Taxes Influence Investment Strategy, and Not Always for the Better

Paul Sullivan for the New York Times writes:  For years, many investors didn’t worry about the taxes they would pay on the gains in their investments until the bill arrived months later. But this year, with taxes higher, some investors have gone to the other extreme, choosing investments as much for their tax rates as for their risks and returns.

That may not be a good thing for their portfolios.

“Clients are definitely asking, because it’s a real issue in today’s environment,” Michael N. Bapis, a managing director and partner with the Bapis Group at HighTower Advisors, said. “We try to keep them focused on the goals — preserving what they have, capturing some of the upside, limiting the downside. At the end of the day, we can’t change the tax laws.”

When asked about how tax rates would affect an investment, he said his advice was almost always the same. “If it doesn’t make sense for your portfolio, then it doesn’t make sense,” he said, even if there is tax savings. “If it does make sense, regardless of the tax consequences, we’re going to put it in your portfolio.”

Last week, I looked at how the changes to the tax code were affecting how people thought about their estate plan. This week, I’m looking at how tax increases can influence people’s investing behavior.

The tax rates on investments have increased significantly from last year. Depending on a person’s income, taxes on long-term capital gains and dividends are now as high as 23.8 percent, an increase of 59 percent over last year’s rate. Taxes on investments that are held for less than a year that incur short-term capital gains tax or investments subject to income tax rates have increased for top earners by 24 percent, to 43.4 percent (with the Medicare surtax included) from 35 percent.

Those are substantial increases, but focusing on them alone can obscure a fuller analysis of risk. Investors can end up paying no taxes on an investment, but that may be because they lost money on it, or they may pay lots of taxes on a large gain that they might not have achieved otherwise. This is why advisers stress that taxes should not be the first concern when deciding whether to buy — or not buy — an investment.

If there is one investment that has been promoted as great for minimizing taxes and achieving a large gain, it is master limited partnerships. Most are involved in the transportation or storage of oil and natural gas. What makes them appealing, from a tax perspective, is that a large portion of the dividend they pay is treated as a return of principal and is not taxed.

But in the rush for one type of tax savings, investors can end up paying other taxes. Master limited partnerships with pipelines that run through several states can incur state tax bills for investors, though usually only when the income goes above a certain threshold.

The bigger tax concern generally comes when investors sell their partnerships, since the part of the dividend that was not taxed for years reduces the original price of the investment. Greg Reid, a managing director at Salient Partners and chief executive of the firm’s $18 billion master limited partnership business, said an investor who bought a partnership and sold it five to 10 years later could be faced with two types of taxes. The first is income tax, because the original purchase price would have been reduced by the amount of principal returned in the dividends. The second is capital gains tax on the increase in the value of the investment itself.

Another way to look at these partnerships is to consider the solid and increasing dividends they have paid over the last 25 years, often 6 to 7 percent.

“The baby boomers are going to need a lot of income to live,” Mr. Reid said. “M.L.P.’s are particularly great for older people who are retiring. They have a growing income stream.”

As for avoiding high taxes, the solution is to give the partnership to charity or die with it in your estate. Both may be viable options for investors in their 70s and 80s but are probably less attractive to people in their 30s.

Municipal bonds, which have long been attractive to wealthier investors because the interest they pay is not taxed by the federal government, pose a different sort of risk.

Mr. Bapis said he was concerned that investors who were not paying attention to the broader economic news were not aware of the current risks of buying an existing municipal bond. With yields on many municipal bonds extremely low — around 0.75 percent for five-year bonds and 1.74 percent for 10-year bonds, according to Bloomberg — even a small increase in their price, which would cause the yield to go down, would cause a loss of principal.

Mr. Bapis calculated that if the yield on the 10-year bond went to 3 percent, that could translate into a loss of 6 to 10 percent. The exception is if someone were to hold the bond until maturity. “But are you going to be able to stomach watching that bond go down 6 to 10 percent in the short term?” he asked.

On the other side of the tax equation are hedge funds, which as a group have fallen from their perch as exclusive vehicles that guaranteed high returns no matter what was happening in the world.

The tax-based argument against them is that funds that aggressively buy and sell securities generate a tremendous amount of short-term capital gains, and the higher taxes on those gains — double the long-term rate — erode the investor’s after-tax return. Since most hedge funds now have returns in the single digits — far-off their peak — along with high management fees and onerous clauses to keep investors from getting their money back or even knowing how it is invested, the higher investment tax could make hedge funds less attractive.

