Financial Frontlines®

Forbes has an excellent article out on some major tax law changes coming up over the next three years…

Forbes Article

It talks about key changes in the following areas:

• Flexible Spending Accounts (FSA) restrictions on reimbursement for over-the-counter medications (2011) and setting a $2,500 cap on pre-tax contributions (2013).  Note that FSAs are not currently available for Active Duty military members, but available in most private sector companies and to other Federal employees.
• Expiration of the majority of the Bush-era tax cuts (2011)
• Significant increase in the “marriage penalty” for high-income dual wage-earner couples (2013)
• Increase in Medicare tax for high-income wage-earners (2013)
• Capital gains surtax that will affect interest, dividends, capital gains, rental income, royalties and other passive income (capital gains from the sale of a primary residence are exempt) (2013)
• Increase in the threshold of deductible medical expenses from 7.5% of AGI to 10% of AGI for those under 65 (2013).  The increase for those over 65 comes in 2016.

Some of the possible financial moves recommended include:

• Moving to muni-bonds for better after-tax yield on your interest-producing investments
• Taking capital gains in 2010 to benefit from the maximum 15% tax bracket currently in place
• Utilizing FSA accounts for things such as LASIK surgery, braces and other expensive items before the $2,500 cap becomes effective in 2013
• Doing a Roth IRA conversion this year

These changes are significant, since they will drive the top tax bracket on capital gains in 2013 to nearly 24% (a 58% increase from current levels) and take the top rate on interest, rent, royalties from 35% to over 43% (a 24% jump from current levels).  It is unclear which bucket dividend income will fall into at this time.

While most of these tax changes will have a mild-to-moderate impact on the Active Duty military member, the second career and fully retired face steep potential tax increases.  Make sure you consult your tax and financial advisor to see what the best moves for your specific situation are…

Forewarned is forearmed!

Phil Dyer, CFP®, RLP®, CPCC

The following is from a MOAA member who works with the IRS as a member of the Taxpayer Advocacy Panel or TAP.  He provides useful information that may help if you find the going tough during this tax season.  Enjoy.

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By:  JOHN S.S. KIM, LtCol, USAF (Retired), TAP Representative from Hawaii

The IRS wants to help you.  IT’S TRUE!!  As we rapidly approach the IRS deadline to file last year’s income taxes, the IRS wants to know of any problems you may have experienced, issues that may have arisen, or suggestions that you may have for improving the process.  In fact, there is a whole staff of IRS employees and volunteers from every state (including the District of Columbia and Puerto Rico) whose purpose is to receive, research, and resolve tax issues and suggestions.  That organization, the TAXPAYER ADVOCACY PANEL (TAP), serves as focus groups for the IRS providing input on strategic initiatives and providing a venue for raising issues identified by citizens.

While TAP does not directly work issues related to or requiring legislative or statutory changes, it has dealt with hard to use forms, confusing instructions, errors in computer processing, and with numerous suggestions to make filing easier for all citizens.

For more information, you can go to the TAP website at  http://www.improveirs.org/ or call the national toll-free phone number: 1-888-912-1227.

If you are interested in serving as a TAP member from your state, TAP will be conducting a new recruiting cycle from March 15 to April 30.  Information about application procedures and timelines are available on the website as well.

TAP want to help the IRS improve the tax filing processes.  To do that, we need input from you.  As you go through this year’s filing season, keep notes about things that didn’t seem to work right, frustrations that you encountered, and suggestions that you may have thought of.  Then, communicate those notes to the TAP.  Even better—apply to become a member of this federal organization whose sole existence is to help American citizens.

As current or former military members and families, we have all previously dedicated ourselves to service our country.  We are willing to contribute resources to keep America strong and free—and that includes paying our fair share of taxes.  The TAP is ready, willing, and able to help make that process better.

Every tax season the email scammers take flight.

