Category: Taxes

Categories
Taxes

How to Tame Your Tax Dragon: Review Your W-4

It's time to think about your W-4
Photo by Kelly Sikkema on Unsplash

It’s just about tax time and almost nothing drives anxiety more than worrying if you might owe a lot at tax time.  Or, maybe you’re in the camp that looks forward to the big refund at tax time.  But then what if your refund isn’t as big as you’d hoped?  Have you reviewed your W-4 lately?  

Whether you prefer to owe a little, get a little refund, or get a big refund, the number one factor driving your experience at tax time is how you completed your W-4.  It’s that important!  But, you’re only required to complete a W-4 ONCE . That means the biggest driver of your tax season experience might be a form you haven’t even thought about in years!  

What is the W-4

The W-4 is the “Employee’s Withholding Certificate”.  It’s the form that tells your employer how to calculate the amount of Federal tax they should withhold from your paycheck.  The goal of the form is to approximate tax withholding as accurately as possible so that you neither owe taxes nor receive a refund at tax time.  

Breaking it down

Your annual tax bill is primarily driven by four things:  

  1. Filing status – Your filing status drives the tax brackets used to calculate your total tax bill as well as limitations applied to tax credit eligibility and some other things.
  2. Total household income – the more income you and your spouse earn, the higher tax rate you pay.  Keep in mind that income includes: military retirement pay, interest/ dividends earned on savings or investment accounts, and capital gains from the sale of assets (like stocks, property, etc).  
  3. Deductions – deductions lower your tax bill by allowing you to deduct income.  In other words, deductions lower your taxable income. You can either:
    1. itemize your deductions – add up your mortgage interest, all taxes you’ve paid, and some other allowable deductions or, 
    2. take the standard deduction.  The standard deduction for 2023 is $13,850 for single filers/ $27,700 for married filing jointly filers.  Because the standard deductions are so high right now, the majority of people simply take the standard deduction.  
  4. Credits – credits lower your tax bill by subtracting the amount of tax you owe.  A common tax credit is the child tax credit which can be up to $2,000.  Let’s assume you qualify for the child tax credit.  Let’s further assume that your tax bill is $10,000.  With the child tax credit your bill would be $2000 less or $8000. 

How the W4 Works

Your employer only knows one thing about your tax situation – they know how much income you earn with them.  Unless you review and update your W-4, they don’t know your current filing status, if you have a second job, if your spouse earns an income, if you have savings/ investments that pay interest or dividends, whether you plan to sell an asset, whether you have children or are eligible for other types of credits.

The W-4 is meant to provide more of this information to your employer so they can adjust your withholdings appropriately.

Completing/ Reviewing your W-4

There are only two sections you absolutely must complete on the W4: Section 1 and Section 5.  Section 1 includes your name, address, SSN, and filing status (single, married filing jointly, etc)  Section 5 is your signature.  

If you are single, have no children, and no other income sources, Sections 1 and 5 are all that’s needed.

Completing/ Review Your W-4 for More Complex Situations

If you are married filing jointly, have children, or other income sources, then complete Sections 2, 3, and/ or 4.

Multiple Jobs?  Spouse Works?

If you have a spouse with a job or if you have more than one job, Section 2 is for you.  The verbiage in this section can seem confusing so let’s break it down.  

Let’s start with the easiest option.  If there are only two jobs in your household (you have 2 OR you have 1 and your spouse has 1) AND the income from the lower paying job is at least half the income from the higher paying job, then you can just check the box at the end of “c)” in Section 2.

In other words, if your income is $100,000, then it’s easier and more accurate to simply check the box as long as the income from the other job is at least $50,000 or higher.

If you earn much less in your side gig, or your spouse earns much less than you (less than half), then you’ll want to either use the estimator tool at www.irs.gov/W4app or use the Multiple Jobs Worksheet that’s part of the complete W-4 (link here).  Both methods will provide insight on whether you should add an amount to Line 4(c) in Section 4.  This is the amount of additional withholding your employer will withhold from each paycheck.  

The estimator tool is very detailed but it’s accurate and will provide a pre-filled W-4 that you can download and either submit directly to your employer OR, if you’re military, you can use the info to update your W-4 in myPay.  

Dependent Credits and Other Credits

If you have children or other dependents, you will want to complete Section 3.  Thankfully it’s more straightforward than Section 2.  Is your household income more or less than $250,000 (single) or $400,000 (married filing jointly)?  How many dependents do you have under age 17?  How many dependents do you have who are age 17 or older?  Then do some simple multiplication. 

Other Adjustments

In Section 4, you get to include information about any other income sources, besides jobs.  If you’re retired from the military then you have a taxable pension.  You may have savings/ investment accounts that pay interest and/ or dividends.  

You also get to include information about deductions.  Recall from above that most people use the standard deduction now.  So you’ll enter the standard deduction.  If you itemize deductions on your taxes, then add your estimated itemized deductions instead.

Now is the Time to Review your W-4

If you haven’t looked at your W-4 since 2019 then your W-4 is definitely out of date.  In December 2019 there was a huge change to the W-4.  If you haven’t made changes since then, then your W-4 is most likely nothing more than Section 1 and Section 5.  

If, since 2020, you’ve owed more than normal or get a refund that’s substantially different from what you were used to, the W-4 format change is likely the reason.  Your employer just doesn’t have enough information about your situation to accurately withhold Federal taxes.  Take a look at your W-4 and make updates as needed.  

When you make updates to your W-4 you should expect the net pay that hits your checking account to change.  The amount may be higher or lower depending on your situation.  If you make the changes early in the year, the changes will likely be smaller than if you wait until later in the year.  So now is the perfect time to review your W-4.

Categories
Taxes

Expanded Tax Credits for Energy Efficient Improvements in 2023

Installer putting solar panel on a roof to qualify for energy efficiency improvement tax credits

Expanded Tax Credits for Energy Efficient Improvements in 2023

Tax credits for making energy efficient improvements to the taxpayer’s home have been around for a while, but they got a boost at the end of last year. The Inflation Reduction Act of 2022 increased both the dollar value of the tax credits and the types of expenses that qualify for the tax credits. There are two separate home energy efficiency improvement tax credits in effect for 2023. They are known as the Energy Efficient Home Improvement Credit and the Residential Clean Energy Credit. This article highlights the particulars of those two credits.

The Energy Efficient Home Improvement Credit

The Energy Efficient Home Improvement Credit is a 30% credit for certain qualified expenses for energy efficient home improvements. As is always the case with tax laws, the details matter. Taxpayers can receive up to a $1200 credit each year for energy efficient improvements to exterior doors, windows, skylights, insulation, as well as home energy audits on their residences. Within that category the following limits are in effect:

  • Maximum credit of $250 per door, maximum of 2 doors
  • Maximum credit of $600 for windows
  • Maximum credit of $150 for home energy audits

Taxpayers can also get up to $1200 of tax credit for insulation and air sealing materials, new central air conditioners, hot water heaters, furnaces, and hot water boilers that use propane, natural gas, or oil but there is a $600 per item limit.  

The maximum amount of the tax credit for all the above in any tax year is $1200. Taxpayers can get an additional $2,000 of Energy Efficient Home Improvement Credit for the purchase of qualified heat pumps, biomass stoves, or biomass boilers. Meaning that it would be possible to claim up to $3,200 of Energy Efficient Home Improvement Credit in one year. The Energy Efficient Home Improvement Credits are not refundable, and unused portions of the tax credits cannot be carried forward to future tax years. The credits are only for improvements to an existing home. They are not available for new construction.

The Residential Clean Energy Credit

The Residential Clean Energy Credit is for other improvements to the taxpayer’s residence, including a secondary residence as long as the residence is located in the United States. The Residential Clean Energy Credit is a 30% credit on the amount spent on solar electric panels, solar water heaters, wind turbines, geothermal heat pumps, fuel cells, and battery storage of at least 3 kilowatts.  

