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American Recovery and Reinvestment Act of 2009: Catch a Break

Tax Tips For Individuals Summer 2010

Want to Save for Future Medical Expenses?
Consider opening a Health Savings Account

If you are covered under a high deductible health plan, you may be eligible to make tax deductible contributions to a Health Savings Account (HSA). Contributions may remain in the account from year-to-year until you use them and can generate tax-deferred or tax-free earnings. An HSA is “portable” so it stays with you if you change employers or leave the work force. Also, the interest or other earnings on the assets in the account accumulate tax free.

For 2010, you can contribute up to:

  • $3,050 if you have self-only coverage with an annual deductible of not less than $1,200 and your annual out-of-pocket expenses do not exceed $5,950.
  • $6,150 if you have family coverage with an annual deductible of not less than $2,400 and your annual out-of-pocket expenses don’t exceed $11,900.
  • $1,000 in catch-up contributions for individuals age 55 or older.

You can receive tax-free distributions from your HSA to pay for any qualified medical expenses for the current or prior year as long as the expenses were incurred after the HSA was established. Most medical expenses incurred by you, your spouse, or any dependents qualify. Nonqualified distributions, however, are taxable and generally subject to a 10-percent penalty. Caution: This penalty increases to 20 percent for nonqualified distributions after 2010.

Because earnings are tax-deferred, an HSA could also be used as a means to save for retirement. Nonqualified distributions after attaining age 65 are taxable but not subject to the additional penalty.

Over-the-Counter Drugs
Get reimbursed before it’s too late!

In 2010, you may receive a nontaxable reimbursement from a health flexible spending account (FSA) or a health reimbursement arrangement (HRA) for qualified medical expenses, including expenses incurred for over-the-counter drugs. In addition, you may take nontaxable distributions from a health savings account (HSA) or an Archer medical savings account (MSA) for over-the-counter drugs.

However, due to changes made by the Affordable Care Act, after 2010 over-the-counter drugs no longer qualify as a medical expense unless they are prescribed. In other words, if you want to use such plans to pay for over-the-counter drugs, 2010 is the last year to do so without a prescription. Note: Insulin is an exception to the rule.

Early Distributions From Qualified Plans
Are you subject to a penalty?

If you take a distribution from a qualified retirement plan before reaching age 59½, it is considered an early distribution and is generally taxable and subject to an additional 10-percent penalty. There are some exceptions for distributions that are:

  • Due to death.
  • Due to the account owner’s disability.
  • Substantially equal periodic payments.
  • Due to separation from service after age 55 (employer-provided plan only).
  • Due to the extent medical expenses exceed 7.5 percent of adjusted gross income.
  • On account of an IRS levy.
  • Under a qualified domestic relations order (employer-provided plan only).

Note: Hardship is not one of the exceptions. It’s simply a means to take an early distribution from a 401(k) or other type of employer plan.

Some exceptions only apply to early distributions from an IRA, including:

  • Health insurance related distributions to the unemployed.
  • Distributions taken for qualified higher education expenses.
  • Distributions taken for first-time home purchases.

If you take an early distribution from an IRA to pay qualified higher education expenses, the 10-percent penalty does not apply. However, if you take an early distribution from a 401(k) for the same purpose, the penalty does apply. You can avoid the penalty if you roll over the distribution from the 401(k) into an IRA first and then take a distribution from the IRA. It’s best to seek the advice of a tax professional before taking a distribution from any retirement plan.

Saver’s Credit
Another reason to save for retirement

If you make contributions to a traditional or Roth IRA, elective deferrals to a 401(k), 403(b), governmental 457, SEP, or SIMPLE plan, voluntary employee contributions to a federal Thrift Savings Plan, or contributions to a 501(c)(18)(D) plan, you may qualify for a Credit for Qualified Retirement Savings Contributions (saver’s credit).

The credit equals a percentage of your eligible contributions (up to $2,000). The percentage varies from 10, 20, or 50 percent depending on your adjusted gross income and filing status. Thus, the maximum credit is $1,000 ($2,000 x 50%). For 2010, the saver’s credit is available if your adjusted gross income does not exceed:

  • $55,500 on a joint return.
  • $41,625 on a head of household return.
  • $27,750 on all other returns.

In addition, your eligible contributions must be reduced by any taxable distributions received after 2007 and before the due date of the 2010 return (including extensions) from any plan to which eligible contributions may be made. Keep this in mind if you qualify for the saver’s credit and are thinking of taking a distribution from one of these plans.

