Q&A: Why failing to pay your taxes is a risky form of protest

Dear Liz: I write in earnest hope that you might consider giving advice to those wondering about withholding federal taxes as a form of protest over the enactment of the new tax bill. What are the possible legal ramifications of withholding federal taxes?

If one is willing to accept the possible consequences, how might one go about the nuts and bolts of not paying federal taxes, and are there any measures one might take to mitigate the legal consequences somewhat? For instance, if one spouse withholds taxes but the other pays, does filing separately at year’s end afford any layer of protection to the paying spouse?

Answer: Please find another way to protest.

The Internal Revenue Service has extraordinary powers to collect what it’s owed. The agency can seize your bank accounts, property and a portion of your income. People who willfully fail to pay their taxes can wind up in prison. Filing taxes separately may keep the paying spouse on the other side of iron bars, but it won’t prevent his or her life from being disrupted.

Our duty to pay taxes doesn’t rest on our approval of every single aspect of the tax code. If that were the case, few of us would pony up. Fortunately, in a representative democracy you have plenty of legal options to work for change. The same Constitution that gives Congress “the power to lay and collect taxes” also gives you the right to express your opinion, to assemble in peaceable protest and to vote for new lawmakers at the appropriate times.

If you want to work for change, do so in ways that actually have a chance at success, rather than one that will succeed only in making your life worse.

Q&A: How to sort out the taxes when you sell your house

Dear Liz: I am trying to understand the capital gains tax exemption as it applies to the sale of a house. If I have no mortgage and I sell my house before I have lived in it for two of the previous five years that are now required for the exemption, is it based on the total selling price of the house or on the amount over what I paid for it? And what is the tax rate based on?

Answer: The home sale exemption can shelter from taxes up to $250,000 per owner ($500,000 for a couple) of capital gains from a home sale. If you don’t live in the home for at least two of the previous five years, you typically can’t use the exemption unless the sale was because of a change in employment, health problems that require you to move or an unforeseen circumstance that forced the sale.

The rules on these exceptions can get pretty tricky, so you’d need to discuss your situation with a tax pro. If you qualify, the amount of the exemption usually would be proportionate to the percentage of the two years that you actually lived in the home. If you sold after one year, for example, you might exempt up to $125,000 per owner.

Whether you have a mortgage does not affect the capital gains calculation. What matters is the difference between the price you get when you sell the house and the price you paid when you bought it.

From the sale price, you get to subtract any selling costs such as real estate commissions. From the purchase price, you can add in certain costs, such as home improvement expenses. What results after these adjustments is your capital gain for tax purposes.

If you have capital gains in excess of the exemption, you would pay long-term capital gains rates on that profit. Long-term capital gains are typically taxed at a 15% federal rate, although the highest-income taxpayers (those in the 39.6% bracket) may pay 20% and the lowest-income taxpayers (those in the 10% and 15% brackets, including taxable capital gains) pay a 0% rate.

States typically have additional taxes.

Q&A: Government financial help after disaster may come as a loan

Dear Liz: With all the recent hurricanes and other natural disasters, people are being helped by the Federal Emergency Management Agency with money for rentals or home replacements. What repayment does the government expect? Are there taxes owed by the recipients of that money?

Answer: FEMA grants aren’t taxable, but they’re typically not enough to replace a home. FEMA may provide up to $33,000, but the typical grant is much smaller — in the $3,000-to-$8,000 range, according to recent data from the agency.

Most financial assistance after a disaster comes in the form of low-interest loans to renters and homeowners, offered through the Small Business Administration. Recipients are expected to repay those loans.

Q&A: To give or not to give can be a taxing question

Dear Liz: A good friend who is childless wishes to give his property to my daughter before his death. He has been an informal uncle for the whole 50 years of my daughter’s life, and we are, in effect, his family. However, I am concerned that the gift tax may be more than he bargained for. He is not tax-aware, and earns very little, so his tax knowledge is skimpy. He owns his property outright, however.

I know that someone can give as much as $14,000 without having to file a gift tax return and that there is a “’lifetime exemption” of more than $5 million. If his property is worth, say, $500,000, can he be tax free on a gift of that magnitude by, in effect, using his lifetime exemption?

