Q: My husband is taking early retirement from his job and will be getting $30,000 from his pension and about $20,000 in severance pay. Right now, our combined annual income is $48,000, and we are in the 28% tax bracket. However, if we get all this money in a lump sum at the end of the year, our bracket could jump. Is there a way to defer any or all of this income until 1991, or even 1992, when our income will be just my $20,000-a-year salary? -- D. T .
A: First, we'll assume that your husband's pension is what's known as a "qualified (pension) plan." If so--and most pensions are--then you can automatically roll the $30,000 distribution into a tax-deferred individual retirement account. The money will earn tax-deferred interest, and you will be taxed only when you make withdrawals from the account.
What can you do about the severance payment of $20,000? Our advisers suggest that you talk to your husband's employer about spreading the payments out over several years. However, even if the employer agrees to your suggestion, you could run into problems with the Internal Revenue Service. Our advisers say the IRS might argue that since you could have taken the full $20,000 this year, you had "constructive receipt" of it, and still should be taxed on the full $20,000 in 1990, regardless of when you actually receive it.
Our advisers nevertheless note that, practically speaking, the IRS knows only what is reported on your W-2 statement of earnings. So if your statements show a series of smaller payments spread out over a few years, rather than a single lump sum severance payment, the chances of the IRS checking further are not great. Talk to your husband's employer about your choices, and before making a final decision, consult a trusted attorney or accountant.
One other caveat: Pay attention to the new tax laws. Tax brackets and income limits of those brackets have changed, and you could be the worse for it. Before going to great lengths to avoid receipt of the severance pay this year, you should determine your likely 1991 tax bracket. Preliminary estimates from tax experts peg the 28% tax bracket for couples filing a joint return at $34,000 to $82,100 adjusted gross income. Taxpayers with incomes below $34,000 fall into the 15% bracket, while those with adjusted gross incomes above $82,100 will be in the 31% bracket.
With just your $20,000 annual salary in 1991, you should be safely in the 15% bracket, with enough room to spare in the event you are able to defer a portion of your husband's severance pay.
Heirs Can't Assume Home-Sale Tax Break
Q: I have a question about the $125,000 tax exemption on home-sale profits given to sellers over 55. In the event of a simultaneous death of a married couple, what happens to the exemption? Is it transferred to the estate for the benefit of the heirs when they sell the house? --F. R. H.
A: No, the exemption is forever lost.
Remember, the IRS allows the exemption to homeowners over 55 who sell the principal residence in which they have lived at least three of the last five years. A single $125,000 exemption is available to unmarried homeowners, as well as married couples. The exemption is not attached to the property, but rather is granted to taxpayers who fit the criteria. It is not transferable.
However, perhaps your fears may be eased by the knowledge that your heirs may not need the $125,000 exemption when it comes time to dispose of your home. Why? The tax basis of bequeathed property is its value on the date of death of its donors--not the original tax basis of its donors. So, if your house is worth $300,000 at your death--regardless of what your tax basis was--its tax basis to your heirs is $300,000. And if your heirs sell it for $300,000, they do not have a taxable gain.
Key to Withholding Is Avoiding a Tax Penalty
Q: I receive a cost of living adjustment to my salary two or three times a year. Should I fill out a revised W-4 tax withholding form every time I receive one of these increases? -- E. J. D .
A: You probably don't have to file a new W-4 form every time you get a cost of living increase. But this doesn't mean you shouldn't pay attention to the underlying tax obligation problems.
Basically you want to "penalty-proof" yourself by making sure that you have prepaid--or told your employer to withhold--sufficient income taxes for both the state and federal governments. You can avoid a penalty in one of two ways: Prepay 90% of your total tax obligation for the tax year, either through withholding or estimated quarterly payments, or prepay an amount equal to your previous year's tax obligation.
Generally speaking, most taxpayers do not have to worry about insufficient withholding if their income gradually increases because the tax bite gradually increases as well.