IRA tax on MLP earnings

Investing in a publicly-traded Master Limited Partnership (MLP) can be a savvy move for some investors.  This is because the MLP, unlike a common or preferred stock, is taxed as a partnership.  In doing so, the earnings of the MLP are distributed to its members on a Form K-1, instead of through dividends or capital gains.  What's even better is that most MLP's make a distribution on a regular basis.  This distribution might appear to be a dividend, but it is not, because the taxpayer is paying tax on the earnings, not the distribution.  Here is an example:

Randy owns 100 units of ABC MLP, a publicly-traded partnership.  The taxpayer receives four quarterly distributions of $100 each, for a total of $400.  At the end of the year, Randy receives a K-1 from ABC which shows $50 of ordinary income.  On Randy's tax return, he will report $50 of passive income on his Schedule E.  The $400 from a tax perspective is basically forgotten, to be deposited into Randy's brokerage account for other investments or reinvested in more units of ABC MLP.

MLP's are also commonly known to have high distribution yields, such as in Randy's situation above.  He received $400 of cash during the year for his investment, but only had to report $50 on his tax return.  How do they do it?  Many MLP's take advantage of tax deductions such as depreciation and domestic production activities in order to reduce their taxable income below their book income.  These deductions are not cash expenses, which allows the MLP's to distribute high amounts of cash even though their taxable income is low.  Good for the MLP, and good for the investor.

Because of their high distribution yields, many investors choose to hold MLPs in their retirement accounts.  From a tax perspective, this is where the situation gets a little dicey.

Retirement accounts, such as IRAs and 401(k)s are technically considered tax-exempt entities.  There is a little known rule that if these entities earn something called Unrelated Business Taxable Income (UBTI) over a certain threshold, they are required to report that income to the IRS and pay tax.  The threshold is $1,000, and the tax rate is 39.6% (gasp)!

Let's go back to Randy, and now he owns 5,000 units of ABC MLP in his IRA.  He receives $20,000 in distributions during the year, and his IRA receives a K-1 with $2,500 of ordinary income.  The IRA is the partner in the MLP, not Randy, so the IRA will have to file a Form 990-T and pay tax of $594 ($2,500 - $1,000 exemption = $1,500 x 39.6% = $594).  It is not Randy's responsibility to file this return; the custodian of the account will do the filing and use money from the IRA to pay the tax.  This scenario shows how a tax-savvy investment in a tax-exempt account just became taxable.

In summary, individuals that hold MLPs in retirement accounts should monitor their positions to ensure that they are not losing any of their retirement savings to taxes.  Those that are interested in making significant investments in publicly-traded MLPs should consider doing so in taxable accounts, the main reason being that the individual tax rate will most likely be lower than 39.6%.

My 9 pound 11 ounce tax deduction

So you became a new parent in 2013?  Congratulations!  

We welcomed our first child in April, and sometimes late at night or early in the morning between diaper changes and feedings, I would find myself wondering "just how much is this kid going to save me on my taxes?" It is a common misconception that the tax benefits of having a child outweigh the actual costs of raising said child.  After accounting for diapers, wipes, food, clothes, carseats, bouncers, bumbos and boppys, the costs of raising a child year over year are higher than the tax benefits received by adding a dependent to your tax return.  But, there are tax benefits to take advantage of if you have become a new parent in 2013.

Personal exemptions

The personal exemption is an automatic exemption for everyone on their Form 1040 individual income tax return.  The personal exemption amount is $3,900 (for 2013) per qualifying individual.  A qualifying individual is you, your spouse (if filing a joint return), and each dependent you list on page 1 of your 1040.  For example, if you are married and filing jointly and have 1 dependent child, your personal exemption for 2013 is $11,700 ($3,900 x 3).  Personal exemptions are deducted from adjusted gross income (AGI) to arrive at taxable income on the 1040, meaning that the personal exemption is not a reduction in tax, but is a reduction in the income that determines how much tax you pay.  However, if you have a high income, you might not get full benefit of your personal exemptions due to the personal exemption limitations brought back by Congress beginning in 2013.

Child tax credit

The child tax credit is a potential credit of up to $1,000 per qualifying child.  Notice that this is a credit instead of a deduction, which means that it directly reduces tax instead of reducing income.  To be a qualifying child, the child must:

• be your son, daughter, foster child, brother, sister, stepchild, grandchild, niece, or nephew
• be under the age of 17 at the end of 2013
• not have provided half of their own support during 2013
• have lived with you for at least half of 2013
• be claimed as a dependent on your return
• the child cannot file a joint return for 2013
• be a US citizen, US national, or US resident alien

Married taxpayers with AGI of $110,000 or less and single taxpayers with AGI of $75,000 or less may claim the credit on Form 8812 and attach to their 1040.

