Tax Information for the Retired Taxpayer

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Tax Information for the Retired Taxpayer

Unfortunately, there is no age limit set by the IRS Tax Code as to when you can stop filing an income tax return.

Whether you are age 1 or 100, you must file an income tax return if your gross income for the tax year should exceed your standard deduction and personal exemption.

Retired taxpayers may be retired because of age or disability. They usually have a substantial reduction in taxable income and in many circumstances question whether they even have to file an income tax return. Sometimes retired taxpayers are not required to file a return, but should to get a refund of taxes withheld from certain disbursements.

Taxpayers, at age 65, get an increase in the amount of their standard deduction.

Retirement income from sources such as pensions or Social Security may be fully, partially or non-taxable depending upon the circumstances for retirement.

So to begin our discussion, we will define the terms gross , taxable and non-taxable income for all taxpayers. Discuss the current standard deduction and personal exemption for all taxpayers, and then discuss certain aspects of the income tax return that most retired taxpayers will encounter.

Gross income is all income you receive in the form of money, goods, property, and services that is not exempt by tax law.

Gross income, for self-employed individuals, is gross receipts minus any cost of goods sold when applicable. The profit after expenses is the taxable income.

Income can either be taxable or non-taxable. Most income received is taxable unless specifically exempt by law.

Taxable income includes compensation for personal services*, interest, dividends, rents, royalties, income from partnerships, estate or trust income, gains from the sale or exchanges of property, pensions or annuities, gross gambling winnings, prizes, cancellation of debts, alimony, and unemployment compensation to name the most common.

* Compensation for services includes wages, tips, salaries, commissions, fees, and payments in the form of goods or services valued at their fair market value.

(NOTE: All gambling winnings must be added to taxable income. The Tax Code does allow you to negate this amount by losses only if you itemize.)

Non-taxable income includes interest from state municipal bonds, inheritances, gifts, your cost in certain pensions and annuities, welfare benefits, and veteran’s benefits to name a few.

Notice that Social Security Benefits are in neither one of these groups. That is because these benefits can become partially taxable depending upon all other income reported on the tax return.

The standard deduction for tax year 2007 is as follows: *

Single (S) or Married Filing Separate (MFS) ** $5,350

Married Filing Joint (MFJ) or Qualifying Widow(er) (QW) $10,700

Head of Household (HH) $7,850

* I f you can be claimed as a dependent on another taxpayer’s return, a worksheet is required to determine your standard deduction.

** I f you are filing as (MFS) you must file a return if your gross income exceeds your personal exemption amount only

($3,400 for 2007).The standard deduction amount allowed for MFS is not taken into consideration when determining whether you must file a return.

If you were born before Jan. 2, 1942 and are:

Filing (MFJ), add $1050 for each spouse born before this date to your standard deduction amount.

Filing as a (QW) or (MFS) add $1,050

Filing as (S)ingle or (HH) add $1300

For tax year 2007, the personal exemption allowance is $3,400. If you are filing an income tax return with your spouse you can include $6,800 for exemptions, all other filing statuses include $3,400 for exemptions in determining filing requirements.

The standard deduction and personal exemption are indexed for inflation each year.

Example: Ed and Mary are filing a joint return. Ed is age 66. Mary is age 63. Their standard deduction for 2007 is

$11,750 ($10,700 + $1,050). Exemptions are $6,800 ( 2 x $3,400). They do not have to file a return unless their gross income exceeds $18,550 ($11,750 + $6,800).

Regardless of gross income, there are times a return must be filed as just an information return.

Total rental income received is included in gross income . You deduction for rental expenses are shown by filing the income tax return. Your profit may show that you do not have enough taxable income to file, but that proof is only shown by filing the information for the rental activity.

A sale of stock, even if at a loss, is not a loss until the return is filed showing the cost of the stock. An information return must be filed.

Receiving advanced Earned Income Credit Requires a return to be filed.

There are other situations when a return must be filed. Further information can be found in IRS PUB-17 , page 8.

We have established the minimum filing requirement for all taxpayers and what types of income are taxable to arrive at gross income . Now we will focus on the types of income that a retired taxpayer may receive and discuss how to determine any taxable portions from these sources.

