Tax Changes Coming in 2018

Congress appears poised to enact a major tax reform law that could potentially make fundamental changes in the way you and your family calculate your federal income tax bill and the amount of federal tax you will pay. Keep in mind, however, that while most experts expect a major tax law to be enacted this year, it is by no means a sure bet. So keep a close eye on the news and don't swing into action until the ink is dry on the President's signature of the tax reform bill.

 

Beginning next year, the bill would repeal or reduce many popular tax deductions in exchange for a larger standard deduction. Here's what you can consider doing before year end to maximize your tax benefits:

For taxpayers that itemize:

• Pay the last installment of estimated state and local taxes for 2017 by December 31 rather than on the 2018 due date and prepay real estate taxes on your home.  They are proposing limiting the taxes that can be included in itemized deductions to $10,000.

• Because most other itemized deductions would be eliminated in exchange for a larger standard deduction (e.g., $24,000 for joint filers), charitable contributions after 2017 may not yield a tax benefit for many. If you think you will fall in this category, consider accelerating some charitable giving into 2017.

Timing of business income and deductions:

Due to a general reduction in tax rates and new reduced tax rates on business income in the tax reform bill, it will often be advisable (more often than most years) to defer income and accelerate expenses. So if you have purchases you need to make in the near future, accelerating those expenses into 2017 will likely result in greater tax savings than incurring the same expense in 2018. Similarly, income may be deferred by delaying billings (cash-basis taxpayers) or delaying deliveries (accrual-basis taxpayers).

We have included the proposed tax rates for single and married taxpayers below.  If you would like more details about any aspect of how the proposed legislation may affect you, please do not hesitate to contact us. 

 

FOR MARRIED INDIVIDUALS FILING JOINT RETURNS

      AND SURVIVING SPOUSES:

If taxable income is:          The tax is:

--------------------           -----------

Not over $19,050               10% of taxable income

Over $19,050 but not           $1,905 plus 12% of the

  over $77,400                   excess over $19,050

Over $77,400 but not           $8,907 plus 22% of the

  over $165,000                  excess over $77,400

Over $165,000 but not          $28,179 plus 24% of the

  over $315,000                  excess over $165,000

Over $315,000 but not          $64,179 plus 32% of the

  over $400,000                  excess over $315,000

Over $400,000 but not          $91,379 plus 35% of the

  over $600,000                  excess over $400,000

Over $600,000                 $161,379 plus 37% of the

                                 excess over $600,000

 

FOR SINGLE INDIVIDUALS (OTHER THAN HEADS OF HOUSEHOLDS AND

      SURVIVING SPOUSES):

If taxable income is:          The tax is:

--------------------           ----------

Not over $9,525                10% of taxable income

Over $9,525 but not            $952.50 plus 12% of the

  over $38,700                    excess over $9,525

Over $38,700 but not           $4,453.50 plus 22% of the

  over $82,500                    excess over $38,700

Over $82,500 but not           $14,089.50 plus 24% of the

  over $157,500                   excess over $82,500

Over $157,500 but not          $32,089.50 plus 32% of the

  over $200,000                   excess over $157,000

Over $200,000 but not          $45,689.50 plus 35% of the

  over $500,000                   excess over $200,000

Over $500,000                  $150,689.50 plus 37% of  

                                  the excess over $500,000

 

Health Savings Accounts

For eligible individuals, health savings accounts (HSAs) offer a tax-favorable way to set aside funds (or have their employer do so) to meet future medical needs. Here are the key tax-related elements:

•       contributions you make to an HSA are deductible, within limits,

•       contributions your employer makes aren't taxed to you,

•       earnings on the funds within the HSA are not taxed, and

•       distributions from the HSA to cover qualified medical expenses are not taxed.

 

Who is eligible? To be eligible for an HSA, you must be covered by a "high deductible health plan" (discussed below). You must also not be covered by a plan which (1) is not a high deductible health plan, and (2) provides coverage for any benefit covered by your high deductible plan. (It's okay, however, to be covered by a high deductible plan along with separate coverage, through insurance or otherwise, for accidents, disability, or dental, vision, or long-term care.)