Phishing. The most common form of scam is called phishing (fishing). These are emails that look like official IRS correspondence and direct you to either take an action off the email or route you to an artificial IRS web site. The objective is collecting your personal information. Don’t be fooled. The IRS does not email anyone. For details of known tax scams check out this real IRS site.

“Net Disability Exclusion.” Lately we have seen and heard about an email floating around that explains how you can recalculate your taxes to gain additional tax benefits from tax-free disability payments. The subject of the email is about the “Net Disability Exclusion” for military retired pay. We highly suggest you consult with a tax attorney, CPA or other tax specialist before you try this procedure.

While we are not tax specialists here at MOAA, we have researched this “Net Disability Exclusion” and believe the procedure to be a misinterpretation of the tax code. We found a letter from the IRS detailing this procedure and how the IRS finds it questionable. From our review, the procedure appears to either claim a tax benefit for a disability twice or seeks to claim a tax benefit for a Service rated disability the member doesn’t have. In the later case, these are typically people who have a VA rating but not a Service rating. Be careful.

Medicare.We are receiving many calls from retirees about their Social Security retirement payments decreasing. This payment decrease can be traced back to the increase in Medicare Part B premiums. Medicare Part B premium increases apply to higher income beneficiaries with a modified adjusted gross income greater than $85,000 for individuals and $170,000 for couples in 2008. The Part B premium increases also apply to new enrollees in Medicare-Social Security but you obviously don’t notice an premium increase since this is your going-in rate. If you don’t see a premium increase and the resulting decrease in your Social Security payment, you are one of the 75% of Medicare enrollees unaffected by this change because you didn’t meet the income requirement.

Retired Pay. The decrease in military retired pay for some continues to be a popular topic. This is due to the 2009 Stimulus Plan expiring. Last year retirees received a break (decrease) in your federal withholding tax in military retired pay. The withholding tax reduction expired for 2010 so the withholding taxes went back up. For most, this is around $17. That’s the cause of the decrease in retired pay. Chances are you didn’t see a change if you submitted a specific amount of withholding tax to your pay agent (DFAS for most) on an IRS form W-4. The increased withholding taxes are in the tax tables under the categories like “single” or “married filing jointly.” When you stipulate a category, your withholding is determined by the tax tables that changed due to the Stimulus Plan expiring.

Military Eligible for Income Tax Filing Extensions. If you serve outside the U.S. or in a combat zone, you qualify for extensions in filing your income taxes. For outside the U.S., you qualify for an extension if you are outside the U.S. on the due date of the return. You can receive a 2 month extension. If you want more time, file an IRS Form 4868 and check block 8 for out of the country for 4 more months. If you’re in a combat zone, you have an extension for the time served in the combat zone plus up to 180 days starting the day you leave the zone. You could qualify for a longer extension depending on when you left for the combat zone. Assessment and collection deadlines will be extended and you will not be charged interest or penalties attributable to the extension period. The deadline extensions also apply to individuals serving in the combat zone in support of the U.S. Armed Forces, such as merchant marines serving aboard vessels under the operational control of the Department of Defense, Red Cross personnel, accredited correspondents, and civilian personnel acting under the direction of the U.S. Armed Forces in support of those forces. Members of the U.S. Armed Forces who perform military service in an area outside a combat zone qualify for the extension of time provisions if their service is in direct support of military operations in the combat zone, and they receive special pay for duty subject to hostile fire or imminent danger as certified by the Department of Defense. You are able to notify IRS directly of your request for combat zone relief for extensions of deadlines through a special e-mail address: combatzone@irs.gov. For more info on these tax filing extensions see this IRS page.

In 2010 the IRS will remove the income limit on conversions from Nondeductible IRAs and Traditional IRAs to a ROTH IRA. We anticipate the tax law change to create a marked increase in conversion activity in 2010. Undoubtedly, savvy individuals and investment managers will take advantage of this opportunity to insulate themselves and their clients against possible future higher income tax rates. Previous to 2010, households with Modified Adjusted Gross Income (MAGI) exceeding $100k were ineligible to make conversions to ROTH IRAs. This change is welcomed news for those households who have been unable to invest in deductible Traditional IRAs or ROTH IRAs due to income limitations.