Social Security Benefits

Social Security Benefits include monthly retirement, survivor, and disability benefits. Supplemental Security Income

(SSI), though administered by the Social Security Administration is not taxable.

Included in this discussion, is the tier 1 benefits received by retired railroad employees or beneficiaries. Tier 1 is the social security benefit equivalent for railroad retirees.

Before any of your SS Benefits become taxable, your “ income

” has to exceed the base amount established for your filing status. The base amounts by filing status are as follows: $25,000 for (S), (HH), (QW), and (MFS) * , $32,000 for

(MFJ).

*If your filing status is (MFS) and you did not live with your spouse at any time during the tax year.

Taxpayers who file (MFS) and lived with their spouse at any time during the year have no base, 85% of their benefits are taxable.

Your “ income

” for this purpose is all of your taxable income reported on the tax return plus 50% of the Social Security

Benefits received. (NOTE: Added to this amount would be any tax exempt interest you received, such as municipal bond interest, and certain other exempt income that was excluded from taxable income.)

If your calculated “ income ” exceeds the base amounts stated but is not more than $34,000 for (S), (HH), (QW), and

(MFS) * , $44,000 for (MFJ), then up to 50% of your benefits can become taxable.

When your calculated “ income ” falls between the base and high end of the bracket, your taxable portion is the lesser of,

50% of the amount exceeding the base or 50% of benefits received.

If your calculated “ income ” exceeds the high end of the bracket, then 85% of every dollar that exceeds this amount becomes taxable and is added to the taxable 50% of benefits.

The taxable portion of your Social Security Benefits cannot exceed 85% of your total benefit received.

Example 1: Joe is (S) and received $7,000 in SS benefits. His other income for the year is $23,000. His “income” for the taxable calculation of his benefits is $26,500 (50% of $7,000 = $3,500 + $23,000). His taxable portion of SS benefits is $750, the lesser of 50% of the benefits received (50% of $7,000 = $3,500) or 50% of the amount that exceeds the base (“ income” $26,500 – base $25,000 = $1,500, 50% of $1,500 = $750)

Example 2: Joe’s SS Benefit remains the same but his other income for the year is $30,000. His “ income” for the taxable calculation of his benefits is $33,500 (50% of $7,000 = $3,500 + $30,000). His taxable portion of SS Benefits is $3,500, the lesser of 50% of benefits received (50% of $7,000 = $3,500) or 50% of the amount that exceeds the base

(“ income” $33,500 – base $25,000 = $8,500, 50% of $8,500 = $4,250).

If your calculated “ income” exceeds the high end of the bracket, then 85% of every dollar that exceeds this amount becomes taxable and is added to the lesser of 50% of the amount exceeding the base to high end of the bracket (either

$9,000 or $12,000 depending upon filing status) or 50% of the benefits received. The taxable portion of your SS

Benefits cannot exceed 85% of the total benefit received.

Example 3: Joe’s SS Benefit remains the same but his other income for the year is $31,900. His “ income” for the taxable calculation of his benefits is $35,400 (50% of $7000 + $31,900). His taxable portion for SS Benefits is $4,690,

$3,500 (the lesser of 50% of benefits received ($3,500) or 50% of the amount exceeding the base to high bracket limit

(50% of $9,000 = $4,500) plus, 85% of the amount that exceeds the high end of the bracket (“ income” $35,400 – high bracket $34,000 = $1,400, $1,400 x 85% = $1,190). $3,500 + $1,190 = $4,690. His total taxable benefits cannot exceed

85% of the benefit or $5,950 ($7,000 x 85%).

Comparing the difference between Ex. 2 and Ex. 3, we see that there is an increase of $1190 in taxable SS Benefits because of an increase of $1900 in other income for the year. At a 15% tax rate, the $1900 caused an increase of $464 in taxes, ($1900 x .15 = $285) other income taxed at the tax rate + ($1190 x .15 = $179) the increase in SS Benefits taxed at the tax rate. The value of the $1900 in other income has decreased dramatically.

Additional distributions from retirement plans, sales of stock, cashing in of mature bonds for non-essential purchases can affect the tax liability of the return. Planning is sometimes required to avoid paying to much in tax. When available, stretch such actions between two tax years to achieve the same result.

