There is a school of economic theory that says that the level of taxation has a strong inverse relationship with economic growth.  In other words, some believe that low tax rates cause high growth and high tax rates cause slow growth.  This is why some believe that we should not use higher tax rates as part of a long term budget solution.

We do not share that fear.  The following chart shows average federal revenue as percent of GDP, and real GDP growth by decade.

Real GDP by Decade vs. Federal Revenue as a % of GDP

So tax rates and revenues were lowest in the 2000s, but that was also the weakest decade for economic growth.  If a strong inverse relationship exists, than the 2000’s should have instead been our highest growth rate decade of the last four.  And the 1990s should have been the slowest growth decade.

Of course we don’t believe that high tax rates cause strong economic growth and that low tax rates cause weak economic growth.  We think that the evidence indicates that tax rates simply do not have as much impact on growth as some people believe.

Closing the long term budget imbalance will be a positive for our economic future, and higher tax rates are most likely to be part of the solving the budget problem.

Where did it all go?

We all hear about how the US is going broke. Depending on the viewpoint or agenda of the source of what we hear, read or see, the cause of the federal government’s financial problems varies.

Unfortunately, there is almost always a lack of actual facts and perspective, so the public is left to try to make sense of the issues with beliefs and emotions that are often manipulated by politicians wanting votes, vested interests wanting to maintain their sources of money, media outlets whose ratings are dependent on keeping their viewers and listeners emotionally agitated, and fund raisers who’ve learned that messages of potential disaster increase contributions.

Now it is possible to get just the facts about how your own tax dollars are spent. This link http://www.thirdway.org/taxreceipt allows you to input the total federal taxes you paid, and then breaks down where that money went. Most of us will likely have some surprises when we see the actual amounts.

Saving too Much?

Eligible to Contribute?

Roth IRA’s have been around since they were established by the Taxpayer Relief Act of 1997 and are named for the late Senator William Roth of Delaware who introduced the legislation.  They have grown in popularity because of the special tax treatment they receive as long as certain requirements are met.  Although you don’t receive a tax deduction for contributions to a Roth, the earnings grow tax free.  There are certain rules that you have to meet in order to contribute to a Roth; you have to have earned income and your adjusted growth income cannot be above certain limits – for 2011 those limits are $179,000 for married filing jointly and $122,000 for single filers.

I Contributed Too Much!

If you have made a contribution to a Roth IRA and find out later that you either don’t meet the requirements or that you’ve contributed too much you’ll need to take corrective action.  IRS publication 590 explains that an excess Roth contribution “withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed.  This treatment only applies if any earnings on the contribution are also withdrawn.”  The earnings will be subject to a 10% early withdrawal penalty if you are under the age of 59 ½. If you have losses in the Roth account since the excess contribution was made then you’ll need to take out the excess contribution less the losses associated with the contribution. Note that the gain or loss is calculated across the account and not the individual holding that was purchased with the excess contribution.

Making the Correction

In the IRS instructions for form 8606 you can find an explanation that a corrective distribution includes the excess Roth contribution plus earnings and must be reported on form 1040, lines 15a and 15b for the year that the excess contribution was made and you should attach a statement explaining the distribution.  You cannot deduct a loss that occurred.  If you were under the age of 59 ½ the earnings generally will be subject to a 10% penalty which is calculated on form 5329.  The following year you will receive a 1099R from the custodian of the Roth account with a distribution code P in box 7 which indicates return of contribution taxable in a prior year.  If you have already filed your return you still can withdraw the contributed amount plus earnings as long as you do it within six months of the due date of the return.  You’ll need to file an amended return in this case.
The other option for correcting the excess contribution is to apply them to the following year.  Be sure, however, that you expect to qualify based on the earned income and AGI limitations for the year you want to apply the excess contribution as there is a 6% excise tax for each year that it is considered an excess contribution.  If you have chosen to apply the excess contribution to the next year the tax reporting is treated differently.   You will report the excess contribution on form 5329 where the excise tax of 6% of the smaller of the excess contribution or the value of your Roth IRAs as of the end of the tax year is calculated.

Take Advantage

Roth IRA’s are a great vehicle for retirement funding.  There are some rather complex rules associated with Roth’s, however, that can trip you up so you should seek out some professional advice if you are uncertain what applies to you.

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Taking Advantage of your Roth 401k?

It’s very possible that you could be saving more money tax-free.  If your company offers a Roth 401k option, then this could be your ticket.  In recent weeks, the question we’ve heard most from clients is “should I be taking advantage of a Roth 401k?”  To help you make a decision we’ve answered the most common questions that people consider when weighing the benefits of using a Roth 401k.

1.       What will my tax picture look like in retirement? If you think your tax rate will be higher than it is now when you retire, then it might make sense to be making contributions to your Roth 401k option.  As you grow older, you will likely pay down your mortgage and have children move out, leaving you with lower itemized deductions, thus increasing your taxable income.  Similarly, if you plan to have an increased spending pattern in your golden years, then higher taxes will most likely be a reality you will be facing.  Some would argue that given our current state in the tax history of this country, we’re very likely to see taxes increase at some point down the line as well.

