Q. When I got my W-2 form, it showed that I earned $48,000 last year. I know that's wrong because I remember how proud I was when I got my raise to $50,000. What do I do to correct the W-2 before I send it to the IRS?
A. Don't be in such a hurry to report more to the IRS. Remember, any amounts you contributed to a 401(k) retirement plan or a medical or child-care reimbursement account shouldn't show up as taxable income on your W-2. If you didn't make such contributions, though, your W-2 could be incorrect. Check with your company's payroll office.
Q. Our church raffled off a $28,000 car as part of a fund-raising drive. I was the lucky winner. Am I right in assuming that prizes awarded by churches are tax-free?
A. Unfortunately, this is considered taxable income. The fair market value of the car is considered taxable income to you. You can deduct what you paid for the raffle tickets to reduce the fair market value. Remember, too, the taxable income is the value of the car, which is usually less than the dealer sticker price. The fair market value generally is what the average person would be willing to pay for the automobile.
Q. I have a flexible spending plan at work that lets me pay medical bills with pre-tax dollars. If I get a Health Savings Account, can I use FSA money to pay my medical bills so I can let money in the HSA accumulate? I figure that would be like having an extra IRA for retirement savings.
A. The IRS is ahead of you on this one; the rules ban such double dipping. You can't have an HSA at all if you have any other kind of health insurance beyond the high-deductible policy to which the HSA is tied. A regular medical reimbursement account for FSA for medical bills is considered insurance for this purpose. However, if your company plan allows reimbursement only for dental and vision care and wellness care (such as annual physicals), then it doesn't put the kibosh on an HSA.
Q. In addition to my job, I do a little carpentry work on the side. Last year, I made about $3,000 doing odd jobs for neighbors. I know it's taxable but am not sure where to report it. Do I count it as "other income" on the Form 1040?
A. No. It is self-employment income and should be reported on a Schedule C. We handle this in the "Your Own Business" section of the interview. On the plus side, you also get to deduct the cost of any materials you used, plus the cost of transportation to and from the jobs. Since your self-employment income was more than $400, you also have to file a Schedule SE and pay Social Security and/or Medicare taxes on the income. (If you earned more than $94,200 on your job in 2006, you don't owe the 12.4% Social Security taxes on self-employment income but you do owe the 2.9% Medicare tax.) TaxCut will automatically prepare the Schedule SE after you answer the interview questions about your business.
Q. I invested in a tax-free municipal bond fund three years ago and when I sold it the shares were worth less than what I paid. Can I deduct the loss even though this was a tax-free investment?
A. Yes. If you sold for less than your basis in the shares, you have a capital loss. You can use it to offset any capital gains and up to $3,000 of other income. An exception to this rule won't affect you because you owned the shares for three years. When muni-bond fund shares are owned for six months or less, any loss must be reduced by the amount of any tax-free income received from the fund during the time the shares were owned.
Q. After my elderly aunt died, I learned she had named me beneficiary of a $25,000 life insurance policy. Where do I report that income on my return?
A. You don't. Proceeds of a life insurance policy are tax-free, as are most inheritances. A major exception to the tax-free rule: If you inherit a retirement plan or traditional IRA, you will be taxed on the money as it is withdrawn, just like the owner would have been taxed. In most cases, that means all income will be taxed in your top tax bracket.
Q. I inherited some stock last year and sold it for several thousand dollars. Do I have to pay any tax on the amount I received from the sale?
A. Maybe. Believe it or not, the sale might actually wind up cutting your tax bill. Your tax basis in the stock, the amount from which you figure your gain or loss, is usually its value on the date the previous owner died. On rare occasions an alternative valuation date six months after the date of death is used if the estate was big enough that a federal estate tax return had to be filed. In either case, the executor of the estate should be able to help you pinpoint the value. If you sold the stock for more than that amount, you must pay tax on the difference. In other words, you owe tax only on appreciation that occurred after you became owner of the stock. No matter how long you own inherited property before selling it, profit is always considered long-term gain so you get the advantage of the 15% long-term gain rate (or just 5% if you're in the 10% or 15% tax bracket). In the interview, type "inherit" in the space for the acquisition date so we know you automatically get long-term gain treatment. If you sold for less than your basis, you have a deductible capital loss.
Q. I got a $600 state tax refund last year and see that I'm supposed to report it as income on my federal return. That doesn't seem fair, since the refund just made up for my overpayment of state taxes. Do I have to pay tax on it?
A. All, part, or maybe none of the state tax refund may be taxable. First of all, if you did not itemize on your federal return last year, none of the refund is taxable. If you itemized, but deducted the sales tax instead of the state income tax, then none of the refund is taxable. If you itemized and claimed state income tax as a deduction, this deduction lowered your federal taxable income and, therefore, it lowered your taxes. In a sense, the refund from the state is evidence that you claimed too big of a deduction for state taxes. Rather than make you file an amended return for the previous year, the IRS requires that you report part or all of the refund as income. The Interview for this subject will determine how much, if any, you have to report.
Q. I invest in a family of mutual funds, primarily so I can easily move my money around from stocks to bonds to money-market funds. Is it true that whenever I transfer money from one fund to another the switch can result in taxable income?
A. Yes. When you tell the fund to transfer funds from a stock fund, for example, to a money-market fund, what occurs is the sale of your shares in the stock fund for a taxable gain or deductible loss and the reinvestment of the money in the money-market fund. Selling the shares in the stock fund will result in taxable income if the shares have risen in value since you purchased them. You don't have to worry about capital gains when you move money out of a money market account because share value stays constant at $1, so there's no gain or loss.
Q. How long do I have to keep my mutual fund statements for tax purposes?
A. Basically, you need to keep back-up for your tax returns for as long as the IRS can question you about them. Usually, that's three years after the due date of the return. So, a 2006 return due April 16, 2007, is subject to audit until April 15, 2010. But this doesn't mean you need to keep every monthly statement. If transactions are summarized on a year-end statement, you can pitch the monthlies.
