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Education Tax Credit Nuances. Don't Leave Money on the Table.
American Opportunity Tax Credit
Lifetime Learning Credit
Which Credit to Take
Maximizing the Credit
Who Claims the Credit
Qualified Educational Institutions
Gift Tax Issues
There are actually two higher-education tax credits. The American Opportunity Tax Credit (AOTC) provides up to $2,500 worth of credit for each student, 40% of which is refundable. The credit is equal to 100% of the first $2,000 of college tuition and qualified expenses and 25% of the next $2,000. The AOTC only applies to the first 4 years of post-secondary education.
The other credit is the Lifetime Learning Credit (LLC), which only provides a maximum $2,000 of credit (20% of up to $10,000 of eligible expenses) per family. None of it is refundable, meaning it can only be used to offset the taxpayer’s tax liability, and any additional credit amount is lost.
When it comes to these credits, it is easy to leave money on the table. Here are the reasons why:
Many students attend local colleges for the first two years and then transfer to a university for the remainder of their education. Knowing the university tuition will be higher, some parents take the LLC and wait on the AOTC, thinking they can use it in years with higher tuition and get a larger credit. What they don’t realize is that the AOTC credit is only good for the first four years of post-secondary education. Thus, it is always better to claim the AOTC in the first four years.
Parents don’t realize what constitutes a year of post-secondary education. Most students start college in the autumn after their May or June graduation from high school. Thus, for them, the first four years of post-secondary education actually span parts of five calendar years, and as a result, the student will qualify for the AOTC in five calendar years. With careful planning, students can qualify for the full $2,500 of the refundable credit in all five calendar years.
A special rule allows the tuition for an academic period that begins in the first three months of the next year to be paid in advance and thus increase the amount of tuition qualifying for the credit in the year the tuition is paid. This allows for planning when to make tuition payments to maximize credits, especially in the first partial calendar year.
Example: Cameron just graduated from high school and will be beginning college in September. Her tuition and credit-qualifying expenses for the semester covering the last four months of the year and January of the next year are $1,500. Her mother, Tricia, is aware of the 3-month rule, and in December she prepays Cameron’s $1,500 tuition for the semester beginning February 1 of the next year, bringing the qualifying expenses to a total of $3,000. The AOTC is equal to 100% of the first $2,000 of qualifying expenses and 25% of the next $2,000. Thus the AOTC for Cameron is $2,250 ($2,000 + 25% of $1,000). Tricia could increase the credit for the year to the full $2,500 maximum by purchasing $1,000 worth of course materials needed for “meaningful attendance or enrollment” in Cameron’s course of study.
Qualifying expenses other than tuition are often overlooked, especially in light of a recent tax regulation change that specifies for the AOTC that qualifying expenses include course materials needed for “meaningful attendance or enrollment” whether purchased from the school or an outside vendor. Previously, only course material purchased from the school qualified (and this is still the rule for the Lifetime Learning Credit). This is a significant change and opens up the possibilities of including expenses not previously allowed.
Taxpayers also often overlook another very important fact: Whoever claims the tax exemption for the student gets to claim the education credit even if someone else paid for the tuition and qualified expenses.
Example: Suppose Cameron’s Uncle Lee pays her tuition but Tricia, her mother, claims Cameron on her tax return. Tricia is the one who qualifies for and receives the credit.
What many also overlook is the fact that the AOTC is phased out for higher-income taxpayers based on their adjusted gross income (AGI). It phases out for AGIs between $160,000 and $180,000 for married taxpayers filing jointly, and between $80,000 and $90,000 for others. The LLC phases out a little quicker than the AOTC: between $112,000 and $132,000 for joint filers and between $56,000 and $66,000 for others. As an exception, married taxpayers filing separately aren’t eligible to claim either credit. (Note: the LLC phaseout ranges are adjusted for inflation annually, and the one quoted is for 2017.)
Thus, in cases when the parent claiming the student has an AGI above the phaseout range, regardless of who paid the tuition and qualified expanses, no one will be able to claim the credit. So it is important to consider the income of the individual who is claiming the student when there is an option of who claims the child, such as in cases of divorced parents.