Child and dependent care expenses

Taxpayers may be able to claim a credit related to expenses they paid during the year for dependent care.  Qualified expenses are for household services such as a nanny, or outside services such as daycare, that were provided so the taxpayer canwork or look for work.  The taxpayer will need to have the name, address, and social security number or employer identification number of the care provider to claim the credit.  The credit can be claimed for dependent care expenses for each child under the age of 13.  The credit is up to 35% of expenses paid for care, and the credit is limited to $3,000 for one child or $6,000 for two or more.  However, there are stipulations.  If the taxpayer’s employer paid the care provider directly on the taxpayer’s behalf, the care was provided by the employer, or the expenses were paid by the taxpayer from pre-tax contributions to a flexible spending arrangement (FSA), then the credit will be limited.  The credit is claimed on Form 2441.

Children are a blessing, and thanks to the credits and deductions listed above, they can also provide some marginal tax benefits.

Idea$ 2014 - January: Budgeting

Starting this month, the Ruggnotes will be dedicated to one personal financial planning idea each month.  I am calling this Idea$ 2014, with the intention that the idea each month will help readers address a new part of their financial lives.  To begin, January 2014 is dedicated to Budgeting. Almost any financial goal can be achieved by using a budget. Unfortunately, the word "budget" has a negative connotation in our society today. People do not want to be limited or told what to do, especially on how they spend their money. A common response is "I work hard for my money, and I don't need anyone telling me what I can and can't spend it on!"  However, speaking from personal experience , once you buy into the budgeting process and see how rewarding it is to set and achieve financial goals, you will find that a budget is not nearly as limiting as you think.

If you already have a budget, January is a great time to update it for the new year.  If you don't have a budget, I am offering the following thoughts on how to analyze spending and create a budget.  To help, I could think of no better example to use than what I do in my own house, so these ideas are coming straight from my personal experience.

Big picture

The first step is to look at major expenditures throughout the previous year. These would include anything that are not monthly recurring amounts or are large enough dollar-wise to not absorb in a normal month. Some examples are car insurance, property/real estate taxes, or annual memberships. We own a home and cars, so we also consider any large maintenance expenses, such as new tires or tree trimming. Identifying these large expenses and when they will occur can help you develop your monthly budget and how much money you need to have in savings.

Once you have looked at the big picture, it's time to develop the monthly budget.  Here is a picture of the spreadsheet we use:

What is "the budget"?

Before budgeting for monthly expenses, it is important to determine your actual "budget".  In simple terms, your budget each month equals your net take home pay for one month.  You can spend less than that (which is encouraged), but you can't spend more.

Fixed expenses

The first part of your monthly budget should be the fixed expense section. Fixed expenses include anything that is paid on a regular basis, is not discretionary, and the amount is known or can be reasonably estimated. Some examples are mortgage/rent payment, utilities, daycare, etc. Knowing these amounts is vital because they will help you determine how much actual discretionary income you have, because you have to pay these items no matter what. We actually include our monthly savings amounts as fixed expenses to be consistent with the theory of paying ourselves first.

Semi-fixed expenses

The next part of a monthly budget can be called the semi-fixed expense section. This includes expenses that are kind of discretionary, but not completely optional, like groceries and gas for the cars. We know we will have to buy groceries and gas, but by setting a budget we are less likely to make impulse purchases at the grocery store.

Variable expenses

Variable expenses are just that - variable, optional, discretionary. This includes eating out, entertainment, gifts,and a column with the very descriptive title "Other". We budget these categories by taking our monthly take home pay and subtracting fixed expenses and semi-fixed expenses. Whatever is left over we allocate between these categories. One key to this is that both my wife and I have our own columns. Each month we both know we have $xx to spend on whatever we want. This is the money we use to go out to lunch, pay entry fees to run in races, play golf, get manicures or buy clothes.  Setting a reasonable budget for variable expenses, and sticking to that budget, is the key to making your budget work each month.

Net (over) under

At the end of each month, we look to see if we are over or under. This is to say that if our monthly expenses exceed our monthly take home pay, we are over.  If we are over, we try to figure out why and make it up next month. If we are under, we transfer that extra money to our savings or make an extra payment on the house.

Budgeting does not have to be an arduous, time consuming project. A simple spreadsheet works for us. There are also some great tools on the internet. My favorite is Mint, which I was introduced to by a friend of mine a few years ago. Mint pulls in your transactions over the internet and lets you categorize them, and will also guide you through creating a budget. Mint also has an app for smartphones and tablets, so you can see in real time where you stand.

