Published December 8, 2007 in the North County Times
(This is the unedited version. The published article was shortened)
Does your 401(k) plan offer the new “Roth” feature?
This option allows you to start directing your payroll deductions into a Roth account instead of one that is pre-tax. Although you don’t receive a current deduction, distributions are all tax free including the earnings. If you believe that your traditional deferred retirement plan is already sufficiently funded, it makes sense to forego the deduction and shift to a Roth. How can any investment compete with the promise of earning income tax free for the rest of your life?
This addresses the problem of many who have been locked out of the Roth IRA option, because their incomes have been too high. High-income earners have been discriminated against in this regard as in so many other parts of the tax law. Now, the coveted Roth is available to many more workers.
Best of all, the matching 401(k) contributions, paid in by the employer, also go into the Roth account. Nevertheless, these are still deductible by the employer. Whether this was the intention or not, this has made possible “deductible Roth contributions” for the very first time. In a small business this is especially huge, since the owner is able to build his Roth account with partially tax-deductible contributions.
In fact, the ability to make Roth contributions is making many small employers rethink their use of the very popular SIMPLE alternative. SIMPLE plans were introduced back in 1997 as a way to allow small employers to offer voluntary retirement plans without a lot of complicated rules. Prior to that, small employers had trouble with setting up such a plan because 401(k) plans were just too complicated and a high level of employee participation was required.
Under a SIMPLE plan, each employee can stash away a total of $10,500 tax free, or $13,000 if they are fifty or older. These 2007 limits are not going up in 2008. The employer generally must kick in a 3% match, for employees who participate. There are no minimum participation rules and all employer contributions vest immediately, so that administration costs are usually minimal or free depending on whom you select as the financial institution.
Even though a SIMPLE plan is a good thing, you should consider if the “safe harbor 401(k)” is going to be better for you going into 2008. The “safe harbor 401(k)” works a lot like a SIMPLE plan but can be set up to allow Roth contributions. There are some additional costs involved. However, since a switch can only be done in January, you should consider the following additional reasons for doing so immediately, before that:
Similar rules allowing less participation- Like with the SIMPLE, you do not need a set percentage of employee participation. In fact, if you are the boss, you could be the only one involved. However, it does mean a higher employer match, generally 4%. As with the SIMPLE there is immediate vesting of employer contributions.
Higher limits- Here is another advantage for the 401(k) over the SIMPLE. 401Ks have always allowed a slightly more generous voluntary contribution. Lately, however, the divergence is becoming significant. For example, in 2007 and 2008, the voluntary contribution maxes out at $15,500 or $20,500 if 50 or over. This is close to 60% greater than that offered by SIMPLE plans and allows those able to do so to stash away more for their retirement.
The ability to do even more- A SIMPLE plan must stand alone. However, once you have a 401K plan, you can also add a “profit sharing plan”, which permits major additional employer contributions. If you are self-employed with no employees, the niftiest way to max out your retirement contributions is to set up a single member 401(k) plan plus a profit sharing plan. Packages that combine both are available from numerous financial institutions.
However you slice it, a 401(k) type of employee program is almost a required company benefit in order to attract and keep good workers. If your employer does not yet offer one, prod your boss to get on the stick.
Many thanks to Donna Neuhauser, APA, from Pensions Ltd in Escondido for help on this article.
Saturday, December 08, 2007
Thursday, November 29, 2007
Short sales raise tax questions
Published on 11/18/07 in the NCTimes
Do you owe more to your bank than your home is worth? You are not alone. In fact, falling prices and the need to sell are pushing many into foreclosure, with the banks taking over the properties. If you are facing this harsh situation, you may have been approached with the idea of a "short sale." A short sale involves negotiating with your bank to reduce the amount owed before completing a sale.
Before you consider this option, you need to be sure that you are not opening yourself up to a tax trap. One problem is that obtaining a reduction in your debt is considered income that stands all by itself. You must frequently report it as a separate transaction and will receive a 1099-C form reminding you of this.
