THE WHALEN GROUP

Tax-Saving Tips

August 2019

How Much is One Trillion:

 There are 60 seconds in a minute, that’s 3600 seconds per hour and 24 hours in a day, that’s 86,400 seconds in a day, 365 days in a year, that’s 31,536,000 seconds in a year.  Since the birth of Christ or since we have kept the calendar we are not 2/3’s the way to a trillion in seconds.  That’s right it takes 3,170 and ½ years of seconds to get to a Trillion. Why is that important?  Many candidates and legislators either do not understand the size of the number or what the economy would have to do to produce enough income to support some of their suggestions.

FACTS:

 A GOVERNMENT DEFICIT– The Social Security Trust Fund paid out $853.5 billion in 2018, more than the $831.0 billion the fund produced in total income. The 2018 deficit breaks a streak of 34 consecutive years (1984-2017) of “income exceeding cost.”  As recently as 2009, the annual surplus was $134 billion (source: OASI Trust Fund).

1. Social Security Issue. The estimated Social Security shortfall today (i.e., a present value number) between the future taxes anticipated being collected and the future benefits expected to be paid out over the next 75 years is 13.9 trillion.  The entire $13.9 trillion deficit could be eliminated by an immediate 2.7 percentage point increase in combined Social Security payroll tax rate (from 12.4% to 15.1%) or an immediate 17% reduction in benefits that are paid out to current and future beneficiaries (source: Social Security Trustees).
2. Medicare Issue. Per a 4/22/19 report, the trust fund supporting Medicare Part A (hospital insurance) is projected to be depleted by 2026.  The long-term (75 year) present value shortfall in the trust fund could be corrected by an immediate 0.91 percentage point increase in combined Medicare payroll taxes (from its current 2.9% to 3.81%) or an immediate 19% reduction in Medicare expenditures (source: Medicare Trustees 2019 Report).

 

Roth IRA versus Traditional IRA: Which Is Better for You?

Roth IRAs tend to get a lot of hype, and for good reason: because you pay the taxes up front, your eventual withdrawals (assuming you meet the age and holding-period requirements—more on these below) are completely tax-free.

While we like “tax-free” as much as the next person, there are times when a traditional IRA will put more money in your pocket than a Roth would.

Making the Decision on What’s Best

Example. Say that your tax rate is 32 percent and that you will invest $5,000 a year in an IRA and earn 6 percent interest. Should you put the $5,000 a year into a Roth or a traditional IRA?

Say further that neither you nor your spouse is covered by a workplace retirement plan, so you can contribute the $5,000 a year without worry because it’s under the contribution limits. If your income is too high for the Roth IRA, you make the $5,000 contribution via the backdoor.

Traditional IRA

If you invest the $5,000 in a traditional IRA, you create a side fund of $1,600 ($5,000 x 32 percent). On the side fund, you pay taxes each year at 32 percent, making your side fund grow at 4.08 percent (68 percent of 6 percent).

Roth IRA

Roth contributions are not deductible; this means no side fund, so your annual investment remains at $5,000.

Cashing Out

For the Roth, your marginal tax rate at the time of your payout doesn’t matter because you paid your taxes before the money went into the account. The whole amount is now yours, with no additional taxes due.

But for the traditional IRA, your current tax bracket matters a great deal. You have taken care of the taxes on the side fund annually along the way, but the traditional IRA (both growth and contributions) is taxed at your current marginal tax rate at the time you cash out.

The table below shows you how this looks with tax rates of 22 percent, 32 percent, and 37 percent at the time you cash out (winners are in bold):

 

Marginal tax rate at cash-out	10 years @ 6%	20 years @ 6%	30 years @ 6%	40 years @ 6%
22%	Trad: $74,557 Roth: $69,858	Trad: $202,074 Roth: $194,964	Trad: $421,482 Roth: $419,008	Trad: $801,048 Roth: $820,238
32%	Trad: $67,571 Roth: $69,858	Trad: $182,578 Roth: $194,964	Trad: $379,581 Roth: $419,008	Trad: $719,024 Roth: $820,238
37%	Trad: $64,079 Roth: $69,858	Trad: $172,830 Roth: $194,964	Trad: $358,630 Roth: $419,008	Trad: $678,012 Roth: $820,238

 

You can see that the traditional IRA needs a low tax rate at the time of cash-out to win. But even in the 22 percent cash-out tax rate, the Roth wins at the 40-year mark.