For 2017, a "high deductible health plan" is a plan with an annual deductible of at least $1,300 for self-only coverage, or at least $2,600 for family coverage. For self-only coverage, the 2017 limit on deductible contributions is $3,400. For family coverage, the 2017 limit on deductible contributions is $6,750. Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits cannot exceed $6,550 for self-only coverage or $13,100 for family coverage.

An individual (and the individual's covered spouse as well) who has reached age 55 before the close of the tax year (and is an eligible HSA contributor) may make additional "catch-up" contributions for 2017 of up to $1,000.

A high deductible health plan does not include a plan if substantially all of the plan's coverage is for accidents, disability, or dental, vision, or long-term care, insurance for a specified disease or illness, or insurance paying a fixed amount per day (or other period) of hospitalization.

HSAs may be established by, or on behalf of, any eligible individual.

Deduction limits: You can deduct contributions to an HSA for the year up to the total of your monthly limitations (1/12 of the annual maximum contribution) for the months you were eligible. Also, taxpayers who are eligible individuals during the last month of the tax year are treated as having been eligible individuals for the entire year for purposes of computing the annual HSA contribution.

However, if an individual is enrolled in Medicare, he is no longer an eligible individual under the HSA rules, and so contributions to his HSA can no longer be made.

Employer contributions: If you are an eligible individual, and your employer contributes to your HSA, the employer's contribution is treated as employer-provided coverage for medical expenses under an accident or health plan and is excludable from your gross income up to the deduction limitation, as described above. Further, the employer contributions are not subject to withholding from wages for income tax or subject to FICA or FUTA. The eligible individual cannot deduct employer contributions on his federal income tax return as HSA contributions or as medical expense deductions.

An employer that decides to make contributions on its employees' behalf must make comparable contributions to the HSAs of all comparable participating employees for that calendar year. If the employer does not make comparable contributions, the employer is subject to a 35% tax on the aggregate amount contributed by the employer to HSAs for that period.

An exception to the comparable contribution requirements applies for contributions made on behalf of non-highly compensated employees. Under this exception, an employer may make larger HSA contributions for non-highly compensated employees than for highly compensated employees.

Earnings: If the HSA is set up properly, it is generally exempt from taxation, and there is no tax on earnings. However, taxes may apply if contribution limitations are exceeded, required reports are not provided, or prohibited transactions occur.

Distributions: Distributions from the HSA to cover an eligible individual's qualified medical expenses, or those of his spouse or dependents, are not taxed. Qualified medical expenses for these purposes generally mean those that would qualify for the medical expense itemized deduction. If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 20% tax will apply to the withdrawal, unless it is made after reaching age 65, or in the event of death or disability.

As you can see, HSAs offer a very flexible option for providing health care coverage, but the rules are somewhat involved. Please contact us if you would like to discuss this topic further.

Year-End Tax Tips for Employees

As year-end approaches, taxpayers generally are faced with a number of choices that can save taxes this year, next year or both years. Employees have some special considerations to take into account that retirees and other nonworking individuals don't face. To help our clients who are employees take advantage of these special tax saving opportunities, we have put together a list of items to consider.

Health flexible spending accounts. Many employees take advantage of the annual opportunity to save taxes by placing funds in their employer's health flexible spending arrangement (health FSA). A pre-tax contribution of $2,600 to a health FSA is the current limit. You save taxes because you use pre-tax dollars in the health FSA to pay for medical expenses that might not otherwise be deductible (due to not itemizing, or due to a portion being nondeductible because of the 10% adjusted gross income floor). Additionally, the amounts that you contribute to a health FSA are not subject to FICA taxes. This would allow you to save $199 in FICA taxes alone, on a health FSA contribution of $2,600. You would save an additional $520 in income taxes based on an effective income tax rate of 20%. Total annual tax savings would equal $719 ($199 + $520).

Your plan should have a listing of qualifying items and any documentation from a medical provider that may be needed to get a reimbursement for these items.

To avoid any forfeiture of your health FSA funds because of application of the use-it-or-lose-it rule, you must incur qualifying medical expenditures by the last day of the plan year, unless the plan allows an optional grace period. Any grace period cannot extend beyond the 15th day of the third month following the close of the plan year (e.g., March 15 for a calendar year plan), so, if the plan allows a grace period, qualifying medical expenses that you incur through that date can be reimbursed using your prior-year health FSA account. An additional exception to the use-it-or lose-it rule permits health FSAs to allow a carryover of a participant's unused health FSA moneys, up to a $500 (or lower plan) maximum.

