Converting a traditional IRA to a Roth IRA can provide tax-free growth and tax-free withdrawals in retirement. But what if you convert your traditional IRA — subject to income taxes on all earnings and deductible contributions — and then discover you would have been better off if you hadn’t converted it?
Before the Tax Cuts and Jobs Act (TCJA), you could undo a Roth IRA conversion using a “recharacterization.” Effective with 2018 conversions, the TCJA prohibits recharacterizations — permanently. But if you executed a conversion in 2017, you may still be able to undo it.
Reasons to recharacterize
Generally, if you converted to a Roth IRA in 2017, you have until October 15, 2018, to undo it and avoid the tax hit.
Here are some reasons you might want to recharacterize a 2017 Roth IRA conversion:
- The conversion combined with your other income pushed you into a higher tax bracket in 2017.
- Your marginal income tax rate will be lower in 2018 than it was in 2017.
- The value of your account has declined since the conversion, so you owe taxes partially on money you no longer have.
If you recharacterize your 2017 conversion but would still like to convert your traditional IRA to a Roth IRA, you must wait until the 31st day after the recharacterization. If you undo a conversion because your IRA’s value declined, there’s a risk that your investments will bounce back during the waiting period, causing you to reconvert at a higher tax cost.
Recharacterization in action
Sally had a traditional IRA with a balance of $100,000 when she converted it to a Roth IRA in 2017. Her 2017 tax rate was 33%, so she owed $33,000 in federal income taxes on the conversion.
However, by August 1, 2018, the value of her account had dropped to $80,000. So Sally recharacterizes the account as a traditional IRA and amends her 2017 tax return to exclude the $100,000 in income.
On September 1, she reconverts the traditional IRA, whose value remains at $80,000, to a Roth IRA. She will report that amount when she files her 2018 tax return. The 33% rate has dropped to 32% under the TCJA. Assuming Sally is still in this bracket, this time she’ll owe $25,600 ($80,000 × 32%) — deferred for a year and resulting in a tax savings of $7,400.
(Be aware that the thresholds for the various brackets have changed for 2018, in some cases increasing but in others decreasing. This, combined with other TCJA provisions and changes in your income, could cause you to be in a higher or lower bracket in 2018.)
Know your options
If you converted a traditional IRA to a Roth IRA in 2017, it’s worthwhile to see if you could save tax by undoing the conversion. If you’re considering a Roth conversion in 2018, keep in mind that you won’t have the option to recharacterize. We can help you assess whether recharacterizing a 2017 conversion or executing a 2018 conversion makes sense for you.
One of the biggest concerns for family business owners is succession planning — transferring ownership and control of the company to the next generation. Often, the best time tax-wise to start transferring ownership is long before the owner is ready to give up control of the business.
A family limited partnership (FLP) can help owners enjoy the tax benefits of gradually transferring ownership yet allow them to retain control of the business.
How it works
To establish an FLP, you transfer your ownership interests to a partnership in exchange for both general and limited partnership interests. You then transfer limited partnership interests to your children.
You retain the general partnership interest, which may be as little as 1% of the assets. But as general partner, you can still run day-to-day operations and make business decisions.
As you transfer the FLP interests, their value is removed from your taxable estate. What’s more, the future business income and asset appreciation associated with those interests move to the next generation.
Because your children hold limited partnership interests, they have no control over the FLP, and thus no control over the business. They also can’t sell their interests without your consent or force the FLP’s liquidation.
The lack of control and lack of an outside market for the FLP interests generally mean the interests can be valued at a discount — so greater portions of the business can be transferred before triggering gift tax. For example, if the discount is 25%, in 2018 you could gift an FLP interest equal to as much as $20,000 tax-free because the discounted value wouldn’t exceed the $15,000 annual gift tax exclusion.
To transfer interests in excess of the annual exclusion, you can apply your lifetime gift tax exemption. And 2018 may be a particularly good year to do so, because the Tax Cuts and Jobs Act raised it to a record-high $11.18 million. The exemption is scheduled to be indexed for inflation through 2025 and then drop back down to an inflation-adjusted $5 million in 2026. While Congress could extend the higher exemption, using as much of it as possible now may be tax-smart.
There also may be income tax benefits. The FLP’s income will flow through to the partners for income tax purposes. Your children may be in a lower tax bracket, potentially reducing the amount of income tax paid overall by the family.
