Last week’s article, Tax Time, 2014 Style, was written in a Question & Answer format to provide answers to often asked tax-related questions. Unfortunately, there was only enough column space for just a couple of Q&As, selected from a virtual storehouse of such information. I feel it important to get some of this information “out there,” before the income tax filing and payment deadlines arrive.
Q. Did he just say “deadlines” with an “S”?
A. Yes, I did. For U.S. taxpayers residing in the USA, both of this year’s return filing and tax payment deadlines fall on the same day: April 15, 2014. For U.S. taxpayers residing
outside of the USA, the tax payment deadline remains April 15, 2014 but the return filing deadline is extended to June 16, 2014 via an automatic 2-month extension.
Additionally, while the tax payment deadline remains the same, no penalties will be charged to U.S. taxpayers residing outside of the USA who pay their taxes prior to June 16, 2014. Those U.S. taxpayers will be charged interest on the tax due, however, during the period of April 15 to the date of payment. If those U.S. taxpayers make payment after June 16, 2014, they will incur a penalty for doing so.
See what I mean? There’s a whole lot of information that needs to be known by U.S. taxpayers living abroad (and even those living in the U.S. itself) that isn’t easily available to them.
SO, OFF WE GO . . .
Today’s first question is based on a classic “Yes It Is / No It Isn’t” argument, and is all too often quite an emotional battle. To those who may identify with this skirmish, I ask you to simply trust my answer. If followed, it will keep you from receiving additional correspondence from the Internal Revenue Service (IRS).
Q. While discussing a tax exclusion program with a friend, he informed me that my pension is “unearned” income. Now, I earned every penny of that retirement money. All those days of slaving away on my way to retirement; and now someone says I didn’t earn it? What’s all this 
mumbo-jumbo of “earned” and “unearned” income about, anyway?
A. First, let me state that you very much earned your pension. But for income tax purposes, we’re not talking about your efforts. We’re talking about categorizing income by its character. For income tax purposes, all income, regardless of its source, can be separated into three categories: 1) earned income; 2) unearned income; and 3) variable income. To be placed into one of these categories, the income must meet the IRS’s definitions. The IRS explains them this way:
- Earned income is “pay for personal services performed, such as wages, salaries, or professional fees.” Examples of earned income include: salaries and wages; commissions; bonuses; professional fees; and tips.
- Unearned income is “generally all income other than salaries, wages, and other amounts received as pay for work actually done.” Examples of unearned income include: dividends; interest; capital gains; gambling winnings; alimony; social security benefits; pensions; and annuities.
- Variable income is “income that may fall into either the earned income category, the unearned income category, or partly into both.” Examples of variable income include: business profits; royalties; rents; and scholarships and fellowships.
So, there you have it – expressed in the IRS’s own vague simplicity! These are the definitions of income that count when dealing with income taxes.
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Q. I’m an ex-pat. While talking with other ex-pats the other day, one of them told us that, in addition to federal income tax, we had to pay state income taxes, too. He also said that the only way out of it was to become a resident of one of the states that do not have an individual income tax. Does this mean I have to move to South Dakota or something?
A. No, you won’t have to move to South Dakota or any other state. Currently, all but seven states have an individual income tax (two of those seven only tax dividend and interest income). Generally, filing state individual income tax returns and paying any associated taxes is based on the taxpayer’s residency. Most states hold that you are either 1) a resident; 2) a part-year resident; or 3) a nonresident. Again, with the definitions. This time, we’re talking about definitions that vary from state to state. For simplicity, we’ll use the definitions provided by the State of California:
Resident: “Everyone who is in this state for other than a temporary or transitory purpose; and every individual who is domiciled in this state who is outside of the state for a temporary or transitory purpose.”- Part-year resident: “A taxpayer who meets both of the following conditions during the same taxable year: 1) is a resident of California during a portion of the taxable year; and 2) is a nonresident of California during a portion of the taxable year.”
- Nonresident: “Every individual other than a resident.”
Of course, these definitions spur on the need for a few more, like “temporary or transitory purpose” and “domicile.”
- Temporary or transitory purpose: “Whether or not an individual is in this state for temporary or transitory purposes depends to a large extent upon the facts and circumstances of each particular case.” Examples include: simply passing through the state; being in the state for a brief rest; being in the state for a vacation; and being in the state for a short period to complete a particular transaction, perform a particular contract, or perform a particular engagement.
- Domicile: “The place where an individual has his or her true, fixed, permanent home and principal establishment. It is the one location with which, for legal purposes, a person is considered to have the most settled and permanent connection.”
Now, hidden among those definitions is a simple fact of life: state residency does not depend on simply owning property in that state, or simply living there, alone. It’s your connection with the state that counts. If you leave the state, never to return again except as a tourist, and cut off all professional, social and government ties to persons, businesses and agencies in the state, you would be deemed to be a nonresident. Have the intent of someday “returning home” to that state and you are a resident. Spend more than a specified amount of time in that state during a taxable year (for California, it’s an aggregate of more than nine months) and you are presumed a resident.