Yet the counterargument is that hedge funds can invest in ways that are not correlated with other markets and may have less volatility. If a hedge fund returns 9 percent before taxes versus 2 percent for a tax-free municipal bond, the hedge fund could be a better investment.

That higher return, known as alpha, against the market return, or beta, is what proponents of hedge funds push. “We’re happy to pay for that alpha as long as we get it,” said Jonathan Hill, investment strategist at Gibraltar Private Bank and Trust. “The worst-case scenario over the past few years is clients have paid for alpha and gotten beta.”

For most investors, though, there are simple strategies that they can use to manage taxes on any investment, and they can do so without tearing up their existing investment plan.

One of them is putting investments that generate higher taxes in tax-deferred accounts and those that generate lower or no taxes in regular brokerage accounts. “Asset allocationis even more important today,” said Eli Niepoky, chairwoman of the investment strategy group at Diversified Trust.

For example, she said, municipal bonds, stocks owned for a long time, and master limited partnerships should be held in taxable accounts, while investments that generate income or short-term capital gains should generally be put into tax-deferred accounts.

Another strategy that fell out of favor in the middle of the last decade but is returning is investing with an eye toward losses for tax purposes. Instead of investing in the S.& P. 500-stock index, a manager employing this strategy would invest in a smaller number of stocks in the index in an attempt to replicate the returns of the index. When a stock fell, say Pepsi, the manager would sell it and replace it with a similar one, like Coca-Cola.

“It’s definitely not an exciting topic,” said David Lyon, investment specialist at J. P. Morgan Private Bank. “Index replication is the ultimate goal, but if you can do it in a more tax advantageous way for the first four to five years than being in a pure index fund, that gives you more tax flexibility going forward.”

The downside, he said, was that your returns could reflect the index with little tax savings. But as long as the index went up, that’s not a bad trade-off.

How to Declare the Money Earned From Side Work / IRS & Tax Returns

Mark Kennan for Demand Media writes: Whether you're selling items online, freelance writing or refereeing travel soccer games for a youth league, a side job is a great way to pad your bank account. But, you're not the only one whose bottom line benefits from the side work you pick up after-hours: Uncle Sam's going to be taking a slice in taxes. Besides income taxes, your side work is also subject to self-employment taxes if you make more than $400 doing it, as of 2013. Besides losing a slice of your income to taxes, you've got some extra tax paperwork to fill out. And, if you were planning on cruising through your taxes with Form 1040-EZ, think again: The long Form 1040 is your only option when you have self-employment income.

ITEMS YOU WILL NEED

• IRS Form 1040
• IRS Schedule C or C-EZ
• IRS Schedule SE

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STEP 1

Calculate your net income from your side work with either Schedule C or Schedule C-EZ. You can use the shorter Schedule C-EZ if you had business expenses of $5,000 or less, are a cash basis taxpayer, did not have any inventory, didn't have a net loss and have only one side business. To use this form, you also can't have any employees, you can't use Form 4562 for depreciation and amortization expenses, you can't deduct expenses for business use of your home and can't have prior year unallowed passive activity losses from this business. If you have any expenses from your side business, such as advertising, car expenses or supplies, you can use those to reduce your earnings.

STEP 2

Copy your net income from line 3 of Schedule C-EZ or line 31 of Schedule C to line 12 of your Form 1040 tax return. This amount adds to your taxable income for the year.

STEP 3

Copy your net self-employment income to line 1 of Schedule SE to figure your self-employment taxes if you have more than $400 for the year. You don't have an employer to split the payroll taxes with, so you're responsible for the entire Social Security tax and Medicare tax yourself. Schedule SE also figures the deductible portion of your self-employment taxes.

STEP 4

Copy your total self-employment taxes due from line 5 of Schedule SE to line 56 of your Form 1040. This is added to your taxes due for the year.

STEP 5

Transfer your total self-employment tax deduction from line 6 of Schedule SE to line 27 of your Form 1040 tax return. This amount reduces your adjusted gross income for the year.

• You should receive a Form 1099-MISC from anyone who pays you more than $600 during the year as an independent contractor. However, even if you didn't receive a form, or made less than $600 from any given job, you're still required to report that income on your taxes.

