Tax Strategies for Individuals

This Financial Guide provides tax saving strategies for deferring income and maximizing deductions, and includes some strategies for specific categories of individuals, such as those with high income and those who are self-employed.

Before getting into the specifics, however, we would like to stress the importance of proper documentation. Many taxpayers forgo worthwhile tax deductions because they have neglected to keep receipts or records. Keeping adequate records is required by the IRS for employee business expenses, deductible travel and entertainment expenses, and charitable gifts and travel. But don't do it just because the IRS says so. Neglecting to track these deductions can lead to overlooking them. You also need to maintain records regarding your income. If your receive a large tax-free amount, such as a gift or inheritance, make certain to document the item so that the IRS does not later claim that you had unreported income.

The checklist items listed below are for general information only and should be tailored to your specific situation. If you think one of them fits your tax situation, we'd be happy to discuss it with you.

Avoid or Defer Income Recognition

Deferring taxable income makes sense for two reasons. Most individuals are in a higher tax bracket in their working years than they are during retirement. Deferring income until retirement may result in paying taxes on that income at a lower rate. Additionally, through the use of tax-deferred retirement accounts you can actually invest the money you would have otherwise paid in taxes to increase the amount of your retirement fund. Deferral can also work in the short term if you expect to be in a lower bracket in the following year or if you can take advantage of lower long-term capital gains rates by holding an asset a little longer.

Tip: You can achieve the same effect of deferring income by accelerating deductions, for example, by paying a state estimated tax installment in December instead of at the following January due date.

Max Out Your 401(k) or Similar Employer Plan

Many employers offer plans where you can elect to defer a portion of your salary and contribute it to a tax-deferred retirement account. For most companies these are referred to as 401(k) plans. For many other employers, such as universities, a similar plan called a 403(b) is available. Check with your employer about the availability of such a plan and contribute as much as possible to defer income and accumulate retirement assets.

Tip: Some employers match a portion of employee contributions to such plans. If this is available, you should structure your contributions to receive the maximum employer matching contribution.

If You Have Your Own Business, Set Up and Contribute to a Retirement Plan

If you have your own business, consider setting up and contributing as much as possible to a retirement plan. These are allowed even for sideline or moonlighting businesses. Several types of plans are available which minimize the paperwork involved in establishing and administering such a plan.

Related Guide: For details on Keogh plans and other retirement plans benefiting self-employed owners, see the Financial Guide: EMPLOYEE BENEFITS: How To Handle Them.

Contribute to an IRA

If you have income from wages or self-employment income, you can build tax-sheltered investments by contributing to a traditional or a Roth IRA. You may also be able to contribute to a spousal IRA -even where the spouse has little or no earned income. All IRAs defer the taxation of IRA investment income and in some cases can be deductible or be withdrawn tax free.

Related Guide: For details on how Roth IRAs work and how they compare in other respects with traditional IRAs, please see the Financial Guide: ROTH IRAS: How They Work And How To Use Them.

Related Guide: For details on the Coverdell Education Savings Account (formerly the Education IRA) - special purpose vehicles for higher education - please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Maximum Deduction.

Tip: To get the most from IRA contributions, fund the IRA as early as possible in the year. Also, pay the IRA trustee out of separate funds, not out of the amount in the IRA. Following these two rules will ensure that you get the most possible tax-deferred earnings from your money.

Defer Bonuses or Other Earned Income

If you are due a bonus at year-end, you may be able to defer receipt of these funds until January. This can defer the payment of taxes (other than the portion withheld) for another year. If you're self employed, defer sending invoices or bills to clients or customers until after the new year begins. Here, too, you can defer some of the tax, subject to estimated tax requirements. This may even save taxes if you are in a lower tax bracket in the following year. Note, however, that the amount subject to social security or self-employment tax increases each year.

Accelerate Capital Losses and Defer Capital Gains

If you have investments on which you have an accumulated loss, it may be advantageous to sell it prior to year-end. Capital losses are deductible up to the amount of your capital gains plus $3,000. If you are planning on selling an investment on which you have an accumulated gain, it may be best to wait until after the end of the year to defer payment of the taxes for another year (subject to estimated tax requirements). For most capital assets held more than 12 months (long-term capital gains) the maximum capital gains tax is 20 percent. However, make sure to consider the investment potential of the asset. It may be wise to hold or sell the asset to maximize the economic gain or minimize the economic loss.

Watch Trading Activity in Your Portfolio

When your mutual fund manager sells stock at a gain, these gains pass through to you as realized taxable gains, even though you don't withdraw them. So you may prefer a fund with low turnover, assuming satisfactory investment management. Turnover isn't a tax consideration in tax-sheltered funds such as IRAs or 401(k)s. For growth stocks you invest in directly and hold for the long term, you pay no tax on the appreciation until you sell them. No capital gains tax is imposed on appreciation at your death.

Use the Gift-Tax Exclusion to Shift Income

You can give away $14,000 ($28,000 if joined by a spouse) per donee in 2014 (same as 2013), per year without paying federal gift tax. You can give $14,000 to as many donees as you like. The income on these transfers will then be taxed at the donee's tax rate, which is in many cases lower.

Note: Special rules apply to children under age 18. Also, if you directly pay the medical or educational expenses of the donee, such gifts will not be subject to gift tax.

Invest in Treasury Securities

For high-income taxpayers, who live in high-income-tax states, investing in Treasury bills, bonds, and notes can pay off in tax savings. The interest on Treasuries is exempt from state and local income tax. Also, investing in Treasury bills that mature in the next tax year results in a deferral of the tax until the next year.

Consider Tax-Exempt Municipal Bonds

Interest on state or local municipal bonds is generally exempt from federal income tax and from tax by the issuing state or locality. For that reason, interest paid on such bonds is somewhat less than that paid on commercial bonds of comparable quality. However, for individuals in higher brackets, the interest from municipal bonds will often be greater than from higher paying commercial bonds after reduction for taxes. Gain on sale of municipal bonds is taxable and loss is deductible. Tax-exempt interest is sometimes an element in computation of other tax items. Interest on loans to buy or carry tax-exempts is non-deductible.

Give Appreciated Assets to Charity

If you're planning to make a charitable gift, it generally makes more sense to give appreciated long-term capital assets to the charity, instead of selling the assets and giving the charity the after-tax proceeds. Donating the assets instead of the cash prevents your having to pay capital gains tax on the sale, which can result in considerable savings, depending on your tax bracket and the amount of tax that would be due on the sale. Additionally you can obtain a tax deduction for the fair market value of the property.

Tip: Many taxpayers also give depreciated assets to charity. Deduction is for fair market value; no loss deduction is allowed for depreciation in value of a personal asset. Depending on the item donated, there may be strict valuation rules and deduction limits.

Keep Track of Mileage Driven for Business, Medical or Charitable Purposes

If you drive your car for business, medical or charitable purposes, you may be entitled to a deduction for miles driven. For 2014, it's 56 cents per mile for business, 23.5 cents for medical and moving purposes, and 14 cents for service for charitable organizations. You need to keep detailed daily records of the mileage driven for these purposes to substantiate the deduction.

Take Advantage of Your Employer's Benefit Plans to Get an Effective Deduction for Items Such as Medical Expenses

Medical and dental expenses are generally only deductible to the extent they exceed 10 percent of your adjusted gross income (AGI). For most individuals, particularly those with high income, this eliminates the possibility for a deduction. You can effectively get a deduction for these items if your employer offers a Flexible Spending Account, sometimes called a cafeteria plan. These plans permit you to redirect a portion of your salary to pay these types of expenses with pre-tax dollars. Another such arrangement is a Health Savings Account. Ask your employer if they provide either of these plans.

Check Out Separate Filing Status

Certain married couples may benefit from filing separately instead of jointly. Consider filing separately if you meet the following criteria:

• One spouse has large medical expenses, miscellaneous itemized deductions, or casualty losses.
• The spouses' incomes are about equal.

Separate filing may benefit such couples because the adjusted gross income "floors" for taking the listed deductions will be computed separately. On the other hand, some tax benefits are denied to couples filing separately. In some states, filing separately can also save a significant amount of state income taxes.

If Self-Employed, Take Advantage of Special Deductions

You may be able to expense up to $25,000 in 2014 for qualified equipment purchases for use in your business immediately instead of writing it off over many years. Additionally, self-employed individuals can deduct 100% of their health insurance premiums as business expenses. You may also be able to establish a Keogh, SEP or SIMPLE plan, or a Health Savings Account, as mentioned above.

If Self-Employed, Hire Your Child in the Business

If your child is under age 18, he or she is not subject to employment taxes from your unincorporated business (income taxes still apply). This will reduce your income for both income and employment tax purposes and shift assets to the child at the same time; however, you cannot hire your child if he or she in under the age of 8 years old.

Take Out a Home-Equity Loan

Most consumer related interest expense, such as from car loans or credit cards, is not deductible. Interest on a home-equity loan, however, can be deductible. It may be advisable to take out a home-equity loan to pay off other nondeductible obligations.

Bunch Your Itemized Deductions

Certain itemized deductions, such as medical or employment related expenses, are only deductible if they exceed a certain amount. It may be advantageous to delay payments in one year and prepay them in the next year to bunch the expenses in one year. This way you stand a better chance of getting a deduction.

If you have a household employee, you may need to pay state and federal employment taxes. Which forms do you need to file for your household employees? Is your maid, housekeeper, or babysitter covered by the rules? This Financial Guide provides the answers to these and other questions.

This Financial Guide will help you decide whether you have a "household employee," as defined by the IRS, and, if you do, whether you need to pay federal employment taxes. It explains the rules for determining, paying, and reporting Social Security tax, Medicare tax, federal unemployment tax, federal income tax withholding, and state unemployment tax for your household employee. It also explains what records you need to keep. In addition, it provides you with the information you need to find out whether you need to pay state unemployment tax for your household employee.

While many people disregard the need to pay taxes on household employees, they do so at the risk of stiff tax penalties. As you will see below, these rules are quite complex and professional tax guidance is highly recommended.

A basic familiarity with these rules will make it easier to work with your tax advisor, saving you time, reducing tax costs, and avoiding tax penalties and interest charges.

Who is a Household Employee?

The "nanny tax" rules apply to you only if (1) you pay someone for household work and (2) that worker is your employee.

1. A household employee is someone who does work in or around your home. Examples of household employees include baby sitters, nannies, health aides, private nurses, maids, caretakers, yard workers, and similar domestic workers.


2. A household worker is your employee if you can control not only what work is done, but how it is done. If the worker is your employee, it does not matter whether the work is full time or part time, or that you hired the worker through an agency or from a list provided by an agency or association. It also does not matter whether you pay the worker on an hourly, daily, or weekly basis, or by the job.
   
   On the other hand, if only the worker can control how the work is done, the worker is not your employee, but is self-employed. A self-employed worker usually provides his or her own tools and offers services to the general public in an independent business. If an agency provides the worker and controls what work is done and how it is done, the worker is not your employee.

Example: You pay Betty to babysit your child and do light housework four days a week in your home. Betty follows your specific instructions about household and child care duties. You provide the household equipment and supplies that Betty needs to do her work. Betty is your household employee.

Example: You pay John to care for your lawn. John also offers lawn care services to other homeowners in your neighborhood. He provides his own tools and supplies, and he hires and pays any helpers he needs. Neither John nor his helpers are your household employees.

How Do You Verify That an Employee Can Legally Work in the United States?

It is unlawful for you to knowingly hire or continue to employ a person who cannot legally work in the United States.

When you hire a household employee to work for you on a regular basis, he or she must complete USCIS Form I-9 Employment Eligibility Verification. It is your responsibility to verify that the employee is either a U.S. citizen or an alien who can legally work and then complete the employer part of the form. Keep the completed form for your records. Do not return the form to the U.S. Citizenship and Immigration Services (USCIS).

Two copies of Form I-9 are contained in the UCIS Employer Handbook. Visit the USCIS website or call 800-767-1833 to order the handbook, additional copies of the form, or to get more information.

Do You Need to Pay Employment Taxes?

If you have a household employee, you may need to withhold and pay Social Security and Medicare taxes, or you may need to pay federal unemployment tax, or you may need to do both. To find out, read the table below.

Note: If neither of these two columns applies, then you do not need to pay any federal unemployment taxes. However, you may still need to pay state unemployment taxes.

You do not need to withhold federal income tax from your household employee's wages. But if your employee asks you to withhold it, you can choose to do so.

Tip: If your household employee cares for your dependent under the age of 13 or your spouse or dependent who is not capable of self-care, so that you can work, you may be able to take an income tax credit of up to 35% (or $1,050) of your expenses for each qualifying dependent. For two or more qualifying dependents, you can claim up to 35% (or $2,100). For higher income earners the credit percentage is reduced, but not below 20%, regardless of the amount of AGI. If you can take the credit, then you can include your share of the federal and state employment taxes you pay, as well as the employee's wages, in your qualifying expenses.

State Unemployment Taxes

To find out whether you need to pay state unemployment tax for your household employee contact your state unemployment tax agency. You'll also need to determine whether you need to pay or collect other state employment taxes or carry workers' compensation insurance.

Note: If you do not need to pay Social Security, Medicare, or federal unemployment tax and do not choose to withhold federal income tax, the rest of this publication does not apply to you.

Social Security and Medicare Taxes

Note: As of January 1, 2013, the employee social security tax rate is 6.2%. The Medicare rate remains unchanged at 1.45%; however, beginning January 1, 2013, Additional Medicare Tax applies to an individual's Medicare wages that exceed a threshold amount based on the taxpayer's filing status. Employers are responsible for withholding the 0.9% Additional Medicare Tax on an individual's wages paid in excess of $200,000 in a calendar year. An employer is required to begin withholding Additional Medicare Tax in the pay period in which it pays wages in excess of $200,000 to an employee. There is no employer match for Additional Medicare Tax.

Both you and your household employee may owe social security and Medicare taxes. Your share is 7.65% (6.2% for social security tax and 1.45% for Medicare tax) of the employee's social security and Medicare wages. Your employee's share is 6.2% for social security tax and 1.45% for Medicare tax for wages below the Additional Medicare Tax threshold (see above).

You are responsible for payment of your employee's share of the taxes as well as your own. You can either withhold your employee's share from the employee's wages or pay it from your own funds.

Social Security and Medicare Wages

You figure Social Security and Medicare taxes on the Social Security and Medicare wages you pay your employee. If you pay your household employee cash wages of $1,900 or more in 2014, all cash wages you pay to that employee in 2014 (regardless of when the wages were earned) up to $117,000 are social security wages and all cash wages are Medicare wages. However, any non-cash wages (food, lodging, clothing, and other non-cash items) you pay do not count as social security and Medicare wages. If you pay the employee less than $1,900 in cash wages in 2014, none of the wages you pay the employee are Social Security and Medicare wages, and neither you nor your employee will owe Social Security or Medicare tax.

