Wealth Management

How Investment Swings Affect Taxes

How This Year’s Investment Swings May Affect Your Taxes
How This Year’s Investment Swings May Affect Your Taxes 850 500 smolinlupinco

If you’ve noticed market fluctuations leading to significant gains or losses on your investments this year, you might be wondering how this will impact your 2023 tax returns.

It’s hard to say with complete certainty since nothing is decided until the final results of your trades at year’s end. However, you can still take measures to avoid tax surprises.

Here’s what you need to know. 

Retirement accounts: tax-favored and taxable accounts

Investment swings in tax-favored retirement accounts, such as 401(k)s, traditional IRAs, Roth IRAs, and SEP IRAs, have no immediate tax impact. Although your account balance is affected by market fluctuations, you won’t be taxed on that balance until you begin withdrawing money.

After you turn 59 ½, qualified withdrawals from your Roth IRA will be federal income tax-free.

What about taxable accounts?

Unrealized gains and losses won’t affect your tax bill. Cumulative gains and losses from trades executed during the year, however, will. 

Overall loss in 2023

If your losses for the year have outpaced your gains, you have a net capital loss. To determine the loss and apply it, take the following three steps.

  1. Divide your gains and losses into short-term gains and losses from investments held for one year or less and long-term gains and losses from investments held for more than one year.
    • You have a net short-term capital loss for the year if your short-term losses exceed your short- and long-term gains.
    • You have a net long-term capital loss for the year if your long-term losses exceed the total of your long- and short-term gains.
  2. Claim your allowable net capital loss deduction of up to $3,000 ($1,500 if you use married filing separate status).
  3. Carry over any remaining net short-term or long-term capital loss after Step 2 to next year, when it can be used to offset capital gains in 2024 and beyond.

Overall gain in 2023

If your gains for the year exceed your losses, congratulations! To calculate your net capital gain, do the following.

  • Divide your gains and losses into short-term gains and losses from investments held for one year or less and long-term gains and losses from investments held for more than one year.
    • If your short-term gains exceed the total of your short- and long-term losses, you have a net short-term capital gain for the year.
    • If your long-term gains exceed the total of your long- and short-term losses, you have a net long-term capital gain for the year.

Net long-term and short-term gain

Your regular federal income tax rate (which can be up to 37%) applies to net short-term capital gain. In addition, you may owe an additional 3.8% on net investment income tax (NIIT), as well as state income tax.

Net long-term capital gain (LTCG) is taxed at the lower federal capital gain tax rate of 0%, 15%, or 20%.

Most people pay 15%. If you’re a high-income individual, you’ll owe the maximum rate of 20% on the lesser of:

1) net LTCG

OR

2) the excess of taxable income, including any net LTCG, over the applicable threshold.

In 2023, the thresholds are: 

  • Married filing jointly: $553,850
  • Single filers: $492,300
  • Heads of household: $523,050

Again, you may also owe the NIIT and state income tax.

NIIT Impact

The 3.8% Net Investment Income Tax (NIIT) applies to the lesser of your net investment income, including capital gains, or the amount by which your modified adjusted gross income (MAGI) exceeds the following thresholds:

  • Married filing jointly: $250,000
  • Singles and heads of household: $200,000
  • Married filing separately: $125,000

Year-end is still months away

While these figures are helpful to avoid end-of-year sticker shock, your 2023 tax outcomes won’t be apparent until all of the gains and losses for the year’s trades are completed and added up. 

Have questions? Smolin can help. 

If you want a clearer picture of what to expect come tax time, we can help. Contact the friendly staff at Smolin to learn more.

How Catch-up Contributions to Your Retirement Account Can Make an Impact
How Catch-up Contributions to Your Retirement Account Can Make an Impact 1275 750 smolinlupinco

If you’re 50 or above, you can likely make extra “catch-up” contributions to your tax-favored retirement accounts. You might wonder if this is worth the trouble; the answer is “Yes!” 