Unlike the Energy Efficient Home Improvement Credit, there is no limit on the value of the Residential Clean Energy Credit. It is 30% of whatever your qualified expenses are. This credit is also available for both existing homes and new construction. Like the Energy Efficient Home Improvement Credit, this credit is not refundable. It cannot exceed the amount of tax owed, but unused portions of the credit can be carried forward to future tax years until all the credits are used.

You may still qualify for the credit if you are using a portion of your residence as a business property by leasing part of it to a tenant or using it as a home office. If the percentage of the property being used for business is 20% or less, then the taxpayer may claim all the qualified expenses for the credit. If more than 20% of the residence is being used for business, then the qualified expenses must be divided between the business and residential portions of the property, and the credit calculated only on the qualified expenses applicable to the residential portion of the property. (Note that you could still deduct the expenses applicable to the business portion of the property on your business schedule or return.)

Additional Rules

Internal Revenue Service guidance indicates the credit cannot be taken until the installation of the qualifying property occurs. A taxpayer might pay for solar panels in December 2023 but not have the solar panels installed until February of 2024. The taxpayer would not be eligible for the credit until they filed their 2024 tax return.

Previous versions of these credits came with a lifetime limit. There is no lifetime limit for the newer versions, only some annual limits for the Energy Efficient Home Improvement Credit. Taxpayers could claim these credits every year if they have qualifying expenses in multiple tax years.

The credits are only valid for new energy efficient improvement property. You cannot purchase solar panels from your neighbor, have the panels moved from their roof to yours, and claim the credit. The energy efficient purchases must be new equipment.

Here is a useful example from the IRS fact sheet (https://www.irs.gov/pub/taxpros/fs-2022-40.pdf)

In one taxable year, a taxpayer purchases and installs the following: two exterior doors at a cost of $1,000 each, windows and skylights at a total cost of $2,200, and one central air conditioner at a cost of $5,000. All property installed meets the applicable energy efficiency and other requirements for qualifying for the Energy Efficient Home Improvement Credit. 

First, 30% of each $1,000 door’s costs is $300, but the per door limit of $250 applies to reduce the maximum possible credit for each door to $250 each. Thus, the taxpayer’s expenditures for exterior doors potentially qualify the taxpayer to claim up to a $500 tax credit. 

Next, 30% of the taxpayer’s total $2,200 of expenditures for windows and skylights is $660, but the $600 limit for all windows and skylights applies to limit the taxpayer’s credit for such expenditures to $600. Thus, the taxpayer’s expenditures for windows and skylights potentially qualify the taxpayer to claim up to $600. 

Finally, 30% of the taxpayer’s $5,000 cost paid for the central air conditioner is $1,500, but the $600 per item limit for energy property applies to limit the taxpayer’s credit for such expenditures to $600. 

Adding these credit amounts yields a sum of $1,700 ($500 + $600 + $600), but the aggregate limit of $1,200 applies to limit the taxpayer’s total amount of Energy Efficient Home Improvement Credit to $1,200

Tax planning is an integral part of financial planning. If you only think about taxes when it is time to prepare your income tax return for the prior year, then you are being reactive and not proactive. MFAA advisors are knowledgeable about tax strategies and can help you build a plan to reduce your tax burden over your entire lifetime, not just for the current or prior year. Find the advisor that’s right for you by checking out their online profiles here.

Categories
Taxes

SECURE Act 2.0

Compass with arrow pointing to the word Retirement

Congress passed the Omnibus Spending Bill on December 23, 2022.  Included in the monstrous 4,000+ document were numerous changes to retirement savings accounts collectively known as SECURE Act 2.0 (Setting Every Community Up for Retirement Enhancement Act).   It builds on the original SECURE Act, which was signed into law in December 2019.

Admittedly, most of these are small changes.  They don’t rise to the same level of the elimination of stretch IRAs in the original SECURE Act.  That doesn’t mean you shouldn’t be aware of the changes and how you it might impact your planning.

Here’s the TLDR Summary of this post and the most impactful SECURE Act 2.0 provisions:

  1. Pushed back the age for starting required minimum distributions (RMDs) to 73 for those born between 1951 and 1959 and to 75 for those born in 1960 or later
  2. Tax credits for military spouse employers
  3. Reduced the penalty for missing a Required Minimum Distribution (RMD)
  4. Employer matches to Roth accounts
  5. Eliminates RMD requirements from employer Roth accounts
  6. Increased the allowed contribution to a Qualified Lifetime Annuity Contract (QLAC)
  7. Increased retirement plan catch-up contributions for those aged 60-63 starting in 2025
  8. Allows a 529 to Roth IRA rollover starting in 2024
  9. Allows for a $50,000 IRA Charitable Rollover to a Charitable Gift Annuity or Charitable Remainder Trust
  10. Student Loan Debt “Matching”

1.  Pushed back the age for starting required minimum distributions (RMDs)

The SECURE Act 2.0 extends the required minimum distribution (RMD) age from 72 to 73 for those born between 1951 and 1959.  For those born in 1960 or later, the age is extended to 75.  RMDs are the minimum amount that must be withdrawn each year based on the owner’s age.   This applies to certain retirement accounts such as traditional IRAs, 401Ks, and Thrift Savings Plan.  The purpose of RMDs is to ensure that retirement accounts are eventually distributed and taxed.  This prevents them from being used as tax-deferred savings vehicles indefinitely.  The extension could allow for increased tax savings options by giving you an additional year (or 3) to perform Roth conversions or take distributions to draw down the account before it becomes mandatory.

2.  Tax credits for military spouse employers

There is a special provision for military spouse employers who offer retirement plan participation with immediate vesting or access within 2 months of hiring.  Employers can receive a tax credit of up to $500 for each military spouse.  This benefit will hopefully incentivize employers to offer retirement plan access to military spouses who often change jobs before they have met the requirements to fully participate in a company’s retirement plan.

3.  Reduced the penalty for missing a Required Minimum Distribution (RMD)

The SECURE Act 2.0 reduces the penalty for missing an RMD from 50% to 25%. If an individual fails to take the required minimum distribution from their retirement account, they were typically subject to a penalty equal to 50% of the amount that should have been withdrawn. Starting in 2023, the SECURE Act 2.0 reduces this penalty to 25%. It further reduces the penalty to 10% if the RMD is fixed within the “correction window.”  This change is intended to provide relief to individuals who may have missed an RMD due to unforeseen circumstances.

4.  Employer matches to Roth accounts

The new law allows employer matching contributions to be made to a Roth 401(k) or Roth 403(b) account. Currently, employer matching contributions can only be made to a traditional 401(k) or 403(b) account, which are funded with pre-tax contributions and are taxed as ordinary income when withdrawn. The SECURE Act 2.0 would allow employers to make matching contributions to a Roth 401(k) or Roth 403(b) account, which are funded with after-tax contributions and are tax-free when withdrawn if certain conditions are met. This change is intended to give employees the option to receive their employer’s matching contributions in a tax-free account, rather than a traditional account that is taxed as ordinary income when withdrawn.  Any employer money contributed to a Roth will be reflected as income to the employee for current-year tax purposes.

5.  Eliminates RMD requirements from employer Roth accounts

The RMD requirement for employer-sponsored Roth plans (Roth 401K, Roth 403B, Roth TSP, etc) will be eliminated in 2024.  This eliminates the disparity between Roth employer plans and Roth IRAs which do not have an RMD requirement.  It will allow employees who are happy with their plan to not have to roll over their accounts to Roth IRAs to avoid forced distribution.  This is great because it allows for continued tax-free growth.

6.  Increased the allowed contribution to a Qualified Lifetime Annuity Contract (QLAC)

The SECURE Act 2.0 increases the maximum contribution to a qualified longevity annuity contract (QLAC) to $200,000.  It also eliminates the maximum percentage of an individual’s retirement plan balance that can be used.  QLACs are a type of annuity that provides a guaranteed stream of income starting at an advanced age, such as 85 or 90. The purpose of a QLAC is to provide a guaranteed source of income in retirement, which can help individuals ensure that they have enough money to cover their expenses in old age. By increasing the maximum contribution to a QLAC, the SECURE Act 2.0 allows individuals to set aside more money for their retirement and provides them with the option to purchase a QLAC with a larger payout.

