Taxes in retirement

As you go through life, you will encounter several "life-changing" moments.  Some are good, such as graduating college or having a child, while others are bad, such as losing a parent or going through a divorce.  These moments can also bring changes to your financial life, including how much tax you owe and how it is paid.  

This article addresses taxes in retirement.  I realize this is not chronologically accurate, but it is an issue that several people are not prepared for when they enter retirement.  

Income and deductions

A retired taxpayer will likely have very different income and deductions than they had earlier in life, maybe even than the year before.  Their wage income will be replaced by distributions from retirement plans, investment income and Social Security.  Personal exemptions for children and mortgage interest will be replaced by charitable contributions and medical expenses.  Changes in income and deductions must be considered when determining how much tax will be owed each year.

Social Security

There's no easy way to say it: if you have other sources of income, up to 85% of the gross Social Security benefits you receive are taxable.   This often comes as a surprise to retired taxpayers, because there is often no tax withholding against this income.  However, you can elect to have Federal withholding taken from your SS benefits if you don't want to change the withholding on your retirement distributions.  Fortunately, SS benefits are not taxed in several states.

Paying taxes

The most challenging part of determining taxes in retirement is determining your income from all sources and electing tax withholding to cover all of it (or pay estimated taxes).  If you are taking distributions from a retirement plan, they will give you the option to withhold taxes on that distribution.  But, this withholding will be based on that distribution alone, and most likely will not cover investment income or Social Security benefits.  The key is to set your withholding high enough to cover taxes on all of your income, not just one source.  

In all, it is important for individuals that are nearing or entering retirement to meet with their tax advisor to determine tax implications of retirement.  Your tax advisor will consider changes in your income and deductions and advise on how much to withhold from retirement distributions or quarterly estimated tax payments that need to be made.  

Unreimbursed expenses as an employee

If you work for an employer that you have a moderate level of respect for, then most likely you have gone out-of-pocket to buy something to benefit your company without getting reimbursed.  This can be a range of expenses, from mileage to birthday cakes, but there are certain rules regarding how these unreimbursed expenses can be treated on an employee's individual tax return.  

Before diving into this, there is one big catch.  For an expense to be considered unreimbursed, they must not be eligible for reimbursement or actually reimbursed by the employer.  For example, if your employer has a policy to reimburse an employee for mileage, but you choose not to seek reimbursement, the mileage is not technically an unreimbursed business expense.  Only expenses incurred above and beyond a set reimbursement policy should be considered.

Common expenses that an employee pays out of pocket that could be considered deductible include:

• Professional dues and licenses
• Depreciation on a computer you pay for yourself and required for your job
• Mileage
• Medical exams required by your employer
• Necessary tools and supplies used for work
• Work-related education
• Specific uniforms or clothing not suitable for everyday use

Of course, there is always a catch.  Here are some expenses that are, by rule, nondeductible:

• Social club dues
• Home repairs or rent
• Lobbying expenses and political contributions
• Expenses related to attendance of board meetings
• Lost vacation time

Unreimbursed business expenses are included as a miscellaneous deduction on Schedule A, and they are subject to a 2% of income limitation.  This means that only miscellaneous deductions exceeding 2% of your income will be deductible.  

Forms schedule

I commonly hear clients tell me this time of year "I'm going to get my stuff to you early this year, as soon as possible."  For most people that don't work in the accounting/tax profession (but maybe even for some that do!), taxes are a pain.  People want to get their forms, get their return done, and move on to get ready for spring.  In an effort to anticipate when you will receive certain tax forms, here is a brief synopsis of the filing deadlines for various information returns:

You should receive the following common forms by February 2, 2015:

• W-2
• 1099-INT (interest)
• 1099-DIV (dividends)
• 1099-MISC (rent, royalties, nonemployee compensation, other misc income)
• 1099-R (retirement plan distributions)
• 1099-C (cancellation of debt)
• 1098 (interest expense)

You should receive the following forms by February 17, 2015:

• 1099-B (proceeds from broker transactions i.e. investment accounts)
• 1099-S (proceeds from real estate transactions)

A quick note about amended forms - with the increased regulation of investment companies to report wash sales on Form 1099-B, you will not receive your 1099-B until the middle of February.  This gives the investment company time to see if any sales that occurred in 2014 were subject to a wash sale as a result of a transaction in the first 30 days of 2015.  As a result, it is not uncommon for the investment company to send a 1099-B in the middle of February, and then send an "amended" form later on.  If you have several transactions in your investment account, it might be a good idea to wait until March to file in case you receive an amended form.  

