TAX ADVICE from Julian Block

renowned tax advisor and Larchmont neighbor, Julian Block, provides help for Gazette readers

Most Social Security recipients escape income taxes completely on all of their benefits. But middle- or upper-income level retirees have to count benefits as reportable income.

GIFT OF THE MAGI. When do taxes kick in? Only when your income -- in tax jargon, your MAGI, short for modified adjusted gross income, exceeds specified amounts.

In calculating whether income exceeds the thresholds for benefits to be taxed, the MAGI rules require you to count salaries, pensions, dividends, capital gains, rents, required minimum distributions starting at age 70 1/2 from traditional IRAs, money moved from traditional IRAs to Roth conversion IRAs, and the like. Add to that roster whatever you receive as tax-exempt interest from municipal bonds (obligations issued by state and local governments) or from muni bond funds, as well as 50 percent of your benefits.

You are not taxed on benefits when MAGI income is under $25,000 for single taxpayers and $32,000 for married couples filing jointly.

You are taxed on: (1) up to 50 percent of benefits when MAGI is between $25,000 and $34,000 for single persons or between $32,000 and $44,000 for couples filing jointly; and (2) up to 85 percent of benefits when MAGI tops $34,000 for singles and $44,000 for joint filers.

COUPLES WHO FILE SEPARATELY. The $32,000 threshold drops to zero, unless the spouses do not reside together at any time during the taxable year. Translation: A couple who live together for just a day and file separate returns are not allowed a base amount of $25,000 each.

This trap snared Thomas W. McAdams, a retired Army colonel. Tom and his wife Norma stayed married but lived apart, she in the home they owned in Boise, Idaho, while for many years he lived most of the time in Ninilchik, Alaska, and other locales far from Boise. They listed themselves on their 1040s as “married filing separately.” In the course of an IRS audit, Tom let slip that he stayed in Norma’s dwelling for more than 30 days during the year in issue, though he always slept in a separate bedroom.

That admission prompted the Tax Court to agree with the IRS that Tom did not, as the law mandates, “live apart” from his wife “at all times during the taxable year.” The court reasoned that living apart can only mean living in separate residences, not separate areas of the same residence. It held that his visits disqualified him for the $25,000 exemption. Hence, none of his benefits sidestepped taxes.

ROTH CONVERSIONS. Because conversion income counts as reportable income, a conversion could increase MAGI by enough to cause otherwise tax-free Social Security benefits to become partially taxable. But as there are no taxes on subsequent Roth withdrawals, they will not expose benefits to taxation. Put another way, you can incur taxes on benefits because of taxable transfers from traditional IRAs to Roth accounts, but not because of later Roth removals.

TAX-EXEMPT INTEREST. Moving money into tax-exempt investments can significantly lower the total tax bill for retirees, just as it does for others, as well. But that maneuver will not diminish the taxes paid on Social Security benefits by retirees who also receive tax-exempt interest. As mentioned earlier, tax-free interest must be added to funds received from pensions and other sources to determine whether MAGI is greater than the $25,000/$32,000 thresholds. So tax-exempt interest can cause income that otherwise would be below the $25,000/$32,000 base amounts to exceed the figure at which benefits begin to be taxed.

DIVORCE AS A TAX SHELTER. Whether by design or inadvertence, Congress crafted rules for taxation of benefits that require a person to pay more taxes on benefits solely because he or she is married. How come? Because two single persons who share quarters without benefit of clergy can each have up to $25,000 in MAGI income before any of their benefits get taxed. With a combined base amount of $50,000, they gain an advantage of $18,000 (the excess of $50,000 over $32,000) over a married couple -- an aspect of the law, that, depending on one's point of view, is a "marriage penalty" or a "sin subsidy."
Certainly, no couple is going to get divorced just to trim the taxes on their benefits. But for a tax-conscious couple contemplating an unhitching, the prospect of a sizable savings at filing time could well be the clincher.

How does this break for singles help a couple? To put more, or even all, of their benefits beyond the reach of the IRS, all that they would need to do is divorce and then live together out of wedlock. Assuming their unaltared arrangement remains unaltered, each would become entitled to use the base amount of $25,000 for a single person. Their unhitching (or forgoing that walk down the aisle to begin with) would enable them thereafter to live a more prosperous life in unwedded bliss.

TIP. Divorce provides another tax advantage for two-income couples with relatively equal incomes. The law mandates that married couples combine their incomes and be taxed at the same rate for the first dollar of the second income as the rate for the last dollar of the first income. Therefore, their tab as marrieds is more than it would be as two singles who report exactly the same incomes.

STATE INCOME TAX RETURNS. Does your reportable income on Form 1040 include Social Security benefits? Check the rules of the state in which you have to file a return. In many states, those benefits escape taxes when figuring your income for purposes of state income taxes. In California and New York, for example, they are a subtraction on page one of the return when computing taxable income.

Julian Block is a syndicated columnist, attorney and former IRS investigator who has been cited by the New York Times as “a leading tax professional” and by the Wall Street Journal as an “accomplished writer on taxes.” His “Tax Tips For Freelance Writers” shows how to save truly big money on taxes – legally – and explains the steps you should take to reduce taxes for this year and even gain a head start for future years. Send $9.95 for an e-mailed copy or $12.95 (in the U.S.) for a postpaid copy to: J. Block, 3 Washington Square, #1-G, Larchmont, NY 10538-2032. Contact him at julianblock@yahoo.com.