Ten Facts on Filing an Amended Tax Return

What should you do if you already filed your federal tax return and then discover a mistake? Don’t worry; you have a chance to fix errors by filing an amended tax return. This year you can use the new IRS tool, ‘Where's My Amended Return?’ to easily track the status of your amended tax return. Here are 10 facts you should know about filing an amended tax return.

1. Use Form 1040X, Amended U.S. Individual Income Tax Return, to file an amended tax return. An amended return cannot be e-filed. You must file it on paper.

2. You should consider filing an amended tax return if there is a change in your filing status, income, deductions or credits.

3. You normally do not need to file an amended return to correct math errors. The IRS will automatically make those changes for you. Also, do not file an amended return because you forgot to attach tax forms, such as W-2s or schedules. The IRS normally will send a request asking for those.

4. Generally, you must file Form 1040X within three years from the date you filed your original tax return or within two years of the date you paid the tax, whichever is later. Be sure to enter the year of the return you are amending at the top of Form 1040X.

5. If you are amending more than one tax return, prepare a 1040X for each return and mail them to the IRS in separate envelopes. You will find the appropriate IRS address to mail your return to in the Form 1040X instructions.

6. If your changes involve the need for another schedule or form, you must attach that schedule or form to the amended return.

7. If you are filing an amended tax return to claim an additional refund, wait until you have received your original tax refund before filing Form 1040X. Amended returns take up to 12 weeks to process. You may cash your original refund check while waiting for the additional refund.

8. If you owe additional taxes with Form 1040X, file it and pay the tax as soon as possible to minimize interest and penalties.

9. You can track the status of your amended tax return three weeks after you file with the IRS’s new tool called, ‘Where’s My Amended Return?’ The automated tool is available on IRS.gov and by phone at 866-464-2050. The online and phone tools are available in English and Spanish. You can track the status of your amended return for the current year and up to three prior years.

10. To use either ‘Where’s My Amended Return’ tool, just enter your taxpayer identification number (usually your Social Security number), date of birth and zip code. If you have filed amended returns for more than one year, you can select each year individually to check the status of each. If you use the tool by phone, you will not need to call a different IRS phone number unless the tool tells you to do so. 

Additional IRS Resources:

• Form 1040X, Amended U.S. Individual Income Tax Return
• Where's My Amended Return? tool
• Tax Topic 308 - Amended Returns
• Q&A about amended returns and Form 1040X

Don't Settle Legal Disputes Without Tax Advice

Robert W. Wood for Forbes writes: After a bitter dispute, you’re collecting a legal settlement. Is it taxable and must you report it? Usually yes, but the tax treatment varies enormously. Consider how you were damaged, how the case was resolved, and how checks and IRS Forms 1099 were issued. See 10 Things To Know About Taxes On Damages.

Settlements and judgments are taxed based on the origin of your claim. If you’re suing a competing business for lost profits, a settlement is lost profits, taxed as ordinary income. If you get fired at work and sue for severance and discrimination, you’ll be taxed as receiving wages. Usually, though, employment settlements are split between wages reported on a Form W-2 and an amount reported on an IRS Form 1099.

These rules are full of exceptions, nuances and special rules. For example, punitive damages and interest are always taxed. But the biggest exclusion from income is for personal physical injury recoveries. Damages for personal physical injuries and physical sickness are tax-free.

Conversely, damages for emotional distress are taxed unless the emotional distress is triggered by the physical injury. Clearly, that’s confusing, and the IRS and courts frequently have to address the point since exactly what constitutes personal physical injuries or sickness isn’t clear. The IRS normally wants to see “observable bodily harm” such as bruises or broken bones before it excludes damages from income.

If the case arises out of employment, the IRS knee-jerk reaction is that such recoveries are wage loss or otherwise taxable. See The IRS Speaks Out On Employment Lawsuit Settlements. However, an employee suit may be partially tax-free if the employee has physical sickness from working conditions. In one case, stress at work produced a heart attack. See Is Physical Sickness the New Emotional Distress? In another, stressful conditions exacerbated the worker’s pre-existing multiple sclerosis. See Tax-Free Physical Sickness Recoveries in 2010 and Beyond. 

Whatever you do, get tax advice before your settlement is documented. See Address Taxes When You Mediate Civil Disputes. The IRS isn’t bound by the parties’ tax characterization, but often the IRS will respect it if it is reasonable. Also note that lawyers’ fees can cause tax trouble.

If a contingent fee lawyer is to receive 40%, the tax law assumes the client received 100% and then paid the lawyer. If the case is an employment dispute, involves your trade or business, or is 100% for physical injuries, you won’t pay tax on the legal fees. In most other cases, though, you may have to include the legal fees in income but then be unable to fully deduct them. See Need A Tax Deduction? Pay Legal Fees By Year-End.

Whatever you do, don’t wait until tax return time to consider these issues. Get some advice before you settle if you can. A little planning and some good tax language in your settlement agreement can make all the difference.

How to Amend a Tax Return

Kiplinger for Daily Finance writes:  Q: When I was doing my 2012 tax return this year, I realized that I could have claimed the child-care credit for my son's summer camp expenses in 2011, but I didn't know I qualified then. Is it too late to get the money?

