Economy

Recharacterization is off the Table

posted by Charley Mills - 1.30.18

William G. Lako, Jr., CFP®
Principal, Henssler Financial

One provision in the new tax reform law is quite applicable to your financial planning. For tax years beginning after Dec. 31, 2017, the Tax Cuts and Jobs Act repealed the option to recharacterize a Roth conversion. It has effectively made Roth IRA conversions irrevocable. For example, let’s say you converted a fully pre-tax traditional IRA worth $100,000 to a Roth IRA in 2018. Further, assume that your Roth IRA is now worth only $60,000. Unfortunately, now you’ll owe federal and state income tax on $100,000, even though the current value of those assets is only $60,000.

Prior to the repeal, recharacterization was one of the few “do-overs” you could get under the tax code. If you convert funds from a pre-tax Traditional IRA to a Roth IRA, it is a taxable event. You will owe taxes at your current marginal rate on the amount converted. Generally, we recommend investors pay the tax on the conversion with money outside of the IRA to avoid any early withdrawal penalties. The deadline to recharacterize a conversion made in 2017 is October 15, 2018, the deadline for individual tax returns. If the investors chose to recharacterize, the conversion was treated as if it never happened for tax purposes. For conversions made in 2018 and onward, recharacterization is not an option.

“Prior to the repeal, recharacterization was one of the few “do-overs” you could get under the tax code”

This “do-over” helped investors who may have rushed into a conversion without fully understanding the tax impact of the decision. A recharacterization could also help investors avoid paying income tax on IRA assets that have lost value since the conversion. Others may have unexpected expenses during the year, which ate into the funds the investors would have otherwise used to pay the taxes due on the conversion. Regardless the reasons, recharacterization allowed investors to control their tax situation.

An important aspect to note is that Roth conversions are not off the table. Investors are still allowed to convert their Traditional IRA to a Roth IRA, opting to pay the taxes due now on the assets. With lower marginal tax brackets and the increased alternative minimum tax threshold that the Tax Cuts and Jobs Act brought, investors still have a golden opportunity to convert funds from a Traditional IRA to a Roth without being pushed into a higher tax bracket because of additional income from the conversion. However, taxpayers may want to wait until closer to the end of the year when they are more certain of their income and deductions for the year.

Once the assets are in a Roth IRA, earnings grow tax-free, and distributions are often tax-free after age 59 ½. Furthermore, Roth IRAs are not subject to mandatory distribution requirements during the life of the owner. While no one can predict tax rates in the future, most investors will be better off having tax-free withdrawal options in retirement. Another advantage of a Roth IRA is when the account holder intends for the Roth IRA to be left to heirs. Heirs must pay income taxes on withdrawals from an inherited Traditional IRA, but if they properly opt for a lifetime income stream from an inherited Roth IRA they won’t have to pay income tax on the money as they withdraw it.

The bottom line is that if you are choosing to do a Roth conversion, you need to have a very clear understanding of the tax implications of doing so. The conversion is a permanent decision, and the tax implications can be further complicated if your IRA is a mix of pre-tax funds and nondeductible contributions. You cannot pick and choose which funds to convert. Instead, the amount you convert is deemed to consist of a pro rata portion of the taxable and nontaxable dollars in the IRA.

William G. Lako, Jr., CFP®, is a principal at Henssler Financial, a financial advisory and wealth management firm that has been delivering comprehensive financial solutions to its individual, corporate, and institutional clients for 30 years. Mr. Lako is a Certified Financial Planner™ professional.

Private School Tuition is Now a Qualified Education Expense for 529 Plans

posted by Hannity Staff - 1.23.18

William G. Lako, Jr., CFP®
Principal, Henssler Financial

It was touch-and-go there for a minute—Congress almost repealed more than a half-dozen provisions in the tax code that help students of low- and middle-income families afford a higher education. Much to the benefit of many taxpayers, many of the provisions were retained that encourage saving for higher education, help students and families pay for college, and assist with the student loan repayment.

The most significant change is that 529 Plans now include tax-free distributions to pay for private kindergarten through high school tuition and expenses. Prior to the reform, 529 Plans earnings growth and withdrawals were only tax-free when used to pay for qualified higher education costs. If families wanted to invest funds to pay for private school in a tax-advantaged account, they were limited to Coverdell Education Savings Accounts. These carry the low maximum annual contribution of $2,000 and contributions were phased out for tax filers with adjusted gross income of $220,000 for married filing jointly, and $110,000 for all others. Furthermore, contributions to Coverdell ESAs are not tax-deductible.

This is a meaningful benefit to families who choose to enroll their children in private schools

The Tax Cuts and Jobs Act amended the treatment of 529 plans so that families can withdraw up to $10,000 per year tax-free for private elementary and high school tuition. This is a meaningful benefit to families who choose to enroll their children in private schools. The National Center for Education Statistics reports that nearly 10 percent of all students are enrolled in a private school. According to Private School Review, an online resource for evaluating potential schools, the national average for private school tuition is around $10,300 per year, which includes both elementary and high school tuition.

