About a month ago, I received a text message from a friend with what he thought was good news. President Trump signed an executive order that would provide a payroll tax holiday potentially putting 6.2% of his income back into his pocket.
After a little bit of research into the matter, I had to break the bad news. While the executive order would boost his pay for the remainder of the year, all of that tax would still be due in 2021.
The payroll tax & holiday
Payroll taxes are divided into three main categories: Federal income, Medicare, and Social Security. Trump’s order specifically targets the Social Security tax.
Typically, employees and employers each pay half of the total 12.4% Social Security tax. But under the executive order, employers wouldn’t withhold the 6.2% for Social Security from the employee’s pay. The employer would still contribute their portion.
The payroll tax “holiday,” or suspension period, runs from September 1 through December 31, 2020, and only applies only to those who earn less than $4,000 bi-weekly and less than $104,000 per year.
Some potentially good news is that your employer isn’t required to participate in the payroll tax holiday, which possibly makes the rest of what you are about to read a moot point.
That is unless you work for the Federal government. The U.S. government will implement an across-the-board payroll tax deferral for about 1.3 million federal employees starting in mid-September.
my employer participating, now what?
So what happens if your employer participates in the holiday?
You’ll see an increase in your paycheck over the next few months but come 2021 you are going to have start paying those taxes back and it will roughly double your Social Security tax rate from January 1 to April 30 when they are required to be paid back by.
If you leave employment or just don’t have enough wages to pay it back, the IRS will apply interest and penalties to the amount not paid back which will fall onto your employer to pay. They (the employer) may in turn try to find a way to make you (the employee) pay the interest and penalties. Talk about an uncomfortable situation to be in!
In order to avoid this, I’d suggest setting aside money now (if you can) and then start taking it out to replace the lost wages in January.
Note, there is always a chance that Congress will pass legislation to forgive the deferred taxes but I wouldn’t rely on that.
As a financial advisor, I look at a lot of tax returns. I’m usually looking for key tax information that guides long-term tax planning. But, something that I’ve noticed is an uptick in people owing an underpayment penalty to the IRS.
I’m not sure what is causing the increase – a byproduct of the recent tax changes? – but if it’s impacting you there are a few ways that you can avoid the penalty and save yourself a few hundred dollars.
What is it, how does it happen, and am I paying?
You owe an underpayment penalty if you didn’t pay enough taxes throughout the year. This can happen even if you are a salaried employee.
Most of the time, employees have taxes withheld from their paychecks and the employer sends them to the IRS. But if you claim the wrong number of allowances on your W-4 you could end up underpaying.
Also, if you a regular employee and have income from other sources you could also be underpaying.
It’s even easier to underpay if you’re self-employed, a freelance worker, or retired. You don’t have taxes withheld as you earn income. You’re required to make estimated quarterly payments based on what you earn, which can be variable. This makes it easy to miscalculate the taxes owed or even skip a payment on accident.
You’ll be able to tell if you’re paying an underpayment penalty by looking at line 24 on page 2 of Form 1040. If there is a number there, it’s likey from an underpayment of taxes.
How to avoid it
Generally, most people will avoid the penalty if they:
owe less than $1,000 in tax after subtracting their withholdings and credits
had no tax liability the previous year
paid at least 90% of the tax for the current year, or 100% of the tax shown on the return for the prior year, whichever is smaller
for high-earners, it’s 90% of the current year or 110% of the prior year, whichever is smaller
The penalty may be waived if either:
you experienced an event, like a natural disaster, that caused the underpayment or,
you are retired (after reaching age 62) or became disabled during and the underpayment was due to reasonable cause, not willful neglect
You’ll have to submit the request for the waiver in writing when you submit your tax return.
If none of the above apply to you, you can’t undo what’s done. You’re stuck with an underpayment penalty but you can take steps to avoid one going forward.
If you’re a regular worker, start by increasing your withholdings on your W-4 so that more tax is taken out of each paycheck. Here is a link to the IRS’s tax withholding calculator to help you determine the amount, https://www.irs.gov/individuals/tax-withholding-estimator
If you’re a worker with income from outside sources, also consider increasing your W-4 withholdings, or make estimated tax payments to cover your taxes. I think that having the amount withheld from your paycheck is much easier than writing quarterly checks to the IRS.
