Reap the Tax Benefits of Education Planning

The tax code includes a number of incentives that, with proper planning, can provide tax benefits while you, your spouse, or your children are being educated.

Education Financing – A major planning issue is how to finance your children’s college education. Those with substantial savings simply pay the expenses as they go, while others begin setting aside money far in advance of the education need, perhaps utilizing a Coverdell account or Sec. 529 plan.

Others will need to borrow the funds, obtain financial aid, or be lucky enough to qualify for a scholarship. Although student loans provide one ready source of financing, the interest rates are generally higher than a home equity debt loan, which can also provide a longer term and lower payments. When choosing between a home equity loan or a student loan, keep in mind the following limitations: (1) Interest on home equity debt is deductible only if you itemize and then only on the first $100,000 of debt, and not at all to the extent that you are taxed by the alternative minimum tax, and (2) student loans must be single-purpose loans; the interest deduction is limited to $2,500 per year, and the deduction phases out for joint filers with income (AGI) between $125,000 and $155,000 ($60,000 to $75,000 for unmarried taxpayers). Still unknown is whether Congress will extend the student loan interest deduction changes included in the Bush tax cuts. Unless extended, beginning in 2013:

• The AGI phase-out ranges (estimated with inflation adjustments) will be $65,000–$90,000 for joint filers and $50,000–$75,000 for other filers (except married separate filers, who are barred from claiming this deduction).
• The deduction will be limited to the interest paid on a qualified loan during only the first 60 months in which the interest payments are required.

Education Tax Credits – The tax code also provides tax credits for post-secondary education tuition paid during the year for the taxpayer and dependents. There are two types of credits: the American Opportunity Credit, which is limited to the first four years of post-secondary education, and the Lifetime Learning Credit which provides credit for years after the first four years of post-secondary schooling and can be used for graduate studies.

The American Opportunity Credit, in many cases, offers greater tax savings than other existing education tax breaks! Here are some key features of the credit:

• Tuition, related fees, books, and other required course materials generally qualify. In the past, books usually were not eligible for education-related credits and deductions.
• The credit is equal to 100 percent of the first $2,000 spent and 25 percent of the next $2,000. This means that the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualified expenses for an eligible student.
• The full credit is available for taxpayers whose modified adjusted gross income (MAGI) is $80,000 or less (for married couples filing a joint return, the limit is $160,000 or less). The credit is phased out for taxpayers with incomes above these levels. These income limits are higher than those under the former Hope and current Lifetime Learning Credits.
• Forty percent of the American Opportunity Credit is refundable. This means that even people who owe no tax can get an annual payment of the credit of up to $1,000 for each eligible student. Other existing education-related credits and deductions do not provide a benefit to people who owe no tax. The refundable portion of the credit is not available to any student whose investment income is taxed at the parent’s rate, commonly referred to as the kiddie tax.

The bad news is that, without congressional intervention, 2012 is the last year for the American Opportunity Credit; it will be replaced by the Hope Credit, which provides only a lesser, non-refundable credit for the first two years of post-secondary education.

The Lifetime Learning Credit provides up to $2,000 of credit for each family each year. The Lifetime Learning Credit is phased out for joint filers with incomes between $104,000 and $124,000 ($52,000 to $62,000 for single filers) and is not allowed at all for married individuals filing separately. If the Hope Credit is reinstated, the phase-out ranges for it likely will be the same as those for the Lifetime Learning Credit.

Careful planning for the timing of tuition payments can provide substantial tax benefits. If Congress does not extend the American Opportunity Credit and you have not paid enough tuition to get the maximum benefit for 2012, you may consider pre-paying (in 2012) the tuition for the first quarter of 2013 so that it will count toward the 2012 credit.

Tax-Favored Savings Programs – For those who wish to establish a long-term savings program for educating their children, the tax code provides two plans. The first is a Coverdell Education Savings Account, which allows the taxpayer to make $2,000 annual nondeductible contributions to the plan. The second plan is the Qualified Tuition Plan, more frequently referred to as a Sec. 529 plan, with annual contributions generally limited to the gift tax exemption amount for the year ($13,000 in 2012). Both plans provide tax-free earnings if they are used for qualified education expenses. When choosing between a Coverdell or Sec. 529 plan, keep the following in mind: (1) Coverdell accounts can be used for kindergarten through post-secondary education and become the property of the child at the age of majority, and contributions are phased out for joint filers between $190,000 and $220,000 ($95,000 and $110,000 for others) of income (AGI), and (2) Sec. 529 plans are only for post-secondary education, but the contributor retains control of the funds.

