A Facebook tax Q&A with two Vanguard experts
March 13, 2013
Recently, two Vanguard tax and investing experts, Maria Bruno, an investment analyst in our Investment Counseling & Research group, and John Kilroy, a financial planner with Vanguard Asset Management Services™, spent their lunch hour answering questions on our Facebook page. Here's an edited transcript of their conversation with our Facebook fans:
How can I avoid paying any tax at all?
Maria Bruno: There's an old adage that there are two certain things in life—death and taxes. While we'd all like to avoid taxes, the reality is that if you have income (whether it's earned or investment, for example), you'll likely be facing some sort of tax.
The best you can do is to try to minimize taxes, through either tax-efficient portfolio construction or by maximizing tax-advantaged accounts. You could consult with a tax professional to see if there are ways to trim your personal tax bill. We often tend to focus on our tax situation during tax season, but it's best to consider taxes throughout the year because there are steps you may be able to take to minimize taxation.
I'm 32. If I have a Roth IRA and max it out every year, will that be enough for me to retire on?
Maria: Congrats on saving in your Roth IRA! While this is a great start, and you'll have many years of tax-advantaged compounding offered by a Roth, you may need to supplement your savings. We recommend that you consider a savings target of 12%–15% of your salary annually. This includes any employer matching in an employer plan (you'll want to make sure you save at least up to the company match). The more you can maximize your tax-advantaged savings, the better shape you'll be in for retirement.
Should I roll over my 401(k) from my old employer to my new employer's program, or into an IRA instead?
Maria: There are several things to consider. An IRA will likely give you the most flexibility and control in terms of selecting investment providers. You can check with your new employer to see if they'll allow you to roll the former plan assets into the new plan. If so, you'll want to carefully consider your investment selections and investment costs. There may potentially be more creditor protection offered by the 401(k) over the IRA, but this may be of lesser overall concern.
Is there a big difference in filing "married jointly" versus "single"?
John Kilroy: Your filing status is based on your marital status as of December 31 of the tax year. If you're married, you can either file jointly or separately.
In almost all cases, the lower tax burden will be due on a married couple filing jointly. There are rare exceptions where each spouse filing separately would produce a lower tax burden than filing a joint return. If one spouse has very low income and very high itemized deductions, then it's possible that filing separately would produce a lower tax burden. In certain states, married filing separately may be more tax-efficient than filing jointly.
What's your advice for reducing the marriage penalty, assuming no IRA eligibility?
John: For those who aren't familiar with it, the "marriage penalty" is the higher tax obligation faced by many married couples in comparison with single taxpayers. The tax attributes of each person (particularly income and deductions) when combined into one tax return may result in a higher tax than if each taxpayer was single. This is especially true when each person has similar levels of income and deductions. Whether you're married or single, the most effective tax planning is done by evaluating your circumstances and options during the tax year. You may even find that your individual circumstances won't produce a marriage "penalty," but rather a marriage "bonus" to your overall tax situation. The key is to plan ahead and not wait until you're filing your tax return.
Should I have my 18-year-old son file a separate tax return, or should I claim him as a dependent on my return?
John: First, you need to determine whether your son qualifies as a dependent; check irs.gov for guidance. If he does qualify, you may need to compare whether it's more beneficial for you to claim the exemption or forgo it.
Your personal tax situation will determine whether you might benefit from tax breaks associated with college expenses such as the American Opportunity Tax Credit, the Lifetime Learning Tax Credit, or the "above the line" deduction. If your income keeps you from qualifying for one of these breaks, your son might take advantage of one of them on his own return, but he can only do that if you forgo claiming him as a dependent. Generally speaking, a tax advisor can help you determine the best way to proceed.
What is the best way to draw down my accounts in retirement and minimize taxes?
