Author: Leon Clinton

Tax

COVID-19 Crisis Creates Silver Lining for Roth IRA Conversions

COVID-19 Crisis Creates Silver Lining for Roth IRA Conversions

For years, financial and tax advisors have lectured about the wonderfulness of Roth IRAs and why you should convert traditional IRAs into Roth accounts.

But, of course, you didn’t get around to it. In hindsight, maybe that was a good thing.

For many, the financial fallout from the COVID-19 crisis creates a once-in-a-lifetime opportunity to do Roth conversions at an affordable tax cost and also gain insurance against future tax rate increases.

Roth IRAs Have Two Big Tax Advantages

Let’s quickly review them.

Tax-Free Withdrawals

Unlike withdrawals from a traditional IRA, qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free, too.

What is a qualified withdrawal? In general, the tax-free qualified withdrawal is one taken after you meet both of the following requirements:

  1. 1. You had at least one Roth IRA open for over five years.
  2. 2. You reached age 59½, became disabled, or died.

To meet the five-year requirement, start the clock ticking on the first day of the tax year for which you make your initial contribution to any Roth account. That initial contribution can be a regular annual contribution, or it can be a contribution from converting a traditional IRA into a Roth account.

Example: Five-Year Rule.

You opened your first Roth IRA by making a regular annual contribution on April 15, 2017, for your 2016 tax year. The five-year clock started ticking on January 1, 2016 (the first day of your 2016 tax year), even though you did not actually make your initial Roth contribution until April 15, 2017.

You meet the five-year requirement on January 1, 2021. From that date forward, as long as you are age 59½ or older on the withdrawal date, you can take federal-income-tax-free Roth IRA withdrawals—including withdrawals from a new Roth IRA established with a 2020 conversion of a traditional IRA.

Exemption from RMD Rules

Unlike with the traditional IRA, you as the original owner of the Roth account don’t have to take annual required minimum distributions (RMDs) from the Roth account after reaching age 72. That’s good, because RMDs taken from a traditional IRA are taxable.

Under those rules, if your surviving spouse is the sole account beneficiary of your Roth IRA, he or she can treat the inherited account as his or her own Roth IRA. That means your surviving spouse can leave the account untouched for as long as he or she lives.

If a non-spouse beneficiary inherits your Roth IRA, he or she can leave it untouched for at least 10 years. As long as an inherited Roth account is kept open, it can keep earning tax-free income and gains. Nice!

Silver Lining for Roth Conversions

A Roth conversion is treated as a taxable distribution from your traditional IRA, because you’re deemed to receive a payout from the traditional account with the money then going into the new Roth account.

So, doing a conversion will trigger a bigger federal income tax bill for the conversion year, and maybe a bigger state income tax bill, too. That said, right now might be the best time ever to convert a traditional IRA into a Roth IRA. Here are three reasons why.

1. Current tax rates are low thanks to the TCJA.

Today’s federal income tax rates might be the lowest you’ll see for the rest of your life.

Thanks to the Tax Cuts and Jobs Act (TCJA), rates for 2018-2025 were reduced. The top rate was reduced from 39.6 percent in 2017 to 37 percent for 2018-2025.

But the rates that were in effect before the TCJA are scheduled to come back into play for 2026 and beyond.

And rates could get jacked up much sooner than 2026, depending on politics and the need to recover some of the trillions of dollars the federal government is dishing out in response to the COVID-19 pandemic.

Believing that rates will only go back to the 2017 levels in the aftermath of the COVID-19 mess might be way too optimistic.

2. Your tax rate this year might be lower due to your COVID-19 fallout.

You won’t be alone if your 2020 income takes a hit from the COVID-19 crisis.

If that happens, your marginal federal income tax rate for this year might be lower than what you expected just a short time ago—maybe way lower. A lower marginal rate translates into a lower tax bill if you convert your traditional IRA into a Roth account this year.

But watch out if you convert a traditional IRA with a large balance—say, several hundred thousand dollars or more. Such a conversion would trigger lots of extra taxable income, and you could wind up paying federal income tax at rates of 32, 35, and 37 percent on a big chunk of that extra income.

3. A lower IRA balance due to the stock market decline means a lower conversion tax bill.

Just a short time ago, the U.S. stock market averages were at all-time highs.

Then the COVID-19 crisis happened, and the averages dropped big-time.

Depending on how the money in your traditional IRA was invested, your account might have taken a substantial hit. Nobody likes seeing their IRA balance go south, but a lower balance means a lower tax bill when (if) you convert your traditional IRA into a Roth account.

