Ask Liz Weston

Get smart with your money

Taxes

Q&A: Should I consider Roth conversions now or after I retire?

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Dear Liz: My husband and I both waited until age 70 to start Social Security. I will be 72 in September and am considering retirement. My husband is retired, 74, and taking required minimum distributions (RMDs). We have always tried to maximize contributions to our pre-tax retirement accounts and are now realizing the downside as we pay taxes on those mandatory withdrawals. Should I consider Roth conversions now or after I retire? I realize I will need to pay taxes on those conversions, but would it be best to do that when my income is lower? I am thinking about my kids and their future.

Answer: Late-in-life Roth conversions can be tricky. The amount you convert is removed from RMD calculations, lowering future tax bills. But the conversion is added to your current taxable income, potentially making more of your Social Security taxable and temporarily raising your Medicare premiums (thanks to income-related monthly adjustment amounts or IRMAA) in addition to generating a big tax bill.

Theoretically, a conversion could still make sense if your current tax rate is lower than the one you’ll have once you start required minimum distributions at 73. The case for conversion is strengthened if you want to pass this money to your kids. They likely would have to empty any inherited retirement account within 10 years, and they could be in their peak earning (and tax-paying) years when they do so. By converting now, you would in effect be paying the tax bill for them, perhaps at a lower rate than they might face, and allowing them to inherit the money tax-free.

A tax pro can help you with the calculations so you’ll understand the financial impact of a conversion. Then you can make an informed decision about whether to proceed.

Q&A: How are IRA withdrawals taxed?

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Dear Liz: I’m aware that assets held in tax-advantaged accounts, such as an IRA or 401(k), avoid capital gains taxes on the sale of an asset. However, will those capital gains taxes have to be paid later when it is time to withdraw money from those accounts? If yes, can I offset it with any capital losses?

Answer: Traditional retirement accounts such as IRAs or 401(k)s change how investment gains are taxed. You don’t pay tax when investments within the accounts are sold, but withdrawals from the account are typically taxed as ordinary income, not as capital gains. So you won’t have an opportunity to directly offset capital gains with losses as you would with nonretirement accounts.

However, if your losses exceed your gains in your nonretirement accounts, you can use up to $3,000 of capital losses to offset ordinary income each year. Any remaining losses can be carried forward to the next year where it’s rinse and repeat: capital losses offset capital gains, with up to $3,000 of any remaining loss used to offset ordinary income. This goes on until the losses are finally used up.

Q&A: What should you do if an accountant ignores you?

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Dear Liz: When my sister became somewhat disabled, I started handling her financial affairs. (I have a power of attorney.) She hadn’t paid her taxes for several years, so I worked with her accountant to get them filed and pay the necessary penalties. I thought she was up to date with both her federal and state taxes. With no warning (to my knowledge), the state tax agency suddenly withdrew over $12,000 from her checking account.

After an attempt to contact the agency for an explanation, I decided to ask her accountant if he could help me understand where she stood tax-wise so we would not be hit with any similar financial shock. He had prepared her taxes for her for many years, but has not returned my calls or emails. I am at a loss as to how to obtain more information about her tax liabilities. I believe she had given him the authority to view her tax accounts. What else can I do to feel satisfied that she will not be subject to any further garnishment?

Answer: Many tax pros struggle to keep up with client communications in the weeks before the April 15 deadline. If you were trying to contact him during crunch time, that could explain why you didn’t hear back immediately. If he still hasn’t reached out, however, you should start looking for a new accountant who can help you sort this out.

State tax agencies don’t usually act without warning. Typically, they mail multiple notices about delinquent taxes and give taxpayers time to respond before taking money from a bank account. It’s possible these notices went to an old address, or that your sister received them but didn’t understand their importance.

Since you have the power of attorney, you should be able to get information directly from the state tax agency. They’ll have a form that allows you to establish your right to communicate with the agency on your sister’s behalf. Once filed, you can access her account history. That information can help you and the new accountant piece together what happened, determine if there are any outstanding liabilities and figure out a plan for preventing future collection actions.

You’ll also probably want to pull her credit reports to look for any other tax liens or collection actions. If she’s struggling to manage her money, you may need to take more proactive steps, such as taking over bill payment. Consider working with a fiduciary financial planner or an elder law attorney who can help you create a system to avoid future catastrophes.

