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IRA Strategy

IRA Strategy #1

The 50/50 Minimum Strategy:  Maintain 50% of your 401(k) and IRA money in Roth accounts

Why pay taxes today when you can postpone them until years later? The obvious answer is to delay paying taxes as long as possible.  But sometimes the obvious answer is not the best answer.  Let’s consider several assumptions that support the 50/50 Minimum Strategy.

First, if one invests the money that would have gone to taxes, it should compound over time and the total investments, less the eventual taxes to be paid, would potentially be greater than the amount of the Roth conversion, plus earnings.  The problem with this is most people will not diligently invest the money that would have gone to pay the tax.  It is more easily spent in the normal household budget.  And even if it were invested, the potential to keep it invested over a long period of time is dependent on many variables. 

Second is the assumption that a person’s income will be lower in retirement. This is true for many taxpayers.  However, many of our clients remain in a high tax bracket after retirement.  This is especially true if one has large IRA balances that require minimum distributions combined with large investment accounts that create capital gains. 

Third is the assumption that tax rates will remain relatively stable over time.  This is the most dangerous assumption.  Congress has the power to change the tax rates at any time and with the skyrocketing budget and related government debt, it appears likely that tax rates will be higher in the future. So, even if one’s income is lower, the tax rate could be higher. 

How high could tax rates go?  The following chart provides a history of the highest marginal tax rate for 1944 through 2022 for married couples filing jointly:

Years                                                 Highest Marginal Rate#                 Taxable Income Over#

1944 through 1951                           91%                                                 $200,000 (1950)

1952 through 1953                           92%                                                  $300,000 (1953)

1954 through 1963                           91%                                                   $300,000 (1958)

1964                                                  77%                                                   $200,000 (1964)

1965 through 1981                           70%                                                   $180,000 (1974)

1982 through 1986                           50%                                                   $108,300 (1984)

1987                                                  38.5%                                                $80,000 (1987)

1988 through 1990                          28%        (Bubble Rate 33%)           $78,400 (1988)

1991 through 1992                           31%                                                    $70,450 (1991)

1993 through 2000                          39.6%                                                  $288,350 (2000)

2001                                                  39.1%                                                  $297,350 (2001)

2002                                                 38.6%$                                                 $307,050(2002)                           

2003 through 2012                           35%                                                     $388,350 (2012)

2013 through 2017                           39.6%                                                  $444,550 (2017)

2018 through 2022                           37.0%                                                  $647,850 (2022)

#  Rate for Married Couples Filing Jointly

 Information provided by The Tax Foundation, Washington, DC. 20005

The strategy that we have continued to recommend to most of our clients is to approach retirement with a minimum of 50% of their IRA and 401(k) assets held in Roth accounts.  With this approach, an investor takes a balanced approach to the payment of taxes.  Pay taxes at the rates in effect now on the Roth contributions and conversion amounts while delaying the taxes on the non-Roth portion of their deferrals or contributions.  If we err on one side or the other, we prefer to convert more of the retirement assets and pay the taxes at today’s rates as opposed to leaving these assets subject to whatever future rate Congress enacts. 

If a client is charitably minded, we do not recommend converting ALL your IRA assets.  The preferred use of a portion of your IRA assets is to process Qualified Charitable Distributions (QCD) with the pre-tax IRA assets.  After age 70.5, taxpayers may donate money directly from their IRA to qualified charities utilizing the QCD provisions.  The annual limit on QCD donations is currently $100,000. 

ACTION:  Consider adopting the strategy of working towards a minimum Roth balance of 50% of your total retirement assets by your retirement date.  Work with your financial advisor to determine if you should convert a higher percentage. 

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

By: Donald P. Bolden, CFP®, CLU & Lewis Robinson, CPA

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

Taxation of Investments

Taxation of Investments

It’s nice to own stocks, bonds, and other investments. Nice, that is, until it’s time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?

Is it ordinary income or a capital gain?

To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate interest income? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won’t get into that here.)

If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. Dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0 percent, 15 percent, and 20 percent depending on your taxable income. (Some types of capital gains may be taxed as high as 25 percent or 28 percent.) The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.

The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.

Categorizing your ordinary income

Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments — including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock — can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.

But not all ordinary income is taxable — and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt, or tax deferred.

  • Taxable income: This is income that’s not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you’ll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
  • Tax-exempt income: This is income that’s free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
  • Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.

A quick word about ordinary losses: It’s possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.

Understanding what basis means

Let’s move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term — basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.

First, initial basis. Usually, your initial basis equals your cost — what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.

Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.

Calculating your capital gain or loss

If you sell stocks, bonds, or other capital assets, you’ll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.

Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you’ll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you’ll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.

