father’s past tax returns or retirement plan options, the advice given above may not be accurate or complete for his specific situation; thus, I advise your father to consult with a qualified tax professional before making a final decision.

Best wishes,
Gina

Steve asks:For income tax, I usually adjust the tax withholding on my salary once or twice a year so that I meet one of the safe harbors. However I sold a rental property which will suddenly give me a lot of additional income. I’ve adjusted my withholding upward somewhat, but I’m worried I won’t be able to cover my whole liabiity this year. Thus, I’m thinking I should make an estimated tax payment–but how exactly do I do that? What kind of a penalty could I be faced with otherwise? Thank you in advance, Steve

My reply: Hello Steve. Thanks for visiting.

Usually once set, withholding will automatically adjust for increases or decreases in wages and usually will be more than your prior year’s tax. It’s sort of an automatic “safe harbor”. Because of this many people, after receiving a tax refund, adjust their withholding so they will no longer be giving the IRS an interest free loan.

Some taxpayers go as far as reducing their withholding to try and meet 90% of their current year’s tax, one of the available safe harbors. Unless your prior year’s tax was considerably more than you expect this year’s tax to be, this method is usually only recommended to those taxpayers who estimate their tax liability on a quarterly basis.

If your withholding is less than last year’s tax, or 90% of this years tax you must either increase withhold some more or make an installment payment, enough to to bring this year’s payments up to either safe harbor level in order to avoid a penalty. Thus, if you have increased your withholding this year such that now it is going to be more than your last year’s tax (110% of last year’s tax if your last years AGI was over $150,000 ) you won’t have a penalty, even if you owe taxes when you file your return.

If you find that you need to make an estimated tax payment I strongly recommend that you seek the help of a qualified tax professional because you will also have to file Form 2210 (at the end of the tax year) and annualize your income on a quarterly basis to prove that you didn’t owe the taxes sooner than you paid them.

If you wish to go this on your own you would complete Form 1040ES. You can download a copy of 1040ES from the www.IRS.gov site.

Best wishes, Gina

Seth writes: I work several times a year as an independent contractor for a company. I travel to various cities and deliver lectures. I receive a set fee for each lecture. In the past, I always submitted my receipts for my travel expenses and was reimbursed by the company. At year end, the only income ever reported to me on my 1099-Misc from this company was from the lecture fees. The money received for my reimbursement expenses was not reported. I was just been notified that this year the income I receive from reimbursed expenses will be reported on my 1099-Misc. Does this change in reporting mean that I will have to pay income taxes on this company’s reimbursement of meals since 50% of meals is not deductible? Thanks in advance for any help. Seth

My reply:Hello Seth and thanks for visiting.

Since you are an independent contractor being reimbursed by your client (the company), and if you adequately document those expenses to your client (the company), then you are not subject to the 50% limitation.

In this situation the 50% limit applies to your client (the company). You can read more about this in IRS Pub. 463, Travel, Entertainment, Gift and Car Expenses, www.irs.gov/pub/irs-pdf/p463.pdf.

Best wishes, Gina

Ryan asks: I’m retired with a federal pension and social security. Financially I do not need to work, but I miss it. I really enjoyed working, but I don’t want the pressure of a full time job anymore. I’ve been told that if I set up a foundation, I can freelance, doing the same work I use to do, only instead of having people pay me, ask them to donate the money to my own foundation. I’ll get to continue to do the work that I enjoy. Technically I will not have any earnings, so I won’t have to pay any taxes on the money I earn. I will get to direct 100% of my earnings to charities of my choosing. And everyone who hires me will get a tax write-off, so it will work great for everyone. My question is, how do I go about setting up this foundation?

My response:Hello Ryan!  By any chance does your idea sound a little bit too good to be true? Well it is.

In the situation you described, you would be providing your services as an independent contractor (note how many times you referred to the income as “earnings” - that should have been a hint that it was taxable).

As far as tax law is concerned, you are not allowed to “assign income”; thus anything you earn are your earnings to report. In the case you described above you would be reporting your earnings as a sole proprietor and you will owe federal taxes and self-employment taxes on any net income from your activity. If you are younger than full retirement age as far as social security is concerned it may affect your social security benefits.

