Minimizing retirement taxes

Eric Tyson for Trib.com writes: The following excerpt comes courtesy of Bob Carlson, publisher of the "Retirement Watch" newsletter and my co-author on the book, "Personal Finance For Seniors For Dummies": 

Most retirement tax planning and discussions have the wrong focus. They look at marginal tax rates -- the rate on the next dollar of income earned. If you're married and earning $50,000 annually, for example, your next dollar will be taxed at 15 percent.

That's a fine approach during the working years of most people. For retired people, some self-employed people and a few other taxpayers, that's the wrong approach. Different types of income are taxed according to different schedules and at different rates.

A better approach is to focus on your effective tax rate. This is the percentage of all your income that is paid in income taxes. Many retirees can structure their income so that the effective tax rate is lower than the rate they pay during their working years. By making adjustments in investments, retirement-plan withdrawals and other income sources, a savvy retiree can keep his or her effective tax rate around 15 percent without reducing income.

For married couples filing jointly, ordinary and earned income is taxed at the 15 percent rate until taxable income exceeds $72,500 in 2013. (For single taxpayers the ceiling is $36,250.) Qualified dividends and long-term capital gains are taxed at the maximum 20 percent rate, regardless of their amount. For taxpayers in the 15 percent or lower marginal income-tax bracket, long-term capital gains and dividends are taxed at 0 percent. In the 25 percent and 35 percent tax brackets, long-term capital gains and qualified dividends face only a 15 percent rate.

Social Security benefits are tax-free until adjusted gross income reaches $32,000 for a married couple filing jointly or $25,000 for a single taxpayer. Distributions from Roth IRAs and interest from state and local bonds generally are tax-free.

Now, let's look at how you can use these features of the tax code to minimize your effective tax rate:

Wait to take Social Security benefits. As a general rule, delaying the benefits not only increases the amount of benefits, but also increases your tax-exempt income.

Defer traditional IRA distributions until you have to take them after age 70 1/2. Your nest egg lasts longer when taxable accounts are spent first. If you're still relatively young, consider the opposite approach, emptying your traditional IRA early by either taking a distribution or converting it to a Roth IRA. Simply taking a distribution may prove more favorable in the long run if you can then allow the money to grow and compound over an extended time (at least 10-plus years). Converting to a Roth avoids the forced IRA distributions after age 70 1/2  and the higher income taxes that come with them.

Make charitable contributions from your IRA. For 2013, the special tax treatment of charitable contributions from IRAs still applies. You must be over age 70 1/2, and the charitable contribution must be made directly from the IRA to the charity. You don't receive a deduction, but the distribution isn't included in gross income. This can be used for up to $100,000 for the year.

Seek tax-advantaged income in taxable investment accounts. Consider receiving some of your income from stocks or mutual funds that pay qualified dividends. Most U.S. corporate dividends qualify (though real estate investment trust distributions don't) and many foreign corporate dividends are qualified. For fixed income, consider purchasing tax-exempt bonds instead of corporate bonds or treasury bonds.

Manage taxable accounts to minimize taxes. Of course, you should avoid taking profits until you've held an asset for more than one year, if that makes investment sense, so the sale qualifies as long-term capital gain. Look for assets that have lost value. Sell them to capture the capital loss. It offsets capital gains for the year dollar-for-dollar and up to $3,000 of additional losses offset other income. Any excess losses can be carried forward to future years to be used in the same way.

Don't let the tax code alone dictate your financial strategies. Be sure that an investment or strategy really is more attractive after considering its after-tax effects.

Filing Time Doesn't Affect Tax Audits / The IRS won't single you out for filing an extension

• TOM HERMAN for the Wall St. Journal writes:  
Question: If I got an extension to file my federal income-tax return and file it before the Oct. 15 deadline, is that likely to make a difference in my chances of getting audited compared to filing by the April 15 deadline?

Answer: No, replies a spokesman for the Internal Revenue Service. "Extensions have no impact on your chances of being audited," he says.

Several private-sector tax experts agree. "In my experience, the simple answer to your reader's question is that filing in April or October does not affect the chances of being 'audited,' " says David A. Lifson, a certified public accountant at Crowe Horwath LLP in New York.

