Other Personal Income Tax Topics

VII. Other Personal Income Tax Topics

1. Withholding Tax Basics

2. Estimated Income Tax Basics

3. Understanding the Alternative Minimum Tax (AMT)

4. Dependent Exemptions and Exemption Planning

5. Capital Gains Tax

6. The “Kiddie” Tax

7. Taxes for Small Business Owners

8. Income Taxes for the Self-Employed

9. Taxes for the Unemployed

10. Taxes and Your Social Security Benefits

11. Taxes and Your 401(k)

12. Taxes and Your IRA

13. Estate and Inheritance Taxes

1. Withholding Tax Basics

Withholding tax (also known as “payroll withholding”) is essentially income tax that is withheld from your wages and sent directly to the IRS by your employer. In other words, it’s like a credit against the income taxes that you must pay for the year.

By subtracting this money from each paycheck that you receive, the IRS is basically withholding your anticipated tax payment as you earn it ― sometimes called “pay-as-you-earn” taxation.

Managing Your Withholding Tax

In general, the more money that is withheld from your wages throughout the year, the greater your tax refund may be because you’ve essentially overpaid the IRS. While everyone likes to get a tax refund, you should keep in mind that you’re only getting back the money you earned that year. A tax refund is basically an interest-free loan that you gave to the IRS!

On the other hand, if too little is withheld from your wages, you will likely owe more tax at the end of the year because you have underpaid the IRS. Additionally, you may be subject to penalties and interest charges for under-withholding.

For most taxpayers, it’s recommended that you try to match your withholding tax as close to your actual tax liability as possible. While you cannot avoid withholding tax altogether, you can control the amount that is withheld from each paycheck when you fill out your W-4 form.

Tax Form W-4

The purpose of Tax Form W-4 is simple ― it is used by your employer to withhold the proper amount of federal income tax from your paycheck. The IRS recommends that employees submit a new W-4 tax form each year, or any time their personal or financial situation changes. Of course, this is required upon beginning any new job.

IRS Tax Form W-4 (Employee’s Withholding Allowance Certificate)

Completing Tax Form W-4 may be easier than you think. The steps for filling out your W-4 are as follows:

Step 1: Obtain a copy of Tax Form W-4 from your employer, or download it from the IRS website. If you download online, you can fill-in your information before printing and signing.

Step 2: Provide your correct name, address, and Social Security Number. It is essential that this information is 100% accurate.

Step 3: Depending on your marital status and filing status, you will either check the box for “single” or “married.”

Step 4: Do you know how many withholding allowances you should claim? If not, you can use Tax Form W-4 to help calculate this number. In most cases, this is the same as your number of personal exemptions.

Note that you do not have to rely on your personal exemptions to determine your withholding allowances. For instance, if you have more than one job, if your spouse works, or if you itemize deductions, you may want to closely calculate your number of allowances to ensure that you are making the right decision.

Step 5: Do you have more than one job? If so, you should claim “0” (zero) for withholding when filling out Tax Form W-4 for your second employer. Just keep in mind that being “exempt” is not the same as claiming zero withholding. When you claim “zero”, the highest possible amount of taxes will be withheld from each of your paychecks.

NOTE: If you decide to claim more than “9” (nine) allowances, your employer will have to send your tax form to the IRS for review.

Step 6: Sign your W-4 tax form to make it valid.

Step 7: Once you give your W-4 form to your employer, they will complete Lines 8, 9, and 10 and complete the process from there.

Whether you are starting a new job, or you just want to change your withholding allowances for the year, it is important to become familiar with Tax Form W-4. Every employee must fill out this tax form and submit it to their employer. This way, you will be able to withhold the proper amount of taxes from each paycheck.

2. Estimated Income Tax Basics

Estimated Income Tax is the method that individuals and businesses use to pay tax on their income that is not subject to withholding. This may include income from self-employment, interest, dividends, alimony, rent, gains from the sale of assets, prizes, and awards. You also may have to pay Estimated Tax if the amount of income tax being withheld from your paycheck (salary, pension, or other income) is not enough.

Estimated taxes are used to pay for income tax and self-employment tax, as well as other taxes and amounts that are required to be reported on your income tax return (Form 1040). If you do not pay enough through withholding or estimated tax payments during the year, you may be charged a penalty by the IRS. If you do not pay enough estimated tax by the due date of each payment period (typically quarterly) you may be charged a penalty -- even if you are due a tax refund when you file your return.

Who Must Pay Estimated Tax?

The following individuals are generally required to make Estimated Tax payments if you owe tax of $1,000 or more when you file your tax return:
           • Sole proprietors
           • Partners
           • S-corporation shareholders
           • Self-employed individuals

Corporations are generally required to make Estimated Tax payments if it’s expect to owe tax of $500 or more when it’s corporate return is filed.

Note that if you had a tax liability for the previous year, you may need to pay Estimated Tax for the current year. For more information regarding who must pay Estimated Taxes, see the Instructions and Worksheet for IRS Tax Form 1040-ES.

Who Doesn’t Have to Pay Estimated Tax?

Most individuals can avoid having to pay Estimated Tax by asking their employer to withhold more tax from their wages. To do this, you must file a new Form W-4 with your employer. There is a special line on the W-4 Form where you can enter the additional amount that you want your employer to withhold from your paychecks.

You do not have to pay Estimated Tax for the current year as long as you meet all 3 of the following requirements:

• You had no tax liability for the previous year (meaning that your total tax was zero, or you did not have to file an income tax return)

           • You have been a U.S. citizen or resident for the entire year
           • Your prior tax year covered a 12-month period

Note that Estimated Tax requirements are different for famers and fishermen. For more information regarding Estimated Tax, see IRS Publication 505 (Tax Withholding and Estimated Tax).

How to Calculate Your Estimated Tax

To calculate your Estimated Tax, you must know your expected Adjusted Gross Income (AGI), taxable income, taxes, deductions, and tax credits for the year.

When determining your Estimated Tax for the current year, it may help to use your prior year income tax return as a guide – using the information from that return as a starting point (for income, deductions and credits). You may also use the worksheet on Form 1040-ES to figure your Estimated Tax.

You will need to estimate the amount of income that you expect to earn for the year. If you estimated your earning too high or too low, simply complete another Form 1040-ES worksheet to recalculate your Estimated Tax for the next quarter. Keep in mind, you want to try to estimate your income as accurately as possible, to avoid being subject to penalties.

Note that you are required to make adjustments for changes in your personal situation as well as any recent changes to the tax law.

When to Pay Estimated Tax

Estimated Tax payments are made in 4 quarterly installments. Each payment period has a specific due date. If you fail to pay enough tax by the quarterly deadlines, you may be charged a penalty (even if you are owed a tax refund when you file your income tax return).

Estimated Tax payments are due on the 15th day of the 4th, 6th, and 9th months of your tax year, and on the 15th day of the 1st month after your tax year ends. Typically, these dates fall on April 15th, June 15th, September 15th, and January 15th.

How to Pay Estimated Taxes

The following individuals should use IRS Tax Form 1040-ES to figure and pay Estimated Tax:
           • Sole proprietors
           • Partners
           • S-corporation shareholders
           • Self-employed individuals

If you are filing as a Corporation, you should use IRS Tax Form 1120-W to calculate your Estimated Tax. Note that a corporation’s Estimated Tax payments must be deposited electronically. For more information, see IRS Publication 542 (Corporations) and/or the Instructions for Form 110-W.

Both individuals and businesses can pay their Estimated Tax online using the Electronic Federal Tax Payment System (EFTPS).

3. Understanding the Alternative Minimum Tax (AMT)

The Alternative Minimum Tax (AMT) is an extra tax that some people are required to pay in addition to their regular income tax. There are several alternative minimum tax strategies that you can implement to better your chance of cutting back on how much additional money you will owe.

The main goal of the alternative minimum tax is to prevent high-earners from using tax strategies and special benefits to greatly decrease their tax liability. Over the years, however, the alternative minimum tax has changed quite a bit. Currently, it affects many taxpayers ― including those who do not have very high income.

