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Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 05 September 2013

The U.S. Tax Court is the court to use when the amount of federal taxes is in dispute and the taxpayer has not yet paid the bill. Several recent decisions from the Tax Court provide guidance for individuals and businesses in planning for future transactions.

Corporate services at cost

It is common practice for a business owner to use the services of his or her company for personal matters. The question that can arise is the extent to which this results in income to the owner.

In one recent case, the sole shareholder of a corporation in the construction business had his company build a lakefront vacation home for him. He had the corporation maintain a “cost plus” job account on its books to keep track of the materials for his home. He reimbursed the corporation for all of the materials, labor, and overhead costs related to his job. He acted as the general contractor, dealing with all of the subcontractors himself.

The IRS said that the profit that corporation would otherwise have made on its building activities for him of more than $48,000 was a constructive dividend. The Tax Court said that at-cost services do not result in a constructive dividend to an owner (Welle, 140 TC No. 19 (2013)). Normally the shareholder’s corporation would have charged customers a profit margin of 6% to 7%. However, the foregone profit was not a constructive dividend because it did not result in a distribution of current or accumulated earnings and profits (Code Sec. 316(a)). While an economic benefit received can amount to a constructive dividend, it only becomes a dividend if it is a distribution from earnings and profits without expectation of repayment. There is no automatic connection between a corporation’s decision not to make a profit on services provided to a shareholder and a corporation’s distribution of earnings and profits. A dividend results only when corporate assets are diverted to or for the benefit of a shareholder.

Planning pointer: A shareholder can have his or her corporation provide services for the owner’s benefit without triggering a constructive dividend as long as the corporation is reimbursed for its outlays.

IRAs and Personal Guarantees

An IRA can be a flexible investment vehicle, allowing for tax deferral of income and gains until distributions are taken. However, tax deferral is thwarted if the IRA is misused by engaging in a prohibited transaction. This causes the IRA to lose its exempt (tax-deferred) status, resulting in immediate taxation of all of the funds in the account (assuming the IRA was created with tax-deductible contributions).

One individual set up a corporation (Corporation A) and had his IRA buy its shares. Then Corporation A purchased another corporation (Corporation B) with cash and a note. The IRA owner personally guaranteed the note issued by Corporation A. After B’s stock had appreciated, he converted his IRA to a Roth IRA. Then B’s stock was sold for a considerable gain.

The IRS said that all of the gain was taxable to him and the Tax Court agreed (Peek, 140 TC No. 12 (2013)). His personal guarantee of the note issued by the corporation whose stock was in his IRA was an indirect extension of credit to the IRA, which is a prohibited transaction. This caused the IRA to lose its exempt status as of the date that the note was made (well before the conversion to a Roth IRA and well before the sale of B’s stock) (Code Secs. 408(e) and 4975(c)(1)(B)).

Planning pointer: Self-directed IRAs offer considerable opportunities for investment growth by savvy individuals. However, exercise care when using self-directed IRAs. Only certain types of investments are permissible. What’s more, any self-dealing can be viewed as a prohibited transaction.

Dependency exemptions for noncustodial parents

When parents get divorced, only one can claim a dependency exemption for their child. Under federal tax law, the exemption belongs to the custodial parent unless that parent waives the right to claim it. A waiver must be made in writing; Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents, is used for this purpose.

Often, divorce courts specify which parent is the one to claim a dependency exemption. This direction may not align with federal tax law, as one parent found out. A divorce decree awarded physical custody of the couple’s three children to the mother. The dependency exemptions were to be divided between the parents, but the divorce decree did not require the mother to execute Form 8332 to release the claim to the exemptions. The father claimed a dependency exemption for two of the children, consistent with his understanding of the divorce decree, but he did not get his ex-wife to sign Form 8332. She claimed a dependency exemption for two children, so that each parent claimed the same child as a dependent on their returns.

The Tax Court concluded that tax law trumps state law on divorce matters when it comes to the dependency exemption (Shenk, 140 TC No. 10 (2013)). Simply put, because the mother did not sign a release of her right as custodial parent to claim the dependency exemptions, the father could not claim them despite the language in the divorce decree.