Here are the ground rules for getting started with catch-up contributions.

The lowdown on IRAs 

Eligible taxpayers can make extra catch-up contributions of up to $1,000 every year to a traditional or Roth IRA. If, by December 31, 2023, you’re over 50 years of age, you can make a catch-up contribution for the 2023 tax year by April 15, 2024.

Additional deductible contributions to a traditional IRA can create tax savings, but your deduction may be limited if you or your spouse are covered by a retirement plan at your place of business and your annual income exceeds specific levels.

These additional contributions to Roth IRAs won’t create any up-front tax savings, but you can make federal-income-tax-free withdrawals once you’re older than 59½. There are also some income limitations on Roth contributions.

Individuals with higher incomes can make additional nondeductible traditional IRA contributions and benefit from the tax-deferred earnings advantage.

How company plans measure up

You must also be 50 or older to make extra salary-reduction catch-up contributions to your employer’s  401(k), 403(b), or 457 retirement plan, assuming these contributions are allowed and you signed up for them.

If this is the case, you’re permitted to make extra contributions of up to $7,500 to these accounts for the 2023 tax year. Check with your HR department to see how to get started with making additional contributions.

Salary-reduction contributions are subtracted from your taxable wages, so you’re essentially getting a federal income tax deduction. You can leverage the resulting tax savings to aid in paying for part of your catch-up contribution, or you can put these savings into a taxable retirement savings account to increase your retirement wealth in the future.

Run the numbers

Here’s an idea of just how much you can accumulate with catch-contributions.

IRAs 

Let’s imagine you’re 50, and you contribute an additional $1,000 catch-up to your IRA this year, and then you continue to do so for the next 15 years. This is how much extra you could have in your IRA by age 65. 

These estimates are rounded to the nearest $1,000.

4% Annual Return 6% Annual Return 8% Annual Return
$22,000$26,000$30,000

It’s essential to remember that making more significant deductible contributions to a traditional IRA can also reduce your tax bills. Making additional contributions to a Roth IRA will not give you this benefit, but you can withdraw more tax-free money later in life.

What about company plans?

Let’s say you’re turning 50 next year. If so, you can contribute an additional $7,500 to your company plan. If you do the same for the next 15 years, here’s how much more you could have in your  401(k), 403(b), or 457 plan account.

These estimates are rounded to the nearest $1,000. 

4% Annual Return 6% Annual Return 8% Annual Return
$164,000$193,000$227,000

As with IRAs, making more significant contributions can also lower your tax bill.

Looking at both IRA and company plans

Lastly, let’s imagine you turn 50 next year. If you’re eligible, you contribute an additional $1,000 to your IRA for next year, and you make an additional $7,500 contribution to your company plan. 

After that, you continue to do the same thing for the next 15 years. Here’s how much extra you could have in both accounts after that time.

These estimates are rounded to the nearest $1,000. 

4% Annual Return 6% Annual Return 8% Annual Return
$186,000$219,000$257,000

Have questions? Smolin can help

Extra catch-up contributions can add up to some pretty big numbers by the time you retire. If your spouse can make them, too, you can potentially accumulate even more wealth for a comfortable retirement. 

If you’re curious to know more about catch-up contributions, contact the team at Smolin, and we’ll answer all your questions.

Are You Married and Not Earning Compensation? You May Be Able to Put Your Money in an IRA
Are You Married and Not Earning Compensation? You May Be Able to Put Your Money in an IRA 1275 750 smolinlupinco

For married couples, if one spouse is unemployed or busy with the daily grind of unpaid care and domestic work, it can be challenging to save as much as you need to enjoy a comfortable retirement. This can feel stressful, but you do have options.

Generally, an IRA (Individual Retirement Account) contribution is only allowed if a taxpayer earns monetary compensation, however, there is an exception for a “spousal” IRA. This exception allows contributions to be made for a spouse who stays at home to care for children and/or elderly relatives or who is out of work. 

