A Dozen Tips for Older Taxpayers

Unfortunately for older Americans, there's no special 2008 tax relief from collapsing housing and securities prices.

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Although the government's stimulus program will provide tax relief in 2009, older taxpayers won't get any breaks on their 2008 returns. And after a year of wrenching losses on investments and falling home prices, the memory of 2008 may be particularly bitter at tax time. Still, the goal remains to pay as little tax as possible, so U.S. News asked H&R Block tax expert Gil Charney, principal tax researcher at the company's Tax Institute, some of this year's commonly asked tax questions. Topics include IRAs and 401(k)s, Social Security, Medicare drugs, estate taxes, long-term care insurance, home deductions, charitable contributions and divorce.

Q: The government has relaxed mandatory minimum withdrawals from IRAs for taxpayers who turn 70 1/2 in 2009. Is there anything I should do with my 2008 tax returns to prepare for this change in 2009?

A: Since the new law affects 2009’s required minimum distributions (RMD) only, there is no action or decision that can be made to affect 2008’s return. However, here are a few comments about this new law: a) If a taxpayer turned 70½ in 2008, he or she would be required to take a distribution for 2008. The deadline for which is April 1, 2009. The taxpayer still needs to take this distribution. Even though the distribution is taken in 2009, it is a required distribution for 2008. To avoid penalties, taxpayers should take the distribution; b) Required minimum distributions are still optional. If taxpayers need to take a distribution for living expenses, they can take any amount desired. Even if the required distribution is waived for 2009, any non-Roth distribution is still taxable; c) There is no “catch-up” or double minimum distribution requirement in 2010. However, for taxpayers who turn 70½ in 2009, the 2010 RMD will still need to be distributed by Dec. 31, 2010.

Q: I participate in the Medicare Part D prescription drug program, but am totally confused about how to handle drug expenses on my tax return, particularly the so-called "doughnut hole." Can you help me out?

A. The “doughnut hole” has no specific tax implications. However, once taxpayers reach the doughnut hole in Medicare Part D, they must pay out-of-pocket costs for prescriptions, which are tax deductible. All out-of-pocket costs for prescriptions, whether part of a deductible, co-pay, or full prescription costs while in the doughnut hole, are qualified medical expenses that may be deducted to the extent all medical expenses exceed 7.5 percent of the taxpayer’s adjusted gross income. In addition to out-of-pocket costs for Medicare Part D, premiums paid for Medicare Part B and Part C (Medicare Advantage) also are deductible. If taxpayers applied for Medicare Part B at age 65 or after disability, they can deduct the monthly premiums. (Note: Normally, Medicare Part B premiums are not paid directly by the taxpayer but are withheld from his Social Security benefits. The amount withheld is shown on the taxpayer’s Form SSA-1099, box 3. If the taxpayer is preparing his own return, he should not forget to include these expenses as a medical deduction.

Q: I'm 64 and drawing down Social Security; my full retirement age is 66. Can you explain how I should handle taxes on any outside income I earn?

A. There are two issues when drawing Social Security before full retirement age. The first issue is the effect of outside income on Social Security benefits. Income earned above a certain threshold will reduce Social Security benefits if the taxpayer is under his full retirement age. The second issue is the taxability of those benefits. Benefits for taxpayers who are under full retirement age and collecting Social Security are reduced by $1 for every $2 earned over a certain limit, which is $13,560 in 2008. For example, if a 62-year-old taxpayer receiving Social Security benefits earns $17,000 at a part-time job and has Social Security benefits of $10,000, the Social Security benefits would be reduced by $1,720 (17,000 – $13,560 ÷ 2 = $1,720). Thus, he would receive only $8,280 ($10,000 - $1,720). In addition, a portion of a taxpayer’s Social Security benefits is taxed if the taxpayer’s income is above a certain “base amount” (which varies according to filing status). Significant outside income could cause as much as 85 percent of Social Security benefits to be taxed. If taxpayers’ income is high enough for their Social Security benefits to be taxed, income tax can be withheld from the payments by filing a Form W-4V. Otherwise, the taxpayers may have to make estimated tax payments.

Q: I understand that the rules for estate taxation may be changing. Can you review the possible scenarios and tell me whether there's anything I should be doing now to get ready for these possible changes?

A. In 2009, the estate tax exclusion is $3.5 million, which means estates in excess of this amount may be subject to the estate tax. However, even if the “gross estate” is larger than this amount, there may not be any estate tax paid. The estate tax exclusion is scheduled for repeal in 2010, which means the estate for anyone who dies in 2010 will not be taxed, regardless of size. In 2011, the exclusion is reduced to $1 million, the same amount in place in 2002. There were about 38,000 estate tax returns filed in 2007, compared to about 138 million Form 1040s in 2006. Although the number of people affected by the estate tax is relatively small, the stakes could be high for them. When compared to the highest individual income tax bracket of 36 percent, the estate tax rate is 45 percent. There are ways to minimize the estate tax, such as making lifetime gifts to children and grandchildren (at or below the annual exclusion of $13,000 per year per person in 2009); using irrevocable trusts to transfer assets-- and control of those assets--to a taxable entity outside the gross estate, and, creating an irrevocable life insurance trust so that the trust receives any life insurance proceeds which could inflate an estate’s total value. Anyone with significant assets should consult an attorney competent in estate planning. Not only are the laws complex, but a mistake also can be extremely expensive.

