Dear Liz: I’m an estate-planning attorney and want to expand on the answer you gave to the parent who wanted to give her children money for their educations or a car but was worried about gift taxes.
Your explanation of the federal rule was accurate — only gifts of more than $13,000 per recipient have to be reported, and gift tax isn’t owed until amounts over that exclusion exceed $1 million — but state laws vary. (California levies no gift tax.) In addition, the $13,000-per-person annual exclusion and the $1-million lifetime exclusion is available for each giver, so a married couple could give $26,000 without reducing their lifetime exemptions.
Also, tuition is not considered a gift if paid directly to the school, irrespective of the amount, so the giver could offer to pay tuition directly and then give money separately for a car. Finally, 529 college savings plans are an excellent way to save for a child’s higher education and are often preferable to giving money directly to the children.
Answer: Thanks for the additional information. College savings plans allow people to contribute up to five times the annual gift exclusion amount at one time, meaning generous parents or grandparents could stow $65,000 into a 529 plan in one lump sum (as long as they make no other gifts to the recipient in that five-year period).
Dear Liz: I lost my job 18 months ago. I am 61 and have back pain that keeps me from standing more than 15 minutes or sitting more than two hours before I have to lie down, which limits my job prospects. I arranged a short sale of my home a year ago to avoid a foreclosure, and recently received a 1099-C form from the lender for $99,000 of forgiven debt. Please warn others about this!
Answer: Don’t panic just yet.
Normally when a lender cancels or forgives debt, you have to include the forgiven amount in your income for tax purposes, which can result in a whopping tax bill.
But the federal Mortgage Forgiveness Debt Relief Act of 2007 provides an exception for homeowners who lose a home to foreclosure, sell it for less than they owe in a short sale or have their debt reduced through a mortgage modification.
You still have to report the forgiven debt on IRS Form 982, but it’s typically not included in your income for federal tax purposes if:
- The home was your primary residence (second homes, vacation property and rentals don’t qualify).
- The forgiven debt was $2 million or less ($1 million for a married person filing separately).
- The debt was forgiven in calendar years 2007 through 2012.
For more information, visit the IRS’ website at http://tinyurl.com/5pe43f. Details can also be found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.
You’ll have to do a little research to see what you might owe under your state’s income tax laws, which could differ. California, for example, hasn’t updated its law to conform with the federal law for mortgage forgiveness occurring on or after Jan. 1, 2009, although there are several bills pending in the Legislature to do so.
If you’re in California, you might want to bookmark this Franchise Tax Board page at http://tinyurl.com /yhx89zw and check back before filing your taxes April 15 to see if you get any relief.
Dear Liz: I would like to give my three children monetary gifts they can use for college or a car. I understand that I can give them up to $13,000 as a nontaxable gift. Is that correct? How would I file the tax return, and would I be allowed to pay the tax on their gift?
Answer: It sounds like you’re misunderstanding how the gift tax works.
You could give your kids a monetary gift of any size, and it wouldn’t be taxable to them. But it could have gift tax implications for you.
If you give more than $13,000 to any one person, you’re supposed to file a gift tax return (IRS Form 709) noting the fact. Any amount over $13,000 per person per year is deducted from your lifetime gift tax exemption, currently $1 million. Once you’ve used up that exemption, you would owe tax on any later gifts in excess of $13,000 per person (or whatever the annual exemption is then). You’d have to be really generous to ever pay a tax.
Dear Liz: I am freaking out and losing sleep. I got a letter about five years ago from the IRS telling me I owed it money, so I stopped filing my taxes. Now I feel scared and nervous and don’t know how to fix this. I have my paperwork and want to file all my returns and see how much I owe. I usually get refunds so hopefully the tax bill won’t be too bad, but I just don’t know where to start. Should I hire an attorney or just throw myself on the mercy of the IRS? Money is tighter than ever, but I feel that I can’t move forward until I resolve this issue.
Answer: It’s too late for you, but others who may be tempted to ignore their obligation to file tax returns need to know two things.
The first is that the failure-to-file penalty is much worse than the failure-to-pay penalty. Since the IRS offers payment plans, it’s better to file than not, even if you can’t pay right away.
The second is that you have only three years to file a tax return before you lose any refunds to which you might have been entitled.
In short, not filing can cost you, big time. You don’t need to throw yourself on the IRS’ mercy, but you should find a good tax preparer who has dealt with this issue before. Many have, as there seems to be no shortage of people like you. Your local certified public accountant society or the National Assn. of Enrolled Agents, at www.naea.org, can provide referrals.
Dear Liz: When the stock market dropped this past year, I decided that was a perfect time to max out my 401(k) deduction to the plan’s 35% limit. The problem is that the IRS maximum contribution is $16,500, and it’s nearly impossible to get my withholding to exactly match the dollar limit. If I am slightly over the maximum at the end of the year, what is the IRS likely to do to me?