This exception is applicable as long as the couple files a joint tax return.

In 2023, the amount that an eligible married couple can contribute to an IRA for their nonworking spouse is $6,500. This is the same limit that applies to the working spouse.

The benefits of an IRA

IRAs offer two crucial advantages for taxpayers who make contributions to them:

Contributions of up to $6,500 a year to a traditional IRA might be tax deductible, and the earnings on funds within the IRA aren’t taxed until the funds are withdrawn. 

Aside from this, you can make contributions to a Roth IRA. There’s no tax deduction for Roth IRA contributions, but if specific requirements are met, your future distributions are tax-free.

If the married couple has a combined earned income of at least $13,000, $6,500 can be paid into an IRA for each partner, creating a total of $13,000.

Contributions for both spouses can be made to either a regular IRA or a Roth IRA or split between them, as long as their combined contributions don’t go over the $13,000 limit.

Higher contribution if 50 or older

Additionally, taxpayers who are age 50 or older can make “catch-up” contributions to an IRA or Roth IRA amounting to $1,000. That means that, for 2023, a taxpayer and their spouse (who have both reached age 50 by the end of the year) can each make a deductible contribution to an IRA of up to $7,500, for a combined deductible limit of $15,000.

With that said, it’s important to note that there are some limitations.

For example, if in 2023 a working spouse is an active participant in one of many kinds of retirement plans, a deductible contribution of up to $6,500 (or $7,500 for a spouse who will be 50 by the end of the year) can be made to the IRA of the non-working spouse only if the couple’s AGI doesn’t exceed a specific threshold. This limit is phased out for AGI between $218,000 and $228,000.

Have questions? Smolin can help

If you’re unsure of how to approach setting up IRA contributions for your non-working spouse, or you need help planning your retirement, contact the professionals at Smolin, and we’ll walk you through this process.

Handle with Care: Including a Family Vacation Home in your Estate Plan
Handle with Care: Including a Family Vacation Home in your Estate Plan 1275 750 smolinlupinco

The fate of a family home can be an emotionally charged estate planning issue for many people, and emotions often run high when dealing with assets like vacation homes that can have a special place in one’s heart.

With that in mind, it’s essential to address your estate planning carefully when deciding what to do with your vacation home.

Keeping the peace

Before determining how to treat your vacation home in your estate plan, discuss it with your loved ones. If you simply divide ownership of the house equally among your relatives, it may cause unnecessary conflict and hurt feelings. 

Some family members may have a greater interest in keeping the family home than in any financial gain it might provide, and others may prefer to sell the property and use the proceeds for other things.

One viable solution is to leave the property to loved ones who wish to keep it and leave other assets to those who don’t. 

Alternatively, you can create a buyout plan that establishes the conditions under which family members who want to keep the property can purchase the interests of those who wish to sell.

Your plan should establish a reasonable price and payment terms, which can include payments in installments over several years.

Consider creating a usage schedule for nonowners who want to be allowed to continue using the vacation home. To help ease the costs of keeping the property in the family, consider setting aside some assets that will generate income to cover the costs of maintenance, property taxes, repairs, and other expenses that might arise.

Transferring your home

Once you’ve decided who will receive your vacation home, there are a variety of traditional estate planning tools you can use to transfer it tax-efficiently. It might make sense to transfer the interests in the property to your beneficiaries now, using tax-free gifts.

However, if you’re not ready to relinquish ownership just yet, consider using a qualified personal residence trust (QPRT). With a QPRT, you can transfer a qualifying vacation home to an irrevocable trust, which allows you to retain the right to occupy the property during the trust term.

When the term of the QPRT ends, the property will be transferred to your family, though it’s possible to continue occupying the home while paying them fair market rent. The transfer of the home is a taxable gift of your beneficiaries’ remainder interest, which is only one small part of the home’s current fair market value.