Without congressional action, beginning in 2013, the contribution to a Coverdell account will be capped at $500 per year, and only post-secondary expenses will qualify.

Savings Bond Program – There is also an education-related exclusion of savings bond interest for Series EE or I Bonds that were issued after 1989 and purchased by an individual over the age of 24. All or part of the interest on these bonds is exempt from tax if qualified higher education expenses are paid in the same year that the bonds are redeemed. As with other benefits, this one also has a phase-out limitation for joint filers with income between $109,250 and $139,250 (between $72,850 and $87,850 for unmarried taxpayers, but those using the married separate status do not qualify for the exclusion).

If you would like to work out a comprehensive plan to take advantage of these benefits, please give our office a call.

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Inheritances Can Be Tricky

If you have received an inheritance or anticipate receiving one in the future, this article may answer many of your questions. The process of claiming an inheritance can be quite complex and it helps to understand the basics and to be aware of potential tax liabilities.

An inheritance is generally received after all applicable taxes have been paid along with any outstanding liabilities the decedent may have had. Exactly how the estate is handled will depend upon whether the assets were owned individually or in a trust. Without going into the intricacies of estates, trusts, and probate, the result for a beneficiary will generally be the same. Inherited items on which the decedent had already paid taxes and for which the estate tax (if any) has been paid will pass to the beneficiary tax-free. On the other hand, items of income that had not previously been taxed to the beneficiary and any appreciation or depreciation of assets acquired from the decedent will have tax implications. Some possible scenarios are provided below:

• Bank Account – Take, for instance, an inherited bank account worth $25,000, where the funds are not immediately distributed to the heir. The $25,000 account earns $375 of interest income after the decedent’s date of death. Out of the $25,375 that is received, the $25,000 is tax-free, but the $375 is taxable as interest income.
• Capital Asset –The basis for gain or loss from the sale of an inherited capital asset, such as stock, real estate, collectibles, etc., is generally based on the value of the asset at the time of the decedent’s death. This is one reason that qualified appraisals are so important.
  
  To explain this further, let’s assume that a vacant parcel of land is inherited with a date of death appraisal that values it at $15,000. If that property is sold for a net price of $15,000, there is neither gain nor loss and the $15,000 is tax-free to the beneficiary. If, on the other hand, the net sales price is more or less than the $15,000, there would be a reportable capital gain or loss. For capital gains tax purposes, the holding period is important. Assets held over one year are generally taxed at substantially less than those held for a shorter period of time. However, for inherited property, the beneficiary receives long-term treatment immediately, whether or not the decedent or the beneficiary had held it over one year. If there are expenses associated with selling the asset, then those expenses are deductible in figuring the gain or loss.
• IRA or other Qualified Plan – Suppose the decedent had a traditional IRA account and the distributions from that account were taxable to the decedent. If you inherit that account, the distributions will be taxable to you as the beneficiary. Why is that? Because the decedent had never paid taxes on the income that went to fund the traditional IRA and therefore you, the beneficiary, will be stuck with the tax liability. The good news is that there are options for taking the income over a number of years, which can soften the tax blow.
• Life Insurance Proceeds – Generally, the proceeds from a life insurance policy are tax-free to the heirs. However, if the policy is not paid immediately, as most are not, the insurance company will include interest. That interest is taxable to the heirs.
• Annuities and Installment Sale Notes – If the decedent purchased an annuity or had an installment sale note from the property he previously sold, the decedent’s basis will be tax-free, but the heirs will be obligated to pay tax on any amount received in excess of the decedent’s basis. For an annuity, the decedent’s basis would be what he paid for it. For an installment note, payments include: (1) a return of a portion of the asset’s cost (basis), which is not taxable; (2) a portion from the prior sale of the asset, which is taxable as a capital gain; and (3) taxable interest on the note.

A trust or estate is required to file an income tax return and to report income earned by the estate or trust after the decedent’s passing and before the assets are distributed to the heirs. Each heir will generally receive a form called Schedule K-1(1041). It will include that heir’s share of income and must be included on the heir’s individual tax return. Although infrequent because the taxes are generally higher, the trust or estate may pay the income tax on the income. The executor or trustee is responsible for making sure the required tax returns are filed and for sending K-1s to the heirs.

There may be taxable income to the heir even though the inheritance has not yet been received. In addition, there are other factors to consider that have not been discussed. Therefore, during your tax appointment, it is important to let us know if you are expecting an inheritance.