Q. I lost my job last year and was on unemployment for five months. Now I get a tax statement saying the benefits are taxable. Is that right?
A. Yes, unemployment benefits are fully taxable that's why we ask you about it in the Interview and the IRS gets the same information you received.
Q. I've heard that the tax benefits of medical reimbursement accounts are so powerful that it makes sense to use them even if you wind up forfeiting part of the money. Is that possible?
A. Absolutely. Money funneled through these accounts escapes federal income and social security taxes and, except in New Jersey, state income taxes, too. Let's say you contribute $1,000 to an account and wind up using just $800 of it. Under the use-it-or-lose-it rule, you forfeit the $200. That hurts, but console yourself with this thought: You probably would have had to earn more than $1,000 to have $800 left after taxes to pay those same medical bills with after-tax dollars. If you're in the 25% federal tax bracket and face a 5% state rate and the 7.65% social security tax, you'd have to earn $1,258 to have $800 of spendable income. So, even after forfeiting $200, you saved $258. Not bad. . .and that's the reason we encourage taxpayers to be aggressive when contributing to reimbursement accounts.
Q. As a new "benefit," my company now offers to buy employees mass transit passes with money withheld from our paychecks. What's the point if the money is coming out of my pocket anyway?
A. The point is that by having the company buy the transit passes, you get your bus or subway fare with pre-tax dollars. The law allows firms to offer workers up to $105 in mass-transit passes each month. If you're in the 25% federal income tax bracket, you have to earn about $155 to have enough to buy $105 in fares after $50 is skimmed off for the IRS and for social security and Medicare taxes. Your money goes a lot farther when you get to spend pre-tax dollars.
Q. Congress seems unable to leave the capital gains rules alone. What's the latest?
A. For a change, the rules for 2006 are the same as those that applied in 2005.For sales any time in 2006, short-term gains are taxed in your top tax bracket, as high as 35%. A short-term gain is the profit from the sale of an asset owned one year or less before the sale. The rate on long-term gains the profit on the sale of assets owned more than one year is a flat 15%, except for taxpayers who fall in the 10% or 15% whose long-term gains are taxed at 5%. And, as the law stands now, in 2008 and only in 2008 the rate for lower-bracket investors will be 0%. That's right, ZERO.
Not all long-term gains get the sweet 15%/5% rates, however. Profits on collectibles are still taxed at 28% and profit on real estate attributable to depreciation deductions is taxed at 25%.
Q. There's been an awful lot of talk about the "marriage tax penalty." Did Congress really fix it, at last?
A. The lawmakers have gone a long way toward eliminating the so-called marriage penalty the quirk in the tax law that made some couples pay more combined tax on a married-filing-jointly return than they would owe if they could file as single individuals. To attack that problem, Congress boosted the size of the standard deduction for married people so it is now exactly twice as big as the standard deduction for single people. (In the past, trading two single standard deductions for one married one cost the couple part of their money savings deductions.) Second, the lawmakers widened the 15% bracket for joint returns so it holds exactly twice as much income as the 15% bracket on single returns. (Since it was less that twice the size in the past, marriage could push more of the couples income into the next higher bracket, costing them money.) These changes significantly reduce the marriage penalty. Even better: they save money for all married couples, even those who used to enjoy a "marriage bonus," paying less tax on a joint return than they would if they filed as single people. The bonus is now bigger than it was before the change.
Q. My wife and I both work and each of our employers offers child-care reimbursement accounts. Is there any reason it might be more advantageous for one of us to use the account than the other?
A. It's possible. Assuming you file a joint return, the income tax savings will be identical. But if one of you will make more than the social security wage base (it was $94,200 in 2006, it could pay to have the lower-earning spouse use the reimbursement account. Why? Because money run through the account escapes social security as well as income taxes, and the 6.2% social security levy stops when income passes the wage base amount. Only if the taxpayer using the account earns less than that do you get the full-powered tax savings.
Q. Our teenage son worked at a neighborhood grocery over the summer and made $1,200. I know the standard deduction is much higher than that so I assume he owes no taxes on his miniscule earnings. The question is, does he have to file a return anyway?
A. Maybe so, maybe not. But, whether or not he has to file, he should file if taxes were withheld from his checks. It's the only way to get that money back.
For 2006, the basic standard deduction on an individual return is $5,150. But, assuming you claim your son as a dependent on your return, his standard deduction is less. For children who are claimed as dependents, the 2006 standard deduction is either $850 or, if greater, the total of earned income plus $300, up to a maximum of $5,150. That means your son's standard deduction is $1,500 (his $1,200 earned income plus $300). So, if your son's investment earnings from a savings account, say, or mutual fund are $300 or less, he'll owe no tax and is not required to file. If investment earnings are over $300, though, he must file and will owe some tax on his investment earnings.
Even if he is not required to file, doing so is the only way to retrieve any income taxes withheld from his paycheck. TaxCut will make short work of this chore. If he has a checking or savings account, be sure to say "yes" to the question about direct deposit of his refund and fill in the necessary information so he gets his money back as soon as possible.
Q. Our daughter baby-sits and, between weekend and summer jobs, made over $2,500 last year. She says most of her friends with similar income don't file tax returns at all. But we want her to file so she can use her earnings as the basis for a Roth IRA contribution. However, we can't figure out where to report the income. She didn't get a W-2 form and we can't believe she has to file a Schedule C as though her babysitting is a business. Do we report her earnings as "other income"?
A. No, but the "other income" part of our interview is where we collect the information about this kind of income, under the sub-topic "other wage type income". On her return, the income will show up on the line for wages. You're correct: She doesn't need a Schedule C. By the way, the law does not require that a return be filed to contribute to a Roth. The Roth contribution is not reported on the return.
Q. My daughter's 13th birthday was April 8, and I see the rules on the child-care credit say that you can only count expenses for the care of children under 13. Does that mean I lose the child-care credit?
