Chapter 1
Some Tax Basics

Once you retire, your financial picture changes. The most obvious change, of course, is that you no longer receive a paycheck; instead, you must live off other sources of income, such as retirement accounts or other investments, Social Security, pensions, or rental income. Your expenses probably will also change, especially if you are facing health problems or making life­style adjustments, such as selling your home or starting a business.

When your income and expenses change, so do your taxes. This book explains the tax benefits that apply to common retirement scenarios, from paying for a grandchild’s education to purchasing long-term care insurance, buying a second home, or turning a favorite hobby into a profitable side business. Before you can take advantage of these benefits, however, you’ll need a basic under­standing of how taxes work.

At the simplest level, of course, you must pay tax on your income. But what counts as income for tax purposes? How do deductions, exemptions, and credits work? And are you going to have to worry about the alternative minimum tax? This chapter will help you answer those questions, so you can better understand the tax benefits associated with retirement issues and activities. Those tax benefits are described in detail in the rest of the book.

Income

It’s pretty common for recent retirees to be nervous about outliving their nest eggs. If you are like many retirees, you will receive Social Security benefits for life, but those benefits are unlikely to sustain you in the style to which you have become accustomed. Hopefully, you also have some investments that generate additional income in the form of interest, dividends, or maybe rental income, and that you can sell if and when you need extra cash.

If you have such investments, one of your tasks during retirement will be to manage that portfolio so it isn’t gone before you are. Fortunately, you have a lot of control. You can decide when to take money out of your accounts and when to sell assets, factoring in how your timing will affect your tax liability. For example, you might find that it makes more sense to wait until January to sell some stock (rather than selling in December) because you expect your income to be lower next year.

This section briefly covers some of the most common sources of retirement income.

Social Security

Most people who work in the corporate world contribute to Social Security through payroll taxes. If you are one of them and have paid into the system for the required time period, you may begin collecting Social Security benefits when you retire, as long as you are at least age 62. The amount you receive depends on a variety of factors, including how long you’ve been contributing to Social Security, how much money you earned over the years, and how old you are when you start receiving benefits.

If you did not contribute to Social Security during your lifetime, but your spouse did, you might be able to collect benefits based on your spouse’s work record, even if you and your spouse are divorced. If your spouse has died, you may be entitled to survivor’s benefits based on your spouse’s Social Security contributions.

Social Security benefits are not subject to income tax if your total income is below $32,000 if you are married filing jointly, or $25,000 if you are single. (To determine whether or not your income is under the threshold, you must total all of your other taxable income and add to it certain tax-exempt income plus half of your Social Security benefits.)

Once your income exceeds the threshold amounts, the portion of your Social Security benefits that is subject to income tax increases as your income increases. However, you can never be taxed on more than 85% of your benefits. For more information about calculating the amount of Social Security that is subject to tax, see IRS Publication 915, Social Security and Equivalent Railroad Retirement Benefits.

Social Security benefits are paid to you for life, so you don’t have to worry about outliving these funds. However, regardless of how much Social Security you receive, it probably won’t cover all of your expenses during retirement.

Retirement Plans and Pensions

Another benefit of having worked in the corporate world might be a retirement nest egg that you accumulated through contributions you and your employer made to a retirement plan, such as a 401(k). Perhaps you are one of the lucky retirees who will receive a monthly pension from a former employer.

If you were self-employed, you might have established and contributed to your own retirement plan—a SEP, perhaps, or a 401(k) of your own. And, whether working for another employer or for yourself, you might also have contributed to a traditional IRA or a Roth IRA.

Now, during your retirement, you will likely be using these plan assets for living expenses. Most of the funds you receive, whether in the form of pension payments or withdrawals you make from your retirement plan or traditional IRA, will be fully taxable in the year you receive them. (Note, however, that Roth IRA distributions generally will not be taxable. And, if you made nondeductible contributions to any of the plans, those contributions generally will not be taxed a second time when you withdraw them.)