January is a great time to create or update your budget. Using the tips above, you should be able to identify trouble areas in your spending, and set and achieve reasonable goals.

To pay or not to pay, that is the question

For taxpayers that make estimated tax payments throughout the year, the payment for the fourth quarter is due on January 15 of the next year. Even though this payment is made in the following year, it is still credited as a payment for the tax year in which it applies. But, if the taxpayer lives in an "income tax state" (a state with its own income tax, like Arkansas or Louisiana, but not Texas) and makes estimated tax payments to the state, there is a catch to when these payments are deductible on a Federal return.

Allowable itemized deductions for individuals on a Federal 1040 include state and local taxes paid. These taxes include income, real estate, and personal property taxes as well as some other taxes paid to a state or local government. The deductible portion of these taxes is the amount actually paid during the year, not amounts assessed or paid in other years. Here are a few examples:

Bob, who does not live in an income tax state, pays his personal property taxes for 2012 in October of 2013 for $500. At the same time, he receives his assessment for 2013 of $600 which will be due in October 2014. Bob's deduction for personal property taxes in 2013 is $500, because that is what he actually paid even though it was related to the previous year.  The $600 will be deductible to him in 2014 when it is paid.

Peggy lives in an income tax state and makes state estimated tax payments quarterly. In January 2013, she made her 4th quarter payment for 2012 for $500. Then, in April, June, and September of 2013 and in January 2014 she made quarterly payments of $600 each for her 2013 state taxes. Peggy's state tax deduction on her Federal return for 2013 is $2,300 ($500 + 3 $600 payments) which is the total of the payments made during 2013, even though one of them was related to a previous year.

This example leads us to the point of this article. If Peggy makes her state fourth quarter payment for 2013 in December 2013 instead of January 2014, her state tax deduction on her Federal return will be $2,900 instead of $2,300. As a result, her Federal tax liability would be decreased slightly because of the added deduction. It is for this reason that taxpayers living in income tax states should always consider paying their final estimated tax payment before the end of the year.

But, as is usually the case, there are caveats with this plan - the Alternative Minimum Tax and the time value of money.

Taxpayers subject to the Alternative Minimum Tax (AMT) will not realize the benefit of paying their state estimated tax payment early because those payments will be added back as a preference item on Form 6251.  Therefore if taxpayers are close to or already subject to the AMT, they should make their payments as scheduled (not early).

Taxpayers must also consider the time value of money when paying estimated tax payments early.  For example, if the funds needed to make the estimated tax payment will be accessed by selling investments at a gain, then the net effect of the transaction might be zero because the additional benefit from the payment could be offset by the additional income recognized from selling the investments in the same year.  Furthermore, the funds used to pay taxes earlier by 15-30 days may lose investment earnings which could be large if the estimated tax payment is large.

In closing, taxpayers should consider making their 4th quarter state estimated tax payment in December (now!) as long as they are not subject to the AMT and they have liquid funds to make the payment without creating additional income.

Straight cash

Cash basis taxpayers can make decisions during these last few days of December to improve their tax situation.

Cash basis taxpayers report income and expenses in the year that they actually occurred.  This allows cash basis taxpayers to defer income or accelerate expenses as the situation requires.

Income

Income must be recognized by a cash basis taxpayer when it has been constructively received and is available to the taxpayer.  If a taxpayer receives a check in January for work performed in December, that income is taxable in the next year.  However, if a taxpayer receives a check in December for work performed in December but puts it in a drawer and doesn't deposit the check until January, this is still income to the taxpayer because it had been constructively received and was available in December.  With this being the case, tax basis taxpayers can manage their cash inflows at year-end by sending out bills later to defer collection to next year, or requiring customers to prepay if more cash/income is needed.

Expenses

Expenses can be recognized by a cash basis taxpayer in the year paid or charged.  Yes, you read that correctly, charged.  The IRS will allow charges on a credit card as cash basis expenditures, even if the bill is not paid until the next month.  This provides some wiggle room for businesses that have cash flow concerns at year-end, because they can use a credit card to make purchases instead of cash.

Cash basis taxpayers can also use the end of the year to stock up on capital assets, especially right now due to the expiring Section 179 and Bonus depreciation provisions.

A word of caution: just because an entity is a cash basis taxpayer does not mean that every cash expense is deductible.  All expenses must still be properly substantiated and properly deductible.

Cash basis taxpayers should also consider their business operations when making year-end decisions on spending.  Yes, buying $5,000 of office supplies on New Years Eve will reduce the tax burden on the entity, but will that cash outlay penalize the business operations in January?