Avoiding Taxes on Your IRA

Bob Carlson for Investing Daily writes: Yes, your IRA could be hit with income taxes, even if it’s a Roth IRA. This is nothing new. The potential for an IRA or other qualified pension plan to owe taxes has been in the law for a long time. It hasn’t affected many investors, because it is only in the last few years that many investors sought investments other than traditional stocks and bonds and related mutual funds.

Keep in mind that an IRA is a separate taxpayer and is subject to different rules than you are. Most of the time IRAs are tax-exempt and have more favorable rules than you do, but there are a few exceptions.

The trap IRAs are most likely to fall into is what the tax code calls unrelated business taxable income (UBTI). When an IRA earns gross UBTI exceeding during a year $1,000, it must file a Form 990-T and pay income taxes at the corporate tax rates. An IRA also must pay estimated income taxes during the year if the tax is expected to exceed $500. The return is filed by and the taxes are paid by the IRA, not by the owner or beneficiary, and the custodian or trustee of the IRA is supposed to be responsible for filing the return and paying the taxes from the IRA. But the custodian might not receive the Form K-1 reporting the income or might not file the return. As the IRA owner and beneficiary you ultimately bear the cost of any taxes and penalties, so be sure to check with your custodian and coordinate who will file the form and pay the taxes. Most trustees and custodians will charge for filing the return.

The $1,000 limit applies to the IRA, not to each investment in the account. If all the UBTI earned by the IRA during the year exceeds $1,000, the tax obligation is triggered. Also, the $1,000 limit applies to the IRA, not per taxpayer. When you have more than one IRA, each IRA has its own $1,000 UBTI limit.

You want to avoid UBTI, because the IRA owner essentially is taxed twice on it. The IRA will be taxed on the income. Subsequently, the owner or beneficiary will be taxed on distributions of that income. No deduction or credit is available to the owner for UBTI paid by the IRA and the tax is not added to the tax basis of the IRA.

An IRA potentially has UBTI if it does any of the following:

* operates a trade or business unrelated to its tax-exempt purpose,

* receives certain types of rental income,

* receives certain passive income from a business entity it controls,

* invests in a pass-through entity, such as a partnership, that conducts a business, or

* uses debt to finance investments.

Any business is considered unrelated to the exempt purposes of an IRA or other retirement plan. Fortunately, the tax code specifically excludes from the definition of trade or business income interest, dividends, capital gains, and profits from options transactions. Royalties also are generally exempt. Some types of rent are exempt; others aren’t.

Controlling a business entity can convert exempt income into UBTI. When an IRA has greater than 50 percent control of a business entity, rent, interest, or royalties paid by the entity to the IRA generally are UBTI.

An IRA is most likely to run afoul of the UBTI restriction when it owns an interest in a pass-through business entity (partnership or limited liability company), because income from these entities is UBTI even if the IRA doesn’t own a controlling interest. Master limited partnerships (MLPs) most often trip up IRA owners.

MLPs are traded on major stock exchanges, and many people think of them as being the same as corporate stock. In fact, these are partnership units, and the income and expenses of the partnerships pass through to the owners at tax time. Owners receive K-1 statements each year instead of 1099s to use in completing their tax returns. The K-1 states the amount of UBTI  and other income and expense items attributable to the IRA.

Individuals generally are urged not to purchase MLPs through IRAs, but it isn’t illegal to own an MLP through an IRA. Owning an MLP through an IRA or other qualified plan is discouraged because of the potential for the IRA to be taxed and have to incur the expense of filing different tax returns.

Owning an MLP through an IRA creates UBTI and possibly the requirement to file a Form 990, pay taxes, and pay estimated taxes during the year. Once the $1,000 income threshold is crossed, there is no tax advantage to owning MLPs through an IRA. (When MLPs generate more than $1,000 of UBTI in an IRA, some tax advisors recommend taking the easier and cheaper route of reporting any IRA-owned pass through items on the individual tax return instead of taking the time and expense to file a separate return for the IRA. It’s not clear this satisfies tax code requirements, and if you choose this route be sure your custodian is not also filing and paying the taxes from the IRA.) Also, remember that UBTI is taxed at corporate rates, not individual rates. That makes holding a large amount of MLPs in an IRA unattractive.

