Hard times bring new twists for tax filing.
By PAMELA YIP and BILL DEENER
KNIGHT RIDDER NEWSPAPERS
IN FINANCIAL TERMS, 2002 WAS NOT the kind of year most people will want to look back on. But it's tax time, so look back we must. The stock market sank for the third straight year, the economy continued to struggle, and the ranks of the unemployed swelled. These situations touch consumers' pocketbooks immediately but can also have far-reaching tax implications.
In many cases, these losses can be turned into tax benefits on your 2002 return. But there are also pitfalls.
Either way, you have to get a handle on your tax situation now. If your financial life has been turned upside down, you may face a big surprise if you wait until April 15 to do your taxes.
We've examined the tax implications of four events that hit many taxpayers in 2002:
UInvestors who bailed out of stocks need to tally up their investment losses.
UThose who lost their jobs need to realize that Uncle Sam may still have his hand out because unemployment benefits are taxed.
UIf you had to take money out of a 401(k) or IRA to pay bills, watch out for that 10 percent penalty.
UIf you had to sell your home in 2002, or if your job situation changed and you worked from home, the Internal Revenue Service has provided some added sweeteners.
Millions of investors' holdings in stocks and mutual funds have declined over the last three years. To get some relief from the pain, many investors transformed those paper losses into realized losses in 2002.
"Capital losses will be a big thing this year," said J. Richard Joyner, a partner in personal financial counseling at Ernst & amp; Young in Dallas. "Many people have reacted to the natural fear of losing it all by selling most or all of the stocks they own."
But you must have actually sold your losing stock or mutual-fund shares to get the tax benefit. Gains and losses that exist only on paper don't count, said Mark Luscombe, a tax attorney and principal federal tax analyst for CCH Inc. in Riverwoods, Ill., a tax research firm.
"If your investments lose value, the tax laws won't restore your fortunes, but they can lessen the pain of your losses," Luscombe said.
Unfortunately, the calculations are complicated.
Taxpayers have to sort out which of their holdings qualify as long-term investments and which are short-term. Investments held for 12 months or less are short-term, and those owned longer are considered long-term.
How they count
Short-term gains are matched against short-term losses, and if there is a gain, it is taxed as ordinary income. Long-term gains are matched against long-term losses. Taxpayers in the 27 percent tax bracket and higher are generally taxed at a 20 percent rate on long-term gains.
Those in the 10 percent and 15 percent brackets are taxed at a 10 percent rate. If you owned these investments longer than five years, the rate drops to 8 percent.
Long-term losses amounting to $3,000 a year can be used to offset that much in ordinary income. If losses were greater than that, they may be carried over to the following year and again matched against ordinary income, up to $3,000. Losses may be carried over in $3,000 increments indefinitely until they're used up.
Of course, using long-term losses to lower ordinary income can be used only for investments held outside of tax-deferred 401(k) plans and regular Individual Retirement Accounts. (There are provisions to get some relief on losses in a Roth IRA if certain requirements are met, but they are difficult to meet.)
The calculations can be even more difficult for mutual fund shareholders.
"If you sold securities in mutual funds in 2002, it is important to get the correct cost basis, because it determines the amount of gain or loss, and it is always complicated for people to retrack the amount of reinvested dividends they have in a mutual fund," Joyner said.
The "cost basis" is generally the original price you paid for the shares.
The higher the basis, the smaller the gain and the less tax you'll owe. In the case of a loss, the higher the basis, the bigger the loss, and the bigger the reduction in taxable income.
Investors must remember to add reinvested dividends to the basis.
"Reinvested dividends raise the basis because you pay tax on them in the year you receive the distributions," Joyner said. "It's the equivalent of your turning around and using the distributions to reinvest and buy more shares in the fund, which raises your basis."
Fortunately, most mutual funds provide you with the average cost basis figure on your redemption statement, and the average cost basis will take into account reinvested dividends.
If you collected unemployment benefits in 2002, you may be surprised to learn that the benefits are taxable. And the taxes weren't necessarily withheld from your unemployment checks.
"That's sneaking up on a lot of people," said Frank Howard, a certified public accountant with Howard & amp; Waltrip PC in Addison, Texas. "They're coming to this time of year, and they're saying, 'Oh, no, I'm owing all this money.' You've got to plan for it ahead of time."
Taxes may bite the jobless in other ways. Just because you didn't collect a full year's salary doesn't mean you won't owe taxes.
