With New Law, Long-Range Planning Is Vital for Middle-Income Filers
In a normal year, middle-income Americans can safely put away their tax information for several months after filing season and forget about it. The little tax planning that’s required of the middle classes can usually be done at the last minute.
But 1998 is no normal year.
Last summer’s tax act created a host of lucrative breaks that could easily be jeopardized if you don’t start planning now. Indeed, taxpayers who earn between $40,000 and $200,000 need to start thinking years ahead if they hope to enjoy their share of the billions of dollars in targeted tax cuts that Congress promised.
Planning is particularly pivotal for those who are considering converting a traditional individual retirement account into one of the much-lauded and heavily advertised Roth IRAs. That’s because the interplay between the income created by a Roth conversion and income restrictions placed on nearly all the new tax breaks are highly likely to create situations in which individuals who convert a substantial retirement nest egg will lose other important tax benefits for an extended period--if not permanently.
“There are so many of these targeted tax breaks that people really need to start planning much earlier,” says Philip J. Holthouse, a partner in the Los Angeles accounting firm of Holthouse Carlin & Van Trigt. “It’s much easier to think about these things now than to wake up in December and try to un-earn some of your income.”
At the heart of the matter are “phaseouts,” which stop upper-income taxpayers from claiming some of the more lucrative tax breaks passed last year. However, the tricky part of the Taxpayer Relief Act of 1997 is how upper-income taxpayers are defined--or, rather, how they are defined differently in different sections of the code.
Consider the following:
When it comes to deducting interest expenses on education loans, the upper crust includes couples earning more than $60,000 and singles earning more than $40,000. Those who earn more than these amounts can deduct only part of their student loan interest. Those who earn more than $55,000 if single and $75,000 if married, filing jointly cannot deduct the interest at all.
For the Hope tax credit or the lifetime learning credit, phaseouts start at $40,000 (singles) and $80,000 (married); singles who earn more than $50,000 and couples with more than $100,000 in wages need not apply.
Phaseouts for the lucrative adoption tax credit start at $75,000.
The list goes on.
The most damaging interplay between these new breaks involves so-called Roth “conversions.” If you convert an old-style IRA into a Roth, you are required to count a quarter of the value of your IRA as income in each of the next four years. Although this additional income is not counted in determining whether you’re too rich to qualify for a Roth IRA conversion, it does count when figuring which federal income tax bracket you are in and whether you are subject to the income phaseouts for all the other tax breaks previously mentioned.
How much does that matter?
Consider a hypothetical consumer, John Saver, a 45-year-old who earns $40,000 and has $100,000 socked away in a traditional IRA. His goal: go back to school and get a career-enhancing advanced degree. Thanks to the 1997 tax law, John qualifies for a $1,000 tax credit that could help him recoup part of the $5,000 he expects to pay in school tuition and fees.
He has heard about the Roth IRA and understands that it could provide him with some long-term benefits by allowing him to earn income tax-free in the account.
(Earnings in traditional IRAs are tax-deferred, not tax-free. There is no tax while the money accumulates in your account. But when you withdraw the money during retirement, you are taxed on that amount, at your ordinary income tax rates. If you withdraw the money before retirement and for a non-qualified purpose, you’ll also owe a 10% penalty. Contributions to a Roth IRA are not tax-deductible. But if you follow the rules, your withdrawals will not be taxable when you start pulling the money out.)
If John converted his traditional IRA into a Roth, he would be required to count $25,000 per year as income for the next four years. He would not owe a penalty on the converted funds, but he would have to pay income tax on the $25,000. John assumes that will cost him about $7,000 in federal tax each year, because he’s in the 28% bracket. But in reality, it would cost dramatically more.
Why? He loses the ability to take the $1,000-a-year lifetime learning credit because his annual income, including the money from the Roth conversion, totals $65,000. If John completes his schooling during the four years during which his income will be inflated from the Roth conversion, he’ll lose out on this lucrative credit.
The impact of a Roth conversion could be equally dramatic for couples who would like to claim the $5,000 adoption tax credit. A couple earning $75,000 annually who converted a $100,000 IRA, for example, would find their adoption tax credit shaved by $3,125 to just $1,875.
Sending kids through college?
Families that meet the income limits during a child’s freshman and sophomore years can qualify for Hope tax credits amounting to $1,500 annually. But if you convert a substantial IRA into a Roth during 1998, it is likely that you would boost your income too much to qualify for these dollar-for-dollar tax reductions for four years. For a family with two qualifying children, that costs $6,000 in federal tax breaks.
And none of these examples account for the impact of potentially pushing yourself into a higher tax bracket.
The bottom line: If you are considering a 1998 Roth conversion, you need to think about what you and your family will be doing over the next four years. If a conversion would make you ineligible for another tax break--particularly one of the newly created credits--you may want to wait.
Roth IRA conversions aren’t the only reason middle-income families need to do more planning this year.
Middle-income wage earners who work for large companies often have the ability to use employee benefit plans--401(k) plans, dependent-care accounts and health-care spending accounts--to reduce their taxable income while increasing their net worth and easing their ability to pay regular bills. Making greater use of these accounts this year has the added benefit of reducing income for the purposes of claiming the new tax breaks. For many families, this can mean a cut in tax liability of hundreds of dollars.
Consider a two-income couple who earn $95,000. They want to adopt a child in 1998, but because their income is over a phaseout thresholds, they’ll qualify for only about half the maximum adoption tax credit of $5,000. However, if both wage earners contribute $7,500 each to a 401(k) plan, they reduce their adjusted gross income to $80,000. That boosts their allowable adoption tax credit from a maximum of $2,500 to roughly $4,375.
In addition, by contributing more to the 401(k) accounts, they reduced their taxable income by a tidy $15,000. That reduces their tax by $4,000 more. In other words, by increasing their retirement preparedness, the couple have cut their federal tax bill by $5,875.
If both parents work and pay day-care expenses, they may also be able to contribute to a dependent-care account. These accounts allow you to set aside day-care funds through employee withholding. If your employer offers a dependent-care account and you elect to contribute to it, your employer will deduct the amount you specify from your paycheck on a pretax basis.
You can tap your savings in the dependent-care account to pay your baby sitter or day-care center at any time during the year, and the government acts as if you’ve never earned the money. Parents can contribute up to $5,000 to these accounts, substantially reducing their taxable income, which reduces their income tax and helps them qualify for more of the new tax credits.
The one caveat: Never contribute more to a dependent-care account than you can use on eligible child-care expenses during that calendar year. Any money that’s left in the account at year-end is lost. You can’t get a refund or apply excess amounts to future day-care costs.
Many companies also offer health-care spending accounts, which work just like dependent-care accounts, except that the money is earmarked to pay unreimbursed medical expenses.
Most companies allow you to sign up for these employee benefit plans at only one time each year. Chances are that’s in the fall during your company’s “open enrollment” season. If you’ve missed open enrollment, it’s unlikely you’ll be able to count on these plans to get a break on your 1998 return.
If that’s the case, there’s always 1999.
