Older Americans Receive Tax Breaks

By Dr. John L. Stancil
Tax Analyst, WebTaxCenter.com

As we age, we are all faced with life changes including retirement, a change in our standard of living, senior discounts, and the like. Often we face major decisions about the direction of our lives. Included in these changes are some changes in our income taxes. It may be that we no longer need to file a return. In other cases, we must file, but some of our income is not subject to tax. Finally, we may find that there are some tax breaks we can receive as older Americans. This article is a discussion only of the Federal income tax as state laws vary.

Do You Need to File?

The level of your gross income determines if you have to file a return. If you and your spouse are over 65 and filing a joint return, you do not have to file if your gross income is less than $18,800. This includes the additional standard deduction you receive when reaching age 65. If you are single and under 65, you must file if your gross income exceeds $8,300. Obviously, there are numerous combinations with different levels of income that exempt you from filing. These two represent the high and low numbers. You can, however receive an additional standard deduction if you are legally blind.

Gross income for this purpose is defined as all income you receive that is not exempt from tax. However, if you are below the required level of income for filing, you can file in order to obtain a refund of any taxes paid in or to receive the earned income credit if you are eligible.

Pensions

If your employer paid the cost of your pension, or it was paid by you with pre-tax dollars, the entire amount of your employee pension or annuity is taxable. If you made after tax contributions to your retirement plan, you can exclude a part of each payment as cost recovery. Using IRS-provided tables, you determine the amount of each payment to exclude from taxes and continue to exclude that amount until you have recovered your cost in the plan. After you recover your cost, the entire amount is taxable.

IRA's

Millions of Americans have invested in IRA's. With a traditional IRA the contributions are generally deductible, and distributions are taxable. You are eligible to begin withdrawals from the plan after you reach age 59 ½. However distributions are not required until April 1 of the year after you reach age 70 ½. There are rules governing the required minimum distributions once you start receiving payment. The penalty for not making the required distributions can be as high as 50% of the amount not distributed as required. Frequently, when a person leaves the employ of one company, he or she will roll the balance in their 401(k) plan into an IRA. These rollover IRA's are not treated any differently than one into which you made direct contributions.

Distributions from a Roth IRA, however are not taxable. With a Roth account, the funds are deposited with after-tax dollars. This investment grows with time and the principal and earnings are not taxable when withdrawn according to the rules for Roth distributions.

Social Security

The taxability of Social Security benefits is one of the puzzling sections of the Internal Revenue Code. Why did they have to make it so complicated? Depending upon your filing status and income level your social security benefits can be exempt from tax, half of your benefits can be taxed, or eighty-five percent of your benefits can be taxed. Although the computation is more complicated than this, the basics state that a single person whose taxable and non-taxable income plus one-half of the social security benefits are less than $25,000 will not pay tax on the social security received. Between $25,000 and $34,000 one-half of your benefits are taxed. And if your amount exceeds $34,000, you will have 85% of your benefits taxed. For persons filing a joint return the base amount is $32,000. Above $44,000 the 85% rule applies. Between those two amounts, 50% of your social security benefits are taxed. If you are married filing separately, 85% of your benefits are taxed regardless of income level.

Disability Income

A disability pension is subject to the same rules regarding taxability as a regular retirement pension. However, if you receive benefits through a disability income policy, those benefits are not taxable if you paid for the policy. If your employer paid for all or part of the cost of the policy, the benefits received are taxable based on how much was paid by the employer.

Long Term Care Insurance Contracts

Long-term care insurance contracts are usually treated as accident and health contracts. As such any benefits you receive under one of these policies is often excluded form income as payments for personal injury or sickness.

Life Insurance Proceeds

There are several scenarios involving life insurance policies. In probably the most common situation, the proceeds are paid to the beneficiary due to the death of the insured. In these cases, amounts received under the policy are not taxable.

However, if you leave the proceeds with the company and receive interest payments on the balance, the interest is taxable income. Similarly, if you choose to receive payments over a period of time a portion of each payment will be subject to tax. For example, if the amount of the policy is $50,000 and you choose to receive payments of $1,000 a month for five years, you will receive a total of $60,000 on the policy. Divide the $50,000 by $60,000 to determine the portion of each payment that is not taxable.

If you surrender the policy in return for the cash value, you will be subject to income tax on amounts received in excess of the total premiums you have paid on the policy. You should receive a 1099-R from the insurance company indicating how much, if any, of the proceeds are taxable.

On occasion, a person who is terminally or chronically ill is in need of funds to pay medical or other bills. In these situations, a person can receive accelerated death benefits either from the insurance company or a viatical settlement provider. Accelerated death benefits are not taxable if the person meets the definition of terminally or chronically ill.

A person is considered terminally or chronically ill if one of the two conditions apply:

• They are unable to perform at least two activities of daily living for a period of 90 days or more because of a loss of functional capacity.
• They require substantial supervision to protect himself or herself from threats to health and safety due to severe cognitive impairment.

In order to receive the exclusion of accelerated benefits from taxation, you should file Form 8853 with your return.

Credits

There are three tax credits that are of special interest to the elderly and disabled. They are the Credit for the Elderly and Disabled, the Child and Dependent Care Tax Credit, and the Earned Income Credit.

The Credit for the Elderly and Disabled is for individuals who are over age 64 or permanently and totally disabled and you income is less than a certain amount. The income limit for a single person is $17,500, for a married couple where both qualify the limit is $25,000, and for a married couple when only one spouse qualifies the limit is $20,000.

If you are eligible you should complete Schedule R to determine the amount of your credit. Fear not! If this form seems too difficult the IRS will calculate the credit for you.

The Child and Dependent Care Credit is usually thought of as a credit to allow working parents to receive a credit for child care expenses paid, allowing them to work. However, this credit also applies if you pay someone to care for your disabled spouse so you can work. The credit is a percentage varying from 20-35% depending on your level of income and applies to a maximum of $3,000 for the care of one qualifying person.

If you report earnings on line 7 of the 1040 you have earned income and may be eligible for the Earned Income Credit. While designed primarily to benefit younger, low-income taxpayers who have dependent children it may apply to older Americans who have no dependent children. There are a number of rules for the eligibility for this credit, but if you are married and have earned income of $13,750 and your investment income is less than $2,700 you probably qualify.

The big feature of the Earned Income Credit is that it is a refundable credit. This means that the amount of the credit may exceed your tax liability, giving you a refund of more than you paid in.

As we get older, life seems to be more complicated. Unfortunately dealing with these changes in the tax law for older Americans does not simplify anything for us. However, they can result in a lower tax bill. For more information, you can consult IRS Publication 554 or go to www.webtaxcenter.com. Your CPA or financial planner should also be able to help you in planning for and dealing with these changes.

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Dr. John L. Stancil, a tax analyst for WebTaxCenter.com, has been a member of the Florida Southern College faculty since 1998. He received his bachelors degree from Mars Hill College and holds a M.B.A. from the University of Georgia. He later earned his doctorate in accounting from the University of Memphis. He holds four professional certifications, including CPA, CMA, CFM and CIA. Stancil has received the Florida Institute of CPAs 2005 Outstanding CPA in Public Service Award. (This award is given annually to a Florida CPA who has demonstrated significant contributions through community and civic activities.) He has also been recognized as the Expert of the Month on several occasions by allexperts.com.

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