Planning pointer: A parent going through a divorce should make sure that an experienced tax advisor review documents related to settlements so he or she understands the consequences of the provisions in the documents.

Easements with strings

An individual who owns a building or land may be able to obtain a current tax deduction without losing the right to use the property. This is accomplished through a conservation easement (or a façade easement with respect to a certified historic structure) granted in perpetuity. To qualify, there must be a legally enforceable restriction on the use of the property so that it is exclusively for (Code Sec. 170(h)):

- Preservation of land areas for outdoor recreation by, or the education of, the general public.

- Protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.

- Preservation of open space (including farmland and forest land).

- Preservation of a historically important land area or a certified historic structure.

The problem arises in how the donation of an easement is structured. In a recent decision, donors made gifts of cash and a façade easement of their property located in a historic preservation district in New York City to the National Architectural Trust (NAT) and claimed a charitable deduction. The easement was appraised at $990,000 (the easement apparently reduced the appraised value of the $9 million property by 11%); they also donated cash equal to 10% of the appraised easement value ($99,000). The IRS disallowed the deduction, maintaining that the gifts were “conditional.” Under the terms of a side letter with NAT (referred to by the donors as a “comfort letter”), the property would be returned to the donors if the IRS disallowed the deduction.

The Tax Court agreed with the IRS that the gift was conditional and not deductible (Graev, 140 TC No. 17 (2013)). The donors argued that the possibility that the condition would be triggered (i.e., that their donation would be disallowed) was so remote as to be negligible (Reg. Secs. 1.170A-1(e), 1.170A-7(a)(3)), and 1.170A-14(g)(3)). They said that under state law (New York in this case), the side letter was unenforceable because it was not part of the recorded deed, making it a nullity.

The court rejected the donors’ arguments. The facts showed that NAT was ready and willing to honor the letter. NAT kept the donors informed about Congressional developments concerning easements and gave them an opportunity to back out of the donation before the deed was recorded. Thus, the donors effectively reserved the right to have their easement and cash returned if certain events occurred, making the gift conditional and nondeductible.

Planning pointer: Donors making conservation easements should follow the rules carefully to avoid a disallowance of the deduction for their charitable donation. Retaining any rights or conditions can disqualify the donation. For more details, review the IRS’ Audit Technique Guide on Conservation Easements at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Conservation-Easement-Audit-Techniques-Guide#_Toc113.

Conclusion

Tax Court decisions offer important guidance on key points in tax laws that serve to help in planning transactions in the future.

Details

Written by: Sidney Kess, CPA, J.D., LL.M. with Robert S. Barnett, CPA, JD, MS (Taxation)

Published: 12 August 2013

Trusts have historically been used for a variety of reasons: to benefit family members, charities, or even pets. They can be “permanent” by making them irrevocable, or they can be changed or terminated at the option of the grantor by making them revocable. They can be set up during life (inter vivos trusts) or at death (testamentary trusts).

Unless trusts are considered to be grantor trusts where income is taxed directly to the grantor, trusts are separate taxpayers, filing their own returns (Form 1041) annually and paying taxes at their own rates on amounts not distributed to beneficiaries. Due to new law changes effective in 2013, several of the tax rules for trusts have changed. Here are the new income tax rules to note.

Higher Ordinary Income Tax Rates

While trusts have graduated income tax rates, they are highly compressed. This means that trusts reach the highest income tax bracket of 39.6% by having taxable income in 2013 over $11,950 (Code Sec. 1(e) as changed by the American Taxpayer Relief Act (ATRA) (P.L. 112-240) and Rev. Rul. 2013-15, IRB 2013-5, 444). In effect, most trusts will pay nearly 40% on most of their taxable income.

The higher tax rate may lead some trusts that had been accumulating income to distribute to beneficiaries who are in tax brackets below 39.6%. However, it should be recognized that overall lower income taxes may come at a price: less funds in the trust for future generations. Thus, trustees given the flexibility to determine accumulations and distributions will have to balance tax savings against the grantor’s expectations.