You’re required to survive the trust term, and the property must qualify as a “personal residence,” which means that, among other things, you must use it for the greater of 14 days per year or more than 10% of the total number of days you rent it out.

Discussing your intentions

These are just a few issues that can come with passing a vacation home down to your loved ones. Estate planning for this process may be complicated, but it doesn’t have to be. The key is to discuss all the options with your family so that you can create a plan that meets everyone’s needs.

Have questions? Smolin can help

Are you unsure of the best way to pass down your vacation home to your children or other relatives? Consult with the knowledgeable professionals at Smolin, and we’ll help you find the solution that meets your needs.

Simple Options for Retirement Savings Plans that can Benefit your Small Business
Simple Options for Retirement Savings Plans that can Benefit your Small Business 1275 750 smolinlupinco

If you’re considering creating a retirement plan for yourself and your employees but you’re concerned about the cost and administrative hurdles involved, take heart: there are some good options available to you. 

In this article, we’ll explore two types of plans that small business owners can use to get the ball rolling with retirement: Simplified Employee Penson (SEP) and Savings Incentive Match Plan for Employees (Simple).

A SEP is designed to be a viable alternative to “qualified” retirement plans and is geared toward small businesses. The relative ease of administration with this plan and your decision as an employer on whether or not to make annual contributions are two features of the plan that can be appealing to business owners. 

SEP setup can be easy for business owners

If your business doesn’t already have a qualified retirement plan, you can set up a SEP by using the IRS model SEP, Form 5305-SEP. When you adopt and implement this model SEP, which isn’t required to be filed with the IRS, you will satisfy the SEP requirements. 

This means that as the employer, you’ll get a current income tax deduction for the contributions you make on behalf of your employees. Employees won’t be taxed when contributions are made but will be taxed in the future when they receive distributions, typically at retirement. 

Depending on your requirements, an individually designed SEP might be a better choice for you than the model SEP.

When you set up a SEP for yourself and your employees, you’ll make deductible contributions to every employee’s IRA, known as a SEP-IRA, which are required to be approved by the IRS. The maximum amount of deductible contributions one can make to an employee’s SEP-IRA (and that the employee can exclude from income) is the lesser of either 25% of compensation or $66,000 for 2023. 

The deduction for your contributions to your employee’s SEP-IRA isn’t limited by the deduction ceiling that’s applicable to an individual’s contribution to a regular IRA. Your employees have control over their individual IRAs and IRA investments, on which the earnings are tax-free.

There are additional requirements that must be met in order to be eligible to set up a SEP: 

  • All regular employees must elect to participate in the program 
  • Contributions must not discriminate in favor of highly compensated employees

The requirements for creating a SEP are minor, though, compared to the administrative and bookkeeping burdens that come with traditional qualified pension and profit-sharing plans.

The detailed records that traditional plans are required to maintain in order to comply with complex nondiscrimination regulations are not not necessary with a SEP. Employers aren’t required to file annual reports with the IRS (which, in the case of a pension plan, could require the services of an actuary). Instead, all required recordkeeping can be handled by a trustee of the SEO-IRAs, usually a mutual fund or a bank.

Consider SIMPLE plans

Another viable option for businesses with fewer than 100 employees is a SIMPLE plan. With these plans, a “SIMPLE IRA” is established for each eligible employee. The employer makes matching contributions based on the contributions chosen by participating employees under a qualified salary reduction arrangement.

Like a SEP, a SIMPLE plan also comes with much less stringent requirements than traditional qualified retirement plans. 

Another option is for an employer to adopt a “simple” 401(k) plan, with features similar to a SIMPLE pan, which creates an automatic passage over the otherwise complex nondiscrimination test for 401(k) plans.

For 2023, SIMPLE deferrals are allowed up to $15,500 plus an additional $3,500 for catch-up contributions available to employees aged 50 and older.

Questions about retirement savings? Smolin can help.

