Avoid These Traps When Moving IRA and Retirement Plan Assets

It pays to be careful when moving money from one traditional individual retirement account (IRA) to another or from an employer’s retirement plan to an IRA. Unless you follow certain guidelines, you may find yourself paying taxes on what could have been a tax-free transaction.

60-day time limit: You can withdraw all or part of the assets from your traditional IRA and reinvest them in the same or another traditional IRA. But you don’t have unlimited time to complete the rollover. For the transaction to be tax-free, you must reinvest within 60 days. The same 60-day time limit applies to rolling over an eligible distribution you receive from your employer’s plan (but see 20% withholding below for another potential trap).

Non-cash rollovers: When you withdraw securities or other non-cash property from your traditional IRA, your rollover to another traditional IRA will be tax-free only if you contribute the same property you withdrew. With a distribution of non-cash property from an employer’s plan, you also have the option of selling the property and contributing the sale proceeds to a traditional IRA. However, you can’t keep the property and contribute cash in its place.

Rolling over a plan distribution of appreciated employer securities into an IRA isn’t necessarily the most tax-wise alternative. Taking the securities is sometimes a better option if you qualify for special tax treatment.

Waiting period: After you’ve made a tax-free IRA rollover, you generally must wait at least a year to do another rollover from that IRA or the IRA into which you rolled over your funds. The one-year period begins on the date you receive the IRA distribution. If you want to move your money to another IRA before the year is up, you can have your IRA trustee transfer funds directly to another IRA trustee. The once-a-year limit doesn’t apply to rollovers of eligible distributions from an employer’s plan.

20% withholding: If you’re rolling over a distribution from an employer’s plan into another employer’s plan or an IRA, it’s usually best to arrange for a direct rollover. With a direct rollover, your plan simply pays the distribution directly to the other plan or your traditional IRA. If the plan pays the distribution directly to you, it’s required to withhold 20% for federal income taxes. You’ll have to replace the 20% withheld with funds from another source if you want to roll over the entire distribution within 60 days. A direct rollover avoids the withholding trap.

Education Expenses — Are They Deductible?

Given the high cost of higher education, this issue is more than academic — significant tax dollars may be at stake.

Job-related Education. Your cost of job-related education is deductible if the education:

• Maintains or improves skills related to your existing job, trade, or business or
• Is required — by law or your employer — to keep your position or job.

Conversely, you aren’t allowed to deduct the cost of education that’s required to enter a field or that qualifies you for a new trade or business.

These rules can be tricky to apply. For example, one taxpayer whose job duties involved sales, marketing, and management was allowed to deduct his cost of obtaining an M.B.A. since the education allowed him to do more complex tasks in those areas. But another taxpayer who got an M.B.A. was not permitted a deduction because the course work improved his general competency in business administration rather than specific employment skills.

If you are employed, you must claim any education expenses that qualify for a deduction as a miscellaneous itemized deduction. Only the amount (when combined with your other miscellaneous expenses) in excess of 2% of your adjusted gross income is deductible.

An Alternative: Depending on the specifics of your situation, you might be able to claim a tax credit (Lifetime Learning or American Opportunity) for a portion of your tuition and related expenses instead of taking a deduction. We can help you analyze your options.

Combining Business and Vacation

Whether it’s responding to e-mail, talking to customers, or participating in meetings, it’s not unusual for taxpayers to stay connected with work while they’re on vacation. But just because you spend time working while sitting in your beach chair doesn’t mean your vacation expenses will be tax-deductible.

Travel expenses represent potentially deductible business expenses only if they’re necessary, reasonable, and directly connected to the pursuit of your trade or business. It’s okay with the IRS if your trip mixes business and vacation, but you’ll have to jump through some hoops to be able to deduct a portion of your travel expenses.

Getting there and back. When a trip is related primarily to your trade or business, you may deduct the cost of getting to and from your U.S. destination (e.g., plane or train fare or auto expenses if you drive). You can take a mini-vacation, just be sure you devote more days to business activities so you can prove that business was the primary purpose of your trip.

Lodging. Hotel charges for the days you spend engaging in business-related activities are deductible.

Meals. You generally may deduct 50% of your reasonable meal expenses for the business portion of your trip. However, the cost of meals on your vacation days won’t be deductible.