Answer: It's not too late. You have up to three years after the due date of your return to file an amended return and claim the credit. The child-care credit is a frequently overlooked tax break for people who have kids under age 13 and pay for child care so they can work or look for work. The cost of a nanny, babysitter, day care, preschool, before-school and after-school care, and day camp during summer and school vacations can all count. The credit can be worth up to $600 to $1,050 if you have one child, or $1,200 to $2,100 if you have two or more children. The lower your income, the larger the credit, but many people don't realize that there's no income cutoff to qualify. See Take a Tax Break for Summer Camp for details.

File an amended return by submitting Form 1040X. You don't need to refile your whole return you just need to mark the year of the return you're amending at the top of the form, note the changes you're making, and include revised copies of any supplemental forms that are affected (such as Form 2441 for the child-care credit, or Schedule A for changes to itemized deductions see IRS.gov for the forms). If the change lowers your tax liability, the IRS will send you a refund, complete with interest (the current rate is 3%) back to the original due date of the return. It usually takes up to 12 weeks for the IRS to process amended returns.

See the Instructions for Form 1040X and the IRS's amended return page for more information. You can check on the status of your amended return after you file using the Where's My Amended Return? tool starting three weeks after you file your amended return.

Reducing your federal income tax could also lower your state income tax liability. File your amended return first, then get a copy of the transcript of your account from the IRS (confirming that you amended your federal return) and file an amended state return, with a copy of your Form 1040X.

Viewpoint on one couple's Roth conversion strategy, another's plan to move into dividend paying stocks, and a third's consideration of buying an annuity to reduce income taxes on their Social Security.

Dan Moisand for MarketWatch.com writes: Tax time is a common point in the year for people to contemplate the state of their finances and seek second opinions. This week I give my viewpoint on one couple's Roth conversion strategy, another's plan to move into dividend paying stocks, and a third's consideration of buying an annuity to reduce income taxes on their Social Security.

Q. We are in our early 60s and of modest means but are financially secure because we have modest wants and were good savers. Our kids and their families are doing very well. We will leave them our house but the rest of our assets will probably go to charity. We converted some traditional IRA money to Roth IRAs for the first time this year because we pay taxes at low rates but we are second guessing whether that was smart because the government seems to mismanage tax revenue. What do you think about our situation? — R.R.

A. I think your situation is enviable. Congratulations. As for the wisdom of the Roth conversions, I can see it both ways.

Generally, converting traditional IRA moneys to a Roth IRA is a good move if the tax rate paid at the time of the conversion is low relative to the rate that would need to be paid later. Paying tax at say, 15% now is better than paying at 25% or more later.

We can usually estimate the tax bill on a conversion with great accuracy. If you find that you converted too much and your tax bill is higher than estimated, you can unwind a conversion by "recharacterizing.” You have until Oct. 15, 2013 to recharacterize a conversion made in 2012.

It can be much harder to estimate a future tax rate with the precision we can apply to the current tax rates. To get a good idea of what the future rate may be, we look at the tax situation of the ultimate recipients. Even with the little I know about you I see several possibilities.

Even though you are in a low tax bracket now, you may not be paying at such low rates in the future. At age 70 1/2, required minimum distributions (RMD) from IRAs and other retirement accounts begin for you. If the projected RMDs will push you into a higher tax bracket, this condition favors a conversion. By converting, the RMD at age 70 1/2 will be lower because less will be in the traditional IRA than if no conversion occurred and Roth IRAs are not subject to RMDs under these circumstances.

Further, when one of you passes away, the survivor will no longer be filing a joint return in future years. It takes a taxable income of $72,501 for a married couple filing jointly to get out of the 15% bracket and into the 25% bracket but only $36,251 for a single to begin paying federal income taxes at that 25 % rate.

You indicated that all but your house could be going to charity ultimately. Qualifying charities are tax exempt. Naming a charity as beneficiary on your IRAs makes converting much less attractive. Converting means you will pay taxes now when no taxes would have been paid later by the charity. When the future tax rate payable is lower than the current rate, converting to a Roth is a poor strategy.

Conversely, if you do opt to leave some traditional IRA moneys to your children, it sounds like they could be in a higher income tax bracket than you. If keeping it in the family becomes important, their high incomes point in favor of conversions to a Roth IRA.

Q. With interest rates so low and our stocks doing so well, we are considering moving some of my bondholdings into dividend paying stocks. What do you think about that? — F.G.

A. I am not a fan of this rationale. Dividend paying stocks are just that — stocks and not bonds. Dividend payers are subject to getting hammered by market forces like any other segment of the stock market. Take a look at the behavior of exchange-traded funds and mutual funds that focused on dividend paying stocks during the 2008-2009 period. They were no safe haven. Good quality bond funds on the other hand did exactly what you would hope they would. They held their value.

Now, if you were contemplating increasing your stockholdings generally, I would say having a fair portion of the stock portion in dividend payers is a good idea. However, moving money into stocks because stocks have been performing well lately is asking for trouble. Chasing what is hot is a notoriously bad way to make money long term.