Want more information on withdrawing money from retirement accounts? Take a look at IRAs, 401(k)s & Other Retirement Plans: Taking Your Money Out, by Twila Slesnick and John C. Suttle (Nolo), which explains the rules governing retirement plan distributions. You’ll learn how to avoid penalties and minimize your tax liability while making the most of your retirement investments.

Investments

If you inherited the thrifty gene from an ancestor, you might also have accumulated a portfolio of investments separate from your various retirement accounts—at a bank or brokerage firm, for example. Those assets might include cash and stocks and bonds that throw off interest and dividends on which you pay tax each year.

During retirement, there will probably be times when you need more money than your interest and dividends provide. In that case, you might have to sell some of your securities or other investment assets. If the asset has appreciated since you bought it, you might have a capital gain on which you must pay tax. If the asset has not appreciated, you might have a capital loss to claim against other income, thereby lowering your tax liability. See “Selling Assets,” below, for more information on calculating capital gains and losses.

Rental Income

Some people enter the retirement phase of their lives with a rental property or two. Often, the property was acquired specifically for the purpose of providing extra income during retirement, or perhaps with an eye to selling the property when cash is tight.

Owning rental property comes with a lot of tax benefits. Although you generally have to declare the rent you receive as income, you may deduct the expenses you pay as a landlord (such as the cost of maintenance, utilities, and insurance). You may also claim depreciation: an additional deduction that might run to thousands of dollars a year. (You’ll find more information on the tax benefits associated with rental property in Chapter 8.)

If you sell rental property during your lifetime, you might face a big gain if you’ve held the property for a long time. See “Selling Assets,” below, for more information on calculating capital gains and losses.

Business Income

Many retirees take on small or part-time jobs during retirement. Some even start their own businesses, whether to pursue a passion, keep busy, or put a little extra money in their pockets. The compensation you earn will be subject to income tax, just as it was during your preretirement years. (If you start your own business, you can offset your income with the expenses you incur.)

As long as you earn income from a job or business, you will also pay Social Security and Medicare taxes either through your employer’s payroll taxes or through self-employment taxes you must pay when you have net income from your own business. See Chapter 3 for more information on the tax issues associated with running a business.

Bear in mind that earning income from a job or business might affect your Social Security benefits, both in terms of how much you receive and how much will be subject to income tax. For more information about Social Security benefits, go to the Social Security Administration’s website, www.ssa.gov.

Selling Assets

At some point during your retirement, you may decide to sell an asset, whether it’s rental property; artwork, antiques, or other valuable personal property; stocks and bonds; or even your home. Perhaps you need more money than your retirement investments are generating. Or, it might just be time to make a change. You might be tired of being a landlord, for example, or feel ready to move to a smaller home.

Whenever you sell an asset, you must calculate your gain or loss. If you have a gain, you might owe tax on it; if you have a loss, you might be able to use it to offset other income.

For tax purposes, your gain or loss is the difference between the sales proceeds and your adjusted basis in the asset. Beware, however: Sales proceeds are not necessarily the price the buyer paid you for the asset, nor is the adjusted basis necessarily what you paid initially to purchase it.

Sales Proceeds

When you sell an asset, the buyer pays you a certain amount to purchase it. In some cases, however, you won’t get to pocket every dollar of the purchase price; some of it will go toward the expenses of the sale (such as a transaction fee, broker’s fee, or commission). To come up with the sales proceeds—the figure you have to use to calculate your capital gain or loss—you subtract your expenses from the sales price.

Adjusted Basis

If you talk taxes with an accountant, you might notice that the word “cost” isn’t used very often. Instead, accountants talk about the “basis” or “adjusted basis” of an asset, which is a more nuanced concept. (Accountants often use the terms basis and adjusted basis interchangeably, and we follow that practice in this book.)

