First Time Homebuyer 10% IRA Penalty Exception
If you withdraw amounts from your 401(k) plan or IRA before you are 59 1/2, the amount will be subject to income tax and a 10% early-distribution penalty. But what if you use those funds to purchase your first home? Well, if done properly, you may be able to avoid the 10% penaly.
Avoiding the penalty. The IRS allows taxpayers to avoid the 10% early distribution penalty from a retirement account under certain circumstances. One of those exceptions is if IRA monies are used to purchase a taxpayer’s first home. The maximum amount that may be distributed from the IRA on a penalty-free basis for the purpose of buying a first home is $10,000. This is a lifetime limit.
Qualified expenses defined. Per the IRS, the funds must be used in the following manner to qualify:
- It must be used to pay qualified acquisition costs (defined later) before the close of the 120th day after the day you received it.
- It must be used to pay qualified acquisition costs for the main home of a first time homebuyer (defined later) who is any of the following.
- Yourself.
- Your spouse.
- Your or your spouse’s child.
- Your or your spouse’s grandchild.
- Your or your spouse’s parent or other ancestor.
- When added to all your prior qualified first-time homebuyer distributions, if any, total qualifying distributions cannot be more than $10,000.
- If both you and your spouse are first time homebuyers each of you can receive distributions up to $10,000 for a first home without having to pay the 10% additional tax.
Qualified acquisition costs include the following items.
- Costs of buying, building, or rebuilding a home.
- Any usual or reasonable settlement, financing, or other closing costs.
Coordination of IRS Form 1099R with your plan administrator. Whenever one takes money out of a retirement plan, the plan administrator will report it to you and the IRS on Form 1099R. The codes in Box 7 will help one report what type of distribution was made and if there were any exceptions. If you are under 59 1/2 an will be using the amounts to purchase a home, while not required, it may be a good idea to let the plan administrator know. That way they can report the amounts with Code 2 on the 1099-R, which indicates that there is an exception to the 10% penalty.
How to make 401(k) funds penalty free. Even if a distribution form your 401(k) will be used towards the purchase of your first home, the first-time homebuyer exception does not apply to distributions from qualified plans such as a 401(k). Furthermore, if the amount you receive is rollover eligible, your employer is required by law to withhold 20% of it for federal income tax.
Assuming you are eligible to receive the distribution and the amount is rollover-eligible, you can instruct the 401(k) plan to process your distribution as a direct rollover to an IRA. You would have to open the IRA before the rollover occurs and tell them to deposit the funds to this new account (or your existing IRA). This will ensure that the 20% federal tax withholding is not applied to the amount. Additionally, you can then withdraw the amount from your IRA for use towards the purchase of your first home, thereby avoiding the 10% early-distribution penalty.
Properly reporting exceptions that were incorrectly reported. Sometimes despite letting the plan administrator know that the IRA funds will be used to purchase your first home, they may still be reported incorrectly on Form 1099R. Typically, this will result in Box 7 of the form indicating Code 1 – Early distribution, no known exception (in most cases, under age 59½).
However, if the funds were used to purchase your first home, there is a fix. One would need to use IRS Form 5329 Part I to report the exception. Specifically, one would list the amount reported on the Form 1099R on line one. You would then list the amount that was used to purchase the home (up to $10K during your lifetime) on line two and enter in exception Code 09 – IRA distributions made for the purchase of a first home, up to $10,000. For more details and specifics on the steps, see the Form 5329 Instructions.
Spending to Save Taxes vs. Generate Revenue
A few weeks ago we were speaking to one of our business clients about their tax planning needs for the upcoming year. During this session, we got to talking about how spending money yields a “tax rate” reduction of one’s taxes for every dollar they spend. This then prompted the analysis of spending to save on taxes versus to generate revenue. Let us elaborate.
How Income Taxes Work. A while back, we wrote about how the income tax system works with regards to refunds and balances due in this post. The short version is that for each $1 you earn, you have to pay an associated amount of taxes based on your marginal tax bracket. Conversely, for each $1 you spend on a deductible expense, it reduces your associated taxes by the tax rate applicable to your highest marginal tax bracket.
Spending To Save On Taxes. One of the things we always try to convey to clients is to spend money on what makes financial, life or business sense. Don’t spend money to save on taxes; if you receive an associated tax benefit, that’s just icing on the cake. Why? Let us illustrate.
Let’s say that Ricky lives in his mothers basement. She doesn’t charge him any rent, but he gets this “idea” of buying a house so he can get a tax deduction. So he goes and gets a mortgage and spends $10,000 on mortgage interest, which is tax deductible. To keep things simple, we’ll assume that all of the mortgage interest is reflected on his return and that his last marginal tax bracket is 25%. Based on this, he can expect to see his tax liability drop by $2,500. But let’s look at it another way…
Ricky wasn’t paying anything to live in the basement. Zero, zip, zilch! But to get a $2,500 tax deduction, he went out and spent $10,000 on mortgage interest? In the world of Finance we go by two rules:
- Cash now is better than cash later – due to inflation $1 today is worth more than $1 in the future so give me the money NOW!
