Tax Management

Tax Management

Since the inception of this nation, taxes have been a part of everyday life. Congress enacted the first income tax laws in 1862, in part to fund the Civil War. In 1913, the 16th Amendment was added to the Constitution, making income taxes a permanent fixture of the country’s taxation system. As a result, tax-related issues can be a big part of the financial planning process. Poor tax management cuts into older Americans’ cash flow and ultimately diminishes lifestyle.

Individuals in each of the three income categories can benefit from some amount of good tax planning. Proper use of available credits, deductions, and exemptions can help reduce income tax. Depending on the income level, IRA or other retirement plan contributions can also help to reduce taxable income, while eventually providing increased retirement income. Enough other possibilities exist to encourage low-income seniors to do at least some tax planning.

The phrase nontraditional lifestyle is being heard more and more today. It is important to note that we have a very traditional tax code. This means that some of those with nontraditional lifestyles may not be able to take advantage of all the tax planning opportunities available to people living more traditional lifestyles. For example, the tax code offers some tax filing breaks to couples who are legally married. Most people in common law marriages or in gay and lesbian domestic partnerships will be required to file as single individuals, not as married filing jointly. Depending on the exact financial arrangements, it may also be difficult for those in a nontraditional relationship to take full advantage of certain deductions and credits.

Income may come from a variety of sources, including compensation, interest, dividend income received from owning an investment (known as holding period income), or capital gains (realized on selling an asset at a profit), rent, Social Security, pension, and so forth.

The taxes that affect a majority of seniors are taxes on:

  • Compensation, which includes wages, salaries, commissions, fees, tips, fringe benefits, and stock options;
  • Interest and dividends;
  • Capital gains;
  • Social Security retirement and disability benefits.

Tax on Compensation

Compensation is taxed at an ordinary income rates. Deductions and exemptions reduce taxable income. Taxpayers who do not itemize deductions may claim the standard deduction. Of particular importance to seniors who do not itemize is that an additional standard deduction is available to taxpayers over age 65 and for taxpayers who are blind. Two additional standard deductions are allowed for a taxpayer who is both age 65 and blind. In 2009, the standard deduction will be enhanced by real property taxes paid, limited to $ 500 for a single taxpayer and $ 1,000 for a married couple filing jointly. (Legislation may extend this enhancement in 2009 and beyond.)


Itemizing Deductions

Some seniors may benefit if the total amount of their itemized deductions exceeds the standard deduction combined with the additional deductions for being age 65 or blind. (These two deductions are not available to seniors who itemize; also, the ability to itemize may be limited for those with substantial incomes.)

Numerous deductions may be itemized (refer to IRS Publication 17) including all real property tax, medical expenses, and charitable gifts.

Medical Expense Deduction

Seniors who itemize deductions may be eligible to deduct medical expenses if the total of medical qualifying deductions exceeds 7 ½ percent of an individual’s or couple’s adjusted gross income (for the year 2009). Expenses qualifying for the medical deduction include:

  • Medical and dental expenses actually paid;
  • Qualified long-term care insurance premiums;
  • Transportation for medical purposes;
  • Special medical items and equipment, including installation of wheelchair access ramps, wall railings, and other similar home modifications;
  • Reasonable home improvements for safety and medical reasons.

The Basic Tax Formula

One of the primary goals of good financial planning is to manage tax liability, preferably lowering the amount of taxes owed. To understand the way income tax minimization works, be familiar with the basic formula for computing federal income tax:

Income (broadly defined) - Exclusions and non-taxable income = Total Income

Total Income - Deductions =  Adjusted Gross Income (AGI)

AGI - The greater of either total itemized deductions or standard deductions - Personal/dependency exemptions = Taxable income

Taxable Income x Tax Rate* = Total federal income tax due

*Tax rates, which increase progressively for larger amounts of income, are multiplied by taxable income to determine the amount of tax due less any tax credits a taxpayer can apply.

In a sense, this formula mimics IRS Forms 1040, which most Americans use to calculate and report their personal income tax. IRS Publication 17 contains instructions for completing Form 1040 and provides accompanying schedules for reporting capital gains, business expenses, and other items.

By understanding common tax consequences and tax-reduction strategies, you can help seniors estimate retirement income, increase spendable income, and leave dollars to heirs rather than to the government (estate taxes are discussed in the Estate Planning section).

Tax law is constantly changing, so it is important to remain aware of changes to both federal and state laws.

  • Transportation for medical purposes;
  • Special medical items and equipment, including installation of wheelchair access ramps, wall railing, and other similar home modifications;
  • Reasonable home improvements for safety and medical reasons.

Charitable Gift Deduction

Deductions are often available for gifts of cash and other property made to a qualified organization operated exclusively for religious, charitable, scientific, literary, or educational purposes, or for the prevention of cruelty to children or animals. Payments to veteran’s organizations and certain burial societies may also qualify for the charitable deduction (see IRS Publication 78 or No deduction is available for volunteer activities, but individuals may deduct related personal expenses such as mileage and auto use.