When the investments in your Roth account recover, you can eventually withdraw the increased account value in the form of federal-income-tax-free qualified Roth IRA withdrawals. If you leave your Roth IRA to your heirs, they can do the same thing.

In contrast, if you keep your account in traditional IRA status, any account value recovery and increase will be treated as high-taxed ordinary income when it is eventually withdrawn.

As mentioned earlier, the current maximum federal income tax rate is “only” 37 percent. What will it be five years from now? 39.6 percent? 45 percent? 50 percent? 55 percent? Nobody knows, but we would bet it won’t be lower than 37 percent.      

The Bottom Line

If you do a Roth conversion this year, you will be taxed at today’s “low” rates on the extra income triggered by the conversion.

On the (far bigger) upside, you avoid the potential for higher future tax rates (maybe much higher) on all the post-conversion recovery and future income and gains that will accumulate in your new Roth account.

That’s because qualified Roth withdrawals taken after age 59½ are totally federal-income-tax-free, as long as you’ve had at least one Roth account open for more than five years when withdrawals are taken.

If you leave your Roth IRA to an heir, he or she can take tax-free qualified withdrawals from the inherited account—as long as at least one of your Roth IRAs has been open for more than five years when withdrawals are taken.

If you want my help thinking this through or executing on the Roth conversion, I’m here to help. Call me on my direct line at 408-778-9651.

Sincerely,

The Financial Dream Team, USA

Tax

COVID-19: Tax Benefits for S Corporation Owners

COVID-19: Tax Benefits for S Corporation Owners

To help your small business, Congress created a lot of new tax-saving provisions due to the COVID-19 pandemic.

Many of you own and operate S corporations and expect the tax law to treat you differently, as it does with your health insurance deduction.

You’ve been asking us to help clarify which of the COVID-19 tax benefits the S corporation owner can use to put cash in his or her pocket.

We’ll go over the most important COVID-19 tax provisions and tell you what we know about how they apply to you.

Payroll Tax Deferral

You can defer payment of your S corporation’s employer share of Social Security tax on federal tax deposits you would otherwise have to make during the period beginning on March 27, 2020, and ending

Your S corporation’s deferred Social Security taxes are due in two installments. You must pay 50 percent

If you are an S corporation owner, the S corporation can defer the employer portion of Social Security tax on your salary just as it can on any other employee.

PPP Exception

If your S corporation receives a Paycheck Protection Program (PPP) loan, and it obtains loan forgiveness, it does not qualify for the payroll tax deferral provision.

PPP exception loophole. The PPP loan forgiveness prohibition doesn’t apply until your S corporation receives a decision from your lender on PPP loan forgiveness. Before that date, you can defer payroll

Example 1. You operate as an S corporation and have three employees, including yourself. Your S corporation’s April payroll is $10,000, including your W-2 salary or wages.

The employer Social Security tax on this payroll is $620. Your S corporation doesn’t have to pay it with its federal tax deposit. Instead, it will pay $310 by December 31, 2021, and the other $310 by December 31, 2022.

Employee Retention Credit

Your S corporation gets a refundable payroll tax credit against the employer share of employment taxes

We review the rules for this tax credit in COVID-19: Significant Payroll and Self-Employment Tax Relief.

But the law also states that “rules similar to the rules of sections 51(i)(1) and 280C(a) . . . shall apply.”

Code Section 280C(a) states you can’t deduct wage expenses equal to the employee retention credit you receive—no double dipping.

Code Section 51(i)(1) affects the S corporation shareholder by denying the employee retention credit for wages paid to the following family members of a 50-percent-or-more shareholder:

  • A child or a descendant of a child
  • A brother, sister, stepbrother, or stepsister
  • The father or mother, or an ancestor of either
  • A stepfather or stepmother
  • A son or daughter of a brother or sister of the taxpayer
  • A brother or sister of the father or mother of the taxpayer
  • A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law

The provision does not prevent the S corporation owner from taking the employee retention credit on his or her wages, provided that the S corporation otherwise meets one of the following requirements:

  • A government order fully or partially suspended your operations during a calendar quarter due to COVID-19.
  • Your calendar-quarter gross receipts are less than 50 percent of gross receipts from the same quarter in the prior year.

PPP Exception. If you receive a PPP loan, then you don’t qualify for the employee retention credit.

