Ask Liz Weston

Get smart with your money

Q&A

Q&A: Here’s a big tax mistake you can easily avoid

By

Dear Liz: I’m self-employed and my wife wasn’t working last year. In December, we returned to California and found a small home to purchase using $107,000 I took out of my IRA. Since we weren’t quite certain of what our income would be, we received our health insurance in Oregon through an Affordable Care Act exchange.

When we filed our taxes we got hit with a $20,000 bill for the insurance, because we earned too much to qualify for subsidies, and a $10,000 bill for the IRA withdrawal. Our goal was to own our home outright, which we do, but now we have a $30,000 tax bill hanging over us.

Can we work with the IRS somehow on this? We didn’t “earn” the $107,000; we invested it in a home. It wasn’t income, so why should we be punished for using our savings to purchase a home?

Answer: If you mean, “Can I talk the IRS out of following the law?” then the answer is pretty clearly no. The IRA withdrawal was income. It doesn’t matter what you did with it.

Consider that you probably got a tax deduction when you contributed to the IRA, which means you didn’t pay income taxes on that money. The gains have been growing tax deferred, which means you didn’t pay tax on those, either.

Uncle Sam gave you those breaks to encourage you to save for retirement, but he wants to get paid eventually. That’s why IRAs and most other retirement accounts are subject to required minimum distributions and don’t get the step-up in tax basis that other investments typically get when the account owner dies.

(If you did not get a tax deduction on your contributions, by the way, then part of your withdrawal should have been tax-free. If you’d contributed to a Roth IRA, your contributions would not have been deductible but withdrawals in retirement would be tax-free.)

The IRS does offer long-term payment plans that may help. People who owe less than $50,000 can get up to six years to pay their balances off. You would file Form 9465 to request a payment plan. The IRS’ site has details.

Here’s a good rule to follow in the future: If you’re considering taking any money from a retirement account, talk to a tax professional first. People often dramatically underestimate the cost of tapping their 401(k)s and IRAs; a tax pro can set you straight.

Q&A: Figuring homes’ adjusted basis

By

Dear Liz: In your response to a question about the adjusted basis of a residence after the death of a spouse, you state that the surviving spouse may add to the adjusted basis “any commissions or fees paid to purchase the property and the cost of improvements.” Your example adds $150,000 in “improvements over the years” to the $850,000 value of the home at the time of the spouse’s death in 1992. Wouldn’t those improvements (and other costs) have to be made after the date of the spouse’s death, since otherwise they would already be included in determining the value of the home at the date of death?

Answer: Good point. If the surviving spouse lives in a community property state, only improvements that happened after the date of the first spouse’s death would increase the basis, because both halves of the property get a step up to the current fair market value when one spouse dies. In other states, only the deceased spouse’s half of the property would get the step up. The surviving spouse can add his or her half of the improvements made before the death, and anything done after the death, to the tax basis to determine home sale profits.

Q&A: His Social Security claiming decision could use a second opinion

By

Dear Liz: I retired in 2013 at 55. I purchased an annuity, which will pay $1,000 a month for life for me and my wife as well. That starts in February 2020. My retirement fund, meanwhile, was rolled into an IRA and I’m withdrawing about 10% of that annually. The balance is about $650,000.

My advisor wants me to start my Social Security at age 62. I would receive $1,800 a month and could reduce my withdrawal rate to 4%. I’ve also been told, however, that it would be better to wait until my full retirement age (66 and 6 months) or 70, when my benefit maxes out. At full retirement age, my monthly benefit would be about $2,500, and at 70, it would be $3,000.

I’m not sure what to do. My wife will be retiring next year and her monthly pension will be about $3,700. We still owe on our house and have other debt as well. What’s my best option?

Answer: There’s a lot of research showing that single people and “primary earners” — the higher wage earner in a married couple — are better off delaying the start of their Social Security benefits. (The article “Understanding Social Security Claiming Decisions Using Survey Evidence” in the November 2018 issue of the Journal of Financial Planning does a good job of summarizing the research.)