As a cautionary note, if you or your spouse intend to participate in a high deductible health plan (HDHP) in 2018, your participation in a health FSA may hamper your ability to contribute to a health savings account (HSA).

Examining your year-to-date expenditures now will also help you to determine how much to set aside for next year. Don't forget to reflect any changed circumstances in making your calculation.

Dependent care FSAs. Some employers also allow employees to set aside funds in dependent care FSAs. A $5,000 maximum annual contribution is permitted ($2,500 for a married couple filing separately). A dependent care FSA allows employees to use pre-tax dollars to pay for dependent care. In particular cases, participating in a dependent care FSA can yield greater tax savings than foregoing participation and claiming a dependent care credit. Taxpayers who are eligible to participate in a dependent care FSA and are (a) in a high tax bracket and/or (b) have only one dependent and more than $3,000 of dependent care-related expenses, should use the FSA to pay for child care expenses. For these taxpayers, the FSA almost always provides greater federal tax savings than does the dependent care credit. State income tax savings also may apply. Additionally, participating in a dependent care FSA also saves you FICA taxes on the amount of the contribution.

However, like health FSAs, dependent care FSAs are subject to the use-it-or lose it rule, but neither the grace period nor the up-to-$500 forfeiture exception applies. Thus, now is a good time to review expenditures to date and to project amounts to be set aside for next year.

Adjustments to federal and state withholding. You can ask your employer to increase withholding of federal and/or state and local taxes by amending your federal and/or state withholding forms before year-end if a) you expect to owe federal and/or state and local income taxes when you file your return next year (this will pull the deduction of those taxes into this year) or b) if you face a penalty for underpayment of estimated tax and you want to eliminate or reduce it. If you become married or single in 2017, or have added or lost a dependent, you should be sure to provide your employer with an updated federal and state tax withholding form that reflects the new filing status or changed exemptions. Be sure to review your withholding if you hold multiple jobs, you and your spouse both work, or you can be claimed as a dependent by another person.

Increase 401(k) contributions. The pre-tax and Roth 401(k) contribution limit for 2017 is $18,000. Employees age 50 or older by year-end are also permitted to make an additional contribution of $6,000, for a total limit of $24,000 in 2017. If your employer makes a matching contribution to your contribution, your total retirement savings will increase even faster. Review and make appropriate adjustments to the contributions you make to your employer's 401(k) retirement plan for the remainder of this year, and next year. It's also a good idea to review your investment elections, and their periodic performance. Keep in mind the amount you need to save for the age at which you plan to retire and consider seeing a financial planner to set, and keep to, your savings goals.

Make Roth IRA contributions. The ability to make a Roth IRA contribution (which is a special after-tax contribution) continues even if you're participating in an employer savings plan (like a 401(k)), so it is not subject to the "active participant" rules that may prevent employees who participate in an employer plan from making a deductible contribution to a traditional IRA. The benefit of the Roth IRA is that the earnings on the IRA will not be taxable to you on distribution (provided, generally, that distributions of income are made to you after you attain age 59 1/2). You are allowed to withdraw contributions you have previously made at any time without penalty.  The 2017 Roth contribution limit is $5,500, rising to $6,500 if you're age 50 or older by the end of 2017. Your ability to make a Roth IRA contribution in 2017 will be reduced if your adjusted gross income (AGI) in 2017 exceeds a certain amount, which is dependent upon your filing status.

Be on the watch for 2018 plan election forms to be coming from your employer.  If you would like to discuss any of these matters in greater detail, please contact us.

Tax Implications of Divorce

Unfortunately, in addition to the difficult personal issues the process entails, several tax concerns need to be addressed when facing a divorce or legal separation to ensure that tax costs are kept to a minimum and that important tax-related decisions are properly made.

Support Provisions: Support payments required to be made from one spouse to another upon divorce or separation are deductible by the payor and taxable to the recipient if they qualify under the tax rules for "alimony." There are several factors that are used to determine if support payments qualify as alimony.

Support payments for children ("child support") aren't deductible by the paying spouse (or taxable to the recipient). These include payments specifically designated as child support as well as payments which otherwise might look like alimony but are linked to an event or date related to a child.