Believe it or not, many people don’t know if they are subject to the alternative minimum tax. In turn, their tax strategies suffer and they are unable to adequately plan for the future. Your best alternative minimum tax strategy is to first determine whether or not this tax is going to affect you.

There are several things that can cause alternative minimum tax liability. The most common AMT triggers include the following:

Personal exemptions
Medical expenses
Incentive stock options
Tax-exempt interest
Long-term capital gains

Make it part of your tax strategy to keep an eye out for these triggers. If you are involved with one or more of the above instances, there is a good chance that the alternative minimum tax will come into play.

Another important tax strategy is to know how to compute the alternative minimum tax. After all, if you are going to owe additional money in taxes, you will need to know how the IRS calculates this amount. That way, you can use effective tax strategies to best plan for the future. When determining alternative minimum tax, remember that it is based on different rules (than regular income tax).

The alternative minimum tax is distinguished by the following characteristics:

Tax benefits that are usually available are eliminated or reduced
There is a tax deduction, known as the alternative minimum tax exemption, which helps prevent alternative minimum tax for those with modest income
Alternative minimum tax rates start at 26% and increase to 28% for higher income levels

Compare the above information to standard income tax rates, which start at 10% and gradually increase several brackets before hitting the tops rate of 35%.

The more you know about the alternative minimum tax, the easier it will be to implement an AMT tax strategy that can help save you money. If you are particularly worried about the alternative minimum tax and whether or not it applies to you, consider speaking with a professional who can help you develop an effective tax strategy.

4. Dependent Exemptions and Exemption Planning

Personal Exemptions for Dependents

A personal exemption, in theory, is equivalent to the minimum amount a person would need to get by on at a subsistence level. The idea is that a citizen’s basic subsistence should be exempt from income tax. Of course, the personal exemption amount for 2011 ($3,700 would be hard to stretch into a year’s food, clothing, and shelter. However, taxpayers with a family to support can use the personal and dependent exemptions tax strategy to claim not only exemptions for themselves, but dependent exemptions for close individuals such as children and nonworking spouses.

In order to claim someone as a dependent on your tax form, you must be providing at least half of that person’s support. If the person is a blood relative or your spouse, they do not need to be living with you for the duration of the year, but otherwise cohabitation is a requirement of the dependent exemption tax strategy. The gross income of this dependent must be less than the personal exemption amount for that tax year. However, if the individual is under 19, or under 24 and a full-time student, the tax strategy of claiming them as a dependent can still be used.

In addition, your dependent must be a U.S. citizen, or else must be an adopted child who lived with you in a foreign country for the duration of the year. Foster children can be claimed using this tax strategy, but not children for whom you received payment from a government agency for taking care of them.

Married couples can file a joint tax return and each can claim themselves as a personal exemption on the return, even if one spouse earned no income in that year. This is part of the reason why filing a joint return is a common tax strategy for couples.

There are exceptions to the tax strategy of claiming personal exemptions. If you are eligible to be claimed as a dependent on someone else’s tax return, you cannot use the personal exemption on your own return. This applies even if the person chooses not to claim you as a dependent. If your spouse can be claimed as someone else’s dependent, you and your spouse must use the tax strategy of filing separate returns.

If you supported your spouse for part of the year, but by year’s end you have divorced, you cannot use the dependent exemption tax strategy to claim him or her on your return.

Strategies for Tax Exemptions

Are you interested in tax strategies for exemption planning? If you believe that you may be granted tax exemption, then you should understand how to claim it. Believe it or not, there are many people and organizations, qualified for tax exemptions. In some cases, a tax exemption is also known as a personal allowance that can be used to decrease the overall taxable income. All in all, a tax exemption may either offer you complete relief from paying a certain tax, or allow you to be taxed at a lower rate.

Charitable organizations most commonly take advantage of tax exemptions. Of course, they need to follow the proper tax strategy to make this happen. You cannot simply decide that you are going to form a tax-exempt organization ― there is more to the process than that.

As a charitable organization, you may have the right to be exempt from many federal and state taxes. That being said, various qualifications must be met. This is when a good tax strategy comes into play. To start, the charitable organization must apply for “tax-exempt status” with the IRS. As you can see, this is obviously something that needs to be worked out in the early stages of the organization.

Many tax exempt organizations are also learning that they need a new tax strategy, one that can help them take full advantage of the tax code. As they continue to form relationships with for-profit companies, it is more important than ever to know the details that govern their tax-exempt status.

Strategies for Tax-Exempt Property

Did you know that there are many types of properties that are often granted exemption status? By having a tax strategy that helps you avoid real estate and/or transaction taxes, you can keep a lot of money in your pocket. It is important to note that tax exemptions may vary based on location.

Speak with a tax professional in your state to determine whether you own a property that qualifies for tax-exempt status. Some of the most common types of tax-exempt real estate include the following:

Property used to manufacturer goods that will later be taxed
Property used by a tax-exempt organization (such as a non-profit group)
Personal, primary residence of a taxpayer (such as with the Homestead Exemption)

Exemption planning is not difficult if you have a solid tax strategy in place. If you are able to take advantage of any exemptions, whether it is on an individual basis or for an organization, creating a good tax strategy will benefit you now and in the future.

5. Capital Gains Tax Basics

A capital asset is basically anything that you own/use for personal or investment purposes. This can include stocks, bonds, home furnishings, and the home itself. When you sell a capital asset, the difference between your “basis” (usually the amount you paid for it) and what you sell it for is called a capital gain or loss.

If you sell an asset for more than your basis, you have a capital gain. Conversely, if you sell an asset for less than your basis, you have a capital loss.

Here are some facts about capital gains and losses:

• Capital gains are either short-term or long-term, depending on how long you hold the asset before selling it. If you hold it for more than one year, it is considered a long-term capital gain or loss. If you hold it for a year or less, it is a short-term capital gain or loss.

• If your long-term capital gains for the year are greater than your capital losses (including short-term and long-term losses), then you have a “net capital gain.”

• Net capital gains are subject to tax. The amount of your tax depends on your tax bracket and whether the asset is short-term or long-term.

• Short-term capital gains are taxed at your regular income tax rate. The maximum tax rate for long-term capital gains is 15% for most taxpayers. Particular types of long-term capital gains are taxed at 25% to 28%. Some lower-income individuals may even qualify for a 0% tax rate on their net capital gains.

• Net capital losses can be claimed for a tax deduction. If you have more capital losses than gains, you may be able to deduct the difference on your tax return to reduce your taxable income.

• All capital gains and deductible capital losses must be reported to the IRS using Tax Form 1040, Schedule D (Capital Gains and Losses). The information reported on Schedule D must also be recorded on Line 13 of Tax Form 1040.

Capital Gains Tax

If you are interested in selling an investment or real estate asset that has appreciated in value, it is important to understand capital gains tax and how it will affect your finances. Unlike ordinary income tax which applies to your earnings, capital gains tax is imposed on the profits that you make from selling capital assets.

No matter how long you have owned an asset, when you sell it for a profit you are making money. Your tax bracket and the amount of time that you hold the asset will determine how much you pay in capital gains tax.

Capital Gains Tax for Long-Term Assets

Long-term capital gains tax is enforced when you sell and profit from an asset that you’ve owned for over a year. Even for the highest income taxpayers, the maximum long term capital gains tax rate is 15%. Low-income individuals, classified as those in the 10% and 15% tax brackets, are not required to pay capital gains tax.

Capital Gains Tax for Short-Term Assets

Short-term gains are generally taxed at a higher rate than long-term gains. Short-term capital gains tax is imposed when you sell and profit from something you have owned for one year or less. Short-term capital gains are taxed at the same rate as your ordinary income. As you may know, that tax rate can be as high as 35% depending on how much you earn.

Managing the Capital Gains Tax

The best way to manage your assets and reduce your capital gains tax is to keep a close watch on the calendar. Based on the information above, you can see that holding an asset for longer than a year before selling is generally more advantageous to your financial situation. If you sell an asset within a year, you will be subject to a higher (short-term) capital gains tax rate.