Because there is a ceiling on the amount of deductible charitable contributions that an individual can make, it is critical that seniors obtain expert tax advice before making substantial charitable gifts.


Personal Exemption

Each taxpayer having income under substantial limits, as specified by the IRS, is entitled to claim a personal exemption.

Dependency Exemption

Seniors who take care of siblings, grandchildren, and others should be made aware of the dependency exemption. Additionally, adult children who take care of their elderly or disabled parents or grandparents should be aware of the exemption opportunity. Expert tax advice is critical to determine whether a particular taxpayer may claim an exemption.

Income from Volunteer Organizations

Many seniors are retired and no longer receive taxable compensation, but some will work to advanced ages. Often seniors volunteer their time to organizations. Income paid for supportive services at the following volunteer organizations is generally excluded from taxable income:

  • Retired Senior Volunteer Program (RSVP)
  • Foster Grandparent Program
  • Senior Companion Program
  • Service Corps of Retired Executives (SCORE)

Tax on Interest and Dividends

Many stocks and mutual funds distribute earnings as taxable dividends. Dividends used to be taxed as ordinary income. Qualified dividend income, however, will be taxed at 0 percent in the period 2008-2010 for taxpayers in the 10 and 15 percent tax brackets and at only 15 percent for taxpayers in higher brackets. Nonqualified dividends will continue to be taxed at ordinary rates.

In addition, taxable interest may be generated from bank certificates of deposit (CDs) and passbook accounts, as well as from corporate and Treasury bonds, bills, and notes. While interest on Treasury bonds is always exempt from state taxes, interest on certain bonds issued by states and municipalities may be exempt from federal, state, and local income tax, resulting in a triple tax exemption. Be aware that tax-exempt income derived from some municipal bonds may ultimately become taxable and may be subject to alternative minimum tax (AMT). See Appendix C for the Taxable Equivalent Yield (TEY) formula that can be used to compare the after-tax interest income between two bonds, tax-exempt and taxable.

Capital Gains Tax

When a capital asset such as an investment, home, or business interest is sold for more than the holder paid to acquire the property, the result is known as a long or short-term capital gain. Short-term gains apply to property held less than 12 months and are generally subject to ordinary income tax rates. Long-term gains apply to property held longer than 12 months and are subject to lower tax rates, generally 15 percent, or 0 percent in the period 2008-2010 for lower-bracket taxpayers (15 percent bracket and below).

Cost Basis

With certain exceptions, the after-tax amount the holder paid to acquire the property is considered its cost basis. The amount of capital gain that may be taxable is calculated by subtracting the cost basis of the asset from the proceeds received from the sale of the asset.

Example: Marian sold 100 shares of ABC common stock at $60.00 per share. She originally paid $ 25.00 per share (cost basis of $ 2,500 = 100 shares x $ 25/share). Although Marian received $ 6,000 from the sale (100 shares x $60/share), her gain is $3,500, because her cost basis was $ 2,500.

Capital Gains and the Sale of a Personal Residence

Section 121 of the Internal Revenue Code provides capital gains tax exclusion on a home sale of up to $ 250,000 for a single taxpayer and up to $ 500,000 for married taxpayers filing jointly. For sales after 2007, a surviving spouse may exclude $ 500,000 if the sale occurs within 2 years after the date of the death of the spouse. In order to enjoy the exclusion, however, the following use requirements must be satisfied:

  • The taxpayer must have owned and used the home as a principal residence for at least two of the five years (the two years need not be consecutive) before the sale.
  • For married joint filers, either spouse may own the home but both must meet the use requirement.
  • If a taxpayer fails to meet the requirement above due to a change in health or employment, the taxpayer may be entitled to a partial exclusion.
  • If one spouse can take a full exclusion and the other cannot, the exclusion is calculated as if the taxpayers had not been married.
  • The Section 121 exclusion can be used once every two years.

Example: Don and Marge Swenson, who are entering the second stage of retirement, wish to sell their four-bedroom home on Cherry Lane, preferring the lower maintenance of condominium living. The Swensons can claim an exclusion of up to $ 500,000 in capital gain realized from the sale of their Cherry Lane home. Six years later, the Swensons decide to sell the condominium and move into an assisted living facility. If they realize capital gain on the sale of the condominium, they may again claim the Section 121 exclusion relative to any capital gain realized from selling the condominium.

If a rental or vacation property is converted to a personal home, capital gains tax is due on that percentage of the gain equal to the percentage of time the house was used other than as a primary residence since January 1, 2009. Any gain attributable to use as a principal residence will remain excludable, up to the $ 250,000 and $ 500,000 limits.