7.  Increased retirement plan catch-up contributions for those aged 60-63 starting in 2025

The law also increases the retirement plan catch-up contributions for those aged 60 to 63 in 2025. Currently, individuals aged 50 and over are eligible to make catch-up contributions, which are additional contributions above the regular contribution limit. The SECURE Act 2.0 increases the catch-up contribution limit for individuals aged 60 to 63 in 2025 from $6,500 to $10,000. This change is intended to give individuals in this age range the opportunity to save more for retirement and potentially make up for any shortfall in their retirement savings.

Additionally, catch-up contributions for higher-earning employees (currently above $145,000) must have contributions made to a Roth portion of the plan.  This will require these employees to use after-tax dollars for these contributions.

8.  Allows a 529 to Roth IRA rollover starting in 2024

The SECURE Act 2.0 allows for a 529 to Roth IRA rollover starting in 2024. Currently, 529 plans (education savings plans) can only be rolled over to another 529 plan or used for qualified education expenses. The SECURE Act 2.0 would allow individuals to roll over funds from a 529 plan to a Roth IRA tax-free.  The lifetime maximum transfer amount is $35,000.

9.  Allows for a $50,000 IRA Charitable Rollover to a Charitable Gift Annuity or Charitable Remainder Trust

The SECURE Act 2.0 creates Roth SEP IRA and SIMPLE IRA options. Currently, SEP IRAs and SIMPLE IRAs (retirement plans for small businesses) can only be traditional IRAs.  Traditional IRAs are funded with pre-tax contributions and are taxed as ordinary income when withdrawn. The SECURE Act 2.0 allows individuals to open a Roth SEP IRA or SIMPLE IRA.  These are funded with after-tax contributions and are tax-free when withdrawn if certain conditions are met.

10.  Student Loan Debt “Matching”

In 2024, employers can provide matching retirement contributions for employees who are making student loan payments.  Employees who weren’t able to pay down their loans and save for retirement will not lose the matching dollars from employers.

There are other many other more nuanced topics in the new law.  These are the ones I felt had the most applicability to the broadest population.  If you’d like to read more about some of the more nuanced topics like the expansion of annuities in retirement plans, improving the access to retirement plans for part-time employees, distributions for long-term care, or provisions around small business retirement plans check out this article.

If you have questions about how this impacts you and your retirement planning consider setting up a call with one of the MFAA advisors who can help you navigate all of these changes.  You can find them here.

Categories
Investing Taxes

New Year IRA Tips

New Year IRA Tips

New Year IRA Tips

Still want to save for retirement in 2022? You can!

Wait, what?  Did you say I can still save for retirement last year?

Maybe you arrived in January 2023 feeling like you didn’t make good on your 2022 goal to save more for retirement.  It was a rough year and keeping cash in the bank probably made a lot of sense while the economy did what it did in 2022.  Maybe you always had the cash, but you just didn’t have the discipline.  Or maybe you only just now have the cash and wish you could go back in time to contribute.  I have some good news for you:  you can still make annual retirement contributions to the 2022 bucket, in some cases even tax-deductible ones!

Am I too late to make a retirement contribution for 2022?

The good news:  you are not too late to contribute to your IRA for the 2022 tax year.  You may continue to contribute up to the annual maximum of $6,000 per year ($7,000 if over age 50) until the tax filing deadline [Monday, April 18, 2023].  This limit applies regardless of how much you have contributed to your employer-sponsored plan such as TSP, 401(k), 403(b), SIMPLE, and SEP-IRA.

The bad news:  Your employer-sponsored plan contributions for the 2022 tax year are over.  The deadline for annual contributions to your employer-sponsored retirement savings plan is always December 31 of the year.  Your employee contribution to these types of plans must come directly from your paycheck each month.  You cannot write a check or initiate a transfer from your bank account to be deposited into an employer-sponsored plan.  This means any deductions from your pay toward those accounts after January 1st of the new year are now counting toward the new year’s limit.  TSP, 401k, and 403b accounts have a new annual limit for 2023: $22,500 per person and an extra $7,500 “catch-up contribution” for those over age 50 ($30,000 total).  For a SIMPLE account, the limits are $15,500 (under 50) and $19,000 (50 & over).

How do I make sure my contribution will count for 2022 if it is already 2023?

Nearly every investment custodian has provisions for designating the tax year for your contribution during this “in-between time” when two years are possible.  When you sign-in to an online account to contribute, you should see both the 2022 and 2023 tax years listed, along with your allowable contribution based on age and the amount you have contributed so far to each of those tax years.

For instance, Captain Sue Savemore is 30-years-old and made an $800 contribution to her Roth IRA in June 2022.  When she logs in to her online account information, it says she can still contribute $5,200 for 2022 ($6,000 – $800) and the full $6,500 for 2023.

There will be a place to designate which tax year and how much she wants to contribute.   She would enter the amount she wants to contribute in the space for the 2022 tax year, up to the available remaining limit for 2022.  If she wanted to contribute more than $5,200, she would need to enter any further amount as a 2023 contribution.

So, if Captain Sue Savemore has $7,000 sitting in her bank account and wants that full sum to go to IRA contributions, she would put $5,200 in the designated space for the 2022 contribution and $1,800 in the designated space for 2023 contribution.

Why do I want to make a 2022 IRA contribution now?

You may be asking yourself why you would want to make 2022 contributions instead of 2023, especially if you are someone who does not typically “max out” their IRA each year.  Filling up the bucket whose window of opportunity is closing (2022) preserves your full capacity to save in the bucket that has the longer window of opportunity (2023).

Consider these scenarios:

  1. You or your spouse have a job where you regularly “max out” your employer’s plan (make the maximum allowable contributions as listed above).  You know and appreciate the value of saving early for retirement.  However, you do not have enough cash flow to also max out your IRA each year.  Then you find yourself leaving a job in 2022 and moving to an employer who does not have a retirement savings plan.  By contributing to the 2023 IRA right now and leaving the 2022 bucket unfilled, you have just robbed yourself of some of your capacity to save.
  2. You may find yourself in a situation with an unexpected raise or bonus or other windfall later in 2023 and want to earmark it all for playing catch-up with retirement savings.  Again, if you leave your 2022 bucket less than full and start using up the capacity in your 2023 bucket, you just shorted yourself on that opportunity.

Does it matter if the contribution is Roth or Traditional?

The remaining 2022 contribution amount can be either Roth or Traditional, no matter what you may have already contributed in 2022.  The annual limit applies only to the total IRA contributions, not the tax treatment of the contribution.  Back to our example using Captain Sue Savemore:  if she should decide she wants to make the remaining 2022 contribution of $5,200 to a Traditional IRA, that is perfectly OK.  If she did not already have a Traditional IRA account, she could open one and fund it before the tax deadline and it would still count for the 2022 tax year.  Her combined contribution for 2022 would be $800 Roth + $5,200 Traditional = $6,000 annual limit.

How do I choose between Roth to Traditional contributions?

One of the beauties of making an IRA contribution late in the tax year is that you have a better sense of your tax scenario for that year.  Choosing between Traditional or Roth tax treatment most often depends on your expected marginal tax rate.  [if you need a quick primer on this, see this video from a recent Military Saves campaign, produced by yours truly].

However, there are two more decision points to consider when making IRA contributions:  (1) whether or not you are covered by an employer’s plan, and (2) what you modified adjusted gross income (modified AGI) is expected to be.

First, let’s define “modified AGI”.  This definition can be found on the IRS website:

“For most taxpayers, MAGI is adjusted gross income (AGI) as figured on their federal income tax return before subtracting any deduction for student loan interest.”