You may also consider offsetting your capital gains with capital losses. If you have more capital losses than gains, you can deduct the difference on your tax return to reduce your taxable income. There is a $3,000 annual deductible limit for taxpayers who are married filing jointly and a $1,500 annual limit if you file separately. Also note that capital losses can be carried over to the next year.

Avoiding capital gains tax altogether is probably not possible, but the more you understand about how gains and losses work, the better chance you have of saving money.

The Cost Basis for Capital Gains and Losses

When an asset is sold, its cost basis is used instead of the actual purchase price to determine the accurate capital gain or loss for capital gains tax purposes. This is very important to remember because it can result in a tremendous difference in the amount of capital gains tax due when an asset is sold. If the asset is real property, also known as real estate, it refers to land and typically anything built on, growing on, or attached to the land.

Regarding real estate, the cost basis of an asset is the original purchase price plus the settlement and closing costs, including the fees and taxes you paid to acquire the property whether you paid for them in cash, in trade or through a loan. Fees include real estate brokerage fees or commissions, legal fees, recording fees, accounting fees, installation and testing fees, transfer and sales fees. Taxes include sales tax, excise tax, revenue stamps, real estate taxes, etc.

Depreciation must be added to the original cost basis to accurately report capital gains tax. Depreciation may be deducted only on the part of your property used for rental purposes as it reduces the yearly income tax paid by the investor by reducing the reportable net rental income. Depreciation increases the capital gains tax when the property is sold or exchanged for another property or asset.

When a property is purchased, make sure you retain a copy of all documents that can support the cost basis calculation. If you make any improvements to a property such as adding a garage or another type of major remodeling or addition , make sure you keep copies of any and all expenses related to the improvement since those items will also be added to your cost basis and affect your capital gain or loss calculation. On the other hand, if you take deductions on your taxes for depreciation of the property or for casualty losses, or you claim certain tax credits, you need to subtract those items from your original cost basis.

The manner in which the real property is purchased can impact the cost basis and the amount of capital gains tax that will apply. For example, property purchased through a no/low interest loan or via a lump sum payment have different capital gains tax treatments for capital gain or loss calculations. As the rules for reporting capital gains tax on real estate can be confusing, you should consult a professional tax preparer for advice.

Capital Gains Tax Rates

When determining capital gains tax rates, there are several details that need to be considered. If you are unsure of how to make this determination on your own, you may want to speak with a tax professional. Not paying the proper capital gains tax can result in future problems, such as owing more money to the IRS.

Did you know that you are responsible for both federal and state capital gains tax? Many people are under the impression that they only have to pay tax to the IRS. The majority of states do not have any special rates for capital gains tax. Instead, they opt to tax capital gains at the same rate as your regular income. While this makes it easier to determine what you owe, it also means that you will have to part with more money on the state level.

In 2008, a 0% capital gains tax rate was introduced. To qualify for this special rate, you must be in the 10% or 15% tax brackets. While this rate was designed for lower-income people, there are many taxpayers who qualify. Unfortunately, the 0% capital gains tax rate expired at the end of 2010. So those who are thinking about taking advantage of it should do so as soon as possible.

There are several different capital gains tax rates that you should be familiar with. They are described below:

• Short-term capital gains tax applies to assets that are purchased and sold in 1 year or less. These gains are taxed at your ordinary income tax rate.

• Long-term capital gains tax applies to assets that are held for longer than 1 year before being sold. Those who are in the 10% and 15% tax brackets must pay 5% capital gains tax ― anyone who falls outside those brackets must pay 15% capital gains tax (for most taxpayers).

• Collectibles fit into a different category (than other assets, such as stocks). Collectibles held for 1 year or less are subject to ordinary tax rates up to 35%, depending on your income level. Collectibles held for longer than 1 year are taxed at a rate of 28% on the money gained.

It is important that you understand the various capital gains tax rates so you don’t end up paying more (or less) than you are required. As you can see, holding onto assets for more than 1 year can result in big savings ― at least on the federal level.

If you are required to pay capital gains tax, for short-term or long-term assets, make sure you do so in an accurate manner.

The 0% Capital Gains Tax Rate

The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 lowered the maximum capital gains tax rate from 10% to 5% for people in the lower two tax brackets. It also lowered the rate from 20% to 15% for people in tax brackets of 25% and higher. Originally, the 0% tax rate applied to low-income taxpayers for the year 2008 only. However, the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005 extended this 0% rate for two more years.

It is important to understand the 0% capital gains tax and whether or not you qualify for it. This is particularly true if you file your own income tax return. If you qualify for this tax rate, now may be the time for you to sell those assets that have been gaining value for years. You may have avoided doing this in the past because you did not want to incur capital gains tax; but now the rules have changed.

Before you jump to conclusions, keep in mind that most taxpayers will still be taxed at the 15% maximum capital gains rate. However, lower income individuals may qualify to have their capital gains taxed at the 0% rate.

So where do you stand?

If you are in the 10% or 15% tax bracket, you will not be taxed on your capital gains. Along with this, if your taxable income is less than $32,000 (single or married filing separately), $65,100 (married filing jointly), or $43,650 (head of household), you will not be required to pay capital gains tax.

Don’t forget that your taxable income includes your capital gains. Your income may exceed the amounts mentioned above, but if your capital gains are included in this income, make sure to subtract them to determine your eligibility. If your capital gains are responsible for bringing you above the allowable threshold, you are technically still within the 10% to 15% tax bracket. In that case, your capital gains will not be taxed.

It is also important to note that 0% tax rate is only applicable to long-term capital gains, which are defined as assets held for more than one year. If you sell an asset within one year or less (i.e. short-term capital gain), you will be taxed at your regular income tax rate.

If you are helping to support your retired parents, it may be a good idea to give your parents stocks or bonds that they can sell at the 0% capital gains tax rate (rather than just giving them cash). Retirees in lower-income brackets who have investments in taxable accounts may also want to consider liquidating their assets while the 0% tax rate is still effective.

Parents who do not qualify for the 0% long-term capital gains rate may consider giving appreciated assets to their younger children to sell. But keep in mind that the “kiddie tax” may inhibit this transfer.

The above information should give you a better understanding of how the 0% capital gains tax works. You should always plan ahead when making transfers or changes to your financial portfolio. It is also recommended that you consult with a tax professional because your tax liability and eligibility for certain benefits may be affected.

Capital Gains Tax for Home Sales

If you sold or are thinking of selling your home in the near future and you owned and lived in it for a minimum of two years total, you can exclude up to $250,000 in capital gains tax from the sale of a primary residence (married couples can exclude up to $500,000).

To qualify for the capital gains tax exclusion, you must have owned the home for at least two years (referred to as the “ownership test”) lived in the home for a cumulative total of two years (the “usage test” and the two years do not need to be consecutive) out of the five years that you owned the home. This is to prove that the home was your principal residence.

This 2-out-of-5 year rule may be used to exclude your capital gains each time you sell or exchange your main home and typically, you can claim the exclusion only once every two years. However, there are exceptions to this capital gains tax rule that enable you to possibly deduct a portion of the capital gain if you had to sell your house because of a job relocation, because of poor health or medical necessity or for other hardships or unforeseen circumstances.

Make sure you have a letter from your physician detailing the medical condition in the event that you are audited or asked to provide evidence to support the capital gains tax exclusion. The IRS is very specific about what they consider unforeseen circumstances in Publication 523 as “the occurrence of an event that you could not reasonably have anticipated before buying and occupying your main home.”

Examples of unforeseen circumstances that qualify for capital gains exclusion to the two year rule include the following:

Natural disasters
Acts of war
Acts of terrorism
Change in employment or unemployment that left you unable to meet basic living expenses
Death
Divorce
Separation
Multiple births from the same pregnancy

Active military personnel on qualified extended duty in the U.S. Armed Services, Foreign Service, or the intelligence community (sales or exchanges after December 20, 2006) may suspend the five-year test period for up to 10 years for the purpose of reporting capital gains tax on real estate sales. This capital gains tax provision may be used for only one property at a time. Qualified extended duty is defined as being assigned to a duty station at least 50 miles from your former principal residence or residing in government housing under orders and the duty lasts for more than 90 days or for an indefinite period.

