Advise your clients how to get cash during hard times without taking a tax hit

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Where will your clients obtain much-needed cash when their expenses run high (e.g. an emergency medical bill or the mortgage payment) and their bank accounts are low? Basically, there are four common sources for emergency money: IRAs, 401(k)s, home equity (for those who still have any), and life insurance. Each of these has its own set of tax rules, affecting how much of the cash will be available to the client and how much must instead be paid in taxes. It will be your job to fully inform your clients of potential tax landmines and consequences, as well as to help them make the best choices that match their overall financial position for the present and the future.

Borrowing Against Real Estate
If your client borrows against home equity in his or her principal residence or a second home, interest on up to $100,000 of home equity debt can be deductible, regardless of how the money is used.

If instead your client sells the principal residence, he or she may be able to exclude from gross income up to $250,000 ($500,000 for joint filers) of gain thanks to the home-sale exclusion. This exclusion does not apply, however, to gain from the sale of a second home. That gain is generally taxed as capital gain.

Of course, in this real estate market, many clients will not have equity to borrow against. These individuals may need to turn to their retirement plans and life insurance policies as sources of cash.

IRAs and 401(k) Accounts
Conventional financial wisdom says whatever you do, do not touch retirement funds because not only will your client have less money for retirement years, but also those withdrawals can produce a hefty tax bill. However, in this tough economic climate, some people have no choice. If your clients who choose to do this are not at retirement age, you should advise them that in general, distributions made before age 59½ are subject to regular income tax rates plus a ten percent additional tax.

Fortunately, the tax law contains exceptions to the ten percent additional tax, but the exceptions can be complicated and the rules can differ for IRAs and 401(k)s. You will need to do some homework on this, and with a bit of planning you may be able to help clients wipe out the additional tax.

For instance, suppose a client's money is still in a former employer's 401(k) plan and she wants to use an exception that applies to only IRAs. If she makes a withdrawal from the 401(k), she will be out of luck. Instead, you can advise her to take the simple step of rolling the funds over to an IRA and then getting the distribution from that account.

Here's a look at some exceptions to the extra tax and how you can avoid common pitfalls to take best advantage of the exceptions:

  • Distributions from an IR A or former employer's 401(k) plan that are part of a series of "substantially equal periodic payments" made for your client's expected life (or the joint lives of the client and a beneficiary). Basically, this lets your client start making withdrawals at any age, provided the payments are figured as though he or she were turning the account into a lifetime annuity. Once your client begins making withdrawals in this form, he or she generally cannot change the payment formula until the later of (a) reaching age 59½ or (b) five years. Otherwise, the client is hit with the ten percent additional tax retroactively.
  • Distributions from an IRA or 401(k) plan to the extent your medical expenses exceed 7.5% of your adjusted gross income. For planning purposes, advise your clients that they need not itemize their deductions and claim a medical expense deduction for the year, but they must receive the distribution in the same year as the medical care. If they make the withdrawal in 2010 for the cost of surgery that is scheduled for 2011, they will not qualify. Similarly, a distribution taken to pay off loans outstanding from prior-year medical costs does not qualify.
  • Distributions from an IR A by a qualifying unemployed individual to the extent of health insurance premium payments made for the individual and his or her spouse and dependents. To qualify, generally a taxpayer should have received unemployment compensation for at least twelve consecutive weeks. In terms of planning, it is wise to let your client know the withdrawal must be made during the year he or she received the unemployment compensation or the following year. Furthermore, to avoid the ten percent tax the client cannot make the withdrawal more than sixty days after starting a new job.
  • Distribution from an IR A by first-time homebuyers. This exception to the additional tax is subject to a $10,000 lifetime limitation. It is important to advise your clients that the distribution must be used for the home purchase by the 120th day after the money is received.
  • Early IRA withdrawals to pay qualified college expenses. The expenses can be for your client, his or her spouse, children, or grandchildren. The withdrawal must be made in the same year as the expenses are incurred.
  • Distributions made after separation from service after attainment of age fifty-five. This exception applies to 401(k) plans, but not to IRAs. A taxpayer must be at least age fifty-five by the end of the year that he or she leaves the job. He or she will not qualify simply by waiting until age fifty-five to begin the withdrawals if he or she left the job at age fifty-three.

 Your client may qualify for multiple exceptions and can use them in tandem. (An example: if the client used IRA distributions to pay for his child's college tuition and the family's health insurance premiums). The Tax Court recently held that you can even combine the exception for substantially equal periodic payments with the exception for higher-education expenses to get an unequal amount during years when college expenses are incurred.

Life Insurance
Until recently, individuals who no longer needed a life insurance policy had few options. In general, they could surrender the policy to the issuing insurance company for its cash surrender value or they could stop paying the premiums and let the policy lapse. For a term insurance or other policy without cash surrender value, the only choice was to let the policy lapse. Now, for some individuals there is a secondary insurance market in which they may be able to sell a policy for more than its cash surrender value or even
sell a policy without cash surrender value, such as a term policy. These transactions are called life settlements.