Wages Not Counted

Do not count wages you pay to any of the following individuals as Social Security and Medicare wages:

1. Your spouse.
2. Your child who is under age 21.
3. Your parent.

Note: However, you should count wages to your parent if both of the following apply: (a) your child lives with you and is either under age 18 or has a physical or mental condition that requires the personal care of an adult for at least 4 continuous weeks in a calendar quarter, and (b) you are divorced and have not remarried, or you are a widow or widower, or you are married to and living with a person whose physical or mental condition prevents him or her from caring for your child for at least 4 continuous weeks in a calendar quarter.

4. An employee who is under age 18 at any time during the year.

Note: However, you should count these wages to an employee under 18 if providing household services is the employee's principal occupation. If the employee is a student, providing household services is not considered to be his or her principal occupation.

Also, if your employee's Social Security and Medicare wages reach $117,000 in 2014, do not count any wages you pay that employee during the rest of the year as Social Security wages to figure Social Security tax. (But continue to count the employee's cash wages as Medicare wages to figure Medicare tax.)

You figure federal income tax withholding on both cash and non-cash wages (based on their value). However, do not count as wages any of the following items:

• Meals provided at your home for your convenience.
• Lodging provided at your home for your convenience and as a condition of employment.
• $130 a month in 2014 for transit passes that you give your employee or, in some cases, for cash reimbursement you make for the amount your employee pays to commute to your home by public transit. A transit pass includes any pass, token, fare card, voucher, or similar item entitling a person to ride on mass transit, such as a bus or train.
• Up to $250 a month in 2014 to reimburse your employee for the cost of parking at or near your home or at or near a location from which your employee commutes to your home.

Withholding the Employee's Share

You should withhold the employee's share of Social Security and Medicare taxes if you expect to pay your household employee Social Security and Medicare wages of $1,900 or more in 2014. However, if you prefer to pay the employee's share yourself; see "Not Withholding the Employee's Share" in the next section.

You may withhold the employee's share of the taxes even if you are not sure your employee's Social Security and Medicare wages will be $1,900 or more in 2014. If you withhold the taxes but then actually pay the employee less than $1,900 in Social Security and Medicare wages for the year, you should repay the employee.

You pay withheld taxes as part of your regular income tax obligation. You don't deposit them periodically-subject to an exception for business owners. See "Payment Options for Business Employers" below.

Withhold 7.65% (6.2% for Social Security tax and 1.45% for Medicare tax) from each payment of Social Security and Medicare wages. Wages exceeding the $200,000 (single filer) threshold amount are subject to the additional Medicare tax or 0.9%. Instead of paying this amount to your employee, you will pay it to the IRS 7.65% for your share of the taxes. Do not withhold any social security tax after your employee's social security wages for the year reach $117,000 (2014).

If you make an error by withholding too little, you should withhold additional taxes from a later payment. If you withhold too much, you should repay the employee.

Example: You hire a household employee (who is an unrelated individual over age 18) to care for your child and agree to pay cash wages of $100 every Friday. You expect to pay your employee $1,900 or more for the year. You should withhold $7.65 from each $100 wage payment and pay your employee the remaining $92.35. The $7.65 is the sum of $6.20 ($100 x 6.2%) for your employee's share of Social Security tax and $1.45 ($100 x 1.45%) for your employee's share of Medicare tax (for wages under $200,000 for single filers). You will pay $7.65 you withhold with $7.65 from your own funds when you pay the taxes.

Not Withholding the Employee's Share

If you prefer to pay your employee's Social Security and Medicare taxes from your own funds, you do not have to withhold them from your employee's wages. The Social Security and Medicare taxes you pay to cover your employee's share must be included in the employee's wages for income tax purposes. However, they are not counted as Social Security and Medicare wages or as federal unemployment (FUTA) wages.

Example: You hire a household employee (who is an unrelated individual over age 18) to care for your child and agree to pay cash wages of $100 every Friday. You expect to pay your employee $1,900 or more for the year. You decide to pay your employee's share of Social Security and Medicare taxes from your own funds. You pay your employee $100 every Friday without withholding any Social Security or Medicare taxes. For each wage payment you will pay $15.30 when you pay the taxes. This is $7.65 ($6.20 for Social Security tax plus $1.45 for Medicare tax) to cover your employee's share plus the $7.65 for your share. For income tax purposes, your employee's wages each payday are $107.65 ($100 plus the $7.65 that you will pay to cover your employee's share of Social Security and Medicare taxes).

Federal Unemployment (FUTA) Tax

The federal unemployment tax is part of the federal and state program under the Federal Unemployment Tax Act (FUTA) that pays unemployment compensation to workers who lose their jobs. Like most employers, you may owe both the federal unemployment tax (the FUTA tax) and a state unemployment tax. Or, you may owe only the FUTA tax or only the state unemployment tax. To find out whether you will owe state unemployment tax, contact your state's unemployment tax agency. See the list of state unemployment agencies at the end of this Guide for the address.

The FUTA tax is 6.0% of your employee's FUTA wages. However, you may be able to take a credit of up to 5.4% against the FUTA tax, resulting in a net tax rate of 0.6%. Your credit for 2014 is limited unless you pay all the required contributions for 2014 to your state unemployment fund by April 15, 2015. The credit you can take for any contributions for 2014 that you pay after April 15, 2015, is limited to 90% of the credit that would have been allowable if the contributions were paid by April 15, 2015.

WARNING: Do not withhold the FUTA tax from your employee's wages. You must pay it from your own funds.

You figure the FUTA tax on the FUTA wages you pay. If you pay cash wages to all of your household employees totaling $1,000 or more in any calendar quarter of 2013 or 2014, the first $7,000 of cash wages you pay to each household employee in 2014 is FUTA wages. (A calendar quarter is January through March, April through June, July through September, or October through December.) If your employee's cash wages reach $7,000 during the year, do not figure the FUTA tax on any wages you pay that employee during the rest of the year. For a discussion of "cash wages," see the section on Social Security Wages, above.

If you pay less than $1,000 cash wages in each calendar quarter of 2014, but you had a household employee in 2013, the cash wages you pay in 2013 may still be FUTA wages. They are FUTA wages if the cash wages you paid to household employees in any calendar quarter of 2013 totaled $1,000 or more.

Do not count wages you pay to any of the following individuals as FUTA wages:

1. Your spouse.
2. Your child who is under age 21.
3. Your parent.

Example: You hire a household employee (not related to you) on January 1, 2014, and agree to pay cash wages of $200 every Friday. During January, February, and March, you pay the employee cash wages of $2,600. Because you pay cash wages of $1,000 or more in a calendar quarter of 2014, the first $7,000 of cash wages you pay the employee (or any other employee) in 2013 or 2014 is FUTA wages. The FUTA wages you pay may also be subject to your state's unemployment tax.

During 2014, you pay your household employee cash wages of $10,400. You pay all the required contributions for 2014 to your state unemployment fund by April 15, 2015. Your FUTA tax for 2014 is $42 ($7,000 x 0.6%).

Do You Need to Withhold Federal Income Tax?

You are not required to withhold federal income tax from wages you pay a household employee. You should withhold federal income tax only if your household employee asks you to withhold it and you agree. The employee must give you a completed Form W-4, Employee's Withholding Allowance Certificate.

If you agree to withhold federal income tax, you are responsible for paying it to the IRS.

Wages

You figure federal income tax withholding on both cash and non-cash wages you pay. Measure wages you pay in any form other than cash by the value of the non-cash item.

Do not count as wages any of the following items:

• Meals provided at your home for your convenience.
• Lodging provided at your home for your convenience and as a condition of employment.

• Up to $130 a month in 2014 for bus or train tokens (passes) you give your employee, or for any cash reimbursement you make for the amount your employee pays to commute to your home by public transit.
• Up to $250 a month in 2014 for the value of parking you provide your employee at or near your home or at or near a location from which your employee commutes to your home.

Paying Tax without Withholding

Any income tax you pay for your employee without withholding it from the employee's wages must be included in the employee's wages for federal income tax purposes. It is also counted as Social Security and Medicare wages and as federal unemployment (FUTA) wages.

How Do You Handle the Earned Income Credit (EIC)?

Certain workers can take the earned income tax credit (EIC) on their federal income tax return. This credit reduces their tax or allows them to receive a payment from the IRS if they do not owe tax. You may have to make advance payments of part of your household employee's EIC along with the employee's wages. You also may have to give your employee a notice about the EIC.

Notice about the EIC

The employee's copy (Copy B) of the IRS 2013 Form W-2, Wage and Tax Statement has a statement about the EIC on the back.

Tip: If you give your employee that copy by January 31, 2014 (as discussed under Form W-2), you do not have to give the employee any other notice about the EIC.

Otherwise, you must give your household employee a notice about the EIC only if you agree to withhold federal income tax from the employee's wages but the income tax withholding tables show that no tax should be withheld. Even if not required, you are encouraged to give the employee a notice about the EIC if his or her 2013 wages are less than the amount shown in the instructions to 2014 Form W-5.

If you do not give your employee Copy B of the IRS Form W-2, your notice about the EIC can be any of the following:

• A substitute Form W-2 with the same EIC information on the back of the employee's copy that is on Copy C of the IRS Form W-2,
• Notice 797, Possible Federal Tax Refund Due to the Earned Income Credit (EIC), or
• Your own written statement with the same wording as Notice 797.

If you give your employee a substitute Form W-2 on time which lacks the required EIC information, you must give notice about the 2014 EIC to the employee within one week of the date you gave him or her the substitute Form W-2. If Form W-2 is required, but not given on time, you must give the employee notice about 2014 EIC by January 31, 2015. If Form W-2 is not required, you must give your notice to the employee by February 2, 2015.

How do You Make Tax Payments?

When you file your 2014 federal income tax return in 2015, attach Schedule H, Household Employment Taxes. Use this Schedule, discussed further below, to figure your household employment taxes. You will add the federal employment taxes on the wages you pay to your household employee in 2014, less any advance earned income credit payments you make to the employee, to your income tax. The amount you owe with your return is due to the IRS by April 15, 2015.

Tip: You can avoid owing tax with your return if you pay enough federal income tax before you file to cover the employment taxes for your household employee, as well as your income tax. If you are employed, you can ask your employer to withhold more federal income tax from your wages in 2014. If you get a pension or annuity, you can ask for more federal income tax withholding from your benefits. Or you can make estimated tax payments for 2014 to the IRS, or increase your payments if you already make them.

Asking for More Federal Income Tax Withholding

If you are employed and want more federal income tax withheld from your wages to cover the employment taxes for your household employee, give your employer a new Form W-4, Employee's Withholding Allowance Certificate. Complete it as before, but show the additional amount you want withheld from each paycheck on line 6.

If you get a pension or annuity and want more federal income tax withheld to cover the employment taxes for your household employee, give the payer a new Form W-4P, Withholding Certificate for Pension or Annuity Payments (or a similar form provided by the payer). Complete it as before, but show the additional amount you want withheld from each benefit payment on line 3.

Paying Estimated Tax

If you want to make estimated tax payments to cover the employment taxes for your household employee, get Form 1040-ES, Estimated Tax for Individuals. Use its payment vouchers to make your payments. You can pay all of the employment taxes at once or in installments. If you have already made estimated tax payments for 2014, you can increase your remaining payments to cover the employment taxes. Estimated tax payments for 2014 are ordinarily due April 15, June 16, September 15, 2014 and January 15, 2015.

Payment Option for Business Employers

If you own a business as a sole proprietor or your home is on a farm operated for profit, you can choose either of two ways to pay the 2014 federal employment taxes for your household employee. You can pay them with your federal income tax as described above, or you can include them with your federal employment tax deposits or other payments for your business or farm employees.

If you pay the employment taxes for your household employee with business or farm employment taxes, you must report them with those taxes on Form 941 or Form 943 and on Form 940 (or 940-EZ).

What Forms Must You File?

You must file certain forms to report your household employee's wages and the federal employment taxes for the employee if you pay the employee:

1. Social Security and Medicare wages,
2. FUTA wages, or
3. Wages from which you withhold federal income tax.

The employment tax forms and instructions you need for 2014 will be sent to you automatically in January 2015 if you reported employment taxes for 2013 on Schedule H (Form 1040), Household Employment Taxes.

Employer Identification Number (EIN)

You must include your employer identification number (EIN) on the forms you file for your household employee. An EIN is a 9-digit number issued by the IRS--not the same as a Social Security number.

Tip: You ordinarily will have an EIN if you previously paid taxes for employees, either as a household employer or in a business you own as a sole proprietor, or if you have a Keogh Plan. If you already have an EIN, use that number. If you do not have an EIN, get Form SS-4, Application for Employer Identification Number. The instructions for Form SS-4 explain how you can get an EIN immediately by telephone or in about 4 weeks if you apply by mail.

Form W-2

A separate 2014 Form W-2, Wage and Tax Statement, must be filed for each household employee to whom you pay:

• Social Security and Medicare wages of $1,900 or more, or
• Wages from which you withhold federal income tax.

You must complete Form W-2 and give Copies B, C, and 2 to your employee by January 31, 2015. You must send Copy A of Form W-2 with Form W-3, Transmittal of Wage and Tax Statements, to the Social Security Administration by February 28, 2015 (March 31, 2015, if you file your Form W-2 electronically).

Schedule H

Use Schedule H (Form 1040), Household Employment Taxes, to report the federal employment taxes for your household employee if you pay the employee:

1. Social Security and Medicare wages of $1,900 or more in 2014,
2. FUTA wages, or
3. Wages from which you withhold federal income tax.

File Schedule H with your 2014 federal income tax return by April 15, 2015. If you get an extension to file your return, the extension will also apply to your Schedule H.

If you are not required to file a 2014 tax return, you must file Schedule H by itself. See the Schedule H instructions for details.

Business Employment Tax Returns

Do not use Schedule H (Form 1040) if you choose to pay the employment taxes for your household employee with business or farm employment taxes. Instead, include the Social Security, Medicare, and withheld federal income taxes for the employee on the Forms 941, Employer's Quarterly Federal Tax Return, that you file for your business or on the Form 943, Employer's Annual Tax Return for Agricultural Employees, that you file for your farm. Include the FUTA tax for the employee on your Form 940 (or 940-EZ), Employer's Annual Federal Unemployment (FUTA) Tax Return.

If you report the employment taxes for your household employee on Form 941 or Form 943, file Form W-2 for the employee with the Forms W-2 and Form W-3 for your business or farm employees.

What Records Must You Keep?

Keep your copies of Schedule H or other employment tax forms you file and related Forms W-2, W-3, W-4, and W-5. You must also keep records to support the information you enter on the forms you file. If you are required to file Form W-2, you will need to keep a record of your employee's name, address, and Social Security number.

Wage and Tax Records

On each payday you should record the date and amounts of:

• Your employee's cash and non-cash wages,
• Any employee Social Security tax you withhold or agree to pay for your employee,
• Any employee Medicare tax you withhold or agree to pay for your employee,
• Any federal income tax you withhold,
• Any advance EIC payments you make, and
• Any state employment taxes you withhold.