How to Report Capital Gains Tax

If you are required to report a capital gains tax on the sale of your principal residence, it is reported on Tax Form 1040, Schedule D (PDF), Capital Gains and Losses. (You cannot report a capital loss on your property).

If you owned your home for less than one year, you will report a short-term capital gain in Part I of Schedule D. If you owned your home for more than one year, you will report a long-term capital gain in Part II of Schedule D. In column (a), you will provide a description of the property. In column (b) you will enter the month, day and year that you acquired the property. In column (c) you will enter the month, day and year that you sold the property. In column (d) you enter the amount you sold the property for and in column (e) you enter the cost basis of the property for capital gains tax purposes.

To calculate the cost basis of the property, refer to your original closing documents and make sure you add the following items as they can significantly lower the amount of capital gains tax you may be subjected to:

Purchase price
Purchase costs (real estate brokerage fees or commissions, legal fees, recording fees, accounting fees, installation and testing fees, transfer and sales fees. Taxes such as sales tax, excise tax, revenue stamps, real estate taxes, etc.)
Improvements (adding a garage, installing a new bathroom, replacing a heating unit, etc.)
Selling costs (title & escrow fees, real estate agent commissions, etc.)

If applicable, subtract:

Accumulated depreciation (for example, if you ever took the office in the home deduction)

The total of these items would equal your cost basis and be entered in column (e) for the purpose of reporting accurate capital gains tax.

To calculate your net capital gain or loss, subtract the amount shown in column (e) from the amount shown in column (d). The amounts reported on Schedule D, Capital Gains and Losses will be transferred to Tax Form 1040.

Capital Gains Tax: Myths vs. Facts

5 Myths about Capital Gains Tax

If you believe any of the myths surrounding capital gains tax and how it affects you, there is a good chance that you will include erroneous information on your income tax return. This can lead to problems in the future, including a lower tax refund or even an audit by the IRS.

It is important to learn the facts regarding capital gains tax, while also being aware of the myths that confuse many taxpayers. Below are 5 major myths concerning capital gains tax:

MYTH #1: Short-term and long-term capital gains tax rates are the same.

This is a myth that too many taxpayers believe. Unfortunately, it is anything but the truth. Short-term capital gains are taxed at your ordinary income tax rate. Long-term capital gains are taxed at no more than 15% (for most taxpayers), based on your income level.

MYTH #2: There is no such thing as a 0% capital gains tax.

In 2008, the federal government introduced the 0% capital gains tax. It gives low-income earners the chance to sell their capital assets without paying taxes on the profits. Those who are in the lowest 2 tax brackets (the 10% and 15% brackets) are not required to pay capital gains tax.

MYTH #3: It is impossible to manage how much you pay in capital gains tax.

While you definitely have to pay capital gains tax to the IRS, there are things you can do to keep your tax to a minimum. For instance, you can offset capital gains by deducting your capital losses (up to $3,000 per year if married filing jointly; up to $1,500 per year for married couples filing separately), which can help keep more money in your pocket. You may also choose to hold your assets for over a year, since the long-term capital gains tax rate tends to be lower than the rate for short-term gains.

MYTH #4: The way that short-term and long-term capital gains are calculated changes every year.

It is difficult to say where this myth comes from, but it is one that many people believe. The truth is that a short-term capital gain stems from the sale (and profit) of an asset that was held for 1 year or less. A long-term capital gain occurs when you sell and profit from an asset that you owned for longer than a year.

MYTH #5: You do not have to report capital gains every year.

This is entirely false. Whether you have short-term or long-term capital gains, you need to report them to the IRS using Schedule D (Capital Gains and Losses) of Tax Form 1040 (U.S. Individual Income Tax Return). If you have deductible capital losses, they must also be reported on your return.

There are many myths related to the capital gains tax ― the 5 listed above are very common and have confused many people over the years. Once you determine the facts versus the myths, you can begin to understand capital gains tax and how it affects you.

Facts about Capital Gains Taxes

Here are 7 important facts about capital gains tax:

1. Capital gains are considered either short-term or long-term. If you own an asset for 1 year or less before selling, it is called a short-term capital gain. On the other hand, long-term capital gains are those that are held for over a year before selling.

2. Short-term capital gains are taxed at the same rate as your ordinary income. This can be as high as 35% depending on your tax bracket and how much money you earn.

3. Long-term capital gains are taxed at a lower rate than short-term gains. The maximum you can pay in long-term capital gains tax is 15% (for most taxpayers). As you can see, you can save money in taxes by holding assets for more than 1 year before selling.

4. Low-income taxpayers (who fit into the 10% and 15% tax brackets) are not required to pay capital gains tax. The 0% capital gains tax was implemented in 2008, allowing many low-income taxpayers to save a lot of money.

5. Capital gains can be offset by capital losses. The IRS allows you to deduct up to $3,000 in losses per year for married taxpayers filing joint returns. That yearly limit is $1,500 for married couples who file separately. Additionally, any losses that exceed the annual limit can be transferred (or “carried over”) to the next tax year.

6. You are required to report all capital gains and deductible losses to the IRS by using Schedule D of Tax Form 1040.

7. Collectibles are not taxed the same way as other capital assets, such as stocks and bonds. Long-term gains for collectibles (i.e., collectibles held for more than a year) are taxed at a rate of 28%. Short-term collectible gains are taxed at your ordinary income tax rate, which may be as high as 35%.

6. The “Kiddie” Tax

The “Kiddie Tax” requires that unearned income generated by children under age 19 (or 24 for full-time students) be taxed at their parents’ rate rather than their own. This does not refer to income from a summer job, but to income from the interest and dividends on investments made for them by their parents.

The Kiddie Tax was originally set up to prevent wealthy parents from shifting their stock holdings to their children in order to pay lower capital gains tax. Prior to 2006, the Kiddie Tax was not applicable after the child turned 14. And now, with the parameters of the Kiddie Tax expanded past the age at which many students graduate college, a custodial account set up in the interest of saving and paying for a child college education may also fall prey to this tax.

Consider moving your child’s college savings to a 529 College Savings account – a savings plan operated by a state or educational institution – in order to avoid the Kiddie Tax. A 529 account can be opened in your home state and used to send your child to school in a different state. They can be either prepaid (where you pre-pay all or part of the tuition costs) or a saving plan that invests your contributions, which is similar to a custodial account.

Additionally, if a child can prove that their own employment income is more than half of their total support in a given year, they may not be subject to the Kiddie Tax. For more information regarding dependency, see IRS Publication 501 to determine what the cost of your child’s support is.

Plan Around the “Kiddie Tax”

The Kiddie Tax was put in place to prevent high-income households from channeling income through the children to decrease their overall taxes. It applies only to unearned income – such as stock dividends, mutual fund dividends, and interest payments.

Up until the year 2007, the Kiddie Tax affected children who were under the age of 18. Moore recently, however, the Kiddie Tax was changed to apply to children under the after of 19 (if they are dependent) or under the age of 24 (if they are full-time students).

Even with the increase in age, there are steps you can take to plan around the Kiddie Tax. To avoid paying the higher tax rate, consider the following strategies:

• Shift the child’s investments to tax-free securities or growth stocks (which do not pay dividends) that defer taxes until the child is old enough to avoid the Kiddie Tax.

• Divide the child’s income with a special trust. Only undistributed income is taxed to the trust – distributed income is taxed to the child. Because trust tax rates are compressed, it is possible to reach the maximum individual rate of 35% for over $11,000 of taxable income. At age 21, or when the child satisfies the terms of the trust, the child will receive the principal and accumulated earnings. Keep in mind that there will be tax consequences, so it’s a good idea to contact your tax professional at that time.

• Report your child’s income on your return to take advantage of your child’s capital gains and to offset any capital losses that may otherwise be limited.

The Kiddie Tax is reported using IRS Form 8615, which must be filed by children who have investment income of more than $1,900.

7. Taxes for Small Business Owners

Tax planning for a small business is not something that occurs once a year. Instead, this is a year-round event that you must focus on at all times. No matter what industry you are in or how much money you are earning, there are many tax strategies that you can rely on.