Tax planning for support payments generally seeks to make them deductible if the paying spouse is in a higher tax bracket than the recipient, as is often the case. The tax savings for the paying spouse can be shared with the recipient through higher payment amounts or other benefit provisions.

Dependency exemptions: To some extent, the parties can determine who's entitled to claim the dependency exemption for their dependent children. The exemption for the child goes to the spouse who has legal custody of the child. However, that spouse can waive his or her right to the exemption, thus allowing the noncustodial spouse to claim it.

The dependency exemption entitles the spouse who claims it to more than just the exemption. For example, the child tax and the higher education credits are only available to the spouse who claims the child as a dependent.

Property settlements: When property is split up in connection with a divorce, there are usually no immediate tax consequences. Thus, property transferred between the spouses won't result in taxable gain or loss to the transferring spouse. Instead, the receiving spouse takes the same basis (cost) in the property that the transferring spouse had. (The receiving spouse may have to pay tax later, however, when the recipient spouse sells the property).

Personal residence: In general, if a married couple sells their home in connection with divorce or legal separation they should be able to avoid tax on up to $500,000 of gain (as long as they owned and used the residence as their principal residence for two of the previous five years). If one spouse continues to live in the home and the other moves out (but they remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect the exclusion for the spouse who moves out.

Pension benefits: A spouse's pension benefits are often part of a property settlement. When this is the case, the commonly preferred method to handle the benefits is to get a "qualified domestic relations order (QDRO)." A QDRO gives one spouse the right to share in the pension benefits of the other and taxes the spouse who receives the benefits. Without a QDRO the spouse who earned the benefits will still be taxed on them even though they are paid out to the other spouse.

A QDRO isn't needed to split up an IRA, but special care must be taken to avoid unfavorable tax consequences. If a specific IRS-approved method for transferring the IRA from one spouse to the other is not used, the transaction could be treated as a taxable distribution (possibly also triggering penalties).

Business interests: When certain types of business interests are transferred in connection with divorce or separation, care must be taken to make sure "tax attributes" aren't forfeited. In particular, interests in S corporations may result in "suspended" losses; where these interests change hands in connection with a divorce, the suspended losses may be forfeited. If a partnership interest is transferred a variety of complex issues may arise involving partners' shares of partnership debt, capital accounts, built-in gains on contributed property, and other complex issues. The parties involved should be aware of the tax consequences that their transfer may generate.

Estate planning considerations: The upheaval a divorce causes in family relations and property holdings makes it imperative for the parties to reassess their wills and estate plans in connection with the divorce. First, the typical will in which all property is left to a surviving spouse is no longer likely to reflect the testator's wishes. Second, the property to be left by the spouses may have changed hands via a property settlement. Finally, guardianship and trustee issues for surviving minor children must be addressed. That is, who will manage the assets of, and serve as guardian for, minor children in the event of the death of the parents.

Tax records: Make sure you get copies of, or access to, any records or documents that can have an impact on your tax situation. You need copies of joint returns filed with your spouse along with supporting documentation. Also, records relating to the cost of jointly owned property or property transferred to you in connection with the divorce are essential. You'll need to establish cost when these assets are eventually sold.

Filing status: If a "final" decree or divorce or, in the case of separation, decree of separate maintenance, is issued by the end of the year, then you can't file your tax return for the year as a married person. Your filing status will be "single." However, if you cover more than half the costs of a household in which a child of yours lives, you may qualify for more favorable "head of household" rates.

If an above-described decree hasn't been issued by year-end, you're treated as still married even if you're separated from your spouse under a separation agreement or "nonfinal" decree. In this case, you may still file jointly with your spouse, which may result in lower overall tax for you and your ex-spouse, but may put you at risk for an unpaid tax obligation of your spouse's. It also requires contact between the parties to prepare the joint return, which may not be desirable in some circumstances. The other available filing status is "married filing separately," which is the least favorable status.

Adjusting income tax withholding: The calculation of your withholding on the Form W-4, Employee's Holding Allowance Certificate, that you gave to your employer is based on your married status and on the earnings of both spouses. When you get divorced, you should submit a new Form W-4 with the revised information. The fact that deductible alimony payments will be made (or taxable alimony received) should also be taken into account. This will ensure that the correct amount of tax is withheld.