Example 2. ABC Corporation is an S corporation with four equal owners who each own 25 percent. It has eight employees: the four owners and four children of the owners. A government order partially suspended the business operations. Because no shareholder has 50 percent or more ownership, the wages of all eight employees qualify for the employee retention credit.

Example 3. DEF Corporation is an S corporation that is 100 percent owned by a married couple. It has four employees: the two owners and two children of the owners. A government order partially suspended the business operations. Only the wages of the two owners qualify for the employee retention credit.

Tax-Free Disaster Payments

As we discussed in Tax Loophole Allows Tax-Free COVID-19 Payments to Employees, Congress allows your S corporation to make tax-deductible disaster-related payments to its employees, and those payments are tax-free to its employees.

But as you likely know, S corporation owners usually can’t take advantage of tax-free fringe benefits, and usually have to include their value as taxable income on their W-2. Be sure to read S Corporation Fringe Benefits after the Recent Tax Return to learn all the details.

We have good news about disaster-related payments: none of the guidance issued about these payments denies their favorable tax treatment to the S corporation shareholder. In addition, the IRS doesn’t mention such payments in Publication 15-B, Employer’s Tax Guide to Fringe Benefits.

But we have some bad news, too—there is no guidance explicitly allowing the S corporation owner to take advantage of the tax-free disaster-related payments.

If you choose to have your S corporation provide tax-free disaster-related payments to you, we recommend you implement a formal, written plan and keep excellent documentation—even though such steps are not required by the law.

Example 4. Your S corporation sets up a plan to give every employee a $500 payment to cover telework supplies and ongoing expenses during the COVID-19 pandemic. Your business is subject to a shutdown order, and all 12 of your employees, including you, must work remotely from home.

The $6,000 in payments your S corporation provides is tax-deductible to the corporation and tax-free to the employees, including the S corporation shareholder.

Takeaways

Many small-business owners, like you, operate out of an S corporation. And as you know, the tax law sometimes isn’t kind to S corporation owners, because the law limits or eliminates tax breaks other business owners can take.

Luckily for you, S corporation owners get to benefit from most of the big COVID-19 tax benefits, including:

  • Payroll tax deferral
  • Employee retention credit
  • Tax-free disaster-related payments

If you need help with any of the COVID-19 tax laws, please call me on my direct line at 408-778-9651.

Sincerely,

The Financial Dream Team, USA

 

Tax

Making Smart Selections from the COVID-19 Tax Relief Buffet

Making Smart Selections from the COVID-19 Tax Relief Buffet

The Paycheck Protection Program (PPP) Increase Act of 2020 adds billions to the $2.2 trillion Coronavirus Aid, Relief, and Economic Security Act (CARES Act).

The CARES Act delivered good news to individuals and businesses, including meaningful tax relief. The recent addition of new funds brings more good news.

The tax relief offered by the CARES Act is over and above the tax relief offered by the earlier Families First Coronavirus Response Act (FFCRA).

The FFCRA requires small employers—those with fewer than 500 employees—to provide limited paid leave to employees who are affected by the coronavirus pandemic.

But those businesses can claim tax credits to cover the cost of mandatory leave payments. They also get federal payroll tax relief.

Finally, the IRS has graciously postponed some federal tax filing and payment deadlines. For the latest postponement, see COVID-19: IRS Dramatically Expands Tax Filing and Payment Relief.

The Issue

All this COVID-19-related federal tax relief is helpful, but taking advantage of certain tax relief measures can conflict with eligibility for certain other federal relief measures that might be more valuable.

So, in many cases, you have choices and must be selective about which items you choose from the COVID-19 tax relief buffet. On the other hand, you can take advantage of some tax relief measures with no downside.

This article summarizes what we think are the most important COVID-19-related tax relief measures. We hope this will help you make smart selections from the COVID-19 tax relief buffet.

Here goes, based on what we know as this was written.

CARES Act Economic Impact Payments for Individuals (No Impact on Eligibility for Other Federal Relief Measures)

Economic impact payments are the highly publicized free-money checks from the federal government. They can be up to $1,200 per individual or $2,400 for a married couple. Folks with under-age-17 dependent children can receive up to another $500 per child.

But this free money is not available to everyone. For example, you likely won’t qualify for an economic impact payment if any of the following apply:

  • Your adjusted gross income was greater than $99,000 if your filing status was single or married filing separately; $136,500 for head of household; and $198,000 for married filing jointly.
  • You can be claimed as a dependent on someone else’s return. For example, this would include a child or student who can be claimed on a parent’s return.
  • You do not have a valid Social Security number.
  • You are a nonresident alien.
  • You filed Form 1040-NR, Form 1040NR-EZ, Form 1040-PR, or Form 1040-SS for 2019.