Use of the so-called “65-day” rule becomes more critical in light of the higher tax rate. Under this rule, a trustee can elect to treat distributions made within 65 days after the close of the trust’s year as having been made in the previous year (Code Sec. 663(b)). For example, distributions made through March 6, 2014, can be treated as having been made in 2013. This is an annual election, so the trustee will have to review the income tax situation each year.

Capital Gains and Qualified Dividends

Once trusts reach the top tax bracket of 39.6% on ordinary income, it means that they also pay the top rate of 20% on long-term capital gains and qualified dividends (Code Sec. 1(h)(1)(D)). The Medicare surtax of 3.8%, as described below, is applied to net investment income once this top bracket is reached. Small trusts with taxable income subject to rates below 39.6% continue to pay a 15% rate on long-term capital gains (or zero if the trusts are in the 15% tax bracket).

Because of the high capital gain rate, some individuals anticipating certain sales may want to use charitable remainder trusts (CRTs). These trusts can defer capital gains on these sales.

Alternative Minimum Tax

Trusts, like individuals, may be subject to an alternative minimum tax (AMT) at the rate of 26% or 28%, depending on the trust’s alternative minimum taxable income. In the past, trusts had the same AMT exemption amount as married individuals who filed separate returns. As a result of the ATRA, the AMT exemption amount for trusts was set at $22,500 (Code Sec. 55(d)(1)). This amount is adjusted annually for inflation, so that the exemption amount for 2013 is $23,100 (Rev. Rul. 2013-15, IRB 2013-5, 444).

Net Investment Income Tax

Starting for 2013, there is a 3.8% additional Medicare tax imposed on net investment income over a threshold amount (Code Sec. 1411). This tax, called the net investment income (NII) tax, is imposed on the lesser of the trust’s net investment income or the excess of the trust’s adjusted gross income over a threshold (Code Sec. 1411(a)(2)). The threshold is the dollar amount for the start of the top tax bracket ($11,950 for 2013). Trusts exempt from the NII tax include:

- Charitable remainder trusts and other trusts exempt from income tax

- Trusts where all of the unexpired interests are devoted to charitable purposes

- Grantor trusts

Trusts not treated as such for federal income tax purposes, such as real estate investment trusts (REITs)

Net investment income. Net investment income casts a wide net, including interest, dividends, capital gains (from the sales of stocks, bonds, and mutual funds; mutual fund distributions; and gains from investment property sales), rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities. Special rules apply to the sale of closely-held stock and partnership interests.

Net investment income does not include wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends, and distributions from qualified retirement plans and IRAs (those described in Code Sections 401(a), 403(a), 403(b), 408, 408A, or 457(b)).

Investment income is reduced by deductions properly allocable to investment income, such as investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in net investment income.

Proposed regulations clarify the application of the NII tax to specific types of trusts, such as electing small business trusts (REG-130507-11, 12/5/12). Any trust that is exempt from taxation (e.g., those exempt under Code Secs. 501(a), 664(c)(1), 220(e)(1), 223(e)(1), 529(a) and 530(a)), are also exempt from the NII tax under Code Sec. 1411.

Special rules apply for trusts with short taxable years (those that start during the taxable year or terminate before the end of the taxable year) (Prop. Reg. § 1.1411–3).

Planning strategies. Looking ahead, grantors with multiple beneficiaries may prefer to set up separate trusts for each one. This will allow each trust to keep no more than the triggering amount of taxable income ($11,950 in 2013) and, thus, avoid the NII tax. On the other hand, a single trust reduces administrative costs and may enable better property management. Thus, tax savings from using multiple trusts should be balanced against the cost and practicalities of a single trust.  Use of grantor trusts may pass the income to lower bracket beneficiaries. In-kind distributions should also be permitted to shift capital gains out of the trust.

State Tax Issues

Trusts with sufficient nexus (connection) to a state may owe income taxes and reporting to more than one state. Nexus can arise from owning property in a state or by having a grantor, trustee, or beneficiary within a state. Each state has its own rules for nexus. If income tax is required to be paid in more than one state, credits are usually available as an offset.