Answer: Essentially, yes, but he may be creating a tax problem for your daughter.

Gift taxes are not something that most people need to worry about. At most, a gift worth more than $14,000 per recipient would require the giver to file a gift tax return. Gift taxes wouldn’t be owed until the amount given away in excess of that annual exemption limit exceeds the lifetime exemption limit of $5.49 million.

Capital gains taxes are another matter and should always be considered before making gifts. Here’s why.

Your friend has what’s known as a “tax basis” in this property. If he sold it, he typically would owe capital gains taxes on the difference between that basis — usually the purchase price plus the cost of any improvements — and the sale price, minus any selling costs. If he has owned the property a long time and it has appreciated significantly, that could be a big tax bill.

If he gives the property to your daughter while he’s alive, she would receive his tax basis as well. If she inherited the property instead, the tax basis would be updated to the property’s value at the time of your friend’s death. No capital gains taxes would be owed on the appreciation that took place during his lifetime.

There’s something else to consider. If your friend doesn’t make much money, he may not have the savings or insurance he would need to pay for long-term care. The property could be something he could sell or mortgage to cover those costs.

If he gives the property away, he could create problems for himself if he has no other resources. Medicaid is a government program that typically pays such costs for the indigent, but there’s a “look back” period that could delay his eligibility for coverage. The look-back rules impose a penalty for gifts or asset transfers made in the previous five years. He should consult an elder-law attorney before making such a move.

Q&A: Obsessing over taxes is foolish

Dear Liz: Most of your articles are from people who have not yet retired. I am retired and always expected to be making less money now than when I was working. But the opposite has happened. I am making almost twice as much and I have a lot of money in stocks, which have increased dramatically. I want to travel and use that money but anything I sell will be taxed at the 25% rate. Any ideas how to get my money out and be able to use it?

Answer: Sure. Place a sell order, set aside 25% for taxes and enjoy your life while you still have a life to enjoy. If you’d like to reduce your yearly tax bill, consider bumping up your charitable contributions to help those who aren’t so fortunate.

Paying taxes is not fun, but obsessing about ways to avoid them or letting them dictate your decisions is foolish. You’ll still be far better off than you expected to be after you pay Uncle Sam, and you’ll have the cash to do what you want. So do it.

Q&A: Hard to predict tax rates

Dear Liz: I read your column answer to the 40-year-old who asked about regular 401(k) versus Roth 401(k) contributions. Obviously, the answer has more moving parts than you have space for. However, using before-tax dollars for the 401(k) gives him a small break now, but when he hits 70 1/2, those dollars will impact the taxability of his Social Security benefits. He could contribute to the 401(k) with after-tax dollars, get the company match and avoid that impact 30 years in the future, right?

Answer: The “right” answer requires knowing what tax rates will be 30 years in the future, at a time when no one is entirely sure what tax rates will be next year. Which means the smart approach is to hedge one’s bets. Given the original reader’s current financial situation, that translates into focusing most contributions into the pretax 401(k) but also making contributions to the Roth. That will give him some flexibility to control his tax bill in retirement without going “all in” on the bet that his tax rate then will be higher than it is now.

Q&A: Saving for retirement also means planning for the tax hit

Dear Liz: I’m 40. We own our house and have a young daughter. Through my current employer, I’m able to contribute to a regular 401(k) and also a Roth 401(k) retirement account. My company matches 3% if we contribute a total of 6% or more of our salaries. Are there any reasons I should contribute to both my 401(k) and Roth, or should I contribute only to my Roth? My salary and bonus is around $80,000 and I have about $150,000 in my 401(k) and about $30,000 in my Roth. Thanks very much for your time.

Answer: A Roth contribution is essentially a bet that your tax rate in retirement will be the same or higher than it is currently. You’re giving up a tax break now, because Roth contributions aren’t deductible, to get one later, because Roth withdrawals in retirement are tax free.

Most retirees see their tax rates drop in retirement, so they’re better off contributing to a regular 401(k) and getting the tax deduction sooner rather than later. The exceptions tend to be wealthier people and those who are good savers. The latter can find themselves with so much in their retirement accounts that their required minimum distributions — the withdrawals people must take from most retirement accounts after they’re 70½ — push them into higher tax brackets.