If you’re self-employed, a freelancer, or retired be sure to make your estimated payments for the current tax year by the deadlines. I recommend setting up an automatic monthly transfer from your checking (or business checking) into a separate account that’s earmarked for your estimated payments. That can help you avoid a cash squeeze when it’s time to send the checks in.
If you’re retired and have IRAs, you can more taxes withheld from each distribution from you IRA. This works especially well if you are taking required minimum distributions (RMDs) but don’t need the income.
I have a friend that is starting a business and they asked for my advice on the most tax-efficient way to set it up (i.e. how to pay the least amount of taxes possible).
After some discussion about what the business is and how much they expect to make, we landed on establishing a Limited Liability Company (LLC) and to elect filing taxes as an S-corporation. In short, here’s why.
Key points:
S Corporations have some tax planning unavailable to your run-of-the-mill LLC. The FICA tax for Social Security and Medicare (also known as self-employment taxes) only applies to wages paid to owner-employees. The remainder of the net earnings passes through as dividend income.
S-Corps avoid double taxation by reporting the gains and losses on the shareholders’ individual tax returns.
For tax years 2018-2025, a deduction equal to 20% of the share of an S-corporation’s profit can be claimed, subject to limitations.
Self-employment tax savings
Technically, S-corporation status is a federal tax status, while an LLC is a type of legal entity created under state corporate law.
LLCs almost always stick with the default tax rules, under which they are treated either as a sole proprietorship or a partnership, depending upon the number of owners. As your income from your LLC increases, so does the self-employment tax. You earn more, you pay more tax.
An S-Corp lets you split your profits into “shareholder wages” (subject to 15.3% Social Security, Medicare, and self-employment taxes) and “distributive share” (NOT subject to 15.3% Social Security, Medicare, and self-employment taxes).
An owner of an LLC with pass-through taxation pays 15.3% on the entire profits. Active owners in an S-Corp must pay themselves a reasonable salary (more on this down below), but realize a 15.3% savings on the rest of their retained profits.
avoid double taxation
Usually, corporations are taxed as its own entity. The corporation files IRS Form 1120 each year to report its income, deductions, and credits, and profits are typically taxed at corporate income tax rates.
That’s pretty cut and dry, but where small business owners can run into trouble is through something called double taxation. That’s because when the corporation distributes dividends to the stockholders (the business owner), these dividends are taxed on their personal tax returns.
If you’re a small business owner and expect to put some of the profit into your own wallet, the money could end up being taxed twice: first, the corporate profits are taxed at the corporate level and then the distributions are taxed on an individual level.
When filing as an S Corporation, the company itself no longer pays taxes on the profits. Instead, any profit or loss is passed to the owner and they report it on their personal tax return.
QBI deduction
In 2017, the Tax Cuts and Jobs Act established IRS Code Section 199A, which provides a 20 percent deduction for eligible pass-through entities with qualifying business income (“QBI”). This new provision has the ability to reduce the maximum individual tax rate of 37% on pass-through income to approximately 29.6%, making it more equitable to the C corporation tax rate of 21%.
The QBI offers a way to lower the effective tax rate on the profits of owners of pass-through entities. These include sole proprietorships (including independent contractors), partnerships, limited liability companies, and S corporations.
Salary amount
As the owner of an S Corp, you take a salary and only this portion is subject to FICA and Medicare taxes. Any remaining profit that is distributed is treated as a dividend and taxed as ordinary income, but not subject to payroll taxes.
Obviously, this creates an incentive for owners who work for an S-corporation to pay themselves the least amount possible. The IRS is aware of this incentive and requires shareholders to pay themselves a reasonable salary.
What is considered a reasonable salary depends on the net income and industry, so it is difficult to give a target dollar figure. You may hear the general rule of that salary can be two-thirds of net income. However, take this with a grain of salt. The salary number is very subjective relative to industry standards and should be supportable.
It’s advisable to work with a Certified Public Accountant to determine how much is a reasonable salary for the field you are in.
