Avoiding the Penalty on Early Distributions

Many people use IRAs, SEP Plans, SIMPLE IRA plans, and employee-sponsored retirement savings plans such as the 401(k) to save money for their retirement years, but what if you need to tap that money before age 59 1/2? The bad news is that you generally have to pay a 10 percent penalty for early withdrawal of your funds. While that may seem unfair (after all, most of it is probably your money), you need to remember that the purpose of these types of plans is to save money for the years when you are no longer working.

Sometimes, however, life intervenes, and there may be times when you need access to those funds before you’ve reached retirement age. The good news is that under IRS rules you may be able to use one of the following exceptions to avoid paying the tax penalty. However, you need to remember that although the exceptions listed below will help you avoid the 10 percent penalty tax, you are still liable for any regular income tax that’s owed on the funds that you’ve withdrawn.

1. Death of the Participant/IRA Owner. If you are the beneficiary of a deceased IRA owner, you do not have to pay the 10 percent penalty on distributions taken before age 59 1/2 unless you inherit a traditional IRA from your deceased spouse and elect to treat it as your own. In this case, any distribution you later receive before you reach age 59 1/2 may be subject to the 10 percent additional tax.

2. Total and Permanent Disability. Distributions made because you are totally and permanently disabled are exempt from the early withdrawal penalty. You are considered disabled if you can furnish proof that you cannot do any substantial gainful activity because of your physical or mental condition. A physician must determine that your condition can be expected to result in death or to be of long, continued, and indefinite duration.

3. Higher Education Expenses. Distributions from IRAs, SEP Plans, and SIMPLE IRA Plans that are used for qualified higher education expenses are also exempt, provided they are not paid through tax-free distributions from a Coverdell education savings account, scholarships and fellowships, Pell grants, employer-provided educational assistance, and Veterans’ educational assistance. Qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution, as well as expenses incurred by special needs students in connection with their enrollment or attendance. If the individual is at least a half-time student, then room and board are considered qualified higher education expenses. This exception applies to expenses incurred by you, your spouse, children and grandchildren.

Caution: Early distributions from employee-sponsored retirement plans such as 401(k)s are not exempt from the 10 percent penalty if used for higher education expenses.

4. IRS Levy. Distributions due to an IRS levy of the qualified plan are exempt from the 10 percent penalty.

5. Healthcare Premiums. Even if you are under age 59 1/2, you may not have to pay the 10 percent additional tax on any distributions during the year that are not more than the amount you paid during the year for medical insurance for yourself, your spouse, and your dependents. You will not have to pay the tax on these amounts if all of the following conditions apply: you lost your job, you received unemployment compensation paid under any federal or state law for 12 consecutive weeks because you lost your job, you receive the distributions during either the year you received the unemployment compensation or the following year, you receive the distributions no later than 60 days after you have been reemployed.

Caution: Early distributions from employee-sponsored retirement plans such as 401(k)s are not exempt from the 10 percent penalty if used for healthcare premiums.

6. Military Reservists called to Active Duty. Generally, these are distributions made to individuals called to active duty after September 11, 2001, and on or after December 31, 2007.

7. Equal Payments. Similar to an annuity, you can take the money as part of a series of substantially equal periodic payments over your estimated lifespan or the joint lives of you and your designated beneficiary. These payments must be made at least annually, and payments are based on IRS life expectancy tables. If payments are from a qualified employee plan, they must begin after you have left the job. The payments must be made at least once each year until age 59 1/2, or for five years, whichever period is longer.

8. Medical Expenses. If you have out-of-pocket medical expenses that exceed 10 percent of your adjusted gross income, you can withdraw funds from a retirement account to pay those expenses without paying the penalty. For example, if you had an adjusted gross income of $100,000 for tax year 2019 and medical expenses of $12,500, you could withdraw as much as $2,500 from your pension or IRA without incurring the 10 percent penalty tax.

9. First-time Homebuyers (up to $10,000). An IRA distribution used to buy, build, or rebuild a first home also escapes the penalty; however, you need to understand the government’s definition of a “first time” home buyer. In this case, it’s defined as someone who hasn’t owned a home for the last two years prior to the date of the new acquisition. You could have owned five prior houses, but if you haven’t owned one in at least two years, you qualify.

The first time homeowner can be yourself, your spouse, your or your spouse’s child or grandchild, parent or another ancestor. The “date of acquisition” is the day you sign the contract for the purchase of an existing house or the day construction of your new principal residence begins. The amount withdrawn for the purchase of a home must be used within 120 days of withdrawal and the maximum lifetime withdrawal exemption is $10,000. If both you and your spouse are first-time home buyers, each of you can receive distributions up to $10,000 for a first home without having to pay the 10 percent penalty.

Caution: First-time homebuyers are not exempt from the 10 percent penalty for early withdrawals of funds from employee-sponsored retirement plans such as 401(k)s.

If you are thinking about tapping your retirement money early, call and speak to a trusted tax advisor first.

Seven Common Small Business Tax Myths

The complexity of the tax code generates a lot of folklore and misinformation that could lead to costly mistakes such as penalties for failing to file on time or, on the flip side, not taking advantage of deductions you are legally entitled to take and giving the IRS more money than you need to. With this in mind, let’s take a look at seven common small business tax myths.

1. Start-Up Costs are Deductible Immediately

Business start-up costs refer to expenses incurred before you actually begin operating your business. Business start-up costs include both start-up and organizational costs and vary depending on the type of business. Examples of these types of costs include advertising, travel, surveys, and training. These start-up and organizational costs are generally called capital expenditures.