Notifying IRS of a new address or name change: If you'll be moving, or if you're changing your name because of divorce, file Form 8822 with IRS so you'll receive any notices or correspondence from IRS promptly.

We hope this overview of a complex area has been helpful to you. Please contact us if we can be of assistance regarding any of these matters.

Tax Aspects of Self-Employment

As a sole proprietor, there are several important rules that you should be aware of:

(1) For income tax purposes, you'll report your income and expenses on Schedule C of your Form 1040. The net income will be taxable to you regardless of whether you withdraw cash from the business. Your business expenses will be deductible against gross income (i.e., "above the line") and not as itemized deductions. If you have any losses, the losses will generally be deductible against your other income, subject to special rules relating to hobby losses, passive activity losses, and losses in activities in which you weren't "at risk."

(2) You may be able to deduct office-at-home expenses. If you'll be working from an office in your home, performing management or administrative tasks from an office-at-home, or storing product samples or inventory at home, you may be entitled to deduct an allocable portion of certain of the costs of maintaining your home. And if you have an office-at-home, you may be able to deduct commuting expenses of going from your home to another work location.

(3) You'll be required to pay self-employment taxes. For 2017, you'll pay self-employment tax (social security and Medicare) at a 15.3% rate on your net earnings from self-employment of up to $127,200, and Medicare tax only at a 2.9% rate on the excess. An additional 0.9% Medicare tax (for a total of 3.8%) will be imposed on self-employment income in excess of $250,000 for joint returns; $125,000 for married taxpayers filing separate returns; and $200,000 in all other cases. Self-employment tax is imposed in addition to income tax, but you can deduct half of your self-employment tax as an adjustment to income.

(4) You'll be allowed to deduct 100% of your health insurance costs as a trade or business expense. This means your deduction for medical care insurance won't be subject to the limitation on your medical expense deduction that is based on a percentage of your adjusted gross income.

(5) You'll be required to make quarterly estimated tax payments. Self-employed individuals are required to pay their income taxes in quarterly using the estimated tax payment guidelines, in order to avoid an underpayment penalty.

(6) You'll have to keep complete records of your income and expenses. In particular, you should carefully record your expenses in order to claim the full amount of the deductions to which you are entitled. Certain types of expenses, such as automobile, travel, entertainment, meals, and office-at-home expenses, require special attention because they're subject to special recordkeeping requirements or limitations on deductibility.

(7) If you hire any employees, you'll have to get a taxpayer identification number and will have to withhold and pay over various payroll taxes.

(8) You should consider establishing a qualified retirement plan. The advantage of a qualified retirement plan is that amounts contributed to the plan are deductible at the time of the contribution, and aren't taken into income until the amounts are withdrawn. Because of the complexities of ordinary qualified retirement plans, you might consider a simplified employee pension (SEP) plan, which requires less paperwork. Another type of plan available to sole proprietors that offers tax advantages with fewer restrictions and administrative requirements than a qualified plan is a "savings incentive match plan for employees," i.e., a SIMPLE plan. If you don't establish a retirement plan, you may still be able to make a contribution to an IRA.

If you’d like any additional information regarding the tax aspects of your business, or if you need assistance in satisfying any of the reporting or recordkeeping requirements, please contact us.

Independent Contractor vs. Employee

The question of whether a worker is an independent contractor or employee for federal income and employment tax purposes is a complex one. It is intensely factual, and the stakes can be very high. If a worker is an employee, the company must withhold federal income and payroll taxes, pay the employer's share of FICA taxes on the wages plus FUTA tax, and often provide the worker with fringe benefits it makes available to other employees. There may be state tax obligations as well. These obligations don't apply for a worker who is an independent contractor. The business sends the independent contractor a Form 1099-MISC for the year showing the amount paid to the contractor (if the amount is $600 or more), and that's it.

Who is an "employee?" There is no uniform definition of the term.

Under the common-law rules (so-called because they originate from court cases rather than from a statute), individuals are generally employees if the enterprise they work for has the right to control and direct them regarding the job they are to do and how they are to do it. Otherwise, the individuals are independent contractors.