This means that for most military families, if your income has stayed more or less the same in 2022 as it was in 2021, look back at your 2021 tax return, line 11 and add in any amount found on Schedule 1, line 21 to get a rough guess on your modified AGI.  You can take a look at your 2022 W-2(s), add interest, and do a quick calculation of your modified AGI using this free 1040 tax calculation tool found on the Office of Financial Readiness website – a great educational resource for servicemembers on a whole host of financial topics.

If you are COVERED by an employer sponsored plan, your ability to make a tax-deductible Traditional IRA contribution is limited.  Being “covered” is not the same at “participating”.  Every servicemember is covered by an employer plan (TSP), whether they have ever contributed any money or not.  If you are covered, then these covered employee IRS limits will tell you if your contribution is deductible.

Looking back at the example of Captain Sue Savemore:  In 2022, Sue is a “single” tax filing status.  With eight years of service as an O-3, her taxable income for 2022 was $81,684.  This puts her above the limit for single taxpayer ($78,000 MAGI) and unable to make a tax-deductible Traditional IRA contribution, even if she did not contribute a single dollar to TSP.

So now you are thinking, “well, just make a Roth contribution instead, since Roth contributions are not tax deductible anyway.” This would be an equivalent tax situation, and Roth contributions are not limited by coverage under an employer plan.  The only limit on Roth contributions would be her MAGI.  Thankfully, that MAGI limit is higher for single Sue ($129,000 for 2022), and she could indeed make the full Roth contribution for 2022.

But what if Sue had gotten married and were “married filing jointly” tax status for 2022?  And what if she were marrying Barry Businessman, who separated from service in 2021 and had almost no income in his new business in 2022?  Maybe Sue and Barry could use a little more cash flow right now but still want to save for retirement.  Even though Sue is still covered by an employer plan, the deductible IRA contribution limit for married filing jointly is much higher, $109,000.  And the good news for Barry is for some time to come, he will be able to make tax-deductible contributions due to different IRS limits for those who are NOT covered by an employer plan.

But what if these IRS limits exclude us from ANY kind of IRA contribution?

Is there some loophole?  I really want to save more!  (this is music to any CFP’s ears)

Yes, there is a little loophole called a Backdoor Roth IRA.  If you are seeking to create more tax-free income in retirement but are a high-income earner with limited means of doing so, this could be a good strategy.  The simplest explanation of the process is:

  1. Make a non-deductible 2022 contribution to a Traditional IRA account.  This contribution should be reported in your 2022 tax return on Form 8606.  There is no MAGI limit or employer plan limitation for NON-DEDUCTIBLE contributions.
  2. Do a “Roth conversion” of the contribution.  A Roth conversionrefers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA.  This could be a taxable event if you have a balance in the Traditional IRA from previous deductible
  3. The IRA custodian will report the “recharacterization” on form 1099-R for the 2023 tax year.
  4. When you file your 2023 taxes, you will include the information from the 1099-R on good ole Form 8606 again.

NOTE:  this is an extremely simplified explanation of the Backdoor Roth.  Please discuss this option with your tax pro and/or financial planner before taking any action.

Whew, many details, lots of things to consider! If you need to talk this over with a financial professional, please check out the list of MFAA professionals on the website.

Happy savings!

Categories
Financial Planning Taxes

End-Of-Year Planning Checklist

End-Of-Year Planning Checklist Pg 1

If you’re like me, you’re probably thinking how can it be December?  Where did 2022 go?  Before we turn the page to 2023, there could be some actions you could take to improve your financial situation.  The major categories are assets and debts, tax considerations, cash flow and timing, insurance, and estate planning.  I’ll walk through the common things that could apply.  I’ll also encourage you to download the PDF of this 2-page End-Of-Year Planning Checklist to run through the whole thing.

Assets & Debt Issues

  1. Unrealized investment losses in your taxable accounts – Let’s face it…2023 has been a brutal year for investors. Tax loss harvesting is the selling of investments that are now below what you paid for them. This can be used to offset other taxable investment gain.  You can also write off up to $3,000 per year against your income if losses are larger than gains.  This can be a great strategy in down markets.  [There specific rules regarding selling and buying the same or very similar securities called the wash-sale rules.  Make sure you understand this or talk to a financial professional]
  2. RMDs – Ensure you are taking any required RMDs. This could be for your own account if you’re 72 or older or you have an inherited IRA.  The IRS recently proposed new rules for inherited IRA distributions based on the 10-year rule in the SECURE act.  This has created some confusion because they aren’t official at this point (11/2022).  Again, consult a financial professional if you’re in this situation.

Tax Planning

  1. Income Changes – Are you approaching military retirement? Are you planning to work after?  If so you’re income and tax bracket may increase significantly.  If so, it may make sense to contribute to a Roth IRA or Roth TSP while your income is lower.Are you approaching your ultimate retirement?  Will your income drop in the future?  If so, that can be a great time to defer taxes by using a Tradition IRA or retirement account.  This can be especially powerful if you’ll have lower income years where you can convert from a Traditional account to a Roth.
  2. Charitably inclined? – The standard deduction has increased significantly.  This limits your ability to itemize taxes.  You could consider charitable contribution stacking or bunching.  I posted this example on LinkedIn you could check out if interested.

Cash Flow

  1. Increasing savings – The maximum salary deferral to an employer plan is 20,500 plus the over 50 catchup of $6,500 for 2022.  You’ve got limited time to make changes for this year, but next year this increases to $22,500 and the catch up goes to $7,500 so if you’re maxing out your contributions know you’ll have to increase your withholdings next year.
  2. 529 Accounts – You can use your annual gift exclusion to contribute up to $16,000 to a beneficiary’s account tax free.  This can be a great option for grandparents who want to help out their grandchildren.

Insurance Planning

  1. FSA – Make sure you spend any FSA funds or see what your employer has for options.  This might include a partial rollover of funds to next year.
  2. Health Insurance Deductible – If you’re over your deductible, consider whether incurring other medical expenses this year makes sense before your deductible resets.

Estate Planning

  1. Annual gift exclusion – Gifts up to the annual exclusion amount of $16,000 (per donor, per year, per donor) are tax free.  A couple could gift $32,000 to a child tax free.

College Planning

  1. Financial Aid and Taxes – Do you have a high schooler?  It’s important to know what year your tax return will be used for filing the FAFSA.  This can get confusing because school years don’t line up with tax years.  The FAFSA uses taxes filings from the year the student starts their junior year.  Since that’s September, the tax year starts in January of the sophomore year.

The end-of-year planning checklist has other considerations tax bracket thresholds, significant windfalls from stock-based compensation, business expenses, FSAs, etc. that might apply to your specific situation.  Some of these things are complex and nuanced.  This isn’t tax or legal advice so make sure you consult with your tax professional.

If you need help building a plan around any of these items the advisors at MFAA are available to help.  Check out their profiles here and schedule a meeting to make 2023 your best year ever.

Categories
Military Pay Military Retirement Taxes

Is My Military Retired Pay Tax Free if I have a VA Disability Rating? – NO!

Military Retirement Tax Free

Is My Military Retired Pay Tax Free if I have a VA Disability Rating? – NO!

 

Every year I have a handful of clients ask me if their military retired pay (a.k.a. pension) is tax free because they have a disability rating from the Department of Veterans Affairs (VA). When I ask why they believe their military pension is not subject to taxation they forward me “the email.” It is semi-official looking and seems to be from someone who ought to know what they are talking about. The email cites an IRS publication and sometimes (depending on which version you get) a court case.

 

It’s all twaddle. Your military retired pay is taxable income.

 

Like everything involving tax rules there are exceptions to the general rule. That is doubtless where the confusion originates. “The email” makes it seem like many more veterans qualify for the exception than do. The simple test to apply is this – do you have a written determination from the VA or your branch of the service specifying that your disability is combat-related. If that answer is ‘no” then you are paying taxes on your military retired pay. (If the answer is “yes”, you might still have to pay taxes on it, but you have no hope of being tax free without that official determination.)

