Financial Frontlines®

Do you have cash value in a life insurance policy or a commercial deferred annuity and own a long term care policy? If so, it may be possible for you to use the money in your life insurance or annuity to pay for your long term care insurance without paying taxes on the life insurance or annuity withdrawal.

Normally the withdrawal of funds from life insurance cash value or a deferred annuity triggers a taxable event. The portion of the withdrawal that’s considered the ‘gain’ is taxable as ordinary income.

Section 1035 of the Tax Code has always allowed tax-free exchanges of entire life insurance and annuity policies; even tax-free partial payments between life insurance policies and annuity contracts. However, now an enhancement to Section 1035 took effect on 1 Jan 2010 that added long term care policies to the mix.

This means money from the cash value in life insurance policies or deferred annuities can be withdrawn and used to pay premiums of long term care insurance without causing a taxable event.

Keep in mind, we talking tax code here so there are catches. There are so many different types of life insurance, annuities and long term care policies that not all of them qualify. Only your insurance provider, or possibly your financial advisor, knows for sure. Retirement accounts don’t qualify—annuities within an IRA or an annuity form of pension plan.

If your policies are eligible, the transfer must be worked between the two insurance companies. They know the process and paperwork and the transaction has to be a direct transfer from one company to the other.

Besides U.S. Code Title 26, Section 1035 of the tax code, also see IRS Internal Revenue Bulletin, 2011-36, Sept 6, 2011. Your long term care insurance provider will probably be your best bet for information and action.

This content is provided courtesy of USAA.

Let’s face it — the American tax system isn’t known for its simplicity. And the confusion factor just climbs higher when you lived or worked in more than one state during the year.

To help out, we’ve tracked down the answers to some of the most common cross-state questions. As you ponder your situation, remember that seven states have no income tax at all: Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming.

1. What if I lived in two different states during the year?
In most cases, you have to file tax returns in each state in which you earned income.

2. What if I live in one state and work in another?
You’ll probably have to file a tax return in both states. Your state of residency usually taxes all your earned income — no matter where you earned it. Meanwhile, states where you worked but didn’t live usually require a non-resident income tax return. Fortunately, your resident state will often give you a credit for the taxes you pay to other states.

3. Where do active duty military service members file?
Generally speaking, military personnel are subject to tax in their “home of record,” which is the state where they resided at the time of their enlistment or commissioning. You may be able to establish a new home of record by taking actions there like:

• Establishing a permanent address.
• Registering to vote.
• Registering your vehicle.
• Getting a driver’s license.

Under federal law, states are prohibited from taxing the military income of nonresident service members who are stationed in their states. Note, this protection only applies to military income. If you also have a nonmilitary job, you’ll be subject to paying resident state income taxes on those wages.

4. Where do military spouses pay taxes?
Until 2009, they were usually subject to taxes in the state where their spouse was stationed. Thanks to the Military Spouse Residency Relief Act, however, they can now choose to be treated as if they still lived in their previous state. That could make them eligible for a state income tax refund. If they had taxes withheld, they could file a state return to claim it.

5. Can I deduct state income taxes on my federal return?
Yes, but only if you itemize your deductions. You may also deduct real estate taxes, personal property taxes and state and local sales tax on your federal tax return.

6. What’s the simplest way to sort all this out?
Using an automated tax preparation program can make it a lot easier. USAA members enjoy a 25% discount on TurboTax, which can help you complete your federal tax return and returns for the states in which you’re obligated to pay taxes.

USAA or its affiliates do not provide tax advice. Taxpayers should seek advice based upon their own particular circumstances from an independent tax advisor.
Intuit Inc. is not affiliated with USAA and is solely responsible for the provided information and content. USAA cannot guarantee that the information and content supplied is accurate, complete, or timely, and does not make any warranties with regard to the results obtained by its use. Quicken TurboTax for the Web is a service mark and Quicken and TurboTax are registered trademarks of Intuit Inc., and are used with permission.

A lot of the readers of this blog are military members or retired military members.  For those who have or will retire from the military there is a potential tax issue you will need to resolve.  This issue comes from the fact that VA Disability Benefits are often awarded retroactively to a prior date.  To my experience, 99.99% of those us who do receive VA Disability Benefits, will receive them retroactively.  And if that is the case, that means your taxes are/will be messed up.  Here is what to do about your situation.

First the good news.  You have the right to reduce your military retirement income by the amount that your pay should have been reduced if your VA Disability Benefits would have started on time.  This right was established by the courts in the Strickland decision (Strickland v Commissioner, 4th Cir. 1976) and is codified in Revenue Rule 78-161.  That is about the end of the good news.