Q. We are being pitched a variable annuity on the premise that by lowering our taxable income, less of our social security will be taxable but I am skeptical. What is your take? — P.J.

A. It is true that the amount of your social security that is taxable is a function of your income. Take half your Social Security payments and add that to your income from all other sources, even tax-free municipal bonds. If the total exceeds $25,000 for a single or $32,000 for a married couple filing joint returns, some portion of your Social Security will likely be subject to federal income taxes. At the most 85% of Social Security payments will be taxable if the total exceeds $34,000 for a single person or $44,000 for joint filers. For more detailed information see IRS Pub 915 .

Earnings from an annuity contract are not included in your gross income until those earnings are withdrawn. So it is possible that putting your savings into an annuity could lower your taxable income enough to reduce or eliminate tax on your Social Security. However, annuities only defer taxable income.

As soon as you or your spouse or your heirs take a withdrawal, earnings will be taxed at ordinary income-tax rates. You may be trading short term relief for a longer term problem. Generally, if you can get your income low enough to decrease the taxable portion of your Social Security, you are in a low tax bracket already.

Heck, long-term capital gains, something you would hope would result from investing in any variable product, are taxed at 0% until the 15% bracket is used up, then capped at 15% until taxable income reaches $400,000 for a single $450,000 for married couples. All ordinary income-tax rates are higher than long term capital gains rates at corresponding income levels. See the above question on Roth conversions for a primer on strategy regarding relative tax rates.

The details of your situation are important. How much of your savings would need to go into the annuity to get you under the income thresholds for taxing Social Security mentioned above? All of it? Forget that. The thresholds listed are not adjusted annually for inflation. How long would you be able to stay under the thresholds and still pay your bills and enjoy retirement? If you couldn't stay below those amounts for long, the most likely person to profit from all this may be the salesperson.

Annuity contracts can be sold with various guarantees other types of investments do not possess but remember none of those features are free so don't be dazzled by such promises. Even if the strategy of using an annuity to get less Social Security taxed makes sense, buying a particularly costly contract can undermine the strategy and the effectiveness of the product severely. You may face restrictions and fees that complicate your situation a great deal.

8 Facts on Late Filing and Late Payment Penalties

April 15 is the annual deadline for most people to file their federal income tax return and pay any taxes they owe. By law, the IRS may assess penalties to taxpayers for both failing to file a tax return and for failing to pay taxes they owe by the deadline.

Here are eight important points about penalties for filing or paying late.

1. A failure-to-file penalty may apply if you did not file by the tax filing deadline. A failure-to-pay penalty may apply if you did not pay all of the taxes you owe by the tax filing deadline.

2. The failure-to-file penalty is generally more than the failure-to-pay penalty. You should file your tax return on time each year, even if you’re not able to pay all the taxes you owe by the due date. You can reduce additional interest and penalties by paying as much as you can with your tax return. You should  explore other payment options such as getting a loan or making an installment agreement to make payments. The IRS will work with you.

3. The penalty for filing late is normally 5 percent of the unpaid taxes for each month or part of a month that a tax return is late. That penalty starts accruing the day after the tax filing due date and will not exceed 25 percent of your unpaid taxes.

4. If you do not pay your taxes by the tax deadline, you normally will face a failure-to-pay penalty of ½ of 1 percent of your unpaid taxes. That penalty applies for each month or part of a month after the due date and starts accruing the day after the tax-filing due date.

5. If you timely requested an extension of time to file your individual income tax return and paid at least 90 percent of the taxes you owe with your request, you may not face a failure-to-pay penalty. However, you must pay any remaining balance by the extended due date.

6. If both the 5 percent failure-to-file penalty and the ½ percent failure-to-pay penalties apply in any month, the maximum penalty that you’ll pay for both is 5 percent.

7. If you file your return more than 60 days after the due date or extended due date, the minimum penalty is the smaller of $135 or 100 percent of the unpaid tax.

8. You will not have to pay a late-filing or late-payment penalty if you can show reasonable cause for not filing or paying on time.

Note: The IRS recently announced special penalty relief to many taxpayers who requested an extension of time to file their 2012 federal income tax returns and some victims of the recent severe storms in parts of the South and Midwest. For details about these relief provisions, see IRS news releases IR-2013-31 and IR-2013-42. The IRS has also provided individual tax filing and payment extensions to those affected by the Boston explosions tragedy. See IR-2013-43 for more information.

Additional IRS Resources:

• Online Payment Agreement tool
• Electronic Payment Options Home Page
• Make a Payment – payment options
• Tax Topic 653 - IRS Notices and Bills, Penalties and Interest Charges
• Q&A about interest and penalties for filing and paying late

Should Clients Ditch or Keep Tax Return Records?

Ken Berry for AccountingWeb writes: Now that the tax return season is over – at least for those filers who didn't request extensions – invariably, some of your clients will ask you this question: How long do I need to keep copies of my tax return? The answer: A minimum of three years, but maybe longer, especially if you're risk-aversive.

