Ask Liz Weston

Get smart with your money

Taxes

Q&A: Those IRS coronavirus-extended deadlines apply to more than just taxes

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Dear Liz: Now that we’re not required to file our taxes until July 15 this year, has anything been said about pushing back the 2019 contribution deadline for IRAs and Roth IRAs?

Answer: The IRS recently confirmed that the deadline for making contributions to IRAs has also been extended to July 15. The deadlines were pushed back from April 15 because of stay-at-home orders and other disruptions stemming from the coronavirus outbreak.

You can contribute up to $6,000 to IRAs for 2019 if you’re under 50, or $7,000 if you’re 50 or older. The limits are the same for 2020.

You didn’t ask, but the deadline for contributing to a health savings account also has been extended.

HSAs allow people with qualifying high-deductible health insurance plans to put away money that can be used tax-free for eligible medical expenses. The maximum amount individuals can contribute to an HSA is $3,500 for individual coverage and $7,000 for family coverage. The “catch up” provision for people 55 and older allows an additional $1,000 contribution.

Q&A: How IRS Free File works

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Dear Liz: I wanted to alert you to the fact that online tax preparation companies are up to their old tricks again this year despite being called out last year for deceptively hiding their free tax filing from eligible filers. My son, who qualifies for free filing, was redirected to the paid “deluxe” version when it turned out he qualifies for a “Savers Tax Credit.” He makes modest tax-deferred contributions through an employer that matched contributions. (He’s a low-income student who works in retail.) He logged out of that website and instead successfully used a competitor provider for free.

Answer: The way to access the IRS’ Free File program is through the IRS website, which directs people to the private tax preparation companies that have agreed to offer this service. Unfortunately, many of those same companies spend a lot of money trying to obscure that fact that most Americans can file for free.

Independent news organization ProPublica reported last year that tax preparation companies were hiding their free file options from online search engines and steering people instead into paid tax preparation. A government report in February confirmed that more than 14 million taxpayers paid for tax preparation last year that they could have received free.

The companies have since been banned from hiding the free option and are supposed to include a link that returns people to the IRS Free File site if they don’t qualify for the company’s free offer. But ProPublica found that they continue to steer people away from free filing in various ways, including advertising that misuses the word “free.”

Also, many people like your son discover only late in the tax preparation process — often after they’ve added most of their information — that they don’t qualify for that company’s free option, although they would qualify elsewhere.

Here’s what people need to know about free filing:

People with adjusted gross incomes under $69,000 a year can qualify for free filing, but they should start their search at the IRS Free File webpage.

People in the military and their families can use MilTax, provided by the Department of Defense.

They can also get advice from a tax professional at (800) 342-9647.

In addition, people may qualify for the IRS’ Volunteer Income Tax Assistance if they make less than $56,000, live with a disability or speak limited English. Use the Volunteer Income Tax Assistance locator tool or call (800) 906-9887.

People who don’t qualify for the above services can still use free fillable forms. In addition, some tax preparation companies may have free options for people filing basic forms. The types of income and credits that allow someone to file for free should be prominently displayed on the company’s free file page.

Q&A: Tax tips for hybrid owners

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Dear Liz: Not a question, but a tip for your readers. I bought a plug-in hybrid in 2018. I couldn’t take advantage of the $7,500 federal tax credit because my income was too low to pay much in federal taxes. So I converted $30,000 of my IRA to a Roth IRA, which added that money to my income for 2018, allowing me to take full advantage of the credit. Hey, I even got some money back. I can’t touch that Roth account for five years, or else the income it generates won’t be tax-free, but when the time comes for my mandatory withdrawals, I’ll tap into the remainder of my regular IRA. This might be of help to some of your readers.

Answer: Normally conversions from a regular IRA to a Roth trigger a hefty tax bill, but your credit allowed you to convert tax-free. Leasing is another option to consider with hybrids and other cars that offer a federal tax credit. The value of the credit typically is built into the deal, so you benefit even if you don’t have a federal tax bill to offset.

Q&A:Don’t make this mistake with your retirement savings

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Dear Liz: My wife and I are in our mid-40s and planning to buy what likely will be the last house we’ll purchase. I’ve decided to withdraw around $15,000 from my IRA to buy down the rate, which will guarantee returns in the form of interest savings, even if those will be less than the returns I would earn if I left the money in the account. My real question is about our current house. We owe around $77,000 on a house that could likely fetch in the low $200,000 range. I’ve looked at it up, down and sideways. Would it make more sense to rent, sell, or rent then sell after a couple of years to avoid the capital gains tax?

