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Don't Get Tripped Up by These Tax Reporting Missteps

Christine Benz

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Now that we are into the new year, many investors are thinking forward to the next big deadline, April 15. Joining me to discuss some tax reporting issues that have the potential to trip up investors and taxpayers is Tim Steffen. He is director of advanced planning for Baird.

Tim, thank you so much for being here.

Tim Steffen: Good to be back.

Benz: Tim, let's discuss what's changing, some of the highlights in terms of 2018 taxes that will be reflected on people's tax forms in 2019. The 1040 itself is changing?

Steffen: Yeah, 2018 is really the first year of all of these tax reforms that we talked about well over a year ago, are finally taking effect. So, people are going to start seeing it in their returns. Most people should look to see, all things being equal between 2017 and 2018, probably higher levels of taxable income. You've got fewer deductions and changes there, but you've also got new tax rates that apply at everything; you've got changes to things like child credits and AMT and personal exemptions; and all of these other things that have changed. So, the whole tax return process is going to be a lot different this year than what people are may be used to.

Benz: And the form itself is going to look different?

Steffen: Yeah. There's going to be some pretty drastic changes to the form. They talked a lot about the whole postcard thing. They can kind of check the box in the postcard thing. They sort of got there. Basically, what they did is, they took the old 1040 that we're used to, and instead of two full pages they cut it to two half pages. So, you've got a full piece of paper but half of it is empty. To do that they took a bunch of lines off of the return and instead of having it be on the 1040, they are on new schedules.

So, the 1040 says instead of these seven lines of information you used to provide us, put it on schedule 1 or schedule 2 or schedule 3. So, yes, it's a shorter 1040, but it's actually more pieces of paper.

Benz: You brought, though, some tax reporting issues that have the potential to trip up investors or at least be a little bit of a head-scratcher around tax time. Let's start with what's called a qualified charitable distribution. You say sometimes people are confused come tax time if they did that QCD--first, let's talk about what that is--but also how that gets reflected or not reflected on their tax returns.

Steffen: A qualified charitable distribution, that's when somebody takes money directly from the IRA and sends it to the charities. So, it doesn't go through you individually. It goes right from the IRA trustee to the charity.

Benz: And that's only available to RMD-subject investors.

Steffen: You have to be at least 70 1/2 at the time of the gift. So, if you are over 70 1/2, you can make that distribution right to the charity. When you do that, the withdrawal from the IRA is not considered taxable income. You don't get a deduction for the charitable gift either because that would be kind of double-dipping, but you don't have to report the IRA withdrawal as income.

The trick that people run into on that is that your IRA custodian, the brokerage house or wherever you have the IRA held, still has to issue you a 1099 as if it was just a normal distribution out of the IRA that went right to you. In your mind, you made the gift. You are saying, well this is tax-free, I don't have to worry about reporting it. All of a sudden, you get a 1099 in the mail from your broker and you are saying, why did I get this? The issue there is, the IRS tells brokers that's what you have to do. They don't necessarily know if you are going to qualify for all the charitable distribution rules. You might have said, go right to the charity, but the IRA trustee doesn't necessarily know that that's going to qualify. They will issue you a 1099 showing you a distribution that's fully taxable, and then it's up to you to report that on your tax return as actually being a tax-free withdrawal.

The way you do that is, if you can kind of picture the tax form, there's a line for IRA distributions, and on one side, it's total distributions and on another side, it's the taxable. You can put the total amount on the left-hand side, and right next to it just write QCD. Whatever portion is not taxable out of that IRA withdrawal, you just leave that off of the column with all the taxable income. You have to report it correctly in your return, make sure your tax preparer knows you did this, because they may not necessarily know. And then, also, make sure you don't take a separate deduction for the gift as well.

Benz: Got it. Another thing that you said sometimes gets a little bit confusing is, if people have made a nondeductible contribution to an IRA. First, why would someone want to do that? And second, what sort of paperwork needs to accompany that nondeductible IRA contribution?

Steffen: Why would somebody make a nondeductible IRA contribution? There's a couple of scenarios. One is, they are just looking to put up more money into a retirement account and aren't as concerned about the tax benefit of it today. People who are over a certain level of income and are maybe covered by an employer plan, they are not eligible to take a deduction for an IRA contribution. Their income is too high to do a Roth which would be the next thing you would consider. So, then they say I'll put it into the traditional IRA. I don't get a deduction for it, but at least I will get some tax-deferred growth on it until I take it out later in life. They will put their contribution in there.

They may combine then, in some cases, with this whole backdoor Roth thing where you convert the IRA to a Roth. But that's not necessarily always what happens. Sometimes they just leave it in the traditional IRA. Regardless of what ultimately happens once it's in the IRA, it's still important to report that correctly in your tax return.

