Talking the Talk
A Foolproof Primer of Essential but Often Confusing Tax Terms and Definitions
The hardest thing in the world to understand is the income tax.
-Albert Einstein
You don't have to become a CPA to understand tax lingo. (I'm a recovering CPA myself.) But you will need to grasp a few key technical terms in order to get the most out of this book as well as benefit from any other information you may come across on the topic of retirement distribution planning and savings protection.
Rather than give you the standard boring glossary that is usually stuck at the rear of a book, requiring you to constantly flip back and forth between pages, accumulating a lot of paper cuts, I've created a primer right here at the beginning, where it'll be more useful and convenient for you (no Band-Aids required).
Also, instead of going the typically sleepy A-to-Z route, I've livened up the format with a fresher presentation called "What's the Difference Between . . . ?"
My rationale (apart from wanting to educate in an entertaining manner) is this: As you read through this book, there will be times when you will need to know not only what a specific tax term means but also how it differs from another tax term that may appear on the surface to have a similar meaning.
How could such conflicts occur?
The writers of our tax rules-Congress and the IRS-have at times conspired to create a broad panoply of easily recognizable words, which, in tax talk, have completely different meanings than in their common usages.
At other times, these writers just make up words out of convenience, words that cannot possibly be defined with any known form of logic-in our lexicon, anyway. (I know they're made up because they don't appear in any spell-check software I've ever seen.)
Likewise, there are terms that some of you may think you know because they seem familiar-but if you guess wrong, the mistake could cost you a bundle at tax time.
Reading through this section to familiarize yourself with these terms before moving on will not only help you to avoid such potentially expensive misinterpretations but will take much of the mystery out of all that follows in the coming chapters. At first this terminology may feel dense, but you'll get used to it in no time, and going through this section now will make the rest of the book much easier to read.
WHAT'S THE DIFFERENCE BETWEEN . . . ?
Adjusted Gross Income (AGI) vs. Taxable Income
AGI is your gross income before any standard or itemized deductions or tax credits. It's an important term to know because many provisions in the tax code are based on AGI, not taxable income, the income on which you are actually taxed. The best tax-planning moves are strategies that lower AGI and in turn lower your tax bill. One great example is qualified charitable distributions (QCDs), which are charitable donations that get transferred directly from your IRA to the charity, reducing your AGI. Learn more about this tax-saving move in Chapter 4.
After-Tax vs. Pre-Tax Money
Either of these can be a good option, depending on your preference. For example, if you scarf up your vegetables fast to get them out of the way so you can get on with dessert, you're a "pay-me-later" (after-tax money) person. But if you like to put the veggies off until last and start with dessert, you're the "pay-me-now" (pre-tax money) type. For example, money that goes into a Roth IRA or a Roth 401(k) is after-tax money because you had to earn it as ordinary income first and pay tax on it before you could contribute it to the Roth. By contrast, 401(k) contributions are pre-tax money because you received a tax deduction on the portion of your salary you contributed and will pay tax later when the funds are withdrawn. Most money accumulating in tax-deferred retirement accounts is pre-tax funds.
It comes down to this: After-tax money is taxable now; pre-tax money is taxable later. It's important to know the distinction so that you don't get into a situation where you're inadvertently shelling out money for taxes on distributions of what should be tax-free funds. Also, the IRS requires that you and your plan keep track of after-tax and pre-tax funds so that it knows how much is taxable when you begin withdrawals.
Cost vs. Basis
Cost is what you paid for a property, whether a stock, a bond, a mutual fund, or a home. Basis is the amount used for figuring any gain or loss when property is sold. To calculate basis, certain adjustments are added to or subtracted from your cost. Here are some examples:
For a home, the amount you pay for improvements will be added to the home's original purchase price to arrive at an increased basis.
For a stock, any reinvested dividends on which you paid tax in the year they were earned will be added to the purchase price of the stock to arrive at an increased basis.
For, say, equipment used in business, such as a tractor on a farm, any depreciation taken will be subtracted from the purchase price of the tractor to arrive at a decreased basis.