For more on the economic impact payments, see COVID-19: Important Tax Breaks from the CARES Act.

Small Employer Tax Credits and Payroll Tax Relief to Cover Required COVID-19-Related Paid Leave for Employees (No Double Tax Benefit Allowed)

The FFCRA preceded the CARES Act. The FFCRA grants tax credits and payroll tax relief to small employers—those with under 500 employees—to cover payments that these employers must now make for COVID-19-related emergency sick leave and emergency family leave pursuant to the FFCRA.

Credit for Required Leave Payments

Small employers can collect a federal tax credit equal to 100 percent of required emergency sick leave and emergency family leave payments made pursuant to the FFCRA. But the credit covers only leave payments made during the period beginning on April 2, 2020, and ending on December 31, 2020.

The credit is increased to cover the portion of the employer’s qualified health plan expenses that is properly allocable to the emergency sick leave and emergency family leave wages paid pursuant to the FFCRA.

The credit is first used to offset the Social Security tax component of the employer’s quarterly federal payroll tax bill for all wages paid to all employees.

Any remaining credit is offset against the employer’s otherwise required federal payroll tax deposits for FICA (Social Security and Medicare) taxes withheld from employee wages, federal income tax withheld from employee wages, and the employer’s share of FICA tax on employee wages.

Any remaining excess is refundable, meaning the government will issue payment to the employer for the excess.

Key point. Employers can request advance payments of the credit by filing new IRS Form 7200 (Advance

The 50 percent employee retention credit allowed by the CARES Act (which we explain later) cannot be claimed for the same wages taken into account for claiming the FFCRA credit for 100 percent of required

Strategy. Small employers should first claim the FFCRA credit for 100 percent of required leave payments and then claim the CARES Act 50 percent employee retention credit for other eligible wages.

The FFCRA credit for required employee leave payments is not available to employers that are already receiving the pre-existing federal credit for paid family and medical leave under Internal Revenue Code Section 45S.

Payroll Tax Relief

Emergency sick leave and family leave payments mandated by the FFCRA are exempt from the 6.2 percent Social Security tax component of the employer’s federal payroll tax that normally applies to wages.

Employers must pay the 1.45 percent Medicare tax component of the federal payroll tax, but they can claim a credit for that outlay.

Leave Credits for Self-Employed Individuals

If you are a self-employed individual who is affected by the coronavirus emergency, the FFCRA allows you to claim a refundable credit against your federal self-employment tax bill.

If the credit exceeds your self-employment tax bill, the government will issue you a payment for the excess.

The credit is equal to:

  • 100% of the sick-leave equivalent amount, plus
  • 67% of the sick-leave equivalent amount for taking care of a sick family member or taking care of your child following the closing of the child’s school or childcare location.

The sick-leave equivalent amount equals the lesser of

  • your average daily self-employment income, or
  • $511 per day for up to 10 days (up to $5,110 in total) to care for yourself due to the coronavirus, or
  • $200 per day for up to 10 days (up to $2,000 in total) to care for a sick family member or to care for your child following the closing of the child’s school or childcare location due to the coronavirus emergency.

Average daily self-employment income means your net self-employment earnings for the year divided by 260.

In addition, you can claim a coronavirus emergency family leave credit for up to 50 days. The credit amount equals the number of qualified family leave days multiplied by the lesser of

  • $200, or
  • your average daily self-employment income. The maximum total family leave credit is $10,000 (50 days x $200 per day).

These credits are allowed only for days during the period beginning on April 1, 2020, and ending on

Key point. As we wrote this, there was no way for self-employed folks to request advance payment of these credits. Will the IRS do something to allow advance payments? Maybe later. Stay tuned.

Key point. To prove your entitlement to the sick leave tax breaks, you must maintain documentation of how you were affected.

CARES Act Employee Retention Credit (Can Conflict with Eligibility for Other Federal Relief, and No Double Tax Benefit Allowed)

The CARES Act allows a refundable federal payroll tax credit that has been dubbed the employee retention credit.

The credit amount equals 50 percent of eligible employee wages paid by an eligible employer in a 2020 calendar quarter. The credit is subject to an overall wage cap of $10,000 per eligible employee.

Eligible Employers

 

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