Adopting a Child?
You may be eligible for a tax credit

If you already adopted a child or have simply started the adoption process, you may be able to claim a credit on your 2010 tax return. For a domestic child with special needs, you may be entitled to a credit of $13,170 regardless of your actual adoption expenses. For all other adoptions, the credit is limited to the qualified adoption expenses you paid, up to $13,170. In addition, the credit is reduced when your modified adjusted gross income is between $182,520 and $222,520. 

The adoption credit is not always claimed in the same year the expenses were paid. In general, if it’s a foreign adoption or a special-needs adoption, the credit is claimed in the year the adoption becomes final. If it’s a domestic adoption, the credit is claimed in the year after the year of payment. However, expenses paid in the final year, or any year after the adoption becomes final, are claimed in the year of payment. 

This credit is refundable in 2010, so it’s not limited by your tax liability. Even if you don’t owe tax, you’ll receive a refund for the full amount of the credit.

First-Time Homebuyer Credit
Are you required to repay it?

If you purchased a home in 2008 and claimed the first-time homebuyer credit, you must repay the credit in equal installments over a 15-year period beginning on your 2010 tax return.

If you purchased a home after 2008 and claimed the first-time homebuyer credit, you do not have to repay the credit if you own and use the home as your principal residence for at least 36 months beginning on the date of purchase. On the other hand, you generally must repay the credit if you dispose of your home or stop using it as your principal residence within this 36-month period. This includes situations where you sell the home, convert the home to business or rental property, abandon the home, or the lender forecloses on the mortgage.

In general, you repay the credit by including it as additional tax on the return for the year you dispose of the home or it ceases to be your main home. Following are some exceptions to the repayment rules:

  • If you sell the home to an unrelated person, the repayment in the year of sale is limited to the amount of gain on the sale. The amount of the credit in excess of the gain does not have to be repaid.
  • If you are a member of the uniformed services, you do not have to repay the credit if, after 2008, you sell the home or cease to use it as your principal residence because you received government orders to serve on qualified official extended duty.
  • If the home is destroyed, condemned, or disposed of under threat of condemnation, you do not have to repay the credit as long as you purchase a new main home within two years of the event and you own and use it as your new main home during the remainder of the 36-month period.
  • If the home is transferred to a spouse or former spouse incident to divorce.
  • If you die, repayment is not required. However, if the credit was claimed on a joint return, your surviving spouse is still subject to the repayment rule for his or her half of the credit.

American Opportunity Tax Credit (AOTC)
Should your child claim the credit?

The AOTC is a partially-refundable tax credit to help make college more affordable. A refundable tax credit allows a taxpayer to receive a refund if the amount of the taxpayer’s tax credit exceeds the taxpayer’s income tax liability. The AOTC is refundable up to a maximum of 40 percent ($1,000) of the maximum tax credit of $2,500.

If you claim your child as a dependent, you can claim an education credit for his or her qualified education expenses. You can even include expenses paid by your child or someone else. You can choose not to claim your child as a dependent so he or she can claim the education credit. However, if an individual is eligible to be claimed as a dependent, that individual’s personal exemption deduction is zero. Please note: If you don’t claim your child as a dependent so he or she can claim the AOTC, your child does not qualify for the refundable portion of the credit if all of the following apply.

  • Your child was:
  • Under age 18 at the end of 2010; or
  • Age 18 at the end of 2010 and his or her earned income (i.e., wages, salaries, tips, etc.) was less than one-half of his or her support; or
  • A full-time student over age 18 and under age 24 at the end of 2010 and his or her earned income was less than one-half of his or her support.
  • At least one of the child’s parents was alive at the end of 2010.
  • Your child is not filing a joint return for 2010.

The AOTC can also be claimed in the same year a beneficiary takes a tax-free distribution from a
529 plan, as long as the same expenses are not used for both benefits.

Foreclosures and Cancellation of Debt
Are there any tax consequences?

If you lose your house in foreclosure, there may be some tax consequences. If you were personally liable for the debt, you must report a sale for the lesser of the debt outstanding or the fair market value (FMV) on the date of foreclosure. If you were not personally liable, the sales price equals the debt outstanding. Up to $250,000 ($500,000 on a joint return) of any gain on the sale may be excluded if you owned and used the home as your principal residence for at least two out of five years ending on the date of the foreclosure. Any loss on the sale is a nondeductible personal loss.