Just be sure to file on time. "I have also noticed that filing a tax return late almost always attracts extra attention," he says. "So I wouldn't consider missing the Oct. 15 extended due date."

The IRS typically audits about 1% of all the individual returns it receives each year. There are several different types of audits. Most are "correspondence" audits, done by mail. Typically, these occur when you report something on your return that differs from what the IRS has received from employers, investment firms and other sources.

In these cases, you would be instructed to send supporting documents to the IRS, says Stephen W. DeFilippis of DeFilippis Financial Group in Wheaton, Ill.

"If your return contains something that would trigger the IRS matching program 'correspondence audit,' I don't believe it matters when you file," says Mr. DeFilippis, who is an enrolled agent, a tax expert authorized to represent taxpayers at all levels of the IRS. "The computer will pick up on the mismatch whether you file in February or October."

Many other factors can lead to an audit. For example, as the IRS says, your return may be selected on the basis of "computer scoring." The IRS scores returns based on a secret formula designed to spot those where "the potential is high that examination of your return will result in a change to your income tax liability."

Estate tax savings strategies

Karin Price Mueller/The Star-Ledger  writes: Question:. If you lived in New Jersey and wanted to avoid probate, what would you do? This is for a married couple who have a house in their joint names in New Jersey. They also have an interest in a Limited Liability Company, and they want to save on estate taxes, which kick in after $675,000 for New Jersey. Is a revocable trust the right thing?

— Seeking Answers

A. In some states, probate is onerous, time-consuming and expensive. Not so in New Jersey, where the process is fairly simple.

Residents should understand how probate works in New Jersey before deciding to incur the costs and go through the trouble of arranging their affairs to avoid probate after their deaths, said Frederick Schoenbrodt, an estate planning attorney with Neff Aguilar in Red Bank.

He said in New Jersey, the probate process typically involves little more than filing an application for appointment as executor with the surrogate of the county where the decedent resided.

"The original will and a death certificate must be filed with the application, along with a small fee," he said. "After the surrogate appoints the executor by issuing certified Letters Testamentary, the executor must send a Notice of Probate to the decedent’s beneficiaries and next of kin notifying them of the executor’s appointment."

In most cases, the mailing of the Notice of Probate concludes the formal part of the probate process, he said. And unlike some states, the continuing oversight of the executor by the probate court and the preparation and filing of formal accounts are usually not required in New Jersey.

Schoenbrodt said it’s important to understand that avoiding probate means something completely different from avoiding or minimizing estate taxes.

"A person’s non-probate assets are part of his or her taxable estate, so any required estate or inheritance tax returns must still be filed, even if the property was owned by a revocable living trust at his or her death," he said. "The administration of a person’s estate, which includes paying debts and expenses, collecting and distributing assets and filing tax returns, will still go on even if probate is effectively avoided."

If you decide to go the trust route, the administration of your trust will be private.

You’re talking about some specific issues that could use some professional planning help, said Victor Medina, an estate planning attorney with Medina Law Group in Pennington.

"For that reason, I would agree with their suggestion to use a revocable living trust for their planning," he said.

Medina said you can use a joint revocable living trust, which places all assets into a single "bucket" using either spouse’s Social Security number to identify the assets in the trust.

"The advantage here is that with separate trusts, you will always have to make sure that the asset values in the respective trusts are equally balanced," he said. "You can still split out assets into credit shelter amounts and a marital trust. So, you would be able to keep the home in a joint trust, rather than splitting into two trusts, or putting into one spouse’s trust."

Schoenbrodt said revocable living trusts can convey other benefits, outside of probate avoidance.

"The use of a revocable living trust may be advisable if a client is elderly and does or could need assistance managing his or her affairs, if a client owns property out-of-state and wishes to avoid an ancillary probate proceeding in that state, or if privacy, after death, is especially important to the family," he said.

It’s worth meeting with an estate planning attorney to discuss all your options.

Placing the deduction for funeral expenses

Q. As the estate’s executor, can I deduct funeral expenses for a family member on his federal income tax return?

A. No. Funeral expenses aren’t deductible. However, if you must file Form 706, (U.S. Estate and Generation-Skipping Transfer), the estate can then deduct the funeral expenses in calculating its federal estate tax liability. Form 706 is required to be filed when nonspousal beneficiaries receive more than the federal exemption amount ($5.25 million for 2013). Otherwise, there is no tax benefit of any kind for paying funeral expenses.