Longer life expectancies mean most people will live beyond the “break even” point at which the larger benefit more than makes up for the checks they pass up in the early years. These larger checks are a kind of longevity insurance, as well. The longer you live, the more likely you will have spent your other resources and wind up depending on your Social Security income to live.

Having the primary earner delay is especially important for married couples because at the first death the number of checks the household receives will drop from two to one. Because the survivor receives the larger of the two checks, it’s usually wise to make that check as large as possible.

The benefits of delay are so substantial — one study shows that the sustainable standard of living is 30% higher for people who start at 66 rather than 62 — that advisors often recommend tapping other resources, including retirement funds, if it enables people to put off starting their checks.

Your situation may be a bit different, though because you mention that your wife has a pension. If the pension is from a job that did not pay into Social Security, it would affect her ability to receive survivor’s benefits from the Social Security system. Something known as the government pension offset would reduce her survivor check by two-thirds of the amount of her pension, which could eliminate her survivor benefit entirely. If that’s the case, it wouldn’t be as crucial for you to delay.

Given how much is at stake, though, you might want to get a second opinion from another advisor who can review the specifics of your situation.

Q&A: Capital gains on house sale

By

Dear Liz: I am one of those seniors who purchased their house in the 1970s. I would like to move but I’m reluctant because of the huge capital gain tax that I would have to pay. The exemption amount has not been raised since 1997 when it was enacted. In comparison, the estate tax exemption has risen from $600,000 in 1997 to more than $11 million currently. Wouldn’t raising the capital gain exemption stimulate the real estate market as more people would put their homes on the market and give more first-time buyers a chance at homeownership?

Answer: Perhaps, but you shouldn’t let tax law be the sole determinant of what you do or don’t do. Minimizing taxes can be a factor in your decisions but shouldn’t be the only one.

Also, keep in mind that the median home price in the U.S. is currently $226,300, according to real estate site Zillow. Most homeowners haven’t seen and probably won’t see enough appreciation to use a single $250,000 exemption, let alone the $500,000 available to couples.

So you may have a problem, but it’s an enviable problem. Even if you pay taxes at top rates, you’ll still have a substantial sum left over. And you may be able to spread out the tax bill using an installment agreement, in which the buyer pays you over time. You’ll want a tax pro’s help if you go that route, but you should consult one in any case to make sure you’re taking advantage of every other legal opportunity to reduce what you owe.

Q&A: Loans, taxes and home sales

By

Dear Liz: You recently answered a question about determining home sale profits for a widow. My question is how you calculate taxes when there’s a loan in the mix. For instance, when I bought my home, I took out a mortgage. Subsequently, I took out a second mortgage to pay for a pool and landscaping. I also refinanced several times, but never took a mortgage with cash out. Please advise me how to calculate my cost basis given these loans. Of course, you can broaden your response to include other loan scenarios and how they play into cost basis.

Answer: This will be a short answer, because they don’t. What you owe the mortgage lender(s) is typically irrelevant for calculating your capital gain.

Q&A: Facing retirement with parent student loans? Transfer them to the kids

By

Dear Liz: I’m 60. Should I take a $50,000 distribution from my 401(k) to pay down my $146,000 parent Plus college loan and then try to refinance the balance with a private lender at a lower interest rate? I have $364,000 in my 401(k). I’m paying 8% interest on the parent Plus loan and planning to retire at age 66 years and 10 months, my full retirement age for Social Security.

Answer: Are you sure you can afford to retire?

You would still have a massive amount of education debt even after paying it down, plus a smaller nest egg. Unless you have a substantial amount of savings outside your 401(k) or another source of income besides Social Security, you could run a substantial risk of running short of money even if you can persuade a private lender to refinance your debt.

That may not be the best option, in any case. Federal loans have more consumer protections, including deferral and forbearance options and income-contingent repayment plans that could lower your payments.

Refinancing with a private lender might make the most sense if you can transfer this debt to the child or children who benefited from the education. Several private lenders offer this option if the kids have good credit and decent incomes.

In any case, you’d be smart to consult a fee-only financial planner who can review the specifics of your finances and offer advice.