Because of gift tax issues, a person other than the one qualifying for the credit, such as a grandparent, may hesitate to volunteer to pay a tuition expense. Where payments are made directly to the educational institution, they are excluded from gift tax rules. However, depending on the amounts involved, there may be a gift tax reporting requirement if a monetary gift is given to the student or the individual who is claiming the credit and then the gift money is used to pay tuition.
A question often arises as to whether tuition payments to a trade school or foreign university will count toward the education credit. To qualify for the credit, the tuition must be paid to any accredited public, nonprofit or proprietary post-secondary institution eligible to participate in the student aid programs administered by the Department of Education. This would rule out foreign educational institutions because they don’t qualify for the student aid program administered by the Department of Education, but it would generally include most accredited public nonprofit or privately owned, profit-making post-secondary educational institutions in the U.S.
As you can see, there are several nuances associated with the education credits that must be considered. Please call this office if you need assistance with education planning or the application of the education tax credits to your particular circumstances.
You May Be Able to Sell Profitable Stocks Without Paying Any Tax
Capital Gains Rates
Zero Tax Rate
Tax Bracket Thresholds
Taxpayers whose top marginal tax bracket is lower than 25% enjoy a long-term capital gain tax rate of zero. Yes, you read correctly: the tax on any long-term capital gains for taxpayers within the 10% or 15% tax bracket is zero! This can provide you with the opportunity to sell some of your winner stocks and pay no tax on the resulting gain. Long-term capital gains apply to stocks and other capital assets you have owned for a year and a day or longer.
Even if you want to hold on to the stock because it is performing well, you can sell it and immediately buy it back, allowing you to include the current accumulated gain in this year's return with no tax while also reducing the amount of taxable gain in the future. If you are concerned about the so-called wash sale rules that require a taxpayer to wait 60 days before buying back stock, don't be—the wash sale rules only apply to stocks sold at a loss.
To see if you can take advantage of this tax-saving strategy, you must determine if your taxable income without the potential sale is below the 25% tax bracket. The following table shows the point at which income becomes taxable at 25% for different filing statuses in 2017.
25% Tax Bracket Threshold for 2017
Head of Household
Marrried Filing Jointly
Married Filing Separately
Example: Suppose you are filing married joint and your taxable income for the year is projected to be $50,000. From the table above, we find that the 25% tax bracket threshold for you is $75,900. This means you could add $25,900 ($75,900 − $50,000) in long-term capital gains to your income and pay zero tax on the capital gains.
Of course, this strategy must be worked out based upon your projected taxable income for the year, and your actual income could be more or less than the estimated amount, meaning that some of the gain may end up getting taxed if your income is greater than projected. Or if you overestimated your income, you will not have taken advantage of as much tax-free long-term capital gains as you might have been able to.
In addition, if you have any loser stocks, you can sell them for a loss, allowing you to bring in that much more zero-taxed long-term capital gains.
There are also somewhat rare situations where the increase in your adjusted gross income as a result of the added long-term capital gains could have unanticipated adverse effects on your taxes that could reduce the overall benefit of this strategy.
If you would like to take advantage of this strategy and need assistance in projecting your 2017 taxable income, checking for adverse effects of the strategy, and determining the approximate amount of long-term capital gains you can assimilate with zero tax, please give this office a call.
Converted Your Traditional IRA to a Roth IRA? Worried You May Have Done It Too Soon if Tax Reform Passes?
Converting Traditional IRA Funds to a Roth IRA
Recharacterizations - Undoing the Conversion
Benefits of Recharacterizations
When you convert a traditional IRA to a Roth IRA, you have to pay the tax on the conversion. However, individuals frequently do this so they can take advantage of future tax-free accumulations. Distributions from Roth IRAs are generally tax free, including any earnings (accumulations) while the account is a Roth account.
Are you considering converting your traditional IRA to a Roth IRA in 2017? Are you hesitant to do so because of uncertainty about the timing and specifics of the Administration’s and Congress’ proposal to cut tax rates for individuals? Have no fear, because you can convert your traditional IRA to a Roth IRA this year, and if tax reform passes with lower tax rates effective next year, you can undo the conversion for 2017 and then re-convert for 2018.
