Your income

Taxable or Not Taxable? – Some of these items may surprise you.

Taxable or Not Taxable? – Some of these items may surprise you.

Here are nine areas of income that are often questioned by taxpayers regarding their taxability. Some items are, others are not. Sometimes the taxable nature of an item depends on other things. Here is what you need to know.

There are a number of areas in the tax code that cause confusion as to the taxability of money received. Here are some of the most common areas of confusion.

Alimony. Alimony is taxable to the person who receives it and deductible to the person who pays it. Special rules apply. Make sure you have proper documentation as part of a divorce decree to ensure you can support your tax position.

Child Support. Child support is not taxable to the person who receives it on behalf of their dependent. It is also not deductible for the person who pays it.

Free Services. Free service is almost always taxable as ordinary income under IRS barter regulations. You should report the fair market value of services received as income on your tax return. If you exchange services, you can deduct allowable business expenses against the value of services provided.

Illegal Activities. Even income received from illegal activities is taxable income and must be reported. Incredibly, the IRS even states that stolen items should be reported at the fair market value on the date the thief stole the item.

Jury Duty Pay. This is taxable as ordinary income. Yes, even doing your civic duty can be a taxable event.

Legal Settlements. A general rule of thumb with legal settlements is to consider what the settlement replaces. If the settlement revenue replaces a taxable item, like lost wages, the settlement often creates taxable income. This area is complex and often requires a detailed review.

Life insurance proceeds. Generally life insurance proceeds paid to you because of the death of an insured are not taxable. However, there are a number of exceptions to this general rule. For example, if you receive benefits in installments above the value of the life insurance policy at time of death or if you receive a cash payout of a policy you could have taxable income.

Prizes. Most prizes received should be reported as ordinary income using the fair market value of the item received. This area has been a major surprise to contestants on game shows and celebrities who have received large gifts at celebrations like the Academy Awards.

Unemployment Compensation. Typically unemployment compensation is to be reported as taxable income. Many are confused by this because of a temporary federal tax law that made unemployment compensation non-taxable during the recent economic recession. This is no longer the case.

Some of these areas can be complicated. What is most important is to realize when to discuss your situation.

Your income

Using Losers to Make Winners

Effectively using your investment losses can make a big impact in your taxable income. Why? These losses could offset income that is barely taxed, or it could offset income taxed at 39.6% or higher! Here are some ideas to make those losers into winners on your tax return.

Understanding the rules surrounding investment losses can really help minimize your tax obligation each year. This is because investment gains and income can be subject to a variety of federal tax rates as high as 39.6%. This and a newly minted tax law in 2013 that could add a 3.8% Medicare investment tax surcharge make planning around when to take investment losses an important tax planning subject.

Know the meaningful rules

What makes investment losses such an important tax planning subject? Here are the relevant tax ramifications surrounding investment losses.

  1. Offsetting gains. Investment losses can be used to offset investment gains every year.
  2. Short-term versus long-term. Short-term investment gains (from assets owned by you for less than one year) can be subject to ordinary income tax rates up to 39.6% while long-term gains have a maximum tax rate of 20% (0% if your income is in the 15% income tax bracket or lower).
  3. Netting rules. You first net investment losses against investment gains prior to applying losses against your ordinary income. Where possible you must net short-term losses against short-term gains and long-term losses against long-term gains.
  4. Excess losses. Up to $3,000 of excess investment losses can be used to offset your ordinary income in any one year.
  5. Unused losses. Unused losses can be carried forward to offset income in future tax years.

So given these rules, here are some tips.

Maximizing the impact of investment losses

  1. Net losses against short-term gains whenever possible. If you are in a high income tax bracket, try to sell stocks with a loss to offset any investments you wish to sell that you have owned less than one year.
  2. Defer taking losses if they will be used to offset lower taxed gains.
  3. Time taking an investment loss to take advantage of the annual $3,000 reduction of income it provides.
  4. Transfer stock from a low tax rate family member to a higher taxed individual.
  5. Take full advantage of the loss carry-forward rules. If you sold an investment that had a huge loss in a prior year, you can only take $3,000 against your regular income each year. If this applies to you, conduct an annual review of your portfolio and consider selling investments with a gain to offset more of this loss carry-forward.

Remember, investment losses can be used to offset investment gains and a limited amount of your ordinary income. Since the tax rates vary so greatly, proper planning to match losses against higher taxed items can make these losers a real winner on your tax return.

Are My Social Security Benefits Taxable? – Don’t be surprised at tax time

The taxability of Social Security Benefits can be confusing. In fact the taxable nature of your benefits should include a discussion of benefit reductions when you decide to receive these benefits prior to your full retirement age. Here is what you need to know.

When it comes to retirement many Americans believe they can count on their full Social Security benefits as a core element of income. You can imagine the surprise at tax-time when some of these same benefits are returned to the Federal Government in the form of benefit reduction and taxation. Here is what you need to know.

  1. Social Security and Retirement Benefits can be “REDUCED” as well as taxed. The benefit reduction calculation is separate from the taxability of your benefits. If you start drawing retirement benefits prior to reaching your full retirement age (65 if born prior to 1938, and it gradually increases up to age 67 if born in 1960 or later) in 2013 your benefits could be reduced $1 for every $2 of earnings over $15,120. This calculation is less punitive if it occurs during the year of retirement, but you should forecast this potential benefit reduction prior to deciding to start taking your benefits.
  2. If you do not work, your Social Security benefit will probably not be subject to tax.
  3. Your Social Security Benefits can be taxed no matter how old you are. There is not an age threshold that protects your Social Security Benefits from federal taxation. If you have excess income, your benefits could be taxed.
  4. If you have other income your Social Security benefits may be taxed. The taxability of Social Security benefits depends on two things; your qualified total income and your marital status. If your total income surpasses certain thresholds (called base amount), some of your benefits could be taxed.
  5. Can you estimate whether your benefits will be taxed? Yes. Per the IRS, here is a quick calculation to determine if your benefits may be taxable:

    1st: Calculate 1/2 of your annual Social Security benefit

    2nd: Add the 1/2 benefit total to all your other estimated income. (Use income from all sources including tax exempt interest.)

    3rd: Compare your calculated total to the base amount for the year. If it exceeds the base amount, some of your Social Security benefit will be taxed.

    2013 Social Security Base Amounts:

    $25,000: Single, Head of Household, Widow or Married Filing Separately:

    $32,000: Married filing Joint

  6. Are all your Social Security benefits taxable? No, a maximum of 85% of your Social Security benefits is subject to federal tax.

Note: To qualify as married filing separately, you must also be living apart for the entire year. The base amount if you lived together is $0. There is also a significant marriage penalty in the taxability of your Social Security benefits as the joint amount is only $32,000 instead of $50,000 (or 2 times the single “base” amount).