 

Until recently I had to provide a long explanation to recipients of “the email,” some of whom ardently believe their retired pay was not taxable because they had a VA disability rating. I would have to explain that the court case did not apply, that IRS publications are not legally authoritative, and that the passages cited are being taken out of context. The explanation got much shorter recently, as one veteran took her case to the US Tax Court. The judge ruled against her, and his explanation sheds some light on the tax status of military retired pay.

 

You can read the full Tax Court Memo here.

 

T.C. Memo 2022-42; Tracy R. Valentine v. Commissioner filed April 28, 2022

 

Valentine is an Army veteran who was honorably discharged in 2002 after 22 years of active duty service. She had a disability rating of 60% that was increased to 90% effective May 1, 2016. For the first 4 months of 2016 she received VA disability payments of $1100 per month. For the remaining 8 months of 2016 she received $1700 per month in VA disability payments. The IRS does not dispute that these payments from the VA are tax free (excluded from income).

 

Valentine also received $23,801 from her Army-based retirement plan in 2016. She received a form 1099R from DFAS, reporting the entire amount as taxable. When Valentine filed her 2016 tax return she reported the taxable income from her military pension as $3,158, excluding the remaining $20,643 as not taxable income. The IRS disputed her claim that part of her military pension should be excluded from income and issued a Notice of Deficiency (NOD). Valentine exercised her right to challenge the NOD and petitioned the Tax Court for relief.

 

At Tax Court Valentine testified that IRC Section 104(a) and 104(b) entitle her to use the VA disability rating to exclude both the VA disability payments and a portion of her military pension from taxable income. Valentine represented herself at Tax Court and did not cite specific sub-paragraphs of the IRC to support her claim.

 

In his ruling Judge Gustafson provided some analysis of the tax code. There are two separate provisions in the tax code that could render a veteran’s military retired pay excludible from income. Under section 104(b)(2)(C) a veteran may exclude a portion of the distributions from income if they qualify as “amounts…received by reason of a combat-related injury”. Valentine did not provide any testimony or evidence at trial to indicate her disability rating was combat-related. Therefore section 104(b)(2)(C) does not apply.

 

The other provision is contained in section 104(b)(2)(D). A veteran may exclude a portion of the distributions from income equal to an amount they “would be entitled to receive as disability compensation”. There is legislative history supporting the court’s interpretation of this to mean that it does not apply if one is already receiving disability compensation from the VA. As Valentine was already receiving disability compensation from the VA, section 104(b)(2)(D) does not apply.

 

The Bottom Line

 

Bottom line: The US Tax Court ruled all the retirement distributions Valentine received are “properly includible in her gross income”. Military retired pay cannot be excluded from income solely because one has a VA disability rating. Valentine was also subject to penalties and interest on the tax owed for not reporting the income on her 2016 tax return.

 

I have had clients contact DFAS, explain they have a VA disability rating, and request the tax withholding on their military retired pay stop. When DFAS stops the withholding the veterans assume DFAS agrees that the pay is not taxable. That is not true. It simply means that DFAS will stop tax withholding on your military retired pay if you request it. When the 1099R is issued it will state that all the retired pay is taxable. Since the IRS also receives a copy of your 1099R, they will expect you to declare it on your individual income tax return and pay taxes on it. If you don’t, they will issue you a Notice of Deficiency and charge you penalties and interest for failing to report it.

 

I am a veteran with a VA disability rating. I want my military retired pay to be tax free. I am also a tax professional. If my military retired pay was tax free I’d know about it. If our military retired pay was tax-free I would be writing about it. My colleagues would be writing about it. The VA, VFW, DAV, and the American Legion would all be writing about it. The IRS would have pages of FAQs about it. You wouldn’t find out about it through an old forwarded email that tells a story too good to be true.

 

If you still have questions, the Military Financial Advisor’s Association has both tax professionals and financial planners with tax planning expertise that can help with your unique situation.

 

 

 

 

Categories
Investing Taxes TSP

Which is Better—A Roth or a TSP?

Roth Versus TSP

Which is Better—A Roth or a TSP?

If my math is correct, half of the readers of this article’s title are about ready to blow up my inbox, half would just like to know the answer, and half haven’t read this far.  Clearly my math isn’t correct, but let’s dive into this question, and the real question that’s usually behind it— “Which is better—Roth or Traditional?”

If you’ve been in the military for a minute, you probably have heard that question, “Which is better—a Roth or a TSP?”  It comes from the very real confusion cluster that is the financial world.  Few primary schools teach personal finance and the topic is at best optional in college.  Most of us learn it through trial and error if we learn it at all.

The answer to the question “Which is better—Roth or TSP” is the same as the answer to “Which is better—Tesla or cars?”  There’s no direct comparison because one is a subset of the other.

TSP Basics

Let’s start with the TSP (Thrift Savings Plan) which is an employer-sponsored, qualified (read: tax advantaged) retirement savings plan.  It’s similar to civilian 401(k) plans (Which doesn’t mean much if you’re still back at the Roth or TSP question, I know).  The TSP allows you to defer part of your paycheck each month, receive preferential tax treatment, and grow the dollars through compounding until you need to use them in retirement.

If you joined the service after 2017, then you’re eligible for the government to match your contributions up to 5% after 2 years of service—which is free money!

The TSP limits your contribution to a certain amount each year based on IRS guidelines and it’s $20,500 in 2022.  Participants over age 50 can contribute an extra $6,500.

What is Roth?

Roth is the last name of the senator that sponsored the legislation creating Roth retirement accounts.  Roth is a synonym for “after-tax,” meaning that you’ll pay your typical income tax on the dollars that you contribute to a Roth account such as the Roth TSP.  The benefit of Roth treatment is that contributions grow without being taxed each year.  Then in retirement (generally after age 59.5), you get to access those dollars tax-free.

Roth treatment is incredibly powerful in that it allows savers to pay a generally low tax rate on dollars when they’re young or in the military and not making much and then avoid higher tax rates in retirement when their tax rates are higher after a lifetime of earning and saving.

Roth treatment can also be though of as “tax insurance.”  We don’t know what future tax rates will be.  Many experts predict that they will have to be higher to afford programs like Medicare and interest on the national debt.  Roth dollars won’t be taxed in retirement, so savers can mitigate future tax risk.

What is Traditional?

Before Roth came along, there was just “TSP” and no need for the adjective “Traditional.” Traditional is a synonym for “pre-tax” or even “tax-deferred.”  With a Traditional retirement account like the TSP, savers skip paying taxes on the contributions as the money is earned, but have to pay taxes when they access the money in retirement after age 59.5.

Savers are allowed to contribute to either or both Roth and Traditional “sides” of their TSP account in a given year, but they can’t exceed the IRS limit unless they’re in a combat zone.  I.e., you can put $10,250 into Roth TSP and Traditional TSP in 2022, but you can’t put $10,251 into both.

Which is Better—Roth or Traditional TSP?

Now that we’ve got the right question squared away, we’ll look at the indigestible answer… it depends.  The most general way to start answering this question for each taxpayer (or family if filing jointly) is to ask, “Do I want more money in my pocket this year, or in my retirement years?”

A contribution to the Traditional TSP puts extra dollars in your wallet this year.  If you’re in the 22% bracket and you contribute $1,000 this year, you’ll have $220 extra in your pocket because you deferred the tax bill until sometime in retirement.

Moving past the most basic question, some families will want to evaluate, “Am I in a temporarily higher tax bracket this year?” Let’s say you receive a large bonus and will have outsized income in a certain year.  It might be appealing to hold on to more of your pay by making Traditional contributions in a high-income year.

An even more sophisticated approach would be to evaluate whether a Traditional contribution might lower your tax bracket for the year.  For example, in 2022, the cutoff between the 12% tax bracket and 22% bracket for a married-filing-joint couple is $83,550, which is really $109,450 after adding the $25,900 standard deduction.  If income before a TSP contribution is $109,450 and the planned TSP contribution was $5,000, then taxable income becomes:

$109,450 – $5,000 – $25,900 = $78,550

$78,550 is squarely in the 12% tax bracket and the tax savings on the year is $600.  So, by choosing to put at least part of the TSP contribution into the Traditional “side,” it’s possible to lower one’s overall tax bracket and tax bill.