Now, the bad news.  You are going to get little to no “automatic” help to do this.  You won’t receive and updated 1099-R.  You might get a note from the VA saying that you have rights under the Strickland Decision.  You won’t get a notice from the IRS letting you know you overstated your income in a prior year due to the VA offset not being taken.  So, you are going to have to do this yourself or bring in a pro from Dover.

What needs to be done?

If you were awarded retroactive VA benefits in 2011 you will need to adjust the amount on your 1099-R by the reduction that should have occurred and use the adjusted amount on your tax return.  If you are like me, you’ll need to do two separate calculations, as I had to prove my sons were in college to get an increase in the Disability payment amount.  So I had a period where the offset was correct, a period where the offset was too little and a period of where there was no offset.  Now, when you file your return you’ll have to decide whether you want to e-file or not.  I’m not 100% sure, but I think your return will go through.  But your 1099-R and your tax return won’t agree and this could trigger an audit or at least some questions.  The other option is to file on paper, include a letter explaining that you reduced your 1099-R income IAW Rev Rul 78-161 and also include a copy of the letter from the VA establishing your retroactive benefits (including your 214 might not hurt either).  Easy, right?

If your retroactive benefits span two years (for example you retired in 2010 and didn’t get a determination until 2011) you’ll have to decide if it is worth your time to try to get the refund that is probably due.  If you are rated more than 50% disabled, the tax benefit may be small and you might want to just let it go.  If you are rated less than 50% disabled it may be worth your time.  What you will do in this case is file an IRS Form 1040X (amended tax return) changing your retirement income to reflect the offset that should have been taken.  Then include all the documentation mentioned above.  Even easier…

So the bottom line is: when you get retroactive VA Disability Benefits, you have the right to retroactively reduce your income.  But you’re going to have to do it yourself or hire someone to do it for you.

If you deployed to a combat zone in 2011 you may have a unique opportunity to get a larger than normal tax refund this year.  You might even be able to get a refund larger than what you had deducted from you paycheck.  How is that?  It involves the Earned Income Tax Credit (EITC).

The EITC is a tax credit that has been around for quite a few years…back to the seventies in one form or another.  The purpose of the EITC is to help low to moderate earners.  The IRS says its purpose is to provide an incentive to work by helping to defray the costs of Social Security and Medicare taxes paid by all wage earners.  The EITC is substantial too.  The maximum EITC is $5,751 and remember since the EITC is a refundable credit you could get that amount back even if you had zero withheld from your military pay and owed zero tax.

Not everyone will qualify for the EITC.  Here are some of the criteria:

1. The taxpayer must have less than $3,150 in investment income
2. The taxpayer must have Earned Income
3. The taxpayer must be at least 25 and younger than 65
4. The taxpayer can not file as Married Filing separately
5. The taxpayer’s Earned Income must be below certain limits (2011)
   1. With 3 or more qualifying children your Adjusted Gross Income (AGI) must be less than $49,078 for Married Filing Jointly (MFJ) or $43,998 for all others (Single, Head of Household, Qualifying Widow)
   2. With 2 qualifying children your AGI must be less than $46,044 for MFJ or $40,964 for all others
   3. With 1 qualifying child your AGI must be less than $41,132 for MFJ or $36,052 for all others
   4. With no children your AGI must be less than $18,740 for MFJ or $13,660 for all others

As mentioned above the credit can be substantial.  The maximum credit amounts are:

1. $5,751 for 3 or more qualifying children
2. $5,112 for two qualifying children
3. $3,094 for one qualifying child
4. $464 for no children

One other thing to keep in mind with the EITC is it starts low at low income levels; then increases as income increases and levels off on a plateau; it then decreases with increasing income until reaching zero at the income limits listed above.  This is an important point.

So, what does this all have to do with Combat Pay?  As I’m sure most readers are aware, Combat Pay is not included in your income on your W-2 and it is not taxable. But in a rarity for the IRS, you are allowed to decide whether you want to include your Combat Pay when you calculate your EITC.  You must include all or none of your Combat Pay in the calculation but regardless of what you decide the Combat Pay will not be included as taxable income.

You can use this option to your advantage as follows;

1. If you are an Officer or Senior NCO most likely you will want to exclude your Combat Pay from the EITC calculation.  Depending on how much of 2011 you were deployed in the combat zone your Earned Income may be low enough to qualify for some or all of the EITC.
2. For those more junior, including Combat Pay in the EITC calculation may actually increase your refund (remember the plateau).  Again, it will depend on your rank and how long you were in the combat zone.

No one is required to pay more tax than what is owed and there is nothing unpatriotic about reducing your taxes.  If you deployed to a combat zone in 2011 for an extended time the odds are favorable that you will be able to qualify for the EITC when you file this year.  Don’t miss the opportunity.