Costs for a particular asset such as machinery or office equipment are recovered through depreciation or Section 179 expensing. When you start a business, you can elect to deduct or amortize certain business start-up costs.

Business start-up and organizational costs are generally capital expenditures. However, you can elect to deduct up to $5,000 of business start-up and $5,000 of organizational costs. The $5,000 deduction is reduced (but not below zero) by the amount your total start-up or organizational costs exceed $50,000. Remaining costs must be amortized.

2. Overpaying the IRS makes you “Audit Proof”

It is never a good idea to knowingly or unknowingly overpay the IRS. You should only pay the amount of tax that you owe. The IRS doesn’t care if you pay the right amount of taxes or overpay your taxes; however, they do care if you pay less than you owe and you can’t substantiate your deductions with good recordkeeping. The best way to “Audit Proof” yourself is to properly document your expenses and make sure you are getting good advice from your tax accountant.

3. You can take more Deductions if your Business is Incorporated.

The good news is that self-employed individuals (sole proprietors and S Corps) qualify for many of the same deductions that incorporated businesses do. As such, becoming incorporated is often an unnecessary expense and burden that many small business owners don’t need. For instance, start-ups can spend thousands of dollars in legal and accounting fees to set up a corporation, only to discover soon thereafter that they need to change their name or take the company in a different direction. Furthermore, plenty of small business owners who incorporate don’t make money for the first few years and find themselves saddled with minimum corporate tax payments and no income.

4. The Home Office Deduction is a Red Flag for an Audit.

While the home office deduction used to be a red flag, this is no longer true. In fact, with so many people operating home-based businesses the IRS rolled out a new simplified home office deduction in 2013, which makes it even easier to claim the home office deduction (as long as it can be substantiated with excellent recordkeeping).

Furthermore, because of the proliferation of home offices, tax officials cannot possibly audit all tax returns of small business owners taking the home office deduction. In other words, there is no need to fear an audit just because you take the home office deduction; however, a high deduction-to-income ratio, however, may raise a red flag and lead to an audit.

5. You can’t Deduct Business Expenses if you don’t take the Home Office Deduction.

You are still eligible to take deductions for business supplies, business-related phone bills, travel expenses, printing, wages paid to employees or contract workers, depreciation of equipment used for your business, and other expenses related to running a home-based business, whether or not you take the home office deduction.

6. An Extension to File gives you an extra Six Months to Pay any Tax you Owe.

Extensions enable you to extend your filing date only. Penalties and interest begin accruing from the date your taxes are due.

7. Part-time Business Owners Cannot Set up Self-employed Pension Plans.

If you start a company while you have a salaried position complete with a 401K plan, you can still set up a SEP-IRA for your business and take the deduction.

If you have any questions about these and other tax myths, don’t hesitate to call and speak to a tax professional.

Tax Filing Season Begins

January 28, 2019, marked the start of this year’s tax filing season, and it’s the first time taxpayers will be filing under the new tax reform laws, most of which became effective in 2018. Complicating matters is a newly revised Form 1040, U.S. Individual Income Tax Return, as well as the partial shutdown of the federal government. With more than 150 million individual tax returns expected to be filed for the 2018 tax year, here’s what individual taxpayers can expect:

Government Shutdown; Filing as Usual, Tax Refunds on Schedule

Despite the government shutdown (referred to by the IRS as the lapse in appropriations) in December and January, all taxpayers should continue to meet their tax obligations as per the normal time frame. That is, individuals and businesses should continue to file tax returns and make payments and deposits with the IRS, as required by law. For taxpayers receiving tax refunds there are no anticipated delays due to the lapse in appropriations.

New Design for Form 1040

The new Form 1040 has been redesigned for 2018. It is now “postcard sized” and gathers information about the taxpayer(s) and dependents. It’s also the form you need to sign and date when filing your return. The new Form 1040 can also be filed by itself; however, more complex tax situations will generally require using one or more of the supplemental Schedules 1 through 6 (also new for 2018), which are briefly described below.

Note: Forms 1040A and 1040EZ no longer exist for tax year 2018. Instead, use the new Form 1040.

Schedules 1 through 6

As mentioned, these supplemental schedules are to be used as needed and are generally for those with more complex tax returns.

Schedule 1, Additional Income and Adjustments To Income – Report income or adjustments to income that can’t be entered directly on Form 1040.

Schedule 2, Tax – To be used if you have additional taxes that can’t be entered directly on Form 1040. These include alternative minimum tax and excess advance premium tax credit repayment.

Schedule 3, Nonrefundable Credits – Used to report nonrefundable credits other than the child tax credit or the credit for other dependents.

Schedule 4, Other Taxes – If you have other taxes that can’t be entered on Form 1040 such as additional tax on IRAs or other qualified retirement plans or household employment taxes.

Schedule 5, Other Payments and Refundable Credits – If you have other payments or refundable credits such as any estimated tax payments for 2018 or the amount paid when requesting an extension to file.

Schedule 6, Foreign Address and Third Party Designee – If you have a foreign address or want to allow another person (other than your paid tax preparer) to discuss this return with the IRS.

Filing Deadline

For most taxpayers the filing deadline to submit 2018 tax returns is Monday, April 15, 2019; however, due to the Patriots’ Day holiday on April 15 in Maine and Massachusetts, and the Emancipation Day holiday on April 16 in the District of Columbia, taxpayers who live in Maine or Massachusetts have until April 17, 2019 to file their returns.

Help is just a phone call away.

Don’t hesitate to contact the office if you have any questions about the new tax forms or need assistance preparing and filing your tax return this year.