If you’re interested in investing in tax-free municipal bonds, you may wonder if they’re really free of taxes. While the investment generally provides tax-free interest on the federal (and possibly state) level, there may be tax consequences. Here’s how the rules work.

Purchasing a bond 

If you buy a tax-exempt bond for its face amount, either on the initial offering or in the market, there are no immediate tax consequences. If you buy such a bond between interest payment dates, you’ll have to pay the seller any interest accrued since the last interest payment date. This amount is treated as a capital investment and is deducted from the next interest payment as a return of capital.

Interest excluded from income 

In general, interest received on a tax-free municipal bond isn’t included in gross income although it may be includible for alternative minimum tax (AMT) purposes. While tax-free interest is attractive, keep in mind that a municipal bond may pay a lower interest rate than an otherwise equivalent taxable investment. The after-tax yield is what counts.

In the case of a tax-free bond, the after-tax yield is generally equal to the pre-tax yield. With a taxable bond, the after-tax yield is based on the amount of interest you have after taking into account the increase in your tax liability on account of annual interest payments. This depends on your effective tax bracket. In general, tax-free bonds are likely to be appealing to taxpayers in higher brackets since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, the tax benefit from excluding interest from income may not be enough to make up for a lower interest rate.

Even though municipal bond interest isn’t taxable, it’s shown on a tax return. This is because tax-exempt interest is taken into account when determining the amount of Social Security benefits that are taxable as well as other tax breaks.

Another tax advantage

Tax-exempt bond interest is also exempt from the 3.8% net investment income tax (NIIT). The NIIT is imposed on the investment income of individuals whose adjusted gross income exceeds $250,000 for joint filers, $125,000 for married filing separate filers, and $200,000 for other taxpayers.

Tax-deferred retirement accounts 

It generally doesn’t make sense to hold municipal bonds in your traditional IRA or 401(k) account. The income in these accounts isn’t taxed currently. But once you start taking distributions, the entire amount withdrawn is likely to be taxed. Thus, if you want to invest retirement funds in fixed income obligations, it’s generally advisable to invest in higher-yielding taxable securities.

We can help

These are only some of the tax consequences of investing in municipal bonds. As mentioned, there may be AMT implications. And if you receive Social Security benefits, investing in municipal bonds could increase the amount of tax you must pay with respect to the benefits. Contact us if you need assistance applying the tax rules to your situation or if you have any questions.

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If you have a child or grandchild who’s going to attend college in the future, you’ve probably heard about qualified tuition programs, also known as 529 plans. These plans, named for the Internal Revenue Code section that provides for them, allow prepayment of higher education costs on a tax-favored basis.

There are two types of programs:

1. Prepaid plans, which allow you to buy tuition credits or certificates at present tuition rates, even though the beneficiary (child) won’t be starting college for some time; and
2. Savings plans, which depend on the investment performance of the fund(s) you place your contributions in.

You don’t get a federal income tax deduction for a contribution, but the earnings on the account aren’t taxed while the funds are in the program. (Contributors are eligible for state tax deductions in some states.) You can change the beneficiary or roll over the funds in the program to another plan for the same or a different beneficiary without income tax consequences.

Distributions from the program are tax-free up to the amount of the student’s “qualified higher education expenses.” These include tuition (including up to $10,000 in tuition for an elementary or secondary public, private or religious school), fees, books, supplies and required equipment. Reasonable room and board is also a qualified expense if the student is enrolled at least half time.

Distributions from a 529 plan can also be used to make tax-free payments of principal or interest on a loan to pay qualified higher education expenses of the beneficiary or a sibling of the beneficiary.

What about distributions in excess of qualified expenses? They’re taxed to the beneficiary to the extent that they represent earnings on the account. A 10% penalty tax is also imposed.

Eligible schools include colleges, universities, vocational schools or other postsecondary schools eligible to participate in a student aid program of the U.S. Department of Education. This includes nearly all accredited public, nonprofit and for-profit postsecondary institutions.

However, “qualified higher education expenses” also include expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private or religious school.

A school should be able to tell you whether it qualifies.

The contributions you make to the qualified tuition program are treated as gifts to the student, but the contributions qualify for the gift tax exclusion amount ($16,000 for 2022, adjusted for inflation). If your contributions in a year exceed the exclusion amount, you can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions. Thus, assuming you make no other gifts to that beneficiary, you could contribute up to $80,000 per beneficiary in 2022 without gift tax. (In that case, any additional contributions during the next four years would be subject to gift tax, except to the extent that the exclusion amount increases.) You and your spouse together could contribute $160,000 for 2022 per beneficiary, subject to any contribution limits imposed by the plan.

A distribution from a qualified tuition program isn’t subject to gift tax, but a change in beneficiary or rollover to the account of a new beneficiary may be. Contact us with questions about tax-saving ways to save and pay for college.

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Now that fall is officially here, it’s a good time to start taking steps that may lower your tax bill for this year and next.

