2023 RMDs Waived for Non-spouse Beneficiaries Subject To The 10-Year Rule

There has been a lot of confusion surrounding the required minimum distribution (RMD) rules for non-spouse beneficiaries who inherited IRAs and 401(k) accounts subject to the new 10-Year Rule.  This has left many non-spouse beneficiaries questioning whether or not they are required to take an RMD from their inherited retirement account prior to December 31, 2023.  Here is the timeline of events leading up to that answer:

December 2019: Secure Act 1.0

In December 2019, Congress passed the Secure Act 1.0 into law, which contained a major shift in the distribution options for non-spouse beneficiaries of retirement accounts. Prior to the passing of Secure Act 1.0, non-spouse beneficiaries were allowed to move these inherited retirement accounts into an inherited IRA in their name, and then take small, annual distributions over their lifetime.  This was referred to as the “stretch option” since beneficiaries could keep the retirement account intact and stretch those small required minimum distributions over their lifetime.

Secure Act 1.0 eliminated the stretch option for non-spouse beneficiaries who inherited retirement accounts for anyone who passed away after December 31, 2019. The stretch option was replaced with a much less favorable 10-year distribution rule.  This new 10-year rule required non-spouse beneficiaries to fully deplete the inherited retirement account 10 years following the original account owner’s death.  However, it was originally interpreted as an extension of the existing 5-year rule, which would not require the non-spouse beneficiary to take annual RMD, but rather, the account balance just had to be fully distributed by the end of that 10-year period.

2022: The IRS Adds RMDs to the 10-Year Rule

In February 2022, the Treasury Department issued proposed regulations changing the interpretation of the 10-year rule.  In the proposed regulations the IRS clarified that RMDs would be required for select non-spouse beneficiaries subject to the 10-year rule, depending on the decedent’s age when they passed away. Making some non-spouse beneficiaries subject to the 10-year rule with no RMDs and others subject to the 10-year rule with annual RMDs.

Why the change? The IRS has a rule within the current tax law that states that once required minimum distributions have begun for an owner of a retirement account the account must be depleted, at least as rapidly as a decedent would have, if they were still alive. The 10-year rule with no RMD requirement would then violate that current tax law because an account owner could be 80 years old, subject to annual RMDs, then they pass away, their non-spouse beneficiary inherits the account, and the beneficiary could voluntarily decide not to take any RMDs, and fully deplete the account in year 10 in accordance with the new 10-year rule. So, technically, stopping the RMDs would be a violation of the current tax law despite the account having to be fully depleted within 10 years.

In the proposed guidance, the IRS clarified, that if the account owner had already reached their “Required Beginning Date” (RBD) for required minimum distributions (RMD) while they were still alive, if a non-spouse beneficiary, inherits that retirement account, they would be subject to both the 10-year rule and the annual RMD requirement.

However, if the original owner of the IRA or 401k passes away prior to their Required Beginning Date for RMDs since the RMDs never began if a non-spouse beneficiary inherits the account, they would still be required to deplete the account within 10 years but would not be required to take annual RMDs from the account.

Let’s look at some examples. Jim is age 80 and has $400,000 in a traditional IRA, and his son Jason is the 100% primary beneficiary of the account. Jim passed away in May 2023. Since Jason is a non-spouse beneficiary, he would be subject to the 10-year rule, meaning he would have to fully deplete the account by year 10 following the year of Jim’s death. Since Jim was age 80, he would have already reached his RMD start date, requiring him to take an RMD each year while he was still alive, this in turn would then require Jason to continue those annual RMDs during that 10-year period.  Jason’s first RMD from the inherited IRA account would need to be taken in 2024 which is the year following Jim’s death.

Now, let’s keep everything the same except for Jim’s age when he passes away. In this example, Jim passes away at age 63, which is prior to his RMD required beginning date. Now Jason inherits the IRA, he is still subject to the 10-year rule, but he is no longer required to take RMDs during that 10-year period since Jim had not reached his RMD required beginning date at the time that he passed.

As you can see in these examples, the determination as to whether or not a non-spouse beneficiary is subject to the mandatory RMD requirement during the 10-year period is the age of the decedent when they pass away.

No Final IRS Regs Until 2024

The scenario that I just described is in the proposed regulations from the IRS but “proposed regulations” do not become law until the IRS issues final regulations. This is why we advised our clients to wait for the IRS to issue final regulations before applying this new RMD requirement to inherited retirement accounts subject to the 10-year rule.

The IRS initially said they anticipated issuing final regulations in the first half of 2023. Not only did that not happen, but they officially came out on July 14, 2023, and stated that they would not issue final regulations until at least 2024, which means non-spouse beneficiaries of retirement accounts subject to the 10-year rule will not face a penalty for not taking an RMD for 2023, regardless of when the decedent passed away. 

Heading into 2024 we will once again have to wait and see if the IRS comes forward with the final regulations to implement the new RMDs rules outlined in their proposed regs.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Requesting FICA Tax Refunds For W2 Employees With Multiple Employers

If you are a W2 employee who makes over $160,200 per year and you have multiple employers or you switched jobs during the year, or you have both a W2 job and a self-employment gig, your employer(s) may be withholding too much FICA tax from your wages and you may be due a refund of those FICA tax overpayments. Requesting a FICA tax refund requires action on your part and an understanding of how the FICA tax is calculated.

How is FICA Tax Calculated

If you are a W2 employee, you will see a FICA deduction on your paychecks, which stands for Federal Insurance Contributions Act.   The FICA tax is the funding vehicle for the Medicare and Social Security programs in the U.S.  The 7.65% FICA tax consists of 6.2% for Social Security and 1.45% for Medicare, but the 6.2% allocated to Social Security has a cap, which means the government only assesses the 6.2% tax up to a specified wage limit each year. That wage limit is called the “taxable wage base,” and for 2023, the taxable wage base is $160,200.    Any income up to the $160,200 taxable wage base is assessed the full 7.65% FICA tax, and any amounts over the taxable wage base are just assessed the 1.45% for Medicare since the Medicare tax does not have a cap. 

Note: The IRS taxable wage base usually increases each year.

Employees with Multiple Employers During The Same Tax Year

For employees who work for more than one company during the year and whose total wages are over the $160,200 taxable wage base, this can cause an over-withholding of FICA tax from their wages. 

Example: Sue is a doctor employed by XYZ Hospital and earns $150,000 between January and August, then Sue accepts a new position with ABC Hospital and earns $100,000 between September and December. Both XYZ Hospital and ABC Hospital will withhold the full 7.65% in FICA tax from Sue’s paycheck because she was below the taxable wage base of $160,200 with each employer.  But Sue is only required to pay the 6.2% Social Security portion of the FICA tax up to $160,200 in wages, so she has too much paid into FICA for the year. 

• XYZ Hospital SS 6.2% x $150,000 = $9,300

• ABC Hospital SS 6.2% x $100,000 = $6,200

• Total SS FICA Actually  Withheld:    $15,500

Annual Limit: SS 6.2% x Taxable Wage Base $160,200 = $9,932

Sue’s FICA tax was over-withheld by $5,568 for the year. So, how does she get that money back from the IRS?

Requesting a FICA Tax Refund (Multiple Employers)

A refund of the excess FICA tax does not automatically occur.  In the example above, if Sue identifies the FICA over withholding prior to filing her taxes for the year, she can recapture the excess withholding when she prepares her tax return (1040) for that tax year. The excess FICA withholding is applied as if it were excess federal income tax withholding.