Foreign Trusts

The overall tax increases on trusts may lead some individuals to conclude that putting money overseas is a solution. Doing so is probably not helpful. Special reporting rules make it virtually impossible to “hide” assets and avoid income taxes if this were the goal:

- Foreign Bank and Financial Accounts (FBAR) reporting is an annual obligation. Serious penalties result from reporting failures and foreign financial institutions are increasingly working with the U.S. to disclose the names of owners of foreign accounts.

- Foreign Account Tax Compliance Act (FATCA) reporting requires beneficiaries with certain interests in foreign trusts to disclose them on their federal income tax returns (and, of course, pay income tax on distributions they receive).

Conclusion

Trusts continue to serve a variety of important financial and personal purposes. They continue to protect vulnerable or incapacitated spouses, provide asset protection, and protect the interests of children from prior marriages. They can provide income and estate tax savings when used to benefit charities (e.g., charitable remainder trusts) or estate tax savings when certain types of gifts are made during life (e.g., grantor retained annuity/unitrusts or qualified personal residence trusts). However, tax law changes must now be taken into account in determining the types of investments held by trusts and the amount of distributions to beneficiaries where such distributions are authorized. These new rules place increased burdens on trustees and their advisors.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

Robert S. Barnett, CPA, JD, MS (Taxation) is a partner at Capell Barnett Matalon & Schoenfeld LLP in Jericho, New York, where he heads the Tax and Estate Planning Departments.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

Details

Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 11 June 2013

In 2013, there is a new, harsher tax landscape for high-income taxpayers. The top rates on ordinary income, capital gains, and qualified dividends are higher than in 2012. There are new phase-outs for itemized deductions and personal exemptions that limit write-offs for these taxpayers. And there are additional Medicare taxes on earned income and net investment income. All of these changes combine to make tax planning more challenging than ever. One of the ways to sidestep some or all of these changes, at least temporarily, is to defer income. Here are some ways to do it.

Deferred compensation

Executives, top management, and other key personnel may be permitted to defer compensation (e.g., year-end bonuses) to a future year. As long as the deferral arrangement is a nonqualified deferred compensation (NQDC) plan that satisfies tax rules (Code Sec. 409A), the deferred compensation is not subject to income tax in the year in which it is earned; it is taxed when received. Usually this is not until retirement or some later event.

However, deferred compensation continues to be subject to Social Security and Medicare (FICA) taxes in the year it is earned. Usually, this proves advantageous because high earners likely have already received compensation in excess of the Social Security wage base ($113,700 in 2013), so there is no additional Social Security tax on the deferred compensation—in the year earned or in the year received.

All compensation is subject to the Medicare portion of FICA; there is no wage limit. For purposes of the additional 0.9% Medicare tax on earnings over a threshold amount, which starts in 2013, the deferred compensation is taken into account in the same way as the basic Medicare tax (IRS Q&As (#24) at www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Questions-and-Answers-for-the-Additional-Medicare-Taxrefer to Reg. §31.3121(v)(2)-1(a)(2)). This means that there will be no additional Medicare tax when the deferred compensation is received. Bottom line for deferred compensation under an NQDC plan: income tax is postponed; FICA and the additional Medicare tax (if applicable) is not.

Savings in qualified retirement plans

Savings in qualified retirement plans and IRAs produce automatic deferral of income. All of the earnings on these savings plans are not immediately taxable. Instead, taxes result only when distributions are taken from the account. At that time, all of the earnings are treated as ordinary income.

Distributions from these plans are not treated as investment income for purposes of the 3.8% additional Medicare tax on net investment income, called the NII tax (Code Sec. 1411 (c)(5)). More specifically, this tax applies to the lesser of net investment income or modified adjusted gross income (MAGI) over a threshold amount ($250,000 for married filing jointly; $200,000 for singles; and $125,000 for married filing separately). However, while the distributions are not treated as net investment income, they do count toward MAGI and can, therefore, produce or increase the NII tax.