The Tax Increase Prevention and Reconciliation Act of 2005, signed into law on May 17, 2006, created the loophole which takes effect in 2010. To demonstrate the potential benefit of this loophole, a previous ineligible household who has not made contributions to an IRA this year could ultimately fund a ROTH IRA with $20k by April 15, 2010. That number increases to $24k for qualified wage earners, married filing jointly, and at least 50 years old. How can this be done? It’s really a simple process. First, establish a Nondeductible IRA and contribute $5k for each spouse for 2009 and again in 2010, then convert the balance into a ROTH IRA in 2010.

Washington’s unabated printing of the U.S. Dollar is setting the stage for future income tax increases. Policy makers have already zeroed in on those earning $250k/year and we anticipate that number to creep lower as spending continues and the deficit surges. The federal debt for Fiscal Year 2009 was $1.4 Trillion. Enacting a conversion strategy now and in future years (until Congress changes the law) enables investors to keep more of their hard earned money as converted ROTHs will provide tax free growth and tax free distributions (as long as distributions are qualified).

Conversions of Traditional IRAs to ROTHs may also be a timely option for those impacted by the current economic downturn. Individuals who have seen a drop in their personal income can benefit from converting their Traditional IRA to a ROTH in 2010 as well. Reduced income levels and low current tax rates equate to a lower tax bill if converted now as opposed to the future when personal incomes recover and tax rates increase. In addition to personal income levels, many retirement accounts have also seen a significant drop in value. Converting now makes sense, as lower current account values translates into lower tax liabilities. The market has rallied nicely this year and as it continues to recover and account balances increase all the gains made over the ensuing years will be tax free when withdrawn as qualified distributions. As if it couldn’t get any better, the IRS is providing an additional benefit in 2010 by extending the timeline for payment of taxes.

Conversions completed in 2010 can be paid over a two year period, reducing the immediate income tax burden for those who convert. This can help offset cash flow concerns for investors in these tough economic times. Understanding the three possible taxation methods is critical and must be reviewed to ensure proper calculation of tax liability. Taxation is based on the type of IRA accounts you own, Nondeductible, Traditional or a combination of both.

1. Investor owns only a Nondeductible IRA: Taxation is based on the gain above contribution. If the investor previous to this year did not own an IRA, he could apply the strategy outlined in paragraph two and incur only a minimal income tax liability, (gain above contribution) while fully funding a ROTH IRA for 2009 and 2010. This is a significant benefit for those who were previously ineligible and made no prior IRA contributions.
2. Individual owns only a Traditional IRA: The entire conversion amount is taxed at their income tax rate.
3. Individual has both a Traditional and Nondeductible IRAs: The balances of each type of account must be aggregated to determine the applicable income tax liability. Example, if an individual has $20k in Traditional IRAs and $10k in Nondeductible IRAs, 2/3 of the conversion amount would be subject to the individual’s income tax rate.

The decision of converting a Nondeductible and/or Traditional IRAs to a ROTH IRA is one that must be analyzed. There are numerous assumptions and planning factors that should be considered to make an informed decision. If one can foresee the future and know that they will be in a higher tax bracket in retirement then the tax free growth and tax free qualified withdrawals are a convincing option for conversion. One should thoroughly research the 2010 conversion tax laws and assess their personal circumstances prior to making a decision and/or seek professional assistance.

• Typically conversions will benefit those who anticipate being in a higher tax bracket in retirement
• IRA Conversions which have not been taxed are includible in your gross income in the year of conversion (Taxes on conversions made in 2010 can be paid over a 2 year period)
• If funds are not available to pay the taxes it is not advisable to use retirement funds to pay the taxes
• You MUST submit IRS Form 8606 for Non-deductible IRA contributions each year a contribution is made
• Converted ROTH can play an effective role in Estate planning for taxes and minimum withdrawals