REFERENCES

• Internal Revenue Service: Filing Requirements for Self-Employed Individuals
• Internal Revenue Service: Form 1099-MISC Instructions
• Internal Revenue Service: Reporting Miscellaneous Income

RESOURCES

• Internal Revenue Service: Schedule C-EZ
• Internal Revenue Service: Schedule C
• Internal Revenue Service: Schedule SE
• Internal Revenue Service: Form 1040 

Goodbye Capital Gains Tax Breaks / Momentum is building for a tax code overhaul, and lower taxes on stock transactions could be doomed.

Joy Taylor for Kiplinger writes: Tax breaks for capital gains and dividends are likely to end by 2015, as lawmakers look for ways to broaden the tax base, allowing income tax rates on individuals to be cut. There is precedent for this — the tax break for long-term capital gains was axed in 1986, the last time that lawmakers significantly reformed the tax code.

Tax overhaul won't happen swiftly. Lawmakers won't have time to complete tax reform until 2014, and when they do finish it, the effective date probably will be prospective, so changes aren't likely to occur until 2015. There will be plenty of time to mull the impact on your investment portfolio and contemplate actions to minimize the tax wallop.

But discussions will intensify in the coming months. One reason: Senator Max Baucus (D-MT), who heads the Senate committee responsible for writing tax laws, has announced that he'll leave the Senate when his term ends at the end of 2014. Look for him to push hard for tax reform before he leaves, making a revamped tax code his policymaking legacy.

In the end, we expect long-term capital gains and dividends to be taxed as ordinary income — a big change from the 20% maximum rate they now incur. If President Obama succeeds in winning a top income tax rate on individuals of more than 28%, however, it's possible that the maximum rate on long-term capital gains and dividends will be limited to 28%.

Consider taking gains before 2015 to lock in the lower rate currently in place. But be careful not to let the tax tail wag the investment dog. Tax savings aren't the only consideration when culling your portfolio; your moves should also make financial sense. Note that we expect taxwriters to keep the stepped-up basis rule for inherited assets, so 100% of pre-death appreciation on those assets will escape income tax when the heirs sell, regardless of the capital gains rate.

Take care in engaging in installment sales before then. The 1986 law provided that installments received after the capital gains rate rose weren't protected, even though the sale occurred before the rate change. We expect that a similar rule will be passed this time, too.

Weigh the impact on succession plans for family firms. Corporate redemptions of shareholders' stock will be hit. Family firms hoping to redeem stock of senior owners to shift control to the next generation will need to take that into account.

Keep in mind that the relative advantages and disadvantages of components in your portfolio may need reevaluating. Dividend paying stocks will lose their tax-favored status if dividends are taxed at ordinary income rates. And there will be no tax disadvantage for having growth stock in retirement plans. Without a capital gains preference, it won't matter that appreciation on the stock will be taxed as ordinary income when distributed to the owner of the retirement plan or IRA.

And it's worth noting one other tax reform proposal that affects investors: Stock sellers could lose the right to direct that the highest-basis stock be sold first. They may be forced to use the average basis of their shares to compute the gain or loss recognized on a sale, rather than use the specific identification method. The tax reform plan drafted in the House includes such a provision, and we think it has a good chance of making it into law.

Spousal Support as a Tax Deduction

Fraser Sherman for Demand Media writes: Recovering after a marriage dissolves is never pleasant, and it's often expensive. Making spousal support, child support or other payments to your ex can add to the break-up stress. If it's any comfort, some of what you pay your ex is probably tax-deductible. You can take the deduction on your Form 1040 without having to itemize.

DEFINING ALIMONY

Helping your ex with extra money in an emergency cash crunch does not count as alimony. Neither does any of the property you give up in the divorce, such as the flat-screen TV or the kitchen appliances. Alimony has to be money, including cash, checks or money orders, and it has to be under a divorce order. If you give your ex money or property when you're not legally obligated, that's generous but it's a gift, not spousal support.

LIVING CONDITIONS

It's not just divorce that gives you a tax write-off. If, instead, you and your spouse live separate lives with an agreement that provides her with separate maintenance payments, you get to deduct that too. Whether you're divorced or legally separated, though, if you and she still share the same house none of the money you give her is deductible. There's also no write-off if the two of you separate but keep filing joint returns.

CHILD SUPPORT

If you pay child support, you can't include that as a tax deduction, even if you write one check for child and spousal support both. If you're not paying everything the divorce court told you to, you can't prioritize the alimony because it's better for your taxes. Suppose you owe $5,000 in child support a month and $3,000 in spousal support. If you fall behind and only pay $3,000 one month, it's all credited to child support. There's no tax write-off.