I was in line at the grocery store this past week and I overheard the family behind me talking with their teenage son about gifting him a car.
The father mentioned that he was pretty sure there was a limit to how much can be gifted to a person before it became taxable.
I politely introduced myself and asked if he is referring to the annual gift exemption of $15,000. “Yes, that’s it!” he proclaimed.
As you can imagine, they had a few more questions about how these gifts work so we spoke for another 10 minutes about it.
This topic is often misunderstood so I thought I’d take the opportunity to cover it this week and hopefully break it down so that it’s easy to understand.
what is the gift tax?
The IRS lumps together all gifts you make during your lifetime with gifts you make as bequests from your estate when you die and assesses a 40% tax that a gift-giver must pay to the Federal government on those gifts.
In the IRS’s eyes, the federal gift tax applies to any gift you make during your lifetime – all the way from the $1 you gave to your niece to something as large as paying off someone’s student debt.
You are technically supposed to track every single gift you make, no matter the size. But the IRS knows that is impractical so they have two options for avoiding the gift tax.
The first is an annual exclusion and the second is a lifetime exemption.
The Annual Gift Tax Exclusion
The annual exclusion allows you to make gifts up to $15,000 per year per person (as of 2020) without being impacted by the gift tax.
You read that right. You can give $15,000 to an unlimited number of individuals in a year without even thinking about the gift tax.
It gets even better if you are married. You and your spouse are each entitled to a $15,000 exclusion and can give up to $30,000 per person.
These gifts don’t count against your lifetime exemption. It will only kick in when you exceed this annual amount in a given year.
The Lifetime Exemption
Only the gifts above the $15,000 annual exclusion begin to impact your lifetime exemption of $11.58 million (as of 2020). And it’s not until you go over the lifetime exemption that you are required to pay the 40% tax on the gifts.
Keep in mind that you do need to report gifts over the annual exclusion to the IRS on Form 709. This records how much you’ve gone over the annual exclusion each year (the amounts that count against your lifetime exemption).
Of course, you are free to pay the taxes on the gifts when you file the tax return. You are not required to let them count against your lifetime exemption.
Eventually, at the end of your life when your estate settles, all these annual overages are added up and applied to your lifetime exemption. It’s only when your excess gifts plus the value of your estate exceed the lifetime exemption of $11.58 million that you’ll be taxed.
A Gift Tax Example
If a father makes a gift of a $30,000 car to his son, $15,000 of that gift is free and clear of the federal gift tax, thanks to the annual exclusion. The remaining $15,000 is a taxable gift and would be applied to his lifetime exemption if he chose not to pay the tax in the year he made the gift.
Remember though, the mother could also gift part of that car, and in this case, none of it would impact their lifetime exemptions.
But what if that car was worth $80,000? The father and mother could both use their annual exclusion of $15,000 ($30,000 total) but the remaining $50,000 would need to be reported on Form 709. There would technically be two Form 709’s – one for each of them – as each individual is responsible for their own 709.
This is a relatively straightforward and oversimplified example. Things can get really complicated when you begin to consider gifts of community property. A topic for another article for sure!
What does the irs consider a gift?
The Internal Revenue Service considers a gift to be virtually any transfer of cash or property in which the giver doesn’t receive something of equal value in return.
If you give someone cash with the understanding that they won’t pay you back, that’s a gift. If you sell someone a $300,000 home for $150,000, you’ve made a gift of $150,000.
This is all based on the IRS definition of “fair market value.” Cash is what it is, so there’s rarely any doubt there. As for that house, the IRS says its fair market value is what someone could be expected to pay for it if neither the buyer nor the seller was under any sort of duress to commit to the transaction.
tax-exempt Gifts
There are a few types of gifts that are inherently tax-free, regardless of the lifetime exemption. These include:
Gifts to IRS-approved charities
Gifts to your spouse (assuming he or she is a U.S. citizen)
Gifts covering another person’s medical expenses, as long as you make the payments directly to medical service providers
Gifts covering another person’s tuition expenses, as long as you make payments directly to the educational institution. (Payments for room and board, books, and supplies don’t qualify for this exception, but you can cover those costs by making a direct gift to the student under the annual exclusion.)