Increasing basis results in a decrease in capital (or ordinary) gains and the tax you'll pay, while decreasing basis results in an increase in capital (or ordinary) gains and the tax you'll pay. You must earn basis. It is earned by spending after-tax dollars. When you invest money on which you have already paid taxes, you create basis. Basis is reduced by any tax deductions you receive. For example, if you contribute $5,000 to a tax-deductible IRA, you do not have basis, because the tax deduction reduced your basis to zero. If, on the other hand, you contribute to a nondeductible IRA or Roth IRA (which is nondeductible by definition), you have created basis.
The basis concept is needed to figure out how much of your IRA distribution will be taxable under the pro-rata rule (see Chapter 3) when you withdraw from an IRA and you have made nondeductible contributions to your IRA, or if your IRA includes after-tax funds rolled over to your IRA from your company plan. After-tax funds and nondeductible IRA contributions are basis in an IRA because they represent funds that have already been taxed. They should not be taxed again upon withdrawal, but to make sure that doesn't happen you must keep track of your IRA basis.
Beneficiary vs. Designated Beneficiary vs.
Eligible Designated Beneficiary
In everyday English, these terms are interchangeable, but in tax language designated beneficiary has special meaning under the retirement distribution rules. And the SECURE Act gave us yet another category of beneficiary that Congress named eligible designated beneficiary or EDB, which is a special type of designated beneficiary that enjoys first-class status, so to speak. While Congress eliminated the stretch IRA for most designated beneficiaries, EDBs still continue to enjoy stretch IRA perks. But to gain EDB status, your beneficiary must first qualify as a designated beneficiary. So, let's first describe what the difference is between a beneficiary and a designated beneficiary.
A designated beneficiary is the beneficiary named on an IRA or company plan beneficiary form, and must be a person-in other words, someone with a pulse and a birthday. If you cannot prove that you have both, you fall into the nonhuman beneficiary category (a beneficiary, but a non-designated beneficiary). One example of an entity that can never become a designated beneficiary is an estate. Another is a trust, but the beneficiaries of trusts can be considered designated beneficiaries if the trust meets certain requirements (see Chapter 10). Here are other entities that can never be designated beneficiaries: charities or any other nonperson in your life, including pets or imaginary friends such as Mr. Snuffleupagus; Calvin's tiger friend, Hobbes; or the Overlook Hotel's ghostly bartender in The Shining; not to mention the characters on the TV show Friends. (My daughter used to think they were real people.) Deceased relatives also fall into the nonperson category because, even though they have birthdays, they lack the second requirement: a pulse.
Good, that's out of the way. Now, here's something else you must know. A beneficiary can be a person who is not a designated beneficiary. Shall I repeat that? Yes, a beneficiary can be a person who is not a designated beneficiary. For example, say you neglect to name a beneficiary on your IRA's beneficiary designation form before you die. After your will goes through probate and your loving but greedy family finally finishes scrounging around beneath the split pi–ata that was once your estate, your son (whom you would have named as beneficiary had you gotten around to filling out the form) winds up inheriting your IRA.
So, what's the difference? Even though your son is a person, he is not a designated beneficiary because he inherited through your estate (the nonperson beneficiary of your account, according to the IRS). Yes, he is deemed a beneficiary and will inherit the IRA funds, but he's a "non-designated beneficiary." On the surface, this may seem like a lot of tortuous nuancing since the outcome in our example is the same either way, right? Not exactly. The distribution rules for a "non-designated beneficiary" and a "designated beneficiary" can result in payout period differences that come with significant tax consequences.
