All You Need to Know About 529 Plans

All You Need to Know About 529 Plans

If you don’t have the right plan for distributions, all of the advantages of a 529 Plan could end up costing you thousands.

Congress created 529 plans in 1996 and they are named after section 529 of the Internal Revenue code. They are plans operated by a state or educational institution, with tax advantages and potentially other incentives to make it easier to save for college and other post-secondary training for a designated beneficiary, such as a child or grandchild. Each state has its own, unique plan and they are allowed to offer both types of plans: prepaid tuition and savings plans. You are not restricted to your own state’s 529 plan. Your state may offer incentives to win your business, but the market is competitive and you may find another plan you like more. Be sure to compare the various features of different plans. You may have to “recapture” some of your deductions if funds were not used for secondary learning.

Each 529 Plan account has only one designated beneficiary, usually the student or future student for whom the plan is intended to provide benefits. The beneficiary is generally not limited to attending schools in the state that sponsors their 529 plan. But to be sure, check with a plan before setting up an account. Earnings are not subject to federal tax and generally not subject to state tax when used for the qualified education expenses of the designated beneficiary, such as tuition, fees, books, as well as room and board. Contributions to a 529 plan are not deductible on your Federal tax return; however, most states allow deductions if you use their plan (Michigan has the MESP that allows a deduction of up to $10,000 for married couple, $5,000 for single).

TAX TIP – There are Federal Estate and Gift Tax Benefits for contributions into a 529 plan. The contributions can lower the overall value of the estate as well as qualifying for the annual federal gift tax exclusion (remains at $14,000 per spouse per beneficiary). Taxpayers can gift up to 5 years at once ($140,000 for married couple) and still be excluded from gift taxes. The maximum amount you can contribute is $235,000 for each beneficiary. You can transfer beneficiaries so long as they are a relative of previous beneficiary.

Accounts can be opened by anyone who is a US Citizen and has reached the age of majority (18). The funds can be used for any secondary school and not just for higher learning institutions in your state. Withdrawals need to be disbursed in the TAX YEAR that the qualified higher education expense were paid. You generally have three options when requesting a distribution from a 529 plan: 1) a check made payable to the account owner, 2) a check made payable to the student or 3) a payment made directly from the 529 plan to the student’s college.

TAX TIP – Consider having the check made payable to the student. They will receive a 1099-Q tax form reporting the distribution to the IRS showing the student’s name and Social Security number. If the student incurs qualifying higher education expenses, or QHEE, during the calendar year that are equal to, or greater than, the gross distribution figure on Form 1099-Q, the distribution is tax-free. And when all 529 plan distributions in a year are tax-free, nothing is shown on the student’s Form 1040.

Another reason for preferring the second option concerns situations where the earnings portion of the distribution is fully or partially taxable because the beneficiary has insufficient qualified educational expenses. This can occur, for example, because the beneficiary received a scholarship and the account owner made a decision to pull unneeded funds from the 529 plan. It’s important to note that taxable distributions avoid the usual 10 percent penalty to the extent the beneficiary received scholarship monies.

TAX TIP – By making sure the distribution is reported to the beneficiary, the earnings are taxed at the student’s tax bracket, which is typically much lower than the account owner’s bracket unless the so-called “kiddie tax” applies. The kiddie tax requires certain children as old as 23 to pay tax on unearned income at their parents’ tax brackets.

Be careful of directing the 529 plan to make payment directly to the school. Those payments will be treated in much the same way that outside scholarships are treated. If the student is awarded a needs-based financial aid package, the school can adjust that award downward on a dollar-for-dollar basis. Be sure you ask about the policies at your child’s particular school beforehand.

Funds can be used for tuition, mandatory fees, books, supplies, and equipment required for enrollment or attendance, certain room and board costs, and expenses for “special needs” students.

A qualified, nontaxable distribution from a 529 plan includes the cost of the purchase of any computer technology, related equipment and/or related services such as Internet access. The technology, equipment or services qualify if they are used by the beneficiary of the plan and the beneficiary’s family during any of the years the beneficiary is enrolled at an eligible educational institution. This means any computer and related peripheral equipment. Related peripheral equipment is defined as any auxiliary machine (whether on-line or off-line) which is designed to be placed under the control of the central processing unit of a computer, such as a printer. This does not include equipment of a kind used primarily for amusement or entertainment. “Computer technology” also includes computer software used for educational purposes. Such costs are generally not qualifying expenses for the American opportunity credit, Hope credit, lifetime learning credit or the tuition and fees deduction.

TAX TIP – There are no income restrictions to contribute to a 529. There is no time limit for the assets to be in the 529 plan and no age requirements for withdrawal. Assets in a 529 plan are not used in calculating RMDs and you can always use your RMDs to deposit into 529 plans.

Taxation and Withdrawal Strategies

Only the earnings portion of a non-qualified withdrawal is subject to a 10% withdrawal penalty. Distributions are allocated on a pro-rate basis, which means that withdrawals will be divided into contributions and earnings based on the formula:

Account Contributions / Account Value X Distributions = Contribution Portion

Please note your contributions will never incur a penalty, and only the earnings portion is ever taxed.

There are a few exceptions to this 10% penalty on non-qualified withdrawals; if the beneficiary dies or becomes disabled; if the student attends a US Military Academy; or if the student receives a scholarship. All earnings on non-qualified distributions will be subject to tax as ordinary income at your tax rate. Withdrawal rates for most 529 account owners is 100% of qualified expenses MINUS $4,000 (American Opportunity Tax Credit – AOTC). If you don’t, you could be facing a 10% penalty plus adding $4,000 to your AGI. There is an income-phase out where the owners of the 529 cannot claim the AOTC so they would not have to adjust for it.

TAX TIP – End of year tax planning, owners of 529 plans should sit down and calculate exactly how much was spent on qualified expenses and make appropriate reimbursement distributions from the 529 plan. Maximize the AOTC by considering paying tuition bill in December rather January.

Most 529 plans allow you to take withdrawals yourself, send the withdrawal straight to the beneficiary or paid directly to the university. Whoever receives the check will receive the 1099-Q representing the distribution. It should not matter for as long as the qualified expenses supported the distribution but the funds received were too much then the distribution becomes a taxable event. One thing to consider, if the institution receives the check, it may treat it as some sort of scholarship, and could reduce the student’s financial aid package.

It is extremely important to have the right strategy going in so you can have the right results coming out. We can help you determine the right amount either in lump sum or over time to contribute, the right plan and the investment choices each plan brings and we will help you plan the right course of action for your distributions.

