Taxation on the Sale of Your Home – Part 1

Jane Young, CFP, EA

In most situations, if you sell your personal residence that you have lived in for 2 of the last 5 years, you will qualify for an IRC Section 121 Exclusion.   Section 121 excludes gains of up to $250,000 for an individual and $500,000 for a married couple filing jointly.  You must own your home and use it as your primary residence.  Married taxpayers may exclude up to $500,000 if either spouse owned the home for 2 of the last 5 years and both spouses lived in the home for 2 of the last 5 years.   If eligible, you can use this exclusion once every two years.  Any gains in excess of the exclusion will be taxed at capital gains rates.  If your gain does not exceed the exclusion you don’t need to report the sale on your tax return.

If you own more than one home, you are only eligible for the exclusion on your primary residence.  Additionally, you are not eligible for the section 121 exclusion if you acquired your home through a like kind exchange (1031 exchange) in the last 5 years or if you claimed an exclusion over the past 2 years.  If you don’t meet the requirements because you lived in your home for less than two years and the reason for the sale is due to poor health, change of employment, death, divorce, or other unforeseen circumstances, you may be eligible for a partial exclusion.  Additionally, special rules apply to qualifying members of the Uniformed Services or the Foreign Service and employees of the intelligence community and the Peace Corps.  The exclusion of gains does not apply to gains attributable to depreciation claimed for rental or business use after May 6, 1997.
If you lived in your home for 2 of the last 5 years but failed to use the home as your primary residence at any time after January 1, 2009, some of your gain may be ineligible for exclusion.   The time during which your home was used as a rental or vacation home is considered non-qualified use.  Any gain on your home during this timeframe is not eligible for exclusion and will be taxed at capital gains rates.  This does not reduce the actual amount of your exclusion and if your gain is large enough you may be able to use your full exclusion.

To calculate the gains attributable to non-qualified use, divide the number of years of non-qualified use (years home not used as primary residence after 2008) by the total number of years the home has been owned.  For example if you rented your home for 4 years and owned your home for 20 years, gains attributed to non-qualified use are equal to 4/20ths or 20%.  Therefore, 20% of the gain will be taxable (plus any depreciation recapture) and 80% may qualify for exclusion.

Depreciation will be addressed in Part 2 of this article.

What You Should Think About Before Becoming Self Employed

Jane Young, CFP, EA

Image result for self employment imagesGoing out on your own as an independent contractor, a consultant or a small business owner is a major decision that can have significant financial implications. You will need to earn 20% to 40% more as an independent contractor than as an employee just to stay even. Self-employed individuals have to pay twice the amount in Social Security and Medicare taxes because they have to cover the portion that employers normally pay. On your own, you will have to pay 12.4% in Social Security, on income up to $127,200, and 2.9% in Medicare. Higher income individuals will also have to pay a Medicare surtax of .9%.

Additionally, taxes will no longer be automatically withdrawn from your paycheck. You will need to start paying quarterly estimates directly to the IRS. It may be wise to hire a tax professional to do some tax planning and help you determine how much tax you should pay each quarter.

Another major expense associated with becoming self-employed is the loss of employee benefits. These may include health insurance, disability insurance, life insurance, and workers compensation. Additionally, you will no longer be eligible for bonuses, profit sharing, unemployment insurance, sick pay, and vacation pay.

Once you leave your company, you can’t contribute to your 401k plan and you will lose the opportunity receive an employer match on your contribution. As a self-employed person you will need to establish an alternative retirement plan such as an IRA, SEP (Simplified Employee Pension) or Solo 401(k). If you leave your employer and decide to move your 401k plan, do a direct rollover to an IRA to avoid income tax and potential penalties.

When you go out on your own you will have more freedom over your compensation, the hours you work and the services you provide. Although you should earn a higher hourly rate you may have less job stability and inconsistent cash flow. Self-employed individuals generally need to maintain a larger emergency fund as a buffer against a less consistent income stream.

In addition to greater freedom and a potential increase in earnings, one the biggest advantages to becoming self-employed is the opportunity to deduct normal business expenses. This may include your cell phone, computer, internet, health insurance, mileage, office expenses, travel, meals and entertainment, business insurance, marketing expenses, accounting expenses and potentially a home office deduction. The ability to deduct your expenses can result in a tremendous tax savings. One of the biggest mistakes made by those new to self-employment is a failure to keep track of all their business expenses.