If Sue does not identify the FICA excess withholding until after she has filed her taxes for the year, she could file IRS Form 843 to recover the excess FICA withholding.  Thankfully, it’s a very easy tax form to complete. Timing-wise, it may take the IRS 3 to 4 months to review and process your FICA tax refund.

Requesting A FICA Tax Refund (Single Employer)

The FICA tax refund process is slightly different for individuals who have only one employer.  Payroll mistakes will sometimes happen, causing an employer to over-withhold FICA taxes from an employee’s wages.  In these cases, the IRS requires you first to try to resolve the FICA excess withholding with your employer before submitting Form 843.  If resolving the FICA excess withholding is unsuccessful with your employer, you can file Form 843. 

Self-Employed FICA Tax Refund

For individuals who have both a W2 job and are also self-employed they can also experience these FICA overpayment situations.   Self-employed individuals pay both the employee portion of the FICA 7.65% and the employer portion of FICA 7.65%, for a total of 15.3% on their self-employment income up to the taxable wage base.

For self-employed individuals who are either sole proprietors or partners in a partnership or LLC, they typically do not have wages, so there is no direct FICA withholding as there is with W2 employees.  Self-employed individuals make estimated tax payments four times a year to cover both their estimated FICA and income tax liability.   If these individuals end up in a FICA overpayment situation due to W2 wages outside of their self-employment income, the overpayment can be applied toward their tax liability for the year or result in a refund from their self-employment income.  They typically do not need to file IRS Form 843. 

Note: S-Corp owners do have W2 wages

Requesting A Reduction In FICA Withholding

For employees that are in this two-employer situation, and they know they are going to have W2 wages over the taxable wage base, in a perfect world, they would be allowed to submit a request to one of their employers to either reduce or eliminate the social security portion of their FICA withholding to avoid the over withholding during the tax year.   However, this is not allowed.  Each employer is responsible for withholding the full 7.65% in FICA tax from the employee’s pay up to the taxable wage base, and this approach makes sense because each individual employer has no way of knowing what you earned in W2 wages at your other employers during the year.

3-Year Status of Limitations

If you are reading this article now, but you realize you have had excess FICA withholding for the past few years without requesting a refund, the IRS allows you to go back 3 years to request a refund of those excess FICA withholdings.  Anything over 3 years back and you are out of luck, the U.S. government thanks you for your additional donations to Social Security and Medicare trusts.

The Employer Does Not Get A Refund

FICA tax is paid by both the employee and the employer:

• Employee Social Security: 6.2%

• Employer Social Security: 6.2%

• Employee Medicare:  1.45%

• Employer Medicare:  1.45%

• Total FICA EE & ER:   15.3%

So if the employee works for 2 different companies, they have combined wages over the $160,200 taxable wage base, making them eligible for a FICA refund for the 6.2% of social security tax on wages paid over the wage base, does the EMPLOYER also get a refund for those excess FICA withholdings?

The answer, unfortunately, is “No”. 

If an employee works for 10 different companies and makes $100,000 in W2 wages with each company, each of those 10 employers would withhold the full FICA tax from that employee’s $100,000 in W2 wages, but since the employee had $1,000,000 in combined wages, they would be due a $52,067 refund in FICA wages ($1M - $160,200 x 6.2%). However, the government keeps that full 6.2% that was paid in by each of the 10 employers with no refund due to any of the companies. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Top 10 Things To Know About Filing A Tax Extension

There are a number of myths out there about filing a tax extension beyond the April 15th deadline.  Many taxpayers incorrectly assume that there are penalties involved or it increases their chances of being audited by the IRS.   In reality, filing for an extension can be a great way to give yourself more time to organize your financial documents, identify tax strategies to implement, and ensure that the information on your return is accurate. But before you file the extension, here are a few things you should know.......

1: You must file your extension by April 15th

To apply for an extension, you must file the appropriate paperwork by the April 15th filing deadline. However, filing for an extension does not extend the due date for payment of any taxes owed.

2: What is the extension deadline?

The tax extension filing due date for individual returns is October 15th in most years, but this can vary by a day or two each year, depending on what day of the week the tax deadline or extension deadline falls on.  If they fall on a Saturday, Sunday, or Holiday, the IRS will typically move the date to the next business date.

3: How do you file an extension?

You or your accountant can file your extension electronically.  This is the quickest and easiest way to file an extension.  If you prefer to file your extension by mail, you can do so by filling out Form 4868 and sending it to the IRS.

4: What if you owe taxes?

If you owe taxes, it’s important to remember that filing for an extension does not extend the due date for payment. At least 90% of the tax owed for the year must be paid with the extension.   Any remaining balance can be paid by the extended due date, although it will be subject to interest (not penalties).   If you do not pay at least 90% of the balance owed, then you will be subject to interest and late payment penalties until the tax is paid.

If you pay your taxes after April 15th but before October 15th, you may be subject to a "failure to pay" penalty. This penalty is typically 0.5% of the tax owed for each month that the taxes remain unpaid, up to a maximum of 25%.

If you pay your taxes after October 15th, the “failure to pay” penalty increases to 1% per month, up to a maximum of 25%. In addition, you may also be subject to a "failure to file" penalty of 5% per month, up to a maximum of 25%.

If you can't pay the taxes due by the April 15th deadline and don't file an extension, you may be subject to both the “failure to pay” and “failure to file” penalties. This can add up to a substantial amount, so it's important to file an extension if you can't pay your taxes by the April 15th due date.

5: What if you are due a refund?

It will not take longer for the IRS to process your refund, however since your return will be submitted at a later date, your refund will be received later than if the return was submitted by April 15th.

6: Are You More Likely To Get Audited By The IRS?

No, there is absolutely no correlation between the filing of an extension and audit risk.  However, filing an incomplete or incorrect tax return which necessitates the filing of an amended tax return, can increase your audit risk.

7: Do You Have To Give A Reason To File An Extension?

When you file for an extension, you don’t have to give a reason for why you need the extra time. The IRS will accept your extension request without question.

8: Do You Still Have To Make Estimated Tax Payments?

If you make estimated tax payments each year, filing an extension for the previous tax year, does not extend the due date of making your estimated tax payment for the current tax year on April 15th, June 15th, September 15th, and January 15th. 

The penalty for not making estimated tax payments is 4.5% of the unpaid taxes for each quarter that the taxes remain unpaid.

9: IRA Contribution Deadline

Even if you file an extension, IRA contributions must still be made by the April 15th tax deadline.

10: Extra Time To Make Contributions to Employer-Sponsored Retirement Plans

While putting your tax return on extension does not extend the IRA contribution deadline, it does extend the deadline for self-employed individuals making contributions to their employer-sponsored retirement plans, which are not due until a tax filing deadline plus extension.  This would include contributions to Simple IRAs, SEP IRAs, Solo(k), Cash Balance Plans, and employer contributions to 401(K) plans.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

The New PTET Tax Deduction for Business Owners

Above is our video about the PTET (pass-through entity tax) deduction which allows business owners to get around the $10,000 SALT cap that was put in place back in 2017.  The PTET allows the business entity to pay the state tax liability on behalf of the business owner and then take a deduction for that expense. This special tax deduction can save a business owner thousands of dollars in taxes. Currently, 31 states, including New York, have some form of PTET program.  In this video, Dave Wojeski & Michael Ruger will cover:

•  How the PTET deduction works?

• Which type of entities are eligible for the PTET deduction

• Deadlines for electing into the PTET program

• How the estimated tax payments are calculated and the deadlines for remitting them

• Changes to the PTET S-corp rules in 2022

• The new NYC PTET program available in 2023

• The challenges faced by companies that have multiple owners that are residents of different states

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Additional Disclosure: Wojeski & Company, American Portfolios and Greenbush Financial Group LLC are unaffiliated entities. Neither APFS nor its Representatives provide tax, legal or accounting advice. Please consult your own tax, legal or accounting professional before making any decisions.