Dialing up the sophist-o-meter a bit, let’s address capital gains.  Capital gains tax is the tax we pay when we sell something for more than we paid for it.  If you sell a stock at $100 per share, but you paid $50, then you have a $50 capital gain per share.

Uncle Sam taxes capital gains in one of two ways—long-term or short-term.  Long-term capital gains receive preferential treatment in that they’re taxed at 0%, 15%, or 20%.  These are lower than ordinary income tax rates for most people paying capital gains tax.  Short-term capital gains are taxed at ordinary income tax rates.

It just so happens that the cutoff between the 0% and 15% long-term capital gains brackets is $83,350 for a married-filing-joint couple…essentially the same as the 12% to 22% transition for ordinary income.

The “so what?” is that by using a traditional TSP contribution to lower taxable income into the 12% bracket, one also can take advantage of the 0% long-term capital gains tax bracket.  If you have stock with capital gains and need to sell some for a goal, you can do so right back up to the top of the 0% long-term capital gains bracket and pay $0.00 on those gains!

The Real Question

While it is important to evaluate the tax opportunities in a given year to assess Roth versus Traditional, the real question is this, “Am I in a higher tax bracket today, or will I be in a higher tax bracket in retirement when I access my TSP savings?”

Let’s say you’re in a 25% bracket this year and you also expect to be in a 25% bracket in retirement when you withdraw money, then there is no mathematical difference between Traditional and Roth TSP.  Want proof?  Plug the following formulas into Excel.

  • =FV(0.1,30,-1000,0,0)*0.75
  • =FV(0.1,30,-750,0,0)

The first is the future value of pre-tax contributions of $1,000 compounding for 30 years at 10% and then taxed at 25% upon distribution in retirement.

The second is the future value of after-tax contributions of $750.  We use $750 to model the effect of a 25% tax as the money is earned.

They both return $123,370.52.  But there’s a hidden twist here—would you really contribute less just because you had to pay tax on the dollars as you earned them?  Probably not.  Most of us will find a way to contribute the same amount regardless of the tax in the year of the contribution.

Thus, =FV(.1,30,-1000,0,0) = $164,494.02 and we can see that we end up with a significantly increased nest egg for choosing Roth.

But how do you know what tax bracket you’ll be in during retirement?  The reality is you’ll need a crystal ball, time machine, or other imaginary tool.  We can only make estimates.  Estimating our income, spending, and savings seems daunting, but it’s likely the easy part.  Estimating future tax rates, including state income tax rates is a bit more difficult.

A common technique is to just use current tax law and then revise projections as tax law changes.  Using that method, let’s look at Figure 1. This example illustration incorporates a family’s projected income, savings, and spending over their remaining life time.  The result is that we can see that the family will pay tax rates from the mid 20% range until retiring early at age 55.   At that point, the expected tax rate is 15% until age 70 when Social Security kicks in and creates a new income floor and higher tax bracket.

Roth versus Traditional 1

This family has a couple of options.  By contributing to Traditional accounts pre-retirement, they can hope to Roth-convert some or all of their Traditional dollars during their low tax years.  They would skip paying 22% to 25% in hopes of paying 15%.

Any Traditional dollars remaining after age 70 would, at-worst, be taxed at about the same rate they would have been at the contribution.  This choice requires an estimation not just of earning, saving, spending, and tax rates, but also how many dollars can be Roth-converted during the early-retirement window before ending right back up in a higher tax bracket.

If instead, the family contributes to Roth accounts prior to retirement, then several additional considerations arise:

  • From age 55 to 70, there could be a missed opportunity to “fill up” low tax brackets like 15%. The family might have unnecessarily paid 25% on some dollars.
  • After age 72, Roth IRA dollars don’t have to be distributed, but Traditional dollars do. These “Required Minimum Distributions (RMD)” create a higher income floor.  (Note that Roth TSP/401(k) accounts do have RMDs.  Roth IRAs don’t. Most people will rollover their Roth TSP/401(k) to an IRA prior to RMD age.)

Figure 2 shows a different family’s profile.  Prior to retirement at age 67, the family earns in the mid-20% to low-30% tax rate range.  They have a small “bathtub” from age 67 to 72 where they can do Roth conversions, but after that, they’ll be trapped in the 30%-plus range for their remaining years.

Roth versus Traditional 2

This family would likely want to mainly contribute to Roth accounts in order to minimize the impact of a high-income floor in retirement.

You can imagine that slight changes in a family’s planned earning, spending, saving, and estimated tax rates have drastic effects on their future tax profile.  This brings us to the key questions that we must answer to make the Roth versus Traditional decision:

  • Do I need extra cash in my pocket this year? Is it worth the risk of higher taxes later?
  • Can I change my tax bracket with a Traditional contribution this year? What benefit do I gain?
  • Do I expect my tax rates to be higher or lower in retirement?
    • If higher, more Roth dollars are your friend.
    • If lower, you leave a tip for the tax man by contributing to Roth today.
  • Do I generally think tax rates will be higher in the future? Roth contributions are an insurance policy against those tax rates.

Cleared to Rejoin

The Roth versus Traditional decision can be complicated.  We have to decide if we want more income this year, or lower taxes in a few decades.  To be as accurate as possible, we need to have reasonable estimates of our lifetime earnings, saving, spending and tax rates.  Ultimately, we have to answer, “What is the effect this year… and all of my retirement years?”  That’s no small task.

A few additional concepts to consider may help:

  • The current tax brackets are very low by historical standards, implying higher rates at some time(s) in the future
  • Interest on the national debt and support of Medicare for the Baby Boom generation will require higher government revenue in the coming years.
  • 30 years after you contributed, are you likely to regret having estimated wrong by a couple percent on your future tax rate, or are you more likely to really like that a sizeable chunk of your retirement income is tax-free?

Fight’s On!

 

Author’s Note:  This article focused almost exclusively on Roth versus Traditional for TSP (and 401(k)) contributions.  There’s a good deal more to know about IRA considerations, so please don’t extrapolate Roth TSP directly to Roth IRA without diving into the nuances.

Categories
Taxes

2021 Tax Updates

Understanding 2021 Tax Updates

(before you file your taxes)

This meme pops up in my social media feed from time to time: It’s clever and a bit funny, but the sad truth is that it would be pointless to teach the specifics of taxes in school. Unlike parallelogram rules, tax rules change every year. Things we learned in high school that might be helpful during tax season would likely be superseded before we finished our first semester in college. In this age of activism and immediate results, our Congress just can’t help themselves. They must legislate! This year was no different. There are numerous changes to the tax laws for 2021. Some you likely know about, others you might not. Here I will cover the handful likely to impact a significant portion of military and veteran families.

Child Tax Credit

Congress made several changes to this popular tax credit. They expanded it, changed the age range, made some of it payable in advance, and made it fully refundable without restrictions. Here are the details
  1. The maximum credit was expanded from $2,000 to $3,000 ($3,600 for children under 6.) There is an AGI limitation on this expanded amount. The expanded amount begins to phase out above AGI of $150,000 for married couples filing jointly, $112,500 for taxpayers filing as head of household, and $75,000 for all other filers. (The unexpanded (regular amount – $2,000 begins to phase out at $400,000 AGI for married couples filing jointly.)
  2. Qualifying children under the age of 18 are eligible for the credit. (In prior years it was qualifying children under the age of 17.)
  3. Part of the 2021 Child Tax Credit was eligible to be paid as an advance. The default was for the IRS to pay 1/12th of the estimated 2021 credit each month to taxpayers from July to December of 2021. You may have received checks or direct deposits to your bank account. Or you may have elected out of some (or all) of the advanced payments. Either way, you will need to rectify the amount of Child Tax Credit for which you are eligible with the amount of Advanced Child Tax Credit already received to determine how much more Child Tax Credit you will receive at the time you file your 2021 federal tax return. The IRS should send you a letter 6419 telling you how much Advanced Child Tax Credit you have received. Verify this letter against your records to ensure they match. Then keep the letter for tax prep time!
  4. The 2021 Child Tax Credit is fully refundable for all taxpayers. In prior years the refundable portion was limited and subject to earned income restrictions. This year it is fully refundable.
The enhancements to the Child Tax Credit were made as part of emergency / pandemic legislation, and are therefore temporary. These enhancements all expire at the end of 2021. Many lawmakers have expressed an interest in extending these enhancements into 2022, but as of this posting, this has not yet happened.