Other. Business-related taxi, subway, or bus fare, as well as car rental fees for the business portion of your trip, are potentially deductible. And don’t overlook charges for business-related phone calls or using a hotel’s business center for work purposes.

We can help you sort through the rules and maximize deduction opportunities.

Can You Deduct Home Office Expenses?

Technology has made it possible for more people to work from home. If you’re among them, you may be eligible to deduct “home office” expenses related to using your home for business purposes.

Potentially Deductible Expenses

Examples of home office expenses include:

• Utilities
• Homeowners insurance
• Security systems
• Home repairs
• Trash removal
• Depreciation

The most common way to determine the amount of a home expense allocable to business use of the home (the deductible amount) is to multiply the expense by the percentage of your home’s total square footage devoted to business use.

Example: Jamie, a freelance graphic designer, uses a 120 square foot extra bedroom in her 1,200 square foot condo as her office. If she otherwise qualifies, Jamie may deduct 10% (120/1,200) of her home expenses.

A second approach basically divides the number of rooms used for business by the total number of rooms in the home to determine the deductible percentage. This method sometimes results in a larger deduction.

Qualifying for the Deduction

The home office deduction may be available if you use part of your home as your principal place of business, taking into account the relative importance of the activities you perform at each place where you conduct business and the amount of time you spend in each of those places. Your home may qualify as your principal place of business if it’s the only fixed location where you perform substantial administrative and management activities for your business.

Even if your home isn’t your principal place of business, you may be eligible for a deduction if:

• You use part of your home to meet or work with clients, customers, or patients in the normal course of business or
• Your workspace is located in a structure that’s separate from your home — a detached garage, for example.

Another requirement for the home office deduction is that you use the space in your home exclusively and regularly for business purposes. The exclusive-use requirement can be difficult for many taxpayers to meet.

Example: Tom is a home-based management consultant who does most of his work on a personal computer located in his home office. Tom often lets his kids use the computer for homework assignments in the evenings. Because Tom does not use his home office exclusively for business, he can’t claim the home office deduction.

There are exceptions to the exclusive-use rule for space used regularly to store product samples or inventory and for certain in-home daycare facilities.

If You’re an Employee

You must meet additional criteria to qualify for the home office deduction if you’re an employee. The deduction will be available only if you use the home office for the convenience of your employer (based on all the facts and circumstances) and your employer does not rent the space from you. You won’t qualify if your use of the home office is merely helpful or appropriate.

Potential Downside

As generous as the home office deduction can be, there is a potential tax downside. Gain resulting from selling your home will be taxable to the extent of depreciation deductions that were allowed for your home office for periods after May 6, 1997.

Tax Planning for Divorce

Taxes are typically not a high-priority concern for divorcing couples. Still, various tax-related issues deserve attention.

Property settlements: Assets generally can be divided up in connection with a divorce on a tax-free basis. But it’s still important to keep taxes in mind in determining who gets what. Here’s an example. Let’s say Maria and Al’s property settlement calls for Al to receive stock worth $100,000 (originally purchased for $25,000) and Maria to receive $100,000 cash. If Al sells the shares after the divorce for $100,000, he’ll have to report — and potentially pay taxes on — a $75,000 capital gain. Maria, on the other hand, has no tax worries since she received cash.

A qualified domestic relations order (QDRO) is typically required if one spouse is to receive a share of the other spouse’s retirement plan benefits. With a QDRO, the spouse who receives the benefits — not the spouse who earned them — will be responsible for any taxes due when the benefits are paid out.

Personal residence: If a divorcing couple sells their home while they are still married, they are entitled to exclude up to $500,000 of gain from their taxable income if otherwise eligible for the exclusion. If the ownership of the home is simply transferred to one spouse as part of the divorce settlement, there is no taxable gain or loss at the time of transfer.

However, if the house is sold at a later time, the capital gain exclusion would be capped at $250,000 (unless the selling spouse has remarried).

Alimony vs. child support: This is an important distinction. Alimony payments are tax-deductible and represent taxable income to the recipient. In contrast, child support payments are not deductible and are not included in the recipient’s income. The IRS characterizes payments linked to an event or date relating to a child — such as high school graduation or a 21st birthday — as child support rather than alimony.

For tax planning assistance in a divorce situation, please contact us.

The general information in this publication is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties