Employers offer 401(k) plans for many reasons, including to attract and retain talent. These plans help an employee accumulate a retirement nest egg on a tax-advantaged basis. If you’re thinking about participating in a plan at work, here are some of the features.
Under a 401(k) plan, you have the option of setting aside a certain amount of your wages in a qualified retirement plan. By electing to set cash aside in a 401(k) plan, you’ll reduce your gross income, and defer tax on the amount until the cash (adjusted by earnings) is distributed to you. It will either be distributed from the plan or from an IRA or other plan that you roll your proceeds into after leaving your job.
Your wages or other compensation will be reduced by the amount of pre-tax contributions that you make — saving you current income taxes. But the amounts will still be subject to Social Security and Medicare taxes. If your employer’s plan allows, you may instead make all, or some, contributions on an after-tax basis (these are Roth 401(k) contributions). With Roth 401(k) contributions, the amounts will be subject to current income taxation, but if you leave these funds in the plan for a required time, distributions (including earnings) will be tax-free.
Your elective contributions — either pre-tax or after-tax — are subject to annual IRS limits. For 2021, the maximum amount permitted is $19,500. When you reach age 50, if your employer’s plan allows, you can make additional “catch-up” contributions. For 2021, that additional amount is $6,500. So if you’re 50 or older, the total that you can contribute to all 401(k) plans in 2021 is $26,000. Total employer contributions, including your elective deferrals (but not catch-up contributions), can’t exceed 100% of compensation or, for 2021, $58,000, whichever is less.
Typically, you’ll be permitted to invest the amount of your contributions (and any employer matching or other contributions) among available investment options that your employer has selected. Periodically review your plan investment performance to determine that each investment remains appropriate for your retirement planning goals and your risk specifications.
Getting money out
Another important aspect of these plans is the limitation on distributions while you’re working. First, amounts in the plan attributable to elective contributions aren’t available to you before one of the following events: retirement (or other separation from service), disability, reaching age 59½, hardship, or plan termination. And eligibility rules for a hardship withdrawal are very stringent. A hardship distribution must be necessary to satisfy an immediate and heavy financial need.
As an alternative to taking a hardship or other plan withdrawal while employed, your employer’s 401(k) plan may allow you to receive a plan loan, which you pay back to your account, with interest. Any distribution that you do take can be rolled into another employer’s plan (if that plan permits) or to an IRA. This allows you to continue deferral of tax on the amount rolled over. Taxable distributions are generally subject to 20% federal tax withholding, if not rolled over.
Employers may opt to match contributions up to a certain amount. If your employer matches contributions, you should make sure to contribute enough to receive the full match. Otherwise, you’ll miss out on free money!
These are just the basics of 401(k) plans for employees. For more information, contact your employer. Of course, we can answer any tax questions you may have.
© 2021 Covenant CPA
Have you heard of the “nanny tax?” Even if you don’t employ a nanny, it may apply to you. Hiring a house cleaner, gardener or other household employee (who isn’t an independent contractor) may make you liable for federal income and other taxes. You may also have state tax obligations.
If you employ a household worker, you aren’t required to withhold federal income taxes from pay. But you can choose to withhold if the worker requests it. In that case, ask the worker to fill out a Form W-4. However, you may be required to withhold Social Security and Medicare (FICA) taxes and to pay federal unemployment (FUTA) tax.
2021 and 2022 thresholds
In 2021, you must withhold and pay FICA taxes if your household worker earns cash wages of $2,300 or more (excluding the value of food and lodging). The Social Security Administration recently announced that this amount would increase to $2,400 in 2022. If you reach the threshold, all the wages (not just the excess) are subject to FICA.
However, if a nanny is under age 18 and childcare isn’t his or her principal occupation, you don’t have to withhold FICA taxes. So, if you have a part-time student babysitter, there’s no FICA tax liability.