SPECIAL CASES

Normally the spousal-support check has to go to your ex. If he tells you to send it to his sick mother instead, that's still deductible if he says in writing that it counts as an alimony payment. If your separate-maintenance agreement lets your spouse live in the house while you retain ownership, you can deduct utility bills as spousal support if you pay them. Other costs, such as property taxes and mortgage checks, aren't alimony; they're the price of ownership.

Could this plan replace the 401(k)? / More employers cut costs with ‘cash balance’ pensions

Robert Powell for MarketWatch.com writes: The retirement world is largely focused on 401(k) and traditional defined benefit plans. But investors and financial advisers alike should be paying closer attention to something called a cash balance pension plan. Cash balance plans are the fastest-growing part of the defined-benefit pension universe and could become as numerous as 401(k) plans within the next few years, according to the trade publication Pension & Investments.

Consider: The number of such plans rose from 1,300 in 2000 to more than 7,600 in 2010, an average annual growth rate of around 20%, according to recent research from Sage Advisory Services. (See Sage Advisory’s recent news release, “Cash balance plans challenge 401(k) supremacy.”)

What’s more, the number of participants nationwide in cash balance plans reached 11 million in 2011, and cash balance plan assets that year totaled $724 billion, according to the most recent Cash balance Research Report from the retirement-plan design firm Kravitz Inc. (Read a recent report from Kravitz, Cash Balance Retirement Plans Double Projected Growth Rate.“)

What are cash balance plans, and what do you need to know about such plans should you have one or should one be in your future?

Often misunderstood, the cash balance plan is becoming increasingly popular for several reasons. First, large firms are converting their defined benefit plans into cash balance plans as a way to cap their pension liabilities. Second, small- and midsize firms are starting to rely on these plans, which when used in combination with 401(k) plans, can help participants cut their current tax bill and sock away quite a bit of money for retirement.

Sage Advisory Services and others describe cash balance plans as hybrids of a defined benefit plan (think: a traditional pension) and a defined contribution plan such as a 401(k). Dan Kravitz, the president of Kravitz Inc. said cash balance plans combine the high contribution limits of a defined benefit plan (employers can contribute on behalf the employee an amount much greater than the maximum an employee can contribute to a 401(k) plan—which is $17,500) with the flexibility and portability of a 401(k) plan.

The Labor Department puts it this way: “A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.” Read the department’s FAQs About Cash balance Pension Plans.

As of 2011, the 10 largest cash balance plans belong to International Business Machines Corp IBM +1.05%  ., AT&T Inc. T -0.59%  , The Boeing Co. BA +1.66%  , Ford Motor Co.F +3.13%  , Alcatel Lucent USA Inc. ALU 0.00%  , 3M Co.MMM +1.69%  , Northrop Grumman Corp. NOC +0.69%  , United Technologies Corp. UTX +1.48%  , Honeywell International Inc. HON +1.72%  , and Citigroup Inc. C +0.92% , according to Kravitz’ 2013 Cash Balance Research Report. (IBM’s plan has been frozen since 2008, but it remains the largest cash balance plan.)

Even states are trying to get in on the trend. The Arnold Foundation, which was founded by John Arnold, a former Enron executive, has partnered with Pew Center on the States to advocate for cash balance plans for state government employees. (In January, however, a Louisiana district court judge struck down as violating the state constitution a recent law there that aims to establish a cash balance plan for some employees in three of the state’s pension funds.)

Offering a guaranteed return

With a cash balance plan, the plan sponsor contributes money into a hypothetical account for each employee based on a set interest crediting rate (for example, the U.S. 30-year Treasury bond rate) and a percentage of the employee’s pay, according to Sage Advisor. That crediting rate essentially represents a guaranteed rate of growth for each employee’s balance.

Kravitz said cash balance plans are IRS-qualified under ERISA, and must pass a range of IRS fairness testing requirements to make sure that the plans don’t benefit owners at the expense of rank-and-file employees.

In the main, advisers and experts seem quite fond of these plans. “I am positive about cash balance plans,” said Michael Angelucci of Angelucci Wealth Management. “It’s a pretty good benefit in an environment where most employer plans are transferring all risk to the employee.”

“I emphasize to participants that they are receiving an employer contribution to an account that is guaranteed to grow,” said Angelucci. The value of your 401(k), by contrast, is likely to rise or fall based on market returns, your asset allocation, and your saving behavior.

Do understand, however, that your cash balance account is a notional account that is part of a larger pooled trust, said Alex Kuhel, a cash balance practice leader at actuarial consulting group Clarity in Numbers. But the vested balance is guaranteed.