Above all else, make sure that you have a good record-keeping system in place. This is one tax strategy that is often times overlooked by small businesses. The reason for this is often simple: they are too focused on growing their business that they overlook other details. While it is important to spend time on sales and marketing, you cannot forget about the importance of a sound record-keeping system.

Are you trying to save money on taxes? Every small business owner wants to be able to minimize their tax liabilities. For this reason, consider tax strategies that are based around finding and taking advantage of tax deductions and write-offs. By doing your best to maximize deductions throughout the year, you will be able to lessen your tax liability.

Note: You have to search for tax deductions and write-offs throughout the year. If you wait until you file your final tax return to search for these, it may be too late.

Maximizing tax deductions goes hand-in-hand with good record-keeping in terms of effective tax strategies. Whether you have a large tax deduction or one that is only a few dollars, it is essential that you record this data and keep a receipt on file. This type of documentation will be helpful when filing your tax return. Additionally, if you are audited by the IRS, you will need this information.

What about your business structure? Before you start a small business you should consider all your options. At the same time, you have the right to make modifications if you feel that it will benefit you from a tax standpoint. That being said, making this type of change and implementing a new tax strategy can be a complex process. The most common types of business structures include: C corporations, S corporations, limited liability companies (LLCs), and sole proprietorships.

As you start your small business, make sure you consider the tax strategies above, as well as any others that may help reduce your tax liability. Your particular tax strategy is not going to be the same as the business next door, and there’s nothing wrong with that. It is important that you do what is best for your organization.

By experimenting with multiple tax strategies you will find what does and does not work for your small business.

Taxes and Small Business Investments

Making an investment in a small business is a great way to encourage entrepreneurship and stimulate an important sector of the economy. It can also give you a break on your taxes.

If a small business has assets of less than $50 million, and is engaged in an active trade or business, it will likely meet the IRS standards to be classified as a Qualified Small Business (QSB). Individuals who make investments in a QSB can deduct up to 50% of those capital gains from their taxes. To be eligible, you must have had the small business stock for at least 5 years, and the capital gains must be generated by selling that stock at a profit.

If you buy small business stock that was issued between February 17, 2009 and January 1, 2011, you may be able to exclude up to 75% of your capital gains on the investment, thanks to the American Recovery and Reinvestment Act (ARRA).

You may defer paying taxes on capital gains if you use them to make investments in additional QSB stock within 60 days ― a tactic known as “rollover.” Keep in mind that if the profit you make from selling your QSB stock exceeds the cost of the new stock, you will still have to pay taxes on those gains.

Small business owners who have made personal investments in their business can save on their taxes by deducting available write-offs (such as start-up costs, insurance, and travel expenses). They can also use bills associated with the cost of business to offset profits, decreasing their total tax liability. Additionally, small business owners may consider hiring independent contractors, for whom they do not pay taxes, rather than full-time employees.

If you end up losing money on your small business investment, you may label your losses as “ordinary losses” rather than capital losses, and deduct them from your income for that tax year. For married couples filing joint tax returns, the maximum amount they can claim for a deduction is $100,000. If your filing status is “single,” the maximum amount you may deduct is $50,000.

8. Income Taxes for the Self-Employed

Self-employed individuals know that organizing and filing taxes can be a complicated process. Remember that just because your employer is not technically withholding money for taxes, it doesn’t mean that you are off the hook. On the contrary, you are personally responsible for making sure all taxes are paid ― including federal, state, and local taxes.

Here are several tax strategies that have been proven to be successful for many self-employed individuals:

Learn as much as you can about self-employment as it relates to taxes
How much do you know about self-employment taxes? A good tax strategy begins with the proper information. You should understand how self-employment tax is calculated to determine how much you will owe every year.

Make estimated payments to avoid future issues
This is one tax strategy that you should definitely consider. It is important to make the regular quarterly payments on time to avoid interest penalties. Note that this tax strategy is not fool-proof by any means ― you are simply making estimated payments. When you file your annual tax return, you will find if you’ve overpaid or underpaid for the year.

Take advantage of an employer-sponsored retirement plan
Consider this tax strategy as one that can help you lower your tax liability. A few of your options include an IRA, Keogh plans, SIMPLE, and SEP. Not only will these plans help you from a tax standpoint, but they will benefit you upon retirement.

Search for tax deductions
Since you are running a business, there are many tax deductions that you can take advantage of and incorporate into your tax strategy. These may include deductions for office supplies, cost of utilities, mileage and other travel expenses, and the home office tax deduction. Of course, you must make sure that these deductions are used strictly for business purposes. Along with this, track all of your expenses and save all the receipts ― this will be vital in case of a tax audit.

Deduct your health care expenses
Many people who are new to self-employment do not realize that they are able to deduct a portion of their health insurance premiums. As long as you are financing your own coverage, you can qualify for this tax deduction. HSA (Health Savings Account) contributions are also considered tax-deductible.

These tax strategies should help those are newly self-employed as well as those who have been working in this capacity for several years. With the right tax strategy in place, you can reduce your tax liability, stay organized, and take full advantage of every potential tax benefit.

9. Income Taxes for the Unemployed

Are you unemployed? If so, there are many tax strategies that you may want to consider following. Understandably, this is a tough time in your life and you do not want to make things worse by owing additional money to the IRS. Any tax strategy that can help lower your tax liability is one that you should definitely look into.

Here are several tax strategies that unemployed people should consider:

Job Searching
Have you been spending money searching for employment? If so, these expenses are considered tax-deductible. If you itemize deductions, you may be able to deduct your job hunting expenses. That being said, you also need to be aware of the rules before you implement this tax strategy. For instance, the tax deduction must be greater than 2% of your adjusted gross income (AGI). Some of the most common tax deductions are for the following expenses: long-distance calls, travel to/from interviews and meetings, postage, and printing costs. Always be sure to save and organize your receipts in case of a tax audit.

Tax Credits
Consider any tax credits that you may now qualify for. Since your income (on unemployment) is lower than it would be with a full-time job, you may be eligible for certain tax credits. Utilizing applicable credits is a tax strategy that’s overlooked by many people. If your income dips, you may qualify for the Earned Income Tax Credit. Other credits that you may be able to take advantage also include the Child Tax Credit and the Additional Child Tax Credit.

Moving Expenses
If you have finally found a new job, you may have to relocate for it. While this is a big change (and a big expense), it can be offset on your tax return. You can deduct moving expenses related to employment as long as your new job is (at least) 50 miles farther away from your old home than your previous job was. You are not required to itemize your deductions to benefit from this option.

Unemployment often times leads to financial distress. Although your income may have changed, you should consider the various tax strategies that can help better your situation. The four tax strategies above apply to millions of people. Ask yourself if you’re able to benefit from these tax strategies or any others.

10. Taxes and Your Social Security Benefits

It is never too early to start saving for retirement and recent tax reform has enhanced certain planning opportunities. You may still have time to accumulate significant retirement assets, provided that you plan ahead, stay disciplined, and regularly review your tax strategies.

Most people spend years planning and saving for retirement. However, they do not realize the tax implications on income received after they stop working. After the age of 65 there will most likely be a reduction in the amount of taxes owed, but it is still important to come up with a tax strategy and to plan ahead in order to minimize your IRS tax bill.

Tax Strategies for Social Security Benefits

For Social Security benefits, a portion of them may be taxable. This depends on your marital status and your total income. Your AGI (half of your Social Security benefits plus your projected income from all other sources), plus any tax-free interest from municipal bonds or foreign income, is called your “provisional income.”

If this sum is greater than $25,000 for singles (or $32,000 for married couples filing jointly), up to half of your Social Security benefits may be taxable. If your provisional income exceeds $34,000 for singles (or $44,000 for married couples filing jointly), up to 85% of your Social Security benefits may be taxable.

Other income sources include distributions from IRAs, 401(k)s, company pensions and annuities, and investment earnings.