The fact that you wish to donate your earnings to charity, whether that be your own foundation or another charity, is irrelevant; thus, under the circumstances that you described I don’t think you would like to set up a foundation. If one were to want to set up a foundation, a qualified attorney can help you do so.

Best wishes,

Gina

Emma asks:My husband and I would like a bigger home. The houses we’ve been looking at are either slightly beyond our reach, or affordable but in need of work. My mom would like to loan us $48K to $60K at zero percent interest. (The exact amount is yet to be determined.) Does the IRS consider the forgone interest to be a gift? Any way to avoid it? Possibly relevant facts:

• Mom plans to give my 2 siblings $12K/year for at least the next five years.
• In lieu of giving me $12K, should would reduce my loan balance by $12K until the loan is paid off.
• She and I would prefer that her name not be on the deed.
• The money will be used for down-payment and remodeling (if needed)
• I can qualify for the mortgage on my own, if need be. But the monthly payments would be higher than I’d like.

If the IRS considers the foregone interest a “gift,” and she forgives $12K of the loan, then her total gift to me will exceed $12K and I’ll have to pay gift tax, right? Can Mom “give” the foregone interest to my husband, rather than me? Are there other tax implications we need to consider? Any suggestions will be appreciated. Thank you.

My response: Hello Emma! Thanks for visiting my site.

The IRS does consider forgone interest to be a gift. The interest amount on a zero percent (0%) loan is imputed based on the Applicable Federal Rate (AFR). The IRS revises AFRs monthly. For your purposes you would use one of three AFRs:

• Short Term AFR is used if your loan has a term of three (3) years or less.
• Mid Term AFR is used if your loan has a term greater than three (3) years but less than nine (9) years.
• Long Term AFR is used if your loan has a term greater than nine (9) years.

You can find an index of Applicable Federal Rates on the IRS website.  The best way to avoid the imputed interest would be to charge an interest rate that is at least equal to the appropriate AFR.

If your mother were to give you $12,000 per year in addition to the imputed interest she would be exceeding the annual gift exclusion limit and she would have to file a gift tax return to reduce her lifetime exemption. Most likely no tax would be due, as tax is not due until she exceeded her lifetime exemption.

Even if your mother’s name is not on the deed you should have a signed loan contact with her. It would need to be treated just like any other legitimate business deal.

If both you and your husband sign theses papers documenting the loan, both the interest and the annual gift would be made to both of you, probably 1/2 each. This would solve the gift tax issues for your mother, but it may raise some issues with your siblings since you would be receiving a larger gift than they would.

In addition to gift tax concerns, your mother may also have income tax concerns. The imputed interest is considered income to your mother, even though she’s not receiving cash (because she’s forgiving the interest payments to you). This would increase her income tax.

You may want to consider waiting a couple of years to purchase a house and saving the money that your mother intends on gifting you each year until you have enough money to purchase they house you want without these other issues.

Best wishes,

Gina

Jeremy asks:My financial planner told me that I can make withdrawals from my 403(b) account at any time without early withdrawal penalties or federal income tax consequences because I obtained this particular 403(b) account as the result of a Qualified Domestic Relations Order (QDRO). Then as I was leaving his office he handed me a pamphlet that states that I cannot rely on any tax advice he provides. Did he give me correct tax advice? Jeremy

My response:  Hello Jeremy, thanks for visiting.

It sounds to me like your financial planner was confused by the fact that your ex was not taxed and did not have to pay a penalty because of the transfer under the QDRO. Now that it’s your retirement account it behaves exactly like an account you had funded on your own. You can read more about this in IRS Pub 575.

Best wishes,

Gina

Adam asks: I bought a new home last year and moved into it. My previous home, which I owned for over 10 years, is for sale but I don’t expect to sell it very soon. How should I treat the expenses on my previous home? Do I have to treat it as a second home or can I treat it as investment property and then deduct all my utilities, association fees, insurance and depreciation? Is it worth it to treat it as investment property or does the depreciation recapture make it not worthwhile? Thank you, Adam

My response:I’m sorry to have to tell you that you are not allowed to deduct your expenses or depreciate investment property, unless you have placed the property in service as a rental.