401(K) Cash Distributions: Understanding The Taxes & Penalties

When an employee unexpectedly loses their job and needs access to cash to continue to pay their bills, it’s not uncommon for them to elect a cash distribution from their 401(K) account. Still, they may regret that decision when the tax bill shows up the following year and then they owe thousands of dollars to the IRS in taxes and penalties that they don’t have.   But I get it; if it’s a choice between working a few more years or losing your house because you don’t have the money to make the mortgage payments, taking a cash distribution from your 401(k) seems like a necessary evil.  If you go this route, I want you to be aware of a few strategies that may help you lessen the tax burden and avoid tax surprises after the 401(k) distribution is processed. In this article, I will cover:

• How much tax do you pay on a 401(K) withdrawal?

• The 10% early withdrawal penalty

• The 401(k) 20% mandatory fed tax withholding

• When do you remit the taxes and penalties to the IRS?

• The 401(k) loan default issue

• Strategies to help reduce the tax liability

• Pre-tax vs. Roth sources

Taxes on 401(k) Withdrawals

When your employment terminates with a company, that triggers a “distributable event,” which gives you access to your 401(k) account with the company.   You typically have the option to:

1. Leave your balance in the current 401(k) plan (if the balance is over $5,000)

2. Take a cash distribution

3. Rollover the balance to an IRA or another 401(k) plan

4. Some combination of options 1, 2, and 3

We are going to assume you need the cash and plan to take a total cash distribution from your 401(k) account. When you take cash distributions from a 401(k), the amount distributed is subject to:

• Federal income tax

• State income tax

• 10% early withdrawal penalty

I’m going to assume your 401(k) account consists of 100% of pre-tax sources; if you have Roth contributions, I will cover that later on.  When you take distributions from a 401(k) account, the amount distributed is subject to ordinary income tax rates, the same tax rates you pay on your regular wages.  The most common question I get is, “how much tax am I going to owe on the 401(K) withdrawal?”.  The answer is that it varies from person to person because it depends on your personal income level for the year.  Here are the federal income tax brackets for 2022:

Using the chart above, if you are married and file a joint tax return, and your regular AGI (adjusted gross income) before factoring in the 401(K) distribution is $150,000, if you take a $20,000 distribution from your 401(k) account, it would be subject to a Fed tax rate of 24%, resulting in a Fed tax liability of $4,800.  

If instead, you are a single filer that makes $170,000 in AGI and you take a $20,000 distribution from your 401(k) account, it would be subject to a 32% fed tax rate resulting in a federal tax liability of $6,400.

20% Mandatory Fed Tax Withholding Requirement

When you take a cash distribution directly from a 401(k) account, they are required by law to withhold 20% of the cash distribution amount for federal income tax.  This is not a penalty; it’s federal tax withholding that will be applied toward your total federal tax liability in the year that the 401(k) distribution was processed.   For example, if you take a $100,000 cash distribution from your 401(K) when they process the distribution, they will automatically withhold $20,000 (20%) for fed taxes and then send you a check or ACH for the remaining $80,000.  Again, this 20% federal tax withholding is not optional; it’s mandatory.

Here's where people get into trouble.  People make the mistake of thinking that since taxes were already withheld from the 401(k) distribution, they will not owe more.  That is often an incorrect assumption.  In our earlier example, the single filer was in a 32% tax bracket. Yes, they withheld 20% in federal income tax when the distribution was processed, but that tax filer would still owe another 12% in federal taxes when they file their taxes since their federal tax bracket is higher than 20%.   If that single(k) tax filer took a $100,000 401(k) distribution, they could own an additional $12,000+ when they file their taxes.

State Income Taxes

If you live in a state with a state income tax, you should also plan to pay state tax on the amount distributed from your 401(k) account.  Some states have mandatory state tax withholding similar to the required 20% federal tax withholding, but most do not. If you live in New York, you take a $100,000 401(k) distribution, and you are in the 6% NYS tax bracket, you would need to have a plan to pay the $6,000 NYS tax liability when you file your taxes.

 10% Early Withdrawal Penalty

If you request a cash distribution from a 401(k) account before reaching a certain age, in addition to paying tax on the distribution, the IRS also hits you with a 10% early withdrawal penalty on the gross distribution amount.  

Under the age of 55: If you are under the age of 55, in the year that you terminate employment, the 10% early withdrawal penalty will apply.

Between Ages 55 and 59½:   If you are between the ages of 55 and 59½ when you terminate employment and take a cash distribution from your current employer’s 401(k) plan, the 10% early withdrawal penalty is waived.   This is an exception to the 59½ rule that only applies to qualified retirement accounts like 401(k)s, 403(b)s, etc.   But the distribution must come from the employer’s plan that you just terminated employment with; it cannot be from a previous employer's 401(k) plan.   

Note: If you rollover your balance to a Traditional IRA and then try to take a distribution from the IRA, you lose this exception, and the under age 59½ 10% early withdrawal penalty would apply.  The distribution has to come directly from the 401(k) account.

Age 59½ and older:  Once you reach 59½, you can take cash distributions from your 401(k) account, and the 10% penalty no longer applies.    

When Do You Pay The 10% Early Withdrawal Penalty?  

If you are subject to the 10% early withdrawal penalty, it is assessed when you file your taxes; they do not withhold it from the distribution amount, so you must be prepared to pay it come tax time.  The taxes and penalties add up quickly; let’s say you take a $50,000 distribution from your 401(k), age 45, in a 24% Fed tax bracket and a 6% state tax bracket.  Here is the total tax and penalty hit:

Gross 401K Distribution:                $50,000

Fed Tax Withholding (24%)          ($12,000)

State Tax Withholding (6%)          ($3,000)

10% Penalty                                       ($5,000)

Net Amount:                                      $30,000

In the example above, you lost 40% to taxes and penalties. Also, remember that when the 401(k) platform processed the distribution, they probably only withheld the mandatory 20% for Fed taxes ($10,000), meaning another $10,000 would be due when you filed your taxes.

Strategies To Reduce The Tax Liability

There are a few strategies that you may be able to utilize to reduce the taxes and penalties assessed on your 401(k) cash distribution.

The first strategy involves splitting the distribution between two tax years. If it’s toward the end of the year and you have the option of taking a partial cash distribution in December and then the rest in January, that would split the income tax liability into two separate tax years, which could reduce the overall tax liability compared to realizing the total distribution amount in a single tax year. 

Note: Some 401(k) plans only allow “lump sum distributions,” which means you can’t request partial withdrawals; it’s an all or none decision. In these cases, you may have to either request a partial withdrawal and partial rollover to an IRA, or you may have to rollover 100% of the account balance to an IRA and then request the distributions from there.

The second strategy is called “only take what you need.”  If your 401(k) balance is $50,000, and you only need a $20,000 cash distribution, it may make sense to rollover the entire balance to an IRA, which is a non-taxable event, and then withdraw the $20,000 from your IRA account. The same taxes and penalties apply to the IRA distribution that applies to the 401(k) distribution (except the age 55 rule), but it allows the $30,000 that stays in the IRA to avoid taxes and penalties.

Strategy three strategy involved avoiding the mandatory 20% federal tax withholding in the same tax year as the distribution.  Remember, the 401(K) distribution is subject to the 20% mandatory federal tax withholding. Even though they're sending that money directly to the federal government on your behalf, it actually counts as taxable income.  For example, if you request a $100,000 distribution from your 401(k), they withhold $20,000 (20%) for fed taxes and send you a check for $80,000, even though you only received $80,000, the total $100,000 counts as taxable income.