Both an employer and a household worker may have FICA tax obligations. As an employer, you’re responsible for withholding your worker’s FICA share. In addition, you must pay a matching amount. FICA tax is divided between Social Security and Medicare. The Social Security tax rate is 6.2% for the employer and 6.2% for the worker (12.4% total). Medicare tax is 1.45% each for the employer and the worker (2.9% total).
If you want, you can pay your worker’s share of Social Security and Medicare taxes. If you do, your payments aren’t counted as additional cash wages for Social Security and Medicare purposes. However, your payments are treated as additional income to the worker for federal tax purposes, so you must include them as wages on the W-2 form that you must provide.
You also must pay FUTA tax if you pay $1,000 or more in cash wages (excluding food and lodging) to your worker in any calendar quarter. FUTA tax applies to the first $7,000 of wages paid and is only paid by the employer.
Paperwork and payments
You pay household worker obligations by increasing your quarterly estimated tax payments or increasing withholding from wages, rather than making an annual lump-sum payment.
As an employer of a household worker, you don’t have to file employment tax returns, even if you’re required to withhold or pay tax (unless you own your own business). Instead, employment taxes are reported on your tax return on Schedule H.
When you report the taxes on your return, include your employer identification number (not the same as your Social Security number). You must file Form SS-4 to get one.
However, if you own a business as a sole proprietor, you include the taxes for a household worker on the FUTA and FICA forms (940 and 941) that you file for the business. And you use your sole proprietorship EIN to report the taxes.
Recordkeeping is important
Keep related tax records for at least four years from the later of the due date of the return or the date the tax was paid. Records should include the worker’s name, address, Social Security number, employment dates, dates and amount of wages paid and taxes withheld, and copies of forms filed.
Contact us for assistance or questions about how to comply with these requirements.
© 2021 Covenant CPA
Here are some of the key tax-related deadlines affecting businesses and other employers during the fourth quarter of 2021. Keep in mind that this list isn’t all-inclusive, so there may be additional deadlines that apply to you. Contact us to ensure you’re meeting all applicable deadlines and to learn more about the filing requirements.
Note: Certain tax-filing and tax-payment deadlines may be postponed for taxpayers who reside in or have a business in federally declared disaster areas.
Friday, October 15
- If a calendar-year C corporation that filed an automatic six-month extension:
- File a 2020 income tax return (Form 1120) and pay any tax, interest and penalties due.
- Make contributions for 2020 to certain employer-sponsored retirement plans.
Monday, November 1
- Report income tax withholding and FICA taxes for third quarter 2021 (Form 941) and pay any tax due. (See exception below under “November 10.”)
Wednesday, November 10
- Report income tax withholding and FICA taxes for third quarter 2021 (Form 941), if you deposited on time (and in full) all of the associated taxes due.
Wednesday, December 15
- If a calendar-year C corporation, pay the fourth installment of 2021 estimated income taxes.
Contact us if you’d like more information about the filing requirements and to ensure you’re meeting all applicable deadlines.
© 2021 Covenant CPA
If you’re fortunate enough to own a vacation home, you may want to rent it out for part of the year. What are the tax consequences?
The tax treatment can be complex. It depends on how many days it’s rented and your level of personal use. Personal use includes vacation use by you, your relatives (even if you charge them market rent) and use by nonrelatives if a market rent isn’t charged.
Less than 15 days
If you rent the property out for less than 15 days during the year, it’s not treated as “rental property” at all. In the right circumstances, this can produce revenue and significant tax benefits. Any rent you receive isn’t included in your income for tax purposes. On the other hand, you can only deduct property taxes and mortgage interest — no other operating costs or depreciation. (Mortgage interest is deductible on your principal residence and one other home, subject to certain limits.)
If you rent the property out for more than 14 days, you must include the rent received in income. However, you can deduct part of your operating expenses and depreciation, subject to certain rules. First, you must allocate your expenses between the personal use days and the rental days. For example, if the house is rented for 90 days and used personally for 30 days, 75% of the use is rental (90 out of 120 total use days). You’d allocate 75% of your costs such as maintenance, utilities and insurance to rental. You’d also allocate 75% of your depreciation allowance, interest and taxes for the property to rental. The personal use portion of taxes is separately deductible. The personal use part of interest on a second home is also deductible (if eligible) where the personal use exceeds the greater of 14 days or 10% of the rental days. However, depreciation on the personal use portion isn’t allowed.