The IRS recently lifted some of the uncertainty surrounding life settlements by explaining their tax consequences. Your clients will need to know that this is important for anyone contemplating a life settlement because they will now be in a position to gauge how much they will be left with after tax once they reach an agreement on the settlement amount and fees.

Life Settlements
There are a number of different reasons why one may consider a life settlement. In these troubled times, some individuals simply can no longer afford the premiums. Others may need the funds for some worthwhile purpose. In some cases, the coverage is no longer needed, such as when the primary beneficiary has died or divorced the insured, or a business has been dissolved. The coverage may have been purchased with the intention of using the proceeds to pay death tax costs. With decreased asset values and more favorable federal estate tax rules now in force, this need may no longer exist.

Settlement Amount
The settlement amount will depend on the unique circumstances of the specific case. Factors bearing on the amount that may be realized include the insured's age, gender, health, life expectancy, type of policy, its face amount, and any cash value. There may be fees and commissions and state law may impose a cap on the amount that may be realized.

Tax Treatment
Recently issued IRS guidance explains the tax treatment of policyholder surrenders and sales of life insurance contracts with and without cash value. Understanding how the IRS treats a surrender is crucial to understanding how it treats sales. The following examples illustrate the various treatments:

Surrender. On January 1, Year One, Andy entered into a "life insurance contract" with cash value. On June 15 of Year Eight, Andy surrendered the contract for its $78,000 cash surrender value, which reflected the subtraction of $10,000 of "cost-of-insurance" charges collected by the issuer for periods ending on or before the surrender of the contract. Through that date, Andy had paid total premiums of $64,000. According to the IRS, Andy has ordinary income of $14,000 ($78,000 minus $64,000 investment in the contract). Thus, if he were in the twenty-five percent bracket, the surrender would trigger a tax of $3,500 and Andy would be left with $74,500 ($78,000 minus $3,500).

Sale of policy with cash value. The facts are the same as above, except that on June 15 of Year Eight, Andy sold the life insurance contract for $80,000 to an unrelated entity. Here, Andy has a gain of $26,000 because the $10,000 cost of insurance protection reduces his basis for the premiums paid from $64,000 to $54,000. Of this $26,000, $14,000 is ordinary income and $12,000 is capital gain. Thus, Andy would pay $3,500 in tax on the ordinary income and $1,800 in tax on the capital gain (fifteen percent of $12,000). As a result, he would be left with $74,700 ($80,000 minus $5,300).

Sale of policy without cash value. The facts are the same as in the case of the surrender, except that the contract was a level premium fifteen-year term life insurance contract without cash surrender value. The monthly premium for the contract was $500. Through June 15 of Year Eight, Andy paid premiums totaling $45,000. On June 15 of Year Eight, he sold the life insurance contract for $20,000 to an unrelated person. In this case, the amount realized from the sale of the term life insurance contract is the sum of money received from the sale or $20,000. The IRS says that Andy's adjusted basis is equal to the total premiums paid less charges for the provision of insurance before the sale. Absent other proof, the cost of the insurance provided to Andy each month is presumed to equal the monthly premium under the contract or $500. The cost of the insurance protection provided to Andy during the 89.5-month period that he held the contract was $500 mulitplied by 89.5 months, or $44,750. Thus, his adjusted basis in the contract on the date of the sale was $250 ($45,000 total premiums paid, less $44,750 cost of insurance protection). Accordingly, he must recognize $19,750 on the sale (the excess of the $20,000 amount realized on the sale over the $250 adjusted basis). The $19,750 is long-term capital gain. The tax on this gain is $2,962.50 (fifteen percent of $19,750) and he is left with $17,037.50 ($20,000 less $2,962.50).

Without further explanation, the IRS states that the conclusions regarding the sales will not be applied adversely to sales occurring before August 26, 2009.

Money may be a fungible commodity, but a dollar that is subject to tax is worth something less than a dollar that is tax-free or more lightly taxed. Clients may overlook this difference when they need cash in a pinch. Enrolled agents can provide a valuable service to their clients (and help to avoid having disgruntled clients at tax return time) by alerting them to the differing tax ramifications of tapping each available source of cash.

About the Authors:

Bob D. Scharin holds a J.D. degree from the University of Michigan Law School and is a member of the New York Bar. He has edited and written for a variety of tax publications geared to both professional and general readerships for more than twenty years. Scharin has been at the Tax & Accounting business of Thomson Reuters since 1994, where he is the editor of Practical Tax Strategies (Warren, Gorham & Lamont/RIA), a monthly journal for tax professionals.

William E. Massey received a J.D. from Hofstra University School of Law in 1979, and an LL.M. in taxation from the NYU School of Law in 1982. He has more than twenty-five years of experience as an editor of tax publications with several major tax publishers. Having previously performed services for the Tax & Accounting business of Thomson Reuters as an independent contractor, he has been a manager of News and Alerts at the Tax & Accounting business of Thomson Reuters since June 1999.

Both Bob and William are senior tax analysts for the Tax & Accounting business of Thomson Reuters.

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