IRA distributions do not have the 20% mandatory federal tax withholding, so you could rollover 100% of your 401(k) balance to your IRA, take the $80,000 out of your IRA this year, which will be subject to taxes and penalties, and then in January next year, process a second $20,000 distribution from your IRA which is the equivalent of the 20% fed tax withholding. However, by doing it this way, you pushed $20,000 of the income into the following tax year, which may be taxed at a lower rate, and you have more time to pay the taxes on the $20,000 because the tax would not be due until the tax filing deadline for the following year.

Building on this example, if your federal tax liability is going to be below 20%, by taking the distribution from the 401K you are subject to the 20% mandatory fed tax withholding, so you are essentially over withholding what you need to satisfy the tax liability which creates more taxable income for you.   By rolling over the money to an IRA, you can determine the exact amount of your tax liability in the spring, and distribute just that amount for your IRA to pay the tax bill.

Loan Default

If you took a 401K loan and still have an outstanding loan balance in the plan, requesting any type of distribution or rollover typically triggers a loan default which means the outstanding loan balance becomes fully taxable to you even though no additional money is sent to you.   For example, if You have an $80,000 balance in the 401K plan, but you took a loan two years ago and still have a $20,000 outstanding loan balance within the plan, if you terminate employment and request a cash distribution, the total amount subject to taxes and penalties is $100,000, not $80,000 because you have to take the outstanding loan balance into account.  This is also true when they assess the 20% mandatory fed tax withholding. The mandatory withholding is based on the balance plus the outstanding loan balance.  I mention this because some people are surprised when their check is for less than expected due to the mandatory 20% federal tax withholding on the outstanding loan balance. 

Roth 401(k) Early Withdrawal Penalty

401(k) plans commonly allow Roth deferrals which are after-tax contributions to the plan. If you request a cash distribution from a Roth 401(k) source, the portion of the account balance that you actually contributed to the plan is returned to you tax and penalty-free; however, the earnings that have accumulated on that Roth source you have to pay tax and potentially the 10% early withdrawal penalty on.   This is different from pre-tax sources which the total amount is subject to taxes and penalties.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

$7,500 EV Tax Credit: Use It or Lose It

Claiming the $7,500 tax credit for buying an EV (electric vehicle) or hybrid vehicle may not be as easy as you think.  First, it’s a “use it or lose it credit” meaning if you do not have a federal tax liability of at least $7,500 in the year that you buy your electric vehicle, you cannot claim the full $7,500 credit and it does not carryforward to future tax years.   Normally, most individuals and business owners adopt tax strategies to reduce their tax liability but this use it or lose it EV tax credit could cause some taxpayers to do the opposite, to intentionally create a larger federal tax liability, if they think their federal tax liability will be below the $7,500 credit threshold. 

There are several other factors that you also have to consider to qualify for this EV tax credit which include:

• New income limitations for claiming the credit

• Limits on the purchase price of the car

• The type of EV / hybrid vehicles that qualify for the credit

• Inflation Reduction Act (August 2022) changes to the EV tax credit rules

• Buying an EV in 2022 vs 2023+

• Tax documents that you need to file with your tax return

• State EV tax credits that may be available

Inflation Reduction Act Changes To EV Tax Credits

On August 16, 2022, the Inflation Reduction Act was signed into law, which changed the $7,500 EV Tax Credits that were previously available. The new law expanded and limited the EV tax credits depending on your income level, what type of EV car you want, and when you plan to buy the car.   Most of the changes do not take place until 2023 and 2024, so depending on your financial situation it may be better to purchase an EV in 2022 or it may be beneficial to wait until 2023+.

$7,500 EV Tax Credit

If you purchase an electronic vehicle or hybrid that qualifies for the EV tax credit, you may be eligible to claim a tax credit of up to $7,500 in the tax year that you purchased the car.  This is the government’s way of incentivizing consumers to buy electric vehicles.   The Inflation Reduction Act also opened up a new $4,000 tax credit for used EVs.

New Income Limits for EV Tax Credits

Starting in 2023, your income (modified AGI) will need to be below the following thresholds to qualify for the federal EV tax credits on a new EV or hybrid:

• Single Filers:                                 $150,000

• Married Filing Joint:                     $300,000

• Single Head of Household:           $225,000

There are lower income thresholds to be eligible for the used EV tax credit which is as follows:

• Single Filers:                                       $75,000

• Married Filing Joint:                        $150,000

• Single Head of Household:           $112,500

Before the passage of the Income Reduction Act, there were no income limitations to claim the $7,500 Tax Credit.  Taxpayers with incomes level above the new thresholds may have an incentive to purchase their new EV before December 31, 2022, before the income limitations take effect in 2023.

Restriction on EV Cars That Qualify

Not all EV or hybrid vehicles will qualify for the EV tax credit. The passage of the Inflation Reduction Act made several changes in this category. 

Removal of the Manufacturers Cap

On the positive side, Tesla and GM cars will once again be eligible for the EV tax credit.  Under the old EV tax credit rules, once a car manufacturer sold over 200,000 EVs, vehicles made by that manufacturer were no longer eligible for the $7,500 tax credit.  The new legislation that just passed eliminated those caps making Tesla, GM, and Toyota vehicles once again eligible for the credit.   The removal of the cap does not take place until January 1, 2023.

Purchase Price Limit

Adding restrictions, the Inflation Reduction Act introduced a cap on the purchase price of new EVs and hybrids that qualify for the $7,500 EV tax credit. The limit on the manufacturer’s suggested retail price is as follows:

• Sedans:                              $55,000

• SUV / Trucks / Vans:       $80,000

If the MSRP is above those prices, the vehicle no longer qualified for the EV tax credit.

Assembly & Battery Requirements

Another change was made to the EV tax credit under the new legislation that will most likely limit the number of vehicles that are eligible for the credit. The new law introduced a final assembly and battery component requirement. First, to be eligible for the credit, the final assembly of the vehicle needs to take place in North America. Second, the battery used to power the vehicle must be made up of key materials and consist of components that are either manufactured or assembled in North America.

Leases Do Not Qualify

If you lease a car, that does not qualify toward the EV tax credit because you technically do not own the vehicle, the manufacturer does. You have to buy the vehicle to be eligible for the $7,500 EV tax credit.

Are You Eligible For The EV Tax Credit?

Bringing everything together, starting in 2023, to determine whether or not you will be eligible for the $7,500 EV Tax Credit, you will have to make sure that:

1.  Your income is below the EV tax credit limits

2. The purchase price of the vehicle is below the EV tax credit limit

3. The vehicles assembly and battery components meet the new requirement

Once there is more clarification around the assembly and components piece of the new legislation there will undoubtedly be a website that lists all of the vehicles that are eligible for the $7,500 tax credit that you will be able to use to determine which vehicles qualify.

Timing of The Tax Credit

Under the current EV tax credit rule, you purchase the vehicle now, but you do not receive the tax credit until you file your taxes for that calendar year.   Starting in 2024, the tax credit will be allowed to occur at the point of sale which is more favorable for consumers.  Logistically, it would seem that an individual would assign the credit to the car dealer, and then the car dealer would receive an advance payment from the US Department of Treasury to apply the discount or potentially allow the car buyer to use the credit toward the down payment on the vehicle.

However, car buyers will have to be careful here.  Since your eligibility for the tax credit is income based, if you apply for the credit in advance, but then your income for the year is over the MAGI threshold, you may owe that money back to the IRS when you file your taxes. It will be interesting to see how this is handled since the credits are being awarded in advance.