Some employers that have misclassified workers as independent contractors are relieved from employment tax liabilities under Section 530 of the 1978 Revenue Act (not the Internal Revenue Code). In brief, Section 530 protection applies only if the employer: filed all federal returns consistent with its treatment of a worker as an independent contractor; treated all similarly situated workers as independent contractors; and had a "reasonable basis" for not treating the worker as an employee. For example, a "reasonable basis" exists if a significant segment of the employer's industry has traditionally treated similar workers as independent contractors. Section 530 doesn't apply to certain types of technical services workers.

Individuals who are "statutory employees," (that is, specifically identified by the Internal Revenue Code as being employees) are treated as employees for social security tax purposes even if they aren't subject to an employer's direction and control (that is, even if the individuals wouldn't be treated as employees under the common-law rules). These individuals are agent drivers and commission drivers, life insurance salespeople, home workers, and full-time traveling or city salespeople who meet a number of tests. Statutory employees may or may not be employees for non-FICA purposes. Corporate officers are statutory employees for all purposes.

Individuals who are statutory independent contractors (that is, specifically identified by the Internal Revenue Code as being non-employees) aren't employees for purposes of wage withholding, FICA, or FUTA and the income tax rules in general. Qualified real estate agents and certain direct sellers are statutory independent contractors.

Some categories of individuals are subject to special rules because of their occupations or identities. For example, corporate directors aren't employees of a corporation in their capacity as directors, and partners of an enterprise organized as a partnership are treated as self-employed persons.

Under certain circumstances, you can ask the IRS (on Form SS-8) to rule on whether a worker is an independent contractor or employee.

If you would like to discuss how these complex rules apply to your business, to make sure that none of your workers are misclassified, please contact us.

Cancellation of Student Loans

In general, if a loan or other debt you owe is canceled, you must report the cancellation as income. This means that you will generally have income if your student loan is canceled. But if your student loan qualifies for the exception described below, you won't have income from the cancellation.

Many student loans contain a provision that all or part of the debt will be canceled if the student works for a certain period of time in certain professions for any of a broad class of employers. If cancellation of all or part of your student loan is contingent on your fulfilling this type of service requirement, you won't have income if any part of the loan is canceled because you performed the required services. Student loans that qualify for this exception are loans that are made to a student to help him attend a tax-exempt educational institution.

Qualifying student loans may be made by government entities (e.g., the U.S., or a state), by tax-exempt public benefit corporations, or by tax-exempt educational institutions out of funds the institution received from a government entity or tax-exempt public benefit corporation. That is, loans made with government funds may qualify.

Loans made by tax-exempt educational institutions out of private, nongovernment funds also qualify, but only if the loan imposes a public service requirement. The institution must have made the loan under a program designed to encourage students to serve in occupations or areas with unmet needs, and the services provided by the student (or former student) must be for or under the direction of a governmental unit or a tax-exempt organization.

The Public Service Loan Forgiveness Program is a federal program that forgives the remaining balance on your federal direct loans if you meet certain requirements. You must work full-time for a qualifying employer and make 120 qualifying monthly loan payments while doing so. Therefore, it is possible to have a loan forgiven after as little as 10 years. Qualifying employers include government organizations, 501(c)(3) nonprofit organizations, and other types of nonprofit organizations if their primary purpose is to provide certain types of qualifying public services.  You can find additional information regarding this program and all of its requirements at https://teststudentaid2.ed.gov/testise2/repay-loans/forgiveness-cancellation/public-service.

With the change in federal administration at the beginning of 2017, it is important to be aware that changes to the Public Service Loan Forgiveness Program may be possible in the future. The most recent proposed White House budget would end the program for loans issued on or after July 1, 2018, unless the loan was provided to help the student finish their current course of study. The budget also proposed changes to an income-based repayment plan, which includes forgiving student loan debt sooner, but at the cost of higher monthly payments. Also, income-based loan forgiveness is taxable to the borrower. Any proposed changes must be approved by Congress.

Many states also have student loan forgiveness programs. These may be general or for specific fields of employment, such as teaching or law. You can find additional information regarding student loan forgiveness programs for a specific state at http://thecollegeinvestor.com/student-loan-forgiveness-programs-by-state/.

It is important to remember that the exception described above is tied to a public service requirement. You will have income from the cancellation of your student loan if you don't fulfill your public service obligation, or if the service obligation doesn't qualify for the exclusion.

Please contact us if you have any questions or would like more information.