No investment decisions for savers

Cash balance participants—unlike those in a 401(k) plan—don’t have to worry about how to invest the money in their account. Participants have no investment discretion; such decisions are made by the plan’s trustees, said Kuhel.

“On the accumulation front, there’s not much a participant can do,” said José Martin Jara, an ERISA managing director at the law firm Dentons. “As with traditional defined benefit plans, under a cash balance plan the employer is responsible for funding the plan and investments in the plan.”

Thus, Jara said, the risk of investment loss remains with the employer.

According to Kravitz, the assets must be invested conservatively so they do not fluctuate dramatically with market swings. A typical cash balance interest crediting rate is in the range of 4% to 5%.

Kravitz also noted that participant accounts increase annually in two ways: through an employer contribution (either a flat amount or a percentage of pay) and a guaranteed interest credit. Both are specified in the plan document.

Tax breaks, and a government backstop

Another good feature of the cash balance plan is that if the employer is on the brink of collapse or actually goes bankrupt, the plan is partly insured by the Pension Benefit Guarantee Corporation.

Of course, this isn’t to say that no one has to worry about the investment strategy. The trustees of the plan sponsor are responsible for that, and management of the plan assets can present a challenge.

Kravitz said cash balance contributions on behalf of owners/partners are tax-deferred, and contributions on behalf of employees are tax deductible. In a recent piece promoting the merits of cash balance plans, Kravitz described the example of a small-business owner with $400,000 having to pay $103,000 in federal income taxes in the absence of a cash balance plan. But that small-business owner could cut that tax bill to $51,000 by putting $150,000 into a cash balance plan.

Angelucci said that cash balance plan participants will have a better idea than 401(k) plan members of what they will have in their account at retirement. Cash balance plan participants won’t have to try to predict future market returns or account for their own investment decision-making. “I emphasize that based on studies of investor behavior, the guaranteed return they will get over time has a high probability of being better than if they received a comparable profit share in a 401(k),” said Angelucci.

Kravitz noted that lifetime contribution limits are about $2.5 million per employee, but that the age-weighted annual maximum contributions for shareholders can exceed $200,000 a year, allowing older owners to catch up rapidly on delayed retirement savings.

What’s more, Kravitz said, cash balance plans are typically combined with a 401(k) profit-sharing plan, and the IRS fairness requirement may be satisfied through an increased profit-sharing contribution, typically in the range of 5% to 7.5% of pay.

Payout options

When you retire, cash balance plans can become, in many ways, like traditional defined benefit pension plans. “Cash balance is what it says it is,” said Nicholas Paleveda, an adjunct professor at Northeastern University and the CEO of consulting and actuarial firm National Pension Partners. “You receive the lump-sum balance in your hypothetical account, or an income for life based upon your current salary. The plan sponsor or your company is responsible to pay you the lump sum or lifetime income.”

Or at least that’s true in some cases. “I believe the single most important issue for a participant in a cash balance plan is whether the participant can elect a lifetime annuity or lump sum,” said Jara. Some plans, Jara said, do not allow lump sum payments. “But if the plan does permit lump sum payments, a participant has to be careful if they do elect a lump sum that they properly manage that money to ensure they don’t deplete it prior to dying,” he said.

Angelucci said reasons why one may want a lump sum include the following: A short life expectancy, desire to leave wealth, and the opportunity to do a part-lump sum and part- annuity strategy. Reasons to take the annuity option include an anticipated long life, or the possible cushion of having other wealth to pass to heirs.

Also of note, Paleveda said some cash balance participants might be unaware of the “actuarial equivalence” of what a lump sum in their cash balance plan can buy as a lifetime income. For example, he noted that a lump sum of $250,000 today will buy a lifetime income of $1,293 a month or $15,516 a year for a female age 65, which he said is “basically the poverty level in the U.S.”

“If you saved $250,000 in your cash balance plan, you saved enough to retire into poverty,” Paleveda said.

In many cases, the vested balance can be rolled over to an IRA or 401(k) plan upon leaving the company, said Kuhel. “Owners and partners must begin taking required minimum distributions in year following age 70 ½,” Kuhel said. “And any balance not taken continues to earn guaranteed interest per the plan’s provisions.”

If you are not an owner, you are not required to take required minimum distributions or RMDs until the later of 70½ or separation from service. So if you are still working as an employee past that age, you are not required to take an RMD. For employer-sponsored plans (401(k), traditional defined benefit, and cash balance), this particular rule is the same, provided the plan document allows for it, Kuhel said.

