Taxes in the real world

Ben (00:06):

Welcome back to the Retirement Tax Podcast. I’m your humble co-host. As always, Benjamin Brent joining me in the same Zoom room, but from across the country, we’ve got Steven Jarvis. Steven, how are you doing today?

Steven (00:17):

Ben, I’m doing really great. It’s always fun to record these after we’ve had a chance to be in person together. We just spent some time in Vegas at a conference for financial advisors, trying to help educate as many people as we can on tax planning so they can go and then help more taxpayers. So yeah, it was a lot of fun getting to see you.

Ben (00:34):

The way that you structured the event. Very frugally-minded, which I appreciate. I flew in, flew out like 40 hours later, didn’t even go to the strip. Didn’t gamble once. I don’t even think I bought a drink the whole time I was there, so it was just work. If the IRS is listening, especially just work.

Steven (00:51):

Well, Ben, that’s a great segue into what we want to talk about today because as we’re recording this, we’re coming up on the extended tax filing deadline of October 16th this year. When you listen to this, that’s already passed, so your taxes really need to have been done hopefully back in March or April, but by October 16th at the latest. All that to say, anytime we’re coming up on a deadline, people tend to pay a little bit more attention to taxes, and I get a few more questions that I might not at other times of the year, and one in particular that came up. Ben, as you know, and as our listeners are somewhat familiar with, I work with advisors all over the country. I have a lot of advisors that come to me for their tax help. So I had an advisor come to me for a client that I don’t personally work with, but they were just looking for some advice on this situation because the client had gotten a whole series of nasty grams from the IRS and the advisor and the client. Both were just kind of at their wit’s end with what to do with this information because your joke about if the IRS is listening, the IRS is involved in all this tax stuff we do, and we need to understand what’s possible and what to do when the IRS does come asking questions.

Ben (02:01):

Right? So I get the letter from the IRS. My first panicking isn’t necessarily the first thing I should do, even though deep down you might get that little bit of anxiety. It doesn’t mean there’s an emergency that’s eminent. It just means there are some steps that need to be taken at some point in the near future.

Steven (02:16):

Yeah, and we’ve talked about it on this show before and there’s a reason we keep coming back to it because until you’ve received that letter yourself the first time, it’s really hard to know how you’re going to emotionally react. And so as I work with clients, I constantly reinforce the idea that in the unlikely event that the IRS ever asks questions about your tax return, we’re going to work through this together and we approach these tax strategies from a standpoint that we’re able to sit across the IRS with a straight face and explain what we did. And to me, that’s really important to be able to confidently say that. And so in this particular situation, this really highlights the importance of having great documentation, understanding the different pieces of your tax return or working with someone does, because in this particular client situation, it’s so frustrating. They received a letter from the IRS basically alleging that they owed $90,000 in taxes and penalties all because of a tax-free 401K to IRA rollover. So then any issues from you on paying $90,000 in taxes on a tax rollover?

Ben (03:22):

Nope. Up here in the great way north, we’d call that an oofta. That’s a mega oofta.

Steven (03:25):

Mega ooftat. What was even more frustrating about this is as far as I can tell, because she went back and shared tax returns with me, I saw the IRS letters as far as I can tell, she did everything right. For some reason, it tripped a sensor in the IRS’s system where they said, Hey, let’s ask some more questions. And what was super frustrating about this is that the IRS already has all the information they’re asking her for. They wanted to see the 1099R, which shows the distribution, which the IRS already has. They wanted to see the form 5498, which usually comes out after tax time and will show you contributions to an IRA. It’ll show you rollovers, it’ll show you fair market value. But again, this is stuff the IRS already has, and I’m not sharing this story to try to scare anyone.

(04:14):

We just want to remind all of you, remind all of us that even as the IRS tries to staff up and hire more people, and there’s more IRS agents out there not kicking down people’s doors to steal their cats, that doesn’t happen that these things do come up. It’s run by humans. There are errors in the matrix. Sometimes these things will come up. And so Ben, to your point, when we get that letter, we need to take a deep breath and stand back and say, okay, what’s going on here? Is there something I need to do differently? Is there something I need to correct? Or is this just misinformation that I need to sort out with the IRS?