When contributing to any savings account with tax-free growth, the longer you can let the investment compound, the more tax benefit you’ll see. If you choose to begin taking withdrawals from your child’s 529 Plan for K-12 education expenses, you may see less tax-advantaged growth. However, more than 30 states offer state tax deductions for contributions to a 529 plan.

If you are currently saving to a Coverdell ESA, you may consider rolling the account into a 529 Plan to take advantage of the absence of annual contribution limits. In 2018, individuals can contribute up to $15,000 to a 529 plan before incurring gift tax issues. That limit is doubled for couples married filing jointly. Overall plan limits vary by state, ranging from $235,000 to $520,000. Some taxpayers may benefit from establishing two 529 plan accounts, one for K-12 expenses and one for college costs. This will allow you to pick investments that correspond to your time horizon. Many plans offer investment tracks that gradually shift to more conservative investments as the beneficiary reaches college age. If you intend to use the funds for private elementary or secondary schools, you may consider a static investment that contains a mix of fixed and growth investments.

Before you spend your 529 Plan funds for K-12 education, make sure your state’s tax laws have been amended to account for these withdrawals. The language that governs state tax deductions for contributions and qualified withdrawals may differ from federal laws—you want to avoid any unintended tax consequences.

William G. Lako, Jr., CFP®, is a principal at Henssler Financial, a financial advisory and wealth management firm that has been delivering comprehensive financial solutions to its individual, corporate, and institutional clients for 30 years. Mr. Lako is a Certified Financial Planner™ professional.

EYE ON YOUR MONEY: Not All Business Tax Cuts Are Simple

posted by Charley Mills - 12.29.17

One of the key promises during President Trump’s campaign was to lower taxes for businesses from 35 percent to 15 percent and eliminate the corporate alternative minimum tax. The final version of the tax bill did eliminate the corporate alternative minimum tax, and lowered the tax for corporations to 21 percent in 2018. Furthermore, businesses organized as “pass-throughs” could get taxed at a less than 30 percent rate.

Taxes are never simple – despite the promise to simplify the tax code

Pass-through businesses are your LLCs, partnerships, S corporation, and sole proprietorships, in which the entity is not subject to income tax. Owners are taxed individually on the income, calculating tax on their share of the profits and losses. Because these business owners were at the mercy of their individual tax rates, some business owners could be taxed as much as 39.6 percent, not including the phase out of itemized deductions for high income earners.

In the finalized bill, pass-through businesses receive a 20 percent deduction of their qualified business income. Because taxes are never simple—despite the promise to simplify the tax code—the deduction is actually the lesser of: 20 percent of the taxpayer’s “qualified business income” or the greater of: 50 percent of the W-2 wages with respect to the business, or 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property.

OK, you want this in English. Qualified business income is income less ordinary deductions that you earn from a pass-through business, such as an LLC, sole-proprietorship, S corporation, or partnership. This does not include wages you earn as an employee. Let’s say you have an LLC (not a “specified service” trade or business), and your share of the qualified business income is $500,000. Multiply that by 20 percent and you get a deduction of $100,000. Woo hoo! Not so fast. There are limitations on the calculation that were added to prevent abuse of the rules.
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How does this work? Let’s look at the example of your LLC of which you only own 40 percent. The company produced $1.25 million in ordinary income. The company paid W-2 wages of $455,000 and holds $200,000 in property. Your allocation of the wages is $182,000 and 50 percent of that is $91,000. One more calculation: 25 percent of the W-2 wages with respect to the business plus 2.5 percent of the unadjusted basis of all qualified property—in our example, this comes to $47,500 ($45,500 + $2,000). You’ve got two numbers: $91,000 and $47,500. The greater of the two is $91,000. This is your income limitation. So, your deduction on your $500,000 qualified business income is now $91,000 versus the simple 20 percent. Mindboggling, isn’t it? And this example was highly simplified for your convenience.

Now, not every LLC is making $1.25 million. Lots of small businesses make around $125,000 a year. There is an exception for you! If your taxable income is less than $157,500 or $315,000 for married filing jointly, you should be able to ignore the W-2 income limitations.

To make things more complicated if you are part of a “specified service” trade or business you will be faced with a phase out.

Wait, what? Yes, “Any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” Will be deemed to be a “specified Service”.

This means if your income is above $207,500 for individuals and $415,000 for joint filers you will not be eligible for the deduction. Welcome to simpler taxes.

William G. Lako, Jr., CFP®, is a principal at Henssler Financial, a financial advisory and wealth management firm that has been delivering comprehensive financial solutions to its individual, corporate, and institutional clients for 30 years. Mr. Lako is a CERTIFIED FINANCIAL PLANNER™ professional.

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