- You only “save” money when you spend $0 – spending money is just that, an expenditure (no matter how big of a discount; sorry discount shoppers).
Using these two rules, it’s pretty clear that Ricky is in violation of the second.
Spending to Generate Revenue. Thus, if you are faced with a decision to spend money, we usually recommend that you do so to generate more revenue (especially if you are in business). Why? There are numerous reasons but some include:
- You won’t see as big of a tax reduction as you would hope for by spending it on deductible expenses (see the example above).
- Increased revenue will allow you to spend on more beneficial expenses (e.g. increased payroll for yourself).
- Who doesn’t like more money? Oh yeah, the Capital One Baby!
So let’s change things up and assume that Ricky owns his own delivery business. He files his business income and expenses on a Schedule C so any profit from his business shows up on his personal return and is taxed at his marginal tax rate (25%). For this tax year thus far, he has $50,000 in profit (income less expenses) from his business.
Instead of buying a house, he decides to spend $10,000 on some billboard advertising. Now his profit is only $40,000 because the advertising expense is tax deductible. But those ads generate $25,000 of new business. Way to go Ricky! So his profit then becomes $65,000. Sure, he will have to pay $3,750 more in taxes ($65K – $50K = $15K x 25%) then he would have had to if he didn’t run the advertisements. But the flip side is that he will be left with $11,250 in more cash.
Now, if Ricky has a smart tax accountant on his team (like us), they might tell him to open a SEP IRA where he could put almost all of that additional $15K above his original $50,000 profit towards his retirement savings. Best thing about that is 1) it’s deductible on his tax return and 2) he’s funding the day he can park that delivery van for good!
Need some help with your tax planning? Want to brainstorm on how you can best spend your money? Give us a call or shoot us an email and we’d be happy to chat with you!
Until next time…
Our 4th Tax Season
It’s sort of become a tradition for us to provide a recap of how our previous tax seasons have gone. What is special about this year is that while it is our fourth with our Beverly retail office, it marks our 10th year in business! Keep your eyes peeled for a future post on that topic and some special things we will be doing to celebrate.
As always, we’ve still got some more analysis to do, but here are some of the preliminary successes that we are aware of:
- 20% growth in client load
- 49 new clients entrusted us with their tax situation
- Revenue growth in excess of 45%
- Processed returns in 19 states, which is slightly down from last year, BUT does not include anything we have on extension (which could send us above the number of states processed last year).
Our Challenges We won’t rehash too much of this here as we already put out a post on why this was the worst tax season in 35 years. We’ll just simply let you read that one at your leisure!
Our Triumphs. There were a lot of things that did go well this season. The short version includes:
- Staffing – We had some of our seasoned folks come back and we added new faces to the lineup. Without either Stephanie or Patricia working in the trenches this year, things would have been a lot harder than they were. Thank you ladies!
- Bus Benches – We’ve written about how bus benches work in the past. What we noticed this year is that the longer they are in the public space, the better they do over the long haul. This year alone we can attribute 18% of our new clients coming as a result of these benches. With a little bit of refining, looks like this will continue to be a medium we advertise with.
- Gaining Scale – Scale can mean a lot of things in business. What we are referring to is that fact that the business is taking on a life of it’s own. It’s reached a size where things are sort of just “naturally occurring” and it’s now our job to simply try and guide it. This is a good thing though and something that we’ve been anticipating for the past 3 years. It now means that we can begin to transition how we do things and set our focus a little further down the road instead of simply where are next sale will come from.
While growing a financial service business is not easy in today’s competitive environment, it’s satisfying to know that we’re still able to make progress towards the goals we set out for ourselves 10 years ago.
If you want to know how any of our past seasons went, feel free to read about them here:
Season One
Season Two
Season Three
Here’s looking to a bright future and since we’re 80’s babies, only this song would be considered fitting!
Want New Clients? Ask Your Existing Ones!
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an act of referring someone or something for consultation, review, or further action.
There are certain professions (e.g. realtors, attorneys, tax professionals, etc.) who source a majority of their “new” business from referrals. However, ALL businesses can benefit by asking for them. The key is to make sure you have a program in place to do so and that you actively utilize it. This post will tell you how to create such a program and set it up so that the probability of you reaping the rewards are maximized.
Create your customer database. The first place to start when creating a referral program is your database or “house list.” Don’t have one? Well, this is where you start! Create a list of anyone and everyone that you have ever done business with. “But I’ve been in business for 10 years. Do you seriously expect me to go back and find everyone who’s ever paid me during that time?” Well, you certainly don’t have to, but it’s to your advantage to so. It’s often said that it cost 5-7 times more to obtain a new customer than it does to keep (or sell to again) an existing one. Thus, the more existing clients you can identify, the better your referral program will work.
Mine your customer database. The next step is to review your database and identify those who match your IDEAL profile. Who are those clients?
- The ones who you like to work with.
- The ones who you have a good relationship with.
- Those who pay their bills in a reasonable amount of time.
- Those whom you have helped with a particular challenge.
- Those whom you saved money.