Perhaps the biggest downside is that the IRS scrutinizes FLPs. If it determines that discounts were excessive or that your FLP had no valid business purpose beyond minimizing taxes, it could assess additional taxes, interest and penalties.
The IRS pays close attention to how FLPs are administered. Lack of attention to partnership formalities, for example, can indicate that an FLP was set up solely as a tax-reduction strategy.
Right for you?
An FLP can be an effective succession and estate planning tool, but it isn’t risk free. Please contact us for help determining whether an FLP is right for you.
If you have a child or other family member with a disabling condition that requires long-term care or prevents (or will prevent) him or her from being able to support him- or herself, consider establishing a special needs trust (SNT). Also known as a supplemental needs trust, an SNT allows you to enhance a family member’s quality of life without jeopardizing his or her eligibility for government benefits, such as Medicaid or Supplemental Security Income (SSI).
An SNT is an irrevocable trust designed to supplement, rather than replace, government assistance. Generally, the trust is funded by someone other than the beneficiary, though in certain instances a beneficiary’s assets may be used to fund the trust.
To preserve eligibility for government benefits, the beneficiary can’t have access to the funds, and the trust must be prohibited from providing for the beneficiary’s “support.” That means it can’t be used to pay for medical care, food, clothing, shelter or anything else covered by Medicaid or SSI, such as the basic medical care provided by those programs.
But an SNT can be used to pay for virtually anything government benefits don’t cover, such as unreimbursed medical expenses, education and training, transportation (including wheelchair-accessible vehicles), insurance, computers, and modifications to the beneficiary’s home. It can also pay for “quality-of-life” needs, such as travel, entertainment, recreation and hobbies.
Careful drafting required
To ensure that an SNT doesn’t disqualify the beneficiary from government benefits, it should prohibit distributions directly to the beneficiary and prohibit the trustee from paying for any support items covered by Medicaid or SSI. Some SNTs specify the types of supplemental expenses the trust should pay; others give the trustee sole discretion over nonsupport items.
Like many trusts, most SNTs contain spendthrift language to protect the trust assets against creditors’ claims. Also, in some states, it may be necessary to include specific language providing that the trust is an SNT, that the funds are intended for only nonsupport purposes and that your intention is to preserve the beneficiary’s eligibility for government benefits. In other states, simply designing the trust as a discretionary trust may be sufficient, but it can’t hurt to include SNT spendthrift language just to be safe.
Communication is key
If you establish an SNT, communicate your plans to everyone concerned. Otherwise, well-meaning relatives or friends might inadvertently undermine your strategy by making gifts or bequests directly to the special needs person. Contact us with questions regarding an SNT.
Under the Tax Cuts and Jobs Act, employees can no longer claim the home office deduction. If, however, you run a business from your home or are otherwise self-employed and use part of your home for business purposes, the home office deduction may still be available to you.
Homeowners know that they can claim itemized deductions for property tax and mortgage interest on their principal residences, subject to certain limits. Most other home-related expenses, such as utilities, insurance and repairs, aren’t deductible.
But if you use part of your home for business purposes, you may be entitled to deduct a portion of these expenses, as well as depreciation. Or you might be able to claim the simplified home office deduction of $5 per square foot, up to 300 square feet ($1,500).
Regular and exclusive use
You might qualify for the home office deduction if part of your home is used as your principal place of business “regularly and exclusively,” defined as follows:
1. Regular use. You use a specific area of your home for business on a regular basis. Incidental or occasional business use is not regular use.
2. Exclusive use. You use the specific area of your home only for business. It’s not necessary for the space to be physically partitioned off. But, you don’t meet the requirements if the area is used both for business and personal purposes, such as a home office that also serves as a guest bedroom.
Regular and exclusive business use of the space aren’t, however, the only criteria.
Principal place of business
Your home office will qualify as your principal place of business if you 1) use the space exclusively and regularly for administrative or management activities of your business, and 2) don’t have another fixed location where you conduct substantial administrative or management activities.
Examples of activities that are administrative or managerial in nature include:
- Billing customers, clients or patients,
- Keeping books and records,
- Ordering supplies,
- Setting up appointments, and
- Forwarding orders or writing reports.
Meetings or storage
If your home isn’t your principal place of business, you may still be able to deduct home office expenses if you physically meet with patients, clients or customers on your premises. The use of your home must be substantial and integral to the business conducted.