Whenever you sell an asset, whether stocks, bonds, a rental property, or even your own home, you need to determine your adjusted basis to calculate your gain or loss. Adjusted basis is essentially what you originally paid for the asset, minus any cost recovery you were entitled to claim (such as depreciation), plus any additional capital expenditures you made. For example, if you own rental property, your adjusted basis is your original purchase price, plus the cost of improvements you have made, less the depreciation you were entitled to claim on your tax return. In the case of securities that you purchase and sell through a broker, your adjusted basis is typically your original cost plus any commissions you pay.

If you inherit property, your adjusted basis when you inherit it is usually the property’s fair market value on the owner’s date of death (the date you inherit it). Of course, your adjusted basis will change if you later make improvements to the property or recover any of your cost through depreciation.

Tax Strategy: Should You Sell Appreciated Property?

If you own property that has appreciated significantly over the years, it might make sense not to sell the property at all, as long as you have other resources to fall back on. If you hold the property until your death, your beneficiaries will get the benefit of a stepped-up basis. Their basis will be the fair market value of the property at the time of your death. Tax liability for the gain (the property’s appreciation during your lifetime) evaporates.

This rule applies to many capital assets, such as rental property and stocks and bonds that are held outside of retirement accounts. (There is no step-up for assets that are held inside a retirement account, such as an IRA or 401(k) plan.) It can be especially beneficial for rental property. You must subtract your depreciation deductions—often thousands of dollars a year—to calculate your basis. This means that your basis in rental property that you’ve held a long time is often quite low (and your gain high). If you allow your heirs to inherit that property rather than selling it during your lifetime, their basis will be stepped up to its fair market value at your death, and all of the depreciation benefits you enjoyed won’t have to be repaid. See Chapter 11 for more information about inherited assets generally; rental property is covered in Chapter 8.

If you receive property as a gift, your adjusted basis when you receive it depends on whether the property appreciated while the donor owned it. If so, your adjusted basis when you receive it is the same as the donor’s adjusted basis when he or she gave it to you.

If the property’s fair market value when you receive it is less than the donor’s adjusted basis, then your basis is calculated in one of two ways. For purposes of determining whether you have a loss when you later sell the property, your basis is the property’s fair market value on the date of the gift. To determine whether you have a gain, your basis is the donor’s adjusted basis on the date of the gift. If you sell the property at a price that falls somewhere in between its fair market value and the donor’s adjusted basis at the time of the gift, you have no gain and no loss.

Example: Your uncle gave you 100 shares of XYZ stock, which he originally bought for $5,000. On the date he gave you the stock, it was worth $4,000. You later sell the stock for $6,000. Because you have a gain from the sale, you use your uncle’s basis of $5,000 to calculate your gain. Your gain is $1,000.

If you sell the stock for $3,000, you have a loss on the sale. In this situation, you use the stock’s fair market value on the date of the gift ($4,000) to calculate your loss. Your loss is $1,000.

If you sell the stock for an amount that is between your uncle’s basis ($5,000) and the fair market value at the date of the gift ($4,000), you are deemed to have no gain and no loss.

Deductions

Once you’ve tallied up your income, you get to subtract your deductions. Generally, deductions represent money you’ve spent for certain items that Congress has decided you shouldn’t have to pay tax on. Examples of deductible expenses are interest you pay on a mortgage, medical bills, operating costs for an ongoing business, and gifts you make to charity.

Not all deductions are created equal, however. Some deductions offset income dollar for dollar, so every deductible dollar you spend is a dollar on which you don’t have to pay tax. Other expenses are not deductible until they exceed a certain dollar amount or a percentage of your gross income. And some deductions must be used to offset specific types of income (for example, business expenses are claimed against business income, and rental expenses against rental income).

There are several different types of deductions: itemized deductions, the standard deduction, and “above-the-line” deductions. Let’s sort these out.

Itemized Deductions

When calculating your taxable income, you are permitted to claim certain personal (nonbusiness) deductions. You subtract these deductions from your income to determine how much of your income is subject to tax. Like exemptions (described below), deductions help to ensure that your tax liability is commensurate with your income. If your income is relatively low, you should pay little or no income tax, with the help of deductions and exemptions.