Employee's Social Security Number

You must keep a record of your employee's name and Social Security number exactly as they appear on his or her Social Security card if you pay the employee:

• Social Security and Medicare wages, or
• Wages from which you withhold federal income tax.

You must ask for your employee's Social Security number no later than the first day on which you pay the wages. You may wish to ask for it when you hire your employee.

An employee who does not have a Social Security number must apply for one on Form SS-5, Application for a Social Security Card. An employee who has lost his or her Social Security card or whose name is not correctly shown on the card should apply for a new card. Employees may get Form SS-5 from any Social Security Administration office or by calling l-800-772-1213.

How Long To Keep Records

Keep your employment tax records for at least four years after the due date of the return on which you report the taxes or the date the taxes were paid, whichever is later.

State Unemployment Tax Agencies

Alabama
Department of Industrial Relations
649 Monroe St.
Montgomery, AL 36131-0099
(334) 242-8830

Alaska
Employment Security Tax
Department of Labor and Workforce Development
PO Box 11509
Juneau, AK 99811-5509
(888) 448-3527

Arizona
Unemployment Tax - 911B
Department of Economic Security
PO Box 6028
Phoenix, AZ 85005-6028
(602) 771-6601

Arkansas
Department of Workforce Services
PO Box 2981
Little Rock, AR 72203-2981
(501) 682-3798

California
Account Services Group, MIC-90
PO Box 942880
Sacramento, CA 94280
(888) 745-3886

Colorado
Unemployment Insurance Operations
Department of Labor and Employment
PO Box 8789
Denver, CO 80201-8789
(800) 480-8299

Connecticut
Connecticut Department of Labor
200 Folly Brook Blvd.
Wethersfield, CT 06109-1114
(860) 263-65504

Delaware
Division of Unemployment Insurance
Department of Labor
PO Box 9950
Wilmington, DE 19809-0950
(302) 761-8484

District of Columbia
Department of Employment Services
Office of Unemployment Compensation Tax Division
609 H Street, NE, 3rd Floor
Washington, DC 20001-4347
(202) 698-7550

Florida
Unemployment Compensation Services
Agency for Workforce Innovation
107 E. Madison Street MSC 229
Tallahassee, FL 32399-0180
(800) 482-8293

Georgia
Department of Labor
148 Andrew Young International Blvd., Suite 800
Atlanta, GA 30303
(404) 232-3301

Hawaii
Department of Labor and Industrial Relations
830 Punchbowl Street, Rm. 437
Honolulu, HI 96813
(808) 586-8913

Idaho
Department of Employment
317 Main Street
Boise, ID 83735-0002
(800) 448-2977

Illinois
Department of Employment Security
33 South State Street
Chicago, IL 60603
(800) 247-4984

Indiana
Department of Workforce Development
10 North Senate Avenue
Room SE 106 Indianapolis, IN 46204-2277
(317) 232-7436

Iowa
Workforce Development
1000 East Grand Avenue
Des Moines, IA 50319-0209
(515) 281-5339

Kansas
Department of Human Resources
401 SW Topeka Blvd.
Topeka, KS 66603-3182
(785) 296-5027

Kentucky
Division for Employment Services
PO Box 948
Frankfort, KY 40602-0948
(502)564-2272

Louisiana
Louisiana Workforce Commission
PO Box 94094
Baton Rouge, LA 70804
(225) 342-2944

Maine
Department of Labor
PO Box 259
Augusta, ME 04332-0259
(207) 621-5120

Maryland
Department of Labor, Licensing & Regulation
1100 North Eutaw Street
Baltimore, MD 21201-2201
(800) 492-5524

Massachusetts
Division of Employment and Training
19 Staniford Street
Boston, MA 02114-2589
(617) 626-5050

Michigan
Department of Labor & Economic Growth
3024 W. Grand Boulevard
Detroit, MI 48202-6024
(313) 456-2180

Minnesota
Department of Employment & Economic Development
332 Minnesota Street
Suite E200
St. Paul, MN 55101-1351
(651) 296-6141

Mississippi
Department of Employment Security
PO Box 1699
Jackson, MS 39215-1699
(866) 806-0272

Missouri
Division of Employment Security
PO Box 59
Jefferson City, MO 65104-0059
(573) 751-3340

Montana
Unemployment Insurance Division
PO Box 6339
Helena, MT 59604-6339
(406) 444-3834

Nebraska
Department of Labor
PO Box 94600
State House Station
Lincoln, NE 68509-4600
(402) 471-9940

Nevada
Department of Employment Training and Rehabilitation
500 East Third Street
Carson City, NV 89713-0030
(775) 684-6300

New Hampshire
Department of Employment Security
32 South Main Street
Concord, NH 03301-4857
(603) 228-4033

New Jersey
Department of Labor & Workforce Development
P.O. Box 947
Trenton, NJ 08625-0947
(609) 633-6400

New Mexico
Department of Workforce Solutions
PO Box 2281
Albuquerque, NM 87103-2281
(505) 841-8576

New York
Department of Labor
State Campus, Building 12
Room 500
Albany, NY 1224-03390
(518) 457-4179

North Carolina
Employment Security Commission
PO Box 26504
Raleigh, NC 27611-6504
(919) 707-1150

North Dakota
Job Service of North Dakota
PO Box 5507
Bismarck, ND 58506-5507
(701) 328-2814

Ohio
Department of Job & Family Services
PO Box 182404
Columbus, OH 43218-2404
(614) 466-2319

Oklahoma
Employment Security Commission
PO Box 52003
Oklahoma City, OK 73152-2003
(405) 557-5362

Oregon
Employment Department
875 Union Street, NE
Room 107
Salem, OR 97311-0030
(503) 947-1488

Pennsylvania
Department of Labor and Industry
7th and Forster Street
Room 915
Harrisburg, PA 17121-0001
(717) 787-7679

Puerto Rico
Department of Labor and Human Resources
PO Box 1020
San Juan, PR 00919-1020
(787) 754-5818

Rhode Island
Division of Taxation
One Capitol Hill, Suite 36
Providence, RI 02908-5829
(401) 574-8700

South Carolina
Employment Security Commission
PO Box 995
Columbia, SC 29202-0995
(803) 737-3075

South Dakota
Department of Labor
PO Box 4730
Aberdeen, SD 57402-4730
(605) 626-2312

Tennessee
Department of Labor and Workforce Development
220 French Landing Drive
Nashville, TN 37243-1002
(615) 741-2486

Texas
Workforce Commission
PO Box 149037
Austin, TX 78714
(512) 463-2700

Utah
Department of Workforce Services
PO Box 45288
Salt Lake City, UT 84145-0288
(801) 526-9400

Vermont
Department of Labor
PO Box 488
Montpelier, VT 05601-0488
(802) 828-4252

Virgin Islands
Department of Labor
PO Box 302608
St. Thomas, VI 00803-2608
(340) 776-1440

Virginia
Employment Commission
PO Box 1358
Richmond, VA 23218-1358
(804) 371-7159

Washington
Employment Security Department
PO Box 9046
Olympia, WA 98507-9046
(360) 902-9360

West Virginia
Bureau of Employment Programs
112 California Avenue
Charleston, WV 25305-0016
(304) 558-2676

Wisconsin
Department of Workforce Development
PO Box 7942
Madison, WI 53707-7942
(608) 261-6700

Wyoming
Unemployment Tax Division
PO Box 2760
Casper, WY 82602-2760
(307) 235-3217

Household Employers Checklist

You may need to do the following things when you have a household employee: When you hire a household employee:

• Find out if the person can legally work in the United States.
• Find out if you need to pay state taxes.

When you pay your household employee:

• Withhold Social Security and Medicare taxes.
• Withhold federal income tax.
• Make advance payments of the earned income credit.
• Decide how you will make tax payments.
• Keep records.

By January 31, 2015:

• Get an employer identification number, if needed.
• Give your employee Copies B, C, and 2 of Form W-2, Wage and Tax Statement.

By February 28, 2015:

• Send Copy A of Form W-2 to the Social Security Administration.

By April 15, 2015:

• File Schedule H (Form 1040), Household Employment Taxes, with your tax return.

Many tax benefits are available to you when you sell your principal residence. However, the rules are complex and personal guidance is necessary to take full advantage of these benefits, so that you and your tax advisor can best work together to minimize the tax on the gain. This financial guide discusses the key rules so that you and your tax advisor can best work together to minimize the tax on the gain.

The IRS allows an exclusion of up to $250,000 of the gain on the sale of your main home ($500,000 if you are married and file a joint return. Most taxpayers can take advantage of the exclusion and will not have to pay any tax on the sale of a main home as long as they meet the IRS ownership and use tests (see below).

Note: If you do have a loss from the sale, it is a personal loss. You cannot deduct the loss.

If you don't qualify for exclusion, your gain exceeds the exclusion, or you used part of the property in business or for rent, you have a taxable gain and must report the sale of your main home on your tax return on IRS Form 8949 and Schedule D.

Principal Residence

Usually, the home you live in most of the time is your main home. In addition to a standard dwelling unit, your home can also be a houseboat, mobile home, cooperative apartment, or condominium.

Example: You own and live in a house in town. You also own beach property, which you use in the summer months. The town property is your main home; the beach property is not.

Example: You own a house, but you live in another house that you rent. The rented home is your main home.

Tip: Where a second residence has soared in value and you want to sell, some tax advisors have suggested moving to the second residence for the required period to qualify for exclusion on its sale. If this is your situation, please consult with a tax professional.

How to Figure Gain or Loss

Key information for determining gain or loss is the selling price, the amount realized, and the adjusted basis.

The selling price is the total amount you receive for your home. It includes money, all notes, mortgages or other debts assumed by the buyer as part of the sale, and the fair market value of any other property or any services you receive. Next, you deduct the selling expenses such as commissions, advertising, legal fees, and loan charges paid by the seller from the selling price.

The difference is the "amount realized". If the amount realized is more than your home's "adjusted basis," discussed later, the difference is your gain. If the amount realized is less than the adjusted basis, the difference is your loss.

However, it does not include amounts you received for personal property sold with your home. Personal property is property that is not a permanent part of the home, such as furniture, draperies, and lawn equipment.

Non-Traditional Sales

The following discussion covers how to determine your gain or loss if you trade one home for another, if your home is foreclosed on or repossessed or if you transfer a jointly owned home.

Jointly owned home. If you and your spouse sell your jointly owned home and file a joint return, you figure and report your gain or loss as one taxpayer. If you file separate returns, each of you must figure and report your own gain or loss according to your ownership interest in the home. Your ownership interest is determined by state law.

If you and a joint owner other than your spouse sell your jointly owned home, each of you must figure and report your own gain or loss according to your ownership interest in the home. Each of you applies the exclusion rules individual basis.

Trading homes. If you trade your old home for another home, treat the trade as a sale and a purchase.

Foreclosure or repossession. If your home was foreclosed on or repossessed, you have what the IRS calls a disposition and will need to determine if you have ordinary income, gain, or loss. The amount of your gain or loss depends on whether you were personally liable for repaying the debt secured by the home and whether the outstanding loan balance is more than the fair market value (FMV) of the property.

If you were not personally liable for repaying the debt secured by the home, the amount you realize includes the full amount of the outstanding debt immediately before the transfer. This is true even if the FMV of the property is less than the outstanding debt immediately before the transfer.

If you were personally liable for repaying the debt secured by the home and the debt is canceled, the amount realized on the foreclosure or repossession includes the smaller of the outstanding debt immediately before the transfer reduced by any amount for which you remain personally liable immediately after the transfer, or the Fair Market Value (FMV) of the transferred property.

In addition to any gain or loss, if you were personally liable for the debt you may have ordinary income. If the canceled debt is more than the home's fair market value, you have ordinary income equal to the difference. However, the income from cancellation of debt is not taxed to you if the cancellation is intended as a gift, or if you are insolvent or bankrupt.

Example: You owned and lived in a home with an adjusted basis of $41,000. A real estate dealer accepted your old home as a trade-in and allowed you $50,000 toward a new house priced at $80,000 (its fair market value). You are considered to have sold your old home for $50,000 and to have had a gain of $9,000 ($50,000 minus $41,000). If the dealer had allowed you $27,000 and assumed your unpaid mortgage of $23,000 on your old home, $50,000 would still be considered the sales price of the old home (the trade-in allowed plus the mortgage assumed).

Transfer to spouse. If you transfer your home to your spouse, or to your former spouse incident to your divorce, you generally have no gain or loss, even if you receive cash or other consideration for the home. Therefore, the rules explained in this Guide do not apply.

If you owned your home jointly with your spouse and transfer your interest in the home to your spouse, or to your former spouse incident to your divorce, the same rule applies. You have no gain or loss.

If you buy or build a new home, its basis will not be affected by your transfer of your old home to your spouse, or to your former spouse incident to divorce. The basis of the home you transferred will not affect the basis of your new home.

Basis

You will need to know your basis in your home as a starting point for determining any gain or loss when you sell it. Your basis in your home is determined by how you got the home. Your basis is its cost if you bought it or built it. If you acquired it in some other way, its basis is either its fair market value when you received it or the adjusted basis of the person you received it from.

While you owned your home, you may have made adjustments (increases or decreases) to the basis. This adjusted basis is used to figure gain or loss on the sale of your home.

Cost as Basis

The cost of property is the amount you pay for it in cash or other property.

Purchase. If you buy your home, your basis is its cost to you. This includes the purchase price and certain settlement or closing costs. Your cost includes your down payment and any debt, such as a first or second mortgage or notes you gave the seller in payment for the home.

Seller-paid points. If you bought your home after April 3, 1994, you must reduce the basis of your home by any points the seller paid, whether or not you deducted them. If you bought your home after 1990 but before April 4, 1994, you must reduce your basis by the amount of seller-paid points only if you chose to deduct them as home mortgage interest in the year paid.

Settlement fees or closing costs. When buying your home, you may have to pay settlement fees or closing costs in addition to the contract price of the property. You can include in your basis the settlement fees and closing costs that are for buying the home. You cannot include in your basis the fees and costs that are for getting a mortgage loan. A fee is for buying the home if you would have had to pay it even if you paid cash for the home.

Settlement fees do not include amounts placed in escrow for the future payment of items such as taxes and insurance.

Some of the settlement fees or closing costs that you can include in the basis of your property are:

• Abstract fees (sometimes called abstract of title fees),
• Charges for installing utility services,
• Legal fees (including fees for the title search and preparing the sales contract and deed),
• Recording fees,
• Surveys,
• Transfer taxes,
• Owner's title insurance, and
• Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

Some settlement fees and closing costs not included in your basis are:

• Fire insurance premiums.
• Rent for occupancy of the house before closing.
• Charges for utilities or other services relating to occupancy of the house before closing.
• Any item that you deducted as a moving expense (settlement fees and closing costs incurred after 1993 cannot be deducted as moving expenses).
• Fees for refinancing a mortgage.
• Charges connected with getting a mortgage loan, such as mortgage insurance premiums (including VA funding fees), loan assumption fees, cost of a credit report, and fee for an appraisal required by a lender.