A Use It or Lose It Tax Credit

There are going to be some challenges with the new EV tax credit rule beyond limiting the number of people that qualify and the number of cars that qualify.  The primary one is that the $7,500 EV federal tax credit is not a “refundable tax credit.”  A refundable tax credit means if your total federal tax liability is less than the credit, the government gives you a refund of the remaining amount, so you receive the full amount as long as you qualify.  The EV tax credit is still a “non-refundable tax credit” meaning if you do not have a federal tax liability of at least $7,500 in the year that you purchase the new EV vehicle, you may lose all or a portion of the $7,500 that you thought you were going to receive.

For example, let’s say you are a single tax filer, and you make $50,000 per year.   If you just take the standard deduction, with no other tax deductions, your federal tax liability may be around $4,200 in 2023.  You buy a new EV in 2023, you meet the income qualifications, and the vehicle meets all of the manufacturing qualifications, so you expect to receive $7,500 when you file your taxes for 2023.  However, since your federal tax liability was only $4,200 and the EV tax credit is not refundable, you would only receive a tax credit of $4,200, not the full $7,500.

No EV Tax Credit Carryforward

With some tax deductions, there is something called tax carryforward, meaning if you do not use the tax deduction in the current tax year, you can “carry it forward” to be used in future tax years to offset future income. The EV tax credit does not allow carryforward, if you can’t use all of it in the year of the EV purchase, you lose it.

Intentionally Creating Federal Tax Liability

If you are in this scenario where you purchase an EV but you expect your federal tax liability to be below the full $7,500 credit threshold, you may have to do what I call “opposite tax planning”. Normally you are trying to find ways to reduce your tax bill, but in these cases, you are trying to find ways to increase your tax liability to get the maximum refund from the government.  But how do you intentionally increase your tax liability? Here are a few ideas:

1. Stop or reduce the contributions being made to your pre-tax retirement accounts.   When you make pretax contributions to retirement accounts it reduces your tax liability.  But you have to be careful here, if your company offers an employer match, you could be leaving free money on the table, so you have to conduct some analysis here.  In many cases, 401(k) / 403(b) allows either pre-tax or Roth contributions.  If you are making pre-tax contributions, you may be able to just switch to Roth contributions, which are after-tax contributions, and still take advantage of the employer match.

2. Push more income into the current tax year. If you are a small business owner, you may want to push more income into the current tax year. If you are a W2 employee, you are expecting to receive a bonus payment, and you have a good working relationship with your employer, you may be able to request that they pay the bonus to you this year as opposed to the spring of next year.

3. Delay tax-deductible expenses into the following tax year. Again, if you are a small business owner and have control over when you realize expenses, you could push those into the following year.  For W2 employees, if you have enough tax deductions to itemize, you may want to push some of the itemized deductions into the following tax year.

4. Delay getting married until the following tax year. Kidding but not kidding. Nothing says I love you like a full $7,500 tax credit. Use it toward the wedding.  You may not qualify under the single file income limit but maybe you would qualify under the joint filer limit.  

State EV Tax Credit

The $7,500 EV tax credit is a federal tax credit but some states also have EV tax credits in addition to the federal tax credit and those credits could have different criteria to qualify. It’s worth looking into before purchasing your new or used EV.

EV Tax Credit Tax Forms

In 2022, you apply for the federal EV tax credit when you file your tax return.  You will have to file Form 8936 with your tax return.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Can You Contribute To An IRA & 401(k) In The Same Year?

The answer to this question depends on the following items:

• Do you want to contribute to a Roth IRA or Traditional IRA?

• What is your income level?

• Will the contribution qualify for a tax deduction?

• Are you currently eligible to participate in a 401(k) plan?

• Is your spouse covered by a 401(k) plan?

• If you have the choice, should you contribute to the 401(k) or IRA?

• Advanced tax strategy: Maxing out both and spousal IRA contributions

 Traditional IRA

Traditional IRA’s are known for their pre-tax benefits. For those that qualify, when you make contributions to the account you receive a tax deduction, the balance accumulates tax deferred, and then you pay tax on the withdrawals in retirement.   The IRA contribution limits for 2022 are:

Under Age 50:  $6,000

Age 50+:            $7,000

However, if you or your spouse are covered by an employer sponsored plan, depending on your level of income, you may or may not be able to take a deduction for the contributions to the Traditional IRA.  Here are the phaseout thresholds for 2022:

Note:  If both you and your spouse are covered by a 401(k) plan, then use the “You Are Covered” thresholds above.

BELOW THE BOTTOM THRESHOLD: If you are below the thresholds listed above, you will be eligible to fully deduct your Traditional IRA contribution

WITHIN THE PHASEOUT RANGE:  If you are within the phaseout range, only a portion of your Traditional IRA contribution will be deductible

ABOVE THE TOP THRESHOLD:  If your MAGI (modified adjusted gross income) is above the top of the phaseout threshold, you would not be eligible to take a deduction for your contribution to the Traditional IRA

 After-Tax Traditional IRA

If you find that your income prevents you from taking a deduction for all or a portion of your Traditional IRA contribution, you can still make the contribution, but it will be considered an “after-tax” contribution.  There are two reasons why we see investors make after-tax contributions to traditional IRA’s. The first is to complete a “Backdoor Roth IRA Contribution”.   The second is to leverage the tax deferral accumulation component of a traditional IRA even though a deduction cannot be taken.  By holding the investments in an IRA versus in a taxable brokerage account, any dividends or capital gains produced by the activity are sheltered from taxes.  The downside is when you withdraw the money from the traditional IRA, all of the gains will be subject to ordinary income tax rates which may be less favorable than long term capital gains rates. 

 Roth IRA

If you are covered by a 401(K) plan and you want to make a contribution to a Roth IRA, the rules are more straight forward.  For Roth IRAs, you make contributions with after-tax dollars but all the accumulation is received tax free as long as the IRA has been in existence for 5 years, and you are over the age of 59½.    Unlike the Traditional IRA rules, where there are different income thresholds based on whether you are covered or your spouse is covered by a 401(k), Roth IRA contributions have universal income thresholds.

 The contribution limits are the same as Traditional IRA’s but you have to aggregate your IRA contributions meaning you can’t make a $6,000 contribution to a Traditional IRA and then make a $6,000 contribution to a Roth IRA for the same tax year.  The IRA annual limits apply to all IRA contributions made in a given tax year.

 Should You Contribute To A 401(k) or an IRA?

 If you have the option to either contribute to a 401(k) plan or an IRA, which one should you choose?  Here are some of the deciding factors:

Employer Match:  If the company that you work for offers an employer matching contribution, at a minimum, you should contribute the amount required to receive the full matching contribution, otherwise you are leaving free money on the table.

Roth Contributions:  Does your 401(k) plan allow Roth contributions? Depending on your age and tax bracket, it may be advantageous for you to make Roth contributions over pre-tax contributions. If your plan does not allow a Roth option, then it may make sense to contribute pre-tax up the max employer match, and then contribute the rest to a Roth IRA.

Fees:  Is there a big difference in fees when comparing your 401(k) account versus an IRA?  With 401(k) plans, typically the fees are assessed based on the total assets in the plan.  If you have a $20,000 balance in a 401(K) plan that has $10M in plan assets, you may have access to lower cost mutual fund share classes, or lower all-in fees, that may not be available within a IRA. 

Investment Options:  Most 401(k) plans have a set menu of mutual funds to choose from.  If your plan does not provide you with access to a self-directed brokerage window within the 401(k) plan, going the IRA route may offer you more investment flexibility.

Easier Is Better:  If after weighing all of these options, it’s a close decision, I usually advise clients that “easier is better”.  If you are going to be contributing to your employer’s 401(k) plan, it may be easier to just keep everything in one spot versus trying to successfully manage both a 401(k) and IRA separately.

 Maxing Out A 401(k) and IRA

As long as you are eligible from an income standpoint, you are allowed to max out both your employee deferrals in a 401(k) plan and the contributions to your IRA in the same tax year.  If you are age 51, married, and your modified AGI is $180,000, you would be able to max your 401(k) employee deferrals at $27,000, you are over the income limit for deducting a contribution to a Traditional IRA, but you would have the option to contribute $7,000 to a Roth IRA.

Advanced Tax Strategy: In the example above, you are above the income threshold to deduct a Traditional IRA but your spouse may not be. If your spouse is not covered by a 401(k) plan, you can make a spousal contribution to a Traditional IRA because the $180,000 is below the income threshold for the spouse that is NOT COVERED by the employer sponsored retirement plan.  

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Kiddie Tax & Other Pitfalls When Gifting Assets To Your Kids

There are a number of reasons why parents gift assets to their kids which include:

•  Reduce tax liability

• Protecting assets from the nursing home

• Estate planning: Avoiding probate

But the pitfalls are many and most people do not find out about the pitfalls until it’s too late.  These pitfalls include:

•  Kiddie tax rules

• Children with self-directed investment accounts

• Treatment of long-term capital gains

• Gifting cost basis rules

• College financial aid impact

• Control of the assets

• 5 Year look-back rule

• Divorce

• Lawsuits

• Distributions from Inherited IRA’s

 Kiddie Tax

The strategy of shifting assets from a parent to a child on the surface seems like a clever tax strategy in an effort to shift investment income or capitals gains from the parent that may be in a high tax bracket to their child that is in a low tax backet.  Unfortunately, the IRS is aware of this strategy, and they have been aware of it since 1986, which is the year the “Kiddie Tax” was signed into law. 

Here is how the Kiddie tax works; if your child’s income is over a certain amount, then the income is taxed NOT at the child’s tax rate, but at the PARENT’S tax rate.  Kiddie tax rules do NOT apply to earned income which includes wages, salary, tips, or income from self-employment.   Kiddie tax ONLY applies to UNEARNED INCOME which includes:

•  Taxable interest

• Dividends

• Capital gains

• Taxable Scholarships

• Income produced by gifts from grandparents

• Income produced by UTMA or UGMA accounts

• IRA distributions  

 There are some exceptions to the rule but in general, your child would be subject to the Kiddie tax if they are:

•  Under the age of 19; or

• Between the ages of 19 and 23, and a full-time student

 The only exceptions that apply are if your child:

•  Has earned income totaling more than half the cost of their support; or

• Your child files their tax return as married filing joint

 Kiddie Tax Calculation

Here is how the Kiddie tax calculation works.  For 2022, the first $1,150 of a child’s unearned income is tax-free, the next $1,150 is taxed at the child’s rate, and any unearned income above $2,300 is taxed at the parent’s marginal income tax rate.

Here is an example, the parents bought Apple stock a long time ago and the stock now has a $30,000 unrealized long term capital gain.   Assuming the parents make $200,000 per year in income, if they sell the stock, they will have to pay the Federal 15% long term capital gains tax on the $30,000 gain.  But they have a child that is age 16 with no income, so they gift the stock to them, have them sell it, with the hopes of the child capturing the 0% long term cap gains rate since they have no income.  Kiddie tax is triggered!!   The first $2,300 would be tax free but the rest would be taxed at the parent’s federal 15% long term cap gain rate; oh and if that family was expecting to receive college financial aid two years from now, they might have just made a grave mistake because now that teenager is showing income.  A topic for later.

That was an example using long term capital gains rates but if we used a source of unearned income subject to ordinary income tax rates, the jump could go from an assumed 0% to the parents 37% tax rate if they are in the highest fed bracket.

Putting Your Kids on Payroll

While we are on the subject of Kiddie Tax, our clients that own small businesses will sometimes ask “Do I have to worry about the Kiddie tax if I put my kids on payroll through my company?”  Fortunately the answer is “No”.  Paying your child W2 wages through your company is considered “earned income” and earned income is not subject to the kiddie tax rules.

Children with Self-Directed Investment Accounts

It’s becoming more common for high school and college students to have their own brokerage accounts where they are trading stocks, ETFs, options, cryptocurrency, and mutual funds.  But the kiddie rules can come into play when they are buying and selling investments in their accounts. If the parents claim the child as a dependent on their tax return and they buy and then sell an investment within a 12 month period, that would create a short term gain subject to ordinary income tax rates. If that gain is above $2,300, then the kiddie tax is triggered, and the gain would be taxed at the parent’s tax rate not the child’s tax rate.  This can lead to tax surprises when the child receives the tax forms from the brokerage platform and then realizes there are big taxes due, and the child may or may not have the money to pay it. 

For the child to file their own tax return to avoid this Kiddie tax situation, the child must be earning enough income to provide at least half of their financial support.

Kiddie Tax Form 8615

How do you report the Kiddie tax on your tax return?  I spoke with a few CPA’s about this and they normally advise their clients that once the child has unearned income over $2,300, the child, even though they may be a dependent on your tax return, files their own tax return, and with their tax return they file Form 8615 which calculates the Kiddie Tax liability based on their parent’s tax rate.

 

Impact on College Financial Aid

Before gifting any assets to your child, income producing or not, if you are expecting to receive any form of need based financial aid for your child for college in the future, be very very careful.  The FAFSA calculation weighs assets and income differently depending on whether it belongs to the parent or the child.

For assets, if the parent owns it, the balance counts 5.64% against the aid awarded. If the child owns it, the balance counts 20% against the aid awarded.  You move a stock into your child’s name that is worth $30,000, if you would have qualified for financial aid, you just cost yourself $4,300 PER YEAR in financial aid.

Income is worse. If you gift your child an asset that produces income or capital gains, income of the parents counts 22% - 47% against college financial aid depending on the size of the household.  If the income belongs to the child, it counts 50% against the FAFSA award.  Another note, the FAFSA process looks back 2 years for purposes of determining the financial aid award, so even though they may only be a sophomore or junior in high school, you don’t find out about that mistake until 2 years later when they are applying for FAFSA as a freshman in college.

Long Term Capital Gains Treatment

The example that I used earlier with the Apple stock highlights another useful tax lesson.  If you are selling a stock, mutual fund, or investment property that you have owned for more than a year, it’s taxed at the preferential long term capital gain rate of 15% as long as your taxable income does not exceed $459,750 for single filers or $517,200 for married filing joint in 2022, it’s a flat 15% tax rate whether it’s a $20,000 gain or a $200,000 gain because the rate does not increase like it does for “earned income”.   I make this point because long term capital gain rates are already taxed at a relatively low rate, and if realized by your child, are subject to Kiddie tax so before you jump through all the hoops of making the gift, make sure the tax strategy is going to work.

Gift Cost Basis Rules

When you make a gift, it’s important to understand how the cost basis rules work.  When you make a gift, there typically is not an immediate tax event, but the recipient inherits your cost basis in that asset. Gifting an asset does not provide the person making the gift with a tax deduction or erase the unrealized gains, unless of course you are gifting it to a charity or not-for-profit.  Let’s keep running with that Apple stock example, you gift the Apple stock to your child with a $30,000 unrealized gain, there is no tax event when the gift is made, but if the child sells the stock the next day, they will have to pay tax on the $30,000 realized gain, and if the kiddie tax applies, it will be taxed at the parent’s tax rate.  