There is another reason to make MLP investments outside of a tax-deferred or tax-free account. Most MLPs already have tax advantages. Their operations generate depreciation deductions or other write offs that make a high percentage of income distributions tax free. These tax benefits are diminished when the MLP is owned inside a tax-favored account. (Though the tax advantages of owning an MLP outside an IRA can diminish after an MLP is owned for about 10 years or so.)

Another time an IRA is very likely to have UBTI is when debt is used to finance investments. Any type of income can become UBTI when debt is used to finance the property that generates the income. For example, if an IRA receives a margin loan from the custodian or broker, income generated by the securities purchased with the loan proceeds would be UBTI. An IRA can own real estate and earn rental income, and that rental income will be tax deferred. If the real estate is financed with a mortgage, however, the rental income becomes UBTI.

What about when an investment that generated UBTI is sold? Suppose, an IRA has a substantial investment in master limited partnerships that generated a few thousand dollars of UBTI each year. The IRA sells the MLPs at a gain. Is the capital gain UBTI? No. Only the business income generated by an investment is UBTI. Any capital gains from selling that investment are not UBTI.

When property that was financed with debt is sold, however, the capital gain from that sale is taxed as capital gains to the IRA. If the MLPs were purchased with margin loans, for example, the capital gains would be UBTI.

The UBTI rules are broad and extensive. You have to be especially careful of debt-financed investments, business ownership, and ownership of pass-through entities.

High-Income Earners Seek Strategies to Cut Year-End Tax Bite

 MARGARET COLLINS AND RICHARD RUBIN and 

BLOOMBERG for accountingtoday write: The higher tax rates passed by Congress this year have some top U.S. earners seeking last-minute strategies to lower their tax bite as year-end calculations turn up unpleasant surprises.

“There are many, many high-income taxpayers now who are finding themselves facing tax rates in excess of 50 percent,” said Suzanne Shier, a tax strategist and director of wealth planning at Chicago-based Northern Trust Corp. “That really gets their attention.”

High earners are seeing a combination of federal tax increases for 2013: a top marginal rate of 39.6 percent, up from 35 percent; a 20 percent tax on long-term capital gains and dividends, up from 15 percent; and a new 3.8 percent tax on investment income. Also, limits on exemptions and deductions are taking effect for this tax year.

Some top earners are only now realizing they may owe much more by April 15 because they’ve been paying quarterly estimated taxes based on their liability for 2012, which the Internal Revenue Service allows in a “safe-harbor” rule, said Elda Di Re, a partner at Ernst & Young LLP.

Others are absorbing the effects as they rush to implement strategies before Dec. 31 to limit the tax bite on earnings, market gains and stakes in businesses.

States’ Take
State taxes can push the bill higher for some high earners. In California, the top rate is 13.3 percent on income exceeding $1 million.

Investors with significant portfolios are seeing some of the biggest increases this year, said Martin Kalb, co-chairman of the global tax group at Greenberg Traurig LLP.

For wealthy taxpayers, the rate on long-term capital gains and qualified dividends now can be as much as 25 percent, including the new surtax and limits on deductions, Kalb said. That’s a 67 percent increase from 2012. The rate on other investment income such as royalties, interest and rents can exceed 43 percent.

“Clients are a little startled at the amount of additional taxes they are paying,” said Maury Cartine, a partner at Marcum LLP whose clients include private equity and hedge fund managers.

According to an analysis by Cartine, a married couple in New York with $600,000 in wages, $100,000 in qualified dividends and $300,000 in long-term capital gains—as well as $145,000 in itemized deductions for real estate taxes, mortgage interest and state and local taxes—would pay about 17 percent, or $37,000, more in U.S. taxes this year.

$450,000 Threshold
By comparison, a family with $600,000 in wages, no investment income and $105,000 in itemized deductions would see about a 2 percent, or $3,000 increase, he said.

Congress set the top tax rate for income above $450,000 for married couples or $400,000 for individuals, after deductions. Those are the same thresholds for the top levy on long-term capital gains and dividends.