That’s why many financial planners suggest their clients put money in different tax “buckets” so they’re better able to control their tax bills in retirement. Those buckets might include regular retirement savings, Roth accounts and perhaps taxable accounts as well. Roths have the added advantage of not having required minimum distributions, so unneeded money can be passed along to your daughter.

Given that you’re slightly behind on retirement savings — Fidelity Investments recommends you have three times your salary saved by age 40 — you might want to put most of your contributions into the regular 401(k) because the tax break will make it easier to save. You can hedge your bets by putting some money into the Roth 401(k), but not the majority of your contributions.

Q&A: Tax implications of parents paying off a child’s loans?

Dear Liz: My wife and I co-signed for student loans for our daughter. My daughter made payments on these loans since she graduated from college four years ago. My wife and I just paid off the loan balance, which was $22,000. Is our payment considered a gift to our daughter?

Answer: Yes, but your gift is within the annual exemption limit, so you won’t have to file a gift tax return. You and your wife can each give your daughter $14,000, or a total $28,000, without having to file a return. Gift taxes aren’t owed until the amounts someone gives away above those annual limits exceeds $5.49 million.

Q&A: How long will a tax lien linger on a credit report?

Dear Liz: You wrote an article about how the credit bureaus are removing civil judgments and tax liens from people’s credit reports. I’ve been denied credit due to a few tax liens. Creditors won’t negotiate, even though the IRS has already deemed me unable to pay due to my disability. (I’m receiving Social Security disability income.) My question now is, how can I be sure it is being removed? Do I need to call the bureaus? Order another credit report?

Answer: Your unpaid tax liens may disappear, or they may not.

Starting in July, Equifax, Experian and TransUnion began removing liens and judgments when those records lack enough personally identifying information to ensure that the negative marks wind up on the right people’s reports. Another new requirement is that the records be properly updated, so that accounts that have been paid or resolved aren’t still showing as unpaid.

The error rate for these records was high, leading to many complaints, disputes and lawsuits. The bureaus expect to purge virtually all civil judgments but only about half of the tax liens.

If your liens aren’t purged and you can’t pay them, you may have to wait a while for them to fall off your credit reports. Paid liens are subject to the seven-year limit on how long most negative items can appear on credit reports. Unpaid liens can technically remain indefinitely, although the bureaus typically remove them after 10 years.

Q&A: Keeping retirement money in various accounts helps with tax bills

Dear Liz: I am having difficulty determining if I should invest money in my 457 deferred compensation account or in a taxable account, as I am in the 15% tax bracket.

Also, does it matter whether I invest in a Roth IRA instead of my traditional IRA? My biggest pot of money is in a taxable account, then my IRA, then a Roth. I am single, no dependents and over 50.

Answer: In retirement, having money in different tax “buckets” can help you better control your tax bill.

Taxable accounts, for example, can allow you to take advantage of low capital gains tax rates plus you can withdraw the money when you want: There are no penalties for withdrawals before age 59½ and no minimum distribution requirements.

Tax-deferred accounts allow you to save on taxes while you’re working but require you to pay income taxes on withdrawals — and those withdrawals typically must start after you turn 70½.

Roth IRAs, meanwhile, don’t have minimum distribution requirements, and any money you pull out is tax free, but contributions aren’t tax deductible.

Because most people drop to a lower tax bracket in retirement, it often makes sense to grab the tax benefit now by taking full advantage of retirement accounts that allow deductible contributions.

That means the 457 (generally offered by governmental and nonprofit entities) and possibly your regular IRA. (Your ability to deduct your IRA contribution depends on your income, since you’re covered by the 457 plan at work.)

If your IRA contribution isn’t deductible, then contribute instead to a Roth. If you still have money to contribute after that, use the taxable account.

If you expect to be in the same or higher tax bracket in retirement, though, consider funding the Roth first. Prioritizing a Roth contribution also can make sense if you have plenty of money in other retirement accounts and simply want a tax-free stash you can use when you want or pass along to heirs.