If you’re looking for manageable options to help create retirement plans for yourself of your employees, contact Smolin today. Our knowledgeable team of accounts can help you decide which plan works best for you and walk you through the process.

If You Inherit Property, You Can Benefit From a “Stepped-Up Basis”
If You Inherit Property, You Can Benefit From a “Stepped-Up Basis” 1275 750 smolinlupinco

One of the most common questions for people planning their estates or inheriting assets is: What is the “cost” (or “basis”) a person gets in property that is inherited from someone else? This vital area is often overlooked when families start planning for the future.

According to the fair market value basis rules (otherwise known as the “step-up” and “step-down” rules), an heir can receive a basis in inherited assets equal to their date-of-death value. For example, if your uncle bought shares in an oil stock in 1942 for $500 and the stock was worth $5 million at the time of his death, the basis would be stepped up to $5 million for your uncle’s heirs, which means that the gain on the stock would escape income taxation forever.

Fair market value basis rules apply to any inherited property that can be included in the gross estate of the deceased individual, whether or not a federal estate tax return was filed. The rules apply even to property inherited from foreign individuals not subject to U.S. estate tax. 

Fair market value basis rules also apply to the inherited portion of the property jointly owned by the inheriting taxpayer and the deceased, but not to the portion of the jointly held property that the inheriting taxpayer owned prior to their inheritance. They don’t apply to reinvestments of estate assets on the part of fiduciaries. 

Lifetime gifting

It’s important to understand the fair market value basis rules so that you can avoid paying more tax than you’re legally required to.

For example, in the previous scenario, if your uncle instead decided to make a gift of the stock during his lifetime (rather than passing it down to his heirs when he died), the “step-up” in basis (from $500 to $5 million) would be lost.

Property acquired as a gift that has increased in value is subject to the “carryover” basis rules. This means that the person who received the gift takes the same basis the donor had in it ($500 in this example), plus a portion of any gift tax the donor pays on the gift. 

If someone dies owning property that has declined in value, a “step-down” occurs. In this case, the basis is lowered to the date-of-death value. Sound financial planning can help avoid this loss of basis, and it’s important to note that giving away the property before death won’t preserve the basis. 

Why is that? Because when a property that has gone down in value is given as a gift, the person who receives the gift must use the date of gift value as the basis for determining their loss on a later sale. An excellent strategy for handling a property that has declined in value is for the owner to sell it before death so they may enjoy the tax benefits of the loss. 

Have questions? Smolin can help

We’ve covered the basic rules here, but other rules and limits may apply. For example, in certain cases, a deceased person’s executor may be able to make an alternate valuation election, and gifts made just before a person died may be included in the gross estate for tax purposes. 

If you’re wondering how you can benefit from a “stepped-up basis” or need guidance with planning your estate, contact the knowledgeable professionals at Smolin. We’re ready to guide you through complicated tax laws to ensure you miss out on possible savings for your estate or inheritance.

Give Your Trusts New Life by Decanting Them
Give Your Trusts New Life by Decanting Them 1275 750 smolinlupinco

Creating flexibility within your estate plan using different strategies is worth considering when planning for the future. Because life circumstances can change over time (especially those involving tax laws and family situations), it’s important to use techniques to provide greater flexibility for your trustees. One such method is decanting a trust.

What is decanting?

Decanting usually refers to pouring wine or another liquid from one container into another. In estate planning terms, it means “pouring” assets from one trust into another with modified terms. 

The idea behind decanting is that if a trustee has discretionary power to distribute trust assets among that trust’s beneficiaries, they also have the ability to distribute those assets into another trust.

Depending on the language of the trust and the provisions of applicable state law, decanting may enable the trustee to:

  • Change the number of trustees or alter their powers
  • Add or enhance spendthrift language to protect the trust assets from creditors’ claims
  • Move funds to a special needs trust for a disabled beneficiary
  • Correct errors or clarify trust language
  • Move the trust to a state with more favorable tax or asset protection laws
  • Take advantage of new tax laws
  • Remove beneficiaries

In contrast to assets transferred at death, assets transferred to a trust to receive a stepped-up basis, so they can subject beneficiaries to capital gains tax on any appreciation in value. A potential solution to this problem is decanting.