Reaching EDB Status
If your beneficiary is a human (with a pulse) and is named on the beneficiary form, he or she qualifies as a designated beneficiary. Designated beneficiaries fall under two categories: noneligible designated beneficiaries (NEDBs) or eligible designated beneficiaries (EDBs). As explained in detail Step #2: SECURE It (Chapter 6), NEDBs are subject to the 10-year post-death payout rule and therefore cannot use the stretch IRA. EDBs are eligible for the stretch. But first they must (in addition to being named) qualify for this special status through inclusion in one of the five classes established in the SECURE Act. Here is the select club of EDB members who still get the stretch IRA:
Five Classes of Eligible Designated Beneficiaries (EDBs)
1. Surviving spouses
2. Minor children, up to majority (or up to age 26 if still in school)-but not grandchildren
3. Disabled individuals-under strict IRS rules
4. Chronically ill individuals-also under strict IRS rules
5. Individuals not more than 10 years younger than the IRA owner (for example, a sibling, partner, or friend)
The final class of designated beneficiaries considered EDBs includes any designated beneficiaries (including qualifying trusts) who inherited before 2020. These beneficiaries are grandfathered under the pre-2020 stretch IRA rules. In addition, trusts for the sole benefit of these EDBs should qualify as an EDB. EDB status is determined at the date of the owner's (or plan participant's) death and cannot be changed. The only exception is when there is a change in qualifying status, such as when a minor child loses EDB status once he or she reaches majority.
Capital Gains vs. Ordinary Income
Capital gains are what everybody wants, and ordinary income is what most people get. A capital gain results from the sale of what is called a "capital asset," which is generally defined as something you own: stocks, bonds, mutual fund shares, your home. Income from your trade or business, or IRA distributions on the other hand, is defined as "ordinary," which means it gets taxed at a higher rate for many taxpayers. For example, if you are in a 32 percent tax bracket, you would pay 32 percent on ordinary income, whereas a capital gain would be taxed at 15 percent if the property was held more than one year before it was sold. The maximum long-term capital gains rate is currently only 20 percent, and the lowest rate is 0 percent. (That's right, nada.)
3.8 Percent Additional Tax on
Net Investment Income
For many higher-income taxpayers, the maximum long-term capital gains rate may actually be 23.8 percent once you add the extra 3.8 percent tax onto net investment income (investment income minus certain expenses). This extra tax applies when your income (your AGI plus any foreign income excluded from AGI) exceeds $250,000 (married, filing jointly), $200,000 (single), or $125,000 (married, filing separately).
Roth Contribution vs. Roth Conversion
These are two different ways to add money to Roth IRAs. The tax rules that apply here are often confused, so allow me to explain. A Roth contribution refers to the limited annual amount you are permitted to deposit into your Roth IRA. A Roth conversion occurs when you transfer funds into your Roth IRA from an account such as a 401(k) or your IRA. While the government doesn't limit how much you can put in through a conversion, bear in mind that any pre-tax funds you convert will be taxable. Thus, your pain threshold for how big a tax bill you can withstand determines the only limit.
Conversion vs. Recharacterization
What language are we speaking here? This is an example of the IRS stumping spell-check once again by using two words to describe the same thing: the transfer of assets between a traditional IRA and a Roth IRA. Conversions can be accomplished through a rollover or a trustee-to-trustee transfer (see "direct transfer" later in this section). A recharacterization (find that one in any dictionary!) of a Roth conversion is when you transfer converted funds back to an IRA, thereby annulling the conversion (and thus any liability, if the conversion was taxable). But the tax law did away with recharacterizations of Roth conversions completed after 2017. Now Roth conversions are permanent and cannot be undone, but recharacterizations are still available for Roth IRA or traditional IRA contributions. This would occur when an account owner makes a traditional IRA contribution and later wants to change it to a Roth IRA contribution or vice versa.
Deductible IRA vs.
Nondeductible IRA Contributions
A deductible contribution to an IRA is taken as a current tax deduction and becomes taxable only when withdrawn. A nondeductible contribution to an IRA receives no current tax deduction, but also is not taxable when withdrawn. The traditional IRA is an example of an IRA that can be deductible (as long as you don't make too much money while you're active in your company's plan), whereas a Roth IRA is an example of a nondeductible IRA. You never receive a tax deduction for money contributed to a Roth IRA.
Direct Transfer vs. Rollover
A direct transfer (aka direct rollover) is the process of actually moving funds from one retirement account to another. It is also referred to as a trustee-to-trustee transfer, which means that the funds go directly from one bank or brokerage firm to another without you ever touching the money en route. This is my preferred method of moving money because it's not only safe but also tax-free. The IRS prefers you to use it too but for a different reason-they tremble at the thought of your taking the money, failing to redeposit it, and not telling them. With a trustee-to-trustee transfer, the IRS is assured (as are you) that your funds arrived safely at their new destination.