Rate of Growth

What about your rate of growth? Do variances here change things any? Let’s take a look.

Here, we’ll look at different rates of growth for a fixed period (30 years) before you withdraw your money. Once again, we’ll consider three different marginal tax rates at the time you cash out—22 percent, 32 percent, and 37 percent.

 

Marginal tax rate at cash-out	3% for 30 years	6% for 30 years	9% for 30 years	12% for 30 years
22%	Trad: $257,760 Roth: $245,013	Trad: $421,482 Roth: $419,008	Trad: $716,547 Roth: $742,876	Trad: $1,256,032 Roth: $1,351,463
32%	Trad: $233,259 Roth: $245,013	Trad: $379,581 Roth: $419,008	Trad: $642,260 Roth: $742,876	Trad: $1,120,886 Roth: $1,351,463
37%	Trad: $221,008 Roth: $245,013	Trad: $358,630 Roth: $419,008	Trad: $605,116 Roth: $742,876	Trad: $1,053,312 Roth: $1,351,463

In the scenarios above, the traditional IRA/side fund combo wins only when your marginal tax rate is lower at the time of withdrawal and only at the lower growth rates.

At higher rates of return—9 percent and 12 percent, in our examples above—the Roth still wins, even if you’re in a higher tax bracket when you withdraw your money.

Tax Factor

What’s going on here? For starters, the side fund is not tax-favored in any way. Plus, taxes hobble your cash-out on the traditional IRA:

• You pay taxes as you earn the money in the side fund.
• You pay taxes on the accumulated growth inside the traditional IRA when you withdraw the money.

Creating More Business Meal Tax Deductions After the TCJA

Here’s good news for business meals: the Tax Cuts and Jobs Act (TCJA) removed the “directly related and associated with” requirements from business meals.

The net effect of this change is to subject business meals once again to the pre-1963 “ordinary and necessary” business expense rules.

You are going to like these rules.

Restaurants and Bars

Question 1. If, for business reasons, you take a customer to breakfast, lunch, or dinner at a restaurant or hotel, or to a bar for a few drinks, but you do not discuss business, can you deduct the costs of the meals and drinks?

Answer 1. Yes. Even though you did not discuss business, the law provides that if the circumstances are of a type generally considered conducive to a business discussion, you may deduct the expenses for meals and beverages to the extent they are ordinary and necessary expenses. Consider this “no discussion” meal a “quiet business meal.”

Question 2. What are circumstances conducive to a business discussion?

Answer 2. This depends on the facts, taking into account the surroundings in which the meals or beverages are furnished, your business, and your relationship to the person entertained. The surroundings should be such that there are no substantial distractions to the discussion.

Generally, a restaurant, a hotel dining room, or a similar place that does not involve distracting influences, such as a floor show, is considered conducive to a business discussion. On the other hand, business meals at nightclubs, sporting events, large cocktail parties, and sizable social gatherings would not generally be conducive to a business discussion.

Meals Served in Your Home

Question 3. Does a business meal served in your home disqualify the deduction?

Answer 3. No, as long as you serve the food and beverages under circumstances conducive to a business discussion. But because you are in your home, the IRS adds that you must clearly show that the expenditure was commercially rather than socially motivated.

Goodwill Meals

Question 4. If, for goodwill purposes, you take a customer and his or her spouse to lunch and don’t discuss business, will the cost of the lunch become non-deductible?

Answer 4. Not if, in light of all facts and circumstances, the surroundings are considered conducive to a business discussion, and the expenses are ordinary and necessary expenses of carrying on the business rather than socially motivated expenses.

Question 5. Is the situation the same if the taxpayer’s spouse accompanies the taxpayer at a dinner for business goodwill reasons?

Answer 5. Yes, the meal is deductible. This is true whether or not the customer’s spouse is present. Again, the meal must meet the ordinary and necessary business expense standards.

Document the Meal Deductions

You need to keep records that prove your business meals are ordinary and necessary business expenses. You can accomplish this by keeping the following:

1. Receipts that show the purchases (food and drinks consumed)
2. Proof of payment (credit card receipt/statement or canceled check)
3. Note of the name of the person or persons with whom you had the meals
4. Record of the business reason for the meal (a short note—say, seven words or fewer)

The costs of your business meals continue to be 50 percent deductible (as they were before the TCJA).