Claiming a loss
If the rental income exceeds these allocable deductions, you report the rent and deductions to determine the amount of rental income to add to your other income. If the expenses exceed the income, you may be able to claim a rental loss. This depends on how many days you use the house for personal purposes.
Here’s the test: if you use it personally for more than the greater of a) 14 days, or b) 10% of the rental days, you’re using it “too much” and can’t claim your loss. In this case, you can still use your deductions to wipe out rental income, but you can’t create a loss. Deductions you can’t use are carried forward and may be usable in future years. If you’re limited to using deductions only up to the rental income amount, you must use the deductions allocated to the rental portion in this order: 1) interest and taxes, 2) operating costs and 3) depreciation.
If you “pass” the personal use test, you must still allocate your expenses between the personal and rental portions. In this case, however, if your rental deductions exceed rental income, you can claim the loss. (The loss is “passive,” however, and may be limited under passive loss rules.)
These are only the basic rules. There may be other rules if you’re considered a small landlord or real estate professional. Contact us if you have questions. We can help plan your vacation home use to achieve optimal tax results.
© 2021 Covenant CPA
A generous gift and estate tax exemption means only a small percentage of families are currently subject to federal estate taxes. But it’s important to consider state estate taxes as well. Although many states tie their exemption amounts to the federal exemption, several states have exemptions that are significantly lower — in some cases $1 million or less.
Moving out of state isn’t necessarily the answer
One way to avoid this tax burden is to retire in a state that imposes low or no estate taxes. But moving to a tax-friendly state doesn’t necessarily mean you’ve escaped taxation by the state you left. Unless you’ve cut all ties with your former state, there’s a risk that the state will claim you’re still a resident and are subject to its estate tax.
Even if you’ve successfully established residency in a new state, you may be subject to estate taxes on real estate or tangible personal property located in the old state (depending on that state’s tax laws). And don’t assume that your estate won’t be taxed on this property merely because its value is less than the exemption amount. In some states, estate taxes are triggered when the value of your worldwide assets exceeds the exemption amount.
Establishing residency in your new state
If you’re relocating to a state with low or no estate taxes, learn about the steps you can take to terminate residency in the old state and establish residency in the new one. Examples include acquiring a residence in the new state, obtaining a driver’s license and registering to vote there, receiving important documents at your new address, opening bank accounts in the new state and closing old ones, and moving cherished personal possessions to the new state.
If you own real estate in the old state, consider transferring it to a limited liability company or other entity. In some states, interests in these entities may be treated as nontaxable intangible property.
Before putting up the “for sale” sign and moving to lower-tax pastures, consult with us about addressing your current and future states’ estate taxes in your estate plan.
© 2021 Covenant CPA
If you own a valuable piece of art, or other property, you may wonder how much of a tax deduction you could get by donating it to charity.
The answer to that question can be complex because several different tax rules may come into play with such contributions. A charitable contribution of a work of art is subject to reduction if the charity’s use of the work of art is unrelated to the purpose or function that’s the basis for its qualification as a tax-exempt organization. The reduction equals the amount of capital gain you’d have realized had you sold the property instead of giving it to charity.
For example, let’s say you bought a painting years ago for $10,000 that’s now worth $20,000. You contribute it to a hospital. Your deduction is limited to $10,000 because the hospital’s use of the painting is unrelated to its charitable function, and you’d have a $10,000 long-term capital gain if you sold it. What if you donate the painting to an art museum? In that case, your deduction is $20,000.
One or more substantiation rules may apply when donating art. First, if you claim a deduction of less than $250, you must get and keep a receipt from the organization and keep written records for each item contributed.
If you claim a deduction of $250 to $500, you must get and keep an acknowledgment of your contribution from the charity. It must state whether the organization gave you any goods or services in return for your contribution and include a description and good faith estimate of the value of any goods or services given.