The "C" refers to "cancellation." Unless you meet certain exceptions, such cancellation of debt is treated as ordinary taxable income.
One exception that allows you to dodge a tax hit resulting from a short sale comes into play if you are "insolvent" or in bankruptcy at the time of the sale. The IRS defines being insolvent as having total liabilities that exceed total assets after the debt is discharged.
Another exception is more technical. It hinges on whether or not the debt being canceled is "nonrecourse." Nonrecourse debt in California generally refers to debt used to buy your home. Having part of such debt canceled should not result in a tax problem. On the other hand, when you refinance and borrow funds against your home that are used for other purposes, it could change the nature of the debt so that it becomes recourse debt. It is somewhat rare to find a lender trying to enforce this recourse by going after the borrower's other assets, especially if it is a short sale. However, debt cancellation of recourse indebtedness may result in taxable income.
A short sale transaction may also interfere with being able to exclude a gain from the sale of your residence. Like others, you may have refinanced your home over the years, using the borrowed funds on autos or other personal expenses. The resulting debt may, as a result, far exceed the basis used to calculate a gain. Going through foreclosure generally means that you are selling the home for the total owed against the property. This could result in a capital gain, even though you do not receive funds. If you have owned your home and lived there for two out of the last five years, you should be able to exclude such a taxable gain of up to $250,000 if single and $500,000 if married.
In contrast, when there is a short sale that involves cancellation of recourse debt, the cancellation part of the transaction is treated separately and usually does not qualify for the gain exclusions associated with selling a home. A complicating issue comes up in cases where there is a second trust deed, since such secondary loans are generally wiped out without being considered part of the sale.
Unfortunately, if you lose money on the sale of your home, there is no tax benefit. You cannot deduct the loss or use it to offset the debt cancellation income. One reason that drives people into short sales is that they hope to salvage their credit. This makes sense, since having a foreclosure on your record is a serious issue. However, a short sale does not solve this issue completely, since most banks will not go this route unless you are already a few months behind on your payments. Your credit will be damaged regardless.
Nevertheless, in many cases, a short sale results in the lender granting a full release and satisfaction of the unpaid debt.
Winding its way through Congress and heavily supported by the nation's Realtors is the Mortgage Cancellation Tax Relief Act of 2007. This legislation would amend the Internal Revenue Code to exclude from gross income amounts attributable to a discharge of indebtedness incurred to acquire a principal residence. It seems to apply the rules already in effect in California to the rest of the country, and it does not seem to offer much help to those in California who are being squeezed right now.
Due to these rather confusing rules and frequently unexpected tax outcomes, it may be advisable to ride out the foreclosure process instead of entering into a short sale. In any case, you need to understand the tax effect before you act and to get solid tax advice to guide you through the land mines. Many thanks to Mark Larson of CaliforniaRealEstateSolutions.net for help on this article.
Do you owe more to your bank than your home is worth? You are not alone. In fact, falling prices and the need to sell are pushing many into foreclosure, with the banks taking over the properties. If you are facing this harsh situation, you may have been approached with the idea of a "short sale." A short sale involves negotiating with your bank to reduce the amount owed before completing a sale.
Before you consider this option, you need to be sure that you are not opening yourself up to a tax trap. One problem is that obtaining a reduction in your debt is considered income that stands all by itself. You must frequently report it as a separate transaction and will receive a 1099-C form reminding you of this.
The "C" refers to "cancellation." Unless you meet certain exceptions, such cancellation of debt is treated as ordinary taxable income.
One exception that allows you to dodge a tax hit resulting from a short sale comes into play if you are "insolvent" or in bankruptcy at the time of the sale. The IRS defines being insolvent as having total liabilities that exceed total assets after the debt is discharged.