A. You can still claim the credit, based on the amount you paid for her care during the part of the year before her birthday. Despite the fact that your child qualified for only part of the year, you may base the credit on up to $3,000 of qualifying costs the same limit that applies to expenses paid for a single child for the entire year. If you have two or more children under 13, you can claim the credit against up to $6,000 of expenses.
Q. My mother lives with us and I'd like to supplement her income by paying her to watch the kids while I work. Will what I pay her count toward the child-care credit?
A. Yes, assuming you don't claim your mother as a dependent on your tax return. Remember, you'll need to report your mother's name and social security number on your return, as the caregiver who was paid. If her income is high enough, she'll have to file and pay tax on the earnings.
Q. The lady who takes care of our kids also cleans and cooks dinner for our family. Can we include her full salary when figuring the child-care credit, or do we need to break it down between child care and other services?
A. Assuming that providing care for the children while you work is one of the reasons you hire the care giver and that the other services performed benefit the children, you can include the full salary.
Q. I know that I can give $10,000 in tax-free gifts to each of my children each year. Where do I deduct these gifts?
A. You don't. (The annual gift tax exclusion is actually $12,000 for 2006.) This doesn't mean you get to deduct your gifts; it means you don't have to pay gift tax on them. The federal gift tax exists to prevent people from getting around the federal estate tax by giving away all their assets before death. So, gifts during your lifetime are taxed just like bequests. Except, and this is a big exception that protects most of us the first $12,000 in gifts to any number of individuals is ignored for gift tax purposes. (The amount doubles to $24,000 if you're married and your spouse joins in the gift.) If you give more, you have to file a federal gift tax return, but you probably won't really owe any tax. That's because everyone has a credit that offsets the tax on the first $2 million of taxable gifts or bequests. Any part of that credit that you use up to offset gift taxes during your lifetime won't be around to offset estate taxes after your death. (Although the estate tax is scheduled to disappear, briefly, in 2010, the life of the gift tax extends beyond that time.)
Q. We want to loan our daughter and son-in-law $10,000 toward the down-payment on their first home. We don't want to charge them interest but a guy at work says the IRS demands that we do so. Is that true?
A. Not on a $10,000 loan. There are rules that require lenders to charge a reasonable amount of interest on larger loans, however. For loans between $10,000 and $100,000, though, that requirement is waived if the borrower's investment income is less than $1,000. Basically, the government is worried about parents loaning money interest-free to their children who would then invest the money and pay tax on the earnings in a lower tax bracket than the one inhabited by the parents. The government doesn't care about your $10,000 loan to help with a down-payment. Be generous.
Q. I'm paying back college loans my daughter took out while she was in school. Can I deduct the interest?
A. Not unless you co-signed the loans. Only a person who is legally responsible for repaying a debt can deduct the interest. If your daughter is responsible for repaying the debt, it would make more sense for you to give her the money and let her make the payments. That way, she gets to deduct the interest. Up to $2,500 of interest on qualifying student loans is deductible on 2006 returns. This deduction is available even to those who do not itemize deductions. The right to this deduction gradually disappears as 2006 adjusted gross income rises from $50,000 to $65,000 on single returns and $105,000 to $135,000 on joint returns.
Q. Last year, my church had a major fund-raising drive and I was asked to donate my time as a photographer in lieu of cash. Billed at my standard rate, the job would have brought me at least $2,000. An accountant tells me that all I can deduct is the cost of the film and other supplies paid for. I think he's being too conservative. Can I deduct the full $2,000 as a charitable contribution?
A. No. Your accountant is correct because the law does not allow a deduction for the value of services. That might not seem fair, but it makes sense. Here's why: If you had charged $2,000 for your services that would have been taxable income. Turning around and donating the cash to the church would have earned a $2,000 write-off. The result would have been no change in your taxable income, or your tax bill. Similarly, donating your time means you don't have the extra income to report in the first place, so there's no need for a deduction to offset it. Sorry.
Q. I gave my 1994 Ford Aerostar to the Salvation Army last summer. How do I figure its value for tax purposes?
A. It's a lot easier than it was in the past, although perhaps not as profitable tax-wise. Concerned that Americans were habitually over-inflating the value of such gifts, Congress changed the rules as of January 1, 2005. Basically, within 30 days of the time the charity sells your old car for more than $500, it must send you a notice showing the selling price. The notice should come on Form 1098-C. That's your deduction. (Some critics of the change say that because charities often auction off donated vehicles in a hurry, the selling price may be less than the true market value, which is what you're supposed to get to deduct.) Now, if the charity fixes up your car to give it to a needy person or uses the vehicle in its charitable activities, you can still base your deduction on the estimated fair market value at the time of the gift -- using estimates from www.kbb.com or www.edmunds.com for example.
Q. I've heard that it makes more sense to give mutual funds to charity rather than cash. If the gift is deductible either way, why does it matter what form it takes?
A. It matters because the tax law includes a special break for gifts of appreciated property, such as mutual fund shares that have increased in value. If you have owned the shares for more than one year, you can deduct the full fair-market value of the shares on the day of the donation and never have to pay tax on the appreciation up to that point. Say, for example, that you bought shares for $1,000 more than one year ago and that they are now worth $2,500, the same amount you want to give to a charity. If you give $2,500 in cash, the charity gets $2,500 and you get a $2,500 deduction (which saves you $825 if you're in the 33% bracket). If you give the shares instead, the charity still gets $2,500 (as a tax-exempt entity, it owes no tax on the appreciation), you still get a $2,500 deduction and you get something more: you get away from the capital gain tax on the $1,500 of profit. That saves you another $225. What if you don't want to part with your mutual fund? Give the shares away anyway and use the $2,500 you were going to give to the charity to buy them back at today's price. That way, only appreciation in the future will be taxed.
Q. I volunteer at school every Friday afternoon. Can I deduct what I pay a baby-sitter to care for my infant while I donate my time?