Additional Exemptions to Capital Gains Tax

In addition to a Section 1031 exemption, capital gains tax may be avoided through:

  • Charitable gifts: Eligible charities generally are not required to pay income tax on capital gains and other income. Outright donations of appreciated property to charities, as well as gifts made through charitable trusts may effectively eliminate capital gains taxation on certain properties (not to mention provide a charitable income tax or estate tax charitable deduction).
  • Step up in Basis: Selling appreciated property during one’s life will generate capital gains tax. Seniors may reduce or eliminate capital gains for themselves and heirs when highly appreciated property is transferred at death rather than sold or gifted during life (refer to Estate Planning).

Tax on Social Security Benefits

Senior taxpayers’ total income determines if their Social Security retirement and disability benefits are taxed. Most seniors do not pay taxes on these benefits because the current tax code is designed to provide a great deal of tax relief for the average senior. However, individuals with higher incomes above certain limits may have to pay taxes on a portion of their Social Security benefits. The portion that is taxable increases as the amount of income from other sources increases.

Specified income thresholds determine the level of taxation. Depending on total income, benefits are taxed at two levels: 50 and 85 percent. No one pays taxes on more than 85 percent of Social Security benefits, and some pay on a small portion.

  • A taxpayer filing an individual return with a combined income between $ 25,000 (base amount) and $ 34,000 may have to pay income tax on $ 0 percent of Social Security benefits. When combined income exceeds $ 34,000, up to 85 percent of Social Security benefits is subject to income tax.
  • A married couple filing a joint return may have to pay taxes on 50 percent of benefits if their combined income is between $ 32,000 (base amount) and $ 44,000. (On the 1040 tax return, combined income is the sum of adjusted gross income, plus nontaxable interest, plus one-half of Social Security benefits.) If combined income is more than $ 44,000, up to 85 percent of Social Security benefits are subject to income tax.

Taxes on Social Security Benefits

Tax Filing Status

Combined Income

Amount of Total Social Security Benefits That Is Taxable


$ 25,000-$34,000

$ 34,000 and more

50 percent

85 percent


$ 32,000-$44,000

$44,000 and more

50 percent

85 percent


Income reported for figuring the Social Security tax is defined as all income including wages, salaries, Social Security income, interest (including interest earning from tax-exempt bonds), dividends, capital gains, rents, and retirement income from IRAs, employer-sponsored plans, Section 457 plans, and tax-sheltered annuities (TSAs). Income from series EE bonds, tax-deferred annuities, and qualified life insurance loan distributions are excluded from these calculations.

Alternative Minimum Tax

The alternative minimum tax (AMT) is a separate tax system established to ensure that wealthier taxpayers pay taxes. Although it targets those with high incomes who make extensive use of tax-reduction strategies, it increasingly affects middle-income taxpayers who have substantial deductions. In this article “The Alternative minimum Tax,” SmartMoney (2004) reported that only 19,000 people owed AMT in 1970, whereas 23 million were paying AMT in 2008, according to the Tax Policy Center. In 2008, legislation provided a temporary “AMT Patch” to decrease the effects on middle income taxpayers. AMT is an ongoing issue and additional legislation may be passed in the future.

AMT uses its own tax rates and rules that are quite different from the familiar rules on Form 1040 regarding itemized deductions and personal and dependency exemptions. SmartMoney recommends that people calculate AMT if their income exceeds $ 75,000 and they have substantial deductions and exemptions. Taxpayers must pay the higher of the AMT or the regular tax. Taxpayers may owe penalties if they should have paid AMT and did not. AMT is fairly complicated, and seniors who may be subject to it should seek advice from tax professionals.

Tax Avoidance

Americans have always struggled to find ways to reduce or eliminate their taxes. Most Americans dutifully pay their fair share each year, but others attempt to avoid paying any taxes at all. It is understandable and perfectly legal to try to decrease one’s tax bill, but there is a distinct difference between tax avoidance and tax evasion. Tax avoidance is permissible under tax regulations. Tax avoidance is permissible under tax regulations. Tax evasion is not and holds serious legal ramifications for those who are caught. You must help your senior clients differentiate between the two.

  • Tax avoidance seeks to minimize tax liability by working within the complex scope of tax law found in the Internal Revenue Code (IRC). You may provide valuable guidance to older clients regarding techniques to minimize their taxes. However, both you and your clients should bear in mind that the economic costs of certain tax strategies could outweigh the tax benefits of the transaction. Good business and investment principles should not be abandoned for the sake of lowering tax liability.
  • Tax evasion is the reduction of tax through illegal means, including tax fraud. Penalties for tax evasion include fines, imprisonment, or both.

Sometimes it can be difficult to differentiate between tax avoidance and tax evasion. Poorly informed seniors may pursue aggressive strategies that create problems with the IRS. Seniors should seek professional guidance in identifying tax strategies that are economically viable and legally sound.

The information above is reprinted from Working with Seniors: Health, Financial and Social Issues with permission from Society of Certified Senior Advisors® . Copyright © 2009. All rights reserved.