Additionally, two new taxes to help finance the 2010 health-care law—a 3.8 percent surtax on investment income and 0.9 percent added levy on wages—apply to income of more than $250,000 a year for married couples and $200,000 for individuals.

Lawmakers also reinstated phaseouts of personal exemptions and itemized deductions for adjusted gross income exceeding $250,000 for individuals and $300,000 for married couples.

‘Big Surprise’
“It’s going to be a big surprise when they find out they aren’t going to be able to take all of their itemized deductions,” said Tracy Green, a vice president in tax and financial planning in the advisory unit of Wells Fargo & Co.

With less than two months left in the tax year, advisers and accountants are focusing on clients with closely held business stakes, mutual-fund holdings, charitable donations and retirement accounts to help maneuver around higher rates.

To minimize the effect of the 3.8 percent tax, high earners are reviewing their interests in S corporations and other flow-through entities to see if they can become active rather than passive participants, said William Zatorski, a partner in PricewaterhouseCoopers LLP’s private company services practice. Business income from active participation isn’t subject to the surtax and that shift in S corporations doesn’t trigger self- employment tax, he said.

This year’s stock market rally—the Standard & Poor’s 500 Index returned 25 percent through October—has tax implications for many investors with mutual funds, said Green of Wells Fargo Advisors.

Capital Gains
“This year the chances of having long-term capital gain distributions are going to be pretty good,” she said.

Mutual fund companies are releasing estimates of distributions this month, which investors can use to plan, Green said. Those intending to sell a fund should do so before distributions, while investors seeking to buy shares should wait until after, she said.

Some high earners may have to shift their usual year-end strategies because the new top rate means they are no longer subject to the alternative minimum tax, or AMT, said Di Re of Ernst & Young. Taxpayers not subject to the minimum tax can pre-pay state income or real estate taxes before Dec. 31 to lower their taxable income, Zatorski of PwC said.

Bumping up charitable donations is another strategy, Kalb of Greenberg Traurig said. Taxpayers with gains in publicly traded stocks can donate them to a public charity or their own private foundation. They’d be eligible for a charitable deduction equal to the fair value of the security, and would avoid the long-term capital gains rates, he said.

Retirement Plans
Individuals age 70 1/2 or older should consider giving as much as $100,000 to a qualified charity directly from an individual retirement account, Wells Fargo’s Green said. The donation can meet all or a portion of the annual required minimum distribution for IRA owners and isn’t recognized as income.

Also, high earners can maximize contributions to tax-advantaged retirement plans and realize some losses to offset capital gains, Green said.

Another recommended strategy is to defer income by investing in private-placement life insurance and private annuities. These are designed for high net-worth individuals, Kalb said.

Looking Ahead
Beyond 2013, high-income investors can add tax-exempt bonds or convert some retirement savings to Roth accounts, Green said. When savers put money into Roth IRAs and Roth 401(k)s, they pay taxes on the money upfront in exchange for tax-free withdrawals later.

Funds that capture losses throughout the year to offset gains will be especially attractive to investors because the strategy can reduce net income reported on tax returns at year-end, Shier of Northern Trust said.

Once high earners figure out this year’s strategy, advisers are saying they should keep an eye on moves in Congress that could change their future tax picture.

House and Senate panels are considering making the biggest changes to the U.S. tax code since 1986. Representative Dave Camp, chairman of the House Ways and Means Committee, wants to lower the top individual rate to 25 percent in a way that would require eliminating or curbing many tax breaks. Camp, a Michigan Republican, has said he will release a plan this year.

Passage of any revisions would be difficult and wouldn’t happen until sometime in 2014, at the earliest.

The possibility of more tax changes has some high earners taking advantage while they can of breaks such as the sales tax deduction, Kalb said. That benefit, which allows deducting sales tax instead of state income tax, is set to expire Dec. 31 along with some other breaks.

“A lot of my clients are looking to buy very expensive assets that will pay a lot of sales tax, especially in Florida,” which doesn’t have a personal income tax, Kalb said. “If someone buys a $2 million boat this year, they can get the deduction for sales taxes.”