One of the first planning steps is to ascertain whether you’ll take the standard deduction or itemize deductions for 2022. Many taxpayers won’t itemize because of the high 2022 standard deduction amounts ($25,900 for joint filers, $12,950 for singles and married couples filing separately and $19,400 for heads of household). Also, many itemized deductions have been reduced or abolished under current law.

If you do itemize, you can deduct medical expenses that exceed 7.5% of adjusted gross income (AGI), state and local taxes up to $10,000, charitable contributions, and mortgage interest on a restricted amount of debt, but these deductions won’t save taxes unless they’re more than your standard deduction.

Bunching, pushing, pulling

Some taxpayers may be able to work around these deduction restrictions by applying a “bunching” strategy to pull or push discretionary medical expenses and charitable contributions into the year where they’ll do some tax good. For example, if you’ll be able to itemize deductions this year but not next, you may want to make two years’ worth of charitable contributions this year.

Here are some other ideas to consider:

• Postpone income until 2023 and accelerate deductions into 2022 if doing so enables you to claim larger tax breaks for 2022 that are phased out over various levels of AGI. These include deductible IRA contributions, child tax credits, education tax credits and student loan interest deductions. Postponing income also is desirable for taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. However, in some cases, it may pay to accelerate income into 2022. For example, that may be the case if you expect to be in a higher tax bracket next year.
• If you’re eligible, consider converting a traditional IRA into a Roth IRA by year end. This is beneficial if your IRA invested in stocks (or mutual funds) that have lost value. Keep in mind that the conversion will increase your income for 2022, possibly reducing tax breaks subject to phaseout at higher AGI levels.
• High-income individuals must be careful of the 3.8% net investment income tax (NIIT) on certain unearned income. The surtax is 3.8% of the lesser of: 1) net investment income (NII), or 2) the excess of modified AGI (MAGI) over a threshold amount. That amount is $250,000 for joint filers or surviving spouses, $125,000 for married individuals filing separately and $200,000 for others. As year-end nears, the approach taken to minimize or eliminate the 3.8% surtax depends on your estimated MAGI and NII for the year. Keep in mind that NII doesn’t include distributions from IRAs or most retirement plans.
• It may be advantageous to arrange with your employer to defer, until early 2023, a bonus that may be coming your way.
• If you’re age 70½ or older by the end of 2022, consider making 2022 charitable donations via qualified charitable distributions from a traditional IRA — especially if you don’t itemize deductions. These distributions are made directly to charities from your IRA and the contribution amount isn’t included in your gross income or deductible on your return.
• Make gifts sheltered by the annual gift tax exclusion before year end. In 2022, the exclusion applies to gifts of up to $16,000 made to each recipient. These transfers may save your family taxes if income-earning property is given to relatives in lower income tax brackets who aren’t subject to the kiddie tax.

These are just some of the year-end steps that may save taxes. Contact us to tailor a plan that will work best for you.

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As a result of the current estate tax exemption amount ($12.06 million in 2022), many estates no longer need to be concerned with federal estate tax. Before 2011, a much smaller amount resulted in estate plans attempting to avoid it. But now, because many estates won’t be subject to estate tax, more planning can be devoted to saving income taxes for your heirs.

While saving both income and transfer taxes has always been a goal of estate planning, it was more difficult to succeed at both when the estate and gift tax exemption level was much lower. Here are three considerations.

Plan gifts that use the annual gift tax exclusion. One of the benefits of using the gift tax annual exclusion to make transfers during life is to save estate tax. This is because both the transferred assets and any post-transfer appreciation generated by those assets are removed from the donor’s estate.

As mentioned, estate tax savings may not be an issue because of the large estate exemption amount. Further, making an annual exclusion transfer of appreciated property carries a potential income tax cost because the recipient receives the donor’s basis upon transfer. Thus, the recipient could face income tax, in the form of capital gains tax, on the sale of the gifted property in the future. If there’s no concern that an estate will be subject to estate tax, even if the gifted property grows in value, then the decision to make a gift should be based on other factors.

For example, gifts may be made to help a relative buy a home or start a business. But a donor shouldn’t gift appreciated property because of the capital gain that could be realized on a future sale by the recipient. If the appreciated property is held until the donor’s death, under current law, the heir will get a step-up in basis that will wipe out the capital gain tax on any pre-death appreciation in the property’s value.

Take spouses’ estates into account. In the past, spouses often undertook complicated strategies to equalize their estates so that each could take advantage of the estate tax exemption amount. Generally, a two-trust plan was established to minimize estate tax. “Portability,” or the ability to apply the decedent’s unused exclusion amount to the surviving spouse’s transfers during life and at death, became effective for estates of decedents dying after 2010. As long as the election is made, portability allows the surviving spouse to apply the unused portion of a decedent’s applicable exclusion amount (the deceased spousal unused exclusion amount) as calculated in the year of the decedent’s death. The portability election gives married couples more flexibility in deciding how to use their exclusion amounts.