A. No, the IRS says that's not a deductible expense. However, you can deduct as a charitable contribution the cost of getting to and from the school, 14 cents a mile if you drive your own car, and any out-of-pocket expenses, such as what you pay for supplies if you're doing craft projects, for example.
Q. What's the story on these so-called "tax-deductible vacations" that let people deduct the cost of exotic travel?
A. You're probably referring to research expeditions sponsored by groups such as Earthwatch and the University of California's Research Expedition Program. They need volunteers to help with projects around the world, most of which focus on animal behavior, anthropology, archaeology, and the environment.
Participants pay to take part, usually between $1,000 and $3,000 or so for ten-day to three-week expeditions. The money supports the research and covers room and board. Participants also have to pay to get to and from the research site. And, yes, the full cost can qualify as a charitable contribution.
As you may suspect, the IRS isn't keen on subsidizing fun and games, which is why expedition sponsors recoil when their projects are called "tax-deductible vacations." While there is no question that the part of the fee paid to support the research is deductible, travel and room and board expenses can be written off only if there's "no significant element" of personal pleasure or vacation involved in the trip. The IRS doesn't say what constitutes "significant" pleasure, but concedes that you don't lose the tax break if you happen to enjoy the expedition.
Q. Last spring my alma mater invited me to return to the campus for a "career day" to talk with graduating seniors about my profession and job prospects in the field. The college agreed to pay $150 of what turned out to be $225 in expenses. When I got the check, however, the payment was labeled an honorarium rather than expenses. I'm concerned that now I'll have to report the $150 and pay taxes on it as well as being out the unreimbursed $75. Is this what they mean when they say no good deed goes unpunished?
A. Don't worry. The trip will wind up cutting your tax bill rather than adding to it. How you handle matters on your return depends on whether the college sent you a Form 1099 listing the $150 as income received by you. If so, the school sent a duplicate to the IRS, and the agency expects the amount to show up somewhere on your return.
The $150 has to be reported as "other income" on the Form 1040 but you then deduct the entire $225 in expenses as a charitable contribution on Schedule A. If you didn't get a Form 1099 from the college, treat the money as what it really was reimbursement of expenses. That means you don't report the $150 as income. And you can still squeeze a charitable contribution out of the remaining $75 in unreimbursed expenses.
Q. I had my eyes "done" last year, undergoing laser eye surgery to correct my vision. I can see great now, but my pocketbook hurts. It cost me $2,500. Can I at least include the cost in my medical expenses?
A. Yes, and it might push you over the high threshold that blocks most taxpayers from getting any benefit from medical expense deductions. Medical expenses are deductible only to the extent they exceed 7.5% of your adjusted gross income. If your total unreimbursed expenses for the year, including what you paid for medical insurance with after-tax dollars, pass the threshold, Uncle Sam will help pay for your new eyes. A tip for those considering such surgery in the future: You also can use pre-tax money funneled through a medical reimbursement account to pay the bill. This has the same money-saving impact as deducting every dime. In fact, it's even better, since medical reimbursement account money also avoids the social security tax. If your employer offers such a plan, take full advantage of it.
Q. Can I deduct the cost of Weight Watchers?
A. The IRS says that if your doctor will attest that you are obese, you can deduct the costs of weight-loss programs to help you shed the extra pounds. The tax agency's change of heart on this issue also means that you can pay for Weight Watchers and other dieting programs with pretax, flexible-spending-account money. (The cost of a health club and special food doesn't count.) To get flex-plan reimbursement, ask your doctor for a note that says the program has been recommended for treatment of obesity. If you're adding the cost to your medical expense deductions, it would also be a good idea to have such a note in your tax records in case you are audited.
Q. What's the rate for deducting mileage for 2006? I know it changes every year.
A. The 2006 business mileage rate is 44.5 cents. For driving to a new location as part of a job-related move and for travel for medical care the rate for 2006 is 18 cents a mile. For volunteer work, a rate that is set by Congress, not the IRS, the rate is 14 cents a mile. For volunteer work related to hurricane Katrina, the rate is 32 cents per mile.
Q. I run a day-care business in my home and claim home-office deductions for part of the utilities, insurance costs, depreciation, etc. The mother of one of the children I care for says claiming home office deductions now could cost me a lot when I sell the home because the profit won't be tax-free. I didn't understand the point. Can you help?
A. Don't worry. In the past, though, there was a potential problem. First, the basic rules: If you have owned and lived in a home for at least two of the five years leading up to the sale, up to $250,000 profit is tax free if you file an individual return and up to $500,000 is tax-free if you file a joint return. Those levels are high enough to protect almost all home sellers. But, until 2003, if you had a home office, that part of the home was considered business property, not a home sweet home. So, that portion of the profit was out in the cold, vulnerable to taxation. If you claimed that 20% of your home is used in your business, then when you sold, 20% of the profit could be taxed.
But in a surprise move in 2003, the IRS reversed itself and declared that having a home office or using part of your home for day care won't scotch the tax-free treatment of a portion of the profit. The full profit can be tax-free, up to the $250,000/$500,000 limit. Actually, not all of the profit will be tax free: Profit resulting from depreciation deductions claimed for business use after May 6, 1997, is taxed at a flat 25% rate (unless you are in the10% or 15% bracket, in which case that rate would apply).
Q. My kids got together and bought new furniture for my office as a Christmas gift. I don't want to play Scrooge, but if I had purchased the furniture myself I could have depreciated it as a business expense. Does the fact that I received it as a gift deny me the opportunity to write off the cost?
A. No. If you could depreciate the furniture if you bought it yourself, you can write it off even though you received it as a gift. Your basis the amount to be depreciated is either the fair market value of the furniture when you received it or what your children paid for it, whichever is less. Since the furniture was a gift, you don't get the option of expensing that is, writing off up to $108,000 of the basis at once. You must depreciate it to get a tax benefit.
Q. As part of a search for a new job, I flew cross-country several times at my own expense for interviews. Is the cost of my flights and other expenses deductible?
