Taxation of Older Adults

Author:
Michael David Schulman, CPA/PFS
Schulman Co., CPA P.C.
New York, NY

Editor's note: If you would like additional information about this column, please contact Mr. Schulman at (212) 736-9353 or michael@schulmancpa.com.

I am 80 years old, the client said, and my friends told me that I do not have to file my taxes any more. Even though older taxpayers are not uniformly exempt from filing, they should plan wisely, giving special attention to how their decisions affect their taxation in areas such as Social Security benefits, marriage, medical care, home improvements, long-term care (LTC) insurance and IRAs. Frequently, these taxpayers do not comprehend how their actions can lead to taxation of otherwise tax-exempt income and excess taxation of taxable income.

Note: The following discussion ignores the effects of the Jobs and Growth Tax Relief Reconciliation Act of 2003.

Taxation of Social Security Benefits

Few clients understand the tax rules for Social Security benefits.

Example 1: In 2003, D and R are married; each is 65 years old. They have $25,000 of Social Security benefits each and take the standard deduction. They can earn interest, dividends, etc., of $12,969 without incurring a tax liability. D and R increase their income by $10,000 to $22,969. As a result, they pay $1,846 in taxesa marginal tax rate of 18.46%. Although D and R are in the 15% tax bracket, the Social Security income imposed a 3.46% additional income tax on the $10,000 increase beyond the bracket.

If D and R instead had an additional $10,000 of tax-exempt income (e.g., municipal bond interest), they would pay only $638 in taxesa 6.38% tax rate on their tax-exempt income. If the couple earns $30,711 of tax-exempt income instead of $12,969, they would have no tax liability. However, if they were then to earn an additional $10,000 of (taxable) income, their tax bill would be $2,179, or 21.79% (6.79% above the 15% bracket).

Wedding Bell Blues

As is the case with their younger counterparts, older adults face a marriage penalty when switching from two single returns to a joint return. The penalty stems from a difference in standard deductions and an increase in the taxability of Social Security benefits.

Example 2: F and E are single, over age 70 and, in 2003, are contemplating marriage. Each collects $12,000 in Social Security benefits. F collects a $35,000 annual pension and E has $30,000 of taxable interest income. They decide not to marry. Thus, their combined tax liability as two singles is $9,395.

If F and E had married in 2003, their tax liability would have jumped to $12,464, a 32.7% increase. Exhibit 1 below presents a summary. The marginal $8,250 of taxable income is taxed at a 37.2% tax rate.

In many cases, couples find it advantageous to marry for other reasons (e.g., to obtain the couples estate tax exemption or favorable treatment on an inherited IRA). Nevertheless, they should consider the effects of the marriage penalty.

Medical Costs

As medical care costs skyrocket, deductibility is an important issue for many older taxpayers. The general rule is that medical expenses are deductible as itemized deductions if they exceed 7.5% of the taxpayers adjusted gross income.

Deductibility of Home Improvements

The elderly often have to renovate their homes to accommodate a medical condition. Home improvement costs are fully deductible under Sec. 213 to the extent that the costs do not increase the homes value; see Rev. Rul. 87-106. Deductible improvements under IRS Pub. 502, Medical and Dental Expenses, include:

• Widening doorways, and widening or modifying hallways.

• Installing entrance ramps; lifts (excluding elevators); and grab bars, bathroom railings and other forms of support.

• Relocating kitchen cabinets.

• Replacing fixtures such as tubs and toilets.

Similarly, costs to make a car usable by a disabled person are deductible (but not the costs of operating the car, unless transportation is primarily for medical care.)

LTC Insurance Premiums

Premiums paid for qualified LTC insurance contracts are deductible under Sec. 213(d)(1)(C) and (d)(10). Exhibit 2 below presents the limits on such deductions.

According to Sec. 7702B(b)(1), a qualified LTC contract is a contract providing exclusively for coverage of LTC services, and which:

• Is guaranteed renewable;

• Has no cash surrender value;

• Has no value that can be pledged, borrowed or assigned;

• Provides that refunds and contract dividends may be used only to reduce future premiums or increase future benefits (except for policy refunds resulting from death, policy cancellation or policy surrender).

• Does not pay for costs reimbursable under Medicare, unless Medicare is secondary coverage.

Qualified LTC services are defined by Sec. 7702B(c) as:

1. Necessary diagnostic, preventative, therapeutic, curing, treating, mitigating and rehabilitative services, and maintenance and personal-care services;

2. Required by a chronically ill individual; and

3. Prescribed by a licensed healthcare practitioner.

Nursing Homes and Other LTC Costs

Although not necessarily fully deductible, amounts paid to nursing homes and other similar facilities may be deductible as medical expenses. If an adults stay in a nursing home is primarily for medical care, the entire cost (including meals and lodging) is deductible. In contrast, if the primary purpose is personal, only specific medical costs would be deductible.

The cost of nursing services is deductible whether services are performed in a specific medical facility or at home. The provider need not be a licensed nurse, but must perform duties generally performed by nurses (e.g., changing dressings and bandages, bathing the patient and administering medication). If the provider is paid wages, associated payroll taxes would also be deductible, as are meals.

If the attendant also provides non-nursing services (e.g., household cleaning), the deduction would be limited to only the amounts paid for nursing services.

IRA Distributions

The basic rule governing required minimum distributions (RMDs) from IRAs is well known: distributions must commence by April 1 of the year following the year in which a person reaches age 70. In certain situations, two distributions have to be taken in the initial year. The distribution amount is the account balance as of the preceding December 31, divided by the appropriate life expectancy; see Exhibit 3 below.

Inherited IRAs

An inherited IRA is often the largest asset in a persons estate. Because it is a taxable asset, careful planning is necessary to preserve as much of it as possible for as long as possible.

Inherited by a spouse: An IRA inherited from a spouse can be converted into an IRA of the surviving spouse. The surviving spouse should change the name of the IRA and establish his or her own beneficiaries. A major advantage is that RMDs can be deferred until the surviving spouse reaches age 70. If he or she is young, this option provides a major opportunity to defer substantial income taxes on an IRA with a large balance.

Alternatively, the surviving spouse can roll over the IRA into his or her own existing IRA. However, if he or she is under age 59 and needs annual income, the above-noted strategy will not only generate ordinary income on the distribution, but a 10% penalty as well. (In each of the above scenarios, the RMD to the deceased spouse in the year of death cannot be rolled over.)

A third alternative is for the surviving spouse to remain a beneficiary of the original IRA. In doing so, he or she has to begin taking distributions by the later of (1) December 31 of the year that follows the year the spouse died or (2) the year that the surviving spouse attains age 70. For this option, the surviving spouse has to be the sole beneficiary. If the surviving spouse is under 59 years old and needs annual income, this option will enable him or her to avoid the 10% penalty. If the deceased spouse was much younger than the surviving spouse, this method will allow the surviving spouse to defer mandatory distributions until the year the deceased spouse would have been 70, regardless of the surviving spouses age.

Not inherited by a spouse: For nonspouse beneficiaries (such as children), Exhibit 4 below presents a single-life table to determine the amount of their distributions, which would begin in the year following the year of the IRA holders death.

Caution: Some IRA documents have mandatory payout options, eliminating a beneficiarys choices. For example, on the IRA owners death, the proceeds might have to be paid in full to the beneficiaries. The IRA provisions should be reviewed to ensure that the designated beneficiary has appropriate distribution and withdrawal options. If not, the IRA should be transferred to a new custodian.