Critical Stuff: If you do a great job of saving for retirement but ignore taxes, you’ll be screwed.

In This Chapter: Tax code distilled. AMT-gotcha. Uncle Sugar wants it all. If you think it’s income, it’s income.

Don’t expect logic or reason in the tax code

Taxes are one of the easiest ways to screw up your retirement saving. The market goes up and down–the changes can help or hurt, but taxes just hurt.

This chapter is heavy on information and very light on advice because you almost certainly need a tax pro to help you in the early stages of tax planning. The only way I can help you here is to steer you to the right questions to ask. But that’s useful. If you’re going to have a conversation with your pro that results in optimal solutions for yourself, you have to know enough to ask the right questions, and refine the answers into strategy. Your tax pro needs a full listing of every source of payment or income you receive to be able to give you advice on the timing of decisions like when to start social security, what the ramifications of a part-time job might be, and how your distributions from tax-free accounts and annuities should be managed.

The tax code is an impenetrable mess, but if you want specific information you should start with the IRS and the tax authority of the state you reside in. They have some decent publications that convert bureaucratic doublespeak into something resembling English. It’s not Hemingway, but you can get what you need from it–probably.

Publication 525 from the IRS lists everything that is taxable as income–you can access it at  www.irs.gov  Of course since it’s the IRS, it’s endless and arcane, but if you’re wondering if an income source is taxable, you’ll find the answer there. Below is a basic list. Don’t consider this to be authoritative, I cribbed it from a number of tax preparer sources. HR Block has good information, well presented and translated into English from govspeak. Use the list below to start your conversation or your own research. There are lots of exceptions and loopholes, especially in service benefits, inheritances, and investment instruments like municipal bonds.

Ordinary income: This means wages, unqualified dividends, distributions from your IRA pension fund, or annuities, rent from real estate, interest from bank accounts or money market funds, and all the other stuff in Pub 525.

Interest from municipal bonds is generally tax exempt–both state and federal. The exception is certain “private purpose” bonds, such as those used to build sports stadiums. Many investors today buy bond funds instead of individual bonds to reduce the risk and reduce the fees from limited diversification of purchasing individual bonds. You don’t lose out on the tax-free status by purchasing these funds, the company that manages the fund will break out the tax exempt interest from the non-exempt on a quarterly basis.

Wages, salaries, and tips — anything that shows up on a W-2, including commissions, bonuses, vacation pay, sick pay and severance pay.

Any money you make on the side should be reported as income, and if you make more than $400 on the side you must pay Social Security and Medicare taxes.

Alimony–if you get it, it’s fully taxable. If you pay it you can deduct it even if you don’t itemize deductions. Child support is not taxable or deductible.

Unemployment compensation benefits are fully taxable.

Pension and annuity payments are fully taxed with some exceptions. After-tax contributions to an annuity are tax-free when withdrawn.

Awards: Fair market value of awards such as all-expenses-paid trip are taxable as income.

Barter: Fair market value of property or services you receive or provide in exchange for work done is taxable income.

Disability payments: If your employer paid the premiums for your disability insurance, disability payments you receive are usually fully taxable. If you paid the premiums it’s tax-free. Veterans’ disability benefits and workers’ comp are tax-free.

Any Gambling or prize winnings

Social Security — Depending upon your income, Social Security benefits might be entirely tax-free or partly taxable. Ex: If your income is more than $25,000 —  or $32,000 if married filing jointly — up to 85% of your Social Security benefits is taxable.

Dividends

Qualified Dividends are subject to a lower tax than ordinary income. Qualified means you have held the stock for more than 60 days in the quarter. Well, actually, it’s weirder than that. You have to hold it for 60 days of the 121 day period that begins 60 days before the dividend date. Okay, who the hell came up with that? If your holdings are in mutual funds, that holding period is subject to the fund managers whims–not yours. So the time that you choose to buy a mutual fund is important. If you buy a mutual fund just before the dividend distribution date you are “buying the dividend”–which is taxable.

Here’s how buying the dividend works: Imagine you buy 100 shares FREDCOM at $20 each, for a total of $2,000. Tomorrow  FREDCOM distributes $2 a share. The market knows this–FREDCOM shares are $20 instead of $18 because FREDCOM is going to distribute two bucks. They send you $2 per share, or $200, and your $20 shares are now worth $18 (probably). That $200 distribution counts as taxable income. You haven’t participated in the growth of FREDCOM, you’ve simply spent two bucks to buy two bucks, and it’s taxable.  Don’t do that.

Capital Gains

Capital gains are the gain (or loss) in value of any asset you own. The asset sale is categorized as a short or long-term capital gain, depending on how long you have held the asset. Short term is one year or less and, in general, the short-term tax rate is the same as the rate for ordinary income. The long-term rate is currently 5 percent if your tax bracket is less than 25 percent and 15 percent if it is higher, though the long-term capital gains tax on some items like coins, precious metals, and jewelry is 28 percent. Something gold bugs should consider in their plans for such investments.