Tax Strategies for Retirees

While most people will pay taxes on their retirement income, there are tax strategies you can use to reduce the taxes owed. Instead of delaying distributions until you need them or until you have to withdraw them, it may be a good idea to withdraw more funds in the years when you claim tax deductions which temporarily lower your tax rate. For instance, you may take advantage of the year(s) in which you itemizing deductions, such as medical expenses or charitable donations.

Another tax strategy is to convert a traditional IRA to a Roth IRA, which eliminates future tax liabilities ― especially useful if you want to pass funds to your heirs. While you will owe taxes on the funds converted, the inheritance rules for Roth IRAs are generally less complex. You can also cash-in your traditional IRA and purchase a life insurance policy or tax-free bonds that allow for tax-free inheritance.

Additionally, you may be eligible for the 0% capital gains tax rate that affects the 10% and 15% tax brackets through 2010. This depends on the types of investments you have and the amount of your taxable income.

Overall, it’s important to understand your options, develop a solid tax strategy, and stay up-to-date on tax law changes.

Once you have reviewed your choices, you can determine the plans that work best for your financial and personal situation.

By remaining educated about the available retirement strategies and their potential tax benefits, you will be able to save money both now and later.

11. Taxes and Your 401(k)

Inheritance Tax for 401(k)s

If you have recently inherited a 401(k) or are set to do so in the future, there are some inheritance tax implications that you should be aware of. Inheritance tax is not something that you should take lightly. The more you learn about inheritance tax the better off you will be ― especially when it comes to inheriting a 401(k).

When a person passes on, his 401(k) becomes part of his estate. That being said, the beneficiary usually does not have to wait to receive access to the balance. The beneficiary is required to pay income tax on the amount received, as well as any required estate or inheritance tax.

Whether or not you owe inheritance tax is based on many factors including where you live, as well as your relationship with the deceased. Some states do not charge an inheritance tax. Others have a graduated system in which direct relatives do not owe as much as friends or distant relatives.

All 401(k)s are the same, right? While many people believe this to be the case, nothing could be further from the truth. When considering your inheritance tax options as a beneficiary, you must realize that each 401(k) has its own rules. The IRS has the right to set basic limits, but the plan itself can be more restrictive. For instance, the IRS may not have any issue with you leaving the funds in the 401(k) plan and not paying inheritance tax on it. But plan rules and regulations may state that you have to withdrawal the money within a certain period of time. Of course, this will affect your inheritance tax situation.

If you inherit a 401(k) you should immediately request a plan description to determine the rules that must be followed. Along with this, get the help of a tax professional. He can assist you in deciphering the plan guidelines, while also helping you save as much as possible on inheritance tax among many other types.

Most people find that they are required to withdrawal the money in one lump sum. This helps the company stay organized from an administrative point of view. In this case you will owe taxes on the money, but will not be charged an early withdrawal penalty ― regardless of your age.

Now that you know more about inheritance tax and 401(k)s you should have a better idea of the steps to take if you are the beneficiary of this type of account.

Tax Strategies for Retirees

While most people will pay taxes on their retirement income, there are tax strategies you can use to reduce the taxes owed. Instead of delaying distributions until you need them or until you have to withdraw them, it may be a good idea to withdraw more funds in the years when you claim tax deductions which temporarily lower your tax rate. For instance, you may take advantage of the year(s) in which you itemizing deductions, such as medical expenses or charitable donations.

Another tax strategy is to convert a traditional IRA to a Roth IRA, which eliminates future tax liabilities ― especially useful if you want to pass funds to your heirs. While you will owe taxes on the funds converted, the inheritance rules for Roth IRAs are generally less complex. You can also cash-in your traditional IRA and purchase a life insurance policy or tax-free bonds that allow for tax-free inheritance.

Additionally, you may be eligible for the 0% capital gains tax rate that affects the 10% and 15% tax brackets through 2010. This depends on the types of investments you have and the amount of your taxable income.

Overall, it’s important to understand your options, develop a solid tax strategy, and stay up-to-date on tax law changes.

Once you have reviewed your choices, you can determine the plans that work best for your financial and personal situation.

By remaining educated about the available retirement strategies and their potential tax benefits, you will be able to save money both now and later.

12. Taxes and Your IRA

It is never too early to start saving for retirement and recent tax reform has enhanced certain planning opportunities. You may still have time to accumulate significant retirement assets, provided that you plan ahead, stay disciplined, and regularly review your tax strategies.

Most people spend years planning and saving for retirement. However, they do not realize the tax implications on income received after they stop working. After the age of 65 there will most likely be a reduction in the amount of taxes owed, but it is still important to come up with a tax strategy and to plan ahead in order to minimize your IRS tax bill.

One tax strategy you may find helpful is to invest in a 401(k), IRA, or other retirement plan. The amount you contribute will be excluded from your taxable income, and many employers will make matching contributions to employees’ retirement funds. If you are self-employed, consider setting up a Keogh plan as an alternative.

Tax Strategies for IRAs and 401(k)s

For IRAs and 401(k)s, earnings and contributions may grow tax-deferred, but distributions are fully taxable. If withdrawals are made after the age of 59½, they are free of penalties.

If you have an IRA or 401(k) account, you must begin making withdrawals by April 1st of the following year after you turn age 70½ ― you must also pay taxes on these distributions.

Tax Strategies for Roth IRAs and Roth 401(k)s

For Roth IRAs and Roth 401(k)s, however, there are no minimum distributions. You may also make tax-free withdrawals from Roth accounts that have been owned for at least five years, if you are at least 59½ years old.

Note: The Worker, Retiree, and Employer Recovery Act of 2008 suspends the rules for required minimum distributions (RMDs) from certain qualified retirement accounts for the year 2009 only.

IRAs for Kids

If your child has earned income from outside the household – such as from babysitting or a summer job – consider opening an IRA (Individual Retirement Account) for them. An IRA will help teach your child to be responsible and to exercise good financial habits.

It is important to keep detailed records of their earnings, including the type of work, the employer, and a log of dates. You can help your child decide between a Traditional IRA and a Roth IRA, and determine which one works best for them. Your child will be more enthusiastic about saving once they see how much their money can grow.

How important is it to start an IRS for your child now? Consider this:

• If your 15-year old child saves $800 from babysitting and purchases a Roth IRA, they will accumulate over $37,000 by the age of 65 – which will be tax-free upon withdrawal. (Note that these numbers assume that the child makes no additional contributions and their funds grow 8% annually.)

• If your 15-year old child opens a Roth IRA with $2,000 and makes annual contributions of $2,000 for the next ten years, the value of their tax-free account will be $700,000 at the age of 65. (Note that these numbers assume an annual growth rate of 8%.)

Bear in mind that this IRA belongs to your child, and they may use it as they choose once they reach the required age. Consider all the factors before you put thousands of dollars into your child’s IRA.

Tax Planning for Inherited IRAs

Do you know anything about inheriting an IRA? If this is something that you will be faced with in the near future, it is important to know what you will be up against and how you can make decisions that will benefit you when dealing with inheritance tax. Tax planning for inherited IRAs is easy enough if you know which steps to take.

Here are several inheritance tax tips that can help you determine what to do next:

IRA Tax Tip #1

Don’t make any quick decisions. If you inherit an IRA, do not do anything until you know the rules and potential inheritance tax that governs your situation. For instance, did you know that you have to re-title the IRA unless you inherited it from a spouse? Anything you do before this will make your inheritance tax situation more confusing.

IRA Tax Tip #2

When you open your IRA, make sure you are smart about who you list as the beneficiary. This may not help you after you are gone, but it is definitely a big deal to those you leave behind. If somebody other than a spouse is the heir, they must begin to take distributions by December 31 of the same year. That being said, they can draw money over the long term to ensure years of income free growth.

For flexibility purposes, name both a primary and alternate beneficiary. For instance, your spouse could be the primary beneficiary and your children the alternate. With this, the primary beneficiary can turn down the account which then passes it on to the alternate beneficiary along with the inheritance tax benefits.

All of the above will also have an effect on the amount of inheritance tax that your beneficiary will be required to pay.