A. Maybe. Reasonable job-hunting expenses can be deductible if you were looking for a new job in the same line of work, rather than trying to switch careers. If you qualify and you can even if you didn't get a new job you can deduct the cost of food, lodging and transportation for trips that took you away from home overnight. (Only 50% of your meals and entertainment count as a deductible expense.) Unfortunately there's a big catch: job-hunting expenses are considered miscellaneous itemized deductions, which means you get a write-off only to the extent that the total of your expenses exceeds 2% of your adjusted gross income. If your AGI is $50,000, then, the first $1,000 of miscellaneous expense don't count.
Q. Is it true the old limit on IRA contributions has been increased?
A. Yes. The limit for 2006 for both traditional IRAs and Roth IRAs is $4,000. It will rise again, to $5,000, in 2008. Taxpayers age 50 and over can make even bigger contributions. Thanks to what's called a "catch-up" contribution, the limit for those 50 and older is $5,000 for 2006 and 2007 and $6,000 for 2008 and later years.
Q. As I was preparing my return, I discovered by my Roth IRA which I converted from a regular IRA early in 2006 is actually worth less now than when I converted. When figuring the income to report from the conversion, do I use the value at the time I made the switch or the value at the end of 2006?
A. You report the value of the account on the day you made the conversion. But there is a way to avoid paying tax on the money that has disappeared in the meantime. You can un-convert the account, "recharacterizing" it as a regular IRA. You do that by telling the IRA sponsor to make a direct transfer to a traditional IRA. You have until October 15, 2007, to recharacterize a 2006 conversion. But if you do it before you file your return, you don't have to pay tax on the conversion. (If you recharacterize after filing, you'll need to file an amended return to retrieve the tax paid on the conversion.) Note this: If you recharacterize a Roth back to a regular IRA in 2007, you can't convert that account back to a Roth until 2008.
Q. I'm 65 and have a substantial amount in a traditional IRA, including money I rolled over from my company 401(k). I've been told that, at my age, it would be a mistake to convert any of my money to a Roth IRA. Do you agree?
A. No. At any age, converting to a Roth can pay off perhaps handsomely. Although converting to a Roth requires that you pay tax sooner than if you would have to otherwise, there are advantages that could easily outweigh that disadvantage. A key is that you have money outside the Roth to pay the tax on the conversion. That lets you leave as much as possible inside this great tax shelter. Remember, since you're older than 59 1/2, once you convert, all future earnings inside the Roth are tax-free. Also, there's no requirement that you begin withdrawing money at any age, giving the tax shelter added life. (You must start tapping a traditional IRA once you hit age 70 1/2.) And, if there's money in the account when you die, your heirs get it tax-free. (The balance of a traditional IRA is taxed to the heirs, in their top tax brackets.) The conversion isn't guaranteed to be a winner, though. If tax rates fall in the future (so the tax rate you wind up avoiding is lower than the tax you paid on the conversion) a conversion could turn out to be a mistake, because it would mean you paid tax at a higher rate than you would have had to. Still, the Roth could overcome even a drop in rates. That depends on how long the money in the Roth has to grow before being withdrawn, how important it is to stretch out the tax shelter and leave money to your heirs tax-free. Also, pay the tax sooner rather than later could save on estate taxes by removing the money from your taxable estate. Bottom line: We think the Roth is likely to pay off IF you have the cash outside of the account to pay the conversion tax.
Q. Can I open a Roth IRA for my wife, even though she doesn't have a job?
A. Yes, assuming you have sufficient income from a job or self-employment and your modified adjusted gross income is less than $160,000. As Modified Adjusted Gross Income (MAGI) which is basically your income before subtracting exemptions and itemized deductions rises between $150,000 and $160,000 on a joint return, the ability to use the Roth IRA disappears. If that test doesn't trip you up, you can contribute up to $4,000 of your 2006 earnings to an account for your wife as well as contributing $4,000 to your own Roth account. The limit is $1,000 higher if you or your wife is age 50 or older. And, the limits will increase in future years.
Q. I'm single and my income is getting close to the cut-off point for Roth IRAs. If I open a Roth this year and then get a raise next year that pushes me over the limit, would I have to close the account?
A. No. That income test controls who can contribute to a Roth not who can have one. On single returns, the right to use this tax shelter disappears as modified adjusted gross income rises between $95,000 and $110,000. Any year in which your modified adjusted gross income exceeds the $110,000 cut-off, you would be prevented from adding to your account. But any money in the Roth would continue to grow tax-free. If you open a Roth and, in the same year, get a raise that pushes you over the limit, you would be required to withdraw the contribution before the due date for filing your return for the year. There would be no tax on penalty on the withdrawal of the contribution, but any earnings which would also have to be withdrawn would be taxed and, if you are under 59 1/2, penalized.
Q. My mother converted her IRA to a Roth and made me the beneficiary. I know she never has to make a withdrawal but, if she dies and I inherit the account, does the same thing apply to me? Since the money is tax-free, I suppose the IRS doesn't care when I withdraw it.
A. Wrong. Even though an inherited Roth would come to you tax-free, the rules written by Congress say you can't keep the cash stashed in the tax shelter for ever. You will basically have two choices: Withdraw 100% by the end of the fifth calendar year after the owner's death; or, by the end of the first year after her death, begin a series of distributions based on your life expectancy. You are correct that money you withdraw from the Roth will be tax-free.
Q. I read all about the wonders of long-term compounding in connection with the recommendation that parents start Roth IRAs for their children. You know, a single, $3,000 contribution at age 16 will be worth over $320,000 at age 65, assuming 10% annual growth. But here's the rub: The mutual fund I contacted to open the Roth says it's illegal for a minor to have an IRA. What's going on?
