As with many areas of financial planning, there is not a blanket statement I can…
Filing a tax return is like skydiving for the first time; it’s nerve-wracking, exhilarating and dangerous. After the parachute deploys—Whew, the ripcord worked— you’re free to enjoy the view. Similarly, after filing taxes some may lose sight of what’s to come—Hello, landing! They don’t think about the contributions they’re making throughout the year or how that new computer is going to impact their carryover from tax year to tax year. Losing track of carryovers can result in consequences that last for years. To illustrate this point, let’s consider the following situations.
Contributions to charity is a popular strategy tax payers use to earn tax deductions, but most forget that you can only gift up to twenty, thirty or fifty percent of your Adjusted Gross Income (AGI) per year. Contributions over twenty, thirty or fifty percent of your AGI is carried forward, or appropriated out, over the next five years.
For example, let’s say that in 2011, Jill donated $20,000, which she had carried forward to the following year. In 2012, she contributed another $20,000. In total, she could deduct $40,000 on her 2012 Schedule A Form. Here’s the snag: Jill’s 2012 AGI is $40,000, which means she can only deduct $20,000 (50% of her 2012 AGI) that year. The $20,000 deduction will cover the contribution from 2011, but not from 2012. Jill can carry forward her 2012 contribution over the next five years. If she loses track of the contribution, she risks losing the ability to earn the deduction for it after 2016.
Contributions to an Individual Retirement Account (IRA) are often tax-deductible, unless your income exceeds a certain amount. You can still contribute, but the contribution is non-deductible. Earnings and growth are taxed on your non-deductible basis. Alternatively, earnings withdrawn from a Roth IRA are tax-free. So, first thing’s first: check your eligibility for a Roth IRA. It is possible to convert a non-deductible basis to a Roth IRA, but this is a complex strategy that requires assistance from a professional.
Every year you contribute to an IRA and do not receive a tax deduction, the basis is recorded on IRS Form 8606. This form should be kept for years into the future until the IRA is empty even when inherited by others.
In 2008, nary a person went without a tax loss in their portfolio. Unfortunately, tax laws only allow up to a $3,000 capital—net—loss per year. So what happens if you lose more? The remaining capital loss will carry forward to the consecutive tax years until it is eliminated.
For instance, Ben has a capital loss in 2008 of $13,000. That year, he would get a $3,000 loss deducted against his AGI and the remaining $10,000 would carry over to the next tax season. In 2009, Ben can take the loss against any gains to the full amount and if he still has a net loss he gets another $3,000 loss to deduct and carry the additional to 2010, and so on and so forth until his loss is wiped out.
The trick here is to keep track on your capital losses to ensure you properly carry them forward every year.
Some taxpayers need to be aware of passive activity loss carry forwards. There are two types of passive activities: trade or business activities and rental activities. Passive activity losses are limited to $25,000 a year, unless you make more than $100,000 when they begin to be phased out or over $150,000 a year—then you get no immediate deduction. Just like with the capital loss carry forward, passive losses are carried over from one tax year to the next until they’re either used against passive income or when the asset is sold or dissolved. In the final year of the passive activity the accumulated losses can be used in total against any income. Losing track of passive activity losses is very common especially with self tax preparing passive activity investors.
Here’s the bottom line: the IRS is not going to keep track of your carryovers year to year. It is your requirement and it represents big tax dollars. To gain a better understanding of these concepts, we recommend hiring a tax advisor—someone you can trust to help pack your parachute.