Why Not Use Tax Preparers To Sign People Up For ObamaCare?

Howard Gleckman,for Forbes writes: What if we bought individual health insurance through our tax preparers? At first, the idea seems bizarre, but give me a minute to explain.

Given the well-known problems of HealthCare.gov and many of the state health exchanges, people seeking insurance coverage need a better way to buy. And commercial alternatives to government sites seem an obvious portal to Affordable Care Act coverage.

You can buy directly through insurance company websites, but the Obama Administration worries that would make it impossible to compare policies offered by different carriers in the way you could on a well-functioning exchange. For instance, if I go the Blue Cross site, I’m not likely to learn much about Kaiser Permanente’s offerings. On the other hand, commercial online health insurance marketplaces allow for comparison shopping, but raise issues of privacy (and perhaps even fraud from fake sites).

Or, you could make your purchase of health insurance a relatively seamless part of filing your tax return.

It actually makes a lot of sense. After all, the Affordable Care Act subsidies are tax credits and the information you need to figure out your subsidy amount is based on the income tax you pay. The penalty you’d owe for not buying insurance is a federal tax. Tax preparers already have—and are legally required to protect—nearly all the personal information they’d need to help figure the subsidy.

Storefront tax preparers can connect customers to health insurance markets through in–person contact. Or people could link electronically through a website such as Intuit INTU +0.56%’s TurboTax.

Brian Haile, Jackson Hewitt’s senior vp for health policy, predicts more people could end up buying through their connection with tax preparers than any other portal. “It’s a no-brainer,” he told me, “The Affordable Care Act is a series of amendments to the Internal Revenue Code and we help customers with their taxes. We can make this far more accessible for folks.”

I’m hardly the first person to think of this. My Urban Institute colleague Stan Dorn has been exploring this idea since 2011—long before the HealthCare.gov site crashed. And now tax prep outfits are taking steps in this direction.

Tax preparers won’t act as insurance brokers themselves. Instead, they are partnering with commercial online health marketplaces to ease enrollment.

For example, Jackson Hewitt is working with the online marketplace Getinsured to enroll people. Jackson Hewitt will calculate subsidies and potential penalties and, if customers choose, transmit that information to Getinsured. If the Jackson Hewitt customer wants to buy coverage, all she’ll need to do is pick an insurance plan. Jackson Hewitt can even fill out all the paperwork for people to enroll in Medicaid. It says it will not charge for any of these insurance-related services.

Because Jackson Hewitt has 2,800 locations in Walmart stores, it could be an especially important link to the uninsured.

H&R Block HRB +1.17% announced in September that it is partnering with the commercial online health exchange GoHealth to help people enroll through Block-branded online chat and phone support. Block also announced that it will have insurance agents located in its Arizona tax offices as part of a pilot program.

Intuit has created a product called TurboTax Health to assist buyers and has entered into its own partnership with the commercial online marketplaceeHealth EHTH +0.75% Inc.

Combined, these three firms alone claim to help file nearly 50 million returns—making them a huge potential portal for insurance buyers. The IRS estimates that about two-thirds of low-income taxpayers use paid preparers–many use walk-in firms such as Block and Jackson Hewitt. And Haile estimates that 90 percent of the uninsured get refunds. He predicts these individuals will be far more interested in buying insurance with those refunds in-hand than they are today, when they are focused on holiday shopping.

Using tax prep firms as a link into the health insurance market won’t solve all the problems of the Affordable Care Act. For instance, the Obama Administration still needs to make sure the back end of its electronic system works, including the government data hub needed to verify buyer information. But Haile is right: For many people-especially those eligible for subsidies—the tax filing season is a perfect time to enroll and tax preparers are a great way to connect them to plan options.

Given its problems with the government site, the Administration ought to be promoting these commercial alternatives. And tax prep firms ought to seize the opportunity.

Tax Prep for Next Year: What You Can Do Right Now

Jim Staats for Daily Finance writes: There's a pretty hefty lineage if you take the time to research the origins of the phrase "the early bird gets the worm," with many branches traced to the hardscrabble foundation of America's Industrial Revolution. Revolution or not, it comes down to the benefits of hard work over laziness.

