Tuesday, February 28, 2006

 

Minister's Housing Allowance

Churches often provide ministers of the gospel with the free use of a home, which is often called a parsonage. The value of the parsonage is not subject to income tax up to the rental value of the home. The value of the parsonage is subject to self-employment tax.

Alternatively, a church may provide a minister with a cash housing allowance as a part of the minister's compensation. Such a housing allowance, up to the fair rental value of the house and associated furnishings, is not subject to income tax. In addition, money the minister receives from the church for utilities is not subject to income tax. However, the minister's housing allowance is subject to self-employment tax.

Who is a minister for the purpose of this exclusion? While determining who is a bona fide minister for this purpose dependsd on the facts and circumstances, a minister is usually an individual who conducts worship services, serves as a church administrator, or teaches at a religious school or seminary.

Although a taxpayer usually cannot deduct expenses incurred in connection with the production of tax-free income, a minister may deduct mortgage interest and real estate taxes for income tax purposes on a home the minister owns. The law allows the minister these deductions even though the housing allowance is not subject to income tax.

If the minister owns and lives in the home as the minister's primary residence for two or more years out of the last five years, and then sells it, the minister may use the exclusion of the gain on the sale of the home up to $250,000 if single or up to $500,000 if married.

A minister receives all the benefits of owning a home that any other homeowner receives. The ability to avoid income tax on a housing allowance adds to the benefits of owning a home for a minister. Therefore, a minister should generally prefer to own a home rather than receive the free use of a home owned by the church.

The exclusion from gross income of a housing allowance for a minister is a generous provision of Section 107 of the Internal Revenue Code. The tax benefits allowed to a minister are magnified with the ability to deduct mortgage interest and real estate taxes and exclude up to $250,000 ($500,000 if married) of the gain on the sale of the home. Ministers of the gospel should take advantage of these provisions so that they can minimize what they must render unto Caesar.

Monday, February 27, 2006

 

Health Savings Accounts

A taxpayer who is covered by a high deductible health insurance policy may establish and contribute to a health savings account (HSA). The contributions the taxpayer makes are deductible in calculating adjusted gross income, so a taxpayer does not have to itemize deductions on Schedule A of Form 1040 to receive the deduction. Contributions made by an employer are not taxable to the employee.

For 2006, for individual coverage, a high-deductible policy must have an annual deductible of at least $1,050. For 2006, for family coverage a high-deductible policy must have an annual deductible of at least $2,100. A plan may have a lower deductible for preventive care. The annual out-of-pocket expenses are limited to $5,250 for an individual or $10,500 for a family.

The maximum monthly contributions an individual may make to an HSA in 2006 are the lesser of 1/12 of the deductible or $2,700. The maximum monthly contributions allowed to an HSA for a family plan in 2006 are the lesser of 1/12 of the annual deductible or $5,450. Individuals who are age 55 or older may contribute up to an additional $700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and later years.

Distributions from the HSA used to pay medical expenses, other than most health insurance, are not taxable. The medical expenses may be those of the taxpayer, the taxpayer's spoouse, the taxpayer's dependents, and certain individual who would be dependents except that they failed certain of the requirements for being a dependent.

If the taxpayer receives a distribution from the HSA and it is not for medical expenses, the distribution is taxable. If the taxpayer receives a distribution from an HSA for other than medical expenses, the distribution is taxable and the taxpayer must pay a 10-percent penalty unless the taxpayer is age 65 or older, disabled, or dead.

Medical expenses include optical, dental, and certain non-prescription drugs as well as expenses for physicians, hospitals, prescription drugs, and other traditional medical expenses. A taxpayer may not pay for a medical expense from an HSA and also deduct the same amount as a medical expenses on Schedule A of Form 1040.

Special rules apply to married taxpayers where each has health insurance. If only one spouse has family health insurance, both spouses are deemed to have family coverage. if both spouses have family health insurance under separate plans, the law treats each spoouse as having a family policy with the lower deductible.

Taxpayers who are interested in the tax benefits of an HSA should consult a competent tax professional and an insurance agent.

Thursday, February 23, 2006

 

No Self-Employment Tax on Notary Income

The work of notaries public is in demand with all so many people buying or refinancing their homes. A notary must attest to many signatures in the closing of a purchase or refinancing of real estate. A notary public serves as a state official who is a bonded witness of a signature. In Florida and perhaps in other states, a notary public can also perform a marriage.

While the net income of a notary public is subject to federal income tax, it is not subject to self-employment tax. Section 1402(c)(1) of the Internal Revenue Code and Regulations Section 1.1402(c)-2(b) provide that the income of a notary public is not subject to self-employment tax.

If a notary public has another business as a self-employed individual, the notary public must pay self-employment tax on the net income from the other business. The notary public must keep a separate account of the income and expenses of each separate business.

A self-employed notary public reports the income and expenses from serving as a notary public on Schedule C of Form 1040. However, the net income from serving as a notary public does not go on Schedule SE because the net income from serving as a notary public is exempt from the self-employment tax.