"Although you're unemployed, you could still owe taxes on investment income and the wages you had when you were employed," said James A. Seidel, senior tax analyst at RIA in New York, which publishes information for tax professionals. "You may have received some kind of severance package, which is taxable."
Many jobless workers started their own businesses in 2002. But often they don't realize the taxes they must pay, said Barbara Moore, unemployment law analyst for CCH. Besides paying income taxes on their profits, they must pay into Social Security and Medicare.
If you're employed by someone else, your Social Security and Medicare tax was 7.65 percent of your income; the employer paid the other 7.65 percent. The self-employed must pay the entire 15.3 percent.
"The only break here is, the self-employed person gets to deduct one-half of the self-employment income tax paid," Seidel said. "That helps take a bit of the sting out of it."
If you pay premiums for individual health-insurance coverage, you may be able to deduct the cost.
But you must itemize deductions, and your insurance premiums and other medical expenses must exceed 7.5 percent of your adjusted gross income, which is a high threshold for most taxpayers.
The double whammy for those who were unemployed in 2002 is that many were forced to tap retirement accounts to pay expenses. The consequences are early withdrawal penalties in addition to the regular income taxes, Moore said.
Money withdrawn from a 401(k) plan before age 59 1/2 is generally subject to a 10 percent early withdrawal penalty. But under some circumstances, withdrawals can be taken earlier than 59 1/2.
Federal income taxes are usually withheld from such a disbursement. But the 10 percent penalty isn't.
Indeed, if you didn't have taxes withheld from your unemployment benefits and you took a disbursement from a 401(k) or IRA, you could be facing a hefty tax bill April 15.
To top it all off, you may just be coming to the realization of how much of a hit your retirement account has taken.
"After all the taxes and penalties are paid, someone tapping their 401(k) plan may be surprised at what's left," Moore said. "The government really discourages people from taking early distributions."
There are also long-term implications. Once you've withdrawn that money, you will never be able to regain the benefit of tax-free investment gains compounded over time.
"You've lost the tax deferral on that money forever," Joyner said.
A better option might have been to borrow money from the retirement plan, if your plan allows it. Money taken as a loan isn't taxed.
Taxpayers who have already withdrawn or borrowed money from their 401(k) plans should get an expert to help them determine the tax consequences, Moore said. Some plans allow "hardship" withdrawals, so the participant should check the terms of the plan.
The news isn't all bad. Although many investors lost money on their stock investments, they probably had one asset that gained in value -- their homes.
For those whose living situation was affected by a job change -- such as the sale of a home or the creation of a home office -- some recent tax changes will be beneficial.
Since 1997, a large amount of the gain from the sale of a personal residence has been excluded from taxation. For it to matter at tax time, however, you must have sold your home in 2002.
The basic rule allows for married homeowners to exclude $500,000 in gains on the sale of their home from income, or $250,000 for single taxpayers. To qualify for this exclusion, the taxpayer must have lived in the home at least two years out of the five years leading up to the sale, said John W. Roth, a tax analyst at CCH.
And the two-year period doesn't have to be continuous, he said. For example, the taxpayer could have lived in the home the first year and last year of the five-year period.
The exclusion can be used only every two years, and it applies only to a principal residence.
But, Roth said, a houseboat, mobile home or condominium can qualify as a principal residence.
Of course, those who have sold their homes and reduced or eliminated their mortgage payments lose some future tax benefits, because mortgage interest and property tax payments are tax-deductible.
Working at home
The new home-sale exclusion rules have a gold nugget for home-office users.
Homeowners have long been able to deduct expenses for a home office if the office is the "principal place of business."
The Internal Revenue Service means that literally. Your home office can't serve as a part-time sleepover site for your kids' pajama parties. "Any personal use of the space knocks out the deduction," Seidel said.
If you have taken a deduction for a home office and sold your home, you previously would have paid tax on the gain attributable to the office portion of the home.
But under a new rule this year, sellers don't have to allocate any part of the gain to the business portion of the home.
There are other caveats, but overall the rule change will encourage more people to take the home-office deduction, Joyner said.
"Having a simplified set of rules that gives you a predictable result will certainly make it easier for people to take the deduction," he said.
Even with the lousy economy, home prices have continued to rise. For many people, higher home equity was the only saving grace of 2002.
For those who had to sell their homes, the tax-free proceeds can help replace a depleted retirement account, Roth said.
"The family home is the largest asset owned by many families, and a profitable sale of a longtime family residence is often a key to financing retirement."