When to collect

Understanding when a participant is entitled to a distribution from a cash balance plan is critical for a participant to optimize their own personal finances. “Plans might provide distribution at normal retirement age,” Jara said. “But some plans can have a normal retirement age that is below the age of 65.”

If a participant switches employers, Jara said they can cash out their “hypothetical account.” But the better course of action would be to roll over those amounts into an IRA or other qualified plan to avoid any tax consequences.

To be sure, there are some negatives associated with cash balance plans. “A cash balance plan is admittedly not as rich as a traditional DB plan,” said Angelucci. But in the main, having one is better than not having either a traditional DB plan or a 401(k) plan.

Join the Roth 401(k) revolution / Strategy: Switch money from your regular 401(k) account into the Roth 401(k) account - the distributions you receive in retirement will be completely exempt from federal income tax.

businessmanagementdaily.com writes: A little-noticed tax break in the new “fiscal cliff” tax law—the American Taxpayer Relief Act of 2012 (ATRA)—could provide a big boost for upper-income retirement-savers. It makes it easier to take advantage of a Roth 401(k)—the 401(k) version of the Roth IRA—when an employer provides this option.  

Strategy: Switch money from your regular 401(k) account into the Roth 401(k) account. Assuming you meet all the tax law requirements, the distributions you receive in retirement will be completely exempt from federal income tax.

This doesn’t have to be an all-or-nothing proposition. For instance, you can keep some of the funds in a regular 401(k) account. Alternatively, you might move all the funds to a Roth 401(k) account over several years, thereby reducing the overall tax bite.  

Here’s the whole story: As with a regular 401(k) plan, contributions to a Roth 401(k) account grow on a tax-deferred basis. However, unlike a regular 401(k), elective deferrals aren’t made with pretax dollars. The amounts contributed to the plan are subject to current tax.

With a Roth 401(k) plan, the benefits come on the back end: Qualified distributions are 100% federal-income tax free and usually state-income tax-free, too. This includes distributions made five years after setting up the Roth 401(k) if you’re older than age 59½ at that time. In comparison, distributions from a regular 401(k) are taxable at ordinary income rates, now reaching as high as 39.6% under ATRA.

The contribution limits for traditional 401(k) and Roth 401(k) plans are the same. For 2013, you can contribute up to $17,500 to either type of account ($23,000 if age 50 or older).

Note that Roth 401(k)s have an edge over Roth IRAs because there are no income limits on your eligibility to make contributions. For 2013, eligibility to make Roth IRA contributions phases out for single filers with modified adjusted gross income (MAGI) between $112,000 and $127,000 for single filers and $178,000 to $188,000 of MAGI for joint filers. But you can contribute to a Roth 401(k) regardless of your income level.

New tax break: Under a “hidden” ATRA provision, you can convert regular 401(k) funds to a Roth 401(k) account at any time. Previously, you had to be eligible for a distribution, usually upon attaining a certain age or leaving the ­company. Thus, the new law creates more opportunities for conversions while you are still working.

Of course, you still must pay tax in the year you convert, but it could be well worth it if you expect to be in a higher tax bracket in retirement.

Example: Suppose you are age 40, you’re in the 25% tax bracket and you have $200,000 in your regular 401(k). For simplicity, let’s say you convert the entire $200,000 to a Roth 401(k)

in 2013 and you pay an effective tax rate of 28%. (The actual amount will depend on all the other variables that affect your taxable income level.) Thus, you must pay tax of $56,000 on the conversion.

Assume that the Roth 401(k) grows to $1 million by the time you’re ready to retire in your 60s. No matter how much you withdraw from the Roth 401(k) during retirement, you’ll pay zero federal income tax on the distributions.

Now compare that to the outcome if you accumulate $1 million in a regular 401(k) and you end up in the 35% tax bracket in retirement. In the unlikely event you pull out the entire amount in lifetime distributions, you would pay a whopping $350,000 in federal income tax and maybe state income tax, too.

A more likely scenario: You might withdraw half and pay tax of $175,000—still $119,000 more than the tax currently owed on the conversion. Also, consider the possibility that tax rates will be even higher by the time you’re ready to retire.

On the flip side, switching to a Roth 401(k) may not make sense if you’ll be retiring soon and you expect to be in a lower tax bracket in the future.