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Why NOT Budgeting for Home Maintenance Can Be Detrimental to Your Retirement

How much should I budget for annual expense on the general maintenance of my house?
Where most people ‘take it for granted’ until they need to replace the windows at $300/pc or the roof at $10/sqft. And if you retired and most of your money is in your IRAs, now we have to add taxes in top of the cost.
While conducting one of our Retirement Planning classes here locally, one of our students had an interesting question regarding how much he should budget for the general maintenance of his house. This is a question that usually arises when we are putting an income plan together in order to bring a couple successfully through retirement. It also happens when we are putting together an estate plan and the trustees want to set aside money specifically for the upkeep of their home so their beneficiaries don’t have to sell home before they are ready. They understand that at any time you ‘have to’ sell anything, especially a large ticket item, the buyer wants a pretty good deal.
There is a general rule of either 1% of your purchase price (Current Market Value) or about $1 per square foot of living area. The living area should include your basement, attic and garage in this calculation. For example: 2 story Colonial with a two car attached garage and full basement. If your assessed size of your home is 2400 sq. ft. then it is safe to assume you have 1200 sqft on the top floor as well as the main floor and the basement. So realistically, you are looking at a potential 3,600 sq ft of living space. A two car garage is usually about 440 sq ft. So if you add it all up, you have a little over 4,000 sq ft that should go into this calculation and not simply the square footage you originally purchased your home.
So the range in which to implement your budget is anywhere from 1% of the purchase price to $1 of the entire square footage of the home. In our example, assuming homes are selling for $100 sqft, and you bought your home for $240,000. The bottom end of your budget for home maintenance should be $2,400 and the top end would be $1 of the total square feet or $4,000.
Now let’s talk about the $100 per sq ft. If we place this as a par value, we can simply investigate what homes are currently selling for in our neighborhood to see if we are above or below that factor. For instance if we find that a similar 2400 sq ft home just sold for $220,000 then we know immediately that is below par value (22/24 = $91.67 sq ft). We would then budget at either 91.67% (2400*.9167) which is $2,200 or (4000 sqft * 92 cents) which is $3,680. Of course our budget would work the opposite way if we find that our home is currently valued above par. For example a similar home sells for $300,000 or 125% above par so our bottom end of the range is $3,000 while the top end is now $5,000.
So why the difference? How does the market value per square feet have any effect on my maintenance cost? When considering a budget for your home there are Geographic Cost of Living, Quantity and Quality of products and services, and level of outside influences as main contributors in how current market fluctuations effect the day to day maintenance costs of your home. More affluent neighborhood stores sell products at a higher premium compared at lower income neighborhoods. Those same stores have more specialized products versus more generic brands to choose. More affluent stores have better opportunity to buy in bulk compared to lower income demographic stores where premium is placed on smaller packages that fetch a lower investment from the customer. Bigger homes usually have more amenities, landscaping and changes in construction materials that add a higher ongoing maintenance cost.
Other Considerations that will affect your long term budget when you purchased the home:
 Age of the house, roof, windows, additions etc
 Age of the appliances, hvac, plumbing, electrical
 Construction of home, vinyl siding, brick, stone etc
 Ongoing maintenance prior to purchase
 Proactive Maintenance, protective paints and seals, and waterproofing
 Warranties on appliances, maintenance
 Topography of home, high ground or valley, windy with no trees or surrounded by trees
 City Water or Well
 Weather extremes
It doesn’t seem that it should cost that much to maintain a home? You’re right it doesn’t seem to but let’s look at the list:
Age of Life for
 Roof – 20 years at about $9/sq ft that is $22,800 ($1140/yr)
 Furnace – 15 to 20 years and will cost about $2500 in today’s dollars ($125/yr)
 Hot Water Heater – 10 years at about $500 ($50/yr)
 Water Softener (if applicable) – 10 to 15 years at about $500 ($35/yr)
 Central Air – 20 years at about $4000 ($200/yr)
 Sprinkler System 30 years at about $2500 ($85/yr)
 Driveway 30 years at about $9000 ($300/yr)
That’s a total of about $1935 in today’s dollars and with the rate of inflation at 2.5%, most of these costs will be quite a bit higher. In 20 years, this monthly maintenance fee will be approximately $3100. While budgeting for the long term maintenance, the day to day maintenance now has a range of approximately $465 and then topped out at $2,065. It’s tuff to take ownership and stick to a budget, especially when there is a chance you may never need it. But as my mother always told me as I scoffed at the umbrella on the way out the door, it is better to have and not need it than to need it and not have it.

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Lifetime Learning Credit

For 2015, there are two tax credits available to help you offset the costs of higher education by reducing the amount of your income tax. They are the American Opportunity Credit and the Lifetime Learning Credit.
TAX BENEFIT – For the tax year, you may be able to claim a Lifetime Learning Credit of up to $2,000 for qualified education expenses paid for all eligible students. There is no limit on the number of years the Lifetime Learning Credit can be claimed for each student. A tax credit reduces the amount of income tax you may have to pay. Unlike a deduction, which reduces the amount of income subject to tax, a credit directly reduces the tax itself. The Lifetime Learning Credit is a nonrefundable credit, so if the credit is more than your tax the excess will not be refunded to you. Your allowable Lifetime Learning Credit is limited by the amount of your income and the amount of your tax.

ONLY ONE EDUCATION CREDIT ALLOWED – For each student, you can elect for any year only one of the credits. For example, if you elect to claim the Lifetime Learning Credit for a child on your 2015 tax return, you cannot, for that same child, also claim the American Opportunity Credit for 2015. If you are eligible to claim the Lifetime Learning Credit and you are also eligible to claim the American Opportunity Credit for the same student in the same year, you can choose to claim either credit, but not both. If you pay qualified education expenses for more than one student in the same year, you can choose to claim certain credits on a per-student, per-year basis. This means that, for example, you can claim the American Opportunity Credit for one student and the Lifetime Learning Credit for another student in the same year.

CLAIMING THE CREDIT – Generally, you can claim the Lifetime Learning Credit if all three of the following requirements are met.
• You pay qualified education expenses of higher education.
• You pay the education expenses for an eligible student (a student who is enrolled in one or more courses at an eligible educational institution).
• The eligible student is either yourself, your spouse, or a dependent for whom you claim an exemption on your tax return.
Table 3-1. Overview of the Lifetime Learning Credit for 2015
Maximum credit Up to $2,000 credit per return
Limit on modified adjusted gross income (MAGI) $128,000 if married filing jointly;
$64,000 if single, head of household, or qualifying widow(er)
Refundable or nonrefundable Nonrefundable—credit limited to the amount of tax you must pay on your taxable income
Number of years of postsecondary education Available for all years of postsecondary education and for courses to acquire or improve job skills
Number of tax years credit available Available for an unlimited number of tax years
Type of program required Student does not need to be pursuing a program leading to a degree or other recognized education credential
Number of courses Available for one or more courses
Felony drug conviction Felony drug convictions do not make the student ineligible
Qualified expenses Tuition and fees required for enrollment or attendance (including amounts required to be paid to the institution for course-related books, supplies, and equipment)
Payments for academic periods Payments made in 2015 for academic periods beginning in 2015 or beginning in the first 3 months of 2015