Be aware that some estate exclusion or valuation discount strategies to avoid inclusion of property in an estate may no longer be worth pursuing. It may be better to have the property included in the estate or not qualify for valuation discounts so that the property receives a step-up in basis. For example, the special use valuation — the valuation of qualified real property used for farming or in a business on the basis of the property’s actual use, rather than on its highest and best use — may not save enough, or any, estate tax to justify giving up the step-up in basis that would otherwise occur for the property.

If you’d like to discuss these strategies and how they relate to your estate plan, contact us.

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In its latest report, the National Association of Realtors (NAR) announced that July 2022 existing home sales were down but prices were up nationwide, compared with last year. “The ongoing sales decline reflects the impact of the mortgage rate peak of 6% in early June,” said NAR Chief Economist Lawrence Yun. However, he added that “home sales may soon stabilize since mortgage rates have fallen to near 5%, thereby giving an additional boost of purchasing power to home buyers.”

If you’re buying a home, or you just bought one, you may wonder if you can deduct mortgage points paid on your behalf by the seller. The answer is “yes,” subject to some important limitations described below.

Basics of points

Points are upfront fees charged by a mortgage lender, expressed as a percentage of the loan principal. Points, which may be deductible if you itemize deductions, are normally the buyer’s obligation. But a seller will sometimes sweeten a deal by agreeing to pay the points on the buyer’s mortgage loan.

In most cases, points that a buyer pays are a deductible interest expense. And seller-paid points may also be deductible.

Suppose, for example, that you bought a home for $600,000. In connection with a $500,000 mortgage loan, your bank charged two points, or $10,000. The seller agreed to pay the points in order to close the sale.

You can deduct the $10,000 in the year of sale. The only disadvantage is that your tax basis is reduced to $590,000, which will mean more gain if — and when — you sell the home for more than that amount. But that may not happen until many years later, and the gain may not be taxable anyway. You may qualify for an exclusion for up to $250,000 ($500,000 for a married couple filing jointly) of gain on the sale of a principal residence.

Important limits

There are some important limitations on the rule allowing a deduction for seller-paid points. The rule doesn’t apply:

• To points that are allocated to the part of a mortgage above $750,000 ($375,000 for married filing separately) for tax years 2018 through 2025 (above $1 million for tax years before 2018 and after 2025);
• To points on a loan used to improve (rather than buy) a home;
• To points on a loan used to buy a vacation or second home, investment property or business property; and
• To points paid on a refinancing, home equity loan or line of credit.

Tax aspects of the transaction

We can review with you in more detail whether the points in your home purchase are deductible, as well as discuss other tax aspects of your transaction.

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High-income taxpayers face two special taxes — a 3.8% net investment income tax (NIIT) and a 0.9% additional Medicare tax on wage and self-employment income. Here’s an overview of the taxes and what they may mean for you.

3.8% NIIT

This tax applies, in addition to income tax, on your net investment income. The NIIT only affects taxpayers with adjusted gross income (AGI) exceeding $250,000 for joint filers, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately.

If your AGI is above the threshold that applies ($250,000, $200,000 or $125,000), the NIIT applies to the lesser of 1) your net investment income for the tax year or 2) the excess of your AGI for the tax year over your threshold amount.

The “net investment income” that’s subject to the NIIT consists of interest, dividends, annuities, royalties, rents and net gains from property sales. Wage income and income from an active trade or business isn’t included. However, passive business income is subject to the NIIT.

Income that’s exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the NIIT. Thus, switching some taxable investments to tax-exempt bonds can reduce your exposure. Of course, this should be done after taking your income needs and investment considerations into account.

How does the NIIT apply to home sales? If you sell your principal residence, you may be able to exclude up to $250,000 of gain ($500,000 for joint filers) when figuring your income tax. This excluded gain isn’t subject to the NIIT.

However, gain that exceeds the exclusion limit is subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn’t qualify for the exclusion, is also subject to the NIIT.

Distributions from qualified retirement plans, such as pension plans and IRAs, aren’t subject to the NIIT. However, those distributions may push your AGI over the threshold that would cause other types of income to be subject to the tax.

Additional 0.9% Medicare tax

Some high-wage earners pay an extra 0.9% Medicare tax on part of their wage income, in addition to the 1.45% Medicare tax that all wage earners pay. The 0.9% tax applies to wages in excess of $250,000 for joint filers, $125,000 for a married individuals filing separately and $200,000 for all others. It applies only to employees, not to employers.

Once an employee’s wages reach $200,000 for the year, the employer must begin withholding the additional 0.9% tax. However, this withholding may prove insufficient if the employee has additional wage income from another job or if the employee’s spouse also has wage income. To avoid that result, an employee may request extra income tax withholding by filing a new Form W-4 with the employer.

An extra 0.9% Medicare tax also applies to self-employment income for the tax year in excess of the same amounts for wage earners. This is in addition to the regular 2.9% Medicare tax on all self-employment income. The $250,000, $125,000, and $200,000 thresholds are reduced by the taxpayer’s wage income.

Reduce the impact

As you can see, these two taxes may have a significant effect on your tax bill. Contact us to discuss these taxes and how their impact could be reduced.

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