As to being required to file and pay state income tax, it again depends on your residency status. Always remember, different states = different requirements. For the most part, however, it’s pretty much broken down like this:
- Residents: Taxed on all income, as adjusted.
- Part-year residents: Taxed on all income, as adjusted, during the period of residency, and taxed on specific items of income that are sourced to the state (i.e., coming from sources within the state) during the period of being a nonresident.
- Nonresident: Only taxed on specific items of income that are sourced to the state.
Did I say simple? Nothing is simple when it comes to income taxes.
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THIS WEEK’S SUMMARY
Here’s your take-away for this week:
- Know the deadlines for filing and paying your individual income tax – both federal and, if required, state.
- Know whether or not you are required to file an individual income tax return and pay the associated taxes to a state or several states.
In future articles, I’ll try to explain methods of making sure that you are not presumed to be a resident of a particular state, and answer more questions.
Yes, I know that this tax stuff can get boring and confusing – not necessarily in that order – but you really should stick it out and keep up with it; at least at this time of year.
Hi Paul – According to your explanation, VA compensation for service-connected disability falls under “unearned income”, just like OPM annuity and Social Security benefits. I receive all three. While I receive from OPM and Social Security the year-end statements, I have never received one from the VA. Is the VA compensation taxable?
Hi John – By definition, VA compensation for service-connected disability is “tax-exempt” income. As such, it is never included in “gross income” and thus not categorized as either “earned” or “unearned” income. Only income that is includible in “gross income” receives the categorization treatment.
(If VA compensation for service-connected disability was includible in “gross income,” then it would be categorized as “unearned” income.)
There is no requirement for issuing a tax reporting document, such as a Form 1099-R or a Form W-2, for “tax-exempt” income. As a result, you do not receive an annual, year-end statement for that income.
Of course, when it comes to tax rules and regulations, there are exceptions. One exception concerns Social Security benefits. 15% of your SS benefits are considered “tax-exempt” income; that is to say, it will never be subject to income tax. The remaining 85% of your SS benefits may be “non-taxable” or “partially taxable,” depending on how much additional income you receive during the tax year The more additional income you receive, the larger the percentage of your SS benefits become “taxable” income.
Since “taxable” SS benefits are includible in “gross income,” and the Social Security Administration does not know whether you have enough additional income to cause some of the benefits to be “taxable,” the SSA sends you a Form SSA-1099, reporting all of your benefits, adjustments to those benefits (such as a deduction for Medicare Part B), and any voluntary income tax withholding.
“The remaining 85% of your SS benefits may be “non-taxable” or “partially taxable,” depending on how much additional income you receive during the tax year The more additional income you receive, the larger the percentage of your SS benefits become “taxable” income.”
OK, here’s the thing, Paul. my Social Security benefits are already reduced because of the Windfall Elimination Provision (WEP) as a consequence of my receiving a full OPM annuity at the same time. I know it’s the law until such time as the WEP is repealed (a bill to abolish it has been languishing in Congress for quite some time). I’m just thinking out loud, going after the remaining 85 percent of the SS benefit sounds to me like double jeopardy, doesn’t it? LOL
Hi John – No, not really. Most other pensions are fully-taxed. I have a sizeable chunk of my SS benefits subjected to taxes because of my military retirement pay and pensions from other companies where I worked. At least that last 15% cannot be touched.
WEP is for “double-dippers” ( 😆 ) and serves to equalize their pensions with the “single-dippers”!
I have another question, Paul. Every year for the past couple of years, I’ve had to pay additional federal income tax because there is not enough money in my withholding to cover the year’s projected taxes. For 2013, on top of federal taxes owed, I was assessed a penalty of $11 for insufficient withholding. In a previous post about taxes, I can’t remember who it was that said set aside tax payments in your bank until the taxes are due, instead of letting the government hold it for you where it does NOT earn interest? As noted above, I had to pay an additional $11 for insufficient withholding, what more if there was zero withholding?
Hi John – In order to play the game of paying minimum estimated tax throughout the year, you have to decide on which method of paying estimated taxes you want to employ and follow through on that method.
There are two methods of tax planning for paying estimated tax: 1) pay in 100% of you previous year’s tax liability (110% if you’re a big-time earner) via four quarterly payments; or 2) pay in 90% of your current year tax liability via four quarterly payments.
Method 1) is pretty straight forward. E.g., your 2012 tax liability was $4,000. Your quarterly estimated tax payments would have to equal $1,000 each (4 x $1,000 = $4,000). If you have taxes withheld by any who pay you, then you would subtract the withholdings from that calculated estimate. I.e., three months worth of your withholding taxes plus an additional estimated tax payment should equal $1,000.