The suitably fed early bird in our little story here is the well-prepared, and thus calm, taxpayer (yes, there is such a thing). These "early birds" do not consider the arrival of W-2 forms early next year the kickoff to their 2013 tax preparation season.

If you're smart, you already are in tax preparation mode, or will be after reading this.

You don't want to be left without a worm, right? Kind of a bummer, at least if you're a bird.

One quick note before we deep dive into tax morass: It is always advisable to consult your tax professional before making any alterations to your tax profile. You're more likely to have some quality time bending this person's ear at this time of year as well. Just another benefit of early tax-preparation efforts.

Politics plays a part Surprisingly, politics plays a role in year-end tax planning strategies -- this year more so than most.

The recent government shutdown forced the IRS to announce a delay to the 2014 tax filing season of up to two weeks. The upshot is that tax refunds could be delayed, while the end of the filing season stays put at April 15.

Recent laws with tax implications include the American Taxpayer Relief Act of 2012 (ATRA, signed into law in January), the Patient Protection and Affordable Care Act of 2010 (with provisions taking effect in 2013 and 2014), recent rulings on same-sex marriage, and additional tax reform likely in 2014, which will require some blind forecasting.

Boiled down, these mean income tax rates remain unchanged for all but higher-income taxpayers. ATRA sets the maximum income tax rate at 39.6%, while the Affordable Care Act's new surtax on net investment income and additional Medicare tax both kicked in as of Jan. 1 this year.

Federal income tax rates for long-term capital gains and dividends for this year also remain the same for most folks: either 0% or 15%. However, higher-income earners take another hit here, as ATRA raised the maximum rate to 20% for singles with taxable income more than $400,000, married joint-filing couples with income more than $450,000, and a head of household earning more than $425,000. In 2014, those thresholds increase to $406,750, $457,600, and $432,200, respectively.

Taxpayers may want to consider using carry-forward losses from 2012 by recognizing capital gains to the extent they are available, because those are taxed at the ordinary-income rates.

This year more than most, year-end planning should look to avoid spikes in income, whether capital gains or other income, that could break through either the 39.6% bracket or 20% capital gains bracket.

And one helpful suggestion for those lucky enough to be in the "high earner" category: While your income may be too high to take advantage of lower rates, you probably have loved ones who can benefit. You can always give them appreciated stock, dividend-paying stocks, or mutual fund shares. Done the right way, and with the assistance of your tax advisor, these can be very tax-smart ideas.

The joy of prepaymentsIf possible, making payments this year that you would normally make early next year, including state and local income tax, property taxes, charitable donations, and deductible expenses (for those who itemize deductions), can help increase your 2013 write-offs and, consequently, lower your tax bill.

Other items to consider for year-end prepayment with possible tax benefits include college tuition bills, planned medical expenses and expenditures like job-hunting and investment fees, and payments for tax preparation and advice.

One caveat to this strategy is owing the alternative minimum tax, or AMT, for this year. If you know that to be the case, prepayment of state and local income and property taxes will backfire, as write-offs for those items are disallowed under AMT rules, as are miscellaneous itemized deductions.

We'll end our fun tax chat here on a high note, especially if you like the idea of retail therapy.

You can deduct sales taxes on a major purchase, such as a motor vehicle, home, or large-scale renovation to your home, so if you've been thinking about pulling the trigger on a big-ticket item, do so before the year's end.

Of course, such write-offs will only be realized for those who itemize, and some benefits could be lost if you're hit with the AMT.

In all, a lot of things done now could put a smile on your face come tax time.

Here are some lifecycle changes to factor into both year-end tax strategies and future tax planning:

• Change in filing status: marriage, divorce, death or head of household changes
• Birth of a child
• Child no longer qualifies for child credit
• Child no longer qualifies for "kiddie" tax
• Casualty losses
• Changes in medical expenses
• Moving/relocation
• College or other tuition expenses
• Employment changes
• Retirement
• Personal bankruptcy
• Inheritance
• Business success or failure

Targeting Offshore Accounts The U.S. Government Is Now Seeking Information Directly From U.S. Banks

Laura Saunders for the Wall St Journal writes: In a fresh assault on undeclared offshore accounts, two federal courts have approved the issuing of summonses to five U.S. banks in connection with transfers made on behalf of two foreign banks, officials announced this week.