Schedule D of your income tax return is where you’ll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You’ll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your taxable income, and the type of asset(s) involved. See IRS Publication 544 for details.

  • Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
  • Taxable income: Long-term capital gains and qualified dividends are generally taxed at special capital gains tax rates of 0%, 15%, and 20% depending on your taxable income. (Some types of capital gains may be taxed as high as 25 percent or 28 percent.) The actual process of calculating tax on long-term capital gains and qualified dividends is extremely complicated and depends on the amount of your net capital gains and qualified dividends and your taxable income.
  • Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.

Using capital losses to reduce your tax liability

You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.

New Medicare contribution tax on unearned income may apply

High-income individuals may be subject to a 3.8 percent Medicare contribution tax on unearned income (the tax, which first took effect in 2013, is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:

  • Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
  • The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return)

So, effectively, you’re subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above. It’s worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.

Getting help when things get too complicated

The sales of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional. 

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

Home Office

Qualifying for the Home Office Deduction

Working from home can certainly provide you with personal benefits, such as a flexible schedule and more family time. But increasing numbers of people are discovering the tax advantages for the home office deduction as well. It’s no secret that you generally can’t deduct certain personal expenses (e.g., homeowners insurance, utilities, and home repairs) on your federal income tax return. But if you’re using part of your home as a home office, you may be able to write off part of these expenses. To qualify for the home office deduction, you must first understand the IRS requirements.

The home office deduction is really a group of deductions

First of all, what is a home office? A home office is a room in your home, a portion of a room in your home, or a separate building next to your home (such as a converted garage or barn) that you use exclusively and regularly to conduct business activities.

This definition is important, because you may be able to deduct part of your housing expenses (such as rent, utilities, and insurance) on your federal income tax return if you have a home office. This deduction (or group of deductions) is known as a home office deduction. To take the deduction, you’ll need to file Form 8829 with the IRS. To even consider the home office deduction, though, your at-home business activities must involve a trade or business — a hobby won’t do.

Now let’s consider the IRS requirements. To qualify for a home office deduction, you must meet two threshold tests — the place of business test, and the regular and exclusive use test.

The place of business test is somewhat flexible

To pass this test, you must show that you use part of your home as:

  • The principal place of business for your trade or business, or
  • A place where you regularly meet with clients, customers, or patients

In some cases, you can also meet the principal place of business requirement if you conduct substantial administrative and management tasks for your outside business at home and have no other fixed location where you conduct these activities. These tasks might include billing customers, keeping books and records, ordering supplies, setting up appointments, or writing reports. For example, assume you’re a doctor at a local HMO who’s been given examination space but no office space. You use a room in your home regularly and exclusively to correspond with insurance companies, bill patients, and read medical journals. You have no other fixed location for conducting these types of activities. In such a case, your space would likely pass the place of business test for a home office deduction.

What if your home office is in a separate structure next to your home, like a shed or garage? In that case, it needn’t be your principal place of business. However, you must use that office regularly and exclusively in connection with your trade or business. Be sure you use this structure only for business purposes — you can’t store your car there.

You must also meet the regular and exclusive use test

In general, you must also pass the regular and exclusive use test before you can take a home office deduction (exceptions apply for taxpayers who run day-care facilities from home and for sellers who use part of their homes for storing inventory). As you might expect, this test requires you to show that you exclusively use a portion of your home for business purposes on a regular basis.

For example, assume you set aside one room in your home as your home office. You also use this room as a playroom for your children. Here, you wouldn’t meet the exclusive use test. Now assume that you use one room in your home exclusively for your side business of selling insurance. You engage in this business only occasionally. Because you don’t use the office on a regular basis, you still won’t qualify for the home office deduction.

Telecommuters might also qualify for the home office deduction

Note: For 2018 to 2025, the deduction for miscellaneous itemized deductions subject to the 2 percent floor (including unreimbursed employee expenses) is suspended.

If you telecommute or are an employee who works at home, you may also qualify for the home office deduction. You’d have to meet the above requirements. In addition, though, your home office must be for the convenience of your employer. In plain English, this means that your employer must ask you to work out of your home. The arrangement must serve your employer’s business needs, not vice versa.

The home office deduction for an employee who works at home is taken as a miscellaneous itemized deduction on Schedule A of Federal Form 1040. This deduction is subject to the 2 percent limit for miscellaneous itemized deductions. However, as noted, this deduction is not currently available.

If you qualify for the deduction, you can deduct all direct expenses and part of your indirect expenses

You can deduct both your direct and indirect expenses regarding your home office. Direct expenses are costs that apply only to your home office. You can deduct these costs in full against your business income. Some examples include the cost of a business telephone line and the cost of painting your home office. However, no deduction is allowed for basic local telephone charges on the first line in your home, even if that line is used for the home office.