Method 2) requires quarterly calculations and projection of your current year tax liability. E.g., for the first payment, you add up your first three months’ worth of income; multiply it by 4 in order to annualize it (project what 12 months of income would be); subtract your projected deductions and exemptions; arrive at a projected, annualized taxable income; compute the tax liability; divide the tax liability by 4; subtract the three months’ worth of withholdings, if any; and pay the balance as estimated tax. For follow-on quarters, you perform the same steps. NOTE: there are modifications to this method that may be employed to obtain a little better accuracy.
That’s one of the reasons that I have good clients who pay me to figure their estimates each year.
A strategy for someone who looks at the IRS as a bank and makes huge estimated payments/withholdings in order to have a large refund is simply giving Uncle Sam an interest-free loan on that refund. There are strategies that include investing in order to pay the bare minimum, legal estimated taxes over the course of a year, then at tax time, pay any residual tax liability with money from the investment, and enjoy the rest of the investment as your personal refund.
Hey Paul,
I may or may not file my 2015 taxes. 2014 will be the last year my wife works. From 2015 on, we’ll both be living on my pension. From what I understand, I’ll have to make more than $20,000 (2013 stats) in gross income to be required to file taxes. Is there any reason why I should?
Hi RT – Hold on to your hat, this is going to be quite a ride! 😀
To start with, you will have to make sure that you are indeed not required to file. You are correct in citing the $20,000 “gross income” threshold for a married couple, both of whom are under the age of 65, who are filing their income taxes jointly (2013 figures).
A problem might appear when you calculate your combined “gross income.” Gross income is not a figure that appears on the tax return – it has to be calculated on the side. Gross income includes all income you receive in the form of money, goods, property, and services that is not exempt from tax. It also includes income from sources outside the United States or from the sale of your main home (even if you can exclude all or part of it). You may also have to Include part of your social security benefits, depending on whether or not certain tests are met.
Second, of course, you would want to file a tax return to retrieve any overpayment of taxes you may have – in the form of a refund or as a credit to carry forward to apply against the next year’s tax liability.
Third, with all of that mumbo-jumbo being said, there are other situations when you must file a tax return. You must file a tax return if any of these four conditions exist during the tax year:
1. You owe any special taxes, including any of the following.
a. Alternative minimum tax.
b. Additional tax on a qualified plan, including an individual retirement arrangement (IRA), or other tax-
favored account. But if you are filing a return only because you owe this tax, you can file Form 5329 by itself.
c. Household employment taxes. But if you are filing a return only because you owe this tax, you can file Schedule H by itself.
d. Social security and Medicare tax on tips you did not report to your employer or on wages you received from an employer who did not withhold these taxes.
e. Recapture of first-time homebuyer credit.
f. Write-in taxes, including uncollected social security and Medicare or RRTA tax on tips you reported to your employer or on group-term life insurance and additional taxes on health savings accounts.
g. Recapture taxes.
2. You (or your spouse, if filing jointly) received HSA, Archer MSA, or Medicare Advantage MSA distributions.
3. You had net earnings from self-employment of at least $400.
4. You had wages of $108.28 or more from a church or qualified church-controlled organization that is exempt from employer social security and Medicare taxes.
So there you have it, RT. Not as simple as it first seems, but easily accomplished if one takes the time to dig in and do it!
I forgot to mention a few non-tax-related reasons for filing annual income tax returns.
When engaging in many financial transactions, such as applying for large loans, submitting an affidavit of support for a visa applicant, &c., the institution or agency you are dealing with may ask to see (or be given) copies of your income tax returns for the past, say, five years as documentation of your cash flow and probable ability to meet the requirements of repayment, support, or whatever.
Too, mistakes happen in this world. This is most certainly true when it comes to tax agencies. A tax agency may inform you that their records indicate that you are delinquent in paying taxes they believe you owe. Tax returns can serve as record documents that have recorded your income and deductions for a specific tax year. Additionally, the tax return in question will be the first piece of information requested by the tax agency in attempting to resolve the issue.
Say what you will, filing income tax returns annually has some definite advantages over not filing them because there isn’t any requirement to do so.
Great article. Thanks for the info, this is really a helpful post. I want to share this site PDFfiller that I mostly use to fill out my tax form. This site also has tons of fillable tax forms that you might find useful. Here is a link to the blank form 5329 that I was able to fill out.
Thanks, Paul – I already have that covered. The only “whine” I have about PDFfiller is that they charge you for their services. The IRS has been steadfastly working to provide all of their tax forms in the “User-fillable” PDF format. Their 2014 library is almost 100% in this regard and, until they started “whining” about their budget being cut (political jargon for not receiving 100% of the increased budgeted funds they requested), they were making good progress with tax forms for prior tax years.
When, on the extremely rare occasion that I obtain a little-known tax form that isn’t in the fillable format, I use Adobe Acrobat to solve the problem.