"Because the statute of limitations is three years, you have to keep tax records at least that long," says James Wood, CPA, a sole practitioner in Hillsborough, New Jersey. "However, if there is fraud, or an allegation of fraud, there is no statute of limitations."  

This means that the IRS has three years to review the situation and assess any tax deficiencies. Once the three years are up, the taxpayer is generally in the clear, so there's usually no pressing need to hold on to the records longer. But the three-year period isextended to six years if gross income is understated by more than 25 percent. And, for tax cheats, returns can be challenged at any time.

If your clients are hoping to remove some of the clutter around the house, they can dump their cumbersome tax records once the statute of limitation lapses. But human nature being what it is, many clients will be inclined to hold on to them longer. Wood says ten years is normal.

Although most tax return preparers now file returns electronically on behalf of clients, the new technology isn't much of a factor, according to Wood. He notes that the IRS doesn't keep images of tax returns, so it's better for clients to rely on their independent records in case of inquiries. Also, he says it saves time and hassle for clients to use their own records.

If a client asks Wood for a digital copy of a return, he can meet the request, within limits. "The tax software only allows you to retain ten years of active files," he claims. "As a practical matter, we hang on to ten years of data." 

Of course, clients should be encouraged to sift through their tax-related documents and shred paperwork that's no longer needed, like W-2s and 1099s from days of yore. But they might want to keep other documents – for example, records showing basis adjustments in a home – that remain relevant.  And even though basis reporting rules for investments now require financial institutions to provide the vital information for new acquisitions, clients should continue to retain the necessary records for older investments.

The bottom line: The length of time you should hold on to tax records depends on the individual. "Five years is a reasonable time for most clients," says Wood. "But if you're superconservative, you might hold them forever."

Fee-only planners can help keep investment costs low / Using a fee-only planner and opting for index funds and exchange-traded funds can keep investment costs low, making a big difference in what you accumulate.

Liz Weston for the LA Times writes:  Dear Liz: You always mention fee-only financial planners and I'm not sure about the true meaning. My husband and I have a financial planner who charges us $2,200 per year, but we got a summary of transaction fees in the amount of $6,200 for last year. Is this reasonable? We have $625,000 in IRAs and are adding $1,000 a month. In addition we have over $700,000 with current employers, adding the max allowed yearly. The planner gives advice on allocations for these employer funds as well. Are we paying too much for the financial planner? The IRAs seem to be doing well, but the market is doing well (today!).

Answer: It appears you're paying both fees and commissions, so you're not dealing with a fee-only planner. Fee-only planners are compensated only by the fees their clients pay, not by commissions or other "transaction fees" for the investments they buy. One big benefit of fee-only planners is that you don't have to worry that commissions they get are affecting the investment advice they give you.

You're paying about 1.3% on the portfolio you have invested with this advisor. That's not shockingly high, but once you add in all the other costs associated with these investments, such as annual expense ratios and any account fees, your relationship with this advisor may be costing you 2% a year or more. That's getting expensive, unless you're getting comprehensive financial planning — help with insurance, taxes and estate planning, as well as investment advice — from someone qualified to provide such planning, such as a certified financial planner.

What you pay makes a big difference in what you accumulate. Let's say your investments return an average of 8% a year over the next 20 years. If your costs average 1% a year, that would leave your IRAs worth about $3 million. If your costs average 2%, you could wind up with $2.5 million, or half a million dollars less.

Keeping your expenses low would mean you stop trying to beat the market with actively traded investments. Instead, you would opt for index funds and exchange-traded funds that seek to match market returns. These funds typically come with low expenses, often a small fraction of 1%. Using a fee-only planner can be another way to reduce what you pay for advice.

At the very least, consider bringing a copy of your portfolio to a fee-only planner for a second opinion. He or she can give you a better idea of whether what you're paying is worth the results you're getting.

Avoid estate planning with in-laws

Dear Liz: My father-in-law's spouse recently died. He is 89 and not in very good health. He has assets of about $3 million and lives in a state (Pennsylvania) that has an inheritance tax. What can he do to avoid state taxes and make sure his assets go where he wants them to go? He does not like to talk about these things but I'm trying to help. I have no interest in benefits to myself but I would hate to see his assets go to the state.

Answer: It's one thing to encourage a parent or in-law to set up estate documents that protect them should they become incapacitated. Everyone should have durable powers of attorney drawn up so that someone else can make healthcare and financial decisions for them if they're unable to do so.

It's quite another matter to urge a potential benefactor to make sure the maximum amounts possible land in inheritors' laps, especially if he or she doesn't want to discuss the matter. You may need to accept that not everyone is interested in minimizing taxes for his heirs. Your father-in-law's resistance to talk about these things is a good indicator that you should back off.

It's not as if the majority of his assets will wind up in state coffers anyway. Although Pennsylvania is one of the few states that has an inheritance tax, the rate isn't exorbitant for most inheritors. (Unlike estate taxes, which are based on the size of the estate, inheritance taxes are based on who inherits.) In Pennsylvania, property left to "lineal descendants" — which includes parents, grandparents, children and grandchildren — faces tax rates of 4.5%. The tax rate is 12% for the dead person's siblings and 15% for all others. Surviving spouses are exempt.