You may also have cancellation of debt income if you were personally liable for the debt, the debt outstanding exceeded the FMV, and the excess debt was canceled. In general, cancellation of debt income is taxable. However, you can exclude it from gross income if it was qualified principal residence indebtedness, to the extent you were insolvent, or due to bankruptcy.

Qualified principal residence indebtedness is debt incurred to acquire, construct, or substantially improve your principal residence. If you took out a home equity loan to pay off credit card debt, that part of the loan does not qualify for the exclusion. In this case, the amount that may be excluded from income is limited to the amount canceled over the amount that is not qualified principal residence indebtedness. The balance of the debt, however, may still qualify for the insolvency or bankruptcy exception.

Quick Tips

  1. In 2009, the first $2,400 of your unemployment benefits was excluded from gross income. This exclusion is no longer available in 2010, so you may need to request additional withholding by filing Form W-4V, Voluntary Withholding Request.
  2. The $400 ($800 if married filing jointly) Making Work Pay Credit is still available for 2010, so your withholding will remain a little lower for one more year. You may need to request additional withholding if you get a second job or your spouse starts working, because each employer is withholding less and the total reduced withholding may exceed the allowable credit.
  3. There is no federal tax credit for individuals who buy energy efficient appliances. There may be a state rebate. You can check to see if your state offers such a rebate by going to www.energystar.gov and clicking on the Appliance Rebate Program map.
  4. If you moved recently, you should notify the IRS of the change of address by filing Form 8822.
  5. In 2010, you can convert a traditional IRA or a qualified plan to a Roth IRA regardless of your adjusted gross income. In addition, half of the taxable income from a 2010 conversion will be included in your gross income in 2011 and the other half in 2012. However, you can elect out of this two-year period and include all of it in 2010.

Tax Tips for Individuals Winter 2009/2010

Plug-in Electric Vehicle Credits
Go green and save!

You may be able to claim one of three credits for plug-in electric vehicles manufactured primarily for use on public streets, roads, and highways. Vehicles manufactured for use on a golf course do not qualify.

(1) The plug-in electric drive motor vehicle credit is available for newly purchased qualified vehicles placed in service for business or personal use after 2008.

  • For 2009, the amount of the credit varies depending on the battery capacity and the weight of the vehicle and ranges from $2,500 to $15,000. 
  • After 2009, the credit tops out at $7,500, depending on the battery capacity. To qualify, vehicles must be newly purchased, have four or more wheels, have a gross vehicle weight rating (GVWR) of less than 14,000 pounds, and draw propulsion using a rechargeable battery with at least four kilowatt hours.

(2) The plug-in electric vehicle credit is available for certain vehicles purchased after February 17, 2009, and before January 1, 2012. The credit equals 10 percent of the cost of a new vehicle, up to a maximum credit of $2,500. You can either purchase: 

  • Certain low-speed vehicles (i.e., four-wheeled vehicles with a GVWR of less than 3,000 pounds) that are propelled to a significant extent by a rechargeable battery with a capacity of at least 4 kilowatt hours; or 
  • A two- or three-wheeled vehicle (i.e., motor scooter, motorcycle, etc.) with a GVWR of less than 14,000 pounds that is propelled to a significant extent by a rechargeable battery with a capacity of at least 2.5 kilowatt hours.

For 2009, you cannot claim this credit for a vehicle that qualifies for the plug-in electric drive motor vehicle credit. You cannot claim both credits for the same vehicle.

(3) The plug-in conversion credit applies to property placed in service after February 17, 2009, and before January 1, 2012. The credit equals 10 percent of the cost of converting any motor vehicle (new or used) to a qualified plug-in electric drive motor vehicle, up to a maximum credit of $4,000. You may claim this credit even if you already claimed a hybrid vehicle credit for the same vehicle in an earlier year.

Check out www.pluginamerica.org and www.eaaev.org for more information on plug-in electric vehicles.

Making Work Pay Credit and Pensions
Should you adjust withholding?

In February 2009, the government reduced the withholding tables for the Making Work Pay Credit. If you are receiving a pension and have no earned income, you do not qualify for the Making Work Pay Credit. However, if you have withholding from your pension payments, you may not have enough, and may end up owing more taxes when you file your tax return.

Pension payors were provided an optional procedure for additional withholding on pension payments to offset the withholding reductions for the Making Work Pay Credit. However, they are not required to use this procedure, so you should check with your pension plan administrator.