IRA Tax Tip #3

A spouse is in the best position in terms of withdrawals and avoiding inheritance tax. A spouse can roll an inherited IRA into his or her own IRA and in turn postpone distributions until turning 70.5. That being said, like other IRA owners, the spouse may have to pay a 10 percent withdrawal penalty should they want to access the money in their own IRA before 59.5. To protect against this, it makes most sense to wait until after becoming 59.5 to rollover the funds.

* * * *

Tax planning for inherited IRAs starts early. The person who owns the IRA should consider the inheritance tax implications to their beneficiary. Along with this, once you inherit an IRA there are several things you can do to better your tax situation and ensure that you get to keep as much money as possible.

With this advice, planning for inheritance tax on an IRA should be less stressful.

13. Estate and Inheritance Taxes

Inheritance Tax Basics

It’s a fallacy that only the ultra-rich have to worry about passing down their assets. It is important for every person to understand how to leave their property and money to heirs (or other designated beneficiaries) with little or no inheritance tax consequences. Simply put, an inheritance tax is a tax that the beneficiary must pay on the total value of their inheritance.

Inheritance tax is different from estate tax, which is a federal tax imposed on an individual’s entire estate (including cash, investments, cars, boats, real property, art, jewelry, etc.) at the time of their death. The estate tax is paid by the estate itself, and it is the responsibility of the executor/administrator (appointed by the decedent) to carry out. Inheritance tax, on the other hand, is a state tax levied by state governments, and it is the responsibility of the beneficiary to pay.

Typically, when an estate is settled, the executor determines the impact of estate taxes ― in many circumstances, they may also calculate inheritance tax so that certain assets can be liquidated to pay the combined taxes. This can alleviate the beneficiaries’ burden of having to pay inheritance tax.

The amount of the inheritance tax depends on the type of the property inherited and the relationship of the beneficiary to the deceased person. In general, a decedent’s immediate relatives (children, spouse, or parents) are able to claim exemptions that can reduce the amount of inheritance tax levied. Beneficiaries who are not direct lineage relatives, however, are typically subject to higher inheritance taxes.

Many people believe that the estate tax (a.k.a. “death tax”) and inheritance tax are unethical and unfair, because they place a strain on the family who has just lost a loved one and they reduce the amount of the inheritance. For instance, if the owner of a family business has passed away, the children may be forced to liquidate the business in order to pay inheritance tax. In addition, some states charge both an estate tax and an inheritance tax ― this “double dipping” is another source of anxiety to those favoring a repeal of the inheritance tax.

Supporters of the inheritance tax claim that it is a way to “redistribute the wealth” and ensure that richer Americans are paying their share of taxes to the government. Whatever your opinion on the matter may be, the inheritance tax is subject to the discretion of the individual states ― some states enforce an inheritance tax, and some states have actually repealed their inheritance tax.

As of July 2010, the following states imposed an inheritance tax: Indiana, Iowa, Kentucky, Maryland, Nebraska, New Jersey, Pennsylvania, and Tennessee.

As of January 1, 2010, the following states collected an estate tax: Connecticut, Delaware, District of Columbia, Maine, Maryland, Massachusetts, Minnesota, New Jersey, New York, Ohio, Oregon, Rhode Island, Tennessee, Vermont, and Washington.

Inheritance Tax and Your Estate

Just as buying the right life insurance is a prudent way to provide protection for your family if you die unexpectedly, so is proper estate planning. It makes sense to sit down with your estate planner/lawyer while you’re in a good frame of mind (and hopefully in good health) to discuss the future disposition of your assets, and how estate and inheritance taxes should be handled.

You will need to go through a check-list of assets that you’ve acquired or amassed over the years in order to approximate the total value of your estate. You must also consider the impact of inheritance tax on any assets that you pass on to your heirs/beneficiaries. If you fail to take the proper steps and create a will that discloses how you wish your estate to be settled, the federal government (and possibly the state) will step-in after your death and a sizable portion of your assets could be lost to estate and inheritance taxes.

Most people appoint a spouse or responsible adult child to act as the executor (or personal representative) of their estate. It is important to make sure that individual is capable of carrying out your wishes and understands the best course of action to minimize the estate and inheritance tax liability. Once the executor receives your will and the official death certificate, he/she can begin the probate process.

Probate is the legal process undertaken by the court to transfer assets from a deceased person to their beneficiaries. Probate involves the court reviewing and approving the legitimacy of the will (if it exists), and authorizing the transfer of assets. State probate laws determine how the assets in your estate can be legally transferred to your beneficiaries/heirs, and the amount of inheritance tax to which they may be subjected. The probate process may take anywhere from a few months to several years, depending on how large and complicated the estate/will is, the number of beneficiaries, and the amount of estate or inheritance tax due.

The executor of your estate is appointed by you. He/she is responsible and accountable for the following duties:

Paying creditors, or others you owed money to at the time of your death
Paying the applicable estate and inheritance taxes
Contacting the Social Security Administration (as well as your life insurance company, bank, and other financial institutions) and providing documentation regarding your death
Canceling credit cards, magazine subscriptions, medical/dental appointments, memberships, etc.
Distributing assets to your heirs and beneficiaries according to the instructions stipulated in your will

It is important for you to consider estate planning tax strategies that can help keep your assets intact and reduce the inheritance tax for your heirs and beneficiaries.

Inheritance Tax vs. Estate Tax

While many people think that inheritance tax and estate tax are identical, nothing could be further from the truth. These terms are not interchangeable despite the fact that some people use them as such.

Before you get too deep, it is important to know that 14 states collect estate taxes and only seven collect inheritance taxes. If you do not live in one of these states, there is a good chance that you will never have to worry about either type of state tax.

So, what are the main differences between the inheritance tax and the estate tax?

Estate tax is a tax that is based on the net value of the property owned by the deceased. When the assets are transferred to the beneficiary, estate tax comes into play. This tax has nothing to do with the person who inherits the assets.

Inheritance tax, on the other hand, is imposed by state governments and the tax rate depends on the person receiving the property, and in some jurisdictions, how much they receive.

For instance, in Pennsylvania, money inherited by a spouse is not taxed. A transfer to a lineal descendent, such as a child, is taxed at a rate of 4.5 percent. Transfers to siblings are taxed at 12 percent, and anybody else must pay 15 percent. As you can see, how much you pay in inheritance tax is based primarily on your relationship.

Of course, there are exemptions that can greatly reduce the amount of inheritance tax that is owed. In some cases, heirs may receive inheritance tax exemptions for taxes that have been previously paid on the property. That being said, it is important to have the proper documentation in place to prove that you qualify for the exemption. Along with this, if any portion of the inheritance is set to go to charity, the beneficiary is not responsible for paying inheritance tax on the value.

As you can see, there are several primary differences between inheritance tax and estate tax. If you receive money/property upon the death of another, you need to consider whether or not you owe estate tax or inheritance tax. To better understand how this will affect you and your tax situation, get in touch with the IRS, your state’s department of revenue, and/or a tax professional. The more you know about inheritance taxes and estate taxes, the better tax strategies you will be able to develop for the future.

Inheritance and Gift Taxes

Winston Churchill once said, “We make a living by what we get, but we make a life by what we give.” If fortune has smiled on you and you are a generous person, you might consider “gifting” some of your assets to another individual. Whether that person is your child who wants to take flying lessons, your friend who wants to install a Koi fish pond in their backyard, or a struggling single mother who you heard about through your church, you need to be aware of the IRS rules pertaining to inheritance and gift taxes.

The gift tax was created to prevent wealthy individuals from “giving away” their money to avoid being subject to estate or inheritance taxes. It allows the federal government to put a cap on the amount of money a person can “gift” to an individual by establishing yearly and lifetime limits. The gift tax is assessed on the donor of the gift, based on the value of the assets that were given away. Inheritance tax, on the other hand, is paid by the beneficiary when he/she receives assets from a deceased person (if the inheritance tax has not already been paid by the executor of the estate).

The IRS allows you to “gift” up to $13,000 annually per person (to any number of individuals) without owing any gift tax ― as long as you do not exceed the $1,000,000 lifetime maximum. If you are married, you and your spouse can each give a gift of $13,000 per year (or $1,000,000 over your lifetime) and not be subjected to the tax.

