Tax and Business Alert - 

June 2005

Roth IRA Option for 401(k) Accounts

The 2001 Tax Act contained a provision allowing elective deferrals (contributions) to Section 401(k) plans to be placed in a Roth IRA beginning in 2006. Congress felt the tax- favored savings choices that some individuals prefer, such as Roth IRAs, should be available to 401(k) participants.

Beginning in 2006, plan participants can elect to have all or a portion of their 401(k) elective deferrals (contributions) up to $15,000 in 2006 (plus an additional $5,000 if age 50 or older at year-end) treated as a Roth contribution, provided the deferrals go into a separate account set up within the 401(k) plan by the plan sponsor. Deferrals treated in such a manner will be included in the participant's income (not deferred from taxation) in the year contributed. However, distributions from such an account will normally not be taxable (similar to the rules for regular Roth IRAs). Traditional 401(k) contributions are not included in current income, but are deferred from income until received, theoretically, after retirement. So, beginning in 2006, plan participants can designate whether they want their contributions to be made before or after tax if their employer's plan adopts this new provision (adoption is not mandatory).

Upon implementation in 2006, higher income individuals, who cannot directly contribute to a Roth IRA because of the adjusted gross income (AGI) limitation, will have the option to designate all or a portion of their allowable elective deferral amounts as Roth contributions. Further, elective deferral participants will not be limited to the annual Roth IRA contribution limit ($4,000 in 2006, plus an additional $1,000 if age 50 or older at year-end). Also, there is no prohibition against participants designating elective deferrals as Roth contributions, and then separately contributing the $4,000 maximum amount (plus an additional $1,000 if age 50 or older at year-end) to a regular Roth IRA in 2006 assuming their AGI permits the latter contributions. So, a fully qualified individual, age 50 or older at year-end, could presumably contribute up to $25,000 ($15,000 in elective deferrals, $5,000 in catch-up contributions plus $4,000 in regular Roth and $1,000 regular Roth catch-up contributions) in Roth accounts in 2006.

Note that only employee elective deferrals are eligible for designation into a Roth account; any associated employer matching contributions will be designated as a non-Roth pretax match. Also, if you subsequently elect to make a rollover distribution from the Roth IRA portion of your 401(k) plan, that distribution can only be rolled over to another Roth account, whether in another 401(k) or a regular Roth IRA.

Favorable Ruling on IRA Wrap Fees

Many brokers offer investment programs that charge an overall fee to cover investment advisory services, trading costs, and other services provided in managing the account. These so-called wrap fee accounts can be used for IRAs. In a recent private letter ruling, the IRS indicated that wrap fees paid by IRA account holders do not constitute contributions to the IRA if the wrap fees are paid with non-IRA funds. This ruling was somewhat unexpected because wrap fees include brokerage commissions and the long-standing practice has been to treat IRA brokerage commissions paid from non-IRA funds as IRA contributions. Nevertheless, the recent ruling does not require the wrap fee to be split into its components to determine the tax consequences, so the brokerage commission and the investment advisory fee components are treated the same for tax purposes.

In this particular case, the fee was based on a percentage of assets in the IRA account. The fact that the wrap fee in question is based on a percentage of assets, rather than the number of transactions or other criteria, seems to be the key decision factor in this ruling.

Cautionary Note: A private letter ruling lets us know what the IRS is thinking about a particular issue. Technically, the only taxpayer allowed to rely on this ruling is the one who requested it. However, similar situations would likely receive a similar ruling.

Online Financial Calculators Website

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These are just a few of the questions that can be answered at www.dinkytown.net from KJE Computer Solutions, LLC. The website offers more than 150 calculators in 10 categories, including loans, mortgages, retirement planning, taxes, and savings. Graphs and reports are incorporated to supplement the calculators.

Anyone can use the free calculators on the website or the calculators may be purchased if a business wants to add one or more to its own website for use by its customers. A free trial version is available.

"Dirty Dozen" Schemes to Avoid

The IRS recently unveiled its annual updated listing of the "Dirty Dozen" tax scams to avoid. The Dirty Dozen for 2005 includes some new scams as well as some holdovers from last year's list.

The following tax scams made this year's list:
(1) the misuse of trusts, (2) return preparer fraud, (3) credit counseling agencies abusing their position, (4) "claim of right" doctrine where filers take a deduction for the full amount of their income, (5) "no gain" deduction which is similar to the previous "claim of right" doctrine, (6) "Corporation Sole" involving a phony one-person religious organization, (7) identity theft, (8) fraudulent charitable organizations and deductions, (9) offshore transactions, (10) "zero return" where filers only enter zero amounts on their return, (11) employment tax evasion, and (12) a warning to be aware of old schemes that may reappear including slavery reparations and improper home-based business deductions.