Estate Tax Planning: Avoid Probate

Sometimes people will gift assets to their kids in an effort to remove those assets from their estate to avoid probate, a big tax issue surfaces with this strategy.  Normally when someone passes away and their kids inherit a house or investments, they receive a “step-up in basis”.  A step-up in basis means no matter what the gain was in the house or investment prior to a person passing away, the cost basis to the person that inherits the assets is now the fair market value of that asset as of decedent’s date of death.

Example: You bought your house 20 years ago for $200,000 and it’s now worth $400,000.  If you were to pass away tomorrow and your kids inherit your house, they receive a step-up in basis to $400,000 so if they sell the house the next day, they have no tax liability. A huge tax benefit.

But if you gift the house to your kids while you are still alive in an effort to avoid the probate process, your kids now lose the step-up in cost basis because the house never passes through your estate.  If you kids sell your house the next day, they will realize a $200,000 gain and have to pay tax on it which at the Federal level of 15%, could cost them $30,000 in taxes which could have been avoided.

There are other ways to avoid probate besides gifting that asset to your kids which allows the asset to avoid the probate process and receive a step up in basis. You could setup a trust to own the asset or change the registration on the account to a “transfer on death” account.

Distributions From An IRA Owned By The Child

If your child inherits an IRA, they may be required to take RMD’s (required minimum distributions) each year from the IRA.  Distribution are not only subject to ordinary income tax but they are also subject to Kiddie tax since IRA distributions are considered unearned income.  If you child inherits a pre-tax IRA or 401(k) be very careful when taking distribution from the account, especially taking into consideration the new distribution rules for non-spouse beneficiaries.

Control of the Asset

As financial planners, we have seen a lot of crazy things happen.  While some teenagers are very responsible, others are not.  When you gift an asset directly to child, they may not use that gift as intended. Even with UTMA and UGMA account, the parents only have control until the child reaches age of majority, and then account belongs to them.  If there is any concern about how the gifted asset will be managed or distributed, you may want to consider a trust or another type of account that provides the you with more control of the asset.

Lawsuits

From a liability standpoint, if you gift assets to your child, and those assets have a meaningful amount of value, those assets could be exposed to a lawsuit if your child were to ever be sued.

Divorce

If you gift assets to your child and they are already married or get married in the future, depending on what state they live in or how those assets are titled, they could be considered marital property. If a divorce happens at some point in the future, their soon to be ex-spouse could now be entitled to a portion of those gifted assets.

5 Year Lookback Rule

Some parents will gift assets to their children to avoid the spend down process should a long term care event happen at some point in the future and they need to go into a nursing home.  Different states have different Medicaid rules but in New York, the gift has to take place 5 years prior to the Medicaid application otherwise the assets are subject to spend down.

The other pitfall of gifting assets to your children is that while you may be able to successfully protect those assets from a Medicaid lookback period, the cost basis issue that we discussed earlier still exists. If you gift the house to your kids, they inherit your cost basis, so when they go to sell the house after you pass, they have to pay tax on the full gain amount, versus if you established a grantor irrevocable trust to own your house, it could satisfy the gift for the 5 year look back period in NY, but then your kids receive a step up in basis when you pass away since the house passes through your estate, and they can sell the house with no tax liability. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

How To Pay 0% Tax On Capital Gains Income

When you sell a stock, mutual fund, investment property, or a business, if you have made money on that investment, the IRS is kindly waiting for a piece of that gain in the form of capital gains tax.  Capital gains are taxed differently than the ordinary income that you received via your paycheck or pass-through income from your business.   Unlike ordinary income, which has a series of tax brackets that range from 10% to 37% in 2022, capital gains income is taxed at a flat rate at the federal level.   Most taxpayers are aware of the 15% long term capital gains tax rate but very few know about the 0% capital gains tax rate and how to properly time the sale of your invest to escape having to pay tax on the gain. 

Short-term vs Long-Term Gains

Before I get into this tax strategy, you first have to understand the difference between “short-term” and “long-term” capital gains.  Short-term capital gains apply to any investment that you bought and sold in less than a 12 month period.  Example, if I buy a stock today for $1,000 and I sell it three months later for $3,000, I would have a $2,000 short-term capital gain.  Short-term capital gains are taxed as ordinary income like your paycheck. There is no special tax treatment for short-term capital gains and the 0% tax strategy does not apply.

Long-term capital gains on the other hand are for investments that you bought and then sold more than 12 months later.  When I say “investments” I’m using that in broad terms. It could be a business, investment property, stock, etc.   When you sell these investments at a gain and you have satisfied the 1 year holding period, you receive the benefit of paying tax on the gain at the preferential “long-term capital gains rate”.

What Are The Long Term Capital Gains Rates?

For federal tax purposes, there are 3 long term capital gains rates:  0%, 15%, and 20%.  What rate you pay is determined by your filing status and your level of taxable income in the year that you sold the investment subject to the long term capital gains tax. For 2022, below are the capital gains brackets for single filers and joint filers.

As you will see on the chart, if you are a single filer and your taxable income is below $41,675 or a joint filer with taxable income below $83,350, all or a portion of your long term capital gains income may qualify for the federal 0% capital gains rate.

An important note about state taxes on capital gains income is that each state has a different way of handling capital gains income. New York state is a “no mercy state” meaning they do not offer a special tax rate for long term capital gains. For NYS income tax purposes, your long term capital gains are taxed as ordinary income.  But let’s continue our story with the fed tax rules which are typically the lion share of the tax liability.

In a straight forward example, assume you live in New York, you are married, and your total taxable income for the year is $50,000.  If you realize $25,000 in long term capital gains, you will not pay any federal tax on the $25,000 in capital gain income but you will have to pay NYS income tax on the $25,000.

Don’t Stop Reading This Article If Your Taxable Income Is Above The Thresholds

For many taxpayers, their income is well above these income thresholds.  But I have good news, with some maneuvering, there are legit strategies that may allow you to take advantage of the 0% long term capital gains tax rate even if your taxable income is above the $41,675 single filer and $83,350 joint filer thresholds.  I will include multiple examples below as to how our high net worth clients are able to access the 0% long term capital gains rate but I first have to build the foundation as to how it all works. 

Using 401(k) Contributions To Lower Your Taxable Income

In years that you will have long term capital gains, there are strategies that you can use to reduce your taxable income to get under the 0% thresholds.  Here is an example, I had a client sell a rental property this year and the sale triggered a long term capital gain for $40,000.  They were married and had a combined income of $110,000.  If they did nothing, at the federal level they would just have to pay the 15% long term capital gains tax which results in a $6,000 tax liability.  Instead, we implemented the following strategy to move the $40,000 of capital gains into the 0% tax rate.

Once they received the sale proceeds from the house, we had them deposit that money to their checking account, and then go to their employer and instruct them to max out their 401(k) pre-tax contributions for the remainder of the year.  Since they were both over 50, they were each able to defer $27,000 (total of $54,000). They used the proceeds from the house sale to supplement the income that they were losing in their paychecks due to the higher pre-tax 401(k) deferrals.  Not only did they reduce their taxable income for the year by $54,000, saving a bunch in taxes, but they also were able to move the full $40,000 in long term capital gain income into the 0% tax bracket.  Here’s how the numbers work:

Adjusted Gross Income (AGI):      $110,000

Pre-tax 401(k) Contributions:         ($54,000)

Less Standard Deduction:              ($25,900)

Total Taxable Income:                     $30,100

In their case, they would be able to realize $53,250 in long term capital gains before they would have to start paying the 15% fed tax on that income ($83,350 – $30,100 = $53,250). Since they were below that threshold, they paid no federal income tax on the $40,000 saving them $6,000 in fed taxes.