To take advantage of many of these personal deductions, you must separately list, or “itemize,” deductions on Schedule A, an IRS form that you must submit with your income tax return.

With only a few exceptions, the law allows you to claim the same deductions after retirement that you were permitted to claim before retirement. However, once you retire, you are likely to spend your money differently—perhaps more on health care and less on business expenses, more on travel and less on a mortgage.

After you retire, you might even discover that you have very few qualified expenses to claim on Schedule A. Perhaps it hardly seems worth the trouble to wade through the receipts you have accumulated during the year. If you do not want to spend your time tallying receipts, or if the totals seem too paltry to bother with, you might choose to claim the standard deduction instead of itemizing your deductions. (See “Standard Deduction,” below.)

Common Itemized Deductions

Looking at the list of possible deductions on Schedule A will help you decide if itemizing is worth your while. Commonly claimed itemized deductions include:

mortgage interest

property tax

state income tax

charitable contributions

medical expenses (but only to the extent they exceed 7.5% of your adjusted gross income)

investment fees, and

tax preparation fees.

Itemized deductions are limited in 2008 and 2009 for high-income taxpayers. If your income is high, you might not be able to claim all of your itemized deductions. For 2008, most of your itemized deductions (but not your medical expense deduction or investment interest expense) will be reduced by 1% of the amount by which your adjusted gross income exceeds $159,950 (this amount may increase for 2009). Even if your itemized deductions exceed the standard deduction, this rule could bring your itemized deductions below the standard deduction, which isn’t subject to this reduction. Beginning in 2010, there will no longer be a reduction in itemized deductions for high-income taxpayers.

Standard Deduction

You don’t have to itemize your deductions and file Schedule A with your income tax return. If you prefer, or if it saves taxes, you may simply claim the standard deduction, a fixed dollar amount that increases each year for inflation.

Although it is to your advantage to complete and file Schedule A when your itemized deductions exceed the standard deduction, you would not be alone if you decided it was just too much trouble. Maybe you have more important things to do, like playing golf or going skiing.

Don’t be too quick to forgo itemizing your deductions. If you have a mortgage or you paid a significant amount of state income taxes, itemizing will almost certainly be more beneficial. And, because the standard deduction amount is adjusted each year for inflation, you will need to calculate your itemized deductions every year anyway, to see which provides a greater benefit.

The actual dollar amount of the standard deduction depends on your filing status. If you are married filing a joint return, your standard deduction is larger than it is for single filers. Also, if you are at least 65 years old or you are blind, you are eligible for a higher standard deduction.

For 2008, the standard deduction amounts are as follows:

You are entitled to claim your full standard deduction no matter how high your income is. Unlike other tax benefits, the standard deduction is not phased out as your income increases. (See Chapter 4 for more detailed information about claiming the standard deduction.)

Above-the-Line Deductions

When claiming itemized deductions or the standard deduction, you first calculate your adjusted gross income (AGI). Then, you subtract your deductions (and exemptions—see below) from your AGI to come up with your taxable income.

Above-the-line deductions are different: They are subtracted from your income to arrive at your AGI. The “line” is essentially your AGI. This distinction might seem insignificant, but in fact, above-the-line deductions can be much more valuable. Like other deductions, they directly reduce the amount of your income that is subject to income tax. But above-the-line deductions also reduce your AGI. A lower AGI is often to your advantage because AGI is used as a measuring stick for phasing out or even eliminating certain tax benefits:

The amount of your Social Security benefits that are subject to tax depends on your AGI. If your AGI falls below a certain level, none of your benefits are taxable. As your AGI increases, more and more of your benefits are subject to tax. (However, no more than 85% of your Social Security benefits are ever subject to tax, regardless of how high your AGI is.)

Until 2010, your itemized deductions and exemptions are subject to a phase-out once your AGI exceeds a certain threshold amount.

Until 2010, you are not permitted to convert a traditional IRA to a Roth IRA if your AGI exceeds $100,000.

