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A New Option for 529 Plan Owners

A 529 plan is a tax-advantaged savings plan designed to help pay for educational expenses. When a parent or grandparent opens a 529 plan, they ensure that their child has the financial support to reach their educational goals. With about 42% of Americans over age 25 holding a college degree, it may seem like a no-brainer to take advantage of the long-term tax savings of investing in a 529 plan.

But what can you do if the beneficiary of the plan ultimately decides to pursue goals that do NOT require additional education? Are the funds “stuck” in the 529 plan?

In the past, using withdrawals from a 529 plan for anything other than qualified educational expenses would result in taxes and usually penalties. Account owners could leave the funds in the account in case the beneficiary changed their mind in the long term. They could decide to change the beneficiary of the account to another person, such as a niece or nephew. However, that may not be a desirable option for many families.

The recently enacted SECURE 2.0 Act provides an additional option for moving funds from a 529 plan that is no longer needed. Starting in 2023, owners of certain 529 Plans can transfer the balance to a Roth IRA. A Roth IRA is a special individual retirement account (IRA) in which withdrawals are tax-free.

The conversion must comply with the following guidelines:

  • 529 plan account must have been in effect for at least 15 years.
  • The amount transferred into the Roth IRA may not exceed the total of the contributions made to the 529 plan during the past five years.
  • The amount transferred into the Roth IRA each year is limited to the amount allowed for Roth IRA contributions that year. (In 2023, the IRA limit is $6,500, but we do not know the limit for 2024 as of the date of publication).
  • The maximum amount of all transfers is limited to $35,000.

 

While 529 savings plans can be beneficial for many families, investors who ultimately decide that they will not use their balance for qualified educational expenses now have another option for using the funds without incurring harsh penalties. Because of the complex rules surrounding such a conversion, we also recommend speaking with a knowledgeable financial advisor. If we can assist you with a referral, call our office at 480-294-4967.

Impact of the 2023 Appropriations Bill on Retirement Savings

In the last week of 2022, President Joe Biden signed into law the Consolidated Appropriations Act of 2023. The $1.7 trillion omnibus spending bill covers a huge range of topics, from spending in support for Ukrainian defense to the social media apps federal employees are allowed to download on their government-issued devices (hint: not TikTok). However, this blog will focus on the impact of the legislation on retirement savings policies, especially 401(k)s.

The retirement-related portion of the omnibus billed is dubbed the “SECURE 2.0 Act of 2022” and builds upon an act passed in 2019. Its goal is to expand the number of Americans saving for retirement and increase the amount they save. Some of the most important provisions of the legislation include:

  1. Mandated Automatic Enrollment
  2. Increased Limits for Catch-up Contributions
  3. Higher Age Threshold for Required Minimum Distributions

Mandated Automatic Enrollment

Effective for plan years beginning after 2023, 401(k) and 403(b) sponsors must automatically enroll employees in plans once they become eligible to participate in the plan. Previously, eligible employees had to elect to enroll. Under the new law, employees must opt out of enrollment if they do not wish to participate.

Generally, the amount of the automatic contribution must be set between 3 and 10%, depending on the employer’s policies.

Increased Limits for Catch-up Contributions

As we have discussed in a previous blog, the maximum catch-up contribution for 2023 is $7,500.

However, the SECURE 2.0 Act allows an additional increase in the contribution amount for participants aged 60 through 63. The additional increase is effective for tax years after 2024. For most plans, this second catch-up limitation would be $10,000. Furthermore, like the standard catch-up amounts, these limitations will also be subject to adjustments for inflation.

Higher Age Thresholds for Required Minimum Distributions

Under current law, plan participants are required to begin taking required minimum distributions (RMDs) at age 72. Under the SECURE 2.0 Act of 2022, the age at which participants must begin taking RMDs is increased over a period of ten years. Starting in 2023, the age is increased to 73 for individuals who turn 72 after 2022 and age 73 before 2033. For individuals who turn 74 after 2032, RMDs must begin at age 75.

 

These provisions aim to increase the rate at which Americans save for retirement. If you have questions about saving for retirement, please call our office at 480-392-6801.

When does it make sense to convert a Traditional IRA to a Roth IRA?