Child and Dependent Care Credit (Child Care Credit)

In past years this credit has likely drawn more sighs and eye-rolls than any other. The government has long admitted child care (or care for a disabled dependent) was necessary for taxpayers to work. Then they offered a ridiculously small credit in comparison to the actual costs actually of such care. Only $3,000 of expenses from one, or $6,000 for multiple dependents were qualifying expenses. A mere fraction of the real-world costs. Then, anyone who earned enough to actually pay those expenses could only claim 20% of the qualifying expenses as the credit. Essentially you got $600 for one child, $1,200 for 2 or more children. In 2021 this credit got significantly beefier. Eligible expenses grew to $8,000 for one dependent, $16,000 for two or more. The income ranges on the percentages grew even more dramatically for most families, with a new top rate of 50%. If you have 2 or more dependents, your child care credit might have grown from $1,200 to $8,000 in 2021! Additionally, in 2021 this credit is refundable for the first time. These Child and Dependent Care Credit enhancements were a big win for working families. They are also only temporary but may be extended or made permanent by subsequent legislation.

Student Loan Debt Cancellation

Money that is borrowed, but not repaid, is treated as income, and subject to income taxes under our tax laws. There are a few exceptions to that general rule, and starting in 2021 you can add student loan debt to that list. If you have student loan debt forgiven, charged off, or otherwise canceled in 2021, it may be excluded from income on your 2021 tax return. This applies to nearly all legitimate student loan debt, whether it was government-backed or private. This law applies to student loan debts canceled between 2021 and 2025.

Assorted Others

Two rules that were in effect for last year, but are hanging around for this year are worth reviewing. The first is the Recovery Rebate Credit. This is the credit you receive if you did not receive your Economic Impact Payment (“stimulus check”), or did not receive the correct amount of Economic Impact Payment. All taxpayers need to know the amount of Economic Impact Payments received in 2021 (round 3 of the stimulus, issued in late March/early April) because this amount is used to calculate your Recovery Rebate Credit. If you don’t remember, the IRS will send you letter 1444 to remind you, or you can log into the IRS website (after you prove your identity) and check it yourself. Spouses filing jointly will both need to check their tax accounts to get the entire amount the IRS sent. The other is the expanded charitable deduction. In 2020 taxpayers could deduct $300 of charitable contributions (cash only, not donated items) in addition to the standard deduction. This is in effect again for 2021, but with a couple of modifications. First (and best!) is that married couples filing jointly can now deduct up to $600 of charitable contributions in addition to the standard deduction. In 2020 they were limited to just $300 per return. Secondly, the deduction is a deduction this year and not an adjustment. In 2020 the deduction was an adjustment to income, which would reduce adjusted gross income (AGI). (Often called an above-the-line deduction.) In 2021 the expanded charitable deduction comes after AGI is calculated. Since it no longer reduces AGI, this deduction no longer helps make you eligible for other AGI-based tax credits and benefits.  In trying to do the right thing for America, Congress often injects a tremendous amount of complexity into the tax code. This year was no different. They heaped tax breaks on us, but they also heaped a mountain of paperwork on the administration of those tax breaks. Military and veteran families enjoy targeted tax benefits, but they should also make sure they are taking advantage of the tax benefits available to all Americans. If you are unsure of your eligibility for a tax benefit, or how to take advantage of it, please consult with a tax professional familiar with military and veteran tax issues.
Categories
Financial Planning Goals Insurance Military Pay Military Retirement Savings Taxes

Military Retirement: Should You Take SBP?

Military Retirement - Should you take SBP

Military Retirement and the Big SBP Decision

This article was jointly written by Adrienne Ross, CFP ®, AFC ®, and Pam Bergeson, CRPC

As you’re working your way through your pre-retirement checklist, you may have discovered a couple of decisions that you need to make before you out process one last time from the military.  Of all these decisions, none is more important or more permanent than your decision to accept or decline the military’s Survivor Benefit Plan (SBP).

This blog dives into some of the most common questions about SBP and shares a few examples of when the SBP can be most useful.  It also addresses some of the common myths surrounding the military’s SBP.

What is the Survivor’s Benefit Plan (SBP)? 

The most important fact to know about the amazing military pension you’ve earned during your 20+ years of service is that it ends at your death.  The only way to ensure your spouse and/or your dependents continue to receive a portion of your retired pay is to sign up for the Survivor Benefit Plan.

In the event you pass away before your spouse or your dependent children, SBP continues to pay an inflation adjusted monthly benefit, known as an annuity, to your survivors.  In the case of your spouse, the annuity continues until their death or remarriage in some instances.

What may surprise you is that while you’re on active duty, you’re already covered by SBP at no cost.  If an active duty service member dies of a service connected cause, their survivors are covered by the Survivor Benefit Plan.

Of all the decisions you’ll make at retirement, the SBP election is the most critical because it is largely irrevocable.

Why is your SBP decision so critical?

The exact decision comes in the form of either accepting or declining SBP in the weeks before your final out processing.  If you’re married and decide to decline SBP or accept less than the full SBP benefit, your spouse will need to sign off on that decision during your out processing. The rationale behind requiring your spouse’s concurrence is he or she has the most to lose if you decline SBP.

If you decline SBP, it is very unlikely that you’ll ever have a chance to regain it, your decision is final.   On the other hand, if you elect to accept SBP, you will have an opportunity to discontinue it during the period between 25-36 months after your retirement.  To be extra clear – this window of opportunity to change your mind in your third year of retirement is a one-way decision – exit only.  You can only choose to discontinue SBP, you cannot regain access to SBP.

The only other opportunities to change your SBP decision occur when you have a qualifying major life event that changes the status of your dependents.  The death of your spouse, marriage to a new spouse, or the birth/adoption of a child are examples of potential events that could trigger a short window to change your SBP decision.  The rules surrounding these life events and which ones do or don’t trigger an opportunity to add SBP coverage are complicated and require detailed information to understand fully.

The decision to accept or decline SBP is unique to each service member and their family.  Because there are so many important variables to consider, it is vital to make your own decision with your family’s specifics in mind rather than simply following the decisions of your peers.

Your SBP decision requires careful consideration of your family’s make-up including your ages, age differences, health status and each spouses’ earning potential along with your children’s ages, health, and educational goals, and finally your spouse’s financial interests.  We take a closer look at many of these variables in the next few paragraphs.

Why do you need SBP?

If your family depends on your income, then your decision on SPB is critical to your financial plan.  

If you’re married or have dependent children, chances are they rely on your military pension for a portion of their monthly living expenses.  If your family depends on both your post retirement civilian income and your military retirement income to cover their living expenses, the impact of your passing would be even more devastating.

If your spouse’s lifetime earnings have been hindered by multiple military moves over the course of your military career, they most likely have accumulated fewer retirement assets of their own.  In this case, the SBP annuity may prove even more important in providing long term security to your family.

As difficult as it is to imagine, you must ask yourself if your family had to live without you, and without your civilian income and your military pension, could they pay the mortgage or rent, would your family be able to afford college tuition, and would your spouse have sufficient income to cover their living expenses well into retirement and old age?

What’s so special about SBP?

