If you don’t qualify for the maximum $250,000 or $500,000 gain exclusion due to failure to pass all the preceding tests, you may still qualify for a prorated (reduced) exclusion amount if you had to sell your home for job-related or health reasons or for certain other IRS-approved reasons.
In one of the best tax-saving deals, an unmarried seller of a principal residence can exclude (pay no federal income tax on) up to $250,000 of gain, and a married joint-filing couple can exclude up to $500,000 of gain. There are some limitations. You must pass the following four tests to qualify.
Proceeds from a life insurance policy paid to you because of an insured person’s death are generally not taxable. (This includes proceeds paid under an accident or health insurance policy or an endowment contract.) However, if you redeem a policy on your own life for cash, any amount that is more than the cost of the policy is taxable. In addition, interest income received as a result of life insurance proceeds may be taxable.
Making Annual Roth IRA Contributions
Annual Roth IRA contributions make the most sense for people who believe they will pay the same or higher tax rates during retirement. Higher future taxes can be avoided on earnings because qualified Roth withdrawals are free from federal income tax (and usually state income tax).
The downside is you get no deductions for Roth contributions.
So if you expect to pay lower taxes during retirement, you might be better off making deductible traditional IRA contributions (assuming your income is low enough to get a deduction), because the current deductions may be worth more to you than tax-free withdrawals later on.
Contributions are limited, earned income is required, and high earners may not be eligible. The maximum amount you can contribute for any tax year to a Roth IRA is the lesser of:
- Your earned income for the year, or
- The annual contribution limit for the year.
Earned income includes wages, salary, bonuses, alimony received and self-employment income.
For 2017, the annual Roth contribution limit is $5,500 ($6,500 if you are age 50 or older as of year-end). This amount is unchanged from 2016.
The eligibility to make annual Roth contributions is phased out when modified adjusted gross income reaches certain levels. Consult with your tax advisor.
Key Point: If your MAGI is too high for Roth contributions, consider converting a traditional IRA into a Roth account.No income restriction. Before 2010, individuals with MAGI above $100,000 were ineligible for Roth conversions. That restriction is now gone. Now, everyone is eligible for Roth conversions. That’s important, because conversion contributions are the only way to quickly get large amounts of money into a Roth IRA. Keep in mind that conversions still trigger taxable income in the year of conversion. Consider the federal income tax (and potentially state tax) that will accompany a conversion and consult with your tax advisor before acting.
Roth IRAs are still a great tax-saving deal and can provide tax-free income. Roth accounts have two big tax advantages.
The first Roth advantage is tax-free withdrawals. Unlike traditional IRA withdrawals, qualified Roth IRA withdrawals are free from federal income tax (and usually state income tax). What is a qualified withdrawal? In general it is one that is taken after the Roth account owner has met both of the following requirements:
- He or she has had at least one Roth IRA open for over five years.
- He or she has reached age 59 1/2, is disabled or is dead.
The second Roth advantage is an exemption from the required minimum distribution rules. Unlike with a traditional IRA, the original owner of a Roth account (the person for whom the account is originally set up) is not burdened with the obligation to start taking required minimum distributions (RMDs) after age 70 1/2 or face a 50% penalty. Therefore, you can leave a Roth account untouched for as long you live. This important privilege makes the Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth IRA money to help cover your own retirement-age living expenses).
- Tax-Free Section 529 Accounts
The biggest advantage of 529 college savings plan accounts is they are allowed to accumulate earnings free of any federal income taxes. When the account beneficiary (typically a child or grandchild) reaches college age, federal-income-tax-free withdrawals can be taken to cover his or her qualified higher education expenses. State income tax breaks are often available too.
Helpfully enough, contributions to a 529 account will also reduce your taxable estate because they are treated as gifts to the account beneficiary. Contributions in are eligible for the $14,000 annual federal gift-tax exclusion. Contributions up to the exclusion amount won’t diminish your unified federal gift and estate tax exemption ($5.49 million in 2017, up from $5.45 million in 2016).