Remember state estate taxes
Even if your estate isn’t big enough to owe federal estate tax, your state may still have an estate tax.
For example, in Oregon, estates worth more than $1 million may owe state estate tax. Property left to a surviving spouse, however, is exempt from state estate tax, just as it is exempt from federal estate tax.
A few states also impose a separate tax, called an inheritance tax, on a deceased person’s property. The rate depends on who inherits the property; usually, property that passes to spouses and other close relatives is not taxed or is taxed at a very low rate.
For the 2019 tax year, a single filer can contribute up to $6,000 to a Roth IRA ($7,000 for age 50 and older) if their modified adjusted gross income (MAGI) is less than $122,000.
As their income goes above that, the allowed contribution amount begins to decrease until they become totally ineligible at $137,000. The limits for those who are married and filing jointly are $193,000 and $203,000 respectively.
So what can you do if you saved diligently to your Roth IRA last year but as you are gathering all of the documents to file your taxes you find that your income was too high to actually contribute to a Roth IRA?
There are three fairly straightforward options to remedy this problem.
Withdraw the Excess Contribution
The first solution is to simply withdraw the excess contribution so it doesn’t count toward that year’s contributions.
According to the IRS:
“For purposes of determining excess contributions, any contribution that is withdrawn on or before the due date (including extensions) for filing your tax return for the year is treated as an amount not contributed. This treatment only applies if any earnings on the contributions are also withdrawn. The earnings are considered earned and received in the year the excess contribution was made.”
What this means is that withdrawals are not treated as distributions — it’s as though the contributions were never made. But earnings on the contributions will be counted as income and you’ll owe taxes on that amount (you’ll also owe the 10% tax for an early withdrawal if you are under the age of 59 1/2).
For example, if you contributed $6,000 and that $6,000 earned $100 you will need to withdraw $6,100 when removing the excess contribution. Only the $100 of earnings will be considered income though.
You can withdraw contributions from a Roth IRA up until the Oct. 15 extended deadline if you’ve requested an extension of time to file your return. If you already filed your tax return, you can still withdraw contributions, but you’ll need to file an amended tax return after withdrawing the funds.
Move the Money to a Traditional IRA
Another option is to “re-characterize” the Roth IRA contribution to a Traditional IRA contribution.
According to the IRS:
“You may be able to treat a contribution made to one type of IRA as having been made to a different type of IRA. This is called re-characterizing the contribution. To recharacterize a contribution, you generally must have the contribution transferred from the first IRA (the one to which it was made) to the second IRA in a trustee-to-trustee transfer. If the transfer is made by the due date (including extensions) for your tax return for the tax year during which the contribution was made, you can elect to treat the contribution as having been originally made to the second IRA instead of to the first IRA.”
The IRS says that you must also:
“Include in the transfer any net income allocable to the contribution. If there was a loss, the net income you must transfer may be a negative amount. Report the recharacterization on your tax return for the year during which the contribution was made. Treat the contribution as having been made to the second IRA on the date that it was actually made to the first IRA.”
Apply the Roth Contribution to the Following Tax Year
If you expect your income will be low enough that you can contribute to a Roth IRA going forward, you also have the option of applying the excess contributions to the next tax year. This allows you to keep the funds invested in the Roth IRA.
The IRS says:
“If contributions to your Roth IRA for a year were more than the limit, you can apply the excess contribution in one year to a later year if the contributions for that later year are less than the maximum allowed for that year.”
what if you don’t take action
If you don’t take any of the actions above, the IRS is going to determine that you made excess contributions and assess an excise tax of 6% to the amount that exceeds your limit for the year. This amount is calculated and reported on Form 5329.
You might say to yourself, “6% doesn’t seem so bad”. But the tax doesn’t just apply to one year, it will continue to be assessed each year for as long as the excess contributions remain in the Roth IRA.
It can be easy to inadvertently contribute too much to your Roth IRA. Luckily, there are a number of easy to administer solutions to fix the problem. Just make sure you take the necessary action so you don’t end up paying the government more money than you need to!