Q&A: Advisor may have overlooked tax bill alternatives

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Dear Readers: The following comment was prompted by my response to the letter from a couple in their 70s asking if they had made a mistake moving their $2-million portfolio, including $340,000 in a taxable account, to a new advisor. The advisor recommended investment sales that resulted in a $50,000 capital gain tax bill, and their accountant disapproved. I wrote that the tax pro might not be in the best position to judge whether the sales were necessary, since accountants are typically focused on reducing tax bills but sometimes diversification is necessary to avoid even bigger financial consequences down the road. Here’s another perspective.

Dear Liz: The comment that the accountant is not in the best position to evaluate is correct, as the accountant is only looking at the taxes. However, as a retired portfolio manager and chartered financial analyst, I really doubt that it was appropriate for the investment manager to take this large of an amount of capital gains. It would only make sense if this taxable portfolio had nothing but speculative issues in it, which I would find doubtful for a couple in their late 70s. If the taxable account was too high in equities or poorly diversified by industry weightings, adjustments can be made in the larger retirement account to bring the combined account into better balance. It may have been appropriate to take some gains, but they can certainly be spread out over several years, as taking them all at once likely puts the couple in a higher tax bracket.

Answer: You’re making a good point that the couple had other options besides “ripping off the Band-Aid” and incurring one big tax bill rather than taking the gains more gradually. Their new advisor, as a fiduciary, should have discussed the options with them and helped them understand the impacts, including the expected tax bills and potential impact on Medicare premiums. If those discussions didn’t happen, that’s all the more reason to seek out a second opinion from another fee-only financial planner.

Q&A: Are IRS quarterly payments mandatory?

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Dear Liz: I live totally on my investment income. I receive the majority of my income at the end of the year, mostly dividends from my brokerage account.

A couple of years ago, when talking to an IRS agent about another matter, I asked when I should make my estimated tax payment. I was told that I had to make the payments quarterly. This year, when I was talking to my accountant, she told me that I could make a lump-sum payment at the end of the year without incurring a penalty. Who is correct, the IRS agent or my accountant?

Answer: Ours is a pay-as-you-go system, and the IRS assumes that your income is received evenly throughout the year, says Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting. Therefore, the agency typically expects four estimated tax payments of roughly equal size, with the payments due April 15, June 15, Sept. 15 and Jan. 15. If the payments aren’t made as expected, you can get hit with an underpayment penalty.

However, the IRS allows a taxpayer to show that their income is not earned equally throughout the year by filing a Form 2210 with a related Schedule AI (Annualized Income Installment Method), Luscombe says. Schedule AI allows you to show when income was earned during the year so you can match your estimated payment dates to when you actually received the money.

Schedule AI is more work, since it requires you to report adjusted gross income for each of the four quarters, as well as your itemized deductions and other tax details items, Luscombe notes. But if your income comes at the end of the year and the corresponding estimated tax payment was made on Jan. 15 of the following year, filing this paperwork may be sufficient to avoid a penalty for underpaying estimated taxes, he says.

Q&A: How do I avoid a Medicare surcharge?

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Dear Liz: I will be applying for Medicare next year. Last year I received an inheritance, and also sold a second home which increased our taxable income for the year. I once read that there is a form that needs to be completed to let Medicare know that this is only a one-time occurrence. However, my tax advisor said that there is no need to let Medicare know and he had not heard of any such form. I feel he does not understand that the higher income might affect our Medicare premiums. My understanding is that if I don’t submit the form, my Medicare payment will be a lot higher than expected. Can you suggest what I should do?

Answer: There is such a form, but it’s unlikely to help in your situation.

Medicare premiums are based on your income from two years earlier, as shown on your tax returns. People with higher incomes face “income related monthly adjustment amounts” (IRMAA) that can substantially increase their Medicare Part B and Part D premiums. (Part B covers doctor’s visits and Part D covers prescriptions.)

Form SSA-44 is designed to help people whose income has taken a hit because of major life changes, such as retirement, divorce or the death of a spouse. It’s not designed to spare people who had taxable windfalls, such as capital gains from a property sale.

Inheritances generally aren’t taxable events, however, with a few exceptions. If you inherit someone’s IRA, for example, you generally must start withdrawals which are typically taxable. Otherwise, inherited money and assets typically don’t show up on your tax returns or affect your Medicare premiums.