Ben (04:48):

It is frustrating that they have the information. My brain would tell me something was just coded incorrectly. It was coded as a distribution rather than a rollover, something like that. Just some wires got crossed, but it’s really frustrating that they have the information, but you still have to kind of figure it out yourself. I think I sent you a meme the other day where it was two gunfighters like facing off the okay corral and one Gunfighter says, how much do I owe? And the other gunfighter says, how much do you think you owe? That’s what it feels like when you’re dealing with the IRS and that they hold the information. We’ve got to refind the information, then prove to them that this is the right information. So very frustrating, but essentially they’re dealing with 300 something million possible taxpayers, and there’s only however many thousand of them, and I get it, it’s one to many, but it’s still frustrating.

Steven (05:28):

Absolutely. The best I can figure what happened in this situation is that the rollover was initiated really late in one tax year, and so it was distributed out of the accounts really late in one tax year, and then it was technically deposited correctly, but in the next tax year, and the IRS is notorious for not internally communicating very well, and so when everything doesn’t fit in a nice neat little box, all these alarms go off, oh, you always saw this money, and so thankfully in this situation, it’s something we’re working together to get resolved. She’s not going to ultimately owe any of these taxes, but it’s still frustrating. It’s still very anxious making, and so again, we just throw this out there to say, these things do happen. They could happen to you. We want to make sure you have great documentation and that you know that these are possibilities because they are just slightly less scary if you know it’s possible as opposed to being surprised for the first time ever that the IRS can in fact send a letter to your mailbox.

Ben (06:26):

A great reminder for me and for, I know you have a lot of advisors in our audience and clients that work with advisors. When we have our fall tax meeting, which is just a starting up here, we want to have our last year-end tax meeting the day before Thanksgiving. We’re telling clients what we’re going to do in the accounts, and then we do those things the first week in December. So we’re doing the modeling, the rebalancing, the distributions, the rollovers, the journaling. We’re trying to do all of that with probably two weeks before the end of the year for that reason because if something gets delayed, something gets lost in the mail. Not that we’re physically mailing much these days. It’s all electronic. We want to give ourselves a good cushion before the end of the year because only bad things can happen if half the transactions in on December 31st, the other half’s on January 1st.

Steven (07:06):

Yeah, those are all great reminders, Ben. Switching gears a little bit to another story I recently came across because we love to share real-life examples still back to the IRS communicating with people. This did come out of an actual IRS audit, which is very rare that especially the types of clients that Ben you and I work with, it is very rare that they end up getting audited, but we don’t, again, we don’t approach tax strategies hoping that no one’s going to notice. We want to do things that we know are supportable, that are defendable that fit within the guidelines the IRS has provided. Thankfully, it wasn’t a year that I had worked with this client on. There were new client to us and were trying to help them get cleaned up from the past. But basically what had happened was they had started renting a property.

(07:48):

They started renting a portion of their own home, and they had unfortunately received some bad advice. They went to a tax professional who, and this is something to look out for. I wouldn’t take tax advice from people who aren’t either in an ongoing relationship with you, like a financial advisor who’s going to be there if the IRS calls or a tax professional who’s going to sign the return. If people are just giving you their thoughts and ideas but aren’t willing to put their name next to yours, I might hesitate a little bit because what had happened here is the taxpayer I’m working with was very well-intentioned. They thought they were doing the right thing. They just got that advice for half of the year they had rented out essentially half of their house, but they deducted all of their mortgage interest for the entire year.

(08:32):

They deducted all of their property taxes for the entire year. They deducted a whole list of home improvements that weren’t all even tied to the portion that was being rented. So they have a rental property on their tax return for the very first time, and they have this massive loss, and then they claim the entire loss, and the IRS said, hold on a second. This doesn’t quite feel right. Why don’t you go ahead and send us all of the support for all of those things, and now we’re working through that process of providing all of that support. Now, a couple of reasons I bring this up. It fits in as we talk about communications from the IRS. It also reinforces that documentation really is critical that when you fill out your tax return, this isn’t just, let me take my best guess and put a nice round number and let’s move on.

(09:19):

These things need to be supported. The other reason, Ben, that I bring this up on this podcast is I get a lot of questions from people about rental properties as it relates to taxes. There’s so much on TikTok online in general about, Hey, all this tax-free income from rental properties, that’s where people really get ahead on taxes. And so I get a lot of questions on it, and then I also meet a lot of people who as they get towards or into retirement, to them, this sounds like an interesting idea. They’ve always wanted to try, let’s go have a rental property. And so there’s a lot of questions around it. There’s also a lot of misunderstandings around it.