Tip: The required minimum distribution (RMD) rules also apply to Roth 401(k)s, but amounts can be rolled over tax-free into a Roth IRA where there are no RMDs.

IRS Oversight Board Fields Tax Season Complaints at Hearing

Michael Cohn for Accounting Today  writes: The Internal Revenue Service’s Oversight Board heard about the various problems encountered by tax practitioners and taxpayers, including the shortened tax season, identity theft and tax fraud.

“We are coming off of one of the most challenging filing seasons I’ve witnessed in my many years as a tax professional,” said Lonnie Gary, chair of the Government Relations Committee at the National Association of Enrolled Agents, at Wednesday’s hearing. “While the ever increasing complexity and instability of the Tax Code provides the assurance that even a ‘good’ filing season will prove challenging, the unprecedented lateness of the American Taxpayer Relief Act of 2012 made planning impossible for many Americans and also compressed a filing season that is already all too brief.”

Gary argued that the IRS’s plans for developing a “real-time tax system” would not be feasible without further truncating the tax-filing season.

“Real-time document matching is infeasible today because IRS does not receive all the information return data in time to perform matching during filing season,” said Gary. “The question before us is how the Service will acquire the information return data in a timely fashion. Something will have to give. Either the filing deadline will need to shift later or the Service will have to require an aggressive due date for the information return data that will be matched. Each of these provides its own challenge—on one hand, the April 15th filing date is deeply entrenched in the American psyche while on the other hand information document providers have struggled to meet the current deadlines.”

AICPA Perspective
Jeffrey Porter, who chairs the American Institute of CPAs’ Tax Executive Committee, testified about tax fraud and identity theft at IRS Oversight Board hearing. He noted that some actions that the AICPA believes would reduce the threat of identity theft would require legislative or regulatory changes. Porter said the IRS’s proposed regulations authorizing filers of certain information returns to voluntarily truncate a taxpayer’s identifying number is a “positive step towards protecting the privacy and security of personal information.” He added that the AICPA is pleased that the proposed regulations would make the truncation program permanent because the AICPA has supported making it permanent for several years.

In addition, Porter said, the truncation program should be extended to permit truncated Social Security numbers on all types of tax forms and returns provided to a taxpayer. That would require a change in the law and he said the AICPA has recommended to Congress that it pass legislation so that truncated Social Security numbers could be used on W-2 forms.

“A fundamental tax administration goal for combating fraud,” Porter said, “is establishing one point of contact within the IRS for prompt resolution of identity theft cases,” as called for by former IRS Commissioner Douglas Shulman and National Taxpayer Advocate Nina Olson.  Currently, 21 units exist within the IRS to help victims of identity theft. Porter emphasized that the IRS “should be provided with the proper resources to fund its mission, since the fight against identity theft fraud is taking a toll on IRS resources.”

He praised the expansion of the IRS Law Enforcement Assistance Program to help state and local law enforcement officials obtain tax return data vital to investigating identity theft cases and the continuing emphasis by the IRS on criminal investigations.

Increased staffing and training are key components of the fight against identity theft, according to Porter.  “We believe the Service should continue to increase the level of staffing dedicated to identity theft cases and improve its training of agency employees to ensure the proper response and assistance for identity theft victims,” Porter said.

Real-Time Tax Challenges
Bernie McKay, chief public policy officer and vice president for corporate affairs at Intuit, testified on behalf of the Council for Electronic Revenue Communication Advancement, or CERCA, noted that the issues of enhancing the accuracy of tax returns and combating identity theft and fraud are strategic priorities, not only for IRS but shared by CERCA as well.

Like Gary, he too shares concerns about the viability of a real-time tax system. “Just as has been the case in the United Kingdom, where the Real Time Tax concept originated, the comprehensive implementation by Government of the initiative is not only a daunting agenda, but, depending on the chosen strategy, potentially a high cost investment for the IRS, and thus the taxpayer, and could represent high cost to the private sector as well, particularly the small business community whose reporting requirements could change significantly,” he said.

James R. White, director of tax issues at the Government Accountability Office’s strategic issues team, pointed out that the IRS is already doing matching, though not in real time. “During 2012, IRS began to match wage and tax withholding data reported on information returns, such as Form W-2, to tax returns in March rather than later in the spring or summer after the tax return filing season,” he said in his prepared testimony. “IRS is exploring the possibility of more extensive matching of information and tax returns before issuing tax refunds. IRS is considering the implications that expanding earlier matching could have for taxpayer and compliance and tax administration efficiency. This approach could also help IRS address identity theft-related fraud.”