Alternatively, you may be able to claim the home office deduction if you have a storage area in your home — or in a separate free-standing structure (such as a studio, workshop, garage or barn) — that’s used exclusively and regularly for your business.
The home office deduction can provide a valuable tax-saving opportunity for business owners and other self-employed taxpayers who work from home. If you’re not sure whether you qualify or if you have other questions, please contact us.
There was talk of repealing the individual alternative minimum tax (AMT) as part of last year’s tax reform legislation. A repeal wasn’t included in the final version of the Tax Cuts and Jobs Act (TCJA), but the TCJA will reduce the number of taxpayers subject to the AMT.
Now is a good time to familiarize yourself with the changes, assess your AMT risk and see if there are any steps you can take during the last several months of the year to avoid the AMT, or at least minimize any negative impact.
AMT vs. regular tax
The top AMT rate is 28%, compared to the top regular ordinary-income tax rate of 37%. But the AMT rate typically applies to a higher taxable income base and will result in a larger tax bill if you’re subject to it.
The TCJA reduced the number of taxpayers who’ll likely be subject to the AMT in part by increasing the AMT exemption and the income phaseout ranges for the exemption:
- For 2018, the exemption is $70,300 for singles and heads of households (up from $54,300 for 2017), and $109,400 for married couples filing jointly (up from $84,500 for 2017).
- The 2018 phaseout ranges are $500,000–$781,200 for singles and heads of households (up from $120,700–$337,900 for 2017) and $1,000,000–$1,437,600 for joint filers (up from $160,900–$498,900 for 2017).
You’ll be subject to the AMT if your AMT liability is greater than your regular tax liability.
In the past, common triggers of the AMT were differences between deductions allowed for regular tax purposes and AMT purposes. Some popular deductions aren’t allowed under the AMT.
New limits on some of these deductions for regular tax purposes, such as on state and local income and property tax deductions, mean they’re less likely to trigger the AMT. And certain deductions not allowed for AMT purposes are now not allowed for regular tax purposes either, such as miscellaneous itemized deductions subject to the 2% of adjusted gross income floor.
But deductions aren’t the only things that can trigger the AMT. Some income items might do so, too, such as:
- Long-term capital gains and dividend income, even though they’re taxed at the same rate for both regular tax and AMT purposes,
- Accelerated depreciation adjustments and related gain or loss differences when assets are sold,
- Tax-exempt interest on certain private-activity municipal bonds, and
- The exercise of incentive stock options.
AMT planning tips
If it looks like you could be subject to the AMT in 2018, consider accelerating income into this year. Doing so may allow you to benefit from the lower maximum AMT rate. And deferring expenses you can’t deduct for AMT purposes may allow you to preserve those deductions. If you also defer expenses you can deduct for AMT purposes, the deductions may become more valuable because of the higher maximum regular tax rate.
Please contact us if you have questions about whether you could be subject to the AMT this year or about minimizing negative consequences from the AMT.
Once upon a time, some parents and grandparents would attempt to save tax by putting investments in the names of their young children or grandchildren in lower income tax brackets. To discourage such strategies, Congress created the “kiddie” tax back in 1986. Since then, this tax has gradually become more far-reaching. Now, under the Tax Cuts and Jobs Act (TCJA), the kiddie tax has become more dangerous than ever.
A short history
Years ago, the kiddie tax applied only to children under age 14 — which still provided families with ample opportunity to enjoy significant tax savings from income shifting. In 2006, the tax was expanded to children under age 18. And since 2008, the kiddie tax has generally applied to children under age 19 and to full-time students under age 24 (unless the students provide more than half of their own support from earned income).
What about the kiddie tax rate? Before the TCJA, for children subject to the kiddie tax, any unearned income beyond a certain amount ($2,100 for 2017) was taxed at their parents’ marginal rate (assuming it was higher), rather than their own likely low rate.
A fiercer kiddie tax
The TCJA doesn’t further expand who’s subject to the kiddie tax. But it will effectively increase the kiddie tax rate in many cases.
For 2018–2025, a child’s unearned income beyond the threshold ($2,100 again for 2018) will be taxed according to the tax brackets used for trusts and estates. For ordinary income (such as interest and short-term capital gains), trusts and estates are taxed at the highest marginal rate of 37% once 2018 taxable income exceeds $12,500. In contrast, for a married couple filing jointly, the highest rate doesn’t kick in until their 2018 taxable income tops $600,000.