Talking the Talk
A Foolproof Primer of Essential but Often Confusing Tax Terms and Definitions
The hardest thing in the world to understand is the income tax.
-Albert Einstein
You don't have to become a CPA to understand tax lingo. (I'm a recovering CPA myself.) But you will need to grasp a few key technical terms in order to get the most out of this book as well as benefit from any other information you may come across on the topic of retirement distribution planning and savings protection.
Rather than give you the standard boring glossary that is usually stuck at the rear of a book, requiring you to constantly flip back and forth between pages, accumulating a lot of paper cuts, I've created a primer right here at the beginning, where it'll be more useful and convenient for you (no Band-Aids required).
Also, instead of going the typically sleepy A-to-Z route, I've livened up the format with a fresher presentation called "What's the Difference Between . . . ?"
My rationale (apart from wanting to educate in an entertaining manner) is this: As you read through this book, there will be times when you will need to know not only what a specific tax term means but also how it differs from another tax term that may appear on the surface to have a similar meaning.
How could such conflicts occur?
The writers of our tax rules-Congress and the IRS-have at times conspired to create a broad panoply of easily recognizable words, which, in tax talk, have completely different meanings than in their common usages.
At other times, these writers just make up words out of convenience, words that cannot possibly be defined with any known form of logic-in our lexicon, anyway. (I know they're made up because they don't appear in any spell-check software I've ever seen.)
Likewise, there are terms that some of you may think you know because they seem familiar-but if you guess wrong, the mistake could cost you a bundle at tax time.
Reading through this section to familiarize yourself with these terms before moving on will not only help you to avoid such potentially expensive misinterpretations but will take much of the mystery out of all that follows in the coming chapters. At first this terminology may feel dense, but you'll get used to it in no time, and going through this section now will make the rest of the book much easier to read.
WHAT'S THE DIFFERENCE BETWEEN . . . ?
Adjusted Gross Income (AGI) vs. Taxable Income
AGI is your gross income before any standard or itemized deductions or tax credits. It's an important term to know because many provisions in the tax code are based on AGI, not taxable income, the income on which you are actually taxed. The best tax-planning moves are strategies that lower AGI and in turn lower your tax bill. One great example is qualified charitable distributions (QCDs), which are charitable donations that get transferred directly from your IRA to the charity, reducing your AGI. Learn more about this tax-saving move in Chapter 4.
After-Tax vs. Pre-Tax Money
Either of these can be a good option, depending on your preference. For example, if you scarf up your vegetables fast to get them out of the way so you can get on with dessert, you're a "pay-me-later" (after-tax money) person. But if you like to put the veggies off until last and start with dessert, you're the "pay-me-now" (pre-tax money) type. For example, money that goes into a Roth IRA or a Roth 401(k) is after-tax money because you had to earn it as ordinary income first and pay tax on it before you could contribute it to the Roth. By contrast, 401(k) contributions are pre-tax money because you received a tax deduction on the portion of your salary you contributed and will pay tax later when the funds are withdrawn. Most money accumulating in tax-deferred retirement accounts is pre-tax funds.
It comes down to this: After-tax money is taxable now; pre-tax money is taxable later. It's important to know the distinction so that you don't get into a situation where you're inadvertently shelling out money for taxes on distributions of what should be tax-free funds. Also, the IRS requires that you and your plan keep track of after-tax and pre-tax funds so that it knows how much is taxable when you begin withdrawals.
Cost vs. Basis
Cost is what you paid for a property, whether a stock, a bond, a mutual fund, or a home. Basis is the amount used for figuring any gain or loss when property is sold. To calculate basis, certain adjustments are added to or subtracted from your cost. Here are some examples:
For a home, the amount you pay for improvements will be added to the home's original purchase price to arrive at an increased basis.
For a stock, any reinvested dividends on which you paid tax in the year they were earned will be added to the purchase price of the stock to arrive at an increased basis.
For, say, equipment used in business, such as a tractor on a farm, any depreciation taken will be subtracted from the purchase price of the tractor to arrive at a decreased basis.
