LOS ANGELES (MarketWatch) – It’s not news that the supercommittee didn’t commit. We’re sitting here in November, once again, waiting for legislation that will or won’t extend certain tax benefits, like the 2% reduction in Social Security withholding.
What can you do to keep your head above water, keep your taxes as low as possible, and take advantage of tax breaks that are still in effect?
Start out by doing a projection of your adjusted gross income (AGI) and potential standard deductions for 2011. Schedule an appointment with your tax professional to discuss these tips. If you’d prefer to do this yourself. then get a planning tool that is powerful and detailed enough to address things like Alternative Minimum Taxes, passive losses and other limitations, if they affect you.
Many tax pros use the versatile CFS Tax Software products for planning purposes.
See the CFS site. If you can’t afford that, or don’t need the complexity, tap into TurboTax’s TaxCaster 2011 free tax calculator
(See site here.) or H&R Block’s 2011 tax estimator
here.Tap your bloated retirement accounts
One of the most overlooked tax planning tools is the retirement account. It’s either used indiscriminately — resulting in excessive taxes and penalties — or it’s not used at all, when you could draw the money practically tax-free.
Folks over age 59½: If 2011 takes you to a 10% or 15% tax bracket, perhaps this is a good year to start drawing IRA and retirement money. Don’t spend it if you can afford to retain the money — roll it into a Roth IRA instead.
For instance, Lawrence has been living on Social Security and his pensions for a couple of years, paying no taxes at all. He has such a substantial build-up in his retirement accounts that he could easily draw up to $15,000 without paying more than $500 in Federal or state taxes.
Wally had more than $40,000 of medical expenses for in-home care he paid for himself and his mother for the past five years. No one ever advised him to tap his $500,000 401(k) account during all those years. He could have moved at least $30,000 a year into a Roth IRA without paying a dime in taxes.
Seniors age 70½ and over must draw the required minimum distribution (RMD) from their retirement accounts — or face substantial penalties. These are often the same people who tend to tithe, or be generous to charities. Through the end of 2011, we still have that special qualified charitable distribution allowing you to donate $100,000 in distributions from your IRA directly to charity. You won’t get a charitable contribution deduction. But you won’t pay any taxes.
See the IRS publication on special qualified charitable distribution here.Geithner: Tax reform isn’t enough
Treasury Secretary Timothy Geithner says the key to U.S. economic growth is to focus on how to make the country a better place to build things.
Let’s not forget you young whippersnappers who built up rich accounts during the height of the market and the heady IPO days. Do you want to retire in your 20s or 30s? But most of your money is in your retirement account? No problem. There’s a special code section that allows you tap into your account right now — without those nasty 10% (plus state) early withdrawal penalties. You are permitted to draw the funds in substantially equal periodic payments over your life expectancy.
See related article from the IRS.Retirement account rape
You are younger than 59½. You aren’t one of the fortunate folks who have managed to build up healthy retirement accounts. In fact, you’ve been out of work, or faced cutbacks and furlough days. Your income has been so dramatically reduced, you’ve had no choice but to deplete your retirement account.
In addition to being broke and having to pay taxes on that money, you’re also faced with 10% early withdrawal penalties from IRS — plus your state’s penalties. Wouldn’t it be great if Congress could unanimously pass legislation waiving all early withdrawal penalties until this financial crisis is over? Alas, no one is even proposing that considerate provision.
What can you do to avoid the penalties?
As it happens, there are a few provisions in the Tax Code you can use. Not as many as you may need, but you will find a list of exceptions to the penalties in the instructions for line 2 of IRS Form 5329.
See IRS instructions for Form 5329 here.Most of these exceptions only work on withdrawals from IRA accounts, not 401(k)s or other pensions. If you haven’t drawn the money yet — move the money to an IRA before you draw it out. Otherwise, most of these exceptions will not help you.
Exception 3 — You can draw as much money as you need if you are permanently and totally disabled. Hopefully, that’s not your situation. But if it is, get documentation from your physician to back that up.
Exception 5 — Qualified retirement plan distributions up to (1) the amount you paid for unreimbursed medical expenses during the year minus (2) 7.5% of your adjusted gross income for the year. That 7.5% of AGI will take in account your IRA withdrawal. So, your income might still be too high to give you any benefit.
Exception 6 — QDROs. Bad times often result in divorces. Should you be in that position, you can transfer part or all of your pension to your spouse without paying either tax or penalty, using a qualified domestic relations order (QDRO) issued by a court. (Note: This only applies to pensions, not IRAs.) Your spouse may roll over all the money to an IRA, also without penalties or taxes. If a spouse needs to live on the money, they have the option to cash out all, or part of the money during that transfer, without penalties.
Exception 7 — This is designed to help people who are unemployed. That applies to nearly 10% of our working population. During the months you are unemployed, the money you’ve drawn to keep paying your health insurance will be penalty-free.
Exception 8 — When you’re not working, or under-employed, it’s a good time to get re-educated into a more marketable skill. Funds used for higher education expenses will also avoid the penalty.
Exception 9 — This is not likely to apply to you when you’re broke. Or it just might, with housing market prices so low, and interest rates the lowest ever. Buying a home might be substantially cheaper than renting in many areas of the country. Draw up to $10,000 as the down payment on a home. You must not have owned a home for more than two years.
Exception 10 — Is for people in trouble. You’re behind on your federal taxes. IRS is after you to pay. The only way you can get this pressure off is to use money from your retirement accounts (IRA or pension). Don’t do it! It’s a trap. Draw that money to pay your taxes and you’re faced with taxes and early withdrawal penalties from IRS, state and your financial institution. If you must use this money, tell IRS to levy your account. At least the IRS and state penalties disappear. IRS staff hate to do this. It requires a mountain of paperwork. But it’s to your advantage to have them do it for you.
Exception 11 — Those noble reservists don’t get their regular income while serving their country. They or their families often find themselves needing funds to cover the shortfall. When on active duty for more than 180 days, draws from any retirement accounts are tax-free.
There are a few other exceptions that might apply to you. Read the rest of the instructions, and get help interpreting them. Wishful thinking often makes the exceptions sound like they apply to you — when they do not.