We all know that contributing to retirement accounts early and often is good advice, but many of our clients question whether it is more beneficial to invest in a traditional IRA or Roth IRA. The answer to this is different for every client and depends upon the expected cash flows during their working years and their retirement years. The good news is that any money contributed to a retirement account is a proactive step to protecting your future. Furthermore, either option will provide tax benefits, and the timing on when those benefits are reaped is the primary difference.

While it is impossible to predict the future, the ability to convert a Traditional IRA to a Roth IRA is a little-known option that can be a powerful source of tax savings for investors who understand the rules.

Unfortunately, taxpayers in the middle of their careers too frequently experience a temporary but dramatic slump in their income. This could be due to unforeseeable factors like the global pandemic that disrupted economies around the world in 2020, contributing to widespread unemployment and loss of business income. In other years, people experience unexpected illnesses like cancer, either for themselves or a loved one, and take a needed break from focusing on work. Former W-2 employees may experience dips in income in the first year that they start a business. However, any of these circumstances can provide a sharp investor with an opportunity to generate tax savings.

In a Traditional IRA, contributions are tax deductible in the year in which they are contributed. The tax bill will be lowered in the current year, and the investor will pay taxes in the future when the funds are withdrawn from the retirement account. On the other hand, contributions to a Roth IRA do not provide a tax deduction in the year contributed; but if the funds are withdrawn after at least five years and over age 59 1/2, no additional taxes will be due.

An investor who has an existing Traditional IRA and experiences a dramatic drop in income may consider converting the account to a Roth IRA. Because of the conversion, they will be required to pay income taxes on the previously tax deferred amount. However, because the taxpayer is in a much lower income bracket than in other years, the tax rate may be significantly lower than at another point in the investors life.

Furthermore, they will take advantage of other features of the Roth IRA:

  • No required minimum distributions
  • Tax-free income for heirs

There are several important factors to consider before deciding to convert an IRA:

  • What is the taxpayer’s normal effective tax rate, and what is the effective tax rate expected to be in the low-income year?
  • Will the taxpayer have adequate funds to pay the tax due as a result of the conversion?
  • Will the increase in taxable income affect the taxpayer’s ability to qualify for programs such as government marketplace health insurance or children’s financial aid for college?

Once the taxpayer determines that converting their IRA from a traditional to a Roth is the most beneficial course of action, they can explore financial institutions. Things like the historic rate of return on investments and the fees charged by the institution will affect their decision to either continue investing with their current institution or moving the funds to another one. The conversion process requires filling out paperwork with the financial institution. At tax time, the taxpayer (or their accountant) will submit a Form 8606.

While converting from a traditional IRA to a Roth IRA will not make sense for everyone, it can be an effective tool for some taxpayers to take advantage of significant drops in their income to generate future tax savings. If you have any questions about this strategy, reach out to your tax preparer or call our office at 480-392-6801.

Want to read more about retirement investing? Check out these past blog posts:

Captive Insurance

When businesses grow and become more profitable, owners may look for strategies to build cash reserves for the unknown future. Forming a captive insurance company, also called an 831(b) Plan, is one strategy for businesses with excess cash to lower their tax bill in the current year while providing flexibility in future years.

A captive insurance company is a wholly owned subsidiary insurer formed to provide risk mitigation services for its parent company. For example, an S-corporation purchasing captive insurance would form a separate C-corporation. That C-Corp would be called the “reinsurance company.”  The reinsurance company can be owned by the business, or its ownership can mirror that of the business. It can even be owned by a trust depending on the circumstances. Regardless of the particulars of ownership, the flow of cash remains the same. The S-corporation pays premiums to the reinsurance company, and the premiums are tax-deductible to the S-corporation.

Most businesses carry some insurance through a traditional insurance provider, but the reinsurance company offers protection against risks that are not sufficiently reduced by other policies. Insurable risks include audit, litigation, and cyber-attacks. The risks being addressed by the plan must be fortuitous in nature, not ordinary business risks.

The deductibility of premiums paid to the reinsurance company is the first part of the tax planning strategy. But after the expiration of the 12-month policy, the investor has a range of options for the remaining funds that were not paid in administrative fees or claims:

  1. The owners of the reinsurance company can leave the excess reserves in the reinsurance company to grow through conservative investments such as bonds. The investment income earned is taxed at the captive insurance company level at the federal corporate tax rate of 21% plus applicable state tax rate.
  2. The reinsurance company may distribute the funds as taxable qualified dividends. The distributions will be taxed at the long-term capital gains rate (currently 15 or 20%).
  3. The reinsurance company may lend up to 65% of the funds to the operating company. The funds may be used to invest in or expand the business. Importantly, interest on the loan must be paid at the IRS prescribed applicable federal rate (AFR) to the reinsurance company.