Increasing basis results in a decrease in capital (or ordinary) gains and the tax you'll pay, while decreasing basis results in an increase in capital (or ordinary) gains and the tax you'll pay. You must earn basis. It is earned by spending after-tax dollars. When you invest money on which you have already paid taxes, you create basis. Basis is reduced by any tax deductions you receive. For example, if you contribute $5,000 to a tax-deductible IRA, you do not have basis, because the tax deduction reduced your basis to zero. If, on the other hand, you contribute to a nondeductible IRA or Roth IRA (which is nondeductible by definition), you have created basis.
The basis concept is needed to figure out how much of your IRA distribution will be taxable under the pro-rata rule (see Chapter 3) when you withdraw from an IRA and you have made nondeductible contributions to your IRA, or if your IRA includes after-tax funds rolled over to your IRA from your company plan. After-tax funds and nondeductible IRA contributions are basis in an IRA because they represent funds that have already been taxed. They should not be taxed again upon withdrawal, but to make sure that doesn't happen you must keep track of your IRA basis.
Beneficiary vs. Designated Beneficiary vs.
Eligible Designated Beneficiary
In everyday English, these terms are interchangeable, but in tax language designated beneficiary has special meaning under the retirement distribution rules. And the SECURE Act gave us yet another category of beneficiary that Congress named eligible designated beneficiary or EDB, which is a special type of designated beneficiary that enjoys first-class status, so to speak. While Congress eliminated the stretch IRA for most designated beneficiaries, EDBs still continue to enjoy stretch IRA perks. But to gain EDB status, your beneficiary must first qualify as a designated beneficiary. So, let's first describe what the difference is between a beneficiary and a designated beneficiary.
A designated beneficiary is the beneficiary named on an IRA or company plan beneficiary form, and must be a person-in other words, someone with a pulse and a birthday. If you cannot prove that you have both, you fall into the nonhuman beneficiary category (a beneficiary, but a non-designated beneficiary). One example of an entity that can never become a designated beneficiary is an estate. Another is a trust, but the beneficiaries of trusts can be considered designated beneficiaries if the trust meets certain requirements (see Chapter 10). Here are other entities that can never be designated beneficiaries: charities or any other nonperson in your life, including pets or imaginary friends such as Mr. Snuffleupagus; Calvin's tiger friend, Hobbes; or the Overlook Hotel's ghostly bartender in The Shining; not to mention the characters on the TV show Friends. (My daughter used to think they were real people.) Deceased relatives also fall into the nonperson category because, even though they have birthdays, they lack the second requirement: a pulse.
Good, that's out of the way. Now, here's something else you must know. A beneficiary can be a person who is not a designated beneficiary. Shall I repeat that? Yes, a beneficiary can be a person who is not a designated beneficiary. For example, say you neglect to name a beneficiary on your IRA's beneficiary designation form before you die. After your will goes through probate and your loving but greedy family finally finishes scrounging around beneath the split pi–ata that was once your estate, your son (whom you would have named as beneficiary had you gotten around to filling out the form) winds up inheriting your IRA.
So, what's the difference? Even though your son is a person, he is not a designated beneficiary because he inherited through your estate (the nonperson beneficiary of your account, according to the IRS). Yes, he is deemed a beneficiary and will inherit the IRA funds, but he's a "non-designated beneficiary." On the surface, this may seem like a lot of tortuous nuancing since the outcome in our example is the same either way, right? Not exactly. The distribution rules for a "non-designated beneficiary" and a "designated beneficiary" can result in payout period differences that come with significant tax consequences.