Roth IRAs. Even better than tax-deferred income is tax-free income. This can be achieved with Roth IRAs, which are savings accounts for those with earned income (with some exceptions). Earnings on contributions become tax-free after the account has been open for five years. The five-year period starts on January 1 of the year to which the contributions relate. Thus, a 2012 Roth IRA contribution made on April 15, 2013, starts the five-year period on January 1, 2012.

However, income limits apply for making Roth IRA contributions. The limits for making a full contribution for 2013 are modified adjusted gross income (MAGI) of $178,000 for taxpayers filing a joint return and qualifying widow(er)s and MAGI of $112,000 for all other taxpayers other than those who are married filing separately (IR-2012-77, 10/18/12). Married persons filing a separate return with any MAGI cannot make a full contribution. The Roth IRA contribution limits for 2013 are $5,500 (plus an additional $1,000 for those 50 or older by the end of the year).

Conversions from traditional IRAs and qualified plans can be made to create tax-free income. There are no income limits on individuals making conversions. However, there is an immediate tax cost for the conversion: the income resulting from the conversion is taxable, so only future earnings on converted amounts become tax-free. Again, while the income is not investment income for the 3.8% additional Medicare tax, the income will increase modified adjusted gross income, which could impact the applicability of this tax. Weigh the current tax cost against the future tax benefit in deciding whether and to what extent to make a conversion.

Like-kind exchanges

Gain on the disposition of business or investment property can be deferred if “like kind” property is acquired within a set time period (Code Sec. 1031). Like-kind property is property of the same nature, character, or class; the quality or grade of the property does not matter. Most real estate will be like-kind to other real estate (e.g., a vacant lot for rental residential property), as long as the realty is located within the United States.

Gain is postponed because the basis of the replacement property is reduced by the amount of gain not recognized. The basis reduction means that the gain will ultimately be recognized on the future sale of the replacement property. The basis reduction has a negative impact: It limits the amount of depreciation that can be claimed on the replacement property.

The exchange can be simultaneous (e.g., a swap of properties of similar value) or it can be more complicated. A qualified intermediary or other exchange facilitator can be used to hold the proceeds from the original disposition. If the owner is directly paid on the disposition of his or her property, the opportunity for a like-exchange exchange is lost. If the owner receives cash in the course of making a like-kind exchange, gain is recognized to the extent of this cash.

Time limits. Potential replacement property must be identified in writing within 45 days of the disposition of the original property (called relinquished property). The exchange must be completed within 180 days of relinquishing the original property.

Tax-wise investments

In view of the new top tax rate on ordinary income of 39.6% on joint filers with taxable income over $450,000 ($425,000 for heads of households; $400,000 for singles; and $225,000 for married persons filing separately), the new 20% rate on capital gains and qualified dividends for those in the 39.6% bracket, and the 3.8% NII tax explained earlier, high-income taxpayers should review their portfolios to see which investments are still desirable. Investment classes that are particularly attractive in the new tax landscape include:

- Tax-exempt bonds. The interest on these bonds is tax free for federal income tax purposes (although the interest can affect the extent to which Social Security benefits are includible in gross income) (Code Sec. 103).

- Growth stocks. Annual appreciation is not taxed; the tax applies only when gain is actualized. Thus, income is deferred until a future sale. Even better, investors who plan to hold these investments indefinitely may never report gains. Instead, their heirs will receive a stepped-up basis to the value of the stock at the time of their death; all appreciation is permanently disregarded.

- Annuities. Commercial annuities allow the earnings on premiums to be deferred until distribution. When a policy is annuitized, only a portion of each payment represents gain. In other words, gain is spread over the period in which payments are received.

- U.S. savings bonds. Interest on Series EE and I bonds can be deferred until the bonds are redeemed or mature (there is a 30-year maturity date). Currently the rates are very low, so they may not be attractive investments. However, because of their absolute safety (backed by the full faith and credit of the United States), they may still have some place in an investment portfolio. There is an annual purchase limit on bonds of $10,000 ($5,000 if purchased with federal tax refunds).

Caution: Taxes are only one factor in investment planning and should not be the determining one to govern investment decisions.