Real estate taxes. Real estate taxes for the year you bought your home may affect your basis, as follows:

If you pay taxes that the seller owed on the home up to the date of sale and the seller does not reimburse you, then the taxes are added to the basis of your home.

If you pay taxes that the seller owed on the home up to the date of sale and the seller does reimburse you, then the taxes do not affect the basis of your home.

If the seller pays taxes for you (taxes owed beginning on the date of sale) and you do not reimburse the seller, then the taxes are subtracted from the basis of your home.

If the seller pays taxes for you (taxes owed beginning on the date of sale) and you reimburse the seller, then the taxes do not affect the basis of your home.

Construction. If you contracted to have your house built on land you own, your basis is the cost of the land plus the amount it cost you to complete the house. This amount includes the cost of labor and materials, or the amounts paid to the contractor, and any architect's fees, building permit charges, utility meter and connection charges, and legal fees directly connected with building your home. Your cost includes your down payment and any debt, such as a first or second mortgage or notes you gave the seller or builder. It also includes certain settlement or closing costs. You may have to reduce the basis by points the seller paid for you. If you built all or part of your house yourself, its basis is the total amount it cost you to complete it. Do not include the value of your own labor, or any other labor you did not pay for, in the cost of the house.

Cooperative apartment. Your basis in the apartment is usually the cost of your stock in the co-op housing corporation, which may include your share of a mortgage on the apartment building.

Condominium. Your basis is generally its cost to you. The same rules apply as for any other home.

Basis Other Than Cost

If your home was acquired in a transaction other than a traditional purchase (such as gift, inheritance, trade, or from a spouse), you may have to use a basis other than cost, such as fair market value.

Note: Fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property.

Home received as gift. If your home was a gift, its basis to you is the same as the donor's adjusted basis when the gift was made. However, if the donor's adjusted basis was more than the fair market value of the home when it was given to you, you must use that fair market value as your basis for measuring any loss on its sale.

If you use the donor's adjusted basis to figure a gain and get a loss, and then use the fair market value to figure a loss and get a gain, you have neither a gain nor a loss on the sale or disposition.

If you received your home as a gift and its fair market value was more than the donor's adjusted basis at the time of the gift, you may be able to add to your basis any federal gift tax paid on the gift. If the gift was before 1977, the basis cannot be increased to more than fair market value of the home when it was given to you. On the other hand, if you received your home as a gift after 1976, you would add to your basis the part of the federal gift tax paid that is due to the home's "net increase" in value (value less donor's adjusted basis).

Home received from spouse. You may have received your home from your spouse or from your former spouse incident to your divorce.

• If you received the home after July 18, 1984, you had no gain or loss on the transfer. Your basis in this home is generally the same as your spouse's (or former spouse's) adjusted basis just before you received it. This rule applies even if you received the home in exchange for cash, the release of marital rights, the assumption of liabilities, or other consideration.
• If you owned a home jointly with your spouse and your spouse transferred his or her interest in the home to you, your basis in the half interest received from your spouse is generally the same as your spouse's adjusted basis just before the transfer. This rule also applies if your former spouse transferred his or her interest in the home to you incident to your divorce. Your basis in the half interest you already owned does not change. Your new basis in the home is the total of these two amounts.
• If you received your home before July 19, 1984, in exchange for your release of marital rights, your basis in the home is generally its fair market value at the time you received it.
• Home acquired from a decedent who died before or after 2010. If you inherited your home from a decedent who died before or after 2010, your basis is the fair market value of the property on the date of the decedent's death (or the later alternate valuation date chosen by the personal representative of the estate). If an estate tax return was filed or required to be filed, the value of the property listed on the estate tax return is your basis. If a federal estate tax return did not have to be filed, your basis in the home is the same as its appraised value at the date of death, for purposes of state inheritance or transmission taxes.
• Surviving spouse. If you are a surviving spouse and you owned your home jointly, your basis in the home will change. The new basis for the interest your spouse owned will be its fair market value on the date of death (or alternate valuation date). The basis in your interest will remain the same. Your new basis in the home is the total of these two amounts.

Example: Your jointly owned home had an adjusted basis of $50,000 on the date of your spouse's death, and the fair market value on that date was $100,000. Your new basis in the home is $75,000 ($25,000 for one-half of the adjusted basis plus $50,000 for one-half of the fair market value).

In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), each spouse is usually considered to own half of the community property. When either spouse dies, the fair market value of the community property becomes the basis of the entire property, including the portion belonging to the surviving spouse. For this to apply, at least half of the community interest must be included in the decedent's gross estate, whether or not the estate must file a return.

Home received in trade. If you acquired your home in a trade for other property, the basis of your home is generally its fair market value at the time of the trade. If you traded one home for another, you have made a sale and purchase. In that case, you may have realized a gain.

Adjusted Basis

Adjusted basis is your cost or other basis increased or decreased by certain amounts.

Increases to basis include:

• Additions and other improvements that have a useful life of more than 1 year.
• Special assessments for local improvements.
• Amounts spent after a casualty to restore damaged property.

Decreases to basis include:

• Discharge of qualified principal residence indebtedness that was excluded from income (but not below zero).
• Gain from the sale of your old home before May 7, 1997 on which tax was postponed.
• Insurance payments for casualty losses.
• Deductible casualty losses not covered by insurance.
• Payments received for granting an easement or right-of-way.
• Depreciation allowed or allowable if you used your home for business or rental purposes.
• Residential energy credit (generally allowed from 1977 through 1987) claimed for the cost of energy improvements that you added to the basis of your home.
• Adoption credit you claimed for improvements that you added to the basis of your home.
• Nontaxable payments from an employer's adoption assistance program that you used for improvements you added to the basis of your home.
• Nonbusiness energy property credit (allowed beginning in 2006 but not for 2008) claimed for making certain energy saving improvements you added to the basis of your home.
• Residential energy efficient property credit (allowed beginning in 2006) claimed for making certain energy saving improvements you added to the basis of your home.
• First-time home buyer's credit (allowed to certain first-time buyers in the District of Columbia--beginning on August 5, 1997).
• Energy conservation subsidy excluded from your gross income because you received it (directly or indirectly) from a public utility after December 3l, 1992, to buy or install any energy conservation measure. An energy conservation measure includes an installation or modification that is primarily designed either to reduce consumption of electricity or natural gas or to improve the management of energy demand for a home.

Discharges of qualified principal residence indebtedness. You may be able to exclude from gross income a discharge of qualified principal residence indebtedness. This exclusion applies to discharges made after 2006 and before 2013. If you choose to exclude this income, you must reduce (but not below zero) the basis of your principal residence by the amount excluded from gross income.

Amount eligible for the exclusion. The exclusion applies only to debt discharged after 2006 and before 2013. The maximum amount you can treat as qualified principal residence indebtedness is $2 million ($1 million if married filing separately). You cannot exclude from gross income discharge of qualified principal residence indebtedness if the discharge was for services performed for the lender or on account of any other factor not directly related to a decline in the value of your residence or to your financial condition.

Improvements. These add to the value of your home, prolong its useful life, or adapt it to new uses. You add the cost of improvements to the basis of your property.

Example: Putting a recreation room in your unfinished basement, adding another bathroom or bedroom, putting up a fence, putting in new plumbing or wiring, installing a new roof, or paving your driveway are improvements.

Here are some other examples:

• Additions: Bedroom, bathroom, deck, garage, porch, patio
• Lawn and grounds: Landscaping, driveway, walkway, fence, retaining wall, sprinkler system, swimming pool
• Miscellaneous: Storm windows or doors, new roof, central vacuum, wiring upgrades, satellite dish, security system
• Heating and air conditioning: Heating system, central air, furnace, duct work, central humidifier, filtration system
• Plumbing: Septic system, water heater, soft water system, filtration system
• Interior: Built-in appliances, kitchen modernization, flooring, wall-to-wall carpet
• Insulation: attic, walls, floor, pipes, duct work
• Improvements no longer part of home. Your home's adjusted basis does not include the cost of any improvements that are no longer part of the home.

Example: You put wall-to-wall carpeting in your home 15 years ago. Later, you replaced that carpeting with new wall-to-wall carpeting. The cost of the old carpeting you replaced is no longer part of your home's adjusted basis.

Repairs. These maintain the good condition of your home. They do not add to its value or prolong its life, and you do not add their costs to the basis of your property.

Example: Repainting your house inside or outside, fixing your gutters or floors, repairing leaks or plastering, and replacing broken window panes are examples of repairs.

Tip: The entire job is considered an improvement, however, if items that would otherwise be considered repairs are done as part of an extensive remodeling or restoration of your home.

Recordkeeping. You should keep records of your home's purchase price and purchase expenses. Furthermore, you should also save receipts and other records for all improvements, additions, and other items that affect the basis of your home.

The records you should keep include:

• Proof of the home's purchase price and purchase expenses;
• Receipts and other records for all improvements, additions, and other items that affect the home's adjusted basis;
• Any worksheets or other computations you used to figure the adjusted basis of the home you sold, the gain or loss on the sale, the exclusion, and the taxable gain;
• Any Form 982 you filed to exclude any discharge of qualified principal residence indebtedness;
• Any Form 2119, Sale of Your Home, you filed to postpone gain from the sale of a previous home before May 7, 1997;
• Any worksheets you used to prepare Form 2119

Exclusion for Sales After May 6, 1997

If you sell your main home after May 6, 1997, you may qualify to exclude up to $250,000 of the gain ($500,000 if married filing jointly) on the sale of your main home; however, to claim the exclusion, you must meet the ownership and use tests. This means that during the 5-year period ending on the date of the sale, you must have:

• Owned the home for at least 2 years (the ownership test)
• Lived in the home as your main home for at least 2 years (the use test)
• During the 2-year period ending on the date of the sale, you did not exclude gain from the sale of another home.

Exception. If you owned and lived in the property as your main home for less than 2 years, you can still claim an exclusion in some cases. However, the maximum amount you may be able to exclude will be reduced.

If you sell the land on which your main home is located, but not the house itself, you cannot exclude any gain you have from the sale of the land.

If you have more than one home, only the sale of your main home qualifies for excluding the gain. If you have two homes and live in both of them, your main home is the one you live in most of the time.

The two years of ownership and use during the five-year period don't have to be continuous. You meet the tests if you can show that you owned and lived in the property as your main home for either 24 full months or 730 days during the five-year period. Short temporary absences, e.g., for vacations, are counted as periods of use, even if you rent out the property during that time.

Example: Professor Moore bought and moved into a house on January 4, 2005. He lived in it as his main home continuously until October 1, 2006, when he went abroad for a one-year sabbatical. During part of the leave, the house was unoccupied, and during the rest of the time he rented it out. On October 1, 2007, he sold the house. Because his leave was not a short temporary absence, he cannot include the period of leave to meet the 2-year use test.

Ownership and Use Tests Met at Different Times. You can meet the ownership and use tests during different 2-year periods. However, you must meet both tests during the 5-year period ending on the date of the sale.

Example: In 1996, Harry was 60 years old and lived in a rental apartment. When the apartment building went co-op, he bought his apartment on December 1, 1999. Harry then went to live with his daughter on April 14, 2001 because he became ill. On July 10, 2003, he sold his co-op while still living with his daughter. Harry can exclude gain on the sale of his co-op because he met the ownership and use tests. His 5-year period runs from July 11, 1998, to July 10, 2003, the date he sold the co-op. Even though, he only owned the co-op from December 1, 1999 to July 10, 2003--over two years, he lived in the apartment from July 11, 1997 (the beginning of the five-year period) to April 14, 2001 (over two years).

Special Situations. There are a number of special situations that may result in exceptions to the general rules.

Individuals with Disabilities. There is an exception to the 2-out-of-5-year use test if you become physically or mentally unable to care for yourself at any time during the 5-year period. You qualify for this exception to the use test if, during the 5-year period before the sale of your home:

• You become physically or mentally unable to care for yourself, and
• You owned and lived in your home as a main home for a total of at least one year during the 5-year period before the sale of your home.

Under this exception, you are considered to live in your home during any time that you live in a facility (including a nursing home) that is licensed by a state or political subdivision to care for persons in your condition.

If you meet this exception to the use test, you still have to meet the 2-out-of-5-year ownership test to claim the exclusion.

Gain postponed on sale of previous home. For the ownership and use tests, you may be able to add the time you owned and lived in a previous home to the time you lived in the home on which you wish to exclude gain. You can do this if you postponed all or part of the gain on the sale of the previous home because of buying the home on which you wish to exclude gain.

Tip: Also, if buying the previous home enabled you to postpone all or part of the gain on the sale of a home you owned earlier, you can also include the time you owned and lived in that earlier home.

Previous home destroyed or condemned. For the ownership and use test, you add the time you owned and lived in a previous home that was destroyed or condemned to the time you owned and lived in the home on which you wish to exclude gain. This rule applies if any part of the basis of the home you sold depended on the basis of the destroyed or condemned home. Otherwise, you must have owned and lived in the same home for 2 of the 5 years before the sale to qualify for the exclusion.

Members of the uniformed services or Foreign Service, employees of the intelligence community, or employees or volunteers of the Peace Corps. You can choose to have the 5-year test period for ownership and use suspended during any period you or your spouse serve on qualified official extended duty (defined later) as a member of the uniformed services or Foreign Service of the United States, or as an employee of the intelligence community.

You can choose to have the 5-year test period for ownership and use suspended during any period you or your spouse serve outside the United States either as an employee of the Peace Corps on qualified official extended duty (defined later) or as an enrolled volunteer or volunteer leader of the Peace Corps. This means that you may be able to meet the 2-year use test even if, because of your service, you did not actually live in your home for at least the required 2 years during the 5-year period ending on the date of sale.

Note: The period of suspension cannot last more than 10 years. Together, the 10-year suspension period and the 5-year test period can be as long as, but no more than, 15 years. You cannot suspend the 5-year period for more than one property at a time. You can revoke your choice to suspend the 5-year period at any time.

Married Persons

If you and your spouse file a joint return for the year of sale, you can exclude gain (up to $500,000) if either spouse meets the ownership and use tests.

Example: Mary sells her home in June of this year and marries John later in the year. She meets the ownership and use tests, but John does not. Emily can exclude up to $250,000 of gain on a separate or joint return for this year.

Example: Now assume that John also sells a home. He meets the ownership and use tests on his home. Mary and John can each exclude $250,000 of gain.

Death of spouse before sale. If your spouse died before the date of sale, you are considered to have owned and used the property as your main home during any period of time when your spouse owned and used it as a main home.

Home transferred from spouse. If your home was transferred to you by your spouse (or former spouse if the transfer was incident to divorce), you are considered to have owned it during any period of time when your spouse owned it.

Use of home after divorce. You are considered to have used property as your main home during any period when you owned it and your spouse or former spouse is allowed to use it under a divorce or separation instrument. Such use is added to your own use before or after divorce.

Special Exceptions Affecting Exclusions

Home destroyed or condemned. If your home is destroyed or condemned after May 6, 1997, any gain (e.g., due to insurance proceeds) qualifies for the exclusion.