2.       Will my paycheck be lower? If you choose the Roth 401k, your paycheck will be lower than when you were making traditional 401k contributions.  This is because your deposits are being taxed before they go into the account.  This is in direct contrast to the 401k you may have already been contributing to.  Those contributions were deposited before they were taxed.  Therefore, less comes out of your paycheck with traditional 401k contributions.

3.       I’m not sure I have enough time before retirement? The time before retirement could make or break your decision.  If you have a 30 year time span in which to invest, the tax-free growth during that time would be hard to beat.  On the other hand, if you are in your late 50’s with retirement no more than 5 years away, the tax-free growth may not be enough to make the switch.

4.       What if I make too much money? There are no income restraints to participate in the Roth 401k.  In order to contribute to Roth IRA’s your income needs to be south of $167k to make the full $5000 ($6,000 if you’re 50 or over in 2010) per year contribution.  By using the Roth 401k, you will be able to deposit $16,500 ($22,000 if you’re over 50) into a tax-free account.

5.       Does my match grow tax-free as well? Even if you decide to fund the Roth 401k, your employer’s match (assuming you receive one) will be funneled to the traditional 401k in pre-tax deposits like it normally would.

Also, as of this year, you are now able to convert a portion of your current 401k to a Roth 401k.  Keep in mind, that each situation is different and you can only truly know if a Roth 401k is right for you by evaluating your own personal situation.

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Deal Nearly Completed

You’ve no doubt heard stories this week that the Obama Administration and Republican leaders have negotiated an end-of-year tax deal which will, among other things, extend the current income tax rates for the next two years for all Americans.  Capital gains and dividends would also be taxed at the current preferred (lower) tax rates.

According to published reports, the compromise measure would also re-institute the estate tax, with a $5 million exemption ($10 million for a married couple), and a top estate tax rate of 35% for amounts above the exemption threshold.

If this estate tax measure is passed, it would fix a major source of estate planning confusion for planning professionals and our clients.  As you know, there is no estate tax for persons who die in 2010; instead, heirs inherit the tax basis of the assets that they receive, which can create some extremely messy tax calculations going forward.  In 2011, if no new law were passed, the estate tax exemption would have reverted to $1 million and the top estate tax rate would have moved up to 55%.

In addition, unemployment benefits would be extended, and there is talk that part of the compromise is to get Republican support for a nuclear treaty that would reduce Russian stockpiles.

From a budget standpoint, the deal will add an estimated $314.9 billion to the U.S. government’s deficit over the next two years.

There appears to be no written version of the compromise; at least nothing has been published in the media so far.  We should know a great deal more in the next few weeks, as Congress hammers out the final details.  Obviously, this last-minute tax measure makes precise tax planning a bit difficult.  But we’ll stay on top of developments, and keep you posted when we know more.

Sources

Estate tax provision: http://www.frumforum.com/the-estate-tax-rises-from-the-dead

Outline of tax compromise: http://blogs.wsj.com/washwire/2010/12/07/the-big-issue-the-cost-of-a-second-year-of-tax-cuts/

This post was authored by Bob Veres as a part of his “Client Articles” service.  He is the publisher of Inside Information, an industry leading publication for financial advisors.

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Photo Credit: David Remer's Hammer Photography

While we emphasize the importance of annual tax planning, it’s also important to not let tax avoidance override your other financial goals.  Liz Davidson, of Forbes.com, wrote a nice piece describing how people lose money when they let tax issues dominate their investment decisions. The article does a great job of examining why payments to the IRS can be such a tough pill to swallow and identifies traps most of us fall into in an attempt to shrink our tax bill.

Please contact us if you have questions about appropriate strategies for reducing your tax bill while also staying on track for your long term goals.

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Know Your IRS Numbers

Unfortunately, there’s no rhyme or reason that will help you to remember the different IRS form codes.  But, remembering the following two will assist you greatly if you encounter a situation like we described above.  After you initiate a rollover of a former 401k or 403b, you should expect to receive a Form 1099R.  This form is used to report distributions from IRAs whether they are taxable or not.  The second form, Form 5498, you will need is not as well-known but equally as important.  This form’s purpose is to report the rollover contribution made to your new IRA.  These two forms work from opposite ends in the event of a rollover, conversion or recharacterization.  Be especially vigilant when reviewing this information when a transaction starts at one trustee and ends up at another.

For example, if you completed a direct trustee-to-trustee rollover out of a Fidelity 401k into a Vanguard IRA you should receive a 1099R from Fidelity and a form 5498 from Vanguard.  The Fidelity 1099R should show the total amount in box 1 and a code G in box 7 for the direct rollover.  The Vanguard 5498 should show the same amount in box 2 Rollover contributions.