Tax law allows individuals who convert in one year to undo that conversion by a procedure referred to as recharacterization. The procedure has been used for years, primarily by individuals whose IRA funds are invested in stocks and who converted from their traditional IRA funds to a Roth IRA only to see the value of their Roth IRA decline after the conversion due to stock market fluctuations. Recharacterizations are also used by individuals who converted their traditional IRA to a Roth IRA and then found they could not or did not want to pay the conversion tax.
This same process can be used by anyone for any purpose. So, for example, if you converted your regular IRA to a Roth IRA in 2017 and tax reform is enacted effective in 2018, you can recharacterize (undo) your 2017 conversion back to a traditional IRA. However, the recharacterization must be accomplished by the extended due date of your 2017 tax return, which is October 15, 2018. If you choose to, you then can then reconvert the traditional IRA to a Roth IRA in 2018 and take advantage of the new lower tax rates.
Generally, you must wait at least 30 days to make the reconversion. However, if you make the recharacterization of the Roth IRA back to your a traditional IRA in 2017, you may not reconvert that amount from the traditional IRA to a Roth IRA before the beginning of 2018 or, if it is later, the end of the 30-day period beginning on the day on which you transferred the amount from the Roth IRA back to a traditional IRA by means of a recharacterization.
Example: For years, Jack has been making deductible traditional IRA contributions. Then, during the summer of 2017, Jack decided to convert $25,000 of those traditional IRA funds into a Roth IRA. After the conversion is completed, late in 2017, Congress passes and the president signs a tax reform bill that reduces Jack’s marginal tax rate in 2018. To take advantage of the lower tax rate, Jack recharacterizes (undoes) the conversion back to a traditional IRA for 2017 and then reconverts it back to a Roth IRA in 2018. To do that, Jack first transfers the $25,000 (plus earnings or minus losses since the original conversion) back to a traditional IRA by way of a trustee-to-trustee transfer (it’s OK for the transfer to be with the same financial institution). He could make the recharacterization as late as October 15, 2018, but chooses to do so on January 15, 2018. Then, after making the transfer back to the traditional IRA, Jack reconverts the amount back to a Roth IRA on Feb. 20, 2018.
For more information on recharacterizations and conversions, and how they might fit into your tax planning, please give this office a call.
Ignoring Those IRS Notices Only Makes It Worse
IRS Informational Forms
Need for Professional Review
Remember those 1099s, W-2s, K-1s and other informational forms you receive each year reporting your interest, dividends, sales, wages, retirement income, IRA withdrawals, health insurance forms and other items having to do with your tax return? Well, the IRS also gets this information and feeds it into its computers. Thanks to modern computer technology, the IRS is able to match that information to what you reported on your tax return, and if something significant is omitted or there's a discrepancy with the numbers, the IRS is going to send you a letter asking for an explanation or a tax payment. You will also receive correspondence if you don't file a return and the data the IRS has indicates that you should have filed. It has form letters for just about every possible situation.
Most frequently, these notices will include a proposed tax due, plus interest and/or penalties, along with an explanation of the examination process and how you can respond. However, the letters must, by law, advise you of your rights and other information. Thus, these letters can become overly lengthy and are sometimes difficult to understand. That is why it is important to have a trained eye review them before you take any action.
Do not procrastinate or throw the letter in a drawer hoping the issue will go away. After a certain period of time, another letter will automatically be produced. And, as you might expect, each succeeding letter will become more aggressive and more difficult to deal with, and it may reach the point where you might have to go to tax court to argue your case or pay whatever amount of money the IRS is demanding.
Most importantly, don't automatically pay an amount the IRS is requesting unless you are positive it is correct. Quite often, you really do not owe the amount being billed, and it will be difficult and time consuming to get your payment back.
It is always good practice to have a tax professional review the correspondence and respond to the IRS in a timely manner. Also, note that these "love letters" from the IRS will come by regular mail, not email. If you receive an email from someone claiming to be from the IRS and demanding a tax payment, this communication will be a fraud, since the IRS does not use email for this purpose. Please call this office immediately in regards to any notice you receive about your tax returns.
Do You Rent a Home to a Relative at Less Than the Fair Rental Value?
If yes, you should be aware of some very special tax restrictions. Watch the video below for specifics.
Trump's Tax Reform for Individuals - Will It Pass Congress?
