Winter 2012 | Volume 110 | Number 662
Money Matters
Photo Credit: Marc Rosenthal
Life and Taxes
How changes in your life in 2011 may affect your tax bill in April.
by Joe Bousquin
Did anything big happen in your life last year? If you have a manila folder – or hard drive – filled with wedding thank-you notes, baby pictures, updated résumés or legal paperwork, you likely have seen some dramatic changes in your personal life in 2011.
Those very same events likely have affected your finances and your upcoming tax return.
"A lot can happen in life, and very rarely does everything unfold as scheduled," says Rick Edinger, a retirement specialist at Thrivent Financial. "The unexpected death of a spouse, divorce or even retirement can have a bigger impact on taxes than people realize."
Just like an annual checkup with your doctor, you should schedule a chat with your tax advisor at least once a year. That's even more important when you've experienced a change in your personal life.
"The best option, of course, is to check in with your financial team before life's big changes occur," says tax advisor Ann Andrews, a Thrivent member and a certified public accountant with Bargsley, Andrews & Steinbach in Austin, Texas. Even if you can't check in before something happens, like a job loss, doing so after is still important. "CPAs, accountants and financial professionals have worked with these situations for years and can help you understand your options more quickly."
As the calendar counts down to April 17, it's important to know which life events may affect how much you pay, and be aware of the tax consequences of things you may not even think of as tax-related. We asked Edinger and Andrews for an overview of things that influence what we owe to Uncle Sam.
Change of family status.
While having or adopting children can lower your tax bill, getting married or divorce affects how the numbers work, too.
If you're newly married, don't assume that filing jointly is always a bad thing. "The marriage 'penalty' doesn't always work out that way," Andrews says. "Some couples pay more after marriage, and some pay less than they paid as singles."
In the case of divorce, it's not just about splitting what you have. Each person should consider future benefits such as stock options and retirement accounts as well.
Job Loss
With today's difficult economy, this is an issue for many people. But just because you stopped earning money doesn't mean you won't owe Uncle Sam at year's end. "Things like severance and unemployment payments are taxable, and early withdrawals from a retirement plan may come with penalties," says Edinger.
On the bright side, you can use your lower income to your advantage. "This may be a good opportunity to convert some money you have in a traditional IRA to a Roth IRA [even with the tax bill that comes with that conversion], since you will likely fall into a lower tax bracket," Andrews says. Low-income years may be the time to take capital gains, possibly with zero tax cost.
Selling Your Home
Millions of Americans have seen their home values decline in recent years. Typically, if you lose your house to foreclosure or sell your home for less than you owe on the mortgage, you have to pay taxes on the amount for-given by the lender. "It's an additional difficulty for taxpayers who often don't have cash to pay the tax," explains Andrews.
Fortunately, the government has decided it will not charge income tax on the amount of mortgage debt forgiven in such situations, at least until Dec. 31, 2012. However, you will need to file the necessary paperwork as part of your annual tax filing.
Natural Disasters
Who can forget the haunting images of tornado-ravaged Joplin, Missouri, or the families who lost everything in the Texas wildfires during 2011? Even Uncle Sam isn't unsympathetic when disaster strikes. "There are almost always filing extensions and often special tax credits for those situations," Edinger says.
People who live in a federally declared disaster area have some options, according to Andrews, who lives in Austin, Texas, where many residents in surrounding areas lost homes to the wildfires. "They're allowed to deduct their entire loss in either the year of the disaster, or the preceding year," she says. If you fall into this category, do the math; it may make sense to file an amended 2010 return and claim the loss in that tax year.
Starting College
"Make sure you know and follow the rules relating to tuition deductions, savings plan distributions, college credits and personal exemptions on the parents' and student's tax returns," Andrews says.
She also reminds people about the so-called "kiddie tax." If you've made taxable investments in your kids' names, and the interest, dividend and investment income on these accounts totals more than $1,900, it's taxable at the parents' tax rate. (This applies only to individual savings and investment accounts, not college-savings 529 plans.)
If your student is helping pay for school by working as a tutor, landscaper, dog walker or other personal service type of work, determine whether he is either an employee or independent contractor. Young workers may not realize how this can affect their taxes, and the costs involved can surprise them, Andrews says. If students are independent contractors, they must pay federal and state income and payroll taxes, as well as federal self-employment tax, which many students don't realize.
Making an Early Withdrawal From a Retirement Plan
Early withdrawals can cost you dearly at tax time. Most financial professionals caution against using early withdrawals except in extreme circumstances, because they usually result in ordinary income tax plus a penalty. "Employees may consider borrowing from their company 401(k) plan, but if the employee leaves before the loan is repaid, the balance will be considered a taxable distribution," Andrews warns.
Starting retirement.
"Starting retirement doesn't mean you stop worrying about money," Edinger says. "You need to evaluate all your options, like the implications of taking distributions from your employer-sponsored retirement plan and taxation of Social Security benefits."
Receiving an inheritance.
If you inherit a retirement plan like a 401(k) or traditional IRA, you will owe income tax when you receive distributions from the account. Depending on your relationship to the person who named you as beneficiary, and the terms of governing the retirement plan, you may have some choices about when and how you receive the money.
"If you inherit other assets [such as stocks, bonds or real estate], receiving those assets will most likely not result in taxable income to you, but each case has unique factors," Andrews says.
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