Q: Some friends of mine say they've been told that getting divorced may save them a lot of money in taxes. Is this true for older couples, and under what circumstances?

A. Divorces between elderly couples offer no special tax benefits. In the past, some elderly couples may have used divorce as a tactic to allocate assets to the healthy spouse so that the sick spouse could qualify for Medicaid. However, the Deficit Reduction Act of 2005 disregarded such asset transfers as acceptable tactics to qualify for Medicaid. Again, this is not a tax benefit, but older couples who think this is a viable option should consult an elder-care attorney before seeking a divorce, which creates far more complex issues and often unfavorable results. In some unusual situations, couples may have advantages by filing separate returns (MFS) instead of a joint return (MFJ). For example, if one spouse has high medical bills and a low AGI and the other spouse does not, the spouse with the high medical bills may be able to claim more of a medical deduction because of the 7.5 percent-of-AGI floor. But by filing as MFS, other tax credits and deductions are unavailable or reduced. Married couples can use tax preparation software (or a tax professional) to determine which filing status is best.

Q: I can no longer afford to write checks out to my favorite charities. Is it still possible for me to contribute directly from my IRA?

A. Taxpayers over 70½ may direct a transfer up to $100,000 from their IRAs directly to a qualified charitable organization. This option expires at the end of 2009. Although no charitable deduction may be claimed for such a contribution, the transfer is tax-free to the IRA owner because the transfer is not a distribution.

Q: I’m in my upper 60s but I do not have long-term care insurance. The premiums are just too expensive for me with my limited income. However, I can afford even less the services of a long-term care facility, since that would wipe me out financially. Are there any tax benefits to owning a long-term care policy that might help subsidize the premiums?

A. Long-term care premiums are deductible as a medical expense (subject to the 7.5 percent-of-AGI floor), although there are limits to the deduction based on the taxpayer’s age. For example, a taxpayer between ages 61 and 70 may deduct as much as $3,080 in 2008 ($3,180 in 2009). A couple filing a joint return can deduct as much as $6,160 in 2008, if each spouse pays premiums on qualified long-term care policies. Payments in excess of any LTC benefits may be deducted as medical expenses.

Q: I am 72 and retired, disabled and living only on Social Security retirement and disability. These benefits are only $14,000 per year. Are there any special tax benefits I might qualify for?

A. There is a credit for the elderly or the disabled, although few qualify for this credit because the income limit typically results in a very low or no tax liability. Since a credit reduces tax liability dollar for dollar, there is no tax benefit if there is already no tax liability before the credit is computed. If you had no other income, your tax liability would be zero; so while you could qualify for the credit, there would be no real tax benefit for you. There is more information in the IRS’ Publication 524, Credit for the Elderly or the Disabled.

Q: I’m in my upper 50s and several years away from retirement, especially in these tough economic times. Can I take a hardship distribution from my 401(k) to help pay for my daughter’s tuition? Since the money would be used for tuition, wouldn’t I avoid any penalties?

A. No. Your 401(k) may be a lot lower now and college tuition is a good “investment” for your daughter’s future, but there is no exception to the 10 percent penalty on early distributions from a 401(k) plan. Even if your employer’s plan allows hardship distributions, your distribution is taxable and subject to the 10 percent penalty. If the plan allows, you can to borrow from your 401(k) account with no tax consequence. However, if you cannot repay the loan (which may become immediately due if you are laid off), the loan is considered a distribution and the entire amount becomes taxable and subject to penalty if you are under age 59½.

Q: I am in my mid-70s and would like to make sure my grandchildren’s college costs are covered as much as I can afford. Are there any special tax benefits available to me?

A. One possibility might be for you to contribute to (or establish) Section 529 accounts for your children. These tax-advantaged accounts allow distributions that are tax-free if used for “qualified” education expenses, such as tuition, fees, and room and board. You can contribute to their accounts as gifts. You also can “front load” a 529 account. Normally, if you give more than $13,000 to one individual during the year, you need to file a gift tax return on the excess over the $13,000 annual exclusion, which has gift tax implications. However, you may contribute as much as the annual exclusion for five years in a single contribution (if you have the funds to do this)--or $65,000--without any gift tax implications. Finally, if you have a grandchild already attending college, you may pay that individual’s college tuition without any dollar limit if you pay the institution directly. If you give the funds to your grandchild to pay tuition or if you are reimbursing the tuition already paid, this option is not available. In this case, you would need to file a gift tax return on the amount over the annual exclusion of $13,000.

Q: I’m 72 and relatively healthy, and I might have to get a part-time job to supplement my income. I have been taking required minimum distributions (RMDs) from my IRA for a few years. Do I have to continue taking them if I go back to work, even part-time?

A. Even though you have “earned income,” you must continue taking RMDs (except for 2009, when the requirement was waived). You cannot contribute to an IRA once you reach age 70½, so if you return to work, there is no tax effect on your situation.

Q: Are there any home tax deductions we could take? We’re a retired couple with a home and mortgage that’s been paid off. However, we still pay real estate taxes on the house and property taxes on our car. We don’t itemize on our taxes.

A. Taxpayers in their 60s or 70s with a home and no mortgage often find they cannot itemize their deductions because they don’t have enough deductions to make it worthwhile itemizing. However, a new law now allows taxpayers who pay real estate taxes to increase the amount of their standard deduction by the amount of real estate taxes paid, up to $1,000 for a couple filing a joint return. The new law applies only to real estate taxes, not the property taxes paid on your car.