Captive insurance plans can be a powerful planning and tax deferment tool for businesses with excess cash reserves. In fact, the National Association of Insurance Commissioners (NAIC) estimates that about 90% of Fortune 500 companies today have captive subsidiaries. However, small and midsized businesses can often benefit as well.

Since the Treasury Regulations surrounding reinsurance companies is extremely complex, we always recommend working with a qualified administrator, such as SRA 831(b) ADMIN and an accounting firm that understands the rules around the small captive insurance company rules.  SRA generally recommends that businesses have at least $100,000 to commit to the reinsurance company.

If you are interested in exploring a captive insurance plan for your business, please call our office at 480-392-6801 to discuss your situation with a Tax Manager.

Client Gifts

Many business owners like to express their appreciation to clients and referral sources with gifts, especially around the holidays. Understanding IRS rules around gifts can help you show your generosity without creating any surprises at tax time.

$25 Limit

Businesses may not deduct more than $25 for business gifts made to the same person. For example, if you purchased a $75 gift basket for a major referral source, only $25 would be deductible on the tax return. The $25 limit does not include shipping costs, sales tax, gift wrapping, or engravings that do not add substantial value.

Of course, this dollar limit is to prevent unreasonable business expenses, but it is interesting to note that the amount has not been updated since 1962.

 

 

Bright Idea

Since the $25 limit is per person, you may deduct a larger gift if the recipient is a business with multiple employees. For example, if one of your clients has five employees, you could give a fruit and cheese basket costing up to $125 and deduct the full expense. Similarly, you could give individual gifts to key contacts within one company.

 

Be Wary of Entertainment

When selecting gift, be careful of gifts that could be considered entertainment. The Tax Cuts and Jobs Act eliminated the deduction for entertainment expenses as of January 1, 2018. Examples of entertainment include tickets to a sporting events and concerts.

 

 

Bright Idea

Instead of providing gifts that could be considered entertainment, consider taking the client to a meal. Business meals at restaurants remain 100% deductible in 2022 (rather than the normal rate of 50%). A meal can provide the same opportunity to connect with a contact as entertainment without the sticky tax rules. Furthermore, meals are not subject to the same low dollar limitation as gifts.

 

Small, Branded Gifts

Branded items that cost less than $4—think pens, chap sticks, or calendars—are considered advertising rather than gifts. Generally, you don’t need to record who you gave them to because they will not count against the $25 per person annual limit.

 

The holidays provide a great opportunity to tangibly express your appreciation for clients and contacts. Who doesn’t love to receive a thoughtful box of chocolates or bottle of wine? If you have any questions about the IRS rules surrounding client gifts or any other deductions, reach out to our office at 480-392-6801.

The 6,000 lb. Gross Vehicle Weight Tax Deduction

In a previous blog post, we discussed how Section 179 of the tax code allows business owners to accelerate deductions for tangible business assets. Today we’ll explore one strategy for further maximizing tax efficiency by increasing the weight of vehicles used for business.

Under the IRS’s depreciation provisions, different rules apply between smaller vehicles such as sedans versus larger vehicles such as trucks and vans. Large vehicles, defined as vehicles that weigh between 6,000 and 14,000 lbs., are eligible for higher tax deductions in the first year that the vehicle is placed into service.

But even S-corporation owners who do not need a heavy-duty truck for their business can benefit from this deduction. If you drive a sport utility vehicle (SUV) that weighs less than the 6,000 lbs. threshold, you may be able to install a tow hitch to increase the weight of the vehicle sufficiently. Most dealers have this option available at purchase, and typically the few hundred dollars charged to install it is a much smaller investment than the thousands of dollars save by reducing your taxes. In 2022, SUVs with loaded vehicle weights over 6,000 lbs. (but less than 14,000 lbs.) can be 100% deducted using bonus depreciation.

The vehicle must also be used primarily (at least 50%) for qualified business use. It can be either new or used. However, the vehicle may not be used for transporting people or property for hire.

Finally, to claim the deduction for 2022, the vehicle must be placed into service by December 21, 2022.