Expatriates. You cannot claim the exclusion if the expatriate tax applies to you because you have renounced their citizenship and one of the primary purposes was to avoid U.S. taxes.

More Than One Home Sold During the Two-Year Period. You cannot exclude gain on the sale of your home if, during the two-year period ending on the date of the sale, you sold another home at a gain and are excluding all or part of that gain. If you cannot exclude the gain, you must include it in your income.

However, you can claim a reduced exclusion if you sold the home due to a change in health or place of employment or experienced unforeseen circumstances such as natural disasters, death, or unemployment (eligible unemployment compensation). When counting the number of sales during a two-year period, do not count sales before May 7, 1997.

The $250,000 (or $500,000) exclusion is reduced according to a formula whose numerator is the number of days of qualified ownership or use (or between sales of the homes) and the denominator is 730 days (for 2 years). If married filing jointly, duplicate the same calculation for your spouse's ownership and use (or days between sales).

Example: You owned and used your main home for 400 days before selling it at a $150,000 gain following your move to a new job location. Your exclusion is $136,986, that is, 400/730 x $250,000.

Change in Place of Employment. You may qualify for a reduced exclusion if the primary reason for the sale of your main home is a change in the location of employment of a qualified individual.

Health. You may qualify for a reduced exclusion if the sale of your main home is because of health if your primary reason for the sale is to obtain, provide, or facilitate the diagnosis, cure, mitigation, or treatment of disease, illness, or injury of a qualified individual, or to obtain or provide medical or personal care for a qualified individual suffering from a disease, illness, or injury.

Unforeseen Circumstances. You may qualify for a reduced exclusion if the sale of your main home is because of an unforeseen circumstance if your primary reason for the sale is the occurrence of an event that you could not reasonably have anticipated before buying and occupying that home. You are not considered to have an unforeseen circumstance if the primary reason you sold your home was that you preferred to get a different home or because your finances improved.

Home used in business. So long as the business use takes place in the same dwelling unit as your main home, the exclusion is not affected by business use, with this exception: You cannot exclude the part of your gain that is equal to any depreciation allowed or allowable for the business use of your home after May 6, 1997. The 2 out of 5 year use-as-the-main-home test is not applied to deny exclusion for gain allocable to business use in the same dwelling unit, except for allowable depreciation.

Example: You bought a home in 1997 and used it throughout 3/4 as your residence and 1/4 as your home office. On December 30, 2002 you sold it. The gain qualifies for exclusion except that you cannot exclude the part of your gain that is equal to any depreciation allowed or allowable for the business use of your home after May 6, 1997.

Recapture of Federal Subsidy

If you financed your home under a federally subsidized program (loans from tax-exempt qualified mortgage bonds or loans with mortgage credit certificates), you may have to recapture all or part of the benefit you received from that program when you sell or otherwise dispose of your home. You recapture the benefit by increasing your federal income tax for the year of the sale. You may have to pay this recapture tax even if you can exclude your gain from income under the rules discussed earlier; that exclusion does not affect the recapture tax.

Glossary

Adjusted basis: This is your basis in the property increased or decreased by certain amounts. See Adjusted Basis, earlier in this Guide, for a list of items that increase or decrease your basis in the property.

Amount realized: This is the selling price of your old home minus your selling expenses.

Basis: Your basis in the property is determined by how you got it. If you bought or built the property, your basis is what it cost you. If you got the property in some other way, your basis will be determined differently. See Cost as Basis and Basis Other Than Cost earlier in this Guide for more information.

Date of sale: If you received a Form 1099-S, Proceeds From Real Estate Transactions, the date should be shown in box 1. If you did not receive this form, the date of sale is the earlier of (a) the date title transferred or (b) the date the economic burdens and benefits of ownership shifted to the buyer. In most cases, these dates are the same.

Fair market value: Fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property.

Fixing-up expenses: These are costs you pay for decorating or repairing your home to make it easier to sell. You may be able to deduct fixing-up expenses from the amount realized on the sale of your old home.

Gain: Your gain on the sale of your home is the amount realized minus the adjusted basis of the home you sold.

Improvements: These add to the value of your home, prolong the life of the property, or allow the property to be used for new purposes. The cost of improvements increases your basis in the property.

Main home: This is the home you live in most of the time. It can be a house, houseboat, cooperative apartment, condominium, etc.

Repairs: These maintain your property in good condition. They differ from Improvements in that they do not add much to the value or life of the property and their cost does not increase your basis in the property.

Seller-financed mortgage: This is a mortgage from the buyer of your home. The buyer makes mortgage payments to you.

Selling expenses: Selling expenses include items such as sales commissions, and advertising and legal fees you pay to sell your home. Selling expenses also usually include loan charges you pay on the buyer's behalf as an aid in selling your home, such as loan placement fees or "points."

Settlement fees (or closing costs): These are amounts paid in purchasing your property in addition to the contract price. Some of these amounts are added to the basis of the property and some are deductible as itemized deductions. Certain amounts are neither deductible nor added to the basis of the property. See Settlement fees or closing costs under Basis, earlier in this Guide, for more details.

Annuities may help you meet some of your mid and long-range goals such as planning for your retirement and for a child's college education. This Financial Guide tells you how annuities work, discusses the various types of annuities, and helps you determine which annuity product (if any) suits your situation. It also discusses the tax aspects of annuities and explains how to shop for both an insurance company and an annuity, once you know which type you'll need.

How Annuities Work

While traditional life insurance guards against "dying too soon," an annuity, in essence, can be used as insurance against "living too long." In brief, when you buy an annuity (generally from an insurance company, that invests your funds), you in turn receive a series of periodic payments that are guaranteed as to amount and payment period. Thus, if you choose to take the annuity payments over your lifetime (keep in mind that there are many other options), you will have a guaranteed source of "income" until your death. If you "die too soon" (that is, you don't outlive your life expectancy), you will get back from the insurer far less than you paid in. On the other hand, if you "live too long" (and do outlive your life expectancy), you may get back far more than the cost of your annuity (and the resultant earnings). By comparison, if you put your funds into a traditional investment, you may run out of funds before your death.

The earnings that occur during the term of the annuity are tax-deferred. You are not taxed on them until they are paid out. Because of the tax deferral, your funds have the chance to grow more quickly than they would in a taxable investment.

How Annuities Best Serve Investors

Tip: Assess the costs of an annuity relative to the alternatives. Separate purchase of life insurance and tax-deferred investments may be more cost effective.

The two primary reasons to use an annuity as an investment vehicle are:

1. You want to save money for a long-range goal, and/or
2. You want a guaranteed stream of income for a certain period of time.

Annuities lend themselves particularly well to funding retirement and, in certain cases, education costs.

One negative aspect of an annuity is that you cannot get to your money during the growth period without incurring taxes and penalties. The tax code imposes a 10% premature-withdrawal penalty on money taken out of a tax-deferred annuity before age 59½ and insurers impose penalties on withdrawals made before the term of the annuity is up. The insurers' penalties are termed "surrender charges," and they usually apply for the first seven years of the annuity contract.

These penalties lead to a de facto restriction on the use of annuities primarily as an investment. It only makes sense to put your money into an annuity if you can leave it there for at least ten years and the withdrawals are scheduled to occur after age 59½. These restrictions explain why annuities work well for either retirement needs or for cases of education funding where the depositor will be at least 59½ when withdrawals begin.

Tip: The greater the investment return, the less punishing the 10% penalty on withdrawal under age 59½ will appear. If your variable annuity investments have grown substantially, you may want to consider taking some of those profits (despite the penalty, which applies only to the taxable portion of the amount withdrawn).

Annuities can also be effective in funding education costs where the annuity is held in the child's name under the provisions of the Uniform Gifts to Minors Act. The child would then pay tax (and 10% penalty) on the earnings when the time came for withdrawals.

Caution: A major drawback is that the child is free to use the money for any purpose, not just education costs.

Types Of Annuities

The available annuity products vary in terms of (1) how money is paid into the annuity contract, (2) how money is withdrawn, and (3) how the funds are invested. Here is a rundown on some of the annuity products you can buy:

• Single-Premium Annuities: You can purchase a single-premium annuity, in which the investment is made all at once (perhaps using a lump sum from a retirement plan payout). The minimum investment is usually $5,000 or $10,000.
• Flexible-Premium Annuities: With the flexible-premium annuity, the annuity is funded with a series of payments. The first payment can be quite small.
• Immediate Annuities: The immediate annuity starts payments right after the annuity is funded. It is usually funded with a single premium, and is usually purchased by retirees with funds they have accumulated for retirement.
• Deferred Annuities: With a deferred annuity, payouts begin many years after the annuity contract is issued. You can choose to take the scheduled payments either in a lump sum or as an annuity, that is, as regular annuity payments over some guaranteed period. Deferred annuities are used as long-term investment vehicles by retirees and non-retirees alike. They are used to fund tax-deferred retirement plans and tax-sheltered annuities. They may be funded with a single or flexible premium.
• Fixed Annuities: With a fixed annuity contract, the insurance company puts your funds into conservative fixed income investments such as bonds. Your principal is guaranteed and the insurance company gives you an interest rate that is guaranteed for a certain minimum period-from a month to several years. This guaranteed interest rate is adjusted upwards or downwards at the end of the guarantee period. Thus, the fixed annuity contract is similar to a CD or a money market fund, depending on the length of the period during which interest is guaranteed. The fixed annuity is considered a low-risk investment vehicle. All fixed annuities also guarantee you a certain minimum rate of interest of 3 to 5% for the entirety of the contract. The fixed annuity is a good choice for investors with a low risk tolerance and a short-term investing time horizon. The growth that will occur will be relatively low. Fixed annuity investors benefit if interest rates fall, but not if they rise.
• Variable Annuities: The variable annuity, which is considered to carry with it higher risks than the fixed annuity--about the same risk level as a mutual fund investment--gives you the ability to choose how to allocate your money among several different managed funds. There are usually three types of funds: stocks, bonds, and cash-equivalents. Unlike the fixed annuity, there are no guarantees of principal or interest. However, the variable annuity does benefit from tax deferral on the earnings.

The variable annuity is a good annuity choice for investors with a moderate to high risk tolerance and a long-term investing time horizon.

Caution: Variable annuities have higher costs than similar investments that are not issued by an insurance company.

Caution: The taxable portion of variable annuity distributions is taxable at full ordinary rates, even if they are based on stock investments. Unlike dividends from stock investments (including mutual funds), there is no capital gains relief (currently set to expire at the end of 2012).

Tip: Before buying an annuity, contribute as much as possible to other tax-deferred options such as IRA's and 401 (k) plans. The reason is that the fees for these plans is likely to be lower than those of an annuity and early-withdrawal fees on annuities tend to be steep.

Tip: IRA contributions are sometimes invested in flexible premium annuities-with IRA deduction, if otherwise available. You may prefer to use IRAs for non-annuity assets. Non-annuity assets gain the ability to grow tax-free when held in an IRA. The IRA regime adds no such benefit to annuity assets which grow tax-free in or outside IRAs.

Choosing A Payout Option

When it's time to begin taking withdrawals from your deferred annuity, you have a number of choices. Most people choose a monthly annuity-type payment, although a lump sum withdrawal is also possible.

Caution: Once you have chosen a payment option, you cannot change your mind.

The size of your payout (settlement option) depends on:

1. The size of the amount in your annuity contract
2. Whether there are minimum required payments
3. Your life expectancy (or other payout period)
4. Whether payments continue after your death

Here are summaries of the most common forms of payout:

Fixed Amount

This type gives you a fixed monthly amount (chosen by you) that continues until your annuity is used up. The risk of using this option is that you may live longer than your money lasts. Thus, if the annuity is your only source of income, the fixed amount is not a good choice. And, if you die before your annuity is exhausted, your beneficiary gets the rest.

Fixed Period

This option pays you a fixed amount over the time period you choose. For example, you might choose to have the annuity paid out over ten years. If you are seeking retirement income before some other benefits start, this may be a good option. If you die before the period is up, your beneficiary gets the remaining amount.

Lifetime or Straight Life

This type of payment continues until you die. There are no payments to survivors. The life annuity gives you the highest monthly benefit of the options listed here. The risk is that you will die early, thus leaving the insurance company with some of your funds. The life annuity is a good choice if (1) you do not need the annuity funds to provide for the needs of a beneficiary and (2) you want to maximize your monthly income.

Life With Period Certain

This form of payment gives you payments as long as you live (as does the life annuity) but with a minimum period during which you or your beneficiary will receive payments, even if you die earlier than expected. The longer the guarantee period, the lower the monthly benefit.

Installment-Refund

This option pays you as long as you live and guarantees that, should you die early, whatever is left of your original investment will be paid to a beneficiary. Monthly payments are less than with a straight life annuity.

Joint And Survivor

In one joint and survivor option, monthly payments are made during the annuitants' joint lives, with the same or a lesser amount paid to whoever is the survivor. In the option typically used for retired employees (employment model), monthly payments are made to the retired employee, with the same or a lesser amount to the employee's surviving spouse or other beneficiary. The difference is that with the employment model , the spouse's (or other co-annuitant's) death before the employee won't affect what the survivor employee collects. The amount of the monthly payments depends on the annuitants' ages, and whether the survivor's payment is to be 100% of the joint amount or some lesser percentage.

How Payouts Are Taxed

The way your payouts are taxed differs for qualified and non-qualified annuities.

Qualified Annuity

A tax-qualified annuity is one used to fund a qualified retirement plan, such as an IRA, Keogh plan, 401(k) plan, SEP (simplified employee pension), or some other retirement plan. The tax-qualified annuity, when used as a retirement savings vehicle, is entitled to all of the tax benefits (and penalties) that Congress saw fit to attach to such qualified plans.

The tax benefits are:

1. Any nondeductible or after-tax amount you put into the plan is not subject to income tax when withdrawn
2. The earnings on your investment are not taxed until withdrawal

If you withdraw money from a qualified plan annuity before the age of 59½, you will have to pay a 10% penalty on the amount withdrawn in addition to paying the regular income tax. There are exceptions to the 10% penalty, including an exception for taking the annuity out in a series of equal periodic payments over the rest of your life.

Once you reach age 70½, you will have to start taking withdrawals in certain minimum amounts specified by the tax law (with exceptions for Roth IRAs and for employees still working after age 70½).

Non-Qualified Annuity

A non-qualified annuity is purchased with after-tax dollars. You still get the benefit of tax deferral on the earnings; however, you pay tax on the part of the withdrawals that represent earnings on your original investment.

If you make a withdrawal before the age of 59½, you will pay the 10% penalty only on the portion of the withdrawal that represents earnings.

With a non-qualified annuity, you are not subject to the minimum distribution rules that apply to qualified plans after you reach age 70½.

Tax on Your Beneficiaries or Heirs

If your annuity is to continue after your death, other taxes may apply to your beneficiary (the person you designate to take further payments) or your heirs (your estate or those who take through the estate if you didn't designate a beneficiary).