Maria: The most flexibility will be offered when you have a combination of taxable, tax-deferred, and Roth accounts. Generally speaking, consider spending your taxable accounts before your tax-advantaged accounts, since capital gains rates are currently lower than ordinary income tax rates. Plus your tax-advantaged accounts can remain untouched longer and potentially benefit from more tax-advantaged growth. But if you do have different types of accounts, you could take a look at your situation on an annual basis to see if it might make sense to tweak this order in any given year. This video has some information that you might find helpful.
For a novice investor, where are the best places to put money?
Maria: Start by defining your investing goal. Then focus on the factors that impact achieving that goal. These include risk tolerance and time horizon. You need to think about how much savings you're willing to commit to achieving that goal. Most investors will prioritize retirement, and rightly so. But you also need to make sure you have emergency reserves—a cash or money market account—of at least three to six months of living expenses. To help get you started, check out Vanguard's Principles for Investing Success. These principles highlight how you can go about defining, creating, and monitoring your investment plan. Best of luck with your investing program!
I lost my job a few years ago and I have to take money out of my IRA to pay the bills. I'm under 59½, but is there any way to waive the 10% tax penalty for early withdrawals?
John: I'm sorry to hear about your situation. You may want to consider consulting a tax professional to discuss Section 72t of the Internal Revenue Code, which deals with exceptions to the 10% penalty. For future distributions from your IRA, you might qualify for what are commonly known as substantially equal periodic payments, or SEPPs. (Please note that SEPP distributions must last five years from the time you begin taking them.)
I just received a letter from Vanguard regarding required minimum distributions (RMDs) from an inherited IRA. Unfortunately, I inherited this IRA in 1995 and haven't done anything with it since then. What are my options now? Will I incur penalties for my delayed distributions?
John: You'll definitely want to consult with a qualified tax advisor for assistance. The RMDs not yet taken will have to be calculated and distributed in a current year, subject to inclusion in your income in that current year. As you noted, missed RMDs are normally subject to a 50% tax. However, the IRS has the authority to waive penalties if the taxpayer establishes reasonable cause for missing the distributions. In your case, given the amount of time that has passed since the first distributions were required, we'd suggest you consult with a qualified tax professional to request that the IRS potentially waive the penalty.
I received stock shares as a gift, but I don't know what the gift-giver originally paid for them. How do I report the shares' cost basis when I sell them?
John: As you know, the cost basis of an asset received as a gift is generally the same as the cost basis of the asset when originally acquired by the donor.
If possible, ask the donor if a gift tax return was filed in the year the shares were given to you. If so, the cost basis may have been reported on that return. If not, make reasonable efforts to establish the cost basis. You may need the donor's help to identify when the shares were purchased. If he or she has old tax records indicating dividends paid on the investment, you may be able to trace back and establish the cost basis.
Alternatively, you may be able to research through the shares' issuing company, or through a brokerage. Don't worry about being perfect. In the absence of complete information, the IRS may accept your reasonable efforts to determine the cost basis.
How is the alternative minimum tax (AMT) calculated? Any suggestions on how to stay under the AMT threshold?
John: Wow! AMT could take a week to explain, but here's a very high-level response.
The AMT is calculated by adding back to a taxpayer's taxable income various adjustments, preferences, and exclusions. Examples include state and local taxes, miscellaneous itemized deductions, and personal exemptions. Once AMT is calculated and the rate of 26% or 28% is applied, the taxpayer pays whichever is higher—the AMT or the regular income tax rate. (See IRS Form 6251 for more information.)
To minimize the AMT tax implication, you may need to rethink your conventional methods of tax minimization. For example, taxpayers who are subject to AMT may favor accelerating income or deferring deductions. This is the opposite of how most taxpayers approach tax minimization. Your specific circumstances, including how you may be exposed to AMT, should be evaluated by a tax professional.
Maria and John: Thanks for letting us join you for the last hour. We enjoyed hearing from you! Many happy tax returns! (Sorry—we couldn't resist!)
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- When taking withdrawals from an employer-sponsored plan or traditional IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
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