Answer: It’s typically not the IRS that takes action in these situations; it’s the 401(k) plan administrator that will either stop your contributions once you hit $16,500 for the year or send you back a check for any amount over the limit you’ve contributed.
You’ll have to pay regular income taxes on that money, but you won’t otherwise be penalized for trying to be aggressive about your retirement savings.
Dear Liz: I’ve been contributing to a traditional individual retirement account for the last few years. Taking one of your recommendations, I would like to move the money to a Roth IRA. I understand that I’ll have to pay taxes on the conversion, but will there also be any penalties involved? If so, how much of a penalty? If there is no penalty and only taxes, what is the rate I should be expecting?
Answer: Roth IRAs offer tax-free withdrawals in retirement, which is why they’re a great deal for many savers, and conversions are about to become easier.
Currently there is no penalty for converting a traditional IRA to a Roth, but you will owe income taxes that are determined by your tax bracket. If you’re in the 25% federal tax bracket, for example, you’ll owe taxes equal to 25% of the amount you convert, assuming your contributions were all tax-deductible. (If you made nondeductible contributions, those will reduce the tax bill proportionately.) You’ll also need to factor in state and local income taxes.
You can convert to a Roth this year only if your modified adjustable gross income is $100,000 or less. Next year, however, the income limit on Roth conversions is scheduled to be removed. Also, for 2010 only, you can opt to have the taxable income from your conversion reported in two equal installments in 2011 and 2012, putting off the tax bill you owe.
Make sure you have enough cash to cover the taxes without raiding the IRA you’ll be converting. But being able to put off the tax bill, and paying it over two years, should lessen the burden. Talk to your tax pro for details.
Dear Liz: I am 74 and retired. Due to the economy I would like to cash out my retirement accounts. I have an individual retirement account, a Simple IRA and an annuity. Only other income is Social Security. How badly would this affect me?
Answer: That depends. How much do you love paying unnecessary taxes?
Cashing out any retirement account, other than a Roth IRA, typically triggers a significant income tax bill. Cashing in an annuity may also trigger surrender charges that can be substantial.
If you took too much risk with your investments, you can shift to safer options inside your retirement accounts. You would be smart to consult a fee-only financial planner first, so you can construct a portfolio that acknowledges your tolerance for risk while still giving you enough money to live on for the rest of your life.
Dear Liz: Since tax filing season is upon us, it’s a good time to get rid of statements and records we don’t need. How long should we keep such things as tax records, credit card statements, mortgage payment statements, utility bills, etc?
Answer: Most tax-related documents should be kept for seven years unless the paperwork concerns a potentially taxable investment or asset, such as your home or stocks bought outside a retirement account. In that case, keep the paperwork as long as you own the investment or asset, plus seven years.
For example, hang on to the paperwork created when you bought your home, such as sales contracts, deeds, mortgage paperwork, appraisals and surveys, as well as the costs of any home improvements, since they can help reduce any potential tax bill when you sell. You can dispose of all this documentation seven years after you sell the property.
Why seven years? Your greatest risk of audit is in the first three years after you file your return, but you can still be audited up to six years later if you substantially underreport your income. Since we file our returns in the following year — last year’s returns are due in April of this year, for example — adding seven years to the tax return year will give you the year that you can toss your return’s documentation. This year, for example, you can toss tax-related documents filed for the 2002 tax year.
You might want to hang on to the actual return, though. They typically don’t take up much room and may come in handy. One reader who discovered errors in her Social Security statements, for example, was able to get those corrected because she still had the tax returns for those years.
If it’s not tax-related, your holding times vary. You typically can ditch credit card statements and utility bills after a year, for example. Old insurance policies can be shredded after they’ve lapsed or been replaced, and there’s no chance you’ll file a claim against them.
You can dispose of your pay stubs after comparing them with your annual W-2 form. (Keep your year-end pay stub too, if it shows information that’s not on your W-2, such as tax-deductible union dues.)
Many people these days simply scan all their paperwork into their computers and discard the originals. The actual paper isn’t as important as the information on it, and most sources — including the IRS — accept electronic documents.
Just make sure to back up regularly and keep those backups in a safe place somewhere off site. A secure website or a safe deposit box are two options.
Dear Liz: I received the $7,500 first-time home buyer tax credit for the house I bought last year, but I understand I have to pay that back over 15 years. Under the new stimulus plan, the tax credit went up $8,000 and doesn’t have to be paid back. Is there a plan to relieve the people from paying back the $7,500 or is it a dead issue?
Answer: When Congress changed the credit, it didn’t go back and change the rules for last year. So as of this writing, you’re still required to pay back the $7,500, even though someone who buys a home this year and qualifies for the larger credit won’t face the same requirement.
Raise the issue with your congressional representatives. You can find them at www.house.gov and www.senate.gov.