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Monday, September 29, 2014

Hiring Children to Lower your Tax impact

If you are a small business owner, instead of looking out in the labor force for employees, maybe hiring your child is an option for you. Don't overlook these three benefits of hiring your minor child to perform necessary operations of the business.

Standard Deduction

One of the benefits of paying your child W-2 wages is that their wages are subject to a whole new standard deduction. For a dependent filer the (2013) standard deduction is the greater of $1,000 or earned income plus 350 (not greater than $6,100).

That means if you pay your child 6,100 in wages, then the entire amount that would have been included in your taxable income is now shifted to your child dependent resulting in 0 tax.

Lower Tax Bracket

Another benefit of shifting your income to your child dependent, is you are able to move your income from your higher tax bracket to your child's lower tax bracket. Lets say you are in the 25% tax bracket, and your child is in the 10% tax bracket, you benefit by this shift.

No FICA Taxes

Most of us know that we are all subject to paying social security/medicare taxes. There are a few exceptions to this rule. According to the IRC Section 3121(b)(3)(A) a minor employed by their parents are exempt from such tax. Therefore the wages that would have been subject to 15.3% in FICA taxes, is now 0%.


Lets say A & B are married and own a small business that produces $100,000 in income annually. In 2013, the couple employs their 15 year old daughter to help out in their business and pay her W-2 wages of $10,000.

Under this scenario, $6,100 of that amount is taxed at 0%, because of the standard deduction for the dependent child. The remaining amount of $3,900 is taxed at 10% (the daughter's tax bracket).The entire $10,000 is exempt from FICA tax. The total tax paid on the 10K of income is $390.

On A&B's return, they would report $90,000 of self employment income, which would result in $24,975 in tax.

Conversely if the family did not hire their child, the self employment income would be 100,000 and the tax on that income would be 28,711.

The tax savings here is $3,346 [28,711 - (24,975 + 390)]. Effectively, you have gained an employee, spared yourself the heartache of paying the IRS an extra 3K, and kept your 10K within the family. Lets hope you can convince your child to use that money to pay for college!

Documentation, Documentation, Documentation!
One thing I would like to emphasize here is that if you are going to take this approach, you should be able appropriately keep record of this strategy.

First, I recommend you appropriately substantiate the the work your child has done. Make them clock-in, signoff on work, or some sort of record that shows they really did work to earn the wage.

Second, find a way to justify their pay, you wouldn't pay someone $90K to do your small business secretarial work. Look out in the market place and see what other companies are paying to do the work you are hiring your child to do, and base their wage as if it were an arm's length arrangement.

Third, make sure you issue a W-2 to your child for the wages they earned during the year.

Essentially, you want to do everything you can to substantiate that your child did work and you paid them a fair wage for doing that work, and you should be okay should the IRS have any questions.

Sunday, September 21, 2014

Using Your 401k To Get an instant 65% Returns

First off I would like to admit that my post is a little misleading. I would like to clarify that this post is not about investing in penny stocks or other risky investments to make ridiculous returns in your 401k.

However, the money you set aside in your 401k can lower your tax liability and have the same effect as getting an instant return, sometimes returns as high as 65%.

In order to get this type of treatment you must be eligible for the Earned Income Credit, the retirement savings contribution credit, and have a 401k account you can contribute to (in some cases a traditional IRA account may suffice, but not always).

Here is a hypothetical scenario:

A couple Married Filing Jointly with one dependent makes $43,250. Lets say only one spouse goes to work, and is eligible to participate in a 401k plan with their employer.

with $0 contributions to their 401k plan, the tax due by April 15th would have been $2,456 (given the 2013 tax, exemption & standard deduction rates).

With the same situation $2,000 of contributions to their 401k plan, the tax due by April 15th would now be $847. Nothing has changed, except the family has deferred $2,000 of income to save $1,609 in tax ($2,456 tax in the prior example, less the $847). The only issue becomes, can the family afford to lock up the $391 in thier 401k account to take advantage of this gain.