Ben (09:50):

Yeah, I don’t love individually owned real estate and retirement. You retire, you are leaving the job that you love to go pursue a passion that maybe doesn’t pay you or more time with family doesn’t pay you. What I don’t see as a good trade off is I’m leaving work that I love to pursue work that I don’t like. I actively don’t like it. So you’re getting income from the job you love. Now you’re going to get from a job you hate. The job you hate is the total explodes at 1:00 AM because they never explode at noon. Any number of things that can happen to a house can go wrong and you are the one that’s in charge of fixing them. So I would much rather you buy a mutual fund, we can do total return investing for almost no money, and we can have very similar returns. We can’t do the fancy tax stuff, but a lot of the times the fancy tax stuff is just deferring income, deferring taxes. It’s not a magic wand for never paying taxes. You’re just getting a bigger and bigger ball of debt with bigger and bigger taxes that might go away someday, but they might not. Of our 80 clients, we have think one or two that do rentals, but we actively do not seek out people that are part-time property entrepreneurs. 

Steven (10:51):

So many great things that you said in there, Ben, I especially appreciate that you included in there. The tax benefit is often actually deferred. This is a misconception for people with their first rental property. While you only have a couple of clients that do this, I’m sure we have listeners who have thought about it, are in the middle of it, are considering it because again, you hear it all the time. And so a couple of things I try to really reinforce to people if they’re going to go down this route. The first is that you really need to understand what this means for your taxes because quite often, especially in the early years of a rental property, it’s not going to do anything for your taxes. It’s going to definitely do something on your cashflow. But the IRS specifically has rules separating our earned income or our active income from passive income.

(11:33):

And rental properties are for most people, our passive income. A couple of years ago, I had a brand new client come on, I hadn’t worked with them during the year. We get to tax time and they were so excited. They didn’t think they were going to owe any taxes. In fact, they had reduced their withholdings and stopped making estimated payments because they had started a rental property and someone on YouTube had told them that they were going to get these huge deductions. They’d spent like a hundred grand on renovations and they thought they were going to get to deduct all of that in the first year, and they weren’t. Those losses get used over time as the property actually generates income or when you eventually sell the property. So the first thing we understand is that typically the tax benefit is over time. And then the next thing that I try to always really reinforce people as we start into this rental property discussion of this is the route that you want to go.

(12:20):

Anything that we’re doing on a tax return, let’s just assume that someday the IRS could ask us questions. We’ve got to have documentation. We’ve got to have reasonable expectations for what we’re putting on there, that this doesn’t just become an excuse to deduct all of our mileage for the year. I’ve seen that this doesn’t become an excuse to suddenly start buying all of our favorite lawnmowers and tools and chainsaws and whatever it might be because now I have a rental property and I conduct anything I want. This has to stay reasonable. This has to stay in line with the rules that are out there.

Ben (12:49):

Well, it reminds me of some bad tax advice that I always, back when I first started, I live in North Dakota, a lot of farmers and ranchers, and they would always get the same tax advice at the end of the year. Well, if you don’t want to pay 20,000 in taxes, you better go buy a $70,000 pickup trucks that you don’t have to spend any money taxes and rinse and repeat for 40 years. They don’t have anything saved, and they also don’t have anything in social security, anything saved, but they do have a nice collection of trucks on blocks behind the barn, so don’t spend money you weren’t intending to spend. Just like with our charitable examples, don’t spend money you weren’t intending to spend just to save on taxes. We could have just assumed put that money in a solo 401K got the same benefit. We’re saving the taxes. It’s growing over time. We’re deferring the taxes and we have some retirement income, and we also have social security, which many people don’t if they don’t have an income for many, many years. So you got to be careful who you’re getting advice from. They did not pay any taxes that year, but from a financial planning perspective, they lost millions of dollars in opportunity costs.

Steven (13:45):

Yeah, that’s something I constantly reinforce to clients that we want to make good life decisions and then figure out the tax-efficient way to go about it. Leading with taxes is almost always going to put you in a worse position than you would’ve been otherwise. The charitable example is great. Rental properties are great examples. Buying trucks, geez, there’s so many examples of what sounds like, Hey, I’m going to come out ahead on taxes, but there’s just the missing the recognition of how much you’re spending to get that alleged tax benefit.

Ben (14:13):

Yeah, sometimes I couldn’t tell if that advice was coming from the local tax office or the local Ford dealership because it would’ve been about the same, by the way. 