When your fixed income (other income) is already exceeding the high end of the bracket due to large pensions, required IRA distributions or large interest/dividend gains on investments, then the affect is not as severe except that you may jump into a higher tax bracket. Planning is required for additional tax withholding to cover the taxable SS

Benefit. This can be accomplished by having taxes withheld from SS Benefits, increasing the tax withholding on pensions or other taxable income, or through estimated tax payments. This will avoid the surprise of a balance due at tax preparation time.

Occasionally, a taxpayer will receive a lump sum (retroactive) payment that includes SS Benefits for multiple years.

This payment must be reported on the current year tax return.

Under such circumstances a taxpayer can elect to calculate the benefit allocated to a prior year with that year’s other income, if it will result in a lower tax.

Any taxable portion for the prior years benefit calculated with that year’s income is added to the taxable portion for the current year and reported on the current year return.

A multiple page worksheet is used to accomplish these calculations.

The designation LSE is listed on the current year income tax return to indicate that the lump sum election was used.

The worksheets are not filed with the return but all copies of the worksheet calculations should be saved with your records. Records of all the applicable prior years income is also required to complete these worksheets.

Social Security Benefits received during the year are reported to the taxpayer on Form SSA-1099, railroad workers receive Form RRB-1099.

Pensions and Annuities

Generally, if you have not contributed to the cost of an employee pension or annuity plan with after tax money, the full amount of your distributions upon retirement are taxable.

If you do have a cost (basis) in such a plan, you can exclude a portion of each payment from taxable income until your cost is recovered. The tax-free portion of each payment is determined when you first start receiving the payments and will remain the same for each year regardless of any increase in payments. Once your cost is recovered, 100% of the payments then become taxable.

There are two different methods used for determining the tax-free portion of a payment.

The Simplified Method is used if your annuity is paid under a qualified plan. A qualified plan is one that meets certain Internal Revenue Code requirements.

The General Rule is the method used for payments from a non-qualified plan.

Without getting into the technicalities of each method, I will give a general explanation of how this works.

Knowledge of whether the plan is qualified or non-qualified and your cost in the contract is required. Even though each method has its own worksheets and life expectancy tables, the formula is similar in its calculations.

Basically, your age, and if applicable, the age of your beneficiary is taken into account on the payment start date to determine the amount of payments expected to be received during your life expectancy. Your cost is then divided by the amount of payments expected to be received, to arrive at the tax-free portion of each payment. Any unrecovered cost realized, in the case of death, is allowed as a miscellaneous itemized deduction on the decedent’s final return.

Disbursements from pensions and annuities are reported on Form 1099-R. The information on this form includes total benefits received for the year and in some cases the taxable portion has already been determined by the custodian of the account.

Railroad employees will receive Form RRB-1099R, the tier 2 pension equivalent.

Payments received from qualified retirement plans before you reach the age of 59 1/2 usually will be subject to an additional 10% penalty tax. This penalty is levied against the taxable portion of the disbursement. There are exceptions to this penalty and further information can be found in IRS PUB-575 .

Payments from qualified retirement plans must begin by the April 1 following the calendar year in which you turn 70 1/2, or the calendar year in which you retire from employment with the employer maintaining the plan.

Taxpayers who do not receive the required minimum distribution are subject to an excise tax that is equal to

50% of the difference between what should have been disbursed and what was disbursed. Most custodians of such accounts will inform you of the required distribution for the year.

Individual Retirement Arrangements

Distributions from traditional IRA’s are usually taxable in the year received. As with pensions and annuities, a taxpayer may have a cost in such a plan, and only a part of the distribution would be taxable. Your basis in a traditional IRA is usually updated every year on Form 8606 . This form is also used to calculate the taxable portion and to keep track of the remaining basis.

Many of the rules for required minimum distributions, penalties on early withdrawals and the availability of exceptions to such penalties are the same as for pensions. Additional information can be found in IRS PUB-590.

Military Retirement Pay

Military retirement pay based upon age or length of service is taxable and reported as pension income on the tax return.

Military pensions received, which are based upon a percentage of disability from active service, are not taxable.

Further information can be found in IRS PUB-525 .