Citigroup's C +0.38% Citibank unit andBank of New York Mellon BK +0.88% have been ordered to turn over information about U.S. taxpayers who might have evaded taxes by holding undisclosed accounts at Switzerland's Zuercher Kantonalbank,ZGLD.EB -0.12% or ZKB.

Citibank, J.P. Morgan Chase, JPM +0.86%HSBC Holdings ' HSBC Bank USA and Bank of America BAC +0.84% have been ordered to turn over similar information in connection with accounts held at the Bank of N.T. Butterfield & Son and its affiliates in the Bahamas, Barbados, Cayman Islands, Guernsey, Hong Kong, Malta, Switzerland and the United Kingdom.

The "John Doe" summonses allow the Internal Revenue Service to obtain names or other information for taxpayers in a certain group, such as tax evaders holding secret offshore accounts, based on evidence that such a group could exist.

The summonses also seek information about U.S. taxpayer accounts held at other foreign banks that might have used ZKB or Butterfield's U.S. "correspondent" accounts. A correspondent account is typically maintained by an overseas bank without U.S. branches to serve U.S. clients.

In a statement, ZKB said that the bank was aware of the summonses, calling them "standard requests" in tax investigations, and noted that they weren't issued to the bank itself.

A spokesman for Butterfield, which was established as a private bank in 1858 in Bermuda, wrote in an email that the bank hasn't been contacted by U.S. authorities about the matter and added, "We intend to cooperate fully with authorities and our correspondent banks in regards to this matter, whilst adhering to the laws of the jurisdictions in which we operate."

A spokeswoman for HSBC wrote in an email that the bank "cooperates with requests from U.S. authorities" while "complying with the law in all jurisdictions where it operates."

Spokesmen for BNY Mellon, Citibank, J.P. Morgan Chase and Bank of America declined to comment.

A John Doe summons played an important role in the U.S. pursuit of Swiss banking giant UBS UBS +0.05% and U.S. account holders at the bank in 2009, which pierced the decades-old veil provided by Swiss bank-secrecy laws.

Experts say the recent moves by U.S. authorities seemed timed to put further pressure on Swiss banks, which face key December deadlines in a program offered by U.S. officials to settle allegations that they helped U.S. account holders evade taxes. Banks that enter the program might have to pay large penalties and turn over U.S. taxpayer account data, but they would avoid prosecution.

A spokesman for the IRS declined to comment.

To support their requests involving ZKB and Butterfield, U.S. officials disclosed that the IRS's limited-amnesty program for taxpayers with undeclared offshore accounts included 371 secret accounts held at ZKB and 81 at Butterfield or its affiliates.

They also argued that U.S. taxpayers with secret offshore accounts often gain access to their funds via transfers through correspondent accounts. In a fresh assault on undeclared offshore accounts, two federal courts have approved the issuing of summonses to five U.S. banks in connection with transfers made on behalf of two foreign banks, officials announced this week.

An IRS declaration filed with the court provided examples of 10 unidentified taxpayers who held secret accounts at Butterfield and later confessed them in the IRS's limited amnesty program, with details of how the accounts were opened and maintained.

According to the declaration, two of the taxpayers were sisters who had money wired to them in the U.S. through a correspondent account at Bank of New York.

"Correspondent accounts are the Achilles' heel of offshore banking, and they can open a window into almost any bank in the world," says Daniel Reeves, a retired senior IRS official who led the agency's civil investigation into UBS.

Scott Michel, a lawyer at Caplin & Drysdale in Washington who has handled many offshore-account cases, says gathering information through John Doe summonses of correspondent accounts is likely to be efficient.

"The IRS is showing that it can tap vast data pools without having to worry about bank secrecy laws in other countries," he says.

—John Letzing contributed to this article.