A capital gain or loss is calculated by subtracting the basis from the sale price. Basis is the purchase price plus any costs associated with the purchase as well as any costs for improvement of the asset. So for stocks and bonds the purchase price plus professional fees associated with the purchase is the basis. Unique to stocks and bonds is the notion of a wash sale, where you sell a stock or bond at a loss and then purchase the same or a very similar asset within 30 days. The loss may be disallowed by the IRS as a deduction from ordinary income or as an offset from a capital gain from another asset, but any amount thus disallowed is added to the cost basis of the new asset.

The tax you owe is the net of short-term gains and losses plus the net of long-term gains and losses. If you have a net loss you can deduct that dollar for dollar from your ordinary income up to $3000 ($1500 if you are married filing separately). Any capital losses beyond that you can carry forward to subsequent years to either offset capital gains or deduct from ordinary income. If you die before the capital loss is all consumed it can be inherited by your spouse, but it’s not transferrable to any other heir.

Yeah, I know, I worked hard to make that more understandable, but the IRS guys are geniuses at making stuff incomprehensible.

Capital gains also apply to the sale of any other asset, such as your home, cars, vacation homes, land–any asset. Part of simplifying your life in retirement and an important part of your nest egg may be the sale of these kinds of assets. Each asset class has some special aspects that may adjust the basis or limit the tax. Professional advice is a good idea for these complexities, but here’s a basic idea of what to look for:

Home Sale  The price you paid for the home plus any improvements you made with a useful life of more than a year, plus assessment for local improvements (like sewer or city water) plus any amount you spent to recover from a casualty, plus closing costs and professional fees but not mortgage fees forms the basis for computing gains. So it’s very important to keep track of all these costs. When you sell your primary home you can exclude $500,000 of the gain ($250,000 if single or filing separately) if you meet the requirements for ownership and residence. The rules are a little complex, but currently, you can take this exclusion every time you sell a home as long as you have lived in it as your main home for more than two years. You can’t have taken the exclusion for another home in that two years, so the timing of the transactions is important. The exclusion forms one of the reasons for “house flipping”, the practice of selling a home, buying another in need of repair and upgrade,  spending two or more years improving its value and then selling it and repeating the process. It’s also a reasonable tactic to sell or rent your main residence and move to a vacation home you own, converting it to your main residence for at least two years before you sell it.  As usual, the relevant tax code is complex, there are provisions for a reduced exclusion for homes where you don’t meet all the ownership and residence rules. You can figure that out by reading the tax code in IRS publication 17, or ask a professional tax advisor (but double-check the answer. They aren’t god-like, they make mistakes).

Alternative Assets  Art, coins, stamps, collectibles, precious metals, and other similar assets are currently taxed at a long-term rate of 28 percent. If a fund you own invests in these kinds of assets you will pay that 28 percent maximum capital gain when you sell the fund. When the fund sells some of those assets that portion of the gain will be taxed at 28 percent. There are other funds that incur higher tax rates as a result of the kinds of investments they make. For example, funds that invest in derivatives may have some part of their gain taxed as ordinary income.

Social Security

Your tax bracket is very important when collecting social security. The reason that many people who collect Social Security find it unprofitable to work is that both the percentage of their Social Security income that is taxable increases, and their tax bracket increases–it’s a double whammy. If you are in a low tax bracket, none of your social security is taxable, but if you have substantial income beyond social security then as much as 85 percent of your Social Security may be taxed at your maximum tax rate. It can be worthwhile to pay close attention to what you do to pay for your living expenses just to keep out of the double-whammy zone. Ultimately retirement is about the quality of life, not the quantity of money, so if you’re doing something that makes you happy but it screws up your social security , then rock on–as long as you fully understand the consequences.

There’s a worthwhile calculator here. You might find it difficult to get accurate numbers for the data required, but you can fudge it a bit. The bad news is that it’s very easy to get to the 85 percent taxable social security level. the good news is that if you’re taxed that much, your lifestyle probably won’t be altered by the tax.

Alternative Minimum Tax

The AMT can be a terrible sinkhole for people in specific income classes. The AMT trigger is a set of calculations that determines the minimum tax that a person with your income should pay. If you fail that test an AMT tax is added to your normal tax amount. The AMT also kills itemized deductions and can turn unexercised options into tax liabilities. The full ramifications are beyond my knowledge though not my experience, I have been stuck paying AMT many times. This is definitely a place for professional advice.

State Taxes

Each of the 50 states plus the US territories has their own tax code. The total tax burden from income tax, sales tax, property tax, and other assessments is one of the primary issues you should consider if you are considering relocating for your retirement. For example, I have my primary home in Oregon and a secondary residence in Maui. Both are delightful places, but I earn the title of tax moron for selecting them for retirement.

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The Retirement Trap Copyright © by Bill Babcock and Babcock, William. All Rights Reserved.

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