Ask Liz Weston

Get smart with your money

Taxes

Q&A: Hard to predict tax rates

By

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

By

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?

By

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?

By

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

By

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.

Q&A: Figuring out capital gains when an inherited house is sold

By

Dear Liz: I’ve have been following your responses related to the tax exemption on home sales. I understand that up to $250,000 per person of home sale profit is exempt from capital gains taxes and that married couples are entitled to exempt up to $500,000.

My spouse and her two siblings inherited a home from their parents. My father-in-law passed away four years ago, and my mother-in-law died last year. My wife was assigned as executor of their living trust. Who is entitled to take the tax exemption of the proceeds from the sale of the house? My wife? All three siblings? All of the above and their spouses?

Answer: None of the above, but don’t despair because the house will incur little if any capital gains when it’s sold.

We’ll assume your mother-in-law inherited the house outright from her husband, since that’s usually the case. When your mother-in-law died, the house received a “step up” in tax basis to reflect its current market value. If the house was worth $2 million when she died, for example, that’s the new value for tax purposes — even if she and your father-in-law paid only $25,000 decades ago for the house. All the gain that occurred in between their purchase and her death won’t be taxed.

If your wife sells the house for $2.2 million, there potentially would be some taxable capital gain. But the costs of marketing and selling the home would be deducted from its sale price. If those costs are 6% of the sale price — which is a pretty conservative assumption — the taxable gain would be about $68,000. (Six percent of $2.2 million is $132,000. Subtract the $2 million value at death and the $132,000 of sales costs, and you’re left with $68,000.) If your wife as executor sells the house and distributes the proceeds to the beneficiaries, the estate would pay the tax. If siblings inherit the house and then sell it, they would pay any tax.

Every year, millions of dollars of potential capital gain vanish this way as people inherit appreciated property. It’s a huge benefit of the estate tax system that many people don’t understand until they’re the beneficiaries of it.