For example, say you want to give your child $26,000 so that he can buy a car. You and your spouse would each have to gift $13,000 in order to qualify for the gift tax exemption. However, if you each make a $15,000 gift to the child, the amount that exceeds your annual limit of $13,000 ($2,000 per person in this case) will be applied towards your $1,000,000 lifetime maximum.

Now suppose you wanted to give your child $13,000 a year for the next 10 or 20 years ― that would be an effective way to give them money and reduce the amount of inheritance tax that your child would have to pay on a lump sum inheritance upon your passing.

It is not uncommon for people who have amassed a large estate to begin gifting away a portion of their assets to their children (or to other beneficiaries) each year. This allows them to share their generosity, experience the appreciation of assets, and reduce the amount of inheritance tax that may be due (had they waited until death to transfer their assets).

In general, according to the IRS, the following items are not considered to be “gifts:”

Gifts that are less than or equal to the annual exclusion for the calendar year
Tuition or medical expenses you pay on behalf of someone (these are accounted for under the educational and medical exclusions on your tax form)
Gifts made to your spouse
Contributions made to a political organization
Contributions to a qualifying charitable organization

The rules pertaining to gift, estate, and inheritance tax laws can be confusing and complex. It’s highly recommended that you consult a qualified tax professional or estate lawyer for additional advice.

Protect Your Assets from Estate and Inheritance Taxes

According to a June 2010 report released by The Boston Consulting Group, the United States has the 7^th highest density of millionaire households. If you’re one of those lucky people, you’ll want to take steps to minimize the amount of estate and inheritance taxes imposed by the federal and state government.

Many Americans cherish the ability to pass one’s wealth down to their children (and even grandchildren). A married individual may leave all of his/her assets to their spouse tax-free, but you’ll need also to do some estate planning to protect your spouse’s assets from estate and inheritance taxes when he/she passes away.

Gift Tax Exemption

One way to protect your assets from estate and inheritance taxes is to “gift” money to your family or friends before you pass away. You and your spouse can each give up to $13,000 per year (to as many individuals as you like) without incurring any gift tax. Even if you exceed the lifetime maximum of $1,000,000 (or $2,000,000 for a married couple), the 35% tax on gifted assets is still lower than the estate tax rate ― unless the estate tax is reinstated at 45%-55%, as the Obama Administration has proposed.

Trust Accounts

Trust accounts can also be useful vehicles to help minimize estate tax and inheritance tax. Below are examples of trusts that are commonly used to ensure the proper distribution of assets.

A Living Trust is set up while you are alive, so that when you pass away, the successor trustee distributes your assets to the beneficiaries you’ve named. By doing this, your assets can avoid the probate process, but estate or inheritance taxes may not be eliminated entirely.

A Bypass Trust provides financial support for a surviving spouse and enables the couple to give the maximum amount of assets to their children (or other heirs) once both spouses pass away.

An Irrevocable Life Insurance Trust is typically set up to benefit children and/or a surviving spouse. When you pass away, the proceeds of your life insurance will not be subject to estate or inheritance taxes.

A Charitable Remainder Trust can also help minimize the impact of estate and inheritance tax. This type of trust lets you designate a qualified charity (or other tax-exempt organization) as the recipient of the proceeds from your estate when you pass away. It also enables you and your spouse to continue receiving income from your assets until each of you passes away. A charitable remainder trust is irrevocable, but you may be able to maintain control over how the assets in the trust are managed and you may be able to modify the beneficiaries. You will have to fulfill the IRS requirement and distribute a minimum portion of your assets (currently 5%) each year to the charity, but you will be also able to claim a tax deduction for charitable contributions. Another benefit to this type of trust is that any realized profits are exempt from capital gains tax, meaning that you can pass on a greater portion of your estate to charity.

A Charitable Lead Trust works in a similar manner as a Charitable Remainder Trust in that a designated charity receives a certain percentage of your income every year. However, when you pass away, a Charitable Lead Trust distributes your remaining assets to your surviving spouse and any other beneficiaries you named (rather than to the charitable organization).

There are several ways to reduce the amount of estate tax or inheritance tax that your assets will be subject to upon your passing. It’s pays to be prepared and have a good estate planning lawyer to help you design an effective and pro-active tax strategy.

Taxes and GRATs (Grantor Retained Annuity Trusts)

A GRAT, or Grantor Retained Annuity Trust, is a useful tax strategy if you want to transfer money to a family member without being subject to the gift tax.

After a taxpayer has given away $1 million in excess of the annual gift limits (currently $13,000 to any number of people) he or she will have to start paying income taxes on additional large gifts. Therefore, simply transferring one’s wealth to family members in order to avoid the estate tax is not, on its own, a very viable tax strategy. (Though the estate tax is repealed for the 2010 tax year, it will return in 2011 with rates and rules identical to 2001.)

An alternative tax strategy is to set up a GRAT, a trust fund started by an initial donation. This trust is an annuity, meaning that the donor receives an annual payment from the fund until the annuity expires. At that point, anything remaining in the fund is transferred to a designated recipient. This recipient must be a family member of the donor. If the donor expires before the term does, the beneficiary of this tax strategy receives what is left in the trust.

If you set up a GRAT with your financial planner, you will calculate not only the value of the initial contribution, but the interest that the principal will earn, with the annuity payments taken out. On paper, since the GRAT is supposed to pay itself out over its term, these payments should add up to the principal plus interest, giving the GRAT a value of zero for tax purposes. Herein lies the popularity of this tax strategy: if assets which are expected to appreciate at a high rate are used to fund the GRAT, its value will not, in fact, be zero, but potentially much larger. After the scheduled annuities, which do not exhaust the GRAT’s actual value, have been paid back to the donor, the remaining amount will go to the beneficiary with no gift tax strings attached, which many high net worth individuals have found to be a useful tax strategy.

The Small Business Lending Fund Act of 2010, passed by the House of Representatives and currently being considered by the Senate, aims to crack down on this tax strategy by re-attaching the gift tax to the GRAT as well as requiring a minimum 10-year term for the life of the fund. Individuals hoping to gift some of their wealth to family members may want to take advantage of the GRAT tax strategy, while it is still advantageous to do so.

Tax Strategies for Lending Money

If wise tax strategy and investing has led you to be financially better off than a close friend or relative, your natural inclination may be to lend them money interest-free in their time of need. However, this is generally a poor tax strategy. If you don’t charge interest, the IRS might charge your beneficiary income tax on the loan, which would not be a good tax strategy for them either. Even worse for you, you may be required to give the IRS the difference between what you charged in interest (which may have been nothing at all) and the current minimum interest rate. And worse still, an extremely large interest-free loan (such as one over $13,000 from an individual who has already given away $1 million or more) may be subject to the gift taxes you thought you had circumvented through other tax strategies.

Instead, make the loan more like a business proposition. Only lend to someone with the ability to pay back the principal and interest. (If your son or daughter needs a helping hand, there are other ways to transfer money to them, such as a trust fund.) Draw up a legal contract for purposes of tax documentation. Having a contract is a common-sense financial strategy as well as a tax strategy; there is often a strong correlation between having one’s name on a contract, even if it is being held by a family member, and actually repaying the loan.

Do these guidelines apply to lending your deadbeat cousin $500 to pay the rent? No, they do not. The interest requirement only applies to loans of $10,000 or more, and if the recipient’s investment income is less than $1,000, the ceiling is raised to $100,000. Thus, make sure that cousin doesn’t put the interest-free $20,000 you lend him to make the down payment on a mortgage into the stock market instead. If this happens, the IRS’ tax strategy will be to tax you on either the minimum interest rate when you loaned the money or the borrower’s own investment income, whichever is smaller.

Consult your financial planner for the proper tax strategies to use when loaning money to family members. If you could have invested the funds you are loaning out, then you are losing potential interest on them, making it even more important for you to charge an interest rate that doesn’t impede your own finances. If you follow the same basic tax strategies as a for-profit lender, while not subjecting your loved one to an extortionate interest rate, the loan could have beneficial financial ramifications for them as well as keeping you in the clear tax-wise.

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