IRS CIRCULAR 230 NOTICE: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed in this communication

This content is provided courtesy of USAA.

Make sure you understand the financial realities of divorce. You may feel 110% ready to divorce, but have you considered the financial implications of splitting up?

“When people are thinking about divorce, many are just ready to get out at any cost. That is exactly the wrong attitude to have. You have to plan carefully,” says June Walbert, a CERTIFIED FINANCIAL PLANNER™ practitioner with USAA. “In virtually every divorce, there is a major lifestyle change. You have to keep in mind the financial ramifications for today as well as for decades to come.”

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The Right Paperwork

If you’re splitting funds from your spouse’s 401(k) or other retirement account or pension, you’ll need a Qualified Domestic Relations Order, which:
– Officially directs the ex’s employer how to pay your portion of the account, as determined by the divorce decree.
– Must be submitted to the plan administrator.
If an annuity is divided in a divorce decree, a similar document may be required to finalize the payment plans. Check with an attorney for additional legal information regarding your particular situation.
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Dollars and Divorce

The good news is that many people seem to grasp the connection between their bank accounts and their marital status. Among the 44 states that collect divorce stats, divorce rates dropped by 5% between 2006 and 2009 — just when the economy was at its worst, according to the Centers for Disease Control and Prevention. In fact, 38% of those who responded to a survey by the National Marriage Project at the University of Virginia who were considering separation or divorce said the recession caused them to put aside their plans. However, law firms nationwide are reporting a recent surge of business, as couples feel more confident that the improving economy can more easily sustain two households.

“The economy affects whether people can afford to divorce. It affects what you do with the house, a family business, child support and alimony,” says Linda Lea M. Viken, president of the American Academy of Matrimonial Lawyers and a Rapid City, S.D., family law attorney with more than 30 years of experience. “If people don’t have money, they can’t even afford appraisers or lawyers. When considering divorce, you have to take off your emotional hat and put on your business hat because you’re making business decisions.”

Even if the recovering economy has boosted your confidence in your ability to afford divorce, make sure you have a clear picture of your financial reality.

Make a Budget

Before you divorce, sit down with a paper, pen and calculator to figure out how you will pay for everything, Walbert says. A divorced couple will suddenly have two households to maintain financially and two retirement accounts to fund.

“When going through a divorce you need to know how the numbers shake out, so know what you can afford and what you can’t,” she says. “The numbers don’t lie.”

Even if one party earns the bulk of the income, it is unlikely that person will walk away with the bulk of the monthly income or assets. Keep in mind, however, that in many states a great deal of discretion is left to the judge or courts. If children are involved, child support and even spousal maintenance often are awarded, making the keeping of the proverbial lights on in two homes a question mark for both parties.

Tax Impact

Even if you calculate your current income and expenses down to the nickel, you probably still don’t have an accurate picture of what your checkbook will look like after a divorce. Divorced couples lose out on the tax benefits of filing jointly, and only one person will have the tax advantage of filing as head of household if awarded primary custody of the kids. Child tax credits, child care deductions, and the family home’s interest and property taxes likely will be declared by just one of the parties — assuming the couple’s house was not sold. “It’s a big difference whether you have those deductions or not,” Viken says.

Further, make sure to tidy up past years’ filings before calculating your new bottom line. There is nothing worse than finding out too late that a dishonest spouse lied about paying or filing previous taxes — or worse, cheated on the filings. Remember, you will be liable for any tax obligations incurred during the marriage.

Bottom line: There’s a good chance that at least one party will be paying more taxes, which slashes take-home pay for everyone. And that further squeezes what is likely a tight financial situation.

Retirement — Your Future Now

“Even if you’re in your 30s or 40s, you must consider the impact that a divorce today will have on your retirement in decades to come,” says Walbert. In many cases, retirement funds amassed during a marriage are split 50-50 — no matter who earned the money. A spouse’s military retirement paycheck or corporate pension may also be considered part of the settlement. Likewise, when couples have been married at least 10 years, the poorer spouse is eligible for up to 50% of the ex-spouse’s Social Security benefits at age 62, if greater than his or her own.

That said, use an online calculator to figure out how far these divvied-up retirement assets will help each of you in retirement, and what earning potential you and your spouse have between now and then. Chances are both parties will have to save more and work longer than originally planned.

Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the United States, which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.
USAA or its affiliates do not provide tax advice. Taxpayers should seek advice based upon their own particular circumstances from an independent tax advisor. This material is for informational purposes. Consider your own financial circumstances carefully before making a decision and consult with your tax, legal or estate planning professional.