Disability Pensions and Income

As previously mentioned, not all retired taxpayers are retired because of age. Some retired taxpayers are retired because of disability. When you are retired on disability and have not reached the minimum retirement age for your employer’s plan, then such benefits are taxed as earned income on the wage line of the income tax return.

Since this is considered to be earned income, taxpayers then qualify for other tax credits or deductions that are based upon earned income such as the Earned Income Credit or Credit for the Elderly or Disabled. Once you reach the minimum retirement age, this income is then reported as a pension or annuity on the tax return.

If part of your disability pension is workers’ compensation, do not include these amounts in taxable income, it is excluded.

Taxpayers receiving Form 1099-R will be able to determine the type of distribution being received by looking in Box 7 of this form. The distribution code found there will indicate if the distribution is an early distribution, regular distribution, disability distribution etc.

If you receive payments from a retirement or profit sharing plan that does not provide for disability retirement, then these payments are reported as a pension or annuity and not as a disability pension.

If you become retired on disability and receive a lump sum payment for accrued annual leave, then this is not considered to be a disability payment but is a taxable salary payment.

Sickness and Injury Benefits

Payments you receive from an accident or health plan for personal injury or sickness may be taxable income on the tax return.

If the plan was completely paid by your employer, then the full payment is taxable income.

 If the premiums were paid by both you and your employer, then only the percentage of the employer’s portion is taxable income to you.

If you paid the complete cost of the plan, then do not report any portion as income.

Long term care contracts are usually treated as accident and health insurance contracts. Amounts received are usually excluded from income but may be limited. Further information can be found in IRS PUB-525 .

Other types of payments for sickness or injury that are excludable income include:

Disability income received for loss of income or earning capacity as a result of injuries from a no-fault car insurance policy.

Compensation received for permanent loss or loss of use of a part or function of your body, or permanent disfigurement. This must be based upon the injury only and not from loss of work. These benefits are not taxable no matter who paid the premiums.

Amounts received under a workman's compensation act or statute in the nature of such, for occupational sickness or injury.

 Payments received under the Federal Employees’ Compensation Act for personal injury or sickness.

However payments received as continuation of pay for up to 45 days or for sick leave while claims are pending are taxable.

Other Considerations

We previously mentioned that a retired taxpayer may not need to file a tax return but may want to do so to receive certain benefits. Sometimes, this reasoning can extend to the state level as well.

The State Of New Hampshire, while not even having a state income tax, did enact a law in 2001 for property tax relief of eligible Low and Moderate Income Homeowners. The claim form, DP-8, must be submitted between May 1st and no later than June 30th of the fiscal year. The form references income as reported on the federal tax return, but a tax return is not required to have been filed to qualify. Though not exclusive to a retired taxpayer, a retired taxpayer who owns a home is a likely candidate for such a benefit. Tax information received for pensions, interest, dividends etc., is required to make the calculations if a federal return was not filed. It is very easy to miss out on this benefit because even resident taxpayers, who are filing a federal return, cannot prepare this state paperwork until after the federal filing season is over.

The State of Massachusetts enacted a similar tax law known as the Senior Circuit Breaker Tax Credit. This refundable credit is received only through the filing of a state income tax return. The benefit is geared for residents who are at least 65 years of age. Taxpayers are not required to own there own home but also qualify with total rent payments made throughout a given year. If 10% of a taxpayer’s gross income, as calculated for this credit, does not exceed the resident taxpayers property tax bill for their main home or 25% of the rent paid during the taxable year, these taxpayers can receive a refund regardless of if they made any payments to the state during the tax year. Many taxpayers who qualify for this benefit are not required to file a federal or state return, and therefore miss out on this refund.

A t Total Tax Solutions , we believe that customer service is number one in any personal service company. This does not only mean preparing your tax return correctly during the tax season, but also bringing certain aspects of the income tax return to your attention so that you can make educated decisions about your finances. That is the reason why we offer free tax seminars on varying tax topics, such as this, to many organizations.

We hope that this material was informative and encourage retired taxpayers who are unsure of whether they are required to file a return, to schedule an appointment with us to review their paperwork. Conditions change from year to year, and there is no fee charged if a return is not required. We also offer senior discounts for taxpayers who are 65 or older when we do prepare a return for you.

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