Great Tax Breaks That Could Go Away

March 22, 2016

Author: Dave Gardner

Now that we’re in the heart of tax season, our focus is to see what can be done to reduce taxes for clients for 2015 and beyond.  While some tax breaks are straightforward, there are those that may face the chopping block when it comes time to “simplify” our federal and state tax codes.  President Obama’s proposed budget includes eliminating many of these tax breaks.  Although that’s unlikely to happen this year, consider using these tax breaks while you can.

Backdoor Roth IRA.  Every time we make it possible for high income earners to contribute to a Roth IRA, we shake our heads at how this can be done under current law.  Roth IRAs are tremendous assets as they allow you to have tax-free growth over your lifetime, yet you can withdraw your contributions at any time.  Once you get to an income of $183,000 in MAGI (for 2015) for a married couple or $116,000 as a single person, your ability to make a Roth contribution begins to phase out.

But there’s a method that high earners can use to contribute to a Roth.  Key to this strategy is having no (or at least very low) balance in your traditional IRAs.  If you pass that test, you can make a non-deductible traditional IRA contribution even with high income and participating in a 401(k) or other retirement plan.  Before April 18th you could possibly contribute for both 2015 and 2016 for a total of $11,000 ($13,000 for those 50 and over) for each tax filer.  Once you have put after tax money into the IRA, soon thereafter you can convert those funds into a Roth IRA with little or no tax hit.  It’s an intricate strategy, so do your homework before embarking upon this.

S Corporation Business Owner.    Let’s say you have a successful small business with $180,000 in profit last year.  You started off life as an LLC taxed as a sole proprietorship.  Your visit with your accountant doesn’t go so well as with your recent success you will owe a hefty tax bill, much of it due to so called self-employment tax, which is essentially the employer and employee side of Social Security and Medicare tax.   You owe $19,515 in self-employment tax.  Your preparer then brings up the idea of changing to an S Corporation tax structure.  There would be more paperwork, accounting hassles, and tax preparation fees, but the savings could be substantial.

With an S Corporation If you could justify a reasonable wage for your “job” is $90,000, then you (and your corporation) would just pay Social Security and Medicare tax on that amount.  The tax would total $13,770.  The remaining $90,000 in profit would be subject to income tax, but not to self-employment tax.    There are some downsides to this practice as mentioned earlier and it could possibly lower your Social Security benefit and ability to contribute to retirement plans.  But most business owners in this situation end up ahead of the game, for a tax policy reason that seems unclear.

Colorado 529 Plan Super Education Coupon.  Even if you haven’t done the best job saving for college, you can still use the tax benefits of a Colorado 529 college savings plan to save on higher education tuition and living expenses for a full time student.   Consider a student with a tuition, room and board bill at a university that totals $40,000 a year.   Once you come up with the funds, deposit $40,000 into a Colorado 529 Plan, take distributions as qualified higher educational expenses occur, and then when you file your Colorado state income taxes you take the state income tax deduction, which means an additional $1,800 or so in your pocket.

Other tax reform targets the lax rules for Roth IRAs, which are currently exempt from mandatory distributions for those 70 ½ and over that apply to traditional IRAs and most retirement plans.  Also under current law, when inherited both Roth IRA and Traditional IRA distributions may be stretched over the lifetime of the beneficiary, while many inherited annuities must be distributed over five years.  Similarly, limiting the deferred gain of 1031 tax-free transfers of real estate and eliminating the step up in basis when inheriting taxable investments have been mentioned in the President’s proposals.

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About Dave Gardner

David Gardner is a certified financial planner with a practice in Boulder County and can be reached at dave@confluencefa.com and at twitter.com/Dave_CFP.