Note that at first glance this example appears to have an 80% return. (1,609/2,000 = 80%). The reduction in tax attributable directly to the 401k account in my opinion is not a real "return" because this money will get taxed later when you withdraw the funds at retirement. The real return comes from the increase in credit you receive with your EIC credit (increased from $0 to $309) and the credits you receive from the Retirement Savings Contribution credit (increased from $0 to $1,000). The total of $1,309 you get by contributing $2,000 to your 401k is a 65% return.

This works because when you contribute money to your 401k account your W-2 Box 1 wages are reduced. This is the amount that gets reported on your tax return. Note had you contributed your money to a traditional IRA, you would not have the benefit of reducing box 1 wages, and instead get a "for AGI deduction"** which has the chance to screw up your EIC calculation (depending on your circumstances).

The reduction in wages lowers your income that is considered for the EIC and Retirement Savings credit, which is more beneficial for lower income earners.

If you can afford to take a hit on cash flow to increase your overall wealth, I think that it would be well worth the investment now before your income rises over the years and you can no longer take advantage of these credits.

**A "for AGI deduction" is a deduction that reduces your Adjusted Gross Income, (line 37 on form 1040) which is commonly used to determine which tax payers are allowed to use certain credits such as the EIC.

Thursday, January 17, 2013

Fiscal Cliff Results

My first blog post consisted of what might happen with the fiscal cliff. This is a follow up as to what happened with the issues brought up in that post.

It is very obvious that the tax changes were meant to place the burden on the wealthy, but the ironic part is all the talk about "simplifying the tax code" isn't happening. In fact this new set of laws just made taxes a tad more complicated. More particularly with the new capital gains rates for taxpayers whose incomes are >200K  (>250K Married Filing Jointly) which now involves an additional 3.8% medicare surtax on top of the new 20% capital gains.

For simplicity sake, I would just like to discuss changes I mentioned in the previous blog:

-Payroll Tax - the 4.2% tax holiday is over. If you haven't noticed already, its now 6.2% and your paychecks are 2% smaller than they used to be.
Negative Impact: All working taxpayers

-Tax Rates - The good news is, not much has changed for the average american. Tax rates were adjusted for inflation (as they always are) and as long as you aren't making more than 400K (450K Married Filing Jointly) your tax bracket hasn't changed much since last year. (see the table below)
Positive Impact: Taxpayers with income less than 400K/450K
Negative Impact: Taxpayers with income more than 400K/450K

-Standard Deduction for Married filing jointly taxpayers keep their preferred standard deduction. It was adjusted for inflation from $11,900 to $12,200.
Positive Impact: Married taxpayers

-Married filing jointly 15% bracket will (NOT!) shrink
Positive Impact: Married taxpayers

-Child tax credit the maximum will remain at $1000 (when they were set to drop to $500)
Positive Impact: Lower income taxpayers with children

-Medical expenses will be more difficult to deduct (7.5% floor reverts to 10% floor)
Negative Impact: taxpayers who itemize deductions and have crazy medical bills

Dependent care expenes credit - the maximum credit remains at 3,000 per child or 6,000 per family.
Positive Impact: Lower income taxpayers with children

Earned Income Tax Credit (EITC) - We get to keep this credit, but additional credit amounts for a 3rd child is no longer available.
Positive Impact: Taxpayers 25 years of age, lower income, working get to keep this.
Negative Impact: Taxpayers with 3+ kids will get less than before.

Education Credits Extended -  the credit (up to $2500) to subsidize our tuition is extended.
Positive Impact: All students (or parents with dependent students)

2013 Tax Rates:

Tax BracketsMarginal Rate
Single   Married
OverBut Not Over   OverBut Not Over20122013
$0 $8,925    $0 $17,850 10%10%
8,92536,250   17,85072,50015%15%
36,25087,850   72,500146,40025%25%
87,850183,250   146,400223,05028%28%
183,250398,350   223,050398,35033%33%
398,350400,000   398,350450,00035%35%
more than 400K or 450K is subject to the new 39.6% tax bracket.

Wednesday, December 5, 2012

Should You Do Your Own Taxes?

With tax season coming up, you might be wondering how your taxes will get done. In this post I hope to provide a little insight into whether preparing taxes by yourself is good idea or not.

I believe there are 3 ways to get your taxes done 1) by yourself, 2) "big box" tax preparers 3) your local CPA or other Tax professional.