Another exception is more technical. It hinges on whether or not the debt being canceled is "nonrecourse." Nonrecourse debt in California generally refers to debt used to buy your home. Having part of such debt canceled should not result in a tax problem. On the other hand, when you refinance and borrow funds against your home that are used for other purposes, it could change the nature of the debt so that it becomes recourse debt. It is somewhat rare to find a lender trying to enforce this recourse by going after the borrower's other assets, especially if it is a short sale. However, debt cancellation of recourse indebtedness may result in taxable income.
A short sale transaction may also interfere with being able to exclude a gain from the sale of your residence. Like others, you may have refinanced your home over the years, using the borrowed funds on autos or other personal expenses. The resulting debt may, as a result, far exceed the basis used to calculate a gain. Going through foreclosure generally means that you are selling the home for the total owed against the property. This could result in a capital gain, even though you do not receive funds. If you have owned your home and lived there for two out of the last five years, you should be able to exclude such a taxable gain of up to $250,000 if single and $500,000 if married.
In contrast, when there is a short sale that involves cancellation of recourse debt, the cancellation part of the transaction is treated separately and usually does not qualify for the gain exclusions associated with selling a home. A complicating issue comes up in cases where there is a second trust deed, since such secondary loans are generally wiped out without being considered part of the sale.
Unfortunately, if you lose money on the sale of your home, there is no tax benefit. You cannot deduct the loss or use it to offset the debt cancellation income. One reason that drives people into short sales is that they hope to salvage their credit. This makes sense, since having a foreclosure on your record is a serious issue. However, a short sale does not solve this issue completely, since most banks will not go this route unless you are already a few months behind on your payments. Your credit will be damaged regardless.
Nevertheless, in many cases, a short sale results in the lender granting a full release and satisfaction of the unpaid debt.
Winding its way through Congress and heavily supported by the nation's Realtors is the Mortgage Cancellation Tax Relief Act of 2007. This legislation would amend the Internal Revenue Code to exclude from gross income amounts attributable to a discharge of indebtedness incurred to acquire a principal residence. It seems to apply the rules already in effect in California to the rest of the country, and it does not seem to offer much help to those in California who are being squeezed right now.
Due to these rather confusing rules and frequently unexpected tax outcomes, it may be advisable to ride out the foreclosure process instead of entering into a short sale. In any case, you need to understand the tax effect before you act and to get solid tax advice to guide you through the land mines. Many thanks to Mark Larson of CaliforniaRealEstateSolutions.net for help on this article.
Foreclosure same as a sale for taxes
Published in the NCTimes on 11/11/07
For the first time in more than 13 years, we are seeing an increasing number of homeowners lose their homes in foreclosure. In fact, as recently reported in the North County Times, California led the nation in total foreclosure filings during the last quarter, showing as many as one filing for every 88 households. On top of all the financial stresses hitting you if you are going through this, there are some complicated tax consequences to deal with.
Essentially, a foreclosure is treated as a sale for tax purposes. Usually, a 1099 form will be issued to you and reported to the IRS, showing the gross proceeds of the sale. There is also an escrow closing statement produced, which shows the total value for which the house was transferred to the lender. This closing statement typically includes the unpaid taxes and interest that have accrued, as well as the principal balance of the loan at the point of transfer.
As the seller, you would generally total all of these "credits" and report this amount as the sales price of your property.
The immediate concern is to determine if there is a taxable gain. Even though the rules relating to the sale of a personal residence were changed in 1997, many taxpayers are not aware of how to apply these rules. As it stands, it is no longer necessary to buy another home or be older than 55 to exclude a gain. The crucial issue is that you need to own and live in your home for two out of the previous five years.
However, even this two-year rule can be bent a little if you are selling because of a job change or if you have other unusual circumstances. Since losing the financial ability to maintain a property has been found to be such an unusual circumstance, homeowners who lose their homes to foreclosure should be able to exclude up to $500,000 in gain if married and $250,000 if single.
Sadly, capital losses resulting from the sale of your home are not deductible.