If your pension payor does not use the optional adjustment procedure, you can increase your withholding by filing Form W-4P, Withholding Certificate for Pension or Annuity Payments. If you submitted a Form W-4P to request additional withholding after the 2009 February withholding tables were issued, and your pension payor is using the optional adjustment procedure, you may want to submit a new Form W-4P to get rid of the additional withholding.

Earned Income Credit (EIC)
Should you request an advance payment?

In 2009 and 2010, there is an increased EIC for taxpayers with three or more qualifying children. The EIC reduces the tax you owe, and gives you a refund even if you do not owe any tax. In 2009, you may be able to claim the credit if:

  • You have three or more qualifying children and your earned income and adjusted gross income (AGI) are less than $43,279 ($48,279 if married filing jointly). The most you can get is $5,657. 
  • You have two qualifying children and your earned income and AGI are less than $40,295 ($45,295 if married filing jointly). The most you can get is $5,028. 
  • You have one qualifying child and your earned income and AGI are less than $35,463 ($40,463 if married filing jointly). The most you can get is $3,043.
  • You have no qualifying children and your earned income and AGI are less than $13,440 ($18,440 if married filing jointly). The most you can get is $457.

If you think you will be eligible for the EIC and you have at least one qualifying child, you may choose to get advance EIC payments (up to $1,826) with your pay by completing Form W-5, Earned Income Credit Advance Payment Certificate, and giving it to your employer. If you are entitled to an EIC greater than the amount advanced, you may claim the additional amount on your 2009 tax return.

Be careful requesting advance EIC payments! If you get advance payments and you are not eligible for the EIC, you must pay back these payments when you file your 2009 tax return. First, consult your tax professional to make sure you qualify for the EIC.

Qualifying Child
Do you need to adjust your withholding?

If you want to claim someone as a dependent, the individual must be a qualifying child or a qualifying relative. In 2009, the definition of a qualifying child was revised. Now:

  • Your qualifying child must be younger than you; 
  • A child cannot be your qualifying child if he or she files a joint return, unless the return was only filed to claim a refund; and 
  • If the parents can claim the child as a qualifying child but no parent so claims the child, no one else can claim the child as a qualifying child unless that person’s AGI is higher than the highest AGI of any parent of the child.

These new provisions generally affect siblings and grandparents. Those parents who didn’t benefit from the dependency exemption because their income was too high can no longer have a younger child claim an older sibling as a qualifying child to benefit from the earned income credit (EIC). In addition, siblings and grandparents cannot claim a child as a qualifying child if the parents can claim the child and either of the parent’s AGI is higher than the sibling’s or the grandparent’s. If you are affected by these provisions, you may need to adjust your withholding.

0-Percent Capital Gains Rate
Tax-free step-up in basis?

If you have owned stock with a low basis for more than a year and think the stock will continue to go up in value, now may be the time to sell it if all of the gain on the sale falls within the 10- or 15-percent income tax brackets. In this case, the gain on the sale is taxed at the 0-percent capital gains rate. In addition, if you buy the stock right back, you effectively receive a tax-free step-up in basis.

You may be thinking that the gain on the sale is disallowed under the wash sale rules when you buy identical stock within 30 days of selling it. However, the wash sale rules only disallow losses on such sales.

The 0-percent capital gains rate is available through 2010. To qualify for the 0-percent capital gains rate in 2009, your income (including long-term capital gains) must be under $33,951 (single and married filing separately), $67,901 (married filing jointly), and $45,501 (head of household). Ordinary income uses up the 10- and 15-percent income tax brackets before long-term capital gains, so if you have a lot of W-2 income, you will not qualify for the 0-percent capital gains rate.

Section 1202 Gain Exclusion
Thinking of selling qualified small business stock?

It may be wise to hold off selling your qualified small business stock if it is issued in 2009 or 2010. In general, you can exclude 50 percent of the gain on the sale of qualified small business stock that was held for more than five years. However, the remaining 50 percent of the gain is taxed at the 28-percent capital gains rate, so the entire gain on the sale is effectively taxed at a rate of 14 percent.

For qualified small business stock issued after February 17, 2009, and before January 1, 2011, the 50-percent exclusion is increased to 75 percent. Thus, only 25 percent of the gain is taxed at the 28-percent rate, which effectively taxes the entire gain at a rate of 7 percent. You still need to hold the stock for five years, so you’ll have to project your tax situation five years from now to determine if it’s worth the wait.