If you claim a deduction in excess of $500, but not over $5,000, in addition to getting an acknowledgment, you must maintain written records that include information about how and when you obtained the property and its cost basis. You must also complete an IRS form and attach it to your tax return.
If the claimed value of the property exceeds $5,000, in addition to an acknowledgment, you must also have a qualified appraisal of the property. This is an appraisal that was done by a qualified appraiser no more than 60 days before the contribution date and meets numerous other requirements. You include information about these donations on an IRS form filed with your tax return.
If your total deduction for art is $20,000 or more, you must attach a copy of the signed appraisal. If an item is valued at $20,000 or more, the IRS may request a photo. If an art item has been appraised at $50,000 or more, you can ask the IRS to issue a “Statement of Value” that can be used to substantiate the value.
In addition, your deduction may be limited to 20%, 30%, 50%, or 60% of your contribution base, which usually is your adjusted gross income. The percentage varies depending on the year the contribution is made, the type of organization, and whether the deduction of the artwork had to be reduced because of the unrelated use rule explained above. The amount not deductible on account of a ceiling may be deductible in a later year under carryover rules.
Other rules may apply
Donors sometimes make gifts of partial interests in a work of art. Special requirements apply to these donations. If you’d like to discuss any of these rules, please contact us.
© 2021 Covenant CPA
Studies have found that more people are engaging in online gambling and sports betting since the pandemic began. And there are still more traditional ways to gamble and play the lottery. If you’re lucky enough to win, be aware that tax consequences go along with your good fortune.
Review the tax rules
Whether you win online, at a casino, a bingo hall, a fantasy sports event or elsewhere, you must report 100% of your winnings as taxable income. They’re reported on the “Other income” line of your 1040 tax return. To measure your winnings on a particular wager, use the net gain. For example, if a $30 bet at the racetrack turns into a $110 win, you’ve won $80, not $110.
You must separately keep track of losses. They’re deductible, but only as itemized deductions. Therefore, if you don’t itemize and take the standard deduction, you can’t deduct gambling losses. In addition, gambling losses are only deductible up to the amount of gambling winnings. Therefore, you can use losses to “wipe out” gambling income but you can’t show a gambling tax loss.
Maintain good records of your losses during the year. Keep a diary in which you indicate the date, place, amount and type of loss, as well as the names of anyone who was with you. Save all documentation, such as checks or credit slips.
Hitting a lottery jackpot
The odds of winning the lottery are slim. But if you don’t follow the tax rules after winning, the chances of hearing from the IRS are much higher.
Lottery winnings are taxable. This is the case for cash prizes and for the fair market value of any noncash prizes, such as a car or vacation. Depending on your other income and the amount of your winnings, your federal tax rate may be as high as 37%. You may also be subject to state income tax.
You report lottery winnings as income in the year, or years, you actually receive them. In the case of noncash prizes, this would be the year the prize is received. With cash, if you take the winnings in annual installments, you only report each year’s installment as income for that year.
If you win more than $5,000 in the lottery or certain types of gambling, 24% must be withheld for federal tax purposes. You’ll receive a Form W-2G from the payer showing the amount paid to you and the federal tax withheld. (The payer also sends this information to the IRS.) If state tax withholding is withheld, that amount may also be shown on Form W-2G.
Since the federal tax rate can currently be up to 37%, which is well above the 24% withheld, the withholding may not be enough to cover your federal tax bill. Therefore, you may have to make estimated tax payments — and you may be assessed a penalty if you fail to do so. In addition, you may be required to make state and local estimated tax payments.
Talk with us
If you’re fortunate enough to win a sizable amount of money, there are other issues to consider, including estate planning. This article only covers the basic tax rules. Different rules apply to people who qualify as professional gamblers. Contact us with questions. We can help you minimize taxes and stay in compliance with all requirements.