Income tax: Annuity payments collected by your beneficiaries or heirs are subject to tax on the same principles that would apply to payments collected by you.

Exception: There's no 10% penalty on withdrawal under age 59½ regardless of the recipient's age, or your age at death.

Estate tax: The present value at your death of the remaining annuity payments is an asset of your estate, and subject to estate tax with other estate assets. Annuities passing to your surviving spouse or to charity would escape this tax.

If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.

How To Shop For An Annuity

Although annuities are typically issued by insurance companies, they may also be purchased through banks, insurance agents, or stockbrokers.

There is considerable variation in the amount of fees that you will pay for a given annuity as well in the quality of the product. Thus, it is important to compare costs and quality before buying an annuity.

First, Check Out The Insurer

Before checking out the product itself, it is important to make sure that the insurance company offering it is financially sound. Because annuity investments are not federally guaranteed, the soundness of the insurance company is the only assurance you can rely on. Consult services such as A.M. Best Company, Moody's Investor Service, or Standard & Poor's Ratings to find out how the insurer is rated.

Next, Compare Contracts

The way you should go about comparing annuity contracts varies with the type of annuity.

• Immediate annuities: Compare the settlement options. For each $1,000 invested, how much of a monthly payout will you get? Be sure to consider the interest rate and any penalties and charges.
• Deferred annuities: Compare the rate, the length of guarantee period, and a five-year history of rates paid on the contract. It is important to consider all three of these factors and not to be swayed by high interest rates alone.
• Variable annuities: Check out the past performance of the funds involved.

If a particular fund has a great track record, ascertain whether the same management is still in place. Although past performance is no guarantee, consistent management will grant you better odds.

Costs, Penalties, And Extras

Be sure to compare the following points when considering an annuity contract:

Surrender Penalties

Find out the surrender charges (that is, the amounts charged for early withdrawals). The typical charge is 7% for first-year withdrawals, 6% for the second year, and so on, with no charges after the seventh year. Charges that go beyond seven years, or that exceed the above amounts, should not be acceptable.

Tip: Be sure the surrender charge "clock" starts running with the date your contract begins, not with each new investment.

Fees And Costs

Be sure to ask about all other fees. With variable annuities, the fees must be disclosed in the prospectus. Fees lower your return, so it is important to know about them. Fees might include:

• Mortality fees of 1 to 1.35% of your account (protection for the insurer in case you live a long time)
• Maintenance fees of $20 to $30 per year
• Investment advisory fees of 0.3% to 1% of the assets in the annuity's portfolios.

Extras

These provisions are not costs, but should be asked about before you invest in the contract.

Some annuity contracts offer "bail-out" provisions that allow you to cash in the annuity if interest rates fall below a stated amount without paying surrender charges.

There may also be a "persistency" bonus which rewards annuitants who keep their annuities for a certain minimum length of time.

In deciding whether to use annuities in your retirement planning (or for any other reason) and which types of annuities to use, professional guidance is advisable.

Risk To Retirees of Using An Immediate Annuity

At first glance, the immediate annuity would seem to make sense for retirees with lump-sum distributions from retirement plans. After all, an initial lump-sum premium can be converted into a series of monthly, quarterly, or yearly payments that represent a portion of principal plus interest and is guaranteed to last for life. The portion of the periodic payout that constitutes a return of principal is excluded from taxable income.

However, this strategy contains risks. For one thing, when you lock yourself into a lifetime of level payments, you fail to guard against inflation. Furthermore, you are gambling that you will live long enough to get your money back. Thus, if you buy a $150,000 annuity and die after collecting only $60,000, the insurer often gets to keep the rest. Unlike other investments, the balance doesn't go to your heirs. Finally, since the interest rate is fixed by the insurer when you buy it, you may be locking yourself into low rates.

You can hedge your bets by opting for a "period certain", or "term certain" which, in the event of your death, guarantees payment for some years to your beneficiaries. There are also "joint-and-survivor" options (which pay your spouse for the remainder of his or her life after you die) or a "refund" feature (in which some or all of the remaining principal is resumed to your beneficiaries).

Some plans offer quasi-inflation adjusted payments. One company offers a guaranteed increase in payments of $10 at three-year intervals for the first 15 years. Payments then get an annual cost-of-living adjustment with a 3% maximum. However, for these enhancements to apply, you will have to settle for much lower monthly payments than the simple version.

Recently, a few companies have introduced immediate annuities that offer potentially higher returns in return for some market risk. These "variable immediate annuities" convert an initial premium into a lifetime income; however, they tie the monthly payments to the returns on a basket of mutual funds.

Older seniors-75 years of age and up- may have fewer worries about inflation or liquidity. Nevertheless, they should question whether they really need such annuities at all.

If you want a comfortable retirement income, consider a balanced portfolio of mutual funds. If you want to guarantee that you will not outlive your money, you can plan your withdrawals over a longer time horizon.

How are distributions from mutual funds taxed? What happens when they are reinvested? How are capital gains on sales of mutual funds determined? This Financial Guide provides you with tips on reducing the tax on mutual fund activities.

A basic knowledge of mutual fund taxation and careful record-keeping can help you cut the tax bite on your mutual fund investments.

You must generally report as income any mutual fund distributions, whether or not they are reinvested. The tax law generally treats mutual fund shareholders as if they directly owned a proportionate share of the fund's portfolio of securities. Thus, all dividends and interest from securities in the portfolio, as well as any capital gains from the sales of securities, are taxed to the shareholders.

Note: The fund itself is not taxed on its income if certain tests are met and substantially all of its income is distributed to its shareholders.

There are two types of taxable distributions: (1) ordinary dividends and (2) capital gain distributions.

1. Ordinary Dividends. Distributions of ordinary dividends, which come from the interest and dividends earned by securities in the fund's portfolio, represent the net earnings of the fund. They are paid out periodically to shareholders. Like the return on any other investment, mutual fund dividend payments decline or rise from year to year, depending on the income earned by the fund in accordance with its investment policy. These dividend payments are considered ordinary income and must be reported on your tax return. In 2014 (same as 2013), dividend income that falls in the highest tax bracket (39.6%) is taxed at 20%. For the middle tax brackets (25-35%) the dividend tax rate is 15%, and for the two lower ordinary income tax brackets of 10% and 15%, the dividend tax rate is zero. Note: In for tax years 2008-2012 the maximum tax rates were 0% for the two lower tax brackets (10% and 15%) and capped at 15% for the higher tax brackets (20%, 25%, 28%, 33% and 35%).

   Qualified dividends. Qualified dividends are the ordinary dividends subject to the same 0% or 15% maximum tax rate that applies to net capital gain. They are subject to the 15% rate if the regular tax rate that would apply is 25% or higher; however the highest tax bracket, 39.6% is taxed at a 20% rate. If the regular tax rate that would apply is lower than 25%, qualified dividends are subject to the 0% rate. Dividends from foreign corporations are qualified where their stock or ADRs are traded on U.S. exchanges or with IRS approval where the dividends are covered by U.S. tax treaties. Dividends from mutual funds qualify where a mutual fund is receiving qualified dividends and distributing the required proportions thereof.

2. Capital gain distributions. When gains from the fund's sales of securities exceed losses, they are distributed to shareholders. As with ordinary dividends, these capital gain distributions vary in amount from year to year. They are treated as long-term capital gain, regardless of how long you have owned your fund shares.

   A mutual fund owner may also have capital gains from selling mutual fund shares.

Capital gains rates. The beneficial long-term capital gains rates on sales of mutual fund shares apply only to profits on shares held more than a year before sale. (Profit on shares held a year or less before sale is ordinary income, but capital gain distributions are long-term regardless of the length of time held before the distribution.)

From 2008 to December 31, 2012, the tax rate was 0% for individuals in the two lowest tax brackets (10% and 15%) and 15% for the higher tax brackets; however, starting with tax year 2013, long term capital gains are taxed at 20% (39.6% tax bracket), 15% for the middle tax brackets (25%, 28%, 33%, and 35%), and 0% for the 10% and 15% tax brackets.

Example: Say your taxable income, apart from long-term capital gains and qualified dividends, puts you in a tax bracket below 25% (that's below $73,801 on a joint return in 2014). In this case you'll get the benefit of the lower rate (0% for long-term gains and qualified dividends) on the amount of gain between your taxable income and the start of your 25% bracket.

Note: The "qualified five-year capital gains" on stock, in which special rules applied to the gains on the sale of capital assets held for more than five years, expired at the end of 2012 and was permanently repealed by the American Taxpayer Relief Act (ATRA) of 2012.

At tax time, your mutual fund will send you a Form 1099-DIV, which tells you what earnings to report on your income tax return, and how much of it is qualified dividends. Because tax rates on qualified dividends are the same as for capital gains distributions and long-term gains on sales, Congress wants these items combined in your tax reporting-that is, qualified dividends added to long-term capital gains. Also, capital losses are netted against capital gains before applying the favorable capital gains rates. Losses will not be netted against dividends.

Undistributed capital gains. Mutual funds sometimes retain a part of their capital gain and pay tax on them. You must report your share of such gains, and can claim a credit for the tax paid. The mutual fund will report these amounts to you on Form 2439. You increase your shares' "cost basis" (more about this in Tip No. 5, below) by 65% of the gain, representing the gain reduced by the credit.

Medicare Tax. Starting with tax year 2013, an additional Medicare tax of 3.8% is applied to net investment income for individuals with modified adjusted gross income above $200,000 (single filers) and $250,000 (joint filers).

Now that you have a better understanding of how mutual funds are taxed, here are 13 tips for minimizing the tax on your mutual fund activities.

Keep Track of Reinvested Dividends

Most funds offer you the option of having dividend and capital gain distributions automatically reinvested in the fund-a good way to buy new shares and expand your holdings. While most shareholders take advantage of this service, it is not a way to avoid being taxed. Reinvested ordinary dividends are still taxed (at long-term capital gains rates if qualified), just as if you had received them in cash. Similarly, reinvested capital gain distributions are taxed as long-term capital gain.

Tip: If you reinvest, add the amount reinvested to the "cost basis" of your account, i.e., the amount you paid for your shares. The cost basis of your new shares purchased through automatic reinvesting is easily seen from your fund account statements. This information is important later on when you sell shares (more about that in ).

Be Aware That Exchanges of Shares Are Taxable Events

The "exchange privilege," or the ability to exchange shares of one fund for shares of another, is a popular feature of many mutual fund "families," i.e., fund organizations that offer a variety of funds. For tax purposes, exchanges are treated as if you had sold your shares in one fund and used the cash to purchase shares in another fund. In other words, you must report any capital gain from the exchange on your return. The same tax rules used for calculating gains and losses when you redeem shares apply when you exchange them.

Note: Gains on these redemptions and exchanges are taxable whether the fund invests in taxable or tax-exempt securities.

Be Wary of Buying Shares Just Before Ex-Dividend Date

Tax law requires that mutual funds distribute at least 98% of their ordinary and capital gain income annually. Thus, many funds make disproportionately large distributions in December. The date on which a fund's shareholders become entitled to future payment of a distribution is referred to as the ex-dividend date. On that date the fund's net asset value (NAV) is reduced on a per share basis by the exact amount of the distribution. Buying mutual fund shares just before this date can trigger an unexpected tax.

Example: You buy 1,000 shares of Fund XYZ at $10 a share. A few days later, the fund goes ex-dividend, entitling you to a $1 per share distribution. Because $1 of your $10 NAV is being distributed to you, the value of your 1,000 shares is reduced to $9,000. As with any fund distribution, you may receive the $1,000 in cash or reinvest it and receive additional shares. In either case, you must pay tax on the distribution.

If you reinvest the $1,000, the distribution has the appearance of a wash in your account, since the value of your fund investment remains $10,000. The $1,000 reinvestment results in the acquisition of 111.1 new shares with a $9 NAV and increases the cost basis of your total investment to $11,000. If you were to redeem your shares for $10,000 (their current value), you would realize a $1,000 capital loss.

In spite of these tax consequences, in some instances it may be a good idea to buy shares right before the fund goes ex-dividend. For instance, the distribution could be relatively small, with only minor tax consequences. Or the market could be moving up, with share prices expected to be higher after the ex-dividend date.

Tip: To find out a fund's ex-dividend date call the fund directly.

Tip: If you regularly check the mutual fund quotes in your daily newspaper and notice a decline in NAV from the previous day, the explanation may be that the fund has just gone ex-dividend. Newspapers generally use a footnote to indicate when a fund goes ex-dividend.

Do Not Overlook the Advantages of Tax-Exempt Funds

If you are in the higher tax brackets and are seeing your investment profits taxed away, then there is a good alternative to consider: tax-exempt mutual funds. Distributions from such funds that are attributable to interest from state and municipal bonds are exempt from federal income tax (although they may be subject to state tax).

The same is true of distributions from tax-exempt money market funds. These funds also invest in municipal bonds, but only in those that are short-term or close to maturity, the aim being to reduce the fluctuation in NAV that occurs in long-term funds.

Many taxpayers can ease their tax bite by investing in municipal bond funds. The catch with municipal bond funds is that they offer lower yields than comparable taxable bonds. For example, if a U.S. Treasury bond yields 7.5%, then a quality municipal bond of the same maturity might yield 6%. If an investor is in a higher tax bracket, the tax advantage makes it worthwhile to invest in the lower-yielding tax-exempt fund. Whether the tax advantage actually benefits a particular investor depends on that investor's tax bracket.

To figure out how much you would have to earn on a taxable investment to equal the yield on a tax-exempt investment, use this formula: Tax-exempt yield divided by (1 minus your tax bracket) = equivalent yield of a taxable investment.

Example: You are planning for the 33% bracket. The yield of a tax-exempt investment is 5.5%. Applying the formula, we get .055 divided by .67 (1 minus .33) = .082. Therefore, 8.2% is the yield you would need from a taxable investment to match the tax-exempt yield of 5.5%.

Note: In limited cases based on the types of bonds involved, part of the income earned by tax-exempt funds may be subject to the federal alternative minimum tax.

Although income from tax-exempt funds is federally tax-exempt, you must still report on your tax return the amount of tax-exempt income you received during the year. This is an information- reporting requirement only and does not convert tax-exempt earnings into taxable income.

Your tax-exempt mutual fund will send you a statement summarizing its distributions for the past year and explaining how to handle tax-exempt dividends on a state-by-state basis.

Note: Capital gain distributions paid by municipal bond funds (unlike distributions of interest) are not free from federal tax. Most states also tax these capital gain distributions.

Keep Records of Your Mutual Fund Transactions

It is very important to keep the statements from each mutual fund you own, especially the year-end statement.

By law, mutual funds must send you a record of every transaction in your account, including reinvestments and exchanges of shares. The statement shows the date, amount, and number of full and fractional shares bought or sold. These transactions are also contained in the year-end statement.

In addition, you will receive a year-end Form 1099-B, which reports the sale of fund shares, for any non-IRA mutual fund account in which you sold shares during the year.