Determining Taxable Income
Child Tax Credit
The GOP’s framework for tax reform is big news right now, but most newscasters can’t seem to get the facts straight. So, here is a little round-up of the proposed changes affecting individual tax returns, but keep in mind these are proposals and not law until passed by Congress and signed by the president. In addition, there is controversy around some of the proposed changes, so we can expect any tax reform legislation, if passed, to be different from the original framework described here.
Based on comments by administration insiders as well as the amount of details that need to be worked out, even if passed, it is unlikely that the changes will apply retroactively to 2017.
First, let’s consider how things are done now and how the proposed tax reform would change them. To determine taxable income, we begin with adjusted gross income (AGI), which includes all of a taxpayer’s income and allowable losses. From the AGI, the taxpayer’s deductions (either a standard allowance or itemized) and exemptions are deducted to arrive at the taxable income. It is the deductions and exemptions where a significant change is being proposed.
Standard Deductions – Under the GOP’s proposed changes, the standard deduction would be increased as shown:
But before you get too excited, under the GOP’s framework, you would no longer be able to also deduct personal exemptions, currently worth $4,050 for each taxpayer and each dependent. Combining the exemptions with the standard deduction is an attempt at simplifying the tax law. To understand how this would play out, let’s compare taking the standard deduction under the current regime to that of the proposed change for a variety of family combinations.
As you can see, the proposed change favors a smaller family size, but this is supposed to be compensated for with a larger and partially refundable child tax credit, as discussed below.
Under the proposed changes, the additional standard deduction currently allowed for individuals age 65 and over and for those who are blind appears to no longer apply. In addition, there is no provision for taxpayers filing as head of household, so presumably they would be filing as single.
Tax Rates – Under the GOP proposal, the current seven tax brackets (10%, 15%, 25%, 28%, 33%, 35% and 39.6%) would be replaced with three (12%, 25% and 35%). However, to determine how these new rates will apply, we need to know the taxable income ranges they apply to. This detail is not available and has been left to the Congressional committees to decide.
Itemized Deductions – Itemized deductions will be severely curtailed under the proposal, limiting them to home mortgage interest and charitable contributions. However, this part of the proposal has already come under heavy flack for a number of reasons, one of which is that state and local income taxes would no longer be deductible by individuals residing in states with income tax. This is not sitting well with Congressional members from states with income tax, especially those from CA, NJ and NY – states with the highest state and local taxes. The real property tax deduction would also be repealed, which is proving to be another contentious change. Medical Deductions – The deduction for medical expenses also would no longer be allowed. This could have a devastating impact on taxpayers burdened with high unreimbursed medical costs, especially those fighting cancer and those who have a disabled child or family member.
Casualty Losses – Itemized deductions currently include casualty losses, but it is highly unlikely, especially in light of the recent hurricane disasters, that casualty losses will actually be cut from the tax code. We can probably expect casualty losses to be accommodated in one way or another after the dust settles.
Child Tax Credit (CTC) – The proposed changes enhance and simplify the child tax credit to make up for the loss of an exemption deduction for dependents. To do this, the CTC will be increased (the amount of the increase has not been specified at this time), and the first $1,000 of the CTC would be refundable. In addition, the proposal adds a $500 non-refundable credit for other dependents who would not meet the child criteria. The proposal expects that the current income amounts at which the child credit begins to phase out will be increased so that the credit will be available to more middle-income families.
Work, Education and Retirement Benefits – According to the GOP tax reform documents, numerous other exemptions, deductions and credits for individuals riddle the tax code. The framework envisions the repeal of many of these provisions to make the system simpler and fairer for all families and individuals, and allow for lower tax rates. However, the framework retains tax benefits that encourage work, higher education and retirement security. The Congressional committees are being encouraged to simplify these benefits to improve their efficiency and effectiveness. An aim of tax reform will be to maintain or raise retirement plan participation by workers and the resources available for retirement.
AMT and Estate Tax – Also biting the dust if the GOP plan makes it through Congress would be the alternative minimum tax (AMT) for individuals, the death tax (estate tax) and the generation-skipping transfer tax.
But keep in mind that these are only proposed changes, and there is no guarantee they will actually become law. If you have any questions, please give this office a call.