The list goes on and on. But essentially what you are looking for are those clients whom you would like more of in your portfolio AND those whom are most likely to recommend you. Those who you have helped in the past are already predisposed to mentioning you to others. But why not just ask all the clients whom you’ve worked with? Well, clients tend to refer those who are similar to themselves. So if you want more problem clients, then ask the ones you hate working with to send you business and you’ll wind up with more of the same!
Create a touch program. Now that you have your list, you need to stay in regular contact with them. You’ll understand why in the next step. You can do this in a number of ways, but essentially you want to create what is referred to as a touch program. A touch is considered an interaction and can materialize in many forms. These include monthly newsletters, email blast, blog posts, holiday cards, birthday/anniversary cards, client promo gifts, client appreciation events, phone calls, emails, etc. The exact mechanism that you use to “touch” your customer is pretty irrelevant. The key is that you simply do it. How often should you contact your customers? The numbers vary depending on who you talk to but most agree that monthly is a minimum.
Maintain top of mind awareness. The real point of the touch program is so that you create Top Of Mind Awareness (TOMA). What exactly is this? Well, it’s when you are the first person (i.e. top of mind) your client thinks of when either they OR a friend have a problem that needs to be solved. You want them to call you first, not the competitor. You want them to tell their friends about you, not that store down the street. Chances are, if they hear from you every month, you will be the one that they think of. But what if they throw your monthly communication straight into the trash? Doesn’t matter. The fact of the matter is that they knew that it came from YOU before they threw it into the trash!
Ask for the referral. Okay, so now that you’ve done all of the above, it’s time to do the following:
- Ask your client for referrals. Yes, ASK them. The number one reason sales folks fail to get business is because they never explicitly ask for the sale. The same can be said for referrals. When you complete a sale or a job, ask your client if there is anyone else they know whom you could help. If the client seems squeamish, hand them a stack of business cards and tell them to just pass them on if they think of someone. If they are willing to give you a name and phone number, that’s even better!
- Have a letter made describing how to refer to you. If you can tell your client who your ideal client is, how to spot them and how to send them to you, it makes the process run that much smoother. We no longer use this exact document, but it is one that we would give our clients who visited our office and picked up hard copies of their returns.
- Incentivize your clients to refer you. Some clients will be motivated by monetary compensation. Some will be happy if you mention their referral action in your newsletter. Some don’t want anything and just want to make sure their friends are sent to someone they trust and know will do good work. But no matter how you incentivize the act of making a referral, make sure that you have a way to say “thank you” to your clients.
If you need help with a business matter (like how to get more clients), why not give us a call for your FREE 30 minute business brainstorming bout. This session (valued at $250) is yours for FREE if you mention this post (or BBB). In it, we’ll evaluate one challenge facing your business and give you an actionable way to address it. To schedule your BBB, simply give us a call at 773-239-8850 or shoot us an email via the link in the footer of this page.
Worst Tax Season In 35 Years!
We’re usually pretty positive and “Pollyannaish” when it comes to things around here. But this tax season is REALLY different. Things are taking much longer than they should, clients are delaying, there aren’t enough hours in the day; the list is endless. The last time things were this bad was back in 1986 when Congress enacted the Passive Activity Loss rules. But why is 2015 so bad? Take a look below:
The Budget. Congress has shrunk the IRS budget over the past five years, while at the same time requiring the agency to administer even more complex laws. The IRS topline budget for 2015 is about 10% less than it was in 2010. But the real drop is actually steeper since the 10% doesn’t account for cost increases that have occurred in the past five years. During roughly the same period, the number of IRS personnel has fallen by at least 8%. Furthermore, the amount of money the agency has for staff training has dropped by more than 85%.
What this means is that the average taxpayer has to 1) wait almost an hour to speak to a representative, 2) greater than 50% of taxpayers that call the IRS wind up hanging up without getting an answer and 3) even us practitioners can’t get our work/cases solved in the same amount of time with the agency. Frustration on all fronts would probably be an understatement.
More Work and Complexity. This tax season is the first where the IRS has to administer the premium tax credits and individual mandates under the Affordable Care Act. Firsts are never perfect, of course, so it should be expected that this will be long, painful and not easy for most taxpayers or professionals. Need help figuring it out? See the first pain point above!
Tangible Property Repair Regulations. New and effective for 2014, these regulations changed how we evaluate repair costs as they relate to tangible property. If you file a Schedule C, E or F, you have the potential to experience what may be the single biggest pain in the arse of the entire 2015 tax season.
While the IRS gave small businesses a reprieve from having to fill out Form 3115, Change in Accounting Method, for those with many years’ worth of assets on their books (e.g. landlords), you may still want to fill one out. This is because 1) you will forego audit protection if you don’t submit it with your return and 2) you may need to calculate a Section 481 adjustment if things are still being depreciated and shouldn’t.
The best part of Form 3115? It has to be sent in via paper to Ogden Utah prior to you filing your return and then again when you electronically file it. With that being said, the average tax preparer is probably completing more Forms 3115 this year than in all of their career.
Needless to say, all of the above hasn’t made for an “easy” tax season to say the least. So if you know someone in the tax industry, make sure you give them a hug or tell them that it will be alright. Many of us could use the love!
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