CANNOT CLAIM THE CREDIT – You cannot claim the Lifetime Learning Credit for 2015 if any of the following apply.
• Your filing status is married filing separately.
• You are listed as a dependent on another person’s tax return.
• Your modified adjusted gross income (MAGI) is $64,000 or more ($128,000 or more in the case of a joint return).
• You (or your spouse) were a nonresident alien for any part of 2015 and the nonresident alien did not elect to be treated as a resident alien for tax purposes. More information on nonresident aliens can be found in Publication 519.
• You claim the American Opportunity Credit or a Tuition and Fees Deduction for the same student in same year.
QUALIFYING EXPENSES – The Lifetime Learning Credit is based on qualified education expenses you pay for yourself, your spouse, or a dependent for whom you claim an exemption on your tax return. Generally, the credit is allowed for qualified education expenses paid in same year for an academic period beginning in the same year or in the first 3 months of the following year. For example, if you paid $1,500 in December 2015 for qualified tuition for the spring 2016 semester beginning in January 2016, you may be able to use that $1,500 in figuring your 2015 credit.
Academic period. An academic period includes a semester, trimester, quarter, or other period of study (such as a summer school session) as reasonably determined by an educational institution. In the case of an educational institution that uses credit hours or clock hours and does not have academic terms, each payment period can be treated as an academic period.
Paid with borrowed funds. You can claim a Lifetime Learning Credit for qualified education expenses paid with the proceeds of a loan. You use the expenses to figure the Lifetime Learning Credit for the year in which the expenses are paid, not the year in which the loan is repaid. Treat loan disbursements sent directly to the educational institution as paid on the date the institution credits the student’s account.
Student withdraws from class (es). You can claim a Lifetime Learning Credit for qualified education expenses not refunded when a student withdraws.
For purposes of the Lifetime Learning Credit, qualified education expenses are tuition and certain related expenses required for enrollment in a course at an eligible educational institution. The course must be either part of a postsecondary degree program or taken by the student to acquire or improve job skills.
Eligible educational institution. An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education. It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions. The educational institution should be able to tell you if it is an eligible educational institution. Certain educational institutions located outside the United States also participate in the U.S. Department of Education’s Federal Student Aid (FSA) programs (such as Oxford University).
Related expenses. Student activity fees and expenses for course-related books, supplies, and equipment are included in qualified education expenses only if the fees and expenses must be paid to the institution for enrollment or attendance.

NO DOUBLE-DIPPING – You cannot do any of the following.
• Deduct higher education expenses on your income tax return (as, for example, a business expense) and also claim a Lifetime Learning Credit based on those same expenses.
• Claim a Lifetime Learning Credit in the same year that you are claiming a tuition and fees deduction for the same student.
• Claim a Lifetime Learning Credit and an American Opportunity Credit based on the same qualified education expenses.
• Claim a Lifetime Learning Credit based on the same expenses used to figure the tax-free portion of a distribution from a Coverdell Education Savings Account (ESA) or Qualified Tuition Program (QTP).
• Claim a credit based on qualified education expenses paid with tax-free educational assistance, such as a scholarship, grant, or assistance provided by an employer.
For each student, reduce the qualified education expenses paid by or on behalf of that student under the following rules. The result is the amount of adjusted qualified education expenses for each student.
Tax-free educational assistance. For tax-free educational assistance received in 2015, reduce the qualified educational expenses for each academic period by the amount of tax-free educational assistance allocable to that academic period. Some tax-free educational assistance received after 2015 may be treated as a refund of qualified education expenses paid in 2015. This tax-free educational assistance is any tax-free educational assistance received by you or anyone else after 2015 for qualified education expenses paid on behalf of a student in 2015 (or attributable to enrollment at an eligible educational institution during 2015).

Tax-free educational assistance includes:
• The tax-free part of scholarships and fellowship grants
• Pell grants (Scholarships, Fellowship Grants, Grants, and Tuition Reductions)
• Employer-provided Educational Assistance
• Veterans’ Educational Assistance
• Any other nontaxable (tax-free) payments (other than gifts or inheritances) received as educational assistance.
Generally, any scholarship or fellowship grant is treated as tax free. However, a scholarship or fellowship grant is not treated as tax free to the extent the student includes it in gross income (if the student is required to file a tax return for the year the scholarship or fellowship grant is received) and either of the following is true.
• The scholarship or fellowship grant (or any part of it) must be applied (by its terms) to expenses (such as room and board) other than qualified education expenses.
• The scholarship or fellowship grant (or any part of it) may be applied (by its terms) to expenses (such as room and board) other than qualified education expenses.
You may be able to increase the combined value of an education credit and certain educational assistance if the student includes some or all of the educational assistance in income in the year it is received.

Refunds. A refund of qualified education expenses may reduce adjusted qualified education expenses for the tax year or require repayment (recapture) of a credit claimed in an earlier year. Some tax-free educational assistance received after 2015 may be treated as a refund.
Refunds received in 2015. For each student, figure the adjusted qualified education expenses for 2015 by adding all the qualified education expenses for 2015 and subtracting any refunds of those expenses received from the eligible educational institution during 2015.
Refunds received after 2015 but before your income tax return is filed. If anyone receives a refund after 2015 of qualified education expenses paid on behalf of a student in 2015 and the refund is paid before you file an income tax return for 2015, the amount of qualified education expenses for 2015 is reduced by the amount of the refund.
Refunds received after 2015 and after your income tax return is filed. If anyone receives a refund after 2015 of qualified education expenses paid on behalf of a student in 2015 and the refund is paid after you file an income tax return for 2015, you may need to repay some or all of the credit.
Credit recapture. If any tax-free educational assistance for the qualified education expenses paid in 2015 or any refund of your qualified education expenses paid in 2015 is received after you file your 2015 income tax return, you must recapture (repay) any excess credit. You do this by refiguring the amount of your adjusted qualified education expenses for 2015 by reducing the expenses by the amount of the refund or tax-free educational assistance. You then refigure your education credit(s) for 2015 and figure the amount by which your 2015 tax liability would have increased if you had claimed the refigured credit(s). Include that amount as an additional tax for the year the refund or tax-free assistance was received.

If you pay qualified education expenses in 2015 for an academic period that begins in the first 3 months of 2015 and you receive tax-free educational assistance, or a refund, as described above, you may choose to reduce your qualified education expenses for 2015 instead of reducing your expenses for 2015.

Amounts that do not reduce qualified education expenses. Do not reduce qualified education expenses by amounts paid with funds the student receives as:
• Payment for services, such as wages,
• A loan;
• A gift;
• An inheritance; or
• A withdrawal from the student’s personal savings.

Do not reduce the qualified education expenses by any scholarship or fellowship grant reported as income on the student’s tax return in the following situations.
• The use of the money is restricted, by the terms of the scholarship or fellowship grant, to costs of attendance (such as room and board) other than qualified education expenses, Scholarships, Fellowship Grants, Grants, and Tuition Reductions.
• The use of the money is not restricted.
COORDINATION WITH PELL GRANTS AND OTHER SCHOLARSHIPS – You may be able to increase your Lifetime Learning Credit when the student (you, your spouse, or your dependent) includes certain scholarships or fellowship grants in the student’s gross income. Your credit may increase only if the amount of the student’s qualified education expenses minus the total amount of scholarships and fellowship grants is less than $10,000. If this situation applies, consider including some or all of the scholarship or fellowship grant in the student’s income in order to treat the included amount as paying nonqualified expenses instead of qualified education expenses. Nonqualified expenses are expenses such as room and board that are not qualified education expenses such as tuition and related fees.