© 2021 Covenant CPA
Given the escalating cost of health care, there may be a more cost-effective way to pay for it. For eligible individuals, a Health Savings Account (HSA) offers a tax-favorable way to set aside funds (or have an employer do so) to meet future medical needs. Here are the main tax benefits:
- Contributions made to an HSA are deductible, within limits,
- Earnings on the funds in the HSA aren’t taxed,
- Contributions your employer makes aren’t taxed to you, and
- Distributions from the HSA to cover qualified medical expenses aren’t taxed.
To be eligible for an HSA, you must be covered by a “high deductible health plan.” For 2021, a high deductible health plan is one with an annual deductible of at least $1,400 for self-only coverage, or at least $2,800 for family coverage. For self-only coverage, the 2021 limit on deductible contributions is $3,600. For family coverage, the 2021 limit on deductible contributions is $7,200. Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits can’t exceed $7,000 for self-only coverage or $14,000 for family coverage.
An individual (and the individual’s covered spouse) who has reached age 55 before the close of the year (and is an eligible HSA contributor) may make additional “catch-up” contributions for 2021 of up to $1,000.
HSAs may be established by, or on behalf of, any eligible individual.
You can deduct contributions to an HSA for the year up to the total of your monthly limitations for the months you were eligible. For 2021, the monthly limitation on deductible contributions for a person with self-only coverage is 1/12 of $3,600. For an individual with family coverage, the monthly limitation on deductible contributions is 1/12 of $7,200. Thus, deductible contributions aren’t limited by the amount of the annual deductible under the high deductible health plan.
Also, taxpayers who are eligible individuals during the last month of the tax year are treated as having been eligible individuals for the entire year for purposes of computing the annual HSA contribution.
However, if an individual is enrolled in Medicare, he or she is no longer eligible under the HSA rules and contributions to an HSA can no longer be made.
On a once-only basis, taxpayers can withdraw funds from an IRA, and transfer them tax-free to an HSA. The amount transferred can be up to the maximum deductible HSA contribution for the type of coverage (individual or family) in effect at the transfer time. The amount transferred is excluded from gross income and isn’t subject to the 10% early withdrawal penalty.
HSA Distributions to cover an eligible individual’s qualified medical expenses, or those of his spouse or dependents, aren’t taxed. Qualified medical expenses for these purposes generally mean those that would qualify for the medical expense itemized deduction. If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 20% tax will apply to the withdrawal, unless it’s made after reaching age 65 or in the event of death or disability.
As you can see, HSAs offer a very flexible option for providing health care coverage, but the rules are somewhat complex. Contact us if you have questions.
© 2021 Covenant CPA
If you use an automobile in your trade or business, you may wonder how depreciation tax deductions are determined. The rules are complicated, and special limitations that apply to vehicles classified as passenger autos (which include many pickups and SUVs) can result in it taking longer than expected to fully depreciate a vehicle.
Cents-per-mile vs. actual expenses
First, note that separate depreciation calculations for a passenger auto only come into play if you choose to use the actual expense method to calculate deductions. If, instead, you use the standard mileage rate (56 cents per business mile driven for 2021), a depreciation allowance is built into the rate.
If you use the actual expense method to determine your allowable deductions for a passenger auto, you must make a separate depreciation calculation for each year until the vehicle is fully depreciated. According to the general rule, you calculate depreciation over a six-year span as follows: Year 1, 20% of the cost; Year 2, 32%; Year 3, 19.2%; Years 4 and 5, 11.52%; and Year 6, 5.76%. If a vehicle is used 50% or less for business purposes, you must use the straight-line method to calculate depreciation deductions instead of the percentages listed above.
For a passenger auto that costs more than the applicable amount for the year the vehicle is placed in service, you’re limited to specified annual depreciation ceilings. These are indexed for inflation and may change annually.
- For a passenger auto placed in service in 2021 that cost more than $59,000, the Year 1 depreciation ceiling is $18,200 if you choose to deduct $8,000 of first-year bonus depreciation. The annual ceilings for later years are: Year 2, $16,400; Year 3, $9,800; and for all later years, $5,860 until the vehicle is fully depreciated.