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Haven’t Filed an Income Tax Return?

If you have been procrastinating about filing your 2011 tax return or have other prior year returns that have not been filed, you should consider the consequences.

Taxpayers should file all tax returns that are due, regardless of whether or not full payment can be made with the return. Depending on an individual’s circumstances, a taxpayer filing late may qualify for a payment plan. All payment plans require continued compliance with all filing and payment responsibilities after the plan is approved.

Facts about Filing Tax Returns

• Failing to file a return or filing late can be costly. If taxes are owed, a delay in filing may result in penalty and interest charges that could substantially increase your tax bill. The late filing and payment penalties are a combined 5% per month (25% maximum) of the balance due.
• If a refund is due, there is no penalty for failing to file a tax return. But by waiting too long to file, you can lose your refund. In order to receive a refund, the return must be filed within three years of the due date. If you file a return and later realize you made an error on the return, the deadline for claiming any refund due is three years after the return was filed, or two years after the tax was paid, whichever expires later.
• Taxpayers who are entitled to the Earned Income Tax Credit must file a return to claim the credit, even if they are not otherwise required to file. The return must be filed within three years of the due date in order to receive the credit.
• If you are self-employed, you must file returns reporting self-employment income within three years of the due date in order to receive Social Security credits toward your retirement.

Taxpayers who continue to not file a required return and fail to respond to IRS requests to do so may be subject to a variety of enforcement actions, all of which can be unpleasant. Thus, if you have returns that need to be filed, please call our office so we can help you bring your tax returns up-to-date, and, if necessary, advise you about a payment plan.

Taxpayers who continue to not file a required return and fail to respond to IRS requests to do so may be subject to a variety of enforcement actions, all of which can be unpleasant. Thus, if you have returns that need to be filed, please call one of our professionals so they can help you bring your tax returns up-to-date, and, if necessary, advise you about a payment plan.

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What's Best, Tax-Free or Taxable Interest Income?

A frequent taxpayer question is whether it is better to invest for tax-free or taxable interest. Generally, taxable interest will provide a greater return, but this may not hold true after taking into account taxes on the income. Therefore, the question is really which provides the greater "after-tax" return.

Making a decision will take on another layer of complexity for higher-income taxpayers beginning in 2013 when the new surtax called the Unearned Income Medicare Contribution Tax is imposed on the unearned income of individuals, estates, and trusts. For individuals, the surtax is 3.8% of the lesser of:

1. The taxpayer’s net investment income, or
2. The excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others).

“Net” investment income is investment income reduced by allowable investment expenses. Investment income includes income from interest, dividends, annuities, royalties, rents (other than those derived from a trade or business), capital gains (other than those derived from a trade or business), trade or business income that is a passive activity with respect to the taxpayer, and trade or business income with respect to the trading of financial instruments or commodities. For surtax purposes, modified adjusted gross income does not include excluded items, such as interest on tax-exempt bonds, veterans' benefits, and excluded gains from the sale of a principal residence.

To avoid or minimize this new tax, higher-income taxpayers may wish to alter their investment portfolios to include more of the non-taxable investments described below.

There are basically four types of interest that can be excluded from income, either on the federal return or the state return, and each has its own special considerations.

Municipal Bond Interest – Interest earned from general-purpose obligations of states and local governments, which are issued to finance their operations, are generally tax-exempt for federal purposes. However, the various states usually only exempt interest from bonds issued by the state itself and local governments within the state. Hence, there are two categories of municipal bonds: the tax-free federal and state and the tax-free federal only. Individuals can invest in municipal bonds by directly purchasing a bond or through mutual funds that invest in municipal bonds. Some mutual funds invest in bonds issued only in a particular state, providing residents of that state with income that is excludable on their state returns as well as their federal returns.

For those drawing Social Security, you must also keep in mind that, even though the income itself is tax-free, it is included in the computation used to determine how much of your Social Security income is taxable.

Private Activity Bond Interest – Some municipal bonds, classified as Private Activity Bonds, are tax-free for the purposes of the regular federal tax but may be taxable for the purposes of the federal Alternative Minimum Tax (AMT). If a taxpayer is subject to the AMT, then the interest from these bonds may be taxable to some extent. The actual rate will depend upon your filing status and other AMT income but could be as high as 28% plus any state tax, if applicable.