Tax Deductions for College Expenses

As a parent of a college-age child, your goal is to pay for current or imminent college bills. We would like to address this concern by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses. (Please note that the following suggestions are strictly related to tax benefits. You may have non-tax-related concerns that make the suggestions inappropriate.)

Tuition tax credits. You can take an American Opportunity tax credit (AOTC) of up to $2,500 per student for the first four years of college-a 100% credit for the first $2,000 in tuition, fees, and books, and a 25% credit for the second $2,000. You can take a Lifetime Learning credit of up to $2,000 per family for every additional year of college or graduate school-a 20% credit for up to $10,000 in tuition and fees.

Both credits are phased out for higher-income taxpayers. The American Opportunity tax credit is phased out for couples with income between $160,000 and $180,000, and for singles with income between $80,000 and $90,000. The Lifetime Learning credit is phased out (for 2017) for couples with income between $112,000 and $132,000, and for singles with income between $56,000 and $66,000. The phase-out range for the Lifetime Learning credit is adjusted annually for inflation.

Only one credit can be claimed for the same student in any given year.

Statement from institution required before tuition credits or qualified tuition deduction can be claimed. To claim the tuition tax credits, a taxpayer must receive a Form 1098-T payee statement from the educational institution. For purposes of this requirement, if a person the taxpayer claims as a dependent receives the Form 1098-T, the statement is treated as received by the taxpayer.

Scholarships. Scholarships are exempt from income tax, if certain conditions are satisfied. The most important are that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies, and similar items (and not for room and board).  Scholarships used for room and board would be taxable to the student.

Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the American Opportunity and Lifetime Learning credits, above, and may therefore reduce or eliminate those credits.

Employer educational assistance programs. If your employer pays your child's college expenses, the payment is a fringe benefit to you, and is taxable to you as compensation, unless the payment is part of a scholarship program that's "outside of the pattern of employment." Then the payment will be treated as a scholarship (if the other requirements for scholarships are satisfied).

Tuition reduction plans for employees of educational institutions. Tax-exempt educational institutions sometimes provide tuition reductions for their employees' children who attend that educational institution, or cash tuition payments for children who attend other educational institutions. If certain requirements are satisfied, these tuition reductions are exempt from income tax.

College expense payments by grandparents and others. If someone other than you pays your child's college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $14,000 for 2017. Married donors who consent to split gifts may exclude gifts of up to $28,000 for 2017.

However, if the other person pays your child's school tuition directly to an educational institution, there's an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant.

The unlimited gift tax exclusion applies only to direct tuition costs. There's no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc. Prepaid tuition payments may qualify for the unlimited gift tax exclusion under certain circumstances.

Student loans. You can deduct interest on qualifying loans used to pay for college education expenses. The maximum deduction is $2,500. However, the deduction phases out for taxpayers who are married filing jointly with AGI between $135,000 and $165,000 (between $65,000 and $80,000 for single filers).

Bank loans. In order to take the student loan interest deduction, the loan must be a “qualifying” student loan.  Therefore, interest on non-qualifying bank student loans will be nondeductible. However, if you use a home equity loan, the interest is deductible for regular income tax purposes (although not for alternative minimum tax purposes). Interest on home equity debt would be reported on Schedule A.

Borrowing against retirement plan accounts. Many company retirement plans permit participants to borrow cash. This option may be an attractive alternative to a bank loan, especially if your other debt burden is high. However, the loan must carry an interest rate equal to the prevailing commercial rate for similar loans, and, unless you qualify for the deduction for education loan interest (described above), there's no deduction for the personal interest paid. Moreover, unless strict requirements are satisfied, a loan against a retirement account is treated as a premature distribution (withdrawal) that's subject to regular income tax and an additional penalty tax.

Withdrawals from retirement plan accounts. IRAs and qualified retirement plans represent the largest cash resource of many taxpayers. You can pull money out of your IRA (including a Roth IRA) at any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 59½. However, the distributions are subject to tax under the usual rules for IRA distributions.

Not all of the above breaks may be used in the same year, and use of some of them reduces the amounts that qualify for other breaks. So it takes planning to determine which should be used in any given situation. If you would like to discuss one or more of the above payment possibilities, or any other alternatives, in more detail, please contact us.