A. You're getting bum advice from the mutual fund. We have been reporting on the fabulous opportunity of kid IRAs since the IRA was invented and we can assure you: There's no minimum age to have an IRA. As soon as a child has earned income that's income from a job, not from investments he or she can put up to $4,000 in an IRA. (The $3,000 limit you mention was for 2004.) It doesn't have to be his or her own money, either. A parent, or other generous soul, can provide100% of the cash or, perhaps, match the child's contribution dollar for dollar. The key is that no more go into the account than the child earned during the year, up to that $4,000 limit. The problem you're encountering is that some financial companies refuse to open accounts for minors because they can't sign legally binding contracts. The companies worry, apparently, that if the IRA lost money, the child might sue. Many mutual funds and brokerages, however, welcome "kid IRAs" and get around that worry by having a parent sign the contract along with the child. Look around: You'll find a home for your child's IRA.
Q. I've heard that there is a way to use a Roth IRA to save for college. Can we set one up for our newborn?
A. It depends on what you mean by "for". If you mean in the child's name, the answer is "no." For a taxpayer to have a Roth, he or she must have earned income. (We're assuming your infant isn't a baby model who is making a living doing commercials.) But there is a way a Roth can be used for college savings. Say, for example, that in the year a child is born, both Mom and Dad begin making $4,000 annual contributions to Roth accounts. When the child is 18 and ready to head off to college, the twin Roths will hold a total of just under $325,000 (assuming 8% annual returns). At that point, the parents can withdraw $144,000 (the total of their contributions) tax- and penalty-free to pay college bills. If they need to dip deeper into the Roths, additional withdrawals would be taxed (assuming the parents are under age 59 1/2) but not penalized. In effect, the Roth will have served as a tax-shelter to allow college savings to grow tax-deferred.
Let's assume the parents withdraw the $144,000 total of their contributions and leave the rest in their Roths to grow for their retirement. If that's 25 years down the road, the Roths will grow to $1.2 million (assuming a continued 8% annual return). It will all be tax-free in retirement and any amount left in the accounts when the parents die will go to their heirs tax-free.
Q. Last summer I gave up on the mutual fund where I had my IRA, withdrew the $4,700 and rolled it over into a new IRA. I got a 1099-R from the mutual fund that lists the $4,700 as a distribution. I assume the IRS got a copy of the form and expects me to include the payout in taxable income. I know that because I made the rollover the money is not taxable, but how do I let the IRS know the money is still in an IRA so they don't hassle me?
A. The tax form makes provisions for your situation. Whether you file a Form 1040 or Form 1040A, there's a line to report the full distribution that's the amount the IRS compares to the reports it receives from IRA trustees and another line to report the taxable part. That's where you'll show $0. TaxCut handles this automatically when you work through the Interview. To qualify as a rollover, the funds must have been deposited in the new IRA within 60 days after you received the distribution.
Q. I asked my IRA sponsor to close my account and send me a check so I could open a new IRA. I know I have only 60 days after closing one account to put the funds in new one. But when does that 60-day period begin, the day the old account is closed or the day I get the check?
A. The 60-day rollover period begins when you receive the distribution from the first IRA. In one case, for example, three weeks passed from the time the first IRA was closed and the time the taxpayer received the proceeds in the mail. The IRS reaffirmed that the 60-day clock didn't start ticking until the day the proceeds were received.
Q. When I retired, I bought a $25,000 single-premium annuity that pays me $185 a month for the rest of my life. Since I paid the premium myself, are the payments I receive tax-free?
A. Not all of them. Only the part of each payment that represents a return of your investment escapes the IRS. The rest is made up of earnings on your investment and is taxable. The 1099-R you received from the insurance company should indicate the taxable amount. If not, call the company.
Q. Is it true there is a way to get money out of a traditional IRA without penalty before age 59 1/2?
A. Yes. The 10% early-withdrawal penalty is waived if you arrange to take the money out evenly over your life expectancy, even if the first payment comes long before you are 59 1/2. (You must maintain these annual withdrawals for at least five years and until you are at least 59 1/2 in order to avoid the penalty.) The early-withdrawal penalty is also waived on up to $10,000 withdrawn to buy a first home or on any amount withdrawn to pay qualifying college bills. The penalty is also waived when the money is used to pay medical bills that exceed 7.5% of your adjusted gross income or to pay for health insurance during an extended period of unemployment.
Q. I got a notice saying that I can ask social security to withhold income taxes from my benefit checks. Why in the world would anyone want to do that?
A. Voluntary withholding from social security can make sense if, by agreeing to it, you can avoid the hassle of making quarterly estimated tax payments. If you're interested get a copy of Form W-4V from social security (call 800-772-1213 or go to social security's website www.ssa.gov or the IRS website www.irs.gov). You can ask that withholding be set at 7%, 10%, 15% or 25%.
Q. I read that Congress created a tax credit for people who contribute to an IRA. Is that instead of or in addition to the deduction for making such contributions?
A. For low- and middle-income Americans, the new credit is in ADDITION to the deduction. This is Congress's latest effort to encourage people to save for retirement. The credit is worth up to 50% of the first $2,000 you put in an IRA or a company retirement plan such as a 401(k). (The credit can make a 401(k) an amazing deal if your employer matches contributions. Imagine, if your employer matches 50 cents on the dollar, a $2,000 contribution can put $3,000 in your retirement account. Because your $2,000 is pre-tax money, that saves you $300 in the 15% bracket. And, the 50% credit would save you almost $1,000 more some technicalities mean no one can really get the full benefit of the 50% credit. Still, for less than $1,000 out of pocket, you could have $3,000 in your 401(k).)
The 50% credit is available if your adjusted gross income on a joint return is $30,000 or less or, on an individual return, if your AGI is $15,000 or less. When income falls between $30,000 and $32,500 on a joint return and between $15,000 and $16,250 on a single return, the credit is 20% of the first $2,000 set aside for your retirement. Income between $32,500 and $50,000 on a joint return and between $16,250 and $25,000 on a single return earns a 10% credit. There's no credit when income exceeds those amounts.
Also, no credit is allowed if the taxpayer is:
Under age 18
Claimed as a dependent on his or her parents' tax return
A full-time student
Q. We just bought our first home and the mortgage payments are staggering. We know the mortgage interest is deductible, but do we have to wait until we file next spring to get any tax-relief?
