Year-end is just around the corner. Now’s the time to consider your taxes and what you can do to minimize them and keep as much wealth as you can. Here are several tax traps you want to avoid now and in the coming year, including business, inheritance, and personal expense tax traps.
Business Tax Traps to Avoid
If you’re self-employed, be sure to plan for your taxes. Sole proprietors pay estimated taxes on a quarterly basis, including income tax, Medicare tax, and social security tax, which is equal to 15.3% of net earnings. The benefit is you get to claim half of those taxes on your personal tax return.
Startup cost deductions sound wonderful. But did you know that you may not be able to claim all of them in the first year? In the first year, you have to make your first sale. Then the IRS allows up to $10,000 in deductions from startup costs ($5,000 for startup and $5,000 in organizational costs) if total expenses do not exceed $50,000. If your startup costs are more than $50,000, but less than $55,000, there are still deductions available, reduced by the dollar amount beyond $50,000.
Business entity selection is key. You might start your company as a C Corp or LLC. However, selecting the wrong entity can impact your tax obligation and personal liability. Speak with us before making a choice.
Inheritance Tax Traps
Inheritance and estate tax traps can be challenging for the heir if things are not properly set up ahead of time. Before cashing out the inheritance money, first determine if you have to pay tax on it. It can be different in each state. The amount you pay is based on the type of asset(s) passed to you, the account in which it was held, and when you choose to receive a payout.
If you inherit a retirement account and the money in the account was deposited as pre-tax dollars, such as a 401(k) or IRA, state and federal income tax may have to be paid. In that case, the amount you withdraw is added as taxable income on your personal tax return. The amount could also put you into a higher tax bracket, also increasing the amount of tax you owe personally.
If you inherit mutual funds, bonds, real state, or stocks from taxable accounts, the value uses what’s called the stepped-up cost basis, or fair market value of the assets based on the death certificate date rather than when it was purchased. If you then sell the asset(s), you pay tax only on the profits calculated from the day you inherited it. Here is an example.
Personal Expense Tax Traps
Health insurance costs will come out of your pocket if you plan to retire before age 65 when you can qualify for Medicare. Search Healthcare.gov for prices for your current age, as well as five and ten years down the road. Keep in mind that insurers can double your premiums when you turn 50. The good news is, those premiums are tax deductible if you’re self-employed. But if you stop working you can only deduct health expenses if they are more than 7.5% of your adjusted gross income.
Mortgage interest is no long deductible if you switch from itemized deductions to the standard deduction on your tax return. If you can pay off your mortgage before you retire, you can save the investment income you’ve set aside. In
addition, you will likely have to withdraw less from your retirement account to pay for the mortgage payments; resulting in less income which could put you in a lower tax bracket.
Municipal bonds may appear to be a good investment, but keep in mind, they are not tax free. While the interest payments on municipal bonds are usually exempt from federal income taxes, but other taxes may apply. In an article by Schwab.com, “It’s important to know the rules, because municipal bonds are one of the few investments available to income-oriented investors looking to reduce their income tax bills.” There are several types of tax that could apply, such as De minimis tax, alternative minimum tax, social security tax, Medicare premium tax, capital gains tax, state income tax, and taxable municipal bonds.
Foreign assets, including property, bank accounts, stock in non-U.S. companies, and non-U.S. mutual funds, can get you into trouble. Failing to file the appropriate tax forms can carry a hefty penalty, starting at $10,000 per form, per year. Be sure to claim these assets and file the appropriate tax forms.
If you plan to rollover a 401(k) to an IRA, there are also tax considerations to keep in mind. You can dodge them by using a direct trustee-to-trustee transfer from the plan into your IRA. That means the money is transferred directly to the trustee or IRA custodian.
Why is a direct transfer a good idea? If you receive a retirement plan check that is payable to you personally or a distribution that is dumped into a personal account via an electronic funds transfer (EFT), 20% of the taxable amount of the payout must be withheld for federal income tax. Then you’ll have 60 days to come up with the “missing” 20% and get it into your IRA. Otherwise, you can’t accomplish a totally tax-free rollover. You’ll owe income tax on the 20% and maybe the dreaded 10% early withdrawal penalty tax too if you’re under age 55. If over 55 when you receive a payout, you miss the 10% penalty, but still have to pay the state and federal tax on the amount you keep outside your IRA.
To avoid dealing with these issues, work closely with a professional, licensed CPA, like me. They can conduct due diligence to spot potential problems before they happen.