If he were interested in reducing future inheritance taxes, your father-in-law could move to one of the many states that doesn't have such a tax. He also could give assets away before he dies, either outright or through an irrevocable trust. He may not be interested in or comfortable with any of those solutions. If he is, it's up to him to take action. If he needs help or encouragement, let your wife or one of her siblings provide it. In estate planning matters, it's usually best for in-laws to take a back seat.

Expanded Guidance From IRS On 403(b) Plans / IRS amends EPCRS, significantly affecting 403(b) plans, and issues guidance to assist 403(b) plan sponsors in identifying and correcting defects.

Amy P. Kelly, Robert L. Abramowitz and R. Randall Tracht for Mogan Lewis write:  On December 31, 2012, the Internal Revenue Service (IRS) issued its updated Employee Plans Compliance Resolution System (EPCRS),¹ which expands and updates existing compliance corrections programs available to retirement plans generally and also now provides 403(b) plan sponsors with expanded opportunities to correct a wide range of retirement plan defects. These new EPCRS provisions were available to 403(b) plan sponsors on a voluntary basis prior to April 1, 2013, but they are mandatory effective April 1, 2013. In addition, to help 403(b) plan sponsors identify and correct possible defects, the IRS issued a plain-English 403(b) plan "fix it" guide on February 21, 2013. Lastly, on March 28, 2013, the IRS issued Revenue Procedure 2013-22,² which provides new IRS procedures for issuing opinion and advisory letters for Internal Revenue Code section 403(b) pre-approved plans. The IRS also issued an information package³ that contains samples of plan provisions that have been found to satisfy certain requirements of section 403(b) of the Internal Revenue Code, the applicable regulations, and related guidance. The information package is intended to assist 403(b) plan sponsors that are preparing pre-approved plan documents and to accelerate the review and approval of the plans by the IRS. This LawFlash focuses on the new EPCRS and the "fix it" guide. We expect to provide further detail on Revenue Procedure 2013-22 and the information package in a separate LawFlash.

What Does the New EPCRS Mean for Section 403(b) Plans?

Sponsors of 403(b) plans may use the new EPCRS to correct a wide range of defects related to operations, demographics, employer eligibility, and plan documents. Such defects include the failure to follow the terms of a written 403(b) plan document, implement elective deferrals, make required matching contributions, or pay required minimum distributions on time, as well as failures relating to the improper exclusion of eligible employees from making deferrals under the plan.

Similar to the existing EPCRS, plan sponsors may correct errors using one of the following three component programs of the new EPCRS:

• Self-Correction Program (SCP), which enables plan sponsors to correct insignificant (and, under limited circumstances, some significant) operational failures.
• Voluntary Correction Program (VCP), which enables plan sponsors to correct errors by paying a compliance fee and having the correction approved by the IRS.
• Audit Closing Agreement Program (Audit CAP), which enables plan sponsors to correct failures identified as a result of an IRS audit. Corrections under the Audit CAP require 403(b) plans to pay a sanction to the IRS.

In addition to these broader changes, there are several specific changes applicable to 403(b) plans. One of the more significant changes is that 403(b) plan sponsors that missed the January 1, 2009, deadline to adopt a written plan document may use the new EPCRS to correct this failure. Furthermore, if the failure to timely adopt a written plan document is the only error, the 403(b) plan may correct the failure under the VCP. The VCP compliance fee will be temporarily reduced by 50%, provided VCP submissions are mailed to the IRS by December 31, 2013. The new EPCRS also added a "safe harbor" correction method for 403(b) plans that have improperly excluded eligible employees from making elective deferrals to the plan in violation of the "universal availability rule."

Although 403(b) plans may use the new EPCRS to retroactively correct errors occurring on or after January 1, 2009, errors occurring before January 1, 2009, must be corrected using the pre-amended version of the EPCRS.

Where Can 403(b) Plan Sponsors Find Guidance on Avoiding and Correcting Defects?

The IRS's recently released "403(b) Plan Fix-It Guide" includes practical tips on how to identify, correct, and avoid 10 of the most common plan document and operational mistakes related to 403(b) plans. The user-friendly guide is available here. In addition to the 403(b) Plan Fix-It Guide, the IRS has published new and updated guidance applicable to 403(b) plan sponsors that need assistance or have questions related to correcting operational and plan document failures.⁴ The guidance includes a VCP submission kit for plan sponsors that missed the deadline to adopt a written 403(b) plan document, responses to frequently asked questions related to retirement plan corrections programs, and a topical index for Revenue Procedure 2013-12, which will enable plan sponsors to quickly find provisions relevant to 403(b) plans in the new EPCRS.

What Should 403(b) Plan Sponsors Do Now?