Why is recordkeeping so important? When you sell mutual fund shares, you will realize a capital gain or loss in the year the shares are sold. You must pay tax on any capital gain arising from the sale, just as you would from a sale of individual securities. (Losses may be used to offset other gains in the current year and deducted up to an additional $3,000 of ordinary income. Remaining loss may be carried for comparable treatment in later years.)

The amount of the gain or loss is determined by the difference between the cost basis of the shares (generally the original purchase price) and the sale price. Thus, in order to figure the gain or loss on a sale of shares, it is essential to know the cost basis. If you have kept your statements, you will be able to figure this out.

Example: In 2010, you purchased 100 shares of Fund JKL at $10 a share for a total purchase price of $1,000. Your cost basis for each share is $10-what you paid for the shares. Any fees or commissions paid at the time of purchase are included in the basis, so since you paid an up-front commission of 2 percent, or $20, on the purchase, your cost basis for each share is $10.20 ($1,020 divided by 100). You sell your Fund JKL shares this year for $1,500. (Assume no adjustments to your $ 1,020 basis, such as basis attributable to shares purchased through reinvestment. For an example of the effect of reinvestment on cost basis, see Tip #6.) On this year's income tax return, you report a capital gain of $480 ($1,500 minus $1,020). (Note: Since they are taken into account in your cost basis, commissions or brokerage fees are not deductible separately as investment expenses on your tax return.)

One of the advantages of mutual fund investing is that the fund provides you with all of the records that you need to compute gains and losses-a real plus at tax time. Some funds even provide cost basis information or compute gains and losses for shares sold. That is why it is important to save the statements. However, you are not required to use the fund's gain or loss computations in your tax reporting.

Re-investing Dividends & Capital Gain Distributions when Calculating

Make sure that you do not pay any unnecessary capital gain taxes on the sale of mutual fund shares because you forgot about reinvested amounts. When you reinvest dividends and capital gain distributions to buy more shares, you should add the cost of those shares (that is, the amount invested) to the cost basis of the shares in that account because you have already paid tax on those shares.

Example: You bought 500 shares in Fund PQR 15 years ago for $10,000. Over the years you reinvested dividends and capital gain distributions in the amount of $8,000, for which you received 100 additional shares. This year, you sell all 600 of those shares for $40,000. If you forget to include the price paid for the 100 shares purchased through reinvestment (even though the fund sent you a statement recording the shares you received in each transaction), you will unwittingly report on your tax return a capital gain of $30,000 ($40,000 - $ 10,000) on your redemption of 600 shares, rather than the correct capital gain of 22,000 ($40,000 - [$10,000 + $8,000]).

Failure to include reinvested dividends and capital gain distributions in your cost basis is a costly mistake.

Adjust Cost Basis for Non-Taxable Distributions

Sometimes mutual funds make distributions to shareholders that are not attributable to the fund's earnings. These are nontaxable distributions, also known as returns of capital. Because a return of capital is a return of part of your investment, it is not taxable. Your mutual fund will show any return of capital on Form 1099-DIV in the box for nontaxable distributions.

Note: Nontaxable distributions are not the same as the tax-exempt dividends described in Tip No. 4.

If you receive a return-of-capital distribution, your basis in the shares is reduced by the amount of the return.

Example: Fifteen years ago, you purchased 1,000 shares of Fund ABC at $10 a share. The following year you received a $1-per-share return-of-capital distribution, which reduced your basis in those shares by $1, to give you an adjusted basis of $9 per share. This year you sell your 1,000 shares for $15 a share. Assuming no other transactions during this period, you would have a capital gain this year of $6 a share ($15 - $9) for a total reported capital gain of $6,000.

Nontaxable distributions cannot reduce your basis below zero. If you receive returns of capital that, taken together, exceed your original basis, you must report the excess as a long-term capital gain.

Your overall basis will not change if non-taxable distributions are reinvested. However, your per-share basis will be reduced.

Use the Best Method of Identifying Sold Shares

Calculating the capital gain or loss on shares you sell is somewhat more complicated if, as is usually the case, you are selling only some of your shares. You then must use some accounting method to identify which shares were sold to determine your capital gain or loss. The IRS recognizes several methods of identifying the shares sold:

• First-in, first-out (FIFO),
• Average cost (single category and double category), and
• Specific identification.

Reports from your funds may include a computation of gain or loss on your sale of mutual fund shares. Typically, these will use the average cost method, single category rule. This is done as a convenience. You are allowed to adopt one of the other methods.

First-In, First-Out (FIFO)

Under this method, the first shares bought are considered the first shares sold. Unless you specify that you are using one of the other methods, the IRS will assume you are using FIFO.

Average Cost

This approach allows you to calculate an average cost for each share by adding up the total cost of all the shares you own in a particular mutual fund and dividing by the number of shares. If you elect to take an average cost approach, you must then choose whether to use a single-category method or a double-category method.

• With the single-category method, you simply group all shares together, add up the cost, and divide by the number of shares. Under this method, you are deemed to have sold first the shares you have held the longest.
• The double-category method enables you to separate short-term and long-term shares. Shares held for one year or less are considered short-term; shares held for more than one year are considered long-term. You average the cost of shares in each category separately. In this way, you may specify whether you are redeeming long-term or short-term shares.

Keep in mind that once you elect to use either average cost method, you must continue to use it for all transactions in that fund unless you receive IRS approval to change your method.

Specific Identification

Under this method, you specify the individual shares that are sold. If you have kept track of the purchase prices and dates of all your fund shares, including shares purchased with reinvested distributions, you will be able to identify, for example, those shares with the highest purchase prices and indicate that they are the shares you are selling. This strategy gives you the smallest capital gain and could save you a significant amount on taxes.

To take advantage of this method, you must, at the time of the sale or exchange, indicate to your broker or to the mutual fund itself the particular shares you are selling. The IRS also insists that you receive written confirmation of your instructions.

Note: To see the advantages and disadvantages of these methods of identifying sold shares, see How The Various Identification Methods Compare

Note: Money market funds present a very simple case when you redeem shares. Because most money market funds maintain a stable net asset value of $1 per share, you have no capital gain or loss when you sell shares. Thus, you only pay tax on any earnings distributed.

Avoid Backup Withholding

One way the IRS makes sure it receives taxes owed by taxpayers is through backup withholding. In the mutual fund context, this means that a mutual fund company is required to deduct and withhold a specified percentage (see below) of your dividend and redemption proceeds if one of the following has occurred:

• You have not supplied your taxpayer identification number (Social Security number) to the fund company;
• You supplied a TIN that the IRS finds to be wrong;
• The IRS finds you have underreported your interest and dividend payments; or
• You failed to tell the fund company you are not subject to backup withholding.

The backup withholding percentage is 28%.

Don't Forget State Taxation

Many states treat mutual fund distributions the same way the federal government does. There are, however, these areas of different treatment:

• If your mutual fund invests in U.S. government obligations, states generally exempt from state taxation dividends attributable to federal obligation interest.
• Most states do not tax income from their own obligations, whether held directly or through mutual funds. On the other hand, the majority of states do tax income from the obligations of other states. Thus, in most states, you will not pay state tax to the extent you receive, through the fund, income from obligations issued by your state or its municipalities.
• Most states don't grant reduced rates for capital gains or dividends.

Don't Overlook Possible Tax Credits for Foreign Income

If your fund invests in foreign stocks or bonds, part of the income it distributes may have been subject to foreign tax withholding. If so, you may be entitled to a tax deduction or credit for your pro-rata share of taxes paid. Your fund will provide you with the necessary information.

Tip: Because a tax credit provides a dollar-for-dollar offset against your tax bill, while a deduction reduces the amount of income on which you must pay tax, it is generally advantageous to claim the foreign tax credit. If the foreign tax doesn't exceed $300 ($600 on a joint return), then you may not need to file IRS form 1116 to claim the credit.

 

Be Careful About Trying the "Wash Sale" Rule

If you sell fund shares at a loss (so you can take a capital loss on your return) and then re-purchase shares in the same fund shortly thereafter, beware of the wash sale rule. This rule bars a loss deduction when a taxpayer buys "substantially identical" shares within 30 days before or after the date of sale.

Tip: Be sure to wait more than thirty (30) days before reinvesting.

Choose Tax-Efficient Funds

Many investors who hold mutual funds directly may hold others through tax-sheltered accounts such as 401(k)s, IRAs, and Keoghs. Your aggressive high-turnover funds, and high income funds, should be in tax-sheltered accounts. These generate more current income and gains, currently taxable if held directly but tax-deferred in tax sheltered accounts. Buy-to-hold funds, and low activity funds such as index funds should be owned directly (as opposed to a tax-sheltered account). With relatively small currently distributable income, such investments can continue to grow with only modest reduction for current taxes.

For some investors, the simpler approach may be to hold mutual funds personally and more highly taxed income (such as bond interest) in the tax-sheltered account.

As you can see, there are many tax pitfalls that await the unwary mutual fund investor. Professional guidance should be considered to minimize the tax impact.

How The Various Identification Methods Compare.

To illustrate the advantages and disadvantages of the various methods of identifying the shares that you sell, assume that you bought 100 shares of Fund PQR in January 2005 at $20 a share, 100 shares in January 2006 at $30 a share, and 100 shares in November 2010 at $46 a share. You sell 50 shares in June of this year for $50 a share. Here are your alternative ways to determine cost basis.

1. First-In, First-Out (FIFO).The FIFO method identifies the 50 shares sold as among the first 100 shares purchased. Your cost basis per share is $20. This rate gives you a capital gain of $1,500 ($2,500 - (50 x $20)).
2. Advantages/Disadvantages: In this example, this method produces the highest amount of capital gain on which you are taxed. FIFO provides the lowest capital gain amount when the fund's net asset value has declined and the first shares purchased were the most expensive. It can also sometimes save tax when shares bought later weren't held long enough to qualify for long-term capital gains treatment.
3. Average Cost/Single Category. Average cost/single category allows you to calculate the average price paid for all shares in the fund. Here, your cost basis per share is $32 (your 300 shares cost $9,600: $9,600 divided by 300 = $32), giving you a capital gain of $900 ($2,500 - (50 x $32)).
4. Advantages/Disadvantages: Compared to FIFO, this method can reduce the amount of your capital gain if the fund's net asset value has increased over time. You could generate a lower long-term capital gain by using specific identification, but average cost/single category is useful if you did not designate shares at the time of sale or you simply do not want to do the record keeping required to use the specific identification method.
5. Average Cost/Double Category. Under this method, you average the cost of the short-term shares (those held for one year or less) and the cost of the long-term shares (those held for more than one year) separately. Thus, in the long-term category, you have 200 shares at $5,000 for an average cost of $25 per share ($5,000 times 200), and in the short-term category, you have 100 shares at $4,600 for an average cost of $46 per share ($4,600 divided by 100). Comparing the two categories, your taxable gain using the long-term shares would be $1,250 ($2,500 - (50 x $25)), to be taxed at up to 20%, while your taxable gain using the short-term shares would be $200 ($2,500 - (50 x $46)), to be taxed at up to 38.6% (top rate for 2002-2003).
6. Advantages/Disadvantages: In this example, using the average cost of the short-term shares produces a better result. However, because of the current spread between the top marginal income tax rates and the maximum rate on long-term capital gains, it could make sense in some instances to choose the long-term shares. Furthermore, as with specific identification, you must plan ahead to use this method by specifying to the broker or mutual fund company at the time of sale that you are selling short-term or long-term shares, and you must receive confirmation of your specification in writing. If you have elected to use average cost-double category, but do not specify for a particular redemption whether you are redeeming short-term or long-term shares, the IRS will deem you to have redeemed the long-term shares first.
7. Specific identification. With this method, you designate which shares you are selling. To reduce your capital gains tax bill the most, you would select the shares with the highest purchase price. In this case, you would identify the 50 shares sold as among those purchased in 1999. Your cost basis, therefore, is $46 per share, giving you a capital gain of $200 ($2,500 - (50 x $46)).
8. Advantages/Disadvantages: This method can produce favorable results in lowering the capital gain, but IRS regulations require you to think ahead by providing instructions before the sale and then receiving confirmation of your specification in writing. The IRS will not let you designate shares after the fact.
   
   

Government and Non-Profit Agencies

• US Securities and Exchange Commission (SEC)

Securities and Exchange Commission
100 F Street, NE
Washington, D.C. 20549
(202) 942-8088
website

The SEC has public reference rooms at its headquarters in Washington, D.C., and at its Northeast and Midwest Regional offices. Copies of the text of documents filed in these reference rooms may be obtained by visiting or writing the Public Reference Room (at a standard per page reproduction rate) or through private contractors (who charge for research and/or reproduction).

Other sources of information filed with the SEC include public or law libraries, securities firms, financial service bureaus, computerized on-line services, and the companies themselves.

Most companies whose stock is traded over the counter or on a stock exchange must file "full disclosure" reports on a regular basis with the SEC. The annual report (Form 10-K) is the most comprehensive of these. It contains a narrative description and statistical information on the company's business, operations, properties, parents, and subsidiaries; its management, including their compensation and ownership of company securities: and significant legal proceedings which involve the company. Form 10-K also contains the audited financial statements of the company (including a balance sheet, an income statement, and a statement of cash flow) and provides management's discussion of business operations and prospects for the future.

Quarterly financial information on Form 8-K may be required as well.

Anyone may search the SEC's Company Filings database for information regarding to including quarterly and annual reports, registration statements for IPOs and other offerings, insider trading reports, and proxy materials.

American Association of Individual Investors
(offers an annual guide to low-load mutual funds):

625 North Michigan Avenue
Chicago, IL 60611
Tel: 312-280-0170 or 800-428-2244

Investment Company Institute
(a trade association of fund companies that publishes an annual directory of mutual funds):

1401 H Street NW, Suite 1200
Washington, DC 20005
Tel: 202-326-5800

Mutual Fund Education Alliance (publishes an annual guide to low-cost mutual funds):

2345 Grand Boulevard, Suite 1750
Kansas City, MO 64108
Tel: 816-454-9427

This Financial Guide discusses the rules that apply when you contribute property--as opposed to money--to charity and is meant to provide general information. Contact your tax advisor if you need tax planning assistance.

Caution: The rules in this area are extremely complex. We urge you not to act on any transaction without seeking the proper advice.

If you contribute property to a qualified organization, the amount of your charitable contribution is generally the fair market value of the property at the time of the contribution. However, if the property fits into one of the categories discussed here, the amount of your deduction must be decreased.

After discussing how to determine the fair market value of something you donate, we'll discuss the following categories of charitable gifts of property:

• Contributions subject to special rules
• Property that has decreased in value;
• Property that has increased in value;
• Food Inventory.
• Bargain Sales.

Related Guide: See What Records You Should Keep To Substantiate Your Charitable Contributions

Determining Fair Market Value

Fair market value is the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all of the relevant facts.

Used Clothing and Household Items.

The fair market value of used clothing and used household goods, such as furniture and furnishings, electronics, appliances, linens, and other similar items is usually much lower than the price paid when new. These items may have little or no market value because they are in a worn condition, out of style, or no longer useful. Claim as the value of used clothing the price that buyers of used items actually pay clothing stores, such as consignment or thrift shops.