Decanting can authorize a trustee to confer a general power of appointment over the assets to the trust’s grantor, causing the assets to be included in the grantor’s estate, and therefore, eligible for a stepped-up basis.

Stay compliant with your state’s laws

Many states have decanting statutes, and in some states, decanting is authorized by common law. No matter the situation, it’s essential to understand your state’s requirements. For example, in certain states, the trustee is required to notify the beneficiaries or even obtain their consent to decant a trust. Even if decanting is permitted, there may be limitations on its uses. 

Some states, for example, bar the use of decanting to remove beneficiaries or add a power of appointment, and most states won’t allow the addition of a new beneficiary. If your state doesn’t allow decanting, or if its decanting laws don’t allow you to achieve your goals, it may be possible to move the trust to a state whose laws are more aligned with your needs.

Be aware of tax implications

One of the risks associated with decanting is uncertainty over its tax implications. 

For example, a beneficiary’s interest is reduced. Have they made a taxable gift? Does it depend on whether the beneficiary has consented to decanting? If the trust language allows decanting, is the trust required to be treated as a grantor trust? Does such language jeopardize the trust’s eligibility for marital deduction? Does the distribution of assets from one trust to another trigger capital gains or other income tax consequences to the trust or its beneficiaries?

Create more flexibility in your trust with Smolin

If you want to create more flexibility with an irrevocable trust or have any questions about the tax implications of your situation, contact us for more information. 

understanding-after-tax-contributions-roth-401k-and-roth-ira

Understanding After-Tax Contributions: ROTH 401(k) and ROTH IRA
Understanding After-Tax Contributions: ROTH 401(k) and ROTH IRA 1600 941 smolinlupinco

Did you know that when it comes to your retirement account, not all contributions are created equal? Tax implications can have a significant impact on your savings. 

In fact, after-tax contributions to a ROTH 401(k) or ROTH IRA can offer significant tax benefits while traditional 401(k)s and IRAs don’t—just one of many reasons you might choose to include them in your overall plan for saving for retirement.

A bite-sized intro to ROTH 401(k) & ROTH IRA contributions

The phrase “after-tax contribution” means that the money you deposit into a ROTH 401(k) or  ROTH IRA account has already been taxed.

Paying taxes on the funds upfront can be convenient, but you’ll also enjoy several other key benefits: 

  • The opportunity to grow an asset on an after-tax basis and lock in a lower tax rate
  • Tax-free contributions and earnings
  • No income tax on funds withdrawn after you turn 59½ 

While contributions to a ROTH 401(k)/IRA don’t provide any current-year tax benefits, there are other long-term benefits to consider:

  • There are no required minimum distributions (RMDs) from a ROTH IRA
  • If a ROTH IRA is inherited, the new owner(s) are not required to withdraw all funds from the plan within ten years (as they would with a traditional IRA) 

Is a ROTH 401(k) or ROTH IRA right for you?

If you’re not in a high federal income tax bracket and don’t live in a high-tax state, making after-tax contributions to a ROTH 401(k) or IRA could be a good choice for you. You may also find these retirement savings options appealing if you don’t want to worry about income tax bills in retirement.  

If you’re looking for immediate tax benefits, it’s important to note that there are no current-year tax benefits to contributing to a ROTH 401(k) or IRA. Still, the long-term benefits outlined in the previous section can be substantial and are worth considering as part of your overall retirement savings strategy.

Maximum contributions for 2023

If you want to maximize your retirement accounts this year, you might be planning to save as much as possible by contributing large amounts to your ROTH 401(k) and ROTH IRA accounts. However, ROTH 401(k) and IRA contributions are capped by the IRS to prevent employees with higher pay rates from enjoying disproportionate tax savings.