Beware: IRS Error in Rental Property Deduction Publication

Here’s a heads-up on mortgage insurance.

Personal Residence Mortgage Insurance

The deduction for mortgage insurance on a qualified residence ended on December 31, 2017. But don’t give up on the deduction.

The personal residence mortgage insurance deduction is part of what is called “tax extenders,” and it’s highly possible that lawmakers will reinstate the deduction retroactively for all of 2018 and 2019. That’s the good news. The bad news is that to claim the retroactive deduction we will need to amend your 2018 tax return.

Rental Property Mortgage Insurance—IRS Mistake

Online at the IRS frequently asked rental property questions, you will find the following question and incorrect answer:

Question: Can you deduct private mortgage insurance (PMI) premiums on rental property? If so, which line item on Schedule E?

Answer: No, you can’t claim a deduction for private mortgage insurance premiums.

This is wrong.

The cause for the error comes from IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes), where on page 1 in the “What’s New” section, the IRS states that the deduction for mortgage insurance premiums expired and you can’t claim that deduction for premiums after 2017 unless lawmakers extend the break.

The mistake that the IRS makes in its publication and FAQ is that the expiration of the mortgage insurance deduction applies to your qualified personal residence, not your rental property.

Rules for Rental Property Mortgage Insurance

You generally treat mortgage insurance on rental property loans and mortgages as an ordinary and necessary business rental expense that you deduct on Schedule E against the income from that rental property. Depending on the type of loan, you could pay the mortgage insurance either in a lump sum or annually as you make your mortgage payments.

How you treat the mortgage insurance premiums depends on how the proceeds of the loan are used, rather than on the character of the property that you mortgage. For example, you could take a mortgage on your personal residence and use the proceeds from the loan for a rental property, an investment, or personal purposes.

Planning note. You deduct the mortgage insurance on the rental properties over the period of benefit. For example, if you make a one-time payment, you amortize the mortgage insurance over the life of the loan.

If you make annual payments because of, say, a mortgagor requirement of a loan-to-equity ratio or other formula, you deduct the mortgage insurance premiums as you pay them.

Record Keeping Requirements and Retention:

Note: Keep copies of your filed tax returns. They help in preparing future tax returns and making computations if you file an amended return.

Period of Limitations that apply to income tax returns

1. Keep records for 3 years if situations (4), (5), and (6) below do not apply to you.
2. Keep records for 3 years from the date you filed your original return or 2 years from the date you paid the tax, whichever is later, if you file a claim for credit or refund after you file your return.
3. Keep records for 7 years if you file a claim for a loss from worthless securities or bad debt deduction.
4. Keep records for 6 years if you do not report income that you should report, and it is more than 25% of the gross income shown on your return.
5. Keep records indefinitely if you do not file a return.
6. Keep records indefinitely if you file a fraudulent return.
7. Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later. I am currently advising my clients to use their employment tax records to verify with Social Security.

The following questions should be applied to each record as you decide whether to keep a document or throw it away.

Are the records connected to property?

Generally, keep records relating to property until the period of limitations expires for the year in which you dispose of the property. You must keep these records to figure any depreciation, amortization, or depletion deduction and to figure the gain or loss when you sell or otherwise dispose of the property.

If you received property in a nontaxable exchange, your basis in that property is the same as the basis of the property you gave up, increased by any money you paid. You must keep the records on the old property, as well as on the new property, until the period of limitations expires for the year in which you dispose of the new property.

What should I do with my records for nontax purposes?

When your records are no longer needed for tax purposes, do not discard them until you check to see if you have to keep them longer for other purposes. For example, your insurance company or creditors may require you to keep them longer than the IRS does.

As a tax professional, I am required to keep a copy of your return or a listing of returns I prepare for only three years.  This I will do, along with the source documents applicable to your filing. I currently keep copies longer than the required three years.

If records are lost or otherwise destroyed, the Internal Revenue Service, for a fee, will provide a copy of the return, but they have no source documents.

This letter also serves as a reminder to keep your records in a safe and secure environment.

Respectfully,

Al Whalen, EA, ATA, CFP®

Email: al@whalengroup.com

Web Site: www.whalengroup.com