Unfortunately, in an environment of rising home prices and frequent refinancing, it is possible to have a gain from foreclosure that far exceeds the excludible gains discussed above ---- $500,000 is not as much as it once was, and the limits have not been adjusted for inflation. To make sure you don't pay unnecessary taxes when you sell, it is important for you to keep track of the "basis," which is, generally the cost of your home. This would include the initial purchase price and all of the improvements during the time that the home is owned. If the original purchase followed a gain on a previous home that was deferred under pre-1997 rules, this will further lower your basis and increase the potential gain.
There could be a surprising tax benefit to having your home foreclosed upon.If you are in this fix, you have probably stopped paying interest and property taxes for a while. During foreclosure, these expenses that have been deferred end up being paid by the lender. The strange result is that even though you lose your home and have not been paying the taxes or interest in cash, you may still be able to claim these items as itemized deductions.Instead of going the foreclosure route, you may be considering a "short sale" to save your credit. I will discuss this in my next column, which will appear next Sunday.
For the first time in more than 13 years, we are seeing an increasing number of homeowners lose their homes in foreclosure. In fact, as recently reported in the North County Times, California led the nation in total foreclosure filings during the last quarter, showing as many as one filing for every 88 households. On top of all the financial stresses hitting you if you are going through this, there are some complicated tax consequences to deal with.
Essentially, a foreclosure is treated as a sale for tax purposes. Usually, a 1099 form will be issued to you and reported to the IRS, showing the gross proceeds of the sale. There is also an escrow closing statement produced, which shows the total value for which the house was transferred to the lender. This closing statement typically includes the unpaid taxes and interest that have accrued, as well as the principal balance of the loan at the point of transfer.
As the seller, you would generally total all of these "credits" and report this amount as the sales price of your property.
The immediate concern is to determine if there is a taxable gain. Even though the rules relating to the sale of a personal residence were changed in 1997, many taxpayers are not aware of how to apply these rules. As it stands, it is no longer necessary to buy another home or be older than 55 to exclude a gain. The crucial issue is that you need to own and live in your home for two out of the previous five years.
However, even this two-year rule can be bent a little if you are selling because of a job change or if you have other unusual circumstances. Since losing the financial ability to maintain a property has been found to be such an unusual circumstance, homeowners who lose their homes to foreclosure should be able to exclude up to $500,000 in gain if married and $250,000 if single.
Sadly, capital losses resulting from the sale of your home are not deductible.
Unfortunately, in an environment of rising home prices and frequent refinancing, it is possible to have a gain from foreclosure that far exceeds the excludible gains discussed above ---- $500,000 is not as much as it once was, and the limits have not been adjusted for inflation. To make sure you don't pay unnecessary taxes when you sell, it is important for you to keep track of the "basis," which is, generally the cost of your home. This would include the initial purchase price and all of the improvements during the time that the home is owned. If the original purchase followed a gain on a previous home that was deferred under pre-1997 rules, this will further lower your basis and increase the potential gain.
There could be a surprising tax benefit to having your home foreclosed upon.If you are in this fix, you have probably stopped paying interest and property taxes for a while. During foreclosure, these expenses that have been deferred end up being paid by the lender. The strange result is that even though you lose your home and have not been paying the taxes or interest in cash, you may still be able to claim these items as itemized deductions.Instead of going the foreclosure route, you may be considering a "short sale" to save your credit. I will discuss this in my next column, which will appear next Sunday.
Fire loss can affect Income Taxes
Published in the NCTimes on 11/03/07
Like many other local residents, you may have suffered losses as a result of the fires that have struck our region over the last few weeks. If so, you need to understand how your loss and this being declared a federal disaster could affect your income taxes.Potentially the most critical tax issue kicks in if you are paid more by your insurance company than the tax basis (generally, the cost) of your property.