A. No. You can pocket your tax savings right away by filing a revised W-4 form with your employer. That's the form that controls how much is withheld from your paychecks. Basically, for each $2,500 you will claim in mortgage interest, you should claim one extra allowance on your W-4. Claiming four extra allowances will cut withholding and boost your monthly pay by about $250 if you're in the 25% bracket. Check out the withholding help in our tax planning section.
Q. We sold our house last year. Since the profit is now tax-free do we even have to report the sale to the IRS?
A. Probably not. In fact the old 2119 form used for reporting home sales has been abolished. At settlement, you should have been asked to sign a form certifying that the profit met the requirements for tax freedom. Basically, home sale profits are tax free (up to $250,000 if you file a single return, $500,000 if you file jointly with your spouse) if you owned and lived in the house for two of the five years leading up to the sale. If you signed such a form, that relieved the settlement agent from reporting the deal to the IRS, and there's no reason for you to report the sale on your return. Even if you didn't sign such a form and therefore received a 1099-S from reporting the proceeds of the sale, you don't have to report it on your tax return if the profit all qualifies as tax free. When a home sale results in a taxable profit because the two year test isn't met or the profit exceeds the tax-free amount the profit is reported on the Schedule D.
Q. Did Congress ever change the rules to allow those who lose money when they sell their homes to deduct the loss, just like investors get to deduct their losses in the stock market?
A. No. Although there's been lots of talk about allowing home sellers to deduct losses, the proposals have never gotten far in Congress.
Q. After several years on foreign assignment, I'm back in the states and looking to buy a home. I bought my first house in 1976 and have owned two others since then. I sold the last one in 1997 when I went abroad. My real estate agent says I can still qualify to take money out of my IRA penalty-free as a "first-time" homebuyer. That sounds crazy to me. Is it?
A. Your agent is correct. As far as the law is concerned, you're a first-time homebuyer if you have not owned a home during the two-year period leading up to the purchase of the new house. The new exception to the 10% early withdrawal tax allows taxpayers under age 59 1/2 to withdraw up to $10,000 from their IRAs for the purchase of a "first" home. Beware, though, that although the withdrawal is penalty free, the money will still be taxed in your top bracket.
Q. As part of the excruciating negotiations over the price of our new home, we forced the seller to pay one point on our mortgage, which cost him $2,500. A friend tells us that if we had made the seller cut the price by $2,500 instead and we had paid the $2,500, we could deduct that amount. Did we shoot ourselves in the foot?
A. A few years ago, we would have told you to check your toes. But, fortunately, the rules on seller-paid points now reflect reality. . .and you get to claim a $2,500 deduction even though you didn't pay the expense personally. The IRS treats this situation as though you paid $2,500 less for the house (and therefore your tax basis is reduced accordingly) and paid the points with your savings. We'll ask you about this in the interview section on points to make sure you get the tax savings you deserve.
Q. I refinanced my home mortgage last year. Now I hear that cutting my mortgage interest rate will trigger a hike in my tax bill. How can that be?
A. Easy. A lower rate means you paid less interest. That, in turn, cuts the size of your mortgage interest deduction. So, Uncle Sam shares in your good fortune. Now, any points you paid to refinance are deductible. . .but only over the life of the loan. Note this: If the mortgage you refinanced is one that you had refinanced earlier, you may be in line for an extra deduction. If you were deducting points paid on the first refinancing, remember to deduct any as yet un-deducted points on this year's return. The life of that first refinancing ended when you paid off the mortgage with the proceeds of the new refinancing. (There's a catch here, however. The IRS says that if you refinanced the already-refinanced loan with the same lender, then the un-deducted points on the first refinancing are supposed to be added to the points on the new loan, and the combination deducted over the life of your latest mortgage.)
Q. We own a vacation home that we rent out most of the year. Year after year we show a tax loss, and I'm worried about the hobby-loss rules. After a while will the IRS reject our loss deductions because we never make a profit on the place?
A. Not necessarily. The hobby-loss rules presume you're in business to make a profit if you report a profit in at least three out of five years. If you fail that test, you may be called on to prove you're trying to make money. You'd need records showing that you charge a reasonable rent, for example, and make reasonable attempts to keep the place rented. Remember, too, that profit on real estate is often based significantly on the appreciation of the property, something that doesn't show up on annual tax returns.
Q. What If my Return Is Audited?
A. Rest easy knowing H&R Block is there to help in the event of an audit. From outlining what to expect and providing guidance on how to prepare for an audit, to having an H&R Block enrolled agent represent you before the IRS upon your request. H&R Block's Worry-free Audit Support provides comprehensive audit support for TaxCut clients that successfully e-file their federal tax return. You can see the full terms and conditions of this program at www.taxcut.com/auditsupport.
Q. I'm having a terrible problem with the IRS. I received a notice accusing me of failing to pay the amount due with my last return. In fact, though, I have the canceled check that proves I paid. After sending a copy of the check, I received one letter telling me everything was straightened out. Then, a couple weeks later, I got another letter saying I'd better pay up right away. Is there any way to get this resolved?
A. Begin by calling your local IRS office and asking to talk with the problems resolution officer or taxpayer advocate. The Problem Resolutions Program (PRP) is designed to rescue taxpayers who are getting the run-around or are being steamrolled by the bureaucracy. It's supposed to pry loose late refunds, straighten out problems such as yours, overrule computer-generated penalty notices and delay IRS seizure of property while a case is being reviewed. With all the bad press the IRS has gotten lately, the agency seems to be working especially hard to listen to and assist taxpayers who need help.
If you don't get satisfaction within four weeks of talking with a problem resolutions officer, take your complaint to the National Taxpayer Advocate at IRS national headquarters, 1111 Constitution Ave., N.W., Washington, D.C. 20224. And, if that doesn't help, don't hesitate to contact your members of Congress. Members of the House of Representatives and Senate usually have staff members who specialize in helping constituents with their problems with the IRS. Call 202-224-3121 and ask for your representative or senator or check your phone book for the number of a local office.
