Ask Liz Weston

Get smart with your money

Taxes

Q&A: Don’t get tripped up by invalid Roth IRA contributions

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Dear Liz: A friend told me that when he takes out his required minimum distribution from his traditional IRA and pays the tax, he then puts the money in his Roth IRA. I believe since this was not earned income, this was wrong. Who’s right?

Answer: The money contributed to an IRA doesn’t have to be earnings, necessarily, but your friend or his spouse must have income earned from working to make an eligible contribution. Earned income includes wages, salary, tips, bonuses, professional fees or small business profits. Earned income does not include Social Security benefits, pension or annuity checks and distributions from retirement accounts.

Another restriction is that contributions can’t be greater than the amount of earned income. If your friend or his spouse earned $3,000 last year, that’s all he’d be allowed to contribute — not the $6,500 maximum allowed for people 50 and over.

The ability to contribute to a Roth begins to phase out when someone’s modified adjusted gross income exceeds certain amounts. In 2017, single filers’ ability to contribute phased out between $118,000 and $133,000. For married couples filing jointly, the phase out began at $186,000 and ended at $196,000.

The penalty for ineligible contributions is 6% of the ineligible amount. The penalty is owed each year the taxpayer allows the lapse without correcting the oversight. If your friend has been doing this for several years, the penalty will be pretty painful.

He could cross his fingers and hope the IRS doesn’t notice, but the error isn’t that hard for the agency to catch. The IRS would simply need to compare Form 5498, which IRA custodians issue to report contributions, to your friend’s income and the sources of that income to know whether he was eligible to put money in an IRA.

Q&A: Revocable living trusts don’t help with taxes

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Dear Liz: Thanks for your recent column on setting up a living trust. This sounds like something that I should do, but I have a few questions. Would federal and state taxes be due on earnings on assets in the trust? Would these taxes due be paid out of earnings of the trust? Would I continue to pay taxes on my income from sources other than the trust?

Answer: Revocable living trusts are an estate-planning tool used to avoid probate, the court process that otherwise follows death. Unlike many other types of trusts, revocable living trusts don’t trigger special tax treatment. You’re still considered the owner of the assets, so you’ll continue reporting earnings and income on your individual tax return, as you previously did.

Revocable living trusts also don’t get special estate tax treatment. Revocable living trusts are designed to eliminate the potential costs and delays of probate, not of the estate tax system. Living trusts may include provisions meant to reduce estate taxes, such as language creating a bypass trust upon death, but those are the same kinds of provisions that can be included in wills.

Q&A: Cash gift to daughter shouldn’t trigger fine

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Dear Liz: I gave my daughter $30,000 in 2015. I was fined $5,000. Why? I had not talked with another daughter, who does my taxes, so I was not aware that I could give only $14,000. If I had known, I could have given her the money over two years. Why wouldn’t they advise me as such?

Answer: It’s not clear whom you mean by “they,” but you need to have a chat with the daughter who does your taxes, because it’s extremely unlikely you were fined by the IRS for your gift.

In 2015, you wouldn’t owe gift taxes until you had given away more than $5 million in your lifetime above the $14,000-per-person annual limit. (That lifetime limit, by the way, has been raised to over $11 million, and the annual gift exclusion limit is now $15,000.)

If you had to pay an extra $5,000, it was for something else. Let’s hope the tax-preparing daughter didn’t decide to “fine” you for favoring your other child.

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

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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

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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

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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.