The IRS has indicated that it intends to increase its enforcement and compliance efforts related to 403(b) plans. As such,403(b) plan sponsors should consider conducting an internal review to determine whether they have errors in need of correction. Because of the lower compliance fees associated with the SCP and the VCP, it will likely be less expensive for 403(b) plan sponsors to voluntarily correct compliance defects rather than wait to correct compliance defects during an IRS audit. In particular, 403(b) plan sponsors that failed to timely adopt a written 403(b) plan document should take corrective action before the end of 2013 to take advantage of the IRS's temporary VCP compliance fee reduction. Lastly, the IRS granted special transition relief to 403(b) plan sponsors that have yet to adopt a written plan and that are under audit (or receive notification of an audit before April 1, 2013). These 403(b) plan sponsors will be permitted to participate in the VCP to correct their failure to timely adopt a written plan document and pay the reduced compliance fee available under the VCP, even though they are under audit.

Participation In A Foreign Pension Plan / Form 8938 (Statement of Foreign Financial Assets), introduced in 2011 as part of the Foreign Account Tax Compliance Act (FATCA), requires taxpayers to report their foreign assets, subject to minimum values, and indicate where the related income is picked up on their tax return.

David Roberts for WTAS writes: One asset often misunderstood and likely overlooked in many cases is a taxpayer’s interest in a foreign pension plan. Foreign nationals who move to the United States or U.S. citizens who have spent significant time overseas are likely to have some form of foreign pension arrangement.

In many cases, there is uncertainty as to the reporting requirements and the application of U.S. tax rules and/or tax treaties to such plans but, in general, for senior level participants it is likely that employer contributions will be taxable as compensation and the growth in the value of the pension will create taxable income annually. Furthermore, the plan will generally need to be reported by the taxpayer on Form 8938, Foreign Bank Account Report (FBAR), and possibly Form 3520 relating to U.S. owners of foreign trusts.

Foreign pension plans will almost certainly not qualify under IRC Sec. 401, which defines 'Qualified Plans' for U.S. tax purposes and includes a requirement that the plan has to be created or organized in the United States. To understand the tax treatment of these plans, it is necessary to first understand the type of plan being addressed. Generally, there are four main types of plans: 1) defined contribution plans funded by the employer and possibly employee; 2) defined benefit plans, typically funded by employer contributions only; 3) personal pension plans, funded by individuals; and 4) unfunded plans which are maintained on the company's books.

A common misconception is that most foreign pension plans would be considered tax-exempt under a tax treaty. While this may be true in some cases, the exemption is generally limited to only those plans that would be correspondingly approved by both governments and any tax benefits are limited to those available to a U.S. qualified plan (e.g., a 401(k) plan).

It is possible that a foreign plan is considered a trust arrangement and, consequently, treated as a foreign grantor trust requiring U.S. participants to report their interest in the trust on a Form 3520. To enable this reporting, the pension trustee must issue a Form 3520-A to the U.S. participant by March 15 following the tax year-end proving specific details of the participant’s interest. However, for senior executives, the form of pension is likely to be a funded employee benefit trust governed by IRC Sec. 402(b), which specifically exempts the trust from being treated as a foreign grantor trust and, consequently, the above filing requirements.

The tax treatment of the pension (or deferred compensation plan) under IRC Sec. 402(b) depends on whether the trust is discriminatory towards highly compensated employees. A highly compensated employee is defined broadly as a 5% owner of a company, one who meets a compensation limit ($115,000 in 2013), or an employee whose pay is in the top 20% of compensation for that company. If the IRC Sec. 402(b) trust is discriminatory, highly compensated employees who participate in the underlying plan are taxed each year on the employee’s “vested accrued benefit,” less the employee’s investment in the contract or the value of the previously taxed portion of that benefit. In other words, if the plan is discriminatory, the employee would effectively be taxed on the increase in the pension value each year.

Within these rules lies a potentially disastrous scenario. A foreign national who moves to the U.S. could find herself fully taxed on any distribution, even if the contributions were made to the foreign plan long before she set foot in the U.S. For distribution purposes, IRC Sec. 72(w) provides that a U.S. resident receiving a distribution will not have any ‘basis’ for any foreign source contributions made during a period as a non-resident alien if those contributions were not previously subject to income tax and would have been subject to income tax if paid as cash compensation. This generally should be creditable against the U.S. tax to the extent any distributions are subject to foreign withholding tax.

With the recent passing of FATCA, the increased focus on reporting foreign trusts and foreign assets makes the disclosure and treatment of such foreign deferred compensation plans more transparent to IRS. Given the potential tax exposure and onerous penalties, it is important to plan ahead to understand the tax treatment of these plans and to understand how to correctly report them.

Court Rules Discounted Stock Options Are Nonqualified Deferred Compensation

Grant Thornton writes: The U.S. Court of Federal Claims has ruled in Sutardja v. United States (Fed. Cl., No. 11-724T) that stock options granted to an employee were deferred compensation subject to Section 409A, pending a ruling on the fair market value of the underlying stock on the grant date. The court did not come to a complete resolution regarding whether the stock options were subject to Section 409A, because a determination had not yet been made regarding whether the stock options were discounted (i.e., issued with an exercise price less than the fair market value of the underlying stock on the grant date).