Indirect expenses are costs that benefit your entire home. You can deduct only the business portion of your indirect expenses. Some examples of indirect costs include rent, deductible mortgage interest, real estate taxes, and homeowners insurance. The business percentage of your home is determined by dividing the area exclusively used for business by the total area of the home. For example, assume your home is 2,000 square feet and your home office is 200 square feet. Your business percentage is 10 percent (200 divided by 2,000). In such a case, if you rent your home, you can deduct 10 percent of your rent as part of your home office deduction.

Even if you don’t qualify for the home office deduction and are unable to deduct home-related expenses (e.g., homeowners insurance), you can still take a deduction for your regular business expenses, such as the purchase of file cabinets, business equipment, and supplies.

Some of your home office expenses may be limited

If the gross income from your business (the one associated with the home office) equals or exceeds your regular business expenses (including depreciation), all expenses for the business use of your home can be deducted. But if your gross income is less than your total business expenses, certain expense deductions for the business use of your home are limited. The deduction isn’t lost forever, though. It’s simply carried forward to the next year.

Can you spell “audit”?

Historically, the IRS has closely scrutinized home office deductions. Here are some steps you can take to substantiate the existence of your home office:

  • Use your home address on your business cards, stationery, and advertisements
  • Install a separate telephone line for your business
  • Instruct clients or customers to visit your home office, and keep a log of those visits
  • Log the dates, hours spent, and type of work performed in your home office
  • Have business mail sent to your home

Having a home office can be a factor when you sell your home

Unless you’re careful, deductions today can cost you money when you sell your home. Homeowners who meet all requirements can generally exclude from federal income tax up to $250,000 of capital gain (up to $500,000 if you’re married and file a joint return) when a principal residence is sold. You may end up paying some taxes, though, if you have a home office. That’s because when you sell your principal residence, an amount of capital gain equal to certain depreciation deductions you were entitled to (as a result of having your home office) won’t qualify for the exclusion. Specifically, the exclusion won’t cover an amount equal to depreciation deductions attributable to the business use of your home after May 6, 1997.

Note: In addition, where the business portion of the home is separate from the dwelling unit (e.g., an office in a converted detached garage) any capital gain on the sale of the house has to be apportioned; only the part of the gain allocable to the residential portion is eligible for exclusion.

For example, assume a self-employed accountant bought a home in 1998 and sells the home several years later at a $20,000 gain. Although the house was always used as his principal residence, the accountant used one room within the house as his business office. Over the years, the accountant claimed $2,000 of depreciation deductions for his office. Under IRS regulations, $18,000 of the capital gain will be tax free. Only the $2,000 of the gain equal to the depreciation deductions will be taxable.

If the accountant’s office had been located in a converted detached garage on his property, he would have to treat the sale as two separate transactions and pay tax on any gain allocable to the converted garage.

Because this area is complex, you should consult a tax professional. Also, you might want to read IRS Publication 587, Business Use of Your Home.

Optional simplified method of calculation available

For tax years beginning on or after January 1, 2013, you’re able to use an optional simplified method of calculating your home office deduction. The simplified method doesn’t change the requirements for claiming the deduction, it simply changes the way the deduction is calculated. Instead of determining and allocating actual expenses, under the simplified method you calculate the home office deduction by multiplying the square footage of the home office (up to a maximum of 300 square feet) by $5. Since square footage is capped at 300, the maximum deduction available under the simplified method is $1,500. You cannot use the simplified method if you are an employee with a home office, and you receive advances, allowances, or reimbursements for expenses related to the business use of your home under an expense or reimbursement allowance with your employer.

Each year, you can choose whether to use the simplified method of calculating the deduction or to use actual expenses. There are two things to keep in mind, though:

  • If you use the simplified method in one year, and in a later year use actual expenses, special rules will apply in calculating depreciation
  • If you are carrying forward an unused deduction (because your business deduction exceeded your business income in a prior year), you will not be able to claim the deduction in any year in which you use the simplified method — you’ll have to wait for the next year you use actual expenses to claim the unused deduction

To discuss this article further or to learn more about CapSouth Wealth Management, visit our website at www.capsouthwm.com or call 800.929.1001 to schedule an appointment to speak with an advisor.

Investment advisory services are offered through CapSouth Partners, Inc, dba CapSouth Wealth Management, an independent registered Investment Advisory firm. Information provided by sources deemed to be reliable. CapSouth does not guarantee the accuracy or completeness of the information. CapSouth does not offer tax, accounting, or legal advice. Consult your tax or legal advisors for all issues that may have tax or legal consequences. This information has been prepared solely for informational purposes, is general in nature and is not intended as specific advice. Any performance data quoted represents past performance; past performance is no guarantee of future results.

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