- For a passenger auto placed in service in 2021 that cost more than $51,000, the Year 1 depreciation ceiling is $10,200 if you don’t choose to deduct $8,000 of first-year bonus depreciation. The annual ceilings for later years are: Year 2, $16,400; Year 3, $9,800; and for all later years, $5,860 until the vehicle is fully depreciated.
- These ceilings are proportionately reduced for any nonbusiness use. And if a vehicle is used 50% or less for business purposes, you must use the straight-line method to calculate depreciation deductions.
Heavy SUVs, pickups, and vans
Much more favorable depreciation rules apply to heavy SUVs, pickups, and vans used over 50% for business, because they’re treated as transportation equipment for depreciation purposes. This means a vehicle with a gross vehicle weight rating (GVWR) above 6,000 pounds. Quite a few SUVs and pickups pass this test. You can usually find the GVWR on a label on the inside edge of the driver-side door.
After-tax cost is what counts
What’s the impact of these depreciation limits on your business vehicle decisions? They change the after-tax cost of passenger autos used for business. That is, the true cost of a business asset is reduced by the tax savings from related depreciation deductions. To the extent depreciation deductions are reduced, and thereby deferred to future years, the value of the related tax savings is also reduced due to time-value-of-money considerations, and the true cost of the asset is therefore that much higher.
The rules are different if you lease an expensive passenger auto used for business. Contact us if you have questions or want more information.
© 2021 Covenant CPA
What if you decide to, or are asked to, guarantee a loan to your corporation? Before agreeing to act as a guarantor, endorser or indemnitor of a debt obligation of your closely held corporation, be aware of the possible tax consequences. If your corporation defaults on the loan and you’re required to pay principal or interest under the guarantee agreement, you don’t want to be blindsided.
Business vs. nonbusiness
If you’re compelled to make good on the obligation, the payment of principal or interest in discharge of the obligation generally results in a bad debt deduction. This may be either a business or a nonbusiness bad debt deduction. If it’s a business bad debt, it’s deductible against ordinary income. A business bad debt can be either totally or partly worthless. If it’s a nonbusiness bad debt, it’s deductible as a short-term capital loss, which is subject to certain limitations on deductions of capital losses. A nonbusiness bad debt is deductible only if it’s totally worthless.
In order to be treated as a business bad debt, the guarantee must be closely related to your trade or business. If the reason for guaranteeing the corporation loan is to protect your job, the guarantee is considered closely related to your trade or business as an employee. But employment must be the dominant motive. If your annual salary exceeds your investment in the corporation, this tends to show that the dominant motive for the guarantee was to protect your job. On the other hand, if your investment in the corporation substantially exceeds your annual salary, that’s evidence that the guarantee was primarily to protect your investment rather than your job.
Except in the case of job guarantees, it may be difficult to show the guarantee was closely related to your trade or business. You’d have to show that the guarantee was related to your business as a promoter, or that the guarantee was related to some other trade or business separately carried on by you.
If the reason for guaranteeing your corporation’s loan isn’t closely related to your trade or business and you’re required to pay off the loan, you can take a nonbusiness bad debt deduction if you show that your reason for the guarantee was to protect your investment, or you entered the guarantee transaction with a profit motive.
In addition to satisfying the above requirements, a business or nonbusiness bad debt is deductible only if:
- You have a legal duty to make the guaranty payment, although there’s no requirement that a legal action be brought against you;
- The guaranty agreement was entered into before the debt becomes worthless; and
- You received reasonable consideration (not necessarily cash or property) for entering into the guaranty agreement.
Any payment you make on a loan you guaranteed is deductible as a bad debt in the year you make it, unless the agreement (or local law) provides for a right of subrogation against the corporation. If you have this right, or some other right to demand payment from the corporation, you can’t take a bad debt deduction until the rights become partly or totally worthless.
These are only a few of the possible tax consequences of guaranteeing a loan to your closely held corporation. Contact us to learn all the implications in your situation.
© 2021 Covenant CPA