The grant of nonqualified stock options that was the center of the case was approved by the compensation committee of Marvell Technology Group Limited on Dec. 26, 2003. But the grant wasn’t ratified until Jan. 16, 2004. The exercise price of the options was set at the trading price of Marvell’s stock on Dec. 26, 2003. In January 2006, Sutardja exercised a portion of the stock options and recognized compensation income equal to the spread of the option. After the exercise of the options, an internal committee of Marvell determined that the grant date of the options was Jan. 16, 2004, at which time the trading price of the company’s stock had increased from the price on Dec. 26, 2003.

Section 409A places strict requirements on nonqualified deferred compensation, which generally includes discounted stock options. If these requirements are not met, the intrinsic value of the discounted stock options can be included in the employee’s income at the time of vesting, even if the options are not exercised, and the income is subject to an additional 20% income tax.

Sutardja argued that if the stock options were in fact discounted, they were not subject to Section 409A for various reasons. First, based on Supreme Court rulings in Comm’r v. LoBue, (351 U.S. 243, 247) and Comm’r v. Smith (324 U.S. 177, 181), stock options are not taxable until they are exercised. Thus, Sutardja argued that Section 409A could not require him to recognize income prior to the exercise of the options, and, therefore, there was no deferred compensation. The court rejected this argument because the Supreme Court’s rulings were based on options that were not discounted.

Second, Sutardja argued that because these options were granted and exercised before the final Section 409A regulations became effective, the definition of deferred compensation should be determined under Treas. Reg. Sec. 31.3121(v)(2)-1(b)(3) and (4), which defines deferred compensation for purposes of FICA taxes. Under these regulations, deferred compensation does not include stock options. The court rejected this argument for two reasons. First, the FICA regulations specifically state that stock options are not deferred compensation for FICA tax purposes only, and the FICA regulations cannot be applied to Section 409A. Second, the court gave deference to Notice 2005-1, which specifically stated that discounted stock options were deferred compensation. This position did not change in the proposed or final Section 409A regulations.

Third, Sutardja argued that he did not have a legally binding right to the compensation until the stock options were exercised, and thus, there was no deferred compensation. For purposes of Section 409A, a plan or arrangement provides for deferred compensation when the employee has a legally binding right to compensation in one taxable year that will or may be paid in a future taxable year. The court concentrated on the definition of a stock option under California law, which provides that an option is a “unilateral contract which binds the optionor to perform an underlying agreement upon the optionee’s performance of a condition precedent.” The court concluded that the “condition precedent” was Sutardja’s meeting the vesting conditions attached to the options, so Sutardja had a legally binding right to the compensation as soon as the options became vested.

The court’s position that Sutardja had a legally binding right when the options became vested is interesting because the Section 409A regulations provide that an employee does not fail to have a legally binding right merely because the compensation is subject to a vesting condition. Thus, under the Section 409A final regulations, an employee may have a legally binding right before the compensation becomes vested. The court’s position seems to conflict with the final Section 409A regulations. The final regulations were issued after the taxable years during which the options were granted and exercised, so those regulations were not considered in the court’s ruling.

Death & taxes: Planning for the unavoidable

Joe Lucey for MarketWatch writes: We're commonly reminded that the two certainties in life are death and taxes. Unfortunately for many retirees, neither certainty is included in their comprehensive financial planning.

While the omission of tax planning most often will slowly erode the value of retirement resources as unnecessary taxation trickles away, avoidance of death planning will typically result in sudden and unexpected financial crises that can rearrange and upend an otherwise secure retirement for a surviving spouse. Each can be costly and leave families living on considerably less than they had hoped for or needed to fulfill a stress free retirement.

It's important that you recognize these potential sinkholes in your own retirement plan so you can discuss them with your financial adviser and make the necessary corrections.

Remaining aware of these potential oversights can avoid damage to your future retirement dreams.

Not planning around taxes

Tax planning should not be a seasonal thing you look at during filing deadlines, but year-round. Sit down with your financial adviser or tax preparer to review this year's tax return line item by line item, addressing additional tax saving strategies both tactically, over the next 12 months, and strategically, looking farther out into the future.

Tax smart financial planning creates additional money earned and reduces the requirements on other retirement resources. Tax efficient withdrawal and investment strategies will enable you to withdraw fewer assets and achieve a similar net income result, allowing unused assets to accumulate untouched. Identifying which accounts you elect to withdraw first, coordinated with the timing of those withdrawals (called the sequence of withdrawals) can make a tremendous difference in the amount of overall net income planning.

While many consumers have been told to continue to defer their retirement assets as long as possible, proceed with caution. Doing so can create a tax planning crisis at the onset of triggered required minimum distributions or when passing IRAs to beneficiaries. Advanced analysis of tax efficient sequence of withdrawals can protect your retirement funds from rising tax rates in the future.

Consider a proactive approach which may include paying more tax today at lower tax rates in order to avoid the erosive effects of rising taxes in the future. Also, learn how Social Security payments are taxed and how to avoid "stealth taxes" where additional income is taxed at higher rates than at the individual's tax bracket.

Thinking in terms of ‘me’ and not ‘we’

At the death of the first spouse, the surviving spouse will lose a Social Security benefit, a possible reduction in a pension, and likely an increase in tax brackets when going from joint to an individual filed return.