Taxation of Long-term Care Insurance Proceeds

Long-term Care (LTC) insurance provides financial protection for health and social services costs incurred by insureds with chronic illnesses or disabilities that prevent them from being able to carry out activities of daily living. A chronically ill individual is generally someone who has been certified within the previous 12 months by a licensed health care practitioner as (1) needing substantial assistance to perform at least two activities of daily living (eating, toileting, transferring, bathing, dressing, and continence) for at least 90 days, due to loss of functional capacity, (2) having a similar level of disability as determined under regulations, or (3) requiring substantial supervision to protect the individual from threats to health or safety due to severe cognitive impairment.

LTC policies generally cover medical and nonmedical services provided outside the hospital, including home health care, nursing home care, adult day care, alternate care, and respite care. Benefits usually are payable to individuals who suffer either an activities-of-daily-living impairment or a cognitive impairment. Medical necessity generally is not the sole prerequisite for receiving benefits.

A long-term care insurance contract is generally treated as an accident and health insurance policy. Amounts received under a qualified long-term care insurance contract (other than policyholder dividends or premium refunds) may be excludable from income as amounts received for personal injury and sickness. Basically, this means the premiums on long-term care insurance contracts and the expenses of qualified long-term care are treated as medical expenses.

Example: Exclusion of payments made under long-term care insurance contract. Clarence is confined to a nursing home for 30 days in 2005. The nursing home charges $210 per day, for a total of $6,300. Clarence's long-term care insurance contract pays 80% of the amount charged by the home after a 10-day waiting period, so the insurance company sends him a check for $3,360 {[$6,300 - (10 x $210)] x 80%}. The $3,360 is not includable in Clarence's income. Furthermore, Clarence can deduct the $2,940 unreimbursed difference ($6,300 $3,360) as a medical expense, subject to the 7.5% of adjusted gross income floor.

Qualifying long-term care expenses include necessary diagnostic and preventive care as well as therapy, rehabilitation, and treatment. They also include maintenance and personal care services for chronically ill individuals if the services are prescribed by a licensed health care practitioner.

Some long-term care insurance contracts pay a certain amount per day, regardless of the actual long-term care costs. For chronically ill individuals receiving benefits from these policies, the exclusion from income is limited to $240 per day (in 2005) or $87,600 annually. However, long-term care insurance proceeds received on a per diem basis can be excluded from income even if they exceed these limits where the taxpayer has long-term care expenses in excess of the cap. For example, there would be no taxable income if the policy paid $250 per day and the cost of the long-term care facility was that amount or more. Otherwise, amounts received in excess of the dollar cap are fully taxable. However, the per diem limitation does not apply if the taxpayer is terminally ill when the insurance payments are received. A terminally ill individual is one who has been certified by a physician as having an illness or physical condition that reasonably can be expected to result in death within 24 months of the date of certification.

Deducting Legal Fees

These days, you are likely to incur some legal fees sooner or later. Then, you will naturally want a tax write-off to at least partially ease the pain. Whether a current deduction is in the cards depends on the circumstances.

Legal fees paid by an individual to produce or collect income or to manage, protect, or maintain income-producing assets can be written off as miscellaneous itemized deductions on Schedule A of Form 1040. For example, this rule covers hiring an attorney to collect alimony owed by an ex-spouse or to resolve a dispute regarding how much interest is due on an installment note receivable. However, you cannot deduct legal expenses for the management, protection, or maintenance of a personal residence.

Individuals are entitled to deduct legal expenses for tax advice, tax calculations, return preparation, contesting tax assessments, or claiming refunds. This is true for taxes levied by any and all jurisdictions and for any and all types of tax. Unfortunately, deductible legal expenses described in the two preceding paragraphs will actually generate a tax benefit only if-when combined with all your other miscellaneous itemized deductions--they exceed 2% of adjusted gross income (AGI). (Your AGI is the number at the bottom of page 1 of your return.) Even worse, if you are subject to the alternative minimum tax (AMT), miscellaneous itemized deductions do you no good because they are completely disallowed in calculating AMT.

On the other hand, legal expenses are fully deductible--for both regular tax and AMT purposes--if they are "ordinary and necessary" in the conduct of your business, including a sole proprietorship operation. For example, if you or your company is forced to take legal action to collect a customer receivable, the fees are deductible just like any other "ordinary and necessary" business expense. The fact that you don't ordinarily have to resort to legal action to collect does not mean you fail the "ordinary" test.

Business organizational expenditures up to $5,000 and business startup costs up to $5,000 incurred after October 22, 2004, can qualify for immediate deduction. However, each $5,000 allowance is reduced by the amount of cumulative costs in excess of $50,000. So, if you incur $55,000 of expenses in either of these categories, all of the expenses for that category will have to be capitalized. Organizational and startup expenditures that are not deductible in the year the business begins must be capitalized and amortized (expensed) over 15 years (180 months) on a straight-line basis.