Be prepared to support your valuation of other household items with photographs, canceled checks, receipts from your purchase of the items, or other evidence. Magazine or newspaper articles and photographs that describe the items and statements by the recipients of the items may be useful. (This documentation does not get filed with your return; it is kept on hand as proof.)

Note: No deduction is allowed after August 17, 2006 for household items in less than "good used condition". However, deduction is allowed where the amount claimed for the item in less than good condition is more than $500 and a qualified appraisal supporting the valuation is filed with the return.

Cars, Boats, and Aircraft

If you donate a car, a boat, or an aircraft to a charitable organization, you must determine the FMV.

The FMV of a donated car, boat, or airplane is generally the amount listed in a used vehicle pricing guide for a private party sale, not the dealer retail value, of a similar vehicle. The FMV may be less than that however, if the vehicle has engine trouble, body damage, high mileage, or any type of excessive wear.

Similar is defined as the same make, model, and year, sold in the same area, in the same condition, with the same or similar options or accessories, and with the same or similar warranties as the donated vehicle.

Boats. Except for inexpensive small boats, the valuation of boats should be based on an appraisal by a marine surveyor because the physical condition is so critical to the value.

If you donate a qualified vehicle to a qualified organization and you claim a deduction of more than $500, you can deduct the smaller of the gross proceeds from the sale of the vehicle by the organization or the vehicle's fair market value on the date of the contribution. If the vehicle's fair market value was more than your cost or other basis, you may have to reduce the fair market value to figure the deductible amount.

Paintings, Antiques, and Other Objects of Art.

Deductions for contributions of paintings, antiques, and other objects of art should be supported by a written appraisal from a qualified and reputable source, unless the deduction is $5,000 or less.

1. Art valued at $20,000 or more. If you claim a deduction of $20,000 or more for donations of art, you must attach a complete copy of the signed appraisal to your return. For individual objects valued at $20,000 or more, a photograph of a size and quality fully showing the object, preferably an 8 x 10 inch color photograph or a color transparency no smaller than 4 x 5 inches, must be provided upon request.

1. Art valued at $50,000 or more. If you donate an item of art that has been appraised at $50,000 or more, you can request a Statement of Value for that item from the IRS. You must request the statement before filing the tax return that reports the donation.

Large quantities. If you contribute a large number of the same item, fair market value is the price at which comparable numbers of the item are being sold.

Example: You purchase 500 Bibles for $1,000. The person who sells them to you says the retail value of these bibles is $3,000. If you contribute the Bibles to a qualified organization, you can claim a deduction only for the price at which similar numbers of the same Bible are currently being sold. Your charitable contribution is $1,000, unless you can show that similar numbers of that Bible were selling at a different price at the time of the contribution.

Contributions Subject to Special Rules

Special rules apply if you contribute:

• Clothing or household items,
• A car, boat, or airplane,
• Taxidermy property,
• Property subject to a debt,
• A partial interest in property,
• A fractional interest in tangible personal property,
• A qualified conservation contribution,
• A future interest in tangible personal property,
• Inventory from your business, or
• A patent or other intellectual property.

These special rules are described here briefly.

Used clothing or household items. You cannot take a deduction for clothing or household items you donate unless the clothing or household items are in good used condition or better. However, there is an exception. You can take a deduction for a contribution of an item of clothing or a household item that is not in good used condition or better if you deduct more than $500 for it and include a qualified appraisal of it with your return.

Car, boat, or airplane. A qualified vehicle is defined as: a car or any motor vehicle manufactured mainly for use on public streets, roads, and highways, a boat, or an airplane. If you donate a qualified vehicle to a qualified organization and you claim a deduction of more than $500, you can deduct the smaller of:

• The gross proceeds from the sale of the vehicle by the organization, or
• The vehicle's fair market value on the date of the contribution. If the vehicle's fair market value was more than your cost or other basis, you may have to reduce the fair market value to figure the deductible amount

Taxidermy property. If you donate taxidermy property to a qualified organization, your deduction is limited to your basis in the property or its fair market value, whichever is less. This applies if you prepared, stuffed, or mounted the property or paid or incurred the cost of preparing, stuffing, or mounting the property.

Your basis for this purpose includes only the cost of preparing, stuffing, and mounting the property. Your basis does not include transportation or travel costs. It also does not include direct or indirect costs for hunting or killing an animal, such as equipment costs. In addition, it does not include the value of your time.

Taxidermy property means any work of art that:

• Is the reproduction or preservation of an animal, in whole or in part,
• Is prepared, stuffed, or mounted to recreate one or more characteristics of the animal, and
• Contains a part of the body of the dead animal.

Property subject to a debt. If you contribute property subject to a debt (such as a mortgage), there are two possible ways your deduction might be reduced. First, special rules require you to reduce your deduction by certain interest payments you make. These rules prevent a double deduction of the same amount as both investment interest and a charitable contribution.

Second, if the debt is assumed by the recipient (or another person), you must reduce the fair market value of the property by the amount of the outstanding debt.

Note: If you sold the property to a qualified organization at a bargain price (discussed later), the amount of the debt is also treated as an amount realized on the sale or exchange of property.

Partial interest in property. Generally, you cannot deduct a charitable contribution (not made by a transfer in trust) of less than your entire interest in property. A contribution of the right to use property is a contribution of less than your entire interest in that property, and is not deductible.

There are important exceptions to this rule. You can deduct a charitable contribution of a partial interest in property if that interest fits one of the following categories:

1. A remainder interest in your personal home or farm. A remainder interest is one that passes to a beneficiary after the end of an earlier interest in the property.

Example: You keep the right to live in your home during your lifetime and give your church a remainder interest that begins upon your death.

2. An undivided part of your entire interest. This must consist of a part of every substantial interest or right you own in the property and must last as long as your interest in the property lasts.

Example: You contribute voting stock to a qualified organization but keep the right to vote the stock. The right to vote is a substantial right in the stock. You have not contributed an undivided part of your entire interest and cannot deduct your contribution.

Where it's an undivided interest in tangible personal property (defined below) the donee must have possession of the property for a part of the year consistent with its interest in the property. Special rules apply for contributions after August 17, 2006 of further undivided interests in the same property by the same donor. And, for contributions after August 17, 2006 of undivided interests in tangible personal property, the deduction is "recaptured" if the donee doesn't get all of the donor's interest in the property by the earlier of 10 years from the first gift or the donor's death.  "Recapture" means the deduction is added back to the donor's income (say, in the 11th year), with interest due from the year of contribution and a tax penalty of 10% of the recaptured income.

3. A partial interest that would be deductible if transferred in trust.

4. A qualified conservation contribution (as specifically defined in the tax law).

Fractional Interest in Tangible Personal Property. A fractional interest in property is an undivided portion of your entire interest in the property. You cannot deduct a charitable contribution of a fractional interest in tangible personal property unless all interests in the property are held immediately before the contribution by you or you and the qualifying organization receiving the contribution.

Qualified Conservation Contribution. A qualified conservation contribution is a contribution of a qualified real property interest to a qualified organization such as a governmental unit or publicly supported charitable, religious, scientific, literary or educational organization that is to be used only for conservation purposes.

The organization also must have a commitment to protect the conservation purposes of the donation and must have the resources to enforce the restrictions. Conservation purposes are defined as:

• Preserving land areas for outdoor recreation by, or for the education of, the general public.
• Protecting a relatively natural habitat of fish, wildlife, or plants, or a similar ecosystem.
• Preserving open space, including farmland and forest land, if it yields a significant public benefit. It must be either for the scenic enjoyment of the general public or under a clearly defined federal, state, or local governmental conservation policy.
• Preserving a historically important land area or a certified historic structure.

If a building in a registered historic district is a certified historic structure, a contribution of a qualified real property interest that is an easement or other restriction on the exterior of the building is deductible only if it meets all of the following three conditions:

Future interest in tangible personal property. You can deduct the value of a charitable contribution of a future interest in tangible personal property only after all intervening interests in and rights to the actual possession or enjoyment of the property have either expired or been turned over to someone other than yourself, a related person, or a related organization.

Related persons include your spouse, children, grandchildren, brothers, sisters, and parents. Related organizations may include a partnership or corporation that you have an interest in, or an estate or trust that you have a connection with.

Tangible personal property. This is any property, other than land or buildings, that can be seen or touched. It includes furniture, books, jewelry, paintings, and cars.

Future interest. This is any interest that is to begin at some future time, regardless of whether it is designated as a future interest under state law.

Example: You own an antique car that you contribute to a museum. You give up ownership, but retain the right to keep the car in your garage with your personal collection. Since you keep an interest in the property, you cannot deduct the contribution. If you turn the car over to the museum in a later year, giving up all rights to its use, possession, and enjoyment, you can take a deduction for the contribution in that later year.

Inventory. If you contribute inventory (property that you sell in the course of your business), the amount you can claim as a contribution deduction is the smaller of its fair market value on the day you contributed it or its basis. The basis of donated inventory is any cost incurred for the inventory in an earlier year that you would otherwise include in your opening inventory for the year of the contribution. You must remove the amount of your contribution deduction from your opening inventory. It is not part of the cost of goods sold.

If the cost of donated inventory is not included in your opening inventory, the inventory's basis is zero and you cannot claim a charitable contribution deduction. Treat the inventory's cost as you would ordinarily treat it under your method of accounting. For example, include the purchase price of inventory bought and donated in the same year in the cost of goods sold for that year.

A special rule applies to donations of food inventory (see Food Inventory below)

Patents and Other Intellectual Property. If you donate a patent or other intellectual property to a qualified organization, your deduction is limited to the basis of the property or the fair market value of the property, whichever is less. After the legal life of the patent or other intellectual property ends, or after the 10th anniversary of the donation, no additional deduction is allowed. Also, additional deductions cannot be taken for patents or other intellectual property donated to certain private foundations. Intellectual property means any of the following:

• Patents.
• Copyrights (other than a copyright described in Internal Revenue Code sections 1221(a)(3) or 1231(b)(1)(C)).
• Trademarks.
• Trade names.
• Trade secrets.
• Know-how.
• Software (other than software described in Internal Revenue Code section 197(e)(3)(A)(i)).
• Other similar property or applications or registrations of such property.

Donating Property That Has Decreased in Value

If you contribute property with a fair market value that is less than your basis in it (generally, less than what you paid for it), your deduction is limited to its fair market value. You cannot claim a deduction for the difference between the property's basis and its fair market value.

Common examples of property that decreases in value include clothing, furniture, appliances, and cars.

Donating Property That Has Increased in Value

If you contribute property with a fair market value that is more than your basis in it, you may have to reduce the fair market value by the amount of appreciation (increase in value) when you figure your deduction.

Again, your basis in property is generally what you paid for it. Different rules apply to figuring your deduction, depending on whether the property is:

1. Ordinary income property, or

2. Capital gain property.

Ordinary Income Property

Property is ordinary income property if its sale at fair market value on the date it was contributed would have resulted in ordinary income or in short-term capital gain. Examples of ordinary income property are inventory, works of art created by the donor, manuscripts prepared by the donor, and capital assets held 1 year or less.

Equipment or other property used in a trade or business is considered ordinary income property to the extent of any gain that would have been treated as ordinary income under the tax law, had the property been sold at its fair market value at the time of contribution.

Amount of deduction. The amount you can deduct for a contribution of ordinary income property is its fair market value less the amount that would be ordinary income or short-term capital gain if you sold the property for its fair market value. Generally, this rule limits the deduction to your basis in the property.

Example: You donate stock that you held for 5 months to your church. The fair market value of the stock on the day you donate it is $1,000, but you paid only $800 (your basis). Because the $200 of appreciation would be short-term capital gain if you sold the stock, your deduction is limited to $800 (fair market value less the appreciation).

Exception. Do not reduce your charitable contribution if you include the ordinary or capital gain income in your gross income in the same year as the contribution.

Capital Gain Property

Property is capital gain property if its sale at fair market value on the date of the contribution would have resulted in long-term capital gain. Capital gain property includes capital assets held more than 1 year.

Capital assets. Capital assets include most items of property that you own and use for personal purposes or investment. Examples of capital assets are stocks, bonds, jewelry, coin or stamp collections, and cars or furniture used for personal purposes.

For purposes of figuring your charitable contribution, capital assets also include certain real property and depreciable property used in your trade or business and, generally, held more than 1 year.

Real property. Real property is land and generally anything that is built on, growing on, or attached to land.

Depreciable property. Depreciable property is property used in business or held for the production of income and for which a depreciation deduction is allowed.

Amount of deduction - general rule. When figuring your deduction for a gift of capital gain property, you usually can use the fair market value of the gift.

However, in certain situations, you must reduce the fair market value by any amount that would have been long-term capital gain if you had sold the property for its fair market value. Generally, this means reducing the fair market value to the property's cost or other basis.

This can happen where the charity's use of tangible personal property is not in connection with its exempt purpose. For contributions after September 1, 2006 of more than $5,000, the deduction is generally reduced to basis if the charity disposes of the property within 3 years of the donation. If disposition takes place after the donation, the appreciation (fair market value less basis) is recaptured as ordinary income in the year of the disposition (absent certification from the charity that use for its exempt purpose occurred or was intended). The charity must notify IRS and the donor of the disposition ( and the certification, if applicable).

Ordinary or capital gain income included in gross income. You do not reduce your charitable contribution if you include the ordinary or capital gain income in your gross income in the same year as the contribution. This may happen when you transfer installment or discount obligations or when you assign income to a charitable organization.

Example: You donate an installment note to a qualified organization. The note has a fair market value of $10,000 and a basis to you of $7,000. As a result of the donation, you have a short-term capital gain of $3,000 ($10,000 - $7,000), which you include in your income for the year. Your charitable contribution is $10,000.

Food Inventory

Special rules apply to certain donations of food inventory to a qualified organization. These rules apply if all of the following conditions are met.

1. You made a contribution of apparently wholesome food from your trade or business. Apparently wholesome food is food intended for human consumption that meets all quality and labeling standards imposed by federal, state, and local laws and regulations even though the food may not be readily marketable due to appearance, age, freshness, grade, size, surplus, or other conditions.
2. The food is to be used only for the care of the ill, the needy, or infants.
3. The use of the food is related to the organization's exempt purpose or function.
4. The organization does not transfer the food for money, other property, or services.
5. You receive a written statement from the organization stating it will comply with requirements (2), (3), and (4).
6. The organization is not a private non-operating foundation.
7. The food satisfies any applicable requirements of the Federal Food, Drug, and Cosmetic Act and regulations on the date of transfer and for the previous 180 days.

Bargain Sales

A bargain sale of property to a qualified organization (a sale or exchange for less than the property's fair market value) is partly a charitable contribution and partly a sale or exchange.

The part of the bargain sale that is a sale or exchange may result in a taxable gain.

Penalty

The IRS may impose a penalty if you overstate the value or adjusted basis of donated property.