In today’s retirement savings environment, pensions are rare; a pension with a cost of living adjustment is like finding a unicorn.

Inflation protected.  Your military pension and its survivor benefit are that rare unicorn.  Your military pension adjusts each year to keep up with inflation and your SBP will continue to do so as well.  SBP ensures your survivors continue to benefit from your decades of dedicated service through continued payments from your inflation-adjusted pension.

As the cost of living increases, so does the SBP payment to your survivors.  For example, if your spouse lives twenty years longer than you, the value of their SBP annuity will keep pace with inflation over those two decades.  A payment of $1000 in 2021 could more than double over the course of your spouse’s lifetime.

SBP eliminates two of the most significant risks a widow or widower faces – longevity risk and inflation risk.  

Risk management. Longevity risk is the risk that your surviving spouse will outlive the money you’ve saved for retirement.  With SBP, you don’t have to worry how long your surviving spouse will live, the payments continue as long as he/she is alive, or in some cases, until he/she remarries.

Inflation risk is the risk that the value of the money you’ve saved for retirement won’t keep up with the cost of living over the decades after you retire.  The SBP payments increase each year commensurate with the national inflation rate.  This increase ensures the payment your spouse receives can still cover key expenses as their costs increase.

A third type of risk avoided with SBP is default risk. Default risk is the risk that your life insurance or annuity provider will run out of money or go out of business before paying all the payments they’ve promised you.  Because the SBP is backed by the US Government, the risk of default is nearly zero.

Pre-tax premium.  Beyond eliminating risk in your long-term retirement plan, your SBP premium is paid before your taxes are calculated, meaning the amount you pay is lower than it appears.  For example, if your SBP premium is $300 per month and you’re in the 15% tax bracket; your pre-tax SBP payment is only $255.  For more senior retirees the benefit of SBP’s pre-tax premium is even greater.  A $800 SBP premium for someone in the 28% tax bracket only costs the retiree $576.

Are there situations when I don’t need SBP?  

There are certainly a few examples of situations where you might not need SBP.  First, if you don’t have anyone depending on your income, no spouse or dependent children, you likely don’t need SBP.

If you’re a dual military couple without dependents who’ve earned very similar military retirement benefits, you may not need SPB, or you may be able to take less than the full SBP rate and still cover your future expenses.

This isn’t true of all dual military couples.  When a dual military couple has substantially different career lengths and where there is a significant difference in rank at retirement between the two service members, the SBP decision is less straightforward.

The same comparison is true if your spouse has their own pension through their civilian employer.  Or if the non-military spouse has higher life-time earnings and retirement savings that set them up for a self-sufficient retirement.

What are some special considerations with SBP?

Special needs. If your retirement income will support a dependent with special needs you may want to designate a special needs trust to receive your SBP benefits instead of passing directly to the special needs child, so as not to negatively impact their access to other government benefits.  If this situation applies to you, you’re advised to work closely with an attorney who specializes in special needs trusts in advance of making your SBP election.

Divorce.  If you’re divorced, your former spouse may have a legal claim to a portion of your pension and therefore a court order could require you to obtain SBP coverage.  Learn more about these requirements at this link. https://militarypay.defense.gov/Benefits/Survivor-Benefit-Program/Costs

Reserve Component. The rules for Guard and Reserve retirees differ slightly in terms of when you make your SBP election and the cost of your SBP premium.  We’ll cover the specifics of the Reserve Component Survivor Benefit Plan (RCSBP) in a future post.

If you’re still wondering why you need SBP, let’s explore some of the myths about the costs and benefits of the program. 

Data from 2018 suggests that retirees from each service have different outlooks on the benefits of SBP.  On average, the participation rates of Army and Air Force retirees exceed 60 percent, while Navy and Marine retirees participation remains below 50 percent.  These differences between services may reflect variations in understanding and potentially misunderstanding of the benefits of SBP.  Let’s explore some of the myths surrounding SBP that may impact your decision on SBP.

Some myths about SBP

Myth #1: I can buy term life insurance a lot cheaper than SBP.

Fact: Depending on your age and health, term insurance may in fact be less expensive than your SBP premium.  What is important to consider is that term life insurance is a temporary solution to a long-term challenge.   Term insurance by its very nature is for a specific term or period of time.  The premium you pay is based on your age and your health; as you age, your premiums will increase dramatically.  Have a history of high blood pressure, smoking or asthma?  These and other health conditions will dramatically increase your premiums. Love to scuba dive or pilot airplanes, you may not be insurable.

Fact: The second part of the “buy term” equation is that you need to “invest the difference” in order to cover your family’s loss of your military pension when your access to inexpensive term life insurance ends.  Because it is difficult to secure affordable term life insurance beyond age 60-65, you will need to use the time between your military retirement and reaching your sixth decade to build up a substantial investment portfolio to offset your lack of life insurance.  The savings you reap between the cost of SBP and the cost of term life insurance needs to be invested in order to earn sufficient gains to cover your family’s expenses and to stay ahead of inflation.  This requires not only persistent discipline to save, but also the willingness to take on investment and market risk to generate long term gains.

Myth #2: I’ve done the math; I’ll save money by not selecting SBP.

Fact: There is way more to your SPB decision than just a math problem.  For that math problem to work in your favor, you need to accurately predict how markets and inflation will behave and then you must accurately predict how you and your beneficiaries will behave.

Inflation & Markets: To adequately replace SBP with term life insurance requires you to accurately estimate several very important unknowns, including inflation over the next four to five decades, investment returns over the same 40-50 years, your life expectancy and your spouse’s life expectancy.  These are some important variables, all of which you have no control over.

In the case of future inflation and investment returns, even economists won’t venture to estimate these factors forty years into the future.   If you’re able to create a scenario where the math works in favor of term life insurance, all you need is a steady increase in inflation or a couple of stock market declines to turn your carefully crafted mathematical solution upside down.

Human Nature: There are also several key behavioral predictions necessary to make this math problem work out.  First is the one mentioned above, you need to follow through with the disciplined investment of the “save the difference” if you buy term life instead of taking SBP.  Then you need to have the aptitude and willingness to take on the necessary market and investment risk to grow your investment in order to come out ahead of inflation.

Next, your spouse will need the aptitude to safely manage the life insurance windfall.  She/he will need to continue to manage these investments, balance risk factors and make decisions about taxes in order to generate sufficient income to pay the bills for the rest of their lives.

Myth #3: Life Insurance proceeds are tax-free, SBP payments are taxable.

Fact: Life insurance proceeds are income tax-free, but once those proceeds are deposited in your spouse’s checking account, she/he will need to invest them in order to generate sufficient income and capital gains to keep up with inflation and replace the loss of your military pension for the remaining decades of their life.   Guess what? Investment earnings are taxed as either income or long-term capital gains, depending on the type and duration of the investment.

Conversely, SBP premiums are paid before tax and life insurance premiums are paid post tax.  This means you can discount the cost of your SBP premium by a factor equal to your tax bracket.  Once you calculate the tax advantaged cost of SBP, there may be very little difference from your post tax term life premiums.

Concluding thoughts on SBP

Unfortunately, myths and misinformation surround SBP.  What’s key to remember is that your SBP decision is the single most important decision you’ll make when you retire from the military because your decision to accept or decline SBP will impact your family when you’re no longer there to support them.

It’s critical to consider all the facts and make an informed decision that best supports your family.  Because this decision can have impacts well beyond a carefully crafted math equation, it is important to consider the lasting impacts on your family and your financial plan.

Sometimes it comes down to one simple consideration: which decision helps you sleep at night knowing your family is protected.  

Because the right answer is unique to each military family, we recommend working with a financial planner who understands your military benefits from firsthand experience. As financial planners who help military families every day, we know from experience that each military family’s SBP decision is unique and depends not just on their present-day budget, but on all the elements that go into a great financial life plan.

The financial planners at the Military Financial Advisor Association can help you work through the various SBP scenarios so you can make the decision that best meets your family’s needs.  Reach out to one of us today!