Steven (14:21):

So many good things to take away for our listeners here when it comes to not just when you receive communication from the IRS, but how we should approach taxes year in and year out so that in the unlikely event that does happen to us, we’re ready for it and it’s not going to be fun. No amount of preparation is going to make me excited for getting an IRS letter, but it’s going to take away some of that anxiety. Definitely take away the fear and just, Hey, we’re going to work through it and we know that we went in with a good strategy that’s supportable and we’ll deal with it.

Ben (14:47):

I love it. And if you have not completed your taxes for 2023, Steven’s personal cell phone number is…Five five five…

Steven (14:52):

Thank you for that, Ben. We better switch to listener questions before you start giving out more personal contact information. Oh, okay. For this episode’s listener question, we had a question come in from Lauren. So Lauren, thanks for sending that in. Everyone can go out to retirementtaxpodcast.com and submit your own question. We love answering ’em on the show here, but Lauren had sent in some questions clarifying what we talked about a few episodes ago around HSAs, around health savings accounts. And Lauren, we had missed specifically addressing these, so I appreciate you bringing ’em up. And really her questions centered around basically when we only are eligible for part of the year to make contributions, we talked about what the contribution limits are, but really we talked about that as if you were eligible for the entire year. And of course, life is always more complicated than that, and so if you’re only eligible for a portion of the year, your contribution limit is going to change.

(15:43):

This gets even more complicated if you are eligibility changes partway through the year. So if for half of the year we had a high deductible plan and for half of the year we didn’t have a high deductible plan, it becomes real easy or we get to take half of the contribution limit and do that for the year. But where I’ve seen this get more complicated is if for half of the year you had single coverage and then for half of the year you had family coverage or again, making it more real to life, if for four and a half months you had single coverage, and then for the other seven and a half months, if I’m doing my math correctly, who knows? Probably not. Again, we’ve got to figure out the balance here. The IRS throws us a little bit of a bone here that we don’t have to do it based on individual days.

(16:23):

We get to do it based on months of what type of coverage did we have for that month, but then we are going to basically do a pro-rata share and most tax prep softwares will help with that. So you don’t need to do that on the back of a napkin. The same whether we’re talking about the base contribution limits or the catchup contribution limits in a year where we didn’t have the same eligibility throughout the entire year, we do need to pay attention to that. This is in contrast, and this wasn’t part of Lauren’s question, but it did make me think of how this is in contrast when we talk about flexible savings accounts or FSAs. That’s the other one that will come up as an employee benefit that’s similar to HSAs and that it’s meant for medical benefits, but it is treated differently because the interesting thing about FSAs, and this is especially important to think about in the year you retire an FSA, you make an election for the year to say, here’s how much I want to contribute for the entire year.

(17:17):

And then you have access to those funds immediately at the beginning of the planned year, and then you slowly make your contributions throughout the year. Now, if I make an election for all of 2024, so I get the full benefit of the FSA beginning of the year and then the middle of January, I say, you know what? Actually I’m going to retire. Where this comes up is that then I’ll have people who say, oh, well, I need to go back to my employer and figure out how to repay the difference. And the interesting thing with FSAs is that you actually don’t, the FSA, that election, that is your money on day one. And so it becomes this balancing game of who’s taking the risk. And in that situation, the employer’s on the hook for the difference because the trade-off to that is that if you get to the end of the year and don’t use your whole FSA, the employer gets to keep the difference. So there’s kind of two ends to that, but that’s the contrast between HSAs versus FSAs.

Ben (18:05):

So FSA use it or lose it by the end of the year, that’s when you got to go buy those glasses or Yeah, I remember doing things like that when I was a younger guy. You had to use it or lose it, but HSA we can compound, we can even invest it over time and have it turn into kind of something pretty neat. So love HSAs. Easy thing to mess up though. I’ve messed it up many times on the podcast before and we have really gracious listeners that’ll write in and correct me, so I appreciate that. But HSAs are tricky and they change from time to time as well, but that’s a great refresher. Thank you. That’s what we’ve got prepared for you this week. I appreciate you tuning in. I appreciate all the listener questions, and until next time, don’t let the tax man hit you. We’re the good Lord split you.

Steven (18:41):

Hi everyone. Quick reminder before you go. While Ben and I feel very strongly about the information we’re sharing on this podcast, it is for educational purposes only and should not be taken as specific tax, investment or legal advice. You need to make sure that you are working with a professional to evaluate how these concepts apply to your specific situation before you take action.