Scholarships and fellowship grants that the student includes in income do not reduce the student’s qualified education expenses available to figure your Lifetime Learning Credit. Thus, including enough scholarship or fellowship grant in the student’s income to report up to $10,000 in qualified education expenses for your Lifetime Learning Credit may increase the credit by enough to increase your tax refund or reduce the amount of tax you owe even considering any increased tax liability from the additional income. However, the increase in tax liability as well as the loss of other tax credits may be greater than the additional Lifetime Learning Credit and may cause your tax refund to decrease or the amount of tax you owe to increase. Your specific circumstances will determine what amount, if any, of scholarship or fellowship grant to include in income to maximize your tax refund or minimize the amount of tax you owe. The scholarship or fellowship grant must be one that may (by its terms) be used for nonqualified expenses.

Finally, the amount of the scholarship or fellowship grant that is applied to nonqualified expenses cannot exceed the amount of the student’s actual nonqualified expenses that are paid in the tax year. This amount may differ from the student’s living expenses estimated by the student’s school in figuring the official cost of attendance under student aid rules. The fact that the educational institution applies the scholarship or fellowship grant to qualified education expenses, such as tuition and related fees, does not prevent the student from choosing to apply certain scholarships or fellowship grants to the student’s actual nonqualified expenses. By making this choice (that is, by including the part of the scholarship or fellowship grant applied to the student’s nonqualified expenses in income), the student may increase taxable income and may be required to file a tax return. But, this allows payments made in cash, by check, by credit or debit card, or with borrowed funds such as a student loan to be applied to qualified education expenses.

Something to consider is whether you will benefit from applying a scholarship or fellowship grant to nonqualified expenses will depend on the amount of the student’s qualified education expenses, the amount of the scholarship or fellowship grant, and whether the scholarship or fellowship grant may (by its terms) be used for nonqualified expenses. Any benefit will also depend on the student’s federal and state marginal tax rates as well as any federal and state tax credits the student claims. Before deciding, look at the total amount of your federal and state tax refunds or taxes owed and, if the student is your dependent, the student’s tax refunds or taxes owed. For example, if you are the student and you also claim the earned income credit, choosing to apply a scholarship or fellowship grant to nonqualified expenses by including the amount in your income may not benefit you if the decrease to your earned income credit as a result of including the scholarship or fellowship grant in income is more than the increase to your Lifetime Learning Credit as a result of including this amount in income.

NON-QUALIFYING EXPENSES – Qualified education expenses do not include amounts paid for:
• Insurance;
• Medical expenses (including student health fees);
• Room and board;
• Transportation; or
• Similar personal, living, or family expenses.
This is true even if the amount must be paid to the institution as a condition of enrollment or attendance.
Sports, games, hobbies, and noncredit courses. Qualified education expenses generally do not include expenses that relate to any course of instruction or other education that involves sports, games or hobbies, or any noncredit course. However, if the course of instruction or other education is part of the student’s degree program or is taken by the student to acquire or improve job skills, these expenses can qualify.
Comprehensive or bundled fees. Some eligible educational institutions combine all of their fees for an academic period into one amount. If you do not receive or do not have access to an allocation showing how much you paid for qualified education expenses and how much you paid for personal expenses, such as those listed above, contact the institution. The institution is required to make this allocation and provide you with the amount you paid (or were billed) for qualified education expenses on Form 1098-T. To help you figure your Lifetime Learning Credit, the student should receive Form 1098-T. Generally, an eligible educational institution (such as a college or university) must send Form 1098-T (or acceptable substitute) to each enrolled student by January 31, 2015. An institution may choose to report either payments received (box 1), or amounts billed (box 2), for qualified education expenses. However, the amounts on Form 1098-T, boxes 1 and 2, might be different from what you paid. When figuring the credit, use only the amounts you paid or are deemed to have paid in 2015 for qualified education expenses.
In addition, Form 1098-T should give other information for that institution, such as adjustments made for prior years, the amount of scholarships or grants, reimbursements or refunds, and whether the student was enrolled at least half-time or was a graduate student. The eligible educational institution may ask for a completed Form W-9S, or similar statement to obtain the student’s name, address, and taxpayer identification number.
CLAIMING DEPENDENT’S EXPENSES – If there are qualified education expenses for your dependent during a tax year, either you or your dependent, but not both, can claim a Lifetime Learning Credit for your dependent’s expenses for that year. For you to claim a Lifetime Learning Credit for your dependent’s expenses, you must also claim an exemption for your dependent. You do this by listing your dependent’s name and other required information on Form 1040 (or Form 1040A), line 6c.
Expenses paid by dependent. If you claim an exemption on your tax return for an eligible student who is your dependent, treat any expenses paid (or deemed paid) by your dependent as if you had paid them. Include these expenses when figuring the amount of your Lifetime Learning Credit. Qualified education expenses paid directly to an eligible educational institution for your dependent under a court-approved divorce decree are treated as paid by your dependent.
Expenses paid by you. If you claim an exemption for a dependent who is an eligible student, only you can include any expenses you paid when figuring the amount of the Lifetime Learning Credit. If neither you nor anyone else claims an exemption for the dependent, only the dependent can include any expenses you paid when figuring the Lifetime Learning Credit.
Expenses paid by others. Someone other than you, your spouse, or your dependent (such as a relative or former spouse) may make a payment directly to an eligible educational institution to pay for an eligible student’s qualified education expenses. In this case, the student is treated as receiving the payment from the other person and, in turn, paying the institution. If you claim an exemption on your tax return for the student, you are considered to have paid the expenses.
Tuition reduction. When an eligible educational institution provides a reduction in tuition to an employee of the institution (or spouse or dependent child of an employee), the amount of the reduction may or may not be taxable. If it is taxable, the employee is treated as receiving a payment of that amount and, in turn, paying it to the educational institution on behalf of the student.
FIGURING THE CREDIT – The amount of the Lifetime Learning Credit is 20% of the first $10,000 of qualified education expenses you paid for all eligible students. The maximum amount of Lifetime Learning Credit you can claim for 2015 is $2,000 (20% × $10,000). However, that amount may be reduced based on your MAGI.
The amount of your Lifetime Learning Credit is phased out (gradually reduced) if your MAGI is between $54,000 and $64,000 ($108,000 and $128,000 if you file a joint return). You cannot claim a Lifetime Learning Credit if your MAGI is $64,000 or more ($128,000 or more if you file a joint return).
Modified adjusted gross income (MAGI). For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return.
MAGI when using Form 1040A. If you file Form 1040A, your MAGI is the AGI on line 22 of that form.
MAGI when using Form 1040. If you file Form 1040, your MAGI is the AGI on line 38 of that form, modified by adding back any:
1. Foreign earned income exclusion,
2. Foreign housing exclusion,
3. Foreign housing deduction,
4. Exclusion of income by bona fide residents of American Samoa, and
5. Exclusion of income by bona fide residents of Puerto Rico.

Phase Out. If your MAGI is within the range of incomes where the credit must be reduced, you will figure your reduced credit using lines 10–18 of Form 8863.
You figure the tentative Lifetime Learning Credit (20% of the first $10,000 of qualified education expenses you paid for all eligible students). The result is a $1,320 (20% x $6,600 eligible expenses) tentative credit.
Because your MAGI is within the range of incomes where the credit must be reduced, you must multiply your tentative credit ($1,320) by a fraction. The numerator of the fraction is $128,000 (the upper limit for those filing a joint return) minus your MAGI. The denominator is $20,000, the range of incomes for the phase out ($108,000 to $128,000). The result is the amount of your phased out (reduced) Lifetime Learning Credit ($1,056).
$1,320 x ($128,000 – $112,000)/$20,000 = $1.056
CLAIMING THE CREDIT – You claim the Lifetime Learning Credit by completing Form 8863 and submitting it with your Form 1040 or 1040A. Enter the credit on Form 1040, line 50, or Form 1040A, line 33.

Why Understanding the Cost of Doing Business and Not Performance should be the first priority when deciding what to do with your Rollover IRA.

“A capacity, and taste, for reading, gives access to whatever has already been discovered by others. It is the key, or one of the keys, to the already solved problems. And not only so. It gives a relish, and facility, for successfully pursuing the [yet] unsolved ones.” – Abraham Lincoln

Most financial advisor’s talk is about performance. How they can outperform the market or outperform their peers. They will also extol about the need for diversification because investing across asset classes will lower market risk thus reducing volatility. Then there is more talk that all portfolios need to have proper Asset Allocation so you can be in position for growth, wherever that my come. The final push is about downside protection either through a fixed annuity or an automated exit strategy where your portfolio goes to cash as soon as your losses cross a certain, pre-determined level.
While those are all very important factors to determine your financial strategy, there are two un-talked-about risks to consider, even if you ultimately decide to do nothing at all… The late actor Gary Collins’ most famous quote, “We can try to avoid making choices by doing nothing, but even that is a decision.”
Opportunity Risks and Unknown Risks
Opportunity Risk happens when you decide one way or another. It is invariably an action that presents other decisions that could have been made with the possibility of a more favorable outcome. Calculating and measuring the performances of any decision now becomes the focal point of any financial discussion. Words you will most likely hear or read is what is the average rate of return. It is how financial advisors sell their portfolios of mutual funds, professionally managed accounts and the value of hiring their services. Even though they are grammatically correct, how you understand the true growth of your investments should be at the foundation of your decisions.
Fool’s Gold
Let’s take the example of buying a certain mutual fund which, over the past 10 years, has an average rate of return, of say, 8.5%. The discussion then, is about the portfolio should realize an average of 8.5% per year but that is not the real math:

 

The numbers in the left column are actual historic returns of a mutual fund over a 10 year period where they report their mutual fund produces an average rate of return, which is true if you take those numbers, add them up and the divide by 10 and you will have an average of 8.5%. The natural tendency is to think, you will make on average 8.5%; however, that is not the case. The middle column follows the annual rates of return of the mutual fund. The actual rate of return of investing $100,000 ten years ago is 8.17% because if it truly was 8.5%, your mutual fund should be worth $226,098.
Now I get it, this difference seems insignificant, but you incorporate this into a bigger portfolio over a longer period of time and the difference can be quite substantial. Besides, we are looking at the true value of risk, so wouldn’t the true appreciative nature of the investment need to be known?
“Unknown” Risks should really be titled, “we know that these risks are out there but they won’t happen to me” risks. As a recovering CFO, I can’t help but institute some basic business fundamentals in a portfolio such as prioritizing income and assets into short term, not-so-short term and long term. In other words; “Cash on Hand”, “It May take a Phone Call” and “Can’t touch it with a 10 foot pole”. Now the accountant in me would say this is “Fund Accounting” where income brought in has a specific purpose and is handled accordingly while the financial advisor in me would call this “Sequence of Returns” where you do not ever distribute money out of an account that can go down in value.
Unknown risks also have another weight that seems to go unnoticed until you have been carrying them too long or they just get too heavy; and those are the Costs of Doing Business. Costs come in two flavors, voluntary and involuntary. The funny thing about voluntary costs is sometimes it is easy to think that they are supposed to be there, permanently.
Examples of Involuntary Costs
Service Costs, these are such things as various account fees, prep fees and transfer fees. We don’t like them, but almost always they are involuntary, unless of course you get someone else to pay them for you. You won’t know, until you ask.
Other Costs of Doing Business are a blend of involuntary and voluntary because these fees are associated with each product you choose to invest in, but that’s just it, you choose. You can always choose to do nothing and incur no cost. Each type of products ranging from mutual funds and ETFs to professional money management to life insurance fees have an even wider range of fees and it is up to you to investigate all of the fees inherent in each investment. ETFs have an average annual fee of less than 1% while mutual funds average almost 2%. What do you get for the difference? You receive more ‘active’ management of the stocks, bonds and cash within the fund to hopefully have more of an opportunity for capital appreciation (you make more money). Stocks, Bonds and Options usually have a buy/sell/get yourself into commission AND the spread between the Bid and the Ask (in stocks); difference in either coupon rate or yield (in bonds); or difference in strike price or the Bid and the Ask (in options). They won’t teach you that in the wire house conference room.
Please be careful of insurance products, there needs to be a conscious effort on your part to get ALL of the fees, explained, clearly concisely and up front before you surrender your assets to an insurance company. Now don’t get me wrong, there are a lot of great products from insurance and I am a big proponent of the right leverage for the right situation for the right price but I have seen how unknowing people have obligated themselves to some pretty expensive mistakes. To understand what I am trying to convey, it would be like your car to the neighborhood mechanic… you can pay them to diagnose your car, give a quote on how to fix it and decide from there if it is worth what they are asking. By now you have gone through a tremendous hassle getting to the mechanics shop, wasting an entire morning and shelled out a bunch of money already, who wants to do this again so you’ll probably do what 99% of us do, “Go ahead and Fix It.” But before you do, get a detailed quote on every part, labor warranty, tax and anything else that could cost more money. Sometimes, like an insurance product, there are some things you can do without fixing.
“I Signed Up for What?”
Voluntary costs can sometimes feel involuntary and downright intrusive, but nevertheless, as the buying public we come to desensitized acceptance of certain ways of business, so paying a certified tax planner $3,500 or an estate planning attorney $2,000 seems all so reasonable. So the question becomes, when does a cost become an investment? Simple, when the value outweighs the expectations. As a Certified Tax Strategist, it is part of my DNA to look at the cost of things. Why did we incur the cost? Are we going to keep incurring the cost? And is it worth it?
Now, as people come in who are looking for retirement planning or asset management they all understand that there will be costs involved. Clients understand we are all here to make a ‘decent’ living, some more decent than others but still the same, people recognize there is some remuneration somewhere.
People pay for the Cost of Advice either to the neighborhood broker or financial planner who works as an independent, for a bank, a wire house and just recently, an on-line brokerage firm. They will charge you a fee for service with a percentage based on household assets under management or by the hour or a flat fee for a ‘project’. All is good, as long as the value outweighs your expectations, but there are somethings to consider, especially as you rollover your IRA.
Normally, rolling over an IRA is a pretty big deal because it normally represents a significant if not all of a person’s nest egg. The asset base they are counting on to grow adequately to bring enough income to keep the expected life style and to pay for anything life throws at them. Here are some key considerations that can derail the success of your retirement:
Fees to any financial advice, either directly or embedded are PAID FIRST. Just like in the classic battle of the A-Share versus the B-Share back 10+ years ago, it is in the best interest of the financial firm to be paid before the assets are invested so the client absorbs all of the risk.
The more layers of professional management, the more costs associated with financial advice. You hire a financial advisor who charges a 1% ‘management fee’ to oversee and recommend your investment portfolio; they hire a professional money manager with a 20 year track record who charges 1% (either directly or embedded and then that money manager buys mutual funds which have another 1.5% embedded fee. So your assets can have 3.5% taken out just by utilizing their knowledge and expertise. But let me reiterate, it is okay so long as the value outweighs the expectation.
Understand the TRUE cost of financial advice. Even as I write this, I can hear people saying that I understand 3.5% seems a little high but hey, it’s only 3.5%. It does seem like a small amount until you look at it for what it really is, a percentage of what you make and NOT a percentage of what you have. A couple came in for a portfolio review, an objective diagnostic analysis that they paid a nominal fee to make sure the advice they were given will get them exactly where they want to go without any surprises. Upon review we uncovered something we normally see with people who go see the financial advisor who charges a fee to help them manage their accounts. They were paying almost 2% for a 3.5% rate of return. Now at first mention of this to them, they did not seem to mind which frankly inspired me to write this article. I simply wrote this on the white board behind me… they are charging you $2,000 to make $3,500 for a net profit of $1,500 so your actual rate of return for the year was 1.5%. And they too, seemed undaunted by this. So I went back to the drawing board and wrote 57%. This got their attention, “What’s that?” How much they are charging you for your profit. You take all of the market risk, they take most of your profit.
Now as a Tax Strategist, I feel a certain affinity to talk about my favorite subject, taxes. More importantly how to avoid overpaying our IRS. This is a seldom discussed topic in financial firm conference rooms, but I believe when not planned for, taxes can truly bring the biggest harm to anyone’s portfolio, especially when considering Rollover IRAs. Mindful facts about qualified money, we all understand that assets grow TAX DEFERRED… so not only is your assets growing but so is the amount of taxes. Income is taxed at your marginal tax rate for both federal and state when it is distributed from the Rollover IRA and not to mention, if you tap into before 59 ½ there is an additional 10% penalty; and it becomes mandatory to distribute at an increasing rate once you hit 70 ½.
Utilizing Your Tax Losses for Your IRA
There are three tax classes of investments: Taxable (PayGo); Tax Deferred; and Tax Free. A good tax plan can utilize each tax class of investments to help the other all in order to create better opportunity for guaranteed capital growth and reduce taxes immediately and for the long term. Projecting income would highlight timing of certain strategies such as tax loss harvesting; tax advantaged investments; or investments that allow a built in capital loss with tax efficient income. With proven tactics, you can pay off your future tax obligations with minimum out of pocket assets thus increasing your cash flow analysis and funded ratio.
Simply put, plan your retirement to be in control of the income you receive and the taxes you will have to pay. We know (pretty much) what taxes are going to be next year and possibly the year after that; however, the future of the revenues needed to fulfill our unfunded liabilities of our Treasury Department and the strength of our dollar may well increase the effective rate of our annual tax obligation. It is important to fully understand how controlling your income can help the rest of your financial decisions. So the time to act is now when putting together a blue print of how you are going to be taxed throughout your retirement.
Diversification is not exclusive to a proper asset allocation, it should be employed during your accumulation phase in order to maximize net income throughout retirement. Understand how income from investments proliferates all areas of your annual taxes that may ultimately produce:
 Higher SSI taxable amount
 Higher marginal tax bracket
 Higher effective tax (through loss of deductions and tax credits)
 Higher Obamacare Tax, AMT and Cap Gains
Part of financial tax planning limits the risk of too much taxable income. Instead, proactive tax strategies identifies other areas in your balance sheet to maximize your funded ratio (assets to future obligation).
Ultimate Goal through Retirement
Basic formula for a successful business: Asset Base – Income – Lifestyle – Protection
The Asset Base as depicted by your balance sheet and financial statement, should be as diverse as it is deep. The strength of any business or retirement plan is dependent on the integrity and sustainability of its resources. It is from the diversity of assets where you can arrange a harmony of income and from the depth of capital to sustain your lifestyle. Comprehensive planning conclusively adds the layer of protection for predictable growth necessary for successful retirement.
Going to the Doctor’s Office – I feel find but a little sluggish and I don’t know why?
As with patient, it is necessary to perform unbiased and objective Diagnostic Testing: What you own (how it’s owned), capital appreciation and loss, 3 types of Income and 4 variations of Risk (market, inflation, opportunity and unforeseen) in order to answer: What do You Want? Are you on the right path to get there? Any surprises? What should you expect?
People spend more time planning their vacation than they do planning their finances.
I would like to think the Certified Planners Association is wrong here. A diagnostic stress test performed on your balance sheet (assets vs liabilities) and financial statement (cash flow analysis: income vs expense) should reveal the minimum: sustainability of assets, future obligations, funded ratio, income projections, net growth rate of capital needed, opportunities for improvement and predictability of continuous net worth.
We offer a comprehensive Financial and Tax Planning Blueprint for a one-time flat fee. We will walk you through our proven process to stress test your current portfolio of assets. You will receive a report detailing every aspect of your portfolio and deliver review and analysis. 30 day Money Back Guarantee if you are not 100% satisfied with your Financial and Tax Planning Blueprint.

Reduce Your College Costs by Great Tax Planning

Saving for your kid’s college can be harder than saving for your retirement. The clock starts ticking the day your child is born and as college draws closer, the less risk you can afford to take. Consider these tax-advantaged tools:
• Coverdell Education Savings Accounts (“ESAs”) let you save up to $2,000 per year per student. Earnings grow tax-deferred, and withdrawals are tax free for education costs.
• Section 529 Plans are state-sponsored college savings plans. Each state sets its own lifetime contribution limit, which ranges between $100,000 and $300,000+. Traditional “prepaid tuition” plans cover specific units of tuition such as a credit hour or course. Newer “college savings” plans invest contributions in mutual funds for potentially higher growth, generally adjusting portfolios from stocks to bonds and cash as your child ages. You can choose any state’s plan; however, some states offer deductions for contributions to their own plans.
• U.S. Savings Bonds let you defer tax on gains until you redeem the bond. Interest on Series EE Savings Bonds issued after 1989 to individuals age 24 or above may be tax-free if you use it the year you redeem the bond for “qualified educational costs” (tuition and fees minus tax-free scholarships, qualified state tuition plan benefits, and costs for which you claim the American Opportunity or Lifetime Learning credit). For 2015, the exclusion phases out for households with “modified AGI” from $77,200-92,200 (singles and heads of households) or $115,750-145,750 (joint filers) and isn’t available for married couples filing separately.
Plan Coverdell ESA Section 529 Plan
Donor AGI Limit $110,000 ($220,000 joint) None
Contribution Limit $2,000 per year $115,000-315,000 lifetime
(varies by state)
Federal Deduction None None
State Deduction None Some
Withdrawals Tax-free for elementary, secondary, and college costs, including reasonable room and board. Expenses paid out of ESA accounts do not qualify for American Opportunity or Lifetime Learning credits. Withdrawals not used for education are taxed as ordinary income. Tax-free for “qualified higher education expenses.” Withdrawals not used for college are taxable only if they exceed contributions.
Age Limit Use by age 30. Otherwise, pay tax on gains or roll into a family member’s ESA. Designate new beneficiary if child chooses not to attend college.

Section 529 plans offer estate-tax breaks in addition to income-tax breaks: Contributions are considered complete gifts for gift tax purposes; you can contribute up to $14,000 per year per student, or $28,000 jointly with your spouse, with no gift tax effect; 5 year accumulation plan states that you can give a beneficiary up to $80,000 in a single year, or $160,000 jointly with your spouse, so long as you give no more for the next four years; plan assets aren’t included in your taxable estate unless you “front-load” contributions in a single year then die before the end of that period.
What’s more is if you lose money in a 529 plan, you can close your account and deduct the loss as a miscellaneous itemized deduction. You can also transfer accounts from one plan to another, but only once a year. If you’re saving for college and you own permanent life insurance, you can deposit savings dollars into your policy and take tax-free cash for college (or anything else for that matter). If you later surrender the policy, any gains exceeding your total premiums are taxed as ordinary income when you surrender the policy (hint you can still get all of your money out while not surrendering the policy).

American Opportunity/Lifetime Learning Credits
These credits are available for parents (if they claim a student as a dependent) or students (if they can’t be claimed as someone else’s dependent). Here are the rules:
College Credits
Credit American Opportunity Lifetime Learning
Eligible Course You, your spouse, or your dependent enrolled at least half-time in the first four years of post-secondary education 1) Any year of postsecondary or graduate education
2) Any course of instruction at an eligible institution to acquire or improve job skills
Eligible Expenses 100% of the first $2,000 in expenses plus 25% of the next $2,000 in expenses; $2,500 maximum per student 20% of the first $10,000 in expenses; $2,000 annual maximum per taxpayer
• You can claim the full American Opportunity credit for as many students as qualify; however, the Lifetime Learning Credit is capped at $2,000 per taxpayer per year.
• The American Opportunity credit phases out as your AGI tops $80,000 ($160,000 for joint filers) (2015). The Lifetime Learning credit phases out as your AGI tops $55,000 ($110,000 joint) (2015).
• You can’t claim credits for expenses you pay out of an Education Savings Account or Section 529 Plan established for that student.
• Married couples filing separately can’t claim the credits.
Give Your Child Appreciated Assets to Pay College Costs
Previously it was possible to give appreciated assets to students age 18 or older before you sold them, to pay college costs. Your child’s tax on those gains would likely be less than yours. And this move kept down your AGI, which preserved your adjustments to income, deductions, and credits. You can give each child up to $14,000 per year ($28,000 per couple) with no gift tax consequence (2015). However, since 2008 the “kiddie tax” rules now apply to full-time students under age 24, thus greatly limiting this strategy.
You can withdraw funds from your IRA or qualified plan for college costs (tuition, room and board, books, and fees) without the usual 10% penalty for withdrawals before age 59½. Tax breaks for parents and students generally phase out as parental AGI rises, and financial aid is based on family income and assets. Emancipating your child severs that financial cord and lets your child qualify for tax breaks and financial aid according to their own income and assets. Your child will have to provide more than half of their own support (from investment and employment income) so that they no longer qualify as your dependent. This, in turn, lets them claim their own personal exemption (which may be phased out on your return anyway).
If dorm life doesn’t suit your scholar, consider buying them off-campus housing. As long as you can trust them not to trash the place, they’ll gain some real-world financial education and responsibility along with their college courses. This offers several tax and financial advantages:
• You can treat it as a second home and deduct mortgage interest and property taxes you pay on Schedule A. Or you can treat it as rental property, charge rent, and report rental income and expenses on Schedule E.
• You can pay your child a management fee and tax-advantaged employee benefits to manage the property.
• You can title the home in your child’s name (or jointly with them) and include them as a co-signer on the mortgage to help build their credit.
• A child who owns and occupies the home for two years can exclude up to $250,000 of gain from their income when they eventually sell.
Traditional tax planning seeks to minimize tax — period. But some tax strategies actually cost you when it comes time to apply for need-based college financial aid. So it’s important to know how your tax choices affect the Free Application for Federal Student Aid (“FAFSA”) that schools use to assess financial need.
All schools use a “federal methodology” to calculate how much federal aid they can disburse. Some schools also use an “institutional methodology” to calculate their own aid. Both methodologies work as follows:
The student’s “assessable income,” minus taxes and an “income protection allowance” times 50%
+ The student’s “assessable assets” times 20%
+ The parents’ “assessable income,” minus taxes and a living allowance times 22% to 47% (depending on income)
+ The parents’ “assessable assets,” minus an “asset protection allowance” (based on the older parent’s age) times 5.6%
= Expected family contribution (“EFC”)
“Cost of attendance” minus EFC equals “financial need.” The key, then, is to minimize assessable income and assets until after the last FAFSA reporting period. Here are key points to consider:
• Assessible assets generally include cash, checking and savings accounts, discretionary securities and investment accounts, and vacation home equity — but not qualified plan or retirement account balances, home equity, or personal assets. Some schools using the “institutional methodology” also include life insurance and annuity cash values, home equity, family farm equity, and siblings’ assets.
• Assessible income includes AGI (adjusted gross income) plus various “untaxed income and benefits” such as:
o earned income and child tax credits
o tax-free interest income
o child support received
o IRA and retirement plan contributions (be careful making contributions before your child enters college, as they are considered “up for grabs” to pay for school)
o untaxed gain on the sale of your primary residence
o gifts of cash (but not property) from friends and relatives (if grandparents or family want to make gifts, consider waiting to until after the student’s last FAFSA is due, or even making gifts after graduation to retire student loans)
o some schools using the “institutional methodology” also include flexible spending and health savings account contributions.
College costs are high enough that even families earning six-figure incomes can qualify for need-based aid. So don’t assume that your income automatically disqualifies you.
College financial aid decisions are based on the previous year’s income and assets — in most cases, with the “base year” starting January 1 of the child’s junior year in high school. This means it’s best to start planning no later than the start of your child’s junior year. FAFSA forms are due annually so long as the student seeks aid.
Assessable income does not include loan proceeds. This rule may make borrowing against life insurance, retirement or investment accounts, or your primary residence an appropriate source of tuition funds.

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What to Know Before Exercising Stock Options

Companies are always trying to attract talented workers by granting options to either buy company stock at a discounted price, which the employee can then sell for (hopefully) at a higher price or as a simple ‘perk’ for being employed. Understanding the difference is paramount in lowering your tax burden. NON-QUALIFIED and INCENTIVE STOCK OPTIONS (“Qualified” Stock Options) are the two most common types of stock options employers arrange for their employees.
Generally, you will owe no tax when Non-Qualified options are granted. You are required to pay ordinary income tax on the difference, or “Spread,” between the Grant Price (the price the company sold you the stock) and the stock’s current market value (set at the exchange close on the day of execution) when you purchase (“exercise”) the shares. Companies get to deduct the “Spread” as a compensation expense. Non-qualified options can be granted at a discount to the stock’s market value. They also are “transferable” to children and to charities, provided your company permits it.
Incentive Stock Options (aka “Qualified” Stock Options), qualify to receive a special tax treatment. Your income tax is deferred until you sell the stock so, there is no income tax due at when the options are granted or exercised.
At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise. If you don’t meet the holding-period requirements, the sale is ruled a “disqualifying disposition,” and you are taxed as if you had held non-qualified options. The spread at exercise is taxed as ordinary income, and only the subsequent appreciation is taxed as capital gain.
Unlike non-qualified options, Incentive Stock Options may not be granted at a discount to the stock’s market value, and they are not transferable, other than by a distribution from a will or trust from the death of the stock options holder. IRS caps the annual amount of Incentive Stock Options exercised in one year to $100,000. The spread at exercise is considered a “preference item” for purposes of calculating alternative minimum tax (AMT), increasing the taxable income for AMT purposes (Bargain Element). A disqualifying disposition can help avoid this tax.
Choosing the right moment to exercise is not as easy as it looks. Improperly exercising stock options can cause real financial headaches, particularly when it comes to paying taxes on your profits. Even if you keep the stock you purchased, you may still have to pay taxes. Many employees are not aware of a strategy for exercising their stock options, which could produce large tax bills when April 15th rolls around.
For many recipients of stock options, employees will wait until the stock price increases so they can use the “windfall” for a big vacation or major update to their house. By waiting, employees may lose their control of when to sell because their options expire and they are forced to sell before they lose all their value. Employees need a disciplined strategy when evaluating stock options, in order to make the smartest possible financial decisions.
Here are 6 Key Questions to Ask for a Successful Financial Outcome.
Timing – When are the Stock Option Vested?
A typical vesting schedule is over four years, with one-quarter of shares vesting after each year. It’s important to understand when you will actually acquire the shares. Once the shares are vested, you can exercise and sell that portion of the stock options.
Taxes – What is the Projected Overall Tax Bill?
By exercising and selling your options assures the stock is taxed at an elevated rate and it will directly affect other sources of income, high tide raises all ships. One of the best pieces of advice is to project the overall tax burden from exercising and selling the options. Timing is everything, waiting a year before selling should qualify the option into capital gains tax rates instead of ordinary income tax rates. This decision involves risk because if the stock price falls after exercise to where the stock options become worthless, the exercise may still be subject to the Alternative Minimum Tax.
Asset Allocation – How much is too much?
The “Concentration” Risk has to be considered so that the success of a portfolio is not dependent on one fluctuating stock price. It is important to have a disciplined financial plan that incorporates an exit strategy that will re-balance if any one stock appreciates over a certain percentage of the overall portfolio (say 10%). We have seen plenty of retirement plans go to zero during the “Tech Bubble” in the early 2000’s and just 8 years later.
Measuring Stick – What are the Quantitative, Qualitative and Technical Attributes of the Company?
Many clients love their company they work for and who can blame them? Working here in the Motor City we are constantly helping executives from the Big Three as well as Automotive Suppliers and they all come in with the same mindset that their companies have been very good to them. They have built a nice living, putting children through college and saving up for a pretty nice retirement. They are right, but it still smart to check the vitals on any organization in any industry, especially when everything is becoming more and more global. There are a lot more moving parts in investigating fundamentals of any company. Simply understanding the Average Deviation of the company’s stock can help determine the trend and volatility to pinpoint the overall risk a single stock can impose on the overall performance of a portfolio.
Dollar Cost Averaging – Is there a Stock Purchase Plan?
Employees generally have access to an employee stock purchase plan (ESPP). By understanding the vested schedule and options that are available, an employee can establish target prices to exercise and sell their respective options.

DILUTE and STOCK BUY-BACK – What is the Company News?
I am not talking insider trading, but keep an eye for company news regarding its stock, especially if they plan to release more stock into the market or what the trends have been lately are stock buy-backs. This is the case where less is better, normally.
A third party professional trained and focused in this area can help tremendously in putting together a plan that will reduce costs, taxes and risk while improving the overall effectiveness of having a stock option plan in the first place.

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Do You Really Save Money Doing Your Own Taxes?

I got a call last week from a woman who opened a small company this year. She wanted to know if it was advisable for her to have a professional prepare her income tax return or should she just get all the forms and do it herself or maybe just get a software package off the shelf and get them done that way?
I’m not surprised at the question, I myself had the same question 15 years ago when I first opened my doors. I’m a smart guy, I’m in finances… I can follow instructions and fill these forms out… besides it is only adding and subtracting from there. It’s not like calculating the time value of money…
But come to think of it, there are 75,000 pages of the tax code. And of course, the laws are ever changing especially for those who write their own paycheck or God forbid, have a payroll. Still, entrepreneurs are a smart bunch. They understand income versus expenses and the fact you don’t have to pay taxes on the money you don’t make right? Every year, scores of sole-proprietors list their sales, add up all the business expenses and viola, their tax return is complete!
My momma always told me, if it sounds too easy then you’re not looking hard enough. As a certified tax coach, we focus our long days on the tax code where we take many things into consideration, especially when it comes to start ups and how those expenses are treated, logged and reported. Unless you have spent thousands of hours researching, studying and networking with tax colleagues, you may miss some valuable deductions or worse, set yourself up for an audit. In fact, according to the Treasury Department, a person who prepares their own Schedule is 5 times more likely to get audited.
The IRS has increased its audit enforcement and will be conducting many more correspondence audits than ever before which leads to me to understand that whatever money a business owner may save on the front end make cost a lot more down the road. And isn’t it funny, how those things happen at the most inopportune times? Not that there is ever a good time for an audit, but it seems they always happen at the worst possible time!
Another client of mine who owns quite a few rental properties, has always done his own taxes. He understood that it is a simple process of adding up all of his rental income and subtract out the expenses. But he always seem to be complaining about the amount of taxes he owed, especially because he was taking all of the risk, doing the repairs and collecting rent. I told him unless you know the rules for depreciation, amortization, passive vs active losses, the difference between capital improvements and repairs and a myriad of other laws, he will continually pay too much in income taxes.
A now this year is going be even more fun because of the healthcare law changes that effect all of us. I always hear at holiday parties and family gatherings that they’re simply going to buy a software package for $50 and it will guide them through all of the ins and outs of the tax returns. They are good to a point. Those software packages cannot hold every question, and they certainly do not give guidance as to how to save on taxes going forward. They are simply there to help you put the right number in the right box on the right form. A seasoned certified tax strategist will intuitively ask all the right questions, to get you to the right answers to minimize your overall tax obligation from this year and every year thereafter.
One final thought, what happens if you make a mistake because you interpreted the rules or laws incorrectly? Is your software company going to come and represent you? One thing is simple when it comes to the IRS, not following the rules and the tax laws that are laid out for us may have serious ramifications. It first starts with a letter, then a visit with a friendly IRS agent who is only too happy to let you know how much you still owe the US Treasury. My momma also said, it’s better to avoid a problem than to fix one.