To substantiate the deduction for heavy vehicles, we recommend that Arizona taxpayers update their registration with the Department of Motor Vehicles (DMV). According to Arizona statute:

“A person may increase the declared gross weight of a vehicle or vehicle combination after the original registration and during the registration year by reregistration of the vehicle or vehicle combination. The person shall pay a fee in addition to the gross weight fee prescribed in this article based on the difference between the fee due at the time of reregistration for the weight class in which the vehicle or vehicle combination was originally registered and the fee due at the time of reregistration for the increased weight class.”

That means that the cost of proving that your vehicle meets the IRS weight requirements should be only a small fee.

As a reminder, make sure that you are capturing all the expenses related to your business vehicle including the following:

  • Registration fees and taxes
  • Maintenance and repairs
  • Auto insurance
  • Fuel

Upgrades to increase the weight of an SUV used for business can have huge payoffs at tax time. If you have any questions about this or other business deductions, call our office at 520-353-4502.

“I filed an extension. Why do I have to pay penalties now?”

This is one of the most frequently asked questions we receive around the extended October deadline! In the spring, we just as frequently hear, “I have an extension. Why do I need to make an estimated payment?”

Unfortunately, even though an extension grants you additional time to file, it does not give you additional time to pay the tax due. That means that penalties and interest accrue on the amount of tax owed from the filing deadline until you pay the tax. We agree: this policy is confusing. We’ll discuss a few strategies on how to avoid these costs.

How can I avoid paying penalties and interest?

There are a few steps you can take to minimize the likelihood of paying penalties and interest.

First of all, if you receive a W-2, speak with your payroll administrator to adjust your withholdings to ensure that you are remitting the appropriate tax payment throughout the year. It is important to consider adjustments for life events such as changing the number of dependents you claim when one of your children begins supporting themselves.

However, withholding correctly becomes complicated for people with multiple income sources and business owners. We recommend reviewing the year-to-date financial statements for your business on an ongoing basis so that you have a good estimate of your taxable income. For our accounting and advisory services clients, we send monthly financial statements so that the data is always timely.

Do I really have to pay this?

Even with planning, surprises can come up. Larger-than-expected capital gains can result in a big tax bill since they typically do not have tax withheld. Waiting on a necessary document such as a Schedule K-1 prepared by another firm can make it impossible to know what income may be flowing from that business until the Schedule K-1 is received.

Generally, the penalties and interest assessed by the IRS must be paid. The IRS calculates the Failure to Pay Penalty based on how long your overdue taxes remain unpaid. The Failure to Pay Penalty is 0.5% of the unpaid taxes for each month or part of a month the tax remains unpaid. Importantly, the IRS applies full monthly charges even if you pay your tax in full before the month ends. They do not pro-rate the penalty. However, the penalty will not exceed 25% of your unpaid taxes.

In rare cases, you may qualify for penalty relief if you tried to comply with tax laws but were unable due to circumstances beyond your control.

Estimated Payments

If your return has been started prior to the April deadline, our tax team may reach out to you about making estimated payments. By making an estimated payment, you can avoid the Failure to Pay penalty. Your tax team will make their best estimate of the amount you owe and can even process the payments to the federal and state governments on your behalf with your authorization.

If a good estimate of the amount owed is not available due to missing information, a good place to start is ensuring that you pay as much tax for the current tax year and you did for the previous year. However, if you expect to receive a refund, no action is required.

The best way to avoid unnecessary penalties and interest around the extended deadline is to regularly communicate with your accounting firm. If you are interested in learning more about our tax planning or business advisory services, call our office at 480-294-4967 to set up a consultation.

Business Owners: Are you deducting your health insurance premiums?

With the high cost of healthcare coverage, self-employed taxpayers may find relief by taking advantage of tax deductions for health insurance premiums.

Self-employed taxpayers include sole proprietors, members of LLCs, partners, and owners of S-corporations.

Who is not eligible?

You may not take the deduction if you were eligible to participate in an employer-subsidized plan. This includes plans sponsored by your spouse’s employer. A subsidized plan is one where the employer pays a portion of the premium.

However, eligibility is determined on a month-by month basis, so even if you were covered by an employer-subsidized plan for part of the year, you may take the deduction for the remainder of the year. For example, someone who is an employee for the first six months of the year and then becomes a self-employed consultant for the final six months of the year can deduct their health insurance premiums paid from July to December.

What is included in the deduction?