Answer: Sometimes it can make sense to buy down a mortgage interest rate by paying more upfront if you plan to stay in the home for many years. The deals vary by lender, but you might pay 1% of the loan amount (one point) to get a rate that’s 0.25% lower, or 2% (two points) to get the rate reduced by 0.5%. For example, paying two points on a $200,000 mortgage, or $4,000, could lower the rate from 4.5% to 4%. You would drop the monthly payment about $59, and it would take you nearly six years for the slightly lower monthly payments to offset what you paid upfront.

You complicate the math, though, when the money used to buy down the rate comes out of a retirement account. That money is taxed as income and would likely be penalized as well because you aren’t yet 59½. (There’s an exception to the penalty for first-time home buyers who withdraw up to $10,000, but they’ll still owe income tax on the withdrawal.) The tax bill varies according to your tax bracket and your state, but you can expect it to equal roughly one-quarter to one-half of the amount withdrawn.

In addition to the tax bill, you’ve also given up future tax-deferred returns on the money. And because most people’s incomes drop in retirement, you’re probably paying a higher tax rate than you would if you withdrew the money later.

A good rule of thumb is to consult a tax pro before you take any money out of a retirement account. The rules can be complex and it’s easy to make an expensive mistake. A tax pro also could advise you about the tax implications of renting vs. selling, although you might also want to talk to anyone you know who’s a landlord about what’s involved with renting out a property.

The simplest solution may be to sell your current home and use the equity to reduce the size of the loan you’ll need on the next residence, rather than raiding a retirement fund to get a slightly lower rate.

Q&A: How to keep tax benefits when renting out your primary residence

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Dear Liz: If my wife and I sell our primary residence of 12 years, I understand we can exclude up to $500,000 in home sale profits from taxes. But if we rent it for a year or two, then sell, have we lost that tax break by converting it to income property?

Answer: As long as you lived in the property at least two of the five years before the sale, you can use the home sale exclusion that allows each owner to protect $250,000 of profits from taxation.

You would pay capital gains rates on profits above that amount, but a big home sale profit could have other tax implications.

If you’re covered by Medicare, for example, profits above the exclusion amounts could temporarily increase your monthly premiums. This is because the income-related monthly adjustment amount, which is added to premiums when modified adjusted gross income exceeds $87,000 for singles or $174,000 for married couples.

If you might be affected, you’d be smart to consult a tax professional to see if there’s a way to structure the sale to reduce these effects.

Also, renting property has its own set of tax rules, making it even more important to have a tax pro who can assist you.

Q&A: This retiree got a big surprise: taxes

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Dear Liz: I’m 76 and retired. During the decades I worked, I contributed to my IRA yearly using my tax refund or having money deducted from my paycheck. No one told me I would have to pay taxes on this when I turned 70. For the past six years, I have been required to withdraw a certain percentage of this IRA money and pay taxes on it. Is there ever going to be an end to this? Do I have to keep paying taxes on the same money every year? And what about when I pass away, do my children have to keep paying?

Answer: Ever heard the expression, “There’s no such thing as a free lunch”?

You got tax deductions on the money you contributed to your IRA over the years, and the earnings were allowed to grow tax deferred. Those tax breaks are designed to encourage people to save, but eventually Uncle Sam wants his cut.

Also, you aren’t “paying taxes on the same money every year,” because the money you withdraw has never been taxed. Plus, you’re required to take out only a small portion of your IRA each year starting at 70½. The required minimum distribution starts at 3.65% and creeps up a bit every year, but even at age 100 it’s only 15.87% of the total. You can leave the bulk of your IRA alone so it can continue to grow and bequeath the balance to your children.

Your heirs won’t get the money tax free. They typically will be required to make withdrawals to empty the account within 10 years and pay income taxes on those withdrawals. Previously, they were allowed to spread required minimum distributions over their own lifetimes. Congress recently changed that to require faster payouts because the intent of IRA deductions was to encourage saving for retirement, not transfer large sums to heirs.

The Roth IRA is an exception to the above rules. There’s no tax deduction when you contribute the money, but the money can be withdrawn tax-free in retirement or left alone — there are no required minimum distributions. Your children would be required to start distributions, but wouldn’t owe taxes on those withdrawals.