If you have rental property that is operating at a loss, the amount of the loss you may claim in the current year is reduced and eventually eliminated as your AGI increases. (You’ll find more information on rental property in Chapter 8.)

Many education benefits, such as the Hope and Lifetime Learning credit, are eliminated when your AGI exceeds a certain threshold. (See Chapter 6 for more on these education credits.)

Your eligibility to make a Roth IRA contribution or claim a saver’s credit for a retirement plan contribution depends on your AGI. (Chapter 3 covers IRAs and the saver’s credit.)

These are just a sampling of tax benefits that are tied to AGI. Because the potential savings can be significant, above-the-line deductions are the most valuable kind. Deductions you can take above the line include:

rental expenses

business expenses

student loan interest

alimony paid

deductible contributions to an IRA or other retirement plan

moving expenses related to a job

self-employed health insurance premiums

health savings account contributions, and

higher education expenses.

Deductions Tied to Particular Types of Income

Even during retirement, you might incur expenses related to a particular money-making activity, such as running a business or renting out property. Many of those expenses are also deductible. In fact, they are considered above-the-line deductions because you claim them to arrive at your AGI. However, you report the income—and claim the deductions—on a separate form. You then transfer the total to Form 1040 and attach the separate form to the rest of your tax return.

For example, if you own rental real estate, you pay real estate taxes on the property. You probably also pay insurance premiums related to that property. You might have cleaning and maintenance expenses. You can claim all of those expenses to offset the rental income you receive. Both the income and the expenses are reported on a separate tax form, Schedule E, Supplemental Income and Loss. You don’t claim any of the expenses as an itemized deduction on Schedule A. (For more information about rental income and expenses, see Chapter 8.)

The same principle applies if you run a business as a sole proprietor. You report the income and the expenses related to the business on Schedule C, Profit or Loss From Business, rather than claiming the expenses as itemized deductions on Schedule A. (Business expenses are covered in Chapter 3.)

Exemptions

With a few exceptions (for example, those who are dependents of another taxpayer), every person may claim a personal exemption on his or her tax return. If you and your spouse file a joint return, you may each claim a personal exemption.

The personal exemption is a set dollar amount that you can subtract from your taxable income. The purpose of the personal exemption is similar to that of the standard deduction: to help ensure that your tax liability is commensurate with your income.

If you are supporting others, you might be able to claim a dependency exemption for one or more of them, in addition to your own personal exemption. This benefit provides some additional tax relief to those who are supporting families.

Like the standard deduction, personal exemptions are increased annually for inflation. However, there is an important difference between the standard deduction and personal exemptions: All personal exemptions you claim on your tax return, including dependency exemptions, are subject to a phase-out as your income increases. This phase-out rule will remain in place until 2010, when you will once again be able to claim the full amount of your exemptions. (For more information about personal exemptions, see Chapter 10.)

Credits

Although deductions reduce the amount of income that is subject to tax, credits reduce your actual tax liability dollar-for-dollar, which makes credits potentially much more valuable than deductions.

Example: You are single. During 2008, you paid $750 in foreign taxes as a result of some foreign investments you own. You will be itemizing your deductions and you qualify to claim the $750 as either an itemized deduction or a tax credit. Your taxable income before claiming either the credit or the deduction is $60,000.

If you claim a deduction, you calculate your tax liability as follows:

If you claim a tax credit instead of a deduction, you calculate your tax liability like this:

Claiming a credit rather than a deduction saves you more than $500. (See Chapter 7 for more information about the foreign tax credit.)

Some of the tax credits that might be available to you as a retiree include:

foreign tax credit

credit for the elderly and disabled

hybrid vehicle credit

dependent care credit

education credits

earned income credit, and

saver’s credit.

Alternative Minimum Tax (AMT)

Once you add up your income and subtract all of your deductions and exemptions, you calculate your tax, claim any credits you qualify for, and send your money to the IRS. All done for the year, right? Not quite. You might have to worry about the alternative minimum tax.