1) By yourself -
If you don't have a particularly complex return I believe there are a few times you can skate by with preparing taxes yourself:
a) you are not in school (or if you are in school you are familiar with the education credits such as the lifetime learning credit, or the american opportunity credit and know when to appropriately take each)
b) you do not have kids
c) you only recieved income listed on a W-2
d) you plan on taking the standard deduction (i.e. you do not have substantial deductible expenses like a mortgage, charitable contributions, medical expenses etc).

If you fit into this category and feel somewhat comfortable with preparing your own taxes, than feel free to use whatever your DIY software you prefer. Of course your ability to prepare your own taxes depends on your competency level.

2) "big box" tax preparers -
Due to sheer volume of returns prepared, it is likely that I will offend someone by saying this, but I think this is the worst option. Last year I was offered a job at one of these "Big Box" firms (and denied) and I learned that thier hiring process is very poor. Most of the preparers go through a tax theory crash course and begin preparing taxes. It could be possible that your tax preparer is just working parttime to supplement his walmart paycheck.

After studying only a few years of tax accounting, it is nearly impossible for these people to be "professionals" after a few months crash course. I personally feel that one should never use this alternative (unless maybe you could do it yourself, but aren't up to the task)

3) Local Tax CPA
I believe that finding a trusted tax advisor is the best option for preparing your taxes. Dave Ramsey (a personal finance guru) recently put out an article highlighting that people who paid for a preparer typically save between $347-$841 on thier taxes. When you are likely to pay $100-$250 for an average return, you win here. (depending on your actual circumstances fees or savings can differ).

Keep in mind that not all CPA's are created equal, and that you should find a CPA firm that is most fitting for you. CPA firms are typically equipped to serve a certain type of client. For example a Big 4 firm usually is equipped to serve the largest of clients, like Microsoft, Amazon, Boeing and their executives. Some CPA's specialize in smaller businesses/individuals. Regardless of your choice of CPA keep in mind you are paying for quality advice and direction. When choosing a tax advisor find someone who:

a) "has the heart of a teacher". Regardless of how much you would (or wouldn't) like to know about your taxes, if your advisor has the heart of a teacher you know they aren't just in it for the money, but are willing to help and teach you.

b) plans to build a relationship with you. A good preparer knows that 2013 isn't the only time you need your taxes done. A good CPA wants to plan to help minimize your tax liability for the future, instead of leaving the tax return up to fate to decide.

c) is familiar with the portion of the tax code that pertains to your needs.

Lastly, I would like to highlight a personal experience to show the importance of using a quality accountant.

Last year I had a friend who wanted to me solve a complicated problem on his taxes in which he prepared online. After solving his problem I noticed he was neglecting to take a specific credit he did not know about. After filing the return he saved over $1,000 just by having me look over it.

There are two points to be made. First, you can't let webMD properly diagnose you with cancer and you can't let free online tax software properly diagnose your tax problems. Second, its not about what you know, its about what you don't know; as well as what you think you know, but actually don't.

Tax benefits of Children Part 2: Exemptions

Another benefit when you have children is the extra tax exemption.

Exemptions are basically deductions based on the size of your household. For each person there is a $3,800 exemption (in 2012). Every exemption can save you $380-$1330 in tax dollars depending on your income and what tax bracket you are in.

As a college student I have heard of parents trying to hang on to that exemption as long as possible, but the reality is if your student child is qualified to file on their own, there are situations when you might want to reconsider. Here is just one scenario:

Scenario: Letting the student child file their own return
(assuming a tax rate of 10%).

If a child is free to file their own taxes, they not only will get their personal exemption  ($380 value), but they will be allowed to take an additional standard deduction ($595 value).

If a parent is in a 35% tax bracket, they are not eligible to take the education credit. (The education credit's income limit for married filing jointly is $180,000).

If the student needs to acquire loans, or at least pay a partial amount for their schooling without scholarship, the value of an education credit could be up to $2,500. (education credits are not discussed in detail here).