If you’re feeling really generous, you can make a larger lump-sum contribution to a 529 account and elect to spread it over five years for gift-tax purposes. This allows you to immediately benefit from five years’ worth of annual gift-tax exclusions while jump-starting the beneficiary’s college fund. You make the five-year spread election by filing the IRS gift-tax return form.
Example: You are unmarried and can make a 2017 (unchanged from 2016) lump-sum contribution of up to $70,000 (5 times $14,000) to a Section 529 account set up for a child, grandchild or other person you want to help. If you’re married, you and your spouse can together contribute up to $140,000 (2 times $70,000). Lump-sum contributions up to these amounts won’t diminish your unified federal gift and estate tax exemption as long as you choose to take advantage of the five-year spread privilege. If you want to help several children or grandchildren, you can run the same 529 account drill for each one.
If you want (or need) to get your money back from a 529 account, it is allowed under the tax rules. You can take back all or part of the account balance. You’ll owe taxes on any withdrawn earnings plus a penalty equal to 10% of the withdrawn earnings. However, that’s a relatively small price to pay for the right to reverse a decision, if desired.
- Tax-Free Coverdell Education Savings Accounts
If you’re not such a high roller when it comes to tax-free college savings opportunities, you also have the option of contributing up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a beneficiary (typically a child or grandchild) who has not yet reached age 18. A CESA is an account set up by a “responsible person,” which means you, to function exclusively as an education savings vehicle for the account beneficiary (typically a child or grandchild).
CESA earnings are allowed to accumulate federal-income-tax-free. Then, tax-free withdrawals can be taken to pay for the beneficiary’s college tuition, fees, books, supplies, and room and board. If you have several beneficiaries in mind, you can contribute up to $2,000 annually to separate CESAs set up for each one.
Here’s the catch: The right to make CESA contributions is phased out if your modified adjusted gross income (MAGI) reaches certain levels.
However, this restriction can often be circumvented by enlisting someone who is unaffected by the income limitation. For example, you can give the contribution dollars to a trustworthy adult who can then open up the CESA as the “responsible person” and make a contribution on behalf of your intended beneficiary. Keep in mind that when the “responsible person” is someone other than yourself, your control over the account is lost.
- Cash Rebates for Items Purchased
A cash rebate received from a dealer or manufacturer for an item you buy is not income. However, you have to reduce your tax basis by the amount of the rebate. For example, you buy a new car for $28,000 and the manufacturer sends you a $2,000 rebate check. Although the $2,000 is not income to you, your basis in the car is now $26,000. That basis is used to calculate gain or loss when you sell the car or depreciation if you use the vehicle for business purposes.
- Tax-Free Capital Gains and Dividends
Thanks to current tax law legislation, the federal income tax rate on long-term capital gains and qualified dividends is still 0% when they fall within the 10% or 15% regular income tax rate brackets. The surprising truth is you can earn a pretty healthy income and still be within the 15% bracket and thus qualify for the 0% rate on some or all of your long-term capital gains and dividends.
Key Point: Adjusted gross income is calculated after subtracting any write-offs allowed on page 1 of Form 1040 (so-called above-the-line deductions). These write-offs include deductible IRA and self-employed retirement account contributions, health savings account contributions, self-employed health insurance premiums, alimony payments, moving expenses and others. So, if you have some above-the-line deductions, your AGI can be that much higher, and you will still be in the 15% rate bracket.
- Qualified Scholarships
Payments received from a qualified scholarship are normally not taxable. Amounts you use for certain costs, such as tuition and required course books, are not taxable. However, amounts required to be used for room and board are taxable.
- Certain Court Awards and Damages
Compensatory damages for personal physical injury or physical sickness (received in a lump sum or installments) are free from federal tax. However, punitive damages are taxable. Awards for unlawful discrimination or harassment are also taxable. If you receive a court award or out-of-court settlement, consult with your tax advisor about the tax implications.
While most sources of income are taxable, you might be fortunate enough to receive income that brings you no federal tax headaches. Consult with your tax advisor for more information in your situation.