It comes as a surprise to many taxpayers that they must actually perform two tax calculations: one to compute their regular income tax, and the second to compute their alternative minimum tax (AMT). Then, they must pay whichever is higher. The AMT is a completely separate tax with its own definitions of taxable income and its own set of deductions, some of which overlap with the regular tax and some of which do not.

The original purpose of the AMT was to ensure that everyone pays his or her fair share of taxes. In 1969, Congress targeted a handful of wealthy individuals who, through the use of arcane tax shelters, managed to rake in substantial income and pay little or no tax on it. The AMT was originally enacted to make sure at least some of that income was subject to tax. Although all taxpayers were required to calculate their regular income tax and AMT, in the good old days, only the wealthy would have seen their liability go up. But Congress’s failure to update the AMT has caused vast numbers of middle income taxpayers to be caught in its web, as well.

When you calculate your AMT liability, you must include some income that is excluded for regular tax purposes. In addition, some items that are deductible for regular tax purposes are not deductible for AMT purposes. Also, the AMT calculation does not take into account personal or dependency exemptions, but instead has its own exemption amount (which is phased out as your income increases). You can’t take the standard deduction, nor can you take certain credits that would otherwise be available.

You are probably already familiar with most of the forms that you must complete when calculating your regular tax liability (Form 1040, Schedules A, B, and so on). When calculating your AMT liability, you must complete Form 6251, Alternative Minimum Tax—Individuals. If you work through the form and discover that you are not subject to AMT (in other words, your regular tax liability is higher than your AMT liability), you are not required to submit Form 6251 with your income tax. If you discover you are subject to AMT, you must include the form with your other tax forms and include an AMT version of some of the regular tax forms.

If you’re subject to the AMT, you won’t be able to take advantage of all the tax benefits covered here. This book is about regular tax deductions and credits. Consequently, some of the deductions and credits described in this book will not be available to you if you are subject to the AMT. Also some calculations will be different. For example, if you are subject to the AMT, you might need to use different figures to calculate your depreciation deduction than you would for regular tax purposes.

Most people can make a reasonably good guess about whether they will be subject to the AMT by looking at certain income items and expenses. Here are some of the circumstances you might encounter—even during retirement—that could require you to pay the AMT:

A high state income tax bill. If you paid an extraordinary amount of state income taxes during the year, it increases the chance that you will be subject to the AMT. State income taxes are not deductible for AMT purposes. Not only are the state income taxes you paid disallowed, but real estate taxes, personal property taxes, sales taxes, and other taxes typically deductible on Schedule A are also disallowed for AMT purposes. (Note, however, that you may still claim taxes as rental expenses on Schedule E or as business expenses on Schedule C: It is only the taxes you claim on Schedule A that are not deductible.) If, for example, you have an unusually high income year in 2010 and pay a big state income tax bill in April of 2011, the big payment will increase the likelihood that you will be subject to the AMT in 2011.

Significant interest paid on home equity debt. If you have a home equity loan (one secured by your first or second home that you didn’t use to purchase or improve the home), the interest on that debt is not deductible for AMT purposes.

Capital gains. If your income from the sale of stocks you have held long term (longer than one year) is large relative to your ordinary income, you might find yourself caught in the AMT.

Large amount of miscellaneous itemized deductions. Miscellaneous itemized deductions, such as investment expenses, tax planning, and other items you claim on Schedule A under “miscellaneous deductions,” are not deductible for AMT purposes. If those expenses happen to be especially high (perhaps you have a large investment portfolio and you pay your investment advisor big bucks to manage it), you might find yourself subject to the AMT.

High medical expenses. Although medical expenses are deductible for both AMT and regular tax purposes, the deduction is limited. For regular tax purposes, you may deduct your medical expenses only to the extent the expenses exceed 7.5% of your adjusted gross income (AGI). For AMT purposes, medical expenses are deductible only to the extent they exceed 10% of your AGI. If you have extraordinary medical expenses in a given year, those expenses might well determine whether you will be subject to the AMT.