80% of all men die married, while 80% of all women die single. Additionally, 75% of all women living in poverty were not poor before they were widowed. Early income and retirement planning decisions should be made with survivor benefits in mind to ensure that both husband and wife are protected in retirement. Evaluate your retirement savings to ensure that a loss of 30%-60% of household income will allow a surviving spouse enough resources.

Consider implementing insurance or annuity tools in addition to traditional market investments to provide adequate protection for your loved ones.

Not planning for longevity

Longevity risk, or living longer than expected, should be one of the biggest concerns of a family entering retirement today. It is hard to imagine a longer life span being classified as a "risk" but if you have not planned for the extra years, they can be filled with the stress of wondering where your income will come from. Statistically, married couples age 65 and older should be planning for a future in which they have a 50% probability that at least one of them will celebrate their 92nd birthday.

Failing to plan for the effects of inflation on a retirement income and investment portfolio can be disastrous. Be cautious when electing fixed payment lifetime income streams that do not adjust for inflation or by not allowing for enough growth in your overall portfolio by leaving too much in cash or CDs.

Ignoring health-care expense planning

Retirees should consider reviewing their Medicare plans on an annual basis in the same way they review their portfolios. Prescriptions change, plans change, and an annual analysis on which is the best plan for you can create valuable premium savings. Also, consider the impact that a chronic illness or long-term care expenses would have on your portfolio.

The national average cost of nursing home care is $200 per day or $6,000 per month. Not having a plan in place that can provide the necessary income to replace these costs can be difficult. An adviser who specializes in working with families entering into retirement should be able to discuss both traditional long-term care insurance, as well as asset-based hybrid plans that utilize life insurance or annuities. These often are better options for families who might otherwise assume they are best self insuring this potential retirement risk.

Planning for the events of death and taxes should be included in all comprehensive financial planning processes. Often financial plans only focus on product selection and consequently many consumers expect only investment selection advice from their financial planner. When that is the case, you are working with a portfolio manager or investment manager, but don't confuse their planning with the financial professionals who are willing and competent in offering comprehensive advice.

A holistic advice approach will include planning for life's certainties.

New tax code would give Americans vested interest

George Noga for BizPacReview writes: The tax filing deadline earlier this week makes this an opportune time to discuss taxation in America.

A progressive shibboleth is that some Americans don’t pay their fair share of federal income tax. They are right in point of fact but dead wrong about who doesn’t pay their fair share.

Let’s recap a few basic facts before I present my proposal to remedy the situation.

• America has the most progressive tax system on Earth. The rich pay a higher share of tax than in any country; our corporate tax rate is the highest in the developed world.
• When including credits, the bottom 60 percent in the US pays only 1 percent of the total tax. No other nation has near 60 percent not paying tax, thus making us the least regressive on the planet.
• In recent decades the share paying no taxes has more than doubled; the US has become much more progressive both over time and relative to other nations and by wide margins.
• Social Security is modestly progressive lifetime and Medicare is extraordinarily progressive. The entire tax  system including payroll taxes is progressive.

New Minimum Federal Income Tax

There is something terribly wrong when the richest nation in the history of mankind has 60 percent of its citizens paying virtually no income tax. So, how do we fix it?

I am okay with the lowest income quintile not paying income tax; the bottom 20percent of Americans can get a pass until their income increases. The second lowest and the middle quintiles however should be required to pay the new minimum income tax.

The second from bottom cohort should pay a low rate of 10 percent subject to a minimum of, “a arguendo,” $100 per month. The middle cohort, half of which earns above average income, should be subject to a rate of 12 percent to 15percent with a minimum of $200-$250 per month – all indexed for inflation.

It is critical for our constitutional republic that the tax base is broad and every citizen (bottom cohort excepted) feels the sting of  higher taxes. 

If tax rates in general rise or fall, the new minimum tax would rise or fall proportionally. Instead of 60 percent paying no income tax, that number would be reduced by 67 percent down to only 20 percent.

This would give nearly all Americans a vested interest in reducing spending and taxes and controlling government – not to mention the quiet dignity of being a taxpayer and contributing to the common weal.

New Maximum Federal Income Tax

When polled, Americans consistently respond no one should pay more than 25percent-33 percent of income in taxes. I therefore propose no American should ever pay more than 40 percent of income in taxes of all kinds.

To effect this I would impose a new maximum tax that works as follows.

The new maximum tax form would include spaces for adding all taxes paid including, “inter alia,” all the following:

Federal income tax, state and local income tax, payroll tax including Social Security and Medicare, real estate tax, sales tax, death tax, intangibles tax, automobile taxes and fees, gasoline tax, transfer taxes and any other tax meeting a “de minimus” threshold.

Finally, I would cap it off by including each person’s share of corporate taxes paid because, as everyone should know, corporate taxes always are paid by real people. Companies could send out a tax form each year reporting the share of corporate tax paid by each shareholder. Once the total taxes reach 40% of income, the taxpayer may reduce the federal income tax by whatever amount is required not to exceed the 40% maximum.