Conclusion

No one knows for sure what the tax rules will be in the future. Depending on political winds and other factors, there could be major tax reform and more tax-friendly treatment for high-income individuals in the future. If things change for the better, deferral is a way to escape some or all of the new tax burdens for high-income clients. If nothing changes, then deferral has at least postponed the tax bill for these individuals.

Details

Written by: Sidney Kess, CPA, J.D., LL.M.

Published: 16 April 2013

Taxes and Retirement Income

Individuals may receive a variety of income when they retire. Different tax rules apply, depending on the type of income involved. Rules may vary for federal and state income tax purposes. And, starting this year, retirement income can impact the additional Medicare surtax on net investment income. Here is a roundup of the key tax rules for retirement income.

Social Security Benefits

Prior to 1983, Social Security benefits were always tax free. Now Social Security benefits are includible in gross income at zero, 50%, or 85%, depending on overall income (including tax-free interest on municipal bonds and one-half of Social Security benefits), technically called “provisional income”  (Code Sec. 86). The applicable income limits on provisional income for each of these inclusion rates varies with filing status.

Benefits are includible in gross income if provisional income exceeds $25,000 if single (including head of household, a qualifying widow(er), or a married person who lives apart for all of the year), or $32,000 if married filing jointly. Those with provisional income over $34,000 if single or $44,000 if married filing jointly include 85% of benefits in gross income. Those with provisional income between these limits (e.g., over $25,000 but not over $34,000 if single) include 50% of benefits in gross income. These threshold amounts are not adjusted annually for inflation; they are statutory.

S.S. Benefits      Single       Joint

       0                <$25        <$32

      50%          $25-$34   $32-$44

      85%           >$34         >$44

Married persons filing separately who do not live apart from their spouses automatically include 85% of their benefits in gross income; there is no provisional income threshold in this case.

State income taxes. Even though benefits may be partially includible in gross income for federal income tax purposes, they may be fully exempt from state income taxes. For example, Social Security benefits are not taxed by New Jersey and New York. In Connecticut Social Security benefits are exempt only for taxpayers with federal adjusted gross income below set limits.

Working after retirement. Working does not prevent you from collecting so-called retirement benefits from Social Security. However, if you are under the normal retirement age (currently 66) and you continue to work while collecting benefits, you face a reduction in the benefits. For 2013, benefits are reduced by $1 for each $2 over $1,260 per month ($15,120 annually). Also, earnings from a job or self-employment continue to be subject to Social Security and Medicare taxes, even when collecting Social Security benefits.

Deferred compensation

Employees may have the option of postponing the receipt of certain compensation, such as bonuses, until they retire or attain some other benchmark set by the deferred compensation arrangement (Code Sec. 409A). Deferred compensation is fully taxable for income tax purposes. The reason for deferral is the expectation that the recipient will be in a lower tax bracket when the deferred compensation is received (i.e., after retirement).

However, the deferred compensation is not subject to Social Security and Medicare (FICA) taxes in the year of receipt. Such compensation is subject to FICA in the year in which it was earned, usually at a time when the recipient’s compensation already exceeds the Social Security wage base (e.g., $113,700 in 2013).

Annuity Payments

Payments from commercial annuities are taxable after taking into account the taxpayer’s investment in the contract (Code Sec. 72). Thus a portion of each annuity payment represents a return of the taxpayer’s investment (not taxable) and earnings on the investment (taxable).

There is no automatic or optional withholding for taxes on annuity payments. Annuitants must take the tax on these payments into account for estimated tax purposes.

Distributions From Qualified Retirement Plans and IRAs

All distributions from qualified retirement plans and deductible IRAs are fully taxable. (There are some minor exceptions.) A special averaging rule for lump-sum distributions from qualified retirement plans (but not IRAs) applies only to those born before January 2, 1936. Even if retired, distributions from an IRA before age 59-1/2 or from a qualified plan before separating from service when at least 55 years old are also subject to a 10% penalty (unless some penalty exception applies) (Code Sec. 72(t)).