The deduction includes premiums for insurance coverage for the self-employed individual, their spouse, and their dependents. While medical insurance premiums are typically the largest dollar amount, premiums for dental insurance and long-term care insurance may also be deductible. And even if you don’t itemize other deductions, you can still deduct self-employed health insurance if you meet the requirements.

Importantly, the amount of the deduction cannot exceed the earned income you collect from your business. But if you have sufficient profit, you can deduct the full amount of the premiums.

Special reporting requirements govern this deduction for S-corp shareholders who own more than 2% of the company, so we recommend talking with a tax professional. If you have questions about this deduction or want to explore other tax-saving opportunities, call our office at 480-392-6801 to schedule your tax planning meeting.

Cost Segregation Studies for Rental Real Estate

Introduction

Last week we discussed how Section 179 depreciation generates upfront cashflow for businesses by deducting the full cost of an asset in the year it is purchased. And while the tangible property we discussed had a useful life for tax purposes of 5 to 7 years, the life for residential rental real estate is far longer: 27.5 years.

For obvious reasons, owners of residential rental real estate are eager to utilize the tax benefit from their purchase more quickly. Cost segregation is a process of identifying assets that are personal property that can be depreciated more quickly than their corresponding real property. While residential rental buildings must be depreciated over 27.5 years, assets like wiring, flooring, plumbing, appliances, fixtures, and air conditioners can be depreciated in just 5 to 7 years.  By capturing depreciation earlier in the life of the property, owners can free up cash and use it for their operating and investment needs now.

Projected Tax Savings

The tax savings generated by a cost segregation study depend upon the price of the rental property. Typically, the higher the cost the property, the greater the benefit of a cost seg will be. For a $500,000 rental property, depreciation expense under the straight-line method would be just $13,940 in the first year. However, our in-house cost segregation method that classifies assets and utilizes bonus depreciation yields a depreciation expense of $168,364—a difference of over $150,000.

If the tax loss on the rental is limited due to your income level, the loss will carry forward into future years. That means that you could earn money from your rental property for years before paying income taxes on it.

Impact of the TCJA

Changes to the tax law in the Tax Cuts and Jobs Act of 2017 fueled the efficacy of cost segregation studies. For certain assets, bonus depreciation was increased from 50% of the cost of the asset to 100%. Therefore, the cost of many building fixtures can be completely depreciated in the first year.

The 100% deduction for bonus depreciation applies to property acquired and placed in service after September 27, 2017, and before January 1, 2023. Beginning in 2023, the rate of bonus depreciation will be gradually phased out, unless Congress passes a law to extend it.

Conclusion

If you invest in real estate, we encourage you to schedule a consultation to discuss your most tax-efficient option. We can assist with the allocation of real assets and personal property, and we have contacts for cost segregation firms for very large projects. We ask that clients provide a copy of the settlement statement from the purchase of their rental property.

To schedule your appointment, call our office at 480-392-6801.

Section 179 Deductions

Tangible business assets include vehicles, equipment, and furniture. Depreciation is an accounting method used to allocate the cost of a tangible asset over its useful life. Depreciation ties the cost of using an asset with the benefit gained over its useful life. The IRS specifies the useful life of many types of assets under the Modified Accelerated Cost Recovery System (MACRS).

For example, if a realtor purchases a car to drive to showings for $30,000, the car would be depreciated over 5 years. Each year, depreciation would be deducted until the accumulated depreciation equals the purchase price.

However, taxpayers might prefer to deduct the full purchase price in the first year instead of over the useful life of the asset. Deducting the full cost of the asset would result in a lower taxable income and therefore a lower tax burden, leaving more cash on hand for investment in the business or for distributions to the owner during that year. Furthermore, the time value of money posits that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim.

In some cases, the taxpayer can elect to immediately expense the asset rather than following the rates outlined in MACRS. The tax code has this provision in place to encourage business owners to grow their business with the purchase of new equipment.

Section 179 of the Internal Revenue Code outlines the requirements for an immediate deduction. For 2022, the maximum deduction is limited to $1,800,000. The property must be placed into service during the tax year in which the deduction is being claimed. In our realtor example, placing the car into service would be driving it to a business appointment. Assets must be used for business purposes more than 50% of the time to qualify for Section 179 deductions.

If you have questions about the purchase of business assets or any other tax-saving opportunities, call our office at 480-392-6801.