If the taxpayer has erroneously paid self-employment tax on the net income from serving as a notary public in previous years, the taxpayer should consider filing an amended return on Form 1040X to claim a refund for all open years. In general, a taxpayer has two years from the time the taxpayer paid the tax or three years from the date the taxpayer filed the return, whichever is later, to claim a refund. Taxpayers should consult a competent tax professional before filing an amended return.

Wednesday, February 22, 2006

 

Where to Deduct Tax Preparation Fees

Where should an individual taxpayer deduct tax preparation fees? The obvious answer might be on Schedule A of Form 1040 as a miscellaneous deduction. Are tax preparation fees deductible only on Schedule A for all taxpayers? Thankfully, the answer is no.

Deducting tax preparation fees on Schedule A will provide little or no benefit for most taxpayers because the total miscellaneous deductions must exceed two percent of the taxpayer's adjusted gross income to provide any benefit. In addition, the taxpayer's total itemized deductions must usually exceed the standard deduction amount to provide any tax benefit.

The IRS ruled in Rev. Rul. 92-29 that taxpayers may deduct tax preparation fees related to a business, a farm, or rental and royalty income on the schedules where the taxpayer reports such income.

A taxpayer who is self-employed may deduct the portion of the tax preparation fees related to the business, including schedules such as depreciation schedules, on Schedule C of Form 1040 as a business expense. The tax preparation fees deducted on Schedule C save the taxpayer income tax and self-employment tax.

A taxpayer who is self-employed as a farmer would deduct the portion of the tax preparation fees related to the farm on Schedule F of Form 1040. The tax preparation fees deducted on Schedule F save the taxpayer income tax and self-employment tax.

A taxpayer who has rental and/or royalty income reported on Schedule E of Form 1040 would deduct the portion of the tax preparation fees related to the rental and/or royalty income on Schedule E. The tax preparation fees deducted on Schedule E save the taxpayer income tax. However, the tax preparation fees deducted on Schedule E do not save the taxpayer any self-employment tax because the rental and/or royalty income reported on Schedule E is not subject to self-employment tax.

A taxpayer may not deduct all of the tax preparation fees on Schedules C, E, and F of Form 1040. The tax preparer should provide a statement to the taxpayer that indicates how much of the tax preparation fee was related to the taxpayer's business, farm, and/or rental and/or royalty income. The taxpayer may deduct the remainder of the tax preparation fee only on Schedule A.

If the tax preparer does not provide the taxpayer with a detailed statement showing how much of the tax preparation fee was for the taxpayer's business, farm, and/or rental and/or royalty income, the taxpayer shoud ask the tax preparer for an itemized statement. If the tax preparer will not provide an itemized statement, the taxpayer should use a reasonable allocation. In that case, the taxpayer should seriously consider using a different tax preparer next year.

Here is an example. Assume that the taxpayer is self-employed and also owns rental real estate. The tax preparation fee for the taxpayer's Form 1040 and related schedules for 2005 was $600. The tax preparer states that of the $600 total fee, $300 was related to the taxpayer's business, $200 was related to the rental real estate, and the remainng $100 was related to other parts of the taxpayer's income tax return. The taxpayer paid the $600 in February 2006.

On the taxpayer's income tax return for 2006, the taxpayer may deduct the $600 tax preparation fee as follows: $300 on Schedule C, $200 on Schedule E, and $100 on Schedule A as a miscellaneous deduction.

Tuesday, February 21, 2006

 

Converting Retirement Plans to Life Insurance

Assume that an older, fairly wealthy widow(er) has a substantial amount in tax-deferred retirement plans such as defined contribution pension plans, 401k plans, 403b plans, and traditional IRAs. The widow(er) wants to leave the retirement plans to his or her children.

The problem is that when the children inherit the retirement plans and take distributions from them, the distributions are fully taxable to the children. The retirement plans are income in respect of a decedent (known as IRD), which is taxable. In addition, the balances in the retirement plans are fully included in the decedent's gross estate for estate tax purposes.

Is there any way to achieve the parent's goal of having enough money to pay living expenses and yet leave a good inheritance to the children? The answer is yes if the older, fairly wealthy parent is insurable for life insurance purposes.

Here is how the solution would work. The parent obtains a life insurance policy large enough to replace the balances in all the tax-deferred retirement plans. However, the parent is not the owner of the life insurance. The parent forms an irrevocable life insurance trust that has a "Crummey Powers" clause, and the irrevocable life insurance trust owns the life insurance policy. This technique will keep the value of the life insurance out of the decedent's gross estate.

A "Crummey Powers" clause gets its name from a court case. It has to do with whether a gift is subject to gift tax. Gifts that are less than the annual exclusion amount are exempt from gift tax as long as the gift is a present interest in property. A "Crummey Powers" clause allows the beneficiary of a life insurance trust the right to withdraw gifts made to the trust that the donor intends to pay for life insurance premiums. As long as the beneficiary has the right to withdraw the donation under the "Crummey Powers" clause, it is a gift of a present interest in property.