Almost all of the big investment companies will publish a schedule of when their customers can expect to receive forms, like this notice I got from Fidelity a few days ago.  Check with your investment company to see if they have a similar publication.  

One final note, if you are expecting a 1099 from your bank or investment company and do not receive one, don't panic.  Companies are only required to issue a 1099 if your income exceeds certain thresholds.  For example, if your savings account did not earn more than $10 for the year, the bank is not required to send you a 1099.  You can check this quickly by looking at your December statement.  

Gifts and Inheritances

There is often times confusion amongst taxpayers about the nature of gifts and inheritances, both for tax and basis purposes.  They can both be misconstrued as the same thing, but they are very different.  It is important to consult professional legal or tax advice regarding gifts and inheritances.  

Gifts

Gifts can be made by individuals to other individuals at their discretion.  Individuals can make gifts of up to $14,000 (2015) without reporting the gift.  Gifts over that amount require reporting on an annual gift tax return.  A recipients basis in the gift is typically the donor's adjusted basis (cost) in the gift when it is given.  There are special rules when the fair market value (FMV) of a gift is less than it's adjusted basis.  The recipient does not report the gift under any circumstance, unless it generates income or is sold for a gain/loss in the future.  

Transfers at death (inheritance)

Transfers received as a result of an individuals death (commonly known as an inheritance) are not taxable to the recipient, and their adjusted basis is typically the FMV of the assets on the date of death.  These assets only become taxable if they generate income or are sold at a gain/loss in the future.  If the transfer is made into a trust, the beneficiary might be required to report the income of the trust on their individual tax return.  

Application

In this scenario, let's say Sue has common stock with an adjusted basis of $10,000 and a current FMV of $13,000.  She gifts this stock to her son, Bob.  Sue does not file a gift tax return because the value of the gift is less than $14,000.  If Bob sells the stock once he receives it, he will have a capital gain of $3,000 because of the difference in the adjusted basis and the FMV.  

On the other hand, let's say Sue dies and Bob inherits the stock and immediately sells it.  He will have no capital gain or loss, because the FMV of the stock at the date of death will become his adjusted basis, which is also the same when he sells it.  

Taxpayers with assets they want to pass on should consult professional legal and tax advice in order to develop a gifting plan and a strong will to benefit their heirs or charitable organizations.  

Beware the wash sale rules

December is a popular time for most investors to review their investment portfolio to see how their year turned out.  During this process, the investor might be encouraged to sell some of their investments by means of "capital gains harvesting".  Capital gains harvesting in simplest terms is the process of selling investments positions with a gain and positions with a loss at the same time in order to generate cash with no tax impact.  Investors will then take this cash and reinvest in other investments.  

However, due to an intricate tax rule that is becoming more well known, there is a possibility that what the investor reinvests their cash in could result in the loss generated by the initial sale being disallowed.  This is known as the "wash sale rule", and states that if an investor sells an investment at a loss and then purchases an identical investment within 30 days before or after the sale (60 days total), then the loss generated on the sale is disallowed and is added to the cost basis of the subsequent purchase.

For example, let's say I own 100 shares of ABC Inc and 100 shares of XYZ inc.  In December, my ABC stock has a $100 gain, and my XYZ stock has a $100 loss.  I decide to sell them both and generate cash, with a net capital gain of $0.  This is great because I now have cash to reinvest and I have no tax impact.  Then on January 3 of the following year, I hear on CNBC that XYZ has developed a new product that is going to make them much more profitable, so I go to my investment account and purchase 100 shares of XYZ again.  Because I sold XYZ at a loss in December, and then repurchased an identical security within 30 days, my $100 loss generated in December is disallowed for tax purposes, and instead the $100 is added to the cost basis of the shares I purchased in January.  

Fortunately, due to new reporting requirements for brokerages, wash sales will be automatically reported on a taxpayer's year-end Form 1099-B.  Investors should watch their investment transactions closely during December and January and be aware of any sales that might be subject to the wash sale rule.  

Additional information on sales of investments and wash sales can be found here at the IRS website.