“Filling The Bracket”

The strategy that I just described is called “filling the bracket”.  We find ways to reduce an individuals taxable income in the year that long term capital gains are realized to “fill up” as much of that 0% long-term capital gains tax rate that we can before it spills over into the 15% long-term capital gains rate.

More good news, it’s not an “all or none” calculation.  If you are married, have $60,000 in taxable income, and $100,000 in long term capital gains, a portion of your $100,000 in capital gains will be taxed at the 0% rate with the majority taxed at the 15% tax rate.  As you might have guessed the IRS is not going to let you get away with paying 0% on a $100,000 in long term capital gains because you maneuvered your taxable income into the 0% cap gain range. But in this case, $23,350 would be taxed at the 0% long term cap gain rate, and the reminder would be taxed at the 15% long term cap gain rate.

Do Capital Gains Bump Your Ordinary Income Into A Higher Bracket?

When explaining this “filling up the bracket” strategy to clients, the most common question I get is: “If long term capital gains count as taxable income, does that push my ordinary income into a higher tax bracket?”   The answer is “no”.  In the eyes of the IRS, capital gains income is determined to be earned “after” all of your other income sources.

In an extreme example, let’s say you have $70,000 in ordinary income and $200,000 in capital gains. If your total ordinary income was $70,000 and you file a joint tax return, your top fed tax bracket in 2022 would be 12%.  However, if the IRS decided to look at the $200,000 in capital gain income first and then put your ordinary income on top of that, your top federal tax bracket would now be 24%.  That would hurt tax wise. Luckily, it does not work that way.  Even if you realized $1M in long term capital gains, the $70,000 in ordinary income would be taxed at the same lower tax brackets since it was earned first in the eyes of the IRS.

Work With Your Accountant

Before I get into the more advanced strategies for how this filling up the brackets strategy is used, I cannot stress enough the importance of working with your tax advisor when executing these more complex tax strategies.  The tax system is complex and making a shift in one area could hurt you in another area.

Even though these strategies may lower the federal tax rate on your long-term capital gain income, capital gains will increase your AGI (adjusted gross income) for the year which could phase you out of certain deductions, tax credits, increase your Medicare premiums, reduce college financial aid, etc. Your accountant should be able to run tax projections for you in their software to play with the numbers to determine the ideal amount of long-term capital gains that can be realized in a given year without hurting the other aspects of your financial picture.

Strategy #1:  I’m Retiring

When people retire, in many cases, their taxable income drops because they no longer have their paycheck and they are typically supplementing their income with social security and distributions from their investment accounts.  This creates a tax planning opportunity because these taxpayers sometimes find themselves in the lowest tax bracket that they have been in over the past 30+ years.  Here are some of the common examples.

Example 1: The First Year Of Retirement

If you retire at the beginning of the calendar year, you may only have had a few months of paychecks, so your income may be lower in that year.  If you have built up cash in your savings account or if you have an after tax investment account that you can use to supplement your income for the remainder of the year to meet your expenses, this may create the opportunity to “fill up the bracket” and realize some long-term capital gains at a 0% federal tax rate in that year.

Example 2:  Lower Expenses In Retirement

We have had clients that were making $150,000 per year and then when they retire they only need $40,000 per year to live off of.  When you retire, the kids are typically through college, the mortgage is paid off, and your expenses drop so you need less income to supplement those expenses.   A portion of your social security will most likely be counted as taxable income but if you do not have a pension, you may have some wiggle room to realize a portion of your long-term capital gains as a 0% rate each year.

Assume this is a single filer. Here is how the numbers would work:

Social Security & IRA Taxable Income:     $40,000

Less Standard Deduction:                          ($12,000)

Total Taxable Income:                                $28,000

This individual would be able to realize $13,675 in long term capital gains each year at the 0% fed tax tax because the threshold is $41,675 and they are only showing $28,000 in taxable income.  Saving $2,051 in fed taxes.

Strategy #2:  Business Owner Experiences A Low Income Year

If you have been running a business for 5+ years, you have probably been through those one or two tough years where either revenue drops dramatically or the business incurs a lot of expenses in a single year, lowering your net profits.  Do not let these low taxable income years go to waste.  If you typically make $250,000+ per year and you have one of these low income years, start planning as soon as possible because once you cross that December 31st threshold, you have wasted a tax planning opportunity.  If you are showing no income for that year, you may want to talk to your accountant about realizing some long term capital gains in your brokerage account to realize those gains at a 0% tax rate.  Or you may want to consider processing a Roth conversion in that low tax year. There are a number of tax strategies that will allow you to make the most of that “bad year” income wise. 

Strategy #3: Leverage Cash Reserves and Brokerage Accounts

If you have been building up cash reserves or you have a brokerage account that you could sell some holdings without incurring big taxable gains, you may be able to use that as your income source for the year which could result in little to no taxable income showing for that tax year.  We have seen both retirees and business owners use this strategy.

Business owners have control over when expenses will be realized which influences how much taxable income is being passed through to the business owner.  If you can overload expenses into a single tax year instead of splitting it evenly between two separate tax years, that could create some tax planning opportunities.

Strategy #4: Moving To Another State

It’s common for individuals to move to more tax friendly states in retirement. If you live in a state now, like New York, that makes you pay tax on long term capital gain income, and you plan to move to Florida next year and change your state of domicile, you may want to wait to realize your capital gains until you are resident of Florida to avoid having to pay state tax on that income. This has nothing to do with the 0% Fed tax strategy but it might reduce your state income tax bill on those capital gains.

Bottom Line

There are few strategies that allow you to pay 0% in federal taxes on any type of gain.  If you are a high income earner, this strategy may not work for you every year but there may be opportunities to use them at some point if income drops or when you enter the retirement years.  Again, don’t let those lower income years go to waste. Work with your accountant and determine if “filling the bracket” is the right move for you. 

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Roth Conversions In Retirement

Roth conversions in retirement are becoming a very popular tax strategy.  It can help you to realize income at a lower tax rate, reduce your RMD’s, accumulate assets tax free, and pass Roth money onto your beneficiaries.   However, there are pros and cons that you need to be aware of, because processing a Roth conversion involves showing more taxable income in a given year. Without proper tax planning, it could lead to unintended financial consequences such as:

·         Social Security taxed at a higher rate

·         Higher Medicare premiums

·         Assets lost to a long term care event

·         Higher taxes on long term capital gains

·         Losing tax deductions and credits

·         Higher property taxes

·         Unexpected big tax liability

In this video, Michael Ruger will walk you through some of the strategies that he uses with his clients when implementing Roth Conversions. This can be a very effective wealth building strategy when used correctly.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

DISCLOSURE: This material is for informational purposes only. Neither American Portfolios nor its Representatives provide tax, legal or accounting advice. Please consult your own tax, legal or accounting professional before making any decisions. Any opinions expressed in this forum are not the opinion or view of American Portfolios Financial Services, Inc. and have not been reviewed by the firm for completeness or accuracy. These opinions are subject to change at any time without notice. Any comments or postings are provided for informational purposes only and do not constitute an offer or a recommendation to buy or sell securities or other financial instruments. Readers should conduct their own review and exercise judgment prior to investing. Investments are not guaranteed, involve risk and may result in a loss of principal. Past performance does not guarantee future results. Investments are not suitable for all types of investors