Exercising an Incentive Stock Option?
How to avoid the alternative minimum tax (AMT)

In general, when you buy stock by exercising an incentive stock option (ISO) and don’t sell that stock in the same year, you could be subject to AMT. For regular tax purposes, no income is recognized when an ISO is exercised. However, additional income is recognized for AMT purposes equal to the excess of the stock’s FMV on the date of exercise over the exercise price. Therefore, you may be taxed on income you haven’t even received (phantom income).

Don’t be caught off guard and end up with an unexpected tax liability when you go to file your tax return. If you exercised an ISO early in the year and the stock has been rapidly declining ever since, consider selling the stock before the end of the year. There is no AMT adjustment when stock that was acquired by exercising an ISO is sold in the same year, so you can avoid paying tax on phantom income. Otherwise, if you want to hold onto the stock and don’t want a big tax liability at year-end, you can make estimated tax payments. Also, the additional tax triggered by the AMT adjustment for ISOs generates a minimum tax credit (MTC) that may reduce your regular tax in future years.

Note: If you owed AMT attributable to the exercise of ISOs for 2007 or any prior year, the amount still owed as of October 3, 2008, was abated. However, your MTC must be reduced accordingly. In addition, any unpaid interest and penalties with respect to such unpaid AMT as of October 3, 2008, were abated. If you already paid such interest and penalties, you can increase your MTC. You should have received a Letter 2719C from the IRS detailing the amount of tax, interest, and penalties that were abated.

Roth IRAs
Is this a good place to put your money?

Roth IRAs can be more beneficial than other retirement accounts because qualified distributions are not taxable, and you don’t have to take required minimum distributions when you reach the age of 70½. However, you cannot make a Roth IRA contribution when your income exceeds certain limits. For 2009, the Roth IRA contribution limit is phased out (reduced) when your modified adjusted gross income (AGI) is between $105,000 and $120,000 ($166,000 and $176,000 if married filing jointly).

If your income is too high to make a Roth IRA contribution for 2009, you can still make a contribution to a traditional IRA. In general, the contribution will be nondeductible if you or your spouse is covered by a retirement plan at work, but it will give you basis in the IRA. On the other hand, if you and your spouse are not covered by a retirement plan at work, the contribution will be fully deductible regardless of your AGI.

For 2010 and beyond, the $100,000 modified AGI limit on converting a traditional IRA to a Roth IRA has been eliminated, so you can convert that 2009 traditional IRA contribution to a Roth IRA in 2010 regardless of your AGI.

You must recognize the amount converted, except any basis, as income. However, any taxable income from a 2010 conversion will be included in gross income ratably over a two-year period beginning in 2011, unless you elect out of the two-year period and include all of it in 2010. This two-year rule only applies to 2010 conversions. Examine your tax situation to determine which year(s) to recognize any taxable income from a 2010 conversion.

Quick Tips

  1. In general, if an inherited IRA has several nonspouse designated beneficiaries, each beneficiary must take required minimum distributions (RMDs) over the oldest beneficiary’s (the shortest) life expectancy. However, if you set up separate accounts with separate beneficiaries by the end of the year following the year of death, you can take RMDs from your separate account over your life expectancy. This allows you to stretch out your payments if you are younger. In addition, there are no RMDs for 2009 because they were waived. 
  2. If you are at least 70½ years old, you can still make tax-free charitable distributions of up to $100,000 from your IRA through December 31, 2009. The distribution must be made directly by the trustee of your IRA to the charitable organization. 
  3. You can deduct employment agency fees and amounts paid for preparing your resume while looking for a new job in your present occupation. You can also deduct the cost of traveling to and from an area if the trip is primarily to look for a new job. However, you cannot deduct job search expenses if you are looking for a job for the first time, or in a new occupation. 
  4. You can rent out your principal residence for a couple years before selling it and still exclude up to $250,000 of gain ($500,000 if married filing jointly) if you owned and used it as your principal residence for at least two out of five years ending on the date of sale. However, any gain due to depreciation and periods of nonqualified use must be recognized. 
  5. If you have an office in your home that is your principal place of business, you may deduct transportation expenses incurred in going between your home office and any other work location in the same trade or business. The information contained in this newsletter is not intended to provide specific tax advice or to take the place of either the written law or regulations.