Total potential savings = $2,145 = ($380 + 545 + $2500) - ($1330)
Total potential savings = (added value to student) - (parent forgoing the student's personal exemption)

I know not everybody's parents make $180,000+ but the analysis gets more complicated if I hadn't made that assumption.

Everybody's situation is different and each situation should be evaluated independently by your trusted tax adviser.

Thursday, November 29, 2012

Tax benefits of Children Part 1: EITC

This is the first post in a series of how having a child benefits you on your taxes. EITC, Child Tax Credit, exemptions etc.

I do not think planning to have more kids is a good tax planning strategy of course, but that bundle of joy gets you a few extra tax benefits along the way!

Credit General Information
In general, a credit is better than a deduction. Deductions reduce income, credits reduce tax owed.

Example: If you have a $100 deduction and a 28% tax rate, then your tax owed will be reduced by $28.
Likewise, If you have a $100 credit (regardless of tax rate), then your tax owed will be reduced by $100.

Earned Income Tax Credit
The Earned Income Tax Credit is meant to provide a extra tax relief for working families and individuals.
The maximum credit for 2012  is $5,891 (Married, 3+ kids, earned income between $13,050-$22,300).

1. Income Limit: If your earned income* exceeds the limit, you are not eligible for the credit.

# of Kids Individual Married file jointly
0  $13,980  $19,190
1  $36,920  $42,130
2  $41,952  $47,162
3+  $45,060  $50,270

*Earned income includes: wages, tips, self employment earnings. NOT earned income: retirement income, unemployment, child support, interest & dividends.

2. Number of Kids: your Child is a child if it meets the following tests:
  • a. Relationship Test (child, stepchild, foster child, sibling, half-sibling, or a descendant thereof)
  • b. Age Test (<19, or <24 if a full time student, or any age and disabled)
  • c. Residency (they lived with you more than 6 months)
  • d. They aren't married, if married they don't file a joint return with their spouse (unless its for a refund).

3. Investment income: Cannot exceed $3,200 (interest, dividends, capital gains, some rents and royalties.)

4. You or your spouse must be at least 25, but less than 65 years old.

Credit Amount
Use the table to find your income amount, and how much your credit is worth!

The IRS has yet to officially release a table, but here is a link to a draft: Unofficial EITC Table

Note that this is a VERY watered down version of the credit rules.
Other considerations not mentioned in this post include:
  • Treatment of Scholarship/grant income
  • Income is actually your AGI number, which includes a series of deductions (including student loan interest deductions, moving expense deductions etc.)
  • Treatment of the credit if you have foreign investment income etc.

Thursday, November 15, 2012

Keeping the Mortgage for a Tax Deduction

Real estate is a favorite topic of mine. A question that often comes up is "should I keep my mortgage for a tax deduction?"

Most people are aware that there is a tax deduction for the interest paid on your mortgage every year. This often times will increase the likelihood of your ability to "itemize" your deductions (i.e. the ability to take more than your standard deduction amount of $11,900 if married filing jointly).

But is it worth it to keep a mortgage for the sake of a tax deduction? My answer is NO! but comes with complexity.

Here is why: Sure, that interest paid to the bank gets you a sweet tax deduction,  but it doesn't make financial sense to pay the bank $10,000 in interest to get a $3,500 cut on your tax bill. (calculated using a 35% tax rate, which is assuming you are rich and in the highest tax bracket, which statistically, most readers won't be!).

So that is it, we are all going to pay down our mortgages right? wrong! As much as I hate to admit, taxes aren't everything! Here is the minor complexity:

Generally speaking, you are likely to get more bang for your buck if you dump your money in that 401K, IRA, or some other investment. Most investments pay a better return than that rockin' 3.25% interest rate you are paying on the mortgage.

But, if you want a guaranteed return on your money, or you don't anticipate getting a return better than 3.25% (or whatever your actual mortgage rate is), then maybe paying down the house is a good idea.

(If you wanted to get real nerdy, you could dive deeper and calculate the after tax impact of paying down your mortgage, vs paying tax on your capital gains!)

Moral of the story: keeping the mortgage around ONLY for the tax deduction makes no sense. Its like asking for a quarter in exchange for a dollar.

(seeing as I do not have a mortgage, your experiences & criticism on this article are openly welcome)