In that case, you should spend all of the insurance proceeds to rebuild and replace the property. Reinvesting in this way will usually eliminate any tax issues relating to gains from the insurance proceeds. Being in a federal disaster area means that you have at least four years to reinvest.
Of course, many taxpayers had losses other than their homes, including vehicles, furniture and other items. Whatever it is that you have lost will be considered a casualty loss and may result in a tax deduction.Here is how this works. First, you need to determine the fair market value and the cost of that which you lost and use the lower number. Form 4684 is used to calculate your loss. This form will direct you to subtract $100 and any insurance proceeds. You must then reduce your loss further by 10 percent of your adjusted gross income. Finally, you will need to carry the remaining loss to Schedule A, where it is treated as an itemized deduction. It only helps if you itemize.
Obviously, overcoming these various thresholds stops most people from claiming a casualty loss unless it is significant.Once you determine that you do have a deductible casualty loss as a result of the recent fires, you have a choice. Since this was a federally declared disaster, you will be able to claim the loss either on your 2007 return or on an amended 2006 tax return. The idea is to get a tax refund back to you as soon as possible. Since it is near time to file for 2007, you may want to wait and be sure that you claim the deduction in the year that will result in the best tax advantage.
Unfortunately, you cannot claim any loss until you know the final settlement.If you are a business owner or investor, you may be able to take advantage of a special recent tax provision that applies only to those in a federally declared disaster. It allows you to use your insurance proceeds to buy other types of property used in any productive trade or business. For example, an avocado farmer could use the insurance proceeds from the loss of his grove to start a pizza parlor.
The most distressing scenario is for those who bought their homes long ago and were underinsured when the fire struck. Over and above experiencing a devastating casualty loss, they will not have any tax relief, either. This disaster is causing many of us to dig up our homeowners policies and to make sure that we have adequate insurance coverage. It is also a reminder to maintain good records that include costs and photographic or video evidence of the many things that we own. Keeping this documentation safely off-site is essential.
Like many other local residents, you may have suffered losses as a result of the fires that have struck our region over the last few weeks. If so, you need to understand how your loss and this being declared a federal disaster could affect your income taxes.Potentially the most critical tax issue kicks in if you are paid more by your insurance company than the tax basis (generally, the cost) of your property.
In that case, you should spend all of the insurance proceeds to rebuild and replace the property. Reinvesting in this way will usually eliminate any tax issues relating to gains from the insurance proceeds. Being in a federal disaster area means that you have at least four years to reinvest.
Of course, many taxpayers had losses other than their homes, including vehicles, furniture and other items. Whatever it is that you have lost will be considered a casualty loss and may result in a tax deduction.Here is how this works. First, you need to determine the fair market value and the cost of that which you lost and use the lower number. Form 4684 is used to calculate your loss. This form will direct you to subtract $100 and any insurance proceeds. You must then reduce your loss further by 10 percent of your adjusted gross income. Finally, you will need to carry the remaining loss to Schedule A, where it is treated as an itemized deduction. It only helps if you itemize.
Obviously, overcoming these various thresholds stops most people from claiming a casualty loss unless it is significant.Once you determine that you do have a deductible casualty loss as a result of the recent fires, you have a choice. Since this was a federally declared disaster, you will be able to claim the loss either on your 2007 return or on an amended 2006 tax return. The idea is to get a tax refund back to you as soon as possible. Since it is near time to file for 2007, you may want to wait and be sure that you claim the deduction in the year that will result in the best tax advantage.
Unfortunately, you cannot claim any loss until you know the final settlement.If you are a business owner or investor, you may be able to take advantage of a special recent tax provision that applies only to those in a federally declared disaster. It allows you to use your insurance proceeds to buy other types of property used in any productive trade or business. For example, an avocado farmer could use the insurance proceeds from the loss of his grove to start a pizza parlor.
