TAX ADVICE from Julian Block
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
You are taxed on: (1) up to 50 percent of benefits when
MAGI is between $25,000 and $34,000 for single persons or
$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
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 firstname.lastname@example.org.