I wouldn’t recommend renting your previous home if you believe your home will sell relatively soon, since as of right now you will still qualify for a $250,000 gain exclusion. Thus, if you believe your home will sell, then it would be treated as a second home and you will be able to deduct, as an itemized deduction, subject to limitations, property taxes and interest.

If you believe it will take you several years to sell your home you should investigate the possibility of converting it to a rental.

Best wishes,

Gina

Carol writes:My mom will be closing on the sale of her house next week to move to assisted living. The profit will be split evenly between her, myself, and my two siblings since the house is in all of our names. My siblings and I want to preserve as much of our portions as possible to help with her assisted living costs. Any thoughts would be appreciated.

My response: It’s a shame that you’re asking this question now, thinking about this now, instead of whenever it was that you decided it was wise for you and your siblings to be put on the title of your mother’s home. Since you already made that mistake, unfortunately it’s too late for most tax planning options.

The best advice I can offer at this point is to find the best tax attorney, best elder law attorney and best tax professional possible before you close on the property. You may be able to transfer the property out of your names somehow, but it would need to be done legally and without fraud (the reason it’s so important to have good representation) before the property is sold.

The tax attorney will hopefully be able to help you with a transfer, assuming it’s possible and feasible. The elder law attorney may be able to assist you with your mother’s assisted living. Many assisted living institutions have a graduated charge depending on assets and income. If your mother’s income and assets are limited, you may be able to get some government assistance. In this instance it would be beneficial to her to not have a large gain from the sale of her house. And of course, a good tax professional will be able to help you with the tax consequences of the sale.

Best wishes,

Gina

Mary would like to know: My husband and I have both been contibuting to Roth’s - 1600.00 combined per year. This past year, because he left a job, had a vacation buy out, and started a new job, we are over the salary limit for the Roth, among other things. We are stymied by what to do. Next year our income will not be over the limt. Do we have to take out everything? Only the amount contibuted this past year? What if we did nothing? We have continued contibuting, but are wondering about converting to a traditional IRA - all of the investment or only the amount from last year?. Any suggestions would appreciated? In addition, we have lost the tuition deduction for the 2 college kids and the 2 other children under 17 because of this income this year. Thanks!

My response: Dear Mary,

The law provides a way to fix an excess contribution that was made to a Roth IRA. If you do not fix the excess contribution (or you do not fix it properly) you are required to pay a 6% penalty tax EACH YEAR the excess contribution remains in error.

You can avoid the 6% penalty tax by taking the excess contribution and any earnings attributed to the excess contribution out as a distribution on or before the due date (including extensions) for filing your return for the year of the excess contribution. You are required to report and pay tax on the net income attributable to the excess contribution in the year of the excess contribution, even if you take it out during the following year. The earnings will be taxed like any other taxable distribution of earnings from a Roth IRA, and will be subject to the early distribution penalty if you’re under 59-1/2 unless an exception applies.

Another potential way to correct the excess contribution is to have the trustee of your Roth IRA make a direct transfer to a trustee for a regular IRA (the IRS refers to this as a “recharacterization”). To avoid penalties, the transfer must occur on or before the due date (including extensions) for filing your return for the year of the excess contribution. This transfer must include the amount of the excess contribution and the earnings that are attributed to it. If this is done properly the contribution will be treated as if it went to the regular IRA in the first place and you don’t have to pay tax on the earnings that are transferred from one IRA to another. As you can see, by recharacterizing the excess contribution and it’s earnings you can eliminate the 6% penalty tax and you’re allowed to keep the earnings in an IRA, instead of taking the earnings out and paying tax on them. Of course you’ll benefit from a recharacterization only if you’re permitted to contribute to a regular IRA. If your excess contribution to the Roth IRA would also be an excess contribution in a regular IRA you can’t use this method to avoid a penalty. If you’d like to research this further you can start with IRS Publication 590: Individual Retirement Arrangements and for various worksheets, calculators and other articles on the Roth IRA you may wish to visit http://rothira.com

I hope I satisfactorily answered your question.

Best wishes, Gina