Even if you’re only planning to make modest after-tax contributions to a ROTH 401(k) or IRA, you need to understand the contribution limits for 2023. Contribution limits for ROTH 401(k)s aren’t determined based on your total income, but contributions to ROTH IRAs may be. 

Maximum contribution for a ROTH 401(k) in 2023

For ROTH 401(k)s, the 2023 maximum contribution is $22,500. If you’re over the age of 50, you may also contribute an additional $7,500 catch-up contribution in an effort to reach your retirement savings goals more quickly. 

Maximum contribution for a ROTH IRA in 2023

For ROTH IRAs, the 2023 maximum contribution is $6,500 with a $1,000 catch-up contribution available if you’re over age 50. 

Withdrawing funds from a ROTH 401(k) or IRA

Whether you’re ready for retirement or you want to put your money toward a particularly large expense, you’ll eventually need to withdraw the funds in your ROTH 401(k) or IRA. To maximize your money, timing is everything—as is understanding the individual rules for each type of account.

Withdrawals from a ROTH IRA are penalty-free (and tax-free) after a five-year holding period and after you reach age 59½. If you withdraw before that age, there are no penalties on withdrawals of contributions. However, your earnings from the withdrawal will be subject to federal income tax and a 10% penalty.

Similarly, if you take a hardship distribution from your ROTH 401(k), income tax and a 10% penalty will be applied. However, you may be able to avoid the 10% penalty if the hardship distribution meets one of the exemptions, so be sure to check with your accountant before moving any money. 

Questions? We’re here to help. 

After-tax contributions to a ROTH 401(k) or IRA offer several important benefits to support the growth of your retirement savings, but you might find that navigating the contribution limits, tax implications, and other factors is easier with advice from a professional.

We can evaluate the possible effects any financial decisions may have on your retirement savings, and assist in ensuring that you’re following the guidelines associated with your retirement savings account. Contact us today. 

what-you-need-to-know-about-retirement-plan-early-withdrawals

What You Need to Know About Retirement Plan Early Withdrawals
What You Need to Know About Retirement Plan Early Withdrawals 1600 941 smolinlupinco

Retirement plan distributions are typically subject to income tax. If you take an early withdrawal, they may be subject to additional tax penalties. But what defines “early?” 

Generally, it’s when withdrawals are taken out of a traditional IRA or another qualified retirement plan before the plan participant reaches the age of 59½.  These distributions are often taxable and may also be subject to a 10% penalty tax (or 25% if taken from a SIMPLE IRA during the first two years of plan participation). 

While there are ways to avoid that penalty tax (but not standard income tax), the rules can be complicated—which one taxpayer had to learn the hard way. 

Exceptions to early withdrawal penalty tax

Some exceptions to the 10% early withdrawal penalty are only available to taxpayers who take early distributions from traditional IRAs. Other exceptions only apply to qualified retirement plans, such as 401(k)s. 

Exceptions include (but are not limited to): 

  • Medical cost payments exceeding 7.5% of your adjusted gross income
  • Annuity-like withdrawals made under IRS guidelines
  • Withdrawals made from an IRA, SEP, or SIMPLE plan up to the qualified amount of higher education expenses for you or a family member 
  • Withdrawals made by qualified first-time homebuyers of up to $10,000 from an IRA, SEP, or SIMPLE plan

Another exception is the total and permanent disability of the IRA owner or retirement plan participant.  

New court case results in tax penalty

In one court case (TC Memo 2023-9), a taxpayer took a $19,365 retirement plan distribution before reaching the age of 59½ after losing his job as a software developer. Per the U.S. Tax Court, he had a diabetes diagnosis which he treated with insulin shots and other medications.