Tip: The federal estate tax return generally has to be filed within nine months of death, but an executor can apply for a six-month extension, if needed.

Fraudulent Tax Returns?

Stephen J. Dunn, for Forbes writes: Filing a tax return which the taxpayer knows materially underreports his tax is unwise.    It can cost the taxpayer far more in assessments of tax and penalties ultimately made, as well as attorney fees, than the amount of tax evaded.  It can even result in the taxpayer being prosecuted, convicted, and imprisoned.

The IRS most commonly learns of alleged fraud in a tax return from an insider—a disgruntled former employee, spouse, or romantic interest of the taxpayer.  In one case, the taxpayer’s estranged daughter came to the taxpayer and asked him for a job.  The taxpayer hired her, and eventually placed her in charge of a business.  But the daughter mismanaged the business, and the taxpayer closed it.  The prodigal daughter became enraged, and reported her father to the Internal Revenue Service.  IRS Criminal Investigation Division then investigated the taxpayer’s tax returns.  A pair of undercover IRS special agents began appearing at the taxpayer’s principal business, feigning interest in purchasing business.  The taxpayer fell for the ruse, and “puffed” to the purported prospective purchasers, claiming that he actually had substantially more income than reported on this tax returns.

The situation would have been manageable if the IRS did not have the most damning evidence of all—documentary evidence from a third party.  The taxpayer had two bank accounts.  He used the first account to deposit receipts which he reported to his accountant, and which the accountant reported on his tax return.  Receipts deposited into the second account were not reported to the accountant, or on the taxpayer’s tax return.  The IRS learned of the second account from the disgruntled daughter, and subpoenaed bank statements of the account.

In divorces, one spouse often attempts to extort a better financial settlement by threatening to report problems in the other spouse’s tax returns to the IRS.  But if the tax returns are joint tax returns, the reporting spouse will need a grant of immunity from the IRS.

Here is some advice for a taxpayer who may have filed a tax return materially underreporting his tax:

Retain competent counsel.  I am talking about an attorney experienced in representing taxpayers in criminal tax cases.  Not a criminal generalist attorney, or a tax generalist.  For God sakes not an accountant.  Accountants are profoundly ill-equipped to represent taxpayers in criminal tax investigations.  Moreover, there is no accountant-client privilege in Federal court.  When the IRS investigates a criminal tax case, one of the first things it does is subpoena the taxpayer’s accountant and compel him to tell everything he knows about the case, and produce his documents concerning the taxpayer.  Concerned about complicity in the alleged tax fraud, the accountant may be anxious to talk with Federal prosecutors, in return for immunity.

Don’t talk with Federal agents, or with anyone who mysteriously appears at the taxpayer’s business.  Tax crimes are specific intent offenses—the IRS must prove beyond a reasonable doubt that the taxpayer knew that his tax return materially understated his tax.   One of the best ways for the government to prove  is by the taxpayer’s own admissions.  IRS agents make detailed notes of an interview of a taxpayer, and often embellish the taxpayer’s statements, or misquote the taxpayer.  The taxpayer is better off leaving communication with Federal agents to his counsel.

Don’t panic.  The IRS has a heavy burden.  The more complicated the facts and the law, the tougher it is to prove that the tax returns materially understated tax, or that the taxpayer knew it. This too shall pass.

Consider  a voluntary disclosure.  If the facts clearly establish a material underreporting of tax, the taxpayer should consider making a voluntary disclosure.  This decision should not be delayed, as the IRS will accept a voluntary disclosure only as long as the IRS has not opened an investigation of the tax returns.  The IRS no longer recognizes “quiet” voluntary disclosures.  Taxpayer’s counsel makes an initial inquiry of IRS CID as to whether there is a tax fraud investigation afoot at to the taxpayer.  If the answer is negative, then taxpayer’s counsel may submit a voluntary disclosure for the taxpayer, under guidelines prescribed by IRS.  IRS CID will then send taxpayer’s counsel a letter stating that if the taxpayer does what the IRS requires, including filing appropriate amended tax returns and paying the tax due thereon, the taxpayer will not be prosecuted.  The IRS will conduct a civil audit of the amended tax returns.