Tax Preparer Oversight
Michael R. Phillips, acting principal deputy inspector general at the Treasury Inspector General for Tax Administration, said that TIGTA remains concerned about the ever-increasing growth in identity theft and tax refund fraud and their impact on tax administration. He pointed to the role of tax preparers and discussed how the IRS’s tax preparer regulation regime had been derailed by a court decision early in tax season.

“Every year, more than half of all taxpayers pay someone else to prepare their federal income tax returns,” he said. “Near the end of 2009, the IRS announced a suite of proposed reforms that were designed to improve taxpayer compliance by providing comprehensive oversight and support of tax professionals through its Return Preparer Program. The IRS stated that a well-educated and competent tax return preparer can prevent inadvertent errors, possibly saving the taxpayer from unwanted problems later. In September 2010, TIGTA reported that it will take years for the IRS to implement this Program and to realize its impact. In January of this year, the United States District Court for the District of Columbia enjoined the IRS from enforcing the regulatory requirements for return preparers. The IRS subsequently announced that it had reopened its preparer tax identification number (PTIN) system for new applications and renewals after the court clarified that the injunction did not affect regulations requiring tax preparers to have a PTIN.”

Phillips argued that tax preparers who steal and disclose any taxpayer’s federal tax information as part of an identity theft scheme cause serious harm to taxpayers. “TIGTA focuses its limited investigative resources on investigating identity theft and refund fraud that involves any type of IRS employee involvement, the misuse of client information by tax preparers, or the impersonation of the IRS through phishing schemes and other means,” he said. “For example, TIGTA found that a preparer stole the personal identifiers of several individuals and unlawfully disclosed the information to co-conspirators so they could fraudulently obtain refunds. The subject of the investigation and his co-conspirators ultimately defrauded or attempted to defraud the IRS of at least $560,000 in tax refunds.”

TIGTA has made numerous recommendations on the subject of tax fraud, identity theft, and the Return Preparer Program, Phillips pointed out. These included recommendations that the IRS should implement additional controls to identify and stop erroneous claims for refundable credits before refunds are issued.

“In addition, we recommended the IRS develop or improve processes that will increase its ability to detect and prevent the issuance of fraudulent tax refunds resulting from identity theft,” he said. “Further, we recommended that the IRS improve its oversight of return preparers and better ensure preparers are electronically filing tax returns as required.”

Larry Gray, government relations liaison at the National Association of Tax Professionals, said he agreed with some of the suggestions for combating tax-related identity theft made by National Taxpayer Advocate Nina Olson in her 2012 Annual Report to Congress. Those include restricting access to the Social Security Administration’s Death Master File while still making it available to entities that need it to combat fraud, working closer with the Bureau of Prisons to shut down prisoners engaged in the perpetration of tax fraud, piloting and then further implementing a Real-Time Tax System that effectively uses upfront matching of third-party information to that reflected on tax returns, and improving information sharing with federal, state and local law enforcement.

However, he also sounded a note of caution. “Everyone that makes a mistake or files an erroneous tax return is not necessarily fraudulent,” said Gray. “That may seem an obvious statement, but it bears thought and focus, particularly in light of the emotion and concern on the part of Congress and the IRS. We see calls and proposals for penalties, increased sanctions and additional detailed legislation. We see legislation that utilizes penalties as a source of funding. In particular, we’ve seen rhetoric and anecdotes directed to the preparer community as a locus for fraud and unscrupulous behavior. We neither deny nor dispute anecdotes. We take issue with a broad-brush characterization of tax professionals as the authors and source of the fraud and identity theft problem we’re experiencing.”

Gray pointed out that the United States tax administration system enjoys the highest voluntary compliance in the world largely because of the contributions of those tax professionals that over 60 percent of taxpayers rely on for advice and help.

“There’s a reason why the American public seeks professional help with their tax returns: the law and its regulations are just too complicated,” he said. “They continue to change and proliferate. Very well-intentioned “experts” have a hard time preparing tax returns correctly. The IRS itself, including counsel, has a very difficult time coming up with correct answers.  It may be that another look needs to be taken at what we mean by the word “fraud.” In the vernacular world of taxpayers, what might be considered fraudulence is a misnomer because the action they take is done ignorantly with full intent to comply with rules and regulations that are just too convoluted for them to understand. To complicate matters, they often perpetuate erroneous action by sharing it with others as innocent advice.”