Similarly, the 15% long-term capital gains rate takes effect at $77,201 for joint filers but at only $2,601 for trusts and estates. And the 20% rate kicks in at $479,001 and $12,701, respectively.
In other words, in many cases, children’s unearned income will be taxed at higher rates than their parents’ income. As a result, income shifting to children subject to the kiddie tax will not only not save tax, but it could actually increase a family’s overall tax liability.
The moral of the story
To avoid inadvertently increasing your family’s taxes, be sure to consider the big, bad kiddie tax before transferring income-producing or highly appreciated assets to a child or grandchild who’s a minor or college student. If you’d like to shift income and you have adult children or grandchildren who’re no longer subject to the kiddie tax but in a lower tax bracket, consider transferring such assets to them.
Please contact us for more information about the kiddie tax — or other TCJA changes that may affect your family.
It may be difficult to consider, but funeral arrangements are a critical component of your estate plan. Failure to clearly communicate your wishes regarding the disposition of your remains can lead to tension, disputes and even litigation among your family members during what is already a difficult time.
Address these issues
The methods for expressing these wishes vary from state to state, and may include a provision in your will, language in a health care proxy or power of attorney, or a separate form specifically designed for this purpose.
Whichever method you use, it should, at a minimum, state:
- Whether you prefer burial or cremation,
- Where you wish to be buried or have your ashes interred or scattered (and any other special instructions), and
- The person you’d like to be responsible for making these arrangements. Some people also request a specific funeral home.
Beware of prepaid funeral plans
To relieve their families of the burden of the costs of a funeral, some people pay for them in advance. Unfortunately, prepaid funeral plans can be fraught with potential traps. Some plans end up costing more than the benefits they pay out. And there may be a risk that you’ll lose your investment if the funeral provider goes out of business or you want to change your plans.
Some states offer protection — such as requiring a funeral home or cemetery to place funds in a trust or to purchase a life insurance policy to fund funeral costs — but many do not. If you’re considering a prepaid plan, find out exactly what you’re paying for. Does the plan cover merchandise only (casket, vault, etc.) or are services included? Is the price locked in or is there a possibility that your family will have to pay additional amounts?
How the state can intercede
If you fail to make your burial wishes clear, and your family members disagree about how you would want your remains disposed of, the outcome will depend on applicable state law. Absent express instructions from the deceased, some states give priority to the wishes of certain family members, such as spouses or children, over other family members, such as siblings.
To avoid this situation, talk to us about your wishes. We can help ensure that they’re properly documented.
Meal, vehicle and travel expenses are common deductions for businesses. But if you don’t properly document these expenses, you could find your deductions denied by the IRS.
A critical requirement
Subject to various rules and limits, business meal (generally 50%), vehicle and travel expenses may be deductible, whether you pay for the expenses directly or reimburse employees for them. Deductibility depends on a variety of factors, but generally the expenses must be “ordinary and necessary” and directly related to the business.
Proper documentation, however, is one of the most critical requirements. And all too often, when the IRS scrutinizes these deductions, taxpayers don’t have the necessary documentation.
What you need to do
Following some simple steps can help ensure you have documentation that will pass muster with the IRS:
Keep receipts or similar documentation. You generally must have receipts, canceled checks or bills that show amounts and dates of business expenses. If you’re deducting vehicle expenses using the standard mileage rate (54.5 cents for 2018), log business miles driven.
Track business purposes. Be sure to record the business purpose of each expense. This is especially important if on the surface an expense could appear to be a personal one. If the business purpose of an expense is clear from the surrounding circumstances, the IRS might not require a written explanation — but it’s probably better to err on the side of caution and document the business purpose anyway.
Require employees to comply. If you reimburse employees for expenses, make sure they provide you with proper documentation. Also be aware that the reimbursements will be treated as taxable compensation to the employee (and subject to income tax and FICA withholding) unless you make them via an “accountable plan.”
Don’t re-create expense logs at year end or when you receive an IRS deficiency notice. Take a moment to record the details in a log or diary at the time of the event or soon after. The IRS considers timely kept records more reliable, plus it’s easier to track expenses as you go than try to re-create a log later. For expense reimbursements, require employees to submit monthly expense reports (which is also generally a requirement for an accountable plan).