If you completed the rollover within 60 days, where you received a check from one trustee and then made the rollover contribution within that time frame you’ll want to make sure that the form 5498 is accurately reporting the rollover in box 2.  More than likely the trustee issuing the 1099R for the distribution will report a taxable transaction.  You should indicate “rollover” on your tax return and the IRS will get the form 5498 to back that up.

May 31st Tax Deadline?

The trustee that maintains your individual retirement accounts (IRAs) is required by the IRS to report contributions, required minimum distributions and the fair market value of the account by May 31.  This date may seem like an odd time to receive a tax form since you’ve probably already filed your return.  However, form 5498 reports contributions made to an IRA during the tax year as well as those made after December 31, but before April 15^th for the previous tax year.  Make sure that those contributions match up to what you have reported on your tax return. If not, contact the trustee that sent the form 5498 and request a correction.

RMD’s not WMD’s

Another place to be sure that the information provided by the trustee matches your records is Required Minimum Distributions.  There are some fairly complicated rules regarding RMDs, especially if the account was inherited, so it makes sense to double check the accuracy on form 5498.

Understanding how this form is used by the IRS can help keep your tax headaches to a minimum.

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What if you never again had to prepare your tax return? Or pay someone to do it for you?  The catch is that the IRS would be the ones who prepare it.  Sound a little scary?  The Bipartisan Tax Fairness and Simplification Act of 2010 introduced in the Senate has a provision for just that scenario.

http://www.theatlantic.com/business/archive/2010/02/will-the-new- tax- reform-bill-kill-h-r-block/36605/

The repeal of the federal estate tax is only in effect for 2010.  After this year, the estate tax is scheduled to be reinstated at levels prior to President Bush’s tax cuts becoming law.  So, rather than receiving a $3.5 million exemption per person and a top tax rate of 45% as was available in 2009, 2011 estate tax law will offer only a $1 million exemption and a maximum rate of 55%.  You don’t have to do the math to realize how big of a change this is.

Secondly, there are some unintended consequences that may come into play as a result of this repeal.  A common estate planning strategy is to use something called a “bypass trust” with the intention of taking advantage of the maximum estate tax exemption.  This strategy was used based on the federal estate tax law being in effect.

Since there is no estate tax for 2010, the wording in the legal documents that are the basis for creation of the trust could be problematic.  They might say something like, “Place all of my assets that are not subject to the estate tax into a trust for my children, then leave everything else to my spouse.”  In the worst case scenario, a spouse could be left with nothing as all of the assets are directed into the trust because they aren’t subject to any estate tax.  Most states have some protection afforded the spouse, however, the potential litigation involved could certainly drain the assets being contested.  This could get especially nasty if there were children from a previous marriage involved.

Another consequence of this repeal is the impact on the “step-up in basis” rule.  This rule basically said that whatever valuation an asset had on the owner’s date of death is the value that the heirs could use as their new tax basis.  For example, if Mrs. Smith died in 2009 while owning stock in IBM that she purchased thirty years ago, under the step-up rule, her heirs could use the stock price as of the day of death to calculate basis for any future sales of the stock.

For 2010, things are a little bit different.  Heirs are only able to use the step-up rule for $1.3 million worth of asset appreciation.  Spouses get an addition $3 million in appreciation.  If Mrs. Smith dies in 2010, depending on the size of her estate, her heirs would need to know what amount Mrs. Smith purchased the IBM stock for, any dividends that were reinvested, and stock splits received in order to assign tax basis.  Not only is this a costly change for heirs, but also a documentation nightmare for tax preparers.  Like the estate tax, the unlimited step-up is scheduled to return in 2011.

Many observers of this mess think that Congress will retroactively impose a fix to undo the estate tax repeal.  However, that is certainly not a given and even if it does happen, what new, unintended consequences will be inflicted on otherwise well-laid plans?

If you have not yet made the maximum contribution, you still have time!  Tax payers have until April 15^th of 2010 to make their Roth contributions for the 2009 tax year.  If you are within the income limitations to make contributions, a Roth IRA is an excellent investment account as investment growth is tax deferred and withdrawals in retirement can be tax free.  For 2009, single filers are able to fund their Roth IRAs with 100% of the contribution limits if their income is below $105,000.  Their amount of contribution availability drops if they are above the $105,000 and are phased out completely at $120,000.  For Married Filing Joint taxpayers, income restraints begin at $166,000 and end at $176,000.

Looking forward for 2010 contributions, contribution limits for this year have stayed the same.  This includes the limits for the Roth and Traditional IRAs and the majority of employer sponsored plans such as 401ks and 403bs. A very good practice is to contribute enough of your salary to receive at least the employer match.  Also, pay raises often present an easy opportunity to increase your deferral, while reducing your adjusted gross income.

The contribution limits for nearly all types of retirement plans are listed in the following chart:

Our wealth management service monitors your income and determines every year how much you should be contributing to each of these investment accounts.  It also reviews your income tax and estate picture, which may provide opportunities for tax savings.  If you are interested in this service, please contact us.