Planning for College Expenses

As a parent with college-bound children, you are concerned with setting up a financial plan to fund future college costs. We would like to address this concern by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses. (Please note that the following suggestions are strictly related to tax benefits. You may have non-tax-related concerns that make the suggestions inappropriate.)

 

In some cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $28,000 (in 2017) in cash or assets to each child with no gift tax consequences. And if your child isn't subject to the "kiddie tax," he or she is taxed on income from assets entirely at his or her lower tax rates-as low as 10% (or 0% for long-term capital gain).

 

However, where the kiddie tax applies, the child's investment income above $2,100 (for 2017) is taxed at your tax rates and not the child's rates. The kiddie tax applies if: (1) the child hasn't reached age 18 before the close of the tax year or (2) the child's earned income doesn't exceed one-half of his or her support and the child is age 18 or is a full-time student age 19 to 23.

 

A variety of trusts or custodial arrangements can be used to place assets in your children's names. Note, it's not enough just to transfer the income, e.g., dividend checks, to your children. The income would still be taxed to you. You must transfer the asset that generates the income to their names.

 

Tax-exempt bonds. Another way to achieve economic growth while avoiding tax is simply to invest in tax-exempt bonds or bond funds. Interest rates and degree of risk vary on these, so care must be taken in selecting your particular investment. Some tax-exempts are sold at a deep discount from face and don't carry interest coupons. Many are marketed as college savings bonds. A small investment in these so-called zero coupon bonds can grow into a fairly sizable fund by the time your child reaches college age. "Stripped" municipal bonds (munis) provide similar advantages.

 

Series EE U.S. savings bonds. Series EE U.S. savings bonds offer two tax-savings opportunities when used to finance your child's college expenses: first, you don't have to report the interest on the bonds for federal tax purposes until the bonds are actually cashed in; and second, interest on "qualified" Series EE (and Series I) bonds may be exempt from federal tax if the bond proceeds are used for qualified college expenses.

 

To qualify for the tax exemption for college use, you must purchase the bonds in your own name (not the child's) or jointly with your spouse. The proceeds must be used for tuition, fees, etc., not room and board. If only part of the proceeds are used for qualified expenses, then only that part of the interest is exempt.

 

If your adjusted gross income (AGI) exceeds certain amounts, the exemption is phased out. For bonds cashed in during 2017, the exemption begins to phase out when joint AGI hits $117,250 for joint return filers ($78,150 for all other returns) and is completely phased out if your AGI is at $147,250 ($93,150 for all other returns).

 

Qualified tuition programs. A qualified tuition program (also known as a 529 plan) allows you to buy tuition credits for a child or make contributions to an account set up to meet a child's future higher education expenses. Qualified tuition programs can be established by state governments or by private education institutions.

 

Contributions to these programs aren't deductible. The contributions are treated as taxable gifts to the child, but they are eligible for the annual gift tax exclusion ($14,000 for 2017). A donor who contributes more than the annual exclusion limit for the year can elect to treat the gift as if it were spread out over a five-year period.

 

The earnings on the contributions accumulate tax-free until the college costs are paid from the funds. Distributions from qualified tuition programs are tax-free to the extent the funds are used to pay qualified higher education expenses. Distributions of earnings that aren't used for qualified higher education expenses will be subject to income tax plus a 10% penalty tax.

 

Coverdell education savings accounts. You can establish Coverdell ESAs (formerly called education IRAs) and make contributions of up to $2,000 for each child under age 18. This age limitation doesn't apply to a beneficiary with special needs, defined as an individual who because of a physical, mental or emotional condition, including learning disability, requires additional time to complete his or her education.

 

The right to make these contributions begins to phase out once your AGI is over $190,000 on a joint return ($95,000 for singles). If the income limitation is a problem, the child can make a contribution to his or her own account.

 

Although the contributions aren't deductible, income in the account isn't taxed, and distributions are tax-free if spent on qualified education expenses. If the child doesn't attend college, the money must be withdrawn when the child turns 30, and any earnings will be subject to tax and penalty, but unused funds can be transferred tax-free to a Coverdell ESA of another member of the child's family who hasn't reached age 30. These requirements that the child or member of the child's family not have reached 30 do not apply to an individual with special needs.

 

The above are just some of the tax-favored ways to build up a college fund for your children. If you wish to discuss any of them, or other alternatives, please contact us.