Assume that the beneficiary does not exercise the right to withdraw the donation. The irrevocable life insurance trust will use the donation by the parent to pay the premiums on the life insurance.

Where does the parent obtain the money to donate the money to the trust to pay the life insurance premiums? The parent converts the balances in the retirement plans into a life annuity. Therefore, the parent receives payments for life and uses part of them to pay the insurance premiums through the trust. At the parent's death, the annuity is worth zero. Therefore, the children do not have any income in respect of a decedent. Nothing from the annuity is included in the gross estate.

The life insurance company pays the children the proceeds of the life insurance policy. The proceeds are not subject to income tax. They are not subject to estate tax because the decedent did not own the policy.

This plan allows the parent to have an income stream during life from the annuity. The annuity payments would be fully taxable unless the individual has any basis in the annuity. The children receive money from the life insurance policy and do not have to pay any income tax or estate tax on it.

This plan converts amounts that would be subject to income tax and estate tax to amounts that are not subject to income tax or estate tax in the hands of the children. The parent can donate money to charity or engage in additional income tax planning to minimize the income tax on the annuity payments during life.

This strategy requires the services of a tax advisor, attorney, and a life insurance agent. They all must be competent and exercise great care in implementing the strategy. However, if done correctly, this strategy can result in substantial tax savings. It also gives the parent more peace of mind knowing that the children will not have to pay taxes on the life insurance.

Monday, February 20, 2006

 

New for 2006, the Roth 401k

One of the new tax strategies available in 2006 is the Roth 401k. A taxpayer may place up to $15,000 ($20,000 if age 50 or older) in a Roth 401k instead of a regular 401k plan in 2006. The 401k plan needs to have the provision that allows contributions to go into a Roth 401k. Just because the tax law allows a Roth 401k plan does not mean that all employers will revise their 401k plans to allow Roth 401k contributions.

The Roth IRA has been one way to invest to generate tax-free income for retirement. A taxpayer does not receive a deduction for placing money into a Roth IRA, but the taxpayer may take the money out at retirement free of federal income tax. The new Roth 401k works in much the same way except that a taxpayer may contribute a larger amount to a Roth 401k

The problem with the Roth IRA has been that the law has not allowed many taxpayers to have Roth IRA because their incomes were too high. The new Roth 401k does not have this problem. A taxpayer may contribute to a Roth 401k no matter how high an income the taxpayer has.

Traditional IRAs, 401k plans, and other pension plans provide for tax-deferred income. The contributions made by the taxpayer are either deductible or excluded from gross income at the time of contribution. However, when the taxpayer withdraws the money, it is fully taxable. A taxpayer receives no deduction for amounts that go into a Roth IRA or a Roth 401k plan, but the taxpayer may withdraw the money at retirement completely free of federal income tax.

The Roth 401k plan is especially good for younger taxpayers. They have a longer time to invest their money wisely and generate a large amount of tax-free earnings on their contributions. Taxpayers should carefully consider the Roth 401k plan in 2006 with the assistance of a competent tax advisor.

Sunday, February 19, 2006

 

Tax Free Gain on the Sale of Your Own Home

When a single taxpayer sells his or her principal residence that he or she has owned and used as a principal residence for at least two of the previous five years, the taxpayer may exclude up to $250,000 of the gain from gross income. A married couple who meets the conditions may exclude up to $500,000 of gain.

This means that the gain is never taxed. The taxpayer does not have to purchase a new home for the exclusion to apply. However, if the taxpayer has ever used the home or any part of it for business purposes, the taxpayer must pay taxes on the gain due to depreciation recapture.

While many people are aware of this exclusion provision contained in Section 121 of the Internal Revenue Code, few people have thought about how to use it as a strategic wealth-building tool. The way to use it as a wealth building tool is to buy a home below market value, such as a foreclosure or probate property, sell the home a little over two years later, and then repeat the process.

Another way to use this provision to its maximum is to act as one's general contractor and build a home. Individuals who act as their own general contractors can often build a home for 80 percent or less of its value. There are books available that explain how to do so.

The advantage of buying a home below market value or building a home is that the taxpayer has a gain from the beginning. If the property appreciates more from the date of purchase or completion of construction, that is even better. The exclusion applies not only to the appreciation from the date of purchase or completion of construction, but it also applies to the gain from buying or building below value.

While moving is a chore, by moving every two to three years, a taxpayer can realize substantial gains that are free from federal income tax and Social Security tax. "Keep moving" is not only a good slogan for physical fitness, it also can be good for fiscal fitness.

If a taxpayer has some extra cash left over after selling a home and buying another one, the taxpayer can place money into a Roth IRA up to the maximum amount allowed if the taxpayer is eligible to do so. Doing so allows the taxpayer to generate even more tax-free income.

For many taxpayers, tax deductions are becoming less valuable because of the alternative minimum tax (AMT). The gain on the sale of a principal residence that is excluded from gross income is not subject to the AMT. Taxpayers should use this generous tax provision to build wealth and minimize their tax obligations. The ability to exclude the gain on the sale of a principal residence is a great tax savings strategy.

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