Q. I've heard that one way to avoid an audit is to file for an extension and send in your return on August 15. Any truth in the rumor that late returns are less likely to be scrutinized?
A. The IRS swears it's not so. The agency says all returns whether filed in January or August get the same treatment. Information on the returns is plugged into IRS's aging supercomputer in West Virginia and "scored" for audit potential. If a late-filed return gets a higher score than one that was filed earlier, it moves ahead on the to-be-audited list. Several independent experts we talked with confirm this view. Chances of an IRS audit are slim to none. Claim every legitimate deduction you've got coming.
Q. We moved last summer. Do we need to advise the IRS of our new address?
A. You probably don't need to if you filed a change of address with the Postal Service. The IRS now routinely checks those records to update its own files. To be sure the IRS knows your new address, you can file Form 8822 with the IRS. This form is used to directly tell the IRS your new address. It is a good idea to file Form 8822 to ensure the IRS knows your current address. This will avoid potential confusion if the IRS needs to contact you to ask about your return or to warn you that it's going to freeze your bank account. They will send the notice to your "last known address." That's supposed to be the address on your most recently processed tax return. Although the post office ought to forward a notice, it's not the IRS's problem if you don't get it. If you miss a deadline, the IRS will proceed without you. TaxCut will generate Form 8822 for you if you request it.
Q. I filed my return in mid February, and now, in mid July, I still haven't received my refund. I'm afraid the return is lost. Is there a special form to file when sending in a duplicate return?
A. Your first step should be to check the status of your return by calling the IRS at 1-800-829-4477 to check on the status of your return. Be sure to have a copy of your return available because you will need to know the first social security number shown on the return, the filing status, and the exact whole-dollar amount of your refund. The IRS updates refund information every 7 days. If your check was mailed but you didn't receive it, the automated telephone system will allow you to enter a claim for a new check.
If the IRS hasn't received your return by now, you can assume it's lost. Send a copy of the return, marked "duplicate," to the service center where you originally filed, along with a letter explaining what has happened. Since you have a refund coming, you won't be penalized for filing late.
If you had owed money, however, you would want to include with your duplicate return evidence that you had filed earlier a copy of the checkbook register showing the date on which you wrote the check for the taxes due, for example. There's a good chance that will deflect the late-payment penalty. If not and you are assessed a penalty, you should write to the service center again, explaining the situation and asking that the penalty be dropped.
Q. I was married during the year and took my husband's last name. Do I have to report my name change to the IRS?
A. No, but you should advise the Social Security Administration. You use Form SSA-5 to change your name on your Social Security records. Since the IRS uses the Social Security number as your taxpayer identification number, confusion could result and any refund you have coming could be delayed if name and number don't match.
Q. Rather than take my husband's surname, I decided to keep my own. Will that cause us problems with the IRS when we file a joint return?
A. It shouldn't, particularly now that the tax form provides separate lines for each spouse's name and Social Security number.
Q. I have a big refund coming. When can I expect to get it?
A. The earlier you file, the sooner you'll get your money. File by mail by mid-February and you should have your refund within four weeks. File electronically and have your money direct deposited to your bank account and you could get your money in two weeks, or even faster. Even last-minute filers should have their refunds within eight weeks. If you file by April 15 and the IRS hasn't mailed the refund by June 1, the government has to pay you interest on what it owes you. You can check on the status of a late refund by calling the IRS at 1-800-829-4477. Have a copy of your tax return handy when you make the call. You'll need it to answer questions you'll be asked. Here's a tip: Avoid having a big refund next year by adjusting your withholding at work. Get your money when you earn it rather than waiting for a tax refund.
Q. When I got my refund check, it was for $188 less than I had requested on my return. I don't know why the IRS shorted me. If I cash the check, does that mean I agree with them?
A. No. Cashing the check wouldn't prevent you from disputing the IRS on whatever issue is involved. There's a good chance that the difference between what you expected and what you got is due to a mathematical error or other simple mistake such as using the incorrect tax rates for your filing status that was caught by the IRS. You should receive a notice from the agency explaining why the change was made. (The explanation is sent by a different office than the refund.)
Q. Going through my tax files, I discovered that I have misplaced a return I filed two years ago. Is there any way I can get a copy?
A. Yes. The IRS generally holds onto returns for six years before destroying them. You can request a copy of your forms by filing Form 4506 with the IRS service center where you filed the missing return. The charge is $39. You can download Form 4506 from the IRS Web site. (We suggest you save this year's return on a floppy disk and keep it with your records so you can print out an extra copy if you need one in the future.)
Q. I own a commercial office building and recently paid $31,000 for a new roof. How do I depreciate that cost?
A. The IRS says such improvements to property should be treated the same as the property itself. In other words, you would depreciate the cost of the roof over 39 years as though it is a separate piece of property. However, in 2002, the Tax Court came up with a more liberal treatment. In a case involving a residential rental property, it allowed the owner who replaced a roof after a tenant complained about a leak to "expense" the cost of the new roof. That meant he could deduct the full amount in the year it was paid. Be aware that if you take the Tax Court route and expense your $31,000 cost, the IRS might challenge your return.
Q. I bought a Toyota Prius last summer. The dealer mentioned a special tax credit for those of us who brought fuel-saving gasoline/electric hybrids. What's the story?
A. For 2006, the new law allows a tax credit. Figuring the exact credit for each qualifying vehicle is complicated. It's based on overall fuel economy and estimated lifetime fuel savings and you need information from the dealer, but your credit could be around $2,000 or more. (Remember, a credit reduces tax liability dollar for dollar.) Further complicating matters, the hybrid credit starts to phase out once a manufacturer has sold 60,000 qualifying vehicles. Car dealers will be more than happy to help buyers sort things out and we have the new rules written into TaxCut