Tax Disasters and Pitfalls
Tony Wrobel, CPA
Now that the tax filing deadline is behind us, at least for now, I thought that it would be helpful to highlight some of the more unexpected problems encountered by taxpayers that I know. These tax nightmares could have been avoided or at least lessened if the taxpayer had been aware of the possible consequences and thus had sufficient time to plan accordingly. Perhaps this information can be helpful to you in planning for your 2006 tax year to avoid any possible tax disasters that may come your way.
Let’s first take a look at a tax disaster scenario and discuss some ways it could have been avoided.
Disaster
At about 4 p.m. on April 17 (last day to file a return without an extension), a friend called and asked me to help him “put together” some numbers, so he could reasonably estimate his 2005 tax liability and remit a check along with his extension. He had received a large bonus early in 2005 and commented that he was not sure that his employer had taken out enough in taxes. He also mentioned that in December he had taken out $35,000 from his 401(k) plan to pay off his credit card debt, even though he was aware that he would have to pay a penalty for early withdrawal.
I quickly prepared a tentative tax return and the tax disaster soon became apparent. He had been accustomed to paying tax in the 15% bracket, but the addition of the bonus income and the 401(k) plan payout now put him into the 28% bracket. His employer had withheld federal income taxes on the bonus money at the required 20% flat rate, but that additional income was now being taxed at the higher 28% marginal rate. He was also faced with the grim reality that not only did he have to pay the 10% penalty on the early distribution from a qualified retirement plan, but that he had to pay “regular” income tax on that same amount. This caused him an overall federal tax burden of 38%. Ouch!
What could taxpayer have done differently to avoid this tax disaster?
Advance planning with a qualified tax professional could have saved him thousands.
Our federal tax structure is progressive. As income is added with no corresponding increase in deductions, it causes a taxpayer to move into another bracket. Each of these brackets carries a higher tax rate. The tax withheld on the taxpayer’s bonus money was too low to account for the effect of “bracket creep.” In this case because of the additional income, he went from paying tax at a 15% marginal rate to a rate of 25% and 28%. A tax projection prepared by his tax preparer would have given him an early warning. He may have opted to have his employer withhold federal income tax on the bonus money at a higher rate or he may have chosen to make an estimated tax payment during the year to help cover the expected tax liability on the bonus money.
There are also several things he could have done to lessen or eliminate the taxes on the early payout from the 401(k) plan. First, the possibility of obtaining a loan from his qualified plan should have been explored. Many plans now have provisions that allow plan participants to borrow money and in essence pay themselves back with interest! The timing was also an issue. If a loan was not an option, then he could have postponed the December plan payout until January and thus the taxation would have been delayed until the next tax year. This would have helped mitigate the “bunching” of income that caused the bracket creep.
Okay, now let’s look at a few common pitfalls.
Pitfall #1
An old friend of the family called me in early April. She was confused as to why she had to pay so much more in taxes this year, since she did not believe she had any significant changes in her tax status from prior years. She is retired, receives a pension and social security benefits, and is heavily invested in mutual funds. Upon examination of her year-end documents, I noticed that the mutual funds had done quite a bit of “internal selling” and the tax reporting statement showed a significant amount of capital gain income. That additional income caused her social security benefits to become taxable at 85%, instead of 50% taxable as in prior years.
Careful consideration must be given to adding (accelerating) income or deductions in a tax year. There are many tax thresholds you need to be aware of that once exceeded can cause a greater inclusion of income or a reduction to an allowed deduction. Obviously, she had no control of the trading activity within her mutual fund account. However, she could have chosen to call the mutual fund broker late in November or early December to get an estimate of the capital gains activity within the fund. She could then have had her tax professional “crunch the numbers” and given her a fair idea of what her tax liability was going to be, so that she had time to plan and prepare before the April filing deadline.
Pitfall #2
Even the savviest taxpayer can experience a “gotcha.” Again, unless you run the numbers by doing a tax projection during the year, a clear picture is not always apparent. For instance, if a taxpayer had a large capital gain in a given tax year from the sale of stock or timber, conventional logic would seem to tell one to shift or bunch deductions in that same tax year to help offset the additional income. However, that strategy may not always prove successful due to the Alternative Minimum Tax or AMT. Taxpayers at greatest risk for paying AMT are those with significant long-term capital gains and dividend income which are subject to preferential low-income tax rates. AMT taxpayers can also be retirees, taxpayers with high state tax deductions, taxpayers with a large number of personal exemptions, and business owners with large depreciation deductions or net operating losses.
Some of the factors that may trigger AMT are highlighted below:
- Owners of closely held businesses operating as S corporations or partnerships that flow through AMT adjustments
- Business owners who incur large long-term gains from the sale of a business
- Business owners who acquire significant assets and utilize accelerate tax depreciation or use the Section 179 expensing provision in the acquisition year
- Executives who exercise incentive stock options
- Individuals who have large long-term capital gains and dividend income, relative to ordinary income
- Employees with large un-reimbursed business expenses, especially from purchase of SUV’s and use of Section 179 expensing deduction
AMT planning operates counter to conventional tax planning. AMT planning frequently focuses on shifting more income to the tax year in which AMT applies. This accelerated income is taxed at the 26% or 28% AMT rate, rather than the higher regular income tax rate. Deferring deductions until the next year may result in a 35% tax benefit, compared to the no tax benefit at all in the current year to the extent AMT applies. This strategy assumes the taxpayer will not be in AMT the succeeding year. A different strategy may need to be developed if it is presumed that the taxpayer will be subject to AMT for successive years. AMT tax planning can be difficult and overwhelming. It is not for the do-it-yourselfer. If you think you may fall into this area, do yourself a favor and discuss it with a well-trained tax professional.
For some years now Congress has been trying to minimize the impact of AMT, especially for the low- to middle-income taxpayers. Even so, it is still anticipated that AMT will remain a problematic area for individual business owners, as well as other higher income taxpayers. If Congress does not enact legislation to minimize the impact of the AMT, it is expected that over 90% of the taxpayers with adjusted gross incomes between $100,000 and $500,000 will be subject to AMT in 2010. We hope Congress moves quickly on this issue, as this is truly a pitfall that could trap a great number of unwary taxpayers and create a tax disaster for some.