Employee annuities are fully taxable if paid entirely with pre-tax dollars. If, however, employees contribute after-tax dollars, only a portion of each payment is taxable. Special rules apply to determine the amount of the annuity payments includible in gross income; these rules are simpler than the rules for determining the taxable portion of commercial annuities.

Different rules may apply for state income tax purposes to distributions from qualified retirement plans and IRAs.

- New York exempts up to $20,000 in distributions from retirement plans and IRAs for those who are age 59-1/2 and older. All military, civil service, and New York state and local government pensions are fully exempt.

- New Jersey excludes pensions only by those who are age 62 or older, with a dollar limit on the total amount excluded.

- Connecticut excludes only 50% of military pensions.

Distributions from Roth IRAs are tax free as long as the funds are withdrawn after age 59-1/2 and after satisfying a five-year period for the account (Code Sec. 408A).

Impact of the NII Tax

Starting in 2013, there is a Medicare surtax on net investment income (NII). More precisely, a tax of 3.8% applies to the lesser of net investment income for the year or modified adjusted gross income (MAGI) over a threshold amount (Code Sec. 1411). The threshold amount is $200,000 for singles, $250,000 for joint filers, and $125,000 for married persons filing separately.

Retirement income may or may not be treated as investment income for purposes of this surtax. Retirement income treated as investment income includes, but is not limited to, interest, dividends, commercial (nonqualified) annuities, royalties, rents, passive business income, and capital gains.

Types of retirement income that are not treated as investment income include tax-exempt interest, veteran’s benefits, Social Security benefits, Alaska Permanent Fund dividends, and distributions from qualified retirement plans and IRAs. However, even if certain types of retirement income are not treated as investment income, to the extent they are included in gross income they increase MAGI, which can help to trigger the surtax on non-retirement income.

Paying Income Taxes on Retirement Income

For the most part, if retirees anticipate owing taxes on their retirement income they usually must pay the taxes through quarterly estimated tax payments. Those who fail to pay enough estimated tax can face a penalty. However, the penalty may be waived for someone age 62 or older who retired in the current or prior year and failure to pay the necessary estimated tax is due to reasonable cause and not to willful neglect. The penalty waiver is not automatic; it must be requested on Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts.

The need to pay estimated taxes can be minimized or avoided entirely by having withholding on retirement income. Here are some withholding rules for certain types of retirement income:

- Social Security benefits. Retirees can voluntarily elect to have federal income tax withheld in their benefits at the rate of 7%, 15%, 27%, or 30%, at the taxpayer’s option. To initiate voluntary withholding, a taxpayer must send a completed IRS Form W-4V, Voluntary Withholding Request, to the Social Security Administration (not the IRS). Withholding then commences within a few weeks of submission. To stop withholding or change the rate, a new Form W-4V must be filed.

- Retirement plan distributions. Distributions from qualified retirement plans are subject to an automatic 20% withholding rate. This withholding cannot be waived by the recipient (retiree). However, with respect to other distributions from qualified plans and IRAs, a voluntary withholding form (Form W-4P, Withholding Certificate for Pension or Annuity Payments) can be used to increase or reduce, or eliminate withholding. Withholding from periodic payments of a pension or annuity is figured in the same manner as withholding from wages. If no Form W-4P is submitted to the payer, the payer must withhold on periodic payments as if the recipient were married claiming three withholding allowances. Generally, this means that tax will be withheld if the pension or annuity is at least $1,680 a month. However, the recipient can indicate a different number of withholding allowances to change the amount of withholding; no set dollar amount for withholding can be specified.

Conclusion

For many seniors, Social Security and benefits from qualified retirement plans and IRAs are their only sources of retirement income. For them, there may be a new tax return in the offing. The Senior’s Tax Simplification Act of 2013 (H.R. 38), introduced earlier this year, would create Form 1040SR for those age 65 or older who have “simple” returns. It remains to be seen whether this measure will be enacted.

Having sufficient income in retirement is dependent not only on the gross amount of retirement income but on the after-tax results. Tax planning for retirement income can help ensure sufficient funds for a comfortable retirement.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.