The taxpayer filed a tax return for the year of the retirement plan withdrawal but did not report the amount as income due to his medical condition. However, the plan administrator reported the amount as an early distribution with no known exception on Form 1099-R, which was sent to the IRS and the taxpayer. 

According to the court’s ruling, the taxpayer did not qualify for an exception due to the disability.  They noted that an individual is considered disabled if they are “unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to result in death or to be of long-continued and indefinite duration” at the time of the withdrawal.

Because the taxpayer, in this case, had been able to work up to the year at issue despite the diabetes diagnosis, the $4,899 federal income tax deficiency was upheld. 

Lesson learned: work with a knowledgeable tax professional

As the taxpayer in this case learned, guidance is important when taking early retirement plan distributions. If you’re unsure whether you’re eligible for an exception to the 10% early withdrawal penalty tax, our CPAs can help.

Contact us to consult with a professional today. 

5-tax-saving-ways-to-pay-for-your-childs-college-education

5 Tax-Saving Ways to Pay for Your Child’s College Education
5 Tax-Saving Ways to Pay for Your Child’s College Education 1600 942 smolinlupinco

Do you have a child or grandchild currently attending college? Congratulations! 

To help cover the costs of post-secondary education, you may have saved up over the course of several years in a tax-favored account, such as a 529 plan. Once your child is enrolled in college, though, you may be able to claim a number of tax breaks. 

For example: 

1. Tuition tax credits

The American Opportunity Tax Credit (AOTC) can be taken up to $2,500 per student for the first four years of college. This includes a 100% credit for the first $2,000 and a 25% credit for the second $2,000 in tuition, fees, and books. This credit is 40% refundable up to $1,000, which means you can get a refund if the credit amount is higher than your tax liability. 

You can also take the Lifetime Learning Credit (LLC) of up to $2,000 per family for each additional year of post-secondary education, which includes a 20% credit for up to $10,000 in tuition and fees. 

That said, only one education tax credit can be claimed per eligible student per year. To claim the credit, the taxpayer must receive a Form 1098-T statement from the school. 

Note that both credits will be phased out for those with certain modified adjusted gross income (MAGI): 

  • Between $160,000 and $180,000 for married couples filing jointly
  • Between $80,000 and $90,000 for singles

2. Scholarships

If certain conditions are met, scholarships can be exempt from income tax. One of these conditions is that the scholarship cannot be compensation for services and must instead be used for tuition, fees, books, and supplies—not for room and board.

Remember that a tax-free scholarship will reduce the expenses considered when computing the AOTC and LLC. As a result, those credits may be reduced or eliminated. 

3. Employer assistance

If your child’s college expenses are covered by your employer, that payment is considered a fringe benefit and is taxable to you as compensation. 

If it’s part of a scholarship program outside of the pattern of employment, however, it will be treated as a scholarship—assuming the scholarship requirements are met. 

4. Tax-exempt gifts

When someone gifts you money to cover your child’s college expenses, that person is generally subject to gift tax. For 2023, the gift tax exclusion threshold is $17,000 per recipient; married donors who give combined gifts may exclude gifts of up to $34,000. 

However, if someone—such as a grandparent—submits your child’s tuition payments directly to the educational institution, there is an unlimited gift tax exclusion. This applies only to direct tuition costs (as opposed to room and board, books, supplies, and more). 

5. Retirement account withdrawals

You can withdraw money from your IRA or Roth IRA account at any time without incurring the 10% early withdrawal penalty, as long as those withdrawals are used to pay for college costs. Note, however, that the distributions are subject to tax under the usual rules. 

You may also have the option to withdraw from or borrow against your employer retirement plan—but before doing so, ensure you fully understand any and all tax implications, including any potential penalties. 

Plan ahead with Smolin

Not all of the above-mentioned tax breaks can be used in the same year, and some may also impact qualification amounts for other tax breaks. 

Not sure which option is best for your situation? Our CPAs can help. Contact us if you would like to discuss any of these options, or other alternatives that may apply to your situation. 

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