You’ve probably heard that, under the Tax Cuts and Jobs Act, entertainment expenses are no longer deductible. There’s some debate as to whether this includes business meals with actual or prospective clients. Until there’s more certainty on that issue, it’s a good idea to document these expenses. That way you’ll have what you need to deduct them if Congress or the IRS provides clarification that these expenses are indeed still deductible.
For more information about what meal, vehicle and travel expenses are and aren’t deductible — and how to properly document deductible expenses — please contact us.
If you’re charitably inclined, you may wish to consider a charitable gift annuity. It can combine the benefits of an immediate income tax deduction and a lifetime income stream. Furthermore, it allows you to support a favorite charity and reduce the size of your future taxable estate.
What is it?
A charitable gift annuity is an arrangement in which you make a gift of cash or other property to a charity in exchange for a guaranteed income annuity for life. This is similar to buying an annuity in the commercial marketplace, except that you potentially can claim an immediate charitable deduction for the excess of the value of the property over the value of the annuity.
The payouts will generally be lower than those of a commercial annuity because a portion of your charitable gift annuity investment benefits charity. For you to claim a charitable deduction, the charity must receive at least 10% of the initial net value of the property transferred.
The annuity may be payable to you over your life, or over the joint lives of you and someone you’ve designated (a joint and survivor annuity). The rate of return is typically set at the time of the gift based in part on your age (and, if it’s a joint and survivor annuity, the age of the other person you’ve designated). A portion of each annuity payment is tax-free, because you’re entitled to recover your original investment over your life expectancy.
What’s my deduction amount?
Your charitable deduction will be less than the total value of your annuity purchase price because the deduction can be claimed for only the present value of the property that the charity will keep after your death. The present value is based on life expectancy and an IRS-prescribed interest rate at the time of purchase of the annuity.
Additional rules and limits apply to charitable gift annuities. Talk with us if you’re charitably inclined and would like to know if a charitable gift annuity is right for your estate plan.
The Tax Cuts and Jobs Act (TCJA) provides a valuable new tax break to noncorporate owners of pass-through entities: a deduction for a portion of qualified business income (QBI). The deduction generally applies to income from sole proprietorships, partnerships, S corporations and, typically, limited liability companies (LLCs). It can equal as much as 20% of QBI. But once taxable income exceeds $315,000 for married couples filing jointly or $157,500 for other filers, a wage limit begins to phase in.
Full vs. partial phase-in
When the wage limit is fully phased in, at $415,000 for joint filers and $207,500 for other filers, the QBI deduction generally can’t exceed the greater of the owner’s share of:
- 50% of the amount of W-2 wages paid to employees during the tax year, or
- The sum of 25% of W-2 wages plus 2.5% of the cost of qualified business property (QBP).
When the wage limit applies but isn’t yet fully phased in, the amount of the limit is reduced and the final deduction is calculated as follows:
- The difference between taxable income and the applicable threshold is divided by $100,000 for joint filers or $50,000 for other filers.
- The resulting percentage is multiplied by the difference between the gross deduction and the fully wage-limited deduction.
- The result is subtracted from the gross deduction to determine the final deduction.
Let’s say Chris and Leslie have taxable income of $600,000. This includes $300,000 of QBI from Chris’s pass-through business, which pays $100,000 in wages and has $200,000 of QBP. The gross deduction would be $60,000 (20% of $300,000), but the wage limit applies in full because the married couple’s taxable income exceeds the $415,000 top of the phase-in range for joint filers. Computing the deduction is fairly straightforward in this situation.
The first option for the wage limit calculation is $50,000 (50% of $100,000). The second option is $30,000 (25% of $100,000 + 2.5% of $200,000). So the wage limit — and the deduction — is $50,000.
What if Chris and Leslie’s taxable income falls within the phase-in range? The calculation is a bit more complicated. Let’s say their taxable income is $400,000. The full wage limit is still $50,000, but only 85% of the full limit applies:
($400,000 taxable income - $315,000 threshold)/$100,000 = 85%
To calculate the amount of their deduction, the couple must first calculate 85% of the difference between the gross deduction of $60,000 and the fully wage-limited deduction of $50,000:
($60,000 - $50,000) × 85% = $8,500
That amount is subtracted from the $60,000 gross deduction for a final deduction of $51,500.
That’s not all
Be aware that another restriction may apply: For income from “specified service businesses,” the QBI deduction is reduced if an owner’s taxable income falls within the applicable income range and eliminated if income exceeds it. Please contact us to learn whether your business is a specified service business or if you have other questions about the QBI deduction.