The most distressing scenario is for those who bought their homes long ago and were underinsured when the fire struck. Over and above experiencing a devastating casualty loss, they will not have any tax relief, either. This disaster is causing many of us to dig up our homeowners policies and to make sure that we have adequate insurance coverage. It is also a reminder to maintain good records that include costs and photographic or video evidence of the many things that we own. Keeping this documentation safely off-site is essential.
Thursday, January 04, 2007
HSAs should be considered
Published January 5, 2007
The Republican Congress delivered one last gift before turning over the ship to Democrats in 2007. Unexpectedly, they enhanced the Health Savings Accounts (HSAs) in ways that make them more attractive.
HSAs are strange animals. At a basic level, they are designed to allow many taxpayers the ability to make virtually all health care expenses tax-deductible. However, HSAs can also act as exceptional retirement saving vehicles.
Anyone who has a qualifying high deductible health insurance policy can now set up an HSA fund, deduct what they invest and pull the money out tax free as medical expenses arise. If you are an employer, buying a high deductible policy for your employees is generally more affordable. It also allows them to invest in an HSA on their own. If you prefer to invest in the HSA for them, you will need to do it for everyone.
The new law allows health insurance policies that have deductibles much lower than in the past, such as about a thousand dollars, to qualify for large HSA contributions. For 2007, the maximum annual contributions are $2,850 for singles and $5,650 for families and even more if you are over fifty-five. All kinds of investment options are available for this money and you are free to choose where you want it invested.
While there are obvious advantages for those who need to use these funds to pay for medical expenses now, the real story is what HSAs can do for those who can leave the money alone. For these fortunate taxpayers, HSAs act very much like supercharged ROTH IRAs. However, unlike Roth accounts, even high-income taxpayers are eligible.
Since a major fear going into retirement is unexpected or expensive health care costs, building up an HSA account can provide a valuable retirement defense fund. Since this option will be available only for those with extra money to invest, it was a surprise that Democrats supported it in the waning days of a Republican Congress.
Our liberal California legislature has been more predictable. The deduction for investing in an HSA is not allowed on the California return and income drawn out is taxable. This complexity makes HSAs less popular here than in the rest of the country.
However, you should consider this, especially if you have the means to leave the money untouched for the long haul.
The Republican Congress delivered one last gift before turning over the ship to Democrats in 2007. Unexpectedly, they enhanced the Health Savings Accounts (HSAs) in ways that make them more attractive.
HSAs are strange animals. At a basic level, they are designed to allow many taxpayers the ability to make virtually all health care expenses tax-deductible. However, HSAs can also act as exceptional retirement saving vehicles.
Anyone who has a qualifying high deductible health insurance policy can now set up an HSA fund, deduct what they invest and pull the money out tax free as medical expenses arise. If you are an employer, buying a high deductible policy for your employees is generally more affordable. It also allows them to invest in an HSA on their own. If you prefer to invest in the HSA for them, you will need to do it for everyone.
The new law allows health insurance policies that have deductibles much lower than in the past, such as about a thousand dollars, to qualify for large HSA contributions. For 2007, the maximum annual contributions are $2,850 for singles and $5,650 for families and even more if you are over fifty-five. All kinds of investment options are available for this money and you are free to choose where you want it invested.
While there are obvious advantages for those who need to use these funds to pay for medical expenses now, the real story is what HSAs can do for those who can leave the money alone. For these fortunate taxpayers, HSAs act very much like supercharged ROTH IRAs. However, unlike Roth accounts, even high-income taxpayers are eligible.
Since a major fear going into retirement is unexpected or expensive health care costs, building up an HSA account can provide a valuable retirement defense fund. Since this option will be available only for those with extra money to invest, it was a surprise that Democrats supported it in the waning days of a Republican Congress.
Our liberal California legislature has been more predictable. The deduction for investing in an HSA is not allowed on the California return and income drawn out is taxable. This complexity makes HSAs less popular here than in the rest of the country.
However, you should consider this, especially if you have the means to leave the money untouched for the long haul.
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