Becoming your own boss can be very rewarding and can provide you with more control over your career. However, independence and freedom comes with added expenses and less stability. The rewards can be tremendous if you understand and plan for the added expenses and truly feel comfortable with more variability in your income.

401k Loan Not a Great Idea

Jane Young, CFP, EA

When you need extra money to pay some bills, make home improvements or buy a new car, a 401k loan may seem like the perfect solution. At first glance, it seems like a great idea to borrow money from your 401k account and pay interest back to yourself. However, in reality taking a loan against your 401k can put a significant dent in your retirement saving and could result in unnecessary taxes.

Most 401k plan providers allow employees to take loans against their 401k account of up $50,000 or 50% of the account value. The interest rate charged on most 401k loans is the prime rate, which is currently around 4%, plus 1 or 2 percentage points. Loans must be paid back in five years, potentially longer if you are borrowing to purchase a primary residence. Repayment is typically made via automatic payroll deduction and loans automatically come due if you discontinue employment.

The advantages of a 401k loan include the ease with which you can get your money. A 401k loan is a quick, no hassle process that doesn’t require a credit check or the completion of a time consuming credit application. The loan is automatically repaid from your paycheck and the interest rate is generally lower than what you would pay for a bank loan or a credit card. There is no income tax or penalty due on the money taken out for the loan and the interest goes back into your account.

On the surface this sounds like a great deal but there are significant disadvantages. The most obvious may be the opportunity cost of losing the chance to earn compounded returns on the money that you have borrowed. This can have a dramatic negative effect on the amount of money you have available at retirement. Additionally, while making payments on a 401k loan, most borrowers stop making contributions. This results in lost tax deductions and may cause you to miss out on your employer’s match, not to mention less money in retirement.

Another less obvious downfall is the double taxation on the interest. Your interest payments are made with after tax dollars and then you pay taxes a second time when distributions are taken in retirement. Additionally, you may have to pay taxes and penalties if you lose or quit your job before your loan is paid off. A 401k loan typically becomes due within 60 days of separation from your employer, regardless of the reason. If you are unable to pay off the loan you will owe regular income tax on the full amount plus a 10% penalty if you are under 59 ½.
Generally, you are better off taking out a bank or home equity loan or postponing consumption until you can pay cash than taking out a 401k loan. Avoid 401k loans unless you are truly in dire circumstances or the money is needed for a very short term loan.

Investing is Not a Competition Between Stocks and Bonds

Jane Young, CFP, EA

Many investors think of investing as a competition between investing in the stock market, interest earning investments and real estate.  Too many people take a strong stance for or against one of these three broad categories rather than embracing the advantages that each one can bring to their portfolio.  A well balanced portfolio should include some of all three with each serving a very different purpose.

All three categories will have their day in the sun depending on the investment climate.  Due to low rates, interest earning investments such as CDs, bonds and savings accounts aren’t getting much love right now.   Despite the current low rates of return, interest earning investments provide a relatively safe place to keep your short term money.  This is money needed to cover living expenses or emergencies over the next several years.  Interest earning investments provide a buffer against more volatile investments in the stock and real estate markets.   Keeping a portion of your portfolio in safer, fixed income investments can give you greater peace of mind and help you stick to your long term plan when the stock market gets rocky.  However, avoid putting too much in interest earning investments; this can make it difficult to keep up with inflation and earn the growth needed to support your retirement goals.

On the other hand, when the stock market is doing well everyone wants to get a piece of the action. Avoid overloading your portfolio with stock when the market is skyrocketing.   Investments in the stock market can provide you with long term growth and a hedge against inflation.  Historically, the stock market has trended upward and over long periods of time has outperformed other investment categories.  However, in the short term the stock market can be very unpredictable and volatile and should only be used for long term needs – money that isn’t needed for five to ten years.  Keep your short term money in interest earning investments.

Real estate serves a dual purpose for most investors, it gives us a place to live and it provides us with an asset that usually appreciates over time.   In addition to your home, as your portfolio grows, you may want to consider additional real estate investments in mutual funds or rental property.  Like the stock market, real estate should be treated as a long term investment.  The real estate market can experience extreme downturns and commonly lacks the liquidity needed to cover short term needs.

These three categories of investments have their advantages and disadvantages.  Focus on the role the asset plays in your financial plan and avoid becoming overly comfortable and confident with a single category – it’s all about balance.  The appropriate amount in each category will vary over time and is dependent on your age, your financial goals, your cash flow needs and your risk tolerance.

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