Benz: OK, and I do that how?

Steffen: The form you are going to use is Form 8606 and that's the form that you use to tell the IRS, I put money into my IRA and I'm not taking a tax deduction for that. The reason you do that is that when you take the money back out of the account later on in retirement, you can take it out tax-free. That form is incredibly useful to document the fact that this money is in there. It's a cumulative form, so, every year you do these contributions, it adds up to the total year-over-year. And then, when it comes to time during retirement to take it out, you take that money out on a pro rata basis. But at least, it tells the IRS you can take that money out tax-free.

Now, if you forgot to do that in the past, and we see that happen sometimes, people think I'm not going to get a deduction for this, I know I'm too high …

Benz: I did that once.

Steffen: There you go. I know my income is too high. I'm not going to even bother telling my tax preparer about it. That's a mistake. Because the preparer needs to know that, so they can fill out that form. If you didn't fill out the form, all is not lost. You can go back and fill out a form for the year that you contributed. Obviously, you got to find the old form which is on the IRS website. You can send that form in. There's a $50 penalty, I think, for each one of those you file late, but at least you get it documented, so that when it comes time to take the money out afterward tax-free, you don't have to worry about the IRS questioning where did this come from.

Benz: Because all the documentation is there.

Steffen: Correct.

Benz: Let's talk about capital gains and losses. I think 2018 may be a year when some investors are able to identify losing securities on their books and maybe did some tax loss selling. You said this is an area that can get a little confusing because you have the opportunity to net the gains and losses. How does all that work, and what kind of reporting do I have to do on that?

Steffen: If I've got a long-term loss or gain and a short-term loss or a gain, can I use those against each or offset each other? And the short answer is, yes. The way the netting works is, if you look at all of your long-term positions, gains and losses, you combine all those long-term ones into one number and you come up with a net long-term position. You do the same thing on the short-term side. All your short-term transactions, gains and losses, combine them all together to come up with the next short-term position. Now, those are both gains, then they are both taxable. If they are both losses, you combine them together and you can use $3,000 of that to offset other income. The rest of that loss carries forward indefinitely, and you can use it every year going forward to offset future gains or the $3,000 per year.

If after you combine them together you have a gain in one category and a loss in the other category, they can offset each other. You can use, for example, a short-term loss to offset a long-term gain--only after they've offset their own kind first. But the short answer is, yeah, you can use losses of one kind to offset gains in the other.

Benz: Last question, it relates to the alternative minimum tax. It sounds like fewer taxpayers will be subject to the AMT than in the past. So, any thoughts on that and what opportunities might be if you've been subject to AMT in the past?

Steffen: The good news is, that with all the changes that ran through the tax reform of 2017 and taking effect in 2018, so many of those changes have combined together to really limit if not almost eliminate the impact of AMT. Some of the studies I've seen have said that we are going to go from 5 million people paying AMT to 200,000. It's really going to have a drastic impact on who pays it.

The good news is, for some people, if you've been an AMT in the past, you may have built up what's called an AMT credit, meaning that extra tax you paid in a prior year, you get to recover that. But you can only recover that in a year when you are not otherwise subject to AMT. So, you may have built up a credit years ago, because of something you did, and you've never been able to use it because you can never get yourself out of AMT. But with these changes this year, so many taxpayers are going to find themselves back out of AMT that those credits, they will be able to start using some of those now.

Benz: Which can further lower their tax bills?

Steffen: Exactly. You can't ever go below the AMT. AMT is a floor. It's the minimum tax. But that floor has fallen quite a bit because of the way the AMT is calculated that that credit you've built up years, you maybe able to use that now. Now, you've got to be careful. That credit is hard to calculate. There's a separate form you use in your tax return, it's form 8801. That's what you use to determine how much of an AMT you paid in a prior is now creditable in a current year. It's a cumulative form; it builds up every year; it keeps your running total of your credit amount. But for a lot of folks those credits have been hanging around for a long time--2018 maybe the year they can finally start to use some of those.

Benz: The good news is, if you use this CPA or if you use good tax-prep software, they are going to flag a lot of these issues for you and kind of walk you through the right forms, correct?

Steffen: Especially, the AMT credit one. The qualified charitable distribution, you'll have to make sure you check the right box in some of those. And again, with the IRA, if you don't tell the person you did the contribution, there's nothing they can do. So, make sure you tell your preparer or your software that you made the contribution.

Benz: Tim, always helpful advice. Thank you so much for taking the time to be here.

Steffen: Good to be here.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.