U.S. Government Bond Interest – Under federal law, direct obligations of the U.S. government cannot be taxed by the states. This includes interest from U.S. savings bonds, U.S. Treasury bills, notes, bonds, or other obligations of the United States. Interest earned from the Federal National Mortgage Association (Fannie Mae), the Government National Mortgage Association (Ginnie Mae), and the Federal Home Loan Mortgage Corporation (FHLMC) are not direct obligations of the U.S. government and, therefore, are not excludable from state taxation unless specifically allowed by state law, which is generally not the case. If you reside in a state with no state income tax, U.S. government bond interest provides no tax benefit.

If you do have a state income tax and the investment is tax-free in your state, then it also makes a difference whether or not you itemize your deductions on your federal return. Since having state tax-free income reduces your state tax, which is deductible if you itemize, the reduced state tax, in effect, reduces your itemized deductions and increases your federal tax.

If you have questions related to tax-free investment income or how the new surtax on investment income might impact you, please give our office a call.

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Assisting Your Child to Acquire a Home

If you are a parent who wants to assist your child in obtaining his or her first home, there are a number of ways you can help.

1. Help with the down payment - Real estate lending laws generally will not allow the parents to loan the down payment on the home, since that is considered part of the debt. However, you can make an outright gift of the down payment. Just keep in mind that to avoid reducing your lifetime gift tax exclusion and filing a gift tax return, the gift cannot exceed the annual $13,000 gift tax exemption. If you are married, the limit could double to $26,000 since both you and your spouse are allowed a separate $13,000 exemption. If your child is married, the gift limit could double again to $52,000, since the annual exemption limit applies to each donee, not the donor.
2. Buy the house in your name – Let your child make payments to you in order to buy the property. Over time, in most cases, the property will have appreciated enough in value to provide the necessary equity required for your child to obtain a favorable bank loan.
3. Slowly gift the home to the child - If you are financially secure, you could purchase the home and then gift a portion of the property to your child each year. By making these gifts over a period of time, you are able to take advantage of the annual gift tax exemption rules.

Sometimes, an elderly parent will transfer the title to their home to their children. Although this might seem to be a good idea at the time, it generally is not for the following reasons:

• If the home title is transferred to a child while the parent is still living, it constitutes a gift and a gift tax return will generally need to be filed.
• The tax basis (point from where gain or loss is measured) will be the parent’s basis. Had the child, instead, inherited the home, the child’s basis would be the fair market value of the home at the parent’s date of death, which means the child would have no taxable gain if the home is immediately sold. On the other hand, if the home had been previously gifted to the child, the gain would be measured from the parent’s basis.

Clients are encouraged to contact this office to determine the tax implications before transferring a title to property.

If you would like to help your child with purchasing his/her first home and need assistance with planning, please call our office.

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October 2012 Due Dates

October 2012 Individual Due Dates

October 10 - Report Tips to Employer

If you are an employee who works for tips and received more than $20 in tips during September, you are required to report them to your employer on IRS Form 4070 no later than October 10. Your employer is required to withhold FICA taxes and income tax withholding for these tips from your regular wages. If your regular wages are insufficient to cover the FICA and tax withholding, the employer will report the amount of the uncollected withholding in box 12 of your W-2 for the year. You will be required to pay the uncollected withholding when your return for the year is filed.

October 15 – Individuals

If you have an automatic 6-month extension to file your income tax return for 2011 file Form 1040, 1040A, or 1040EZ and pay any tax, interest, and penalties due.

October 15 - SEP IRA & Keogh Contributions

Last day to contribute to SEP or Keogh retirement plan for calendar year 2011 if tax return is on extension through October 15.

October 2012 Business Due Dates

October 15 - Electing Large Partnerships

File a 2011 calendar year return (Form 1065-B). This due date applies only if you were given an additional 6-month extension. March 17 was the due date for furnishing Schedules K-1 or substitute Schedule K-1 to the partners.

October 15 - Social Security, Medicare and withheld income tax

If the monthly deposit rule applies, deposit the tax for payments in September.

October 15 - Nonpayroll Withholding

If the monthly deposit rule applies, deposit the tax for payments in September.

October 31 - Social Security, Medicare and Withheld Income Tax

File Form 941 for the third quarter of 2012. Deposit or pay any undeposited tax under the accuracy of deposit rules. If your tax liability is less than $2,500, you can pay it in full with a timely filed return. If you deposited the tax for the quarter in full and on time, you have until November 13 to file the return.

October 31 - Certain Small Employers

Deposit any undeposited tax if your tax liability is $2,500 or more for 2012 but less than $2,500 for the third quarter.

October 31 - Federal Unemployment Tax

Deposit the tax owed through September if more than $500.

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