Reaching EDB Status
If your beneficiary is a human (with a pulse) and is named on the beneficiary form, he or she qualifies as a designated beneficiary. Designated beneficiaries fall under two categories: noneligible designated beneficiaries (NEDBs) or eligible designated beneficiaries (EDBs). As explained in detail Step #2: SECURE It (Chapter 6), NEDBs are subject to the 10-year post-death payout rule and therefore cannot use the stretch IRA. EDBs are eligible for the stretch. But first they must (in addition to being named) qualify for this special status through inclusion in one of the five classes established in the SECURE Act. Here is the select club of EDB members who still get the stretch IRA:
Five Classes of Eligible Designated Beneficiaries (EDBs)
1. Surviving spouses
2. Minor children, up to majority (or up to age 26 if still in school)-but not grandchildren
3. Disabled individuals-under strict IRS rules
4. Chronically ill individuals-also under strict IRS rules
5. Individuals not more than 10 years younger than the IRA owner (for example, a sibling, partner, or friend)
The final class of designated beneficiaries considered EDBs includes any designated beneficiaries (including qualifying trusts) who inherited before 2020. These beneficiaries are grandfathered under the pre-2020 stretch IRA rules. In addition, trusts for the sole benefit of these EDBs should qualify as an EDB. EDB status is determined at the date of the owner's (or plan participant's) death and cannot be changed. The only exception is when there is a change in qualifying status, such as when a minor child loses EDB status once he or she reaches majority.
Capital Gains vs. Ordinary Income
Capital gains are what everybody wants, and ordinary income is what most people get. A capital gain results from the sale of what is called a "capital asset," which is generally defined as something you own: stocks, bonds, mutual fund shares, your home. Income from your trade or business, or IRA distributions on the other hand, is defined as "ordinary," which means it gets taxed at a higher rate for many taxpayers. For example, if you are in a 32 percent tax bracket, you would pay 32 percent on ordinary income, whereas a capital gain would be taxed at 15 percent if the property was held more than one year before it was sold. The maximum long-term capital gains rate is currently only 20 percent, and the lowest rate is 0 percent. (That's right, nada.)
3.8 Percent Additional Tax on
Net Investment Income
For many higher-income taxpayers, the maximum long-term capital gains rate may actually be 23.8 percent once you add the extra 3.8 percent tax onto net investment income (investment income minus certain expenses). This extra tax applies when your income (your AGI plus any foreign income excluded from AGI) exceeds $250,000 (married, filing jointly), $200,000 (single), or $125,000 (married, filing separately).
Roth Contribution vs. Roth Conversion
These are two different ways to add money to Roth IRAs. The tax rules that apply here are often confused, so allow me to explain. A Roth contribution refers to the limited annual amount you are permitted to deposit into your Roth IRA. A Roth conversion occurs when you transfer funds into your Roth IRA from an account such as a 401(k) or your IRA. While the government doesn't limit how much you can put in through a conversion, bear in mind that any pre-tax funds you convert will be taxable. Thus, your pain threshold for how big a tax bill you can withstand determines the only limit.
Conversion vs. Recharacterization
What language are we speaking here? This is an example of the IRS stumping spell-check once again by using two words to describe the same thing: the transfer of assets between a traditional IRA and a Roth IRA. Conversions can be accomplished through a rollover or a trustee-to-trustee transfer (see "direct transfer" later in this section). A recharacterization (find that one in any dictionary!) of a Roth conversion is when you transfer converted funds back to an IRA, thereby annulling the conversion (and thus any liability, if the conversion was taxable). But the tax law did away with recharacterizations of Roth conversions completed after 2017. Now Roth conversions are permanent and cannot be undone, but recharacterizations are still available for Roth IRA or traditional IRA contributions. This would occur when an account owner makes a traditional IRA contribution and later wants to change it to a Roth IRA contribution or vice versa.
Deductible IRA vs.
Nondeductible IRA Contributions
A deductible contribution to an IRA is taken as a current tax deduction and becomes taxable only when withdrawn. A nondeductible contribution to an IRA receives no current tax deduction, but also is not taxable when withdrawn. The traditional IRA is an example of an IRA that can be deductible (as long as you don't make too much money while you're active in your company's plan), whereas a Roth IRA is an example of a nondeductible IRA. You never receive a tax deduction for money contributed to a Roth IRA.
Direct Transfer vs. Rollover
A direct transfer (aka direct rollover) is the process of actually moving funds from one retirement account to another. It is also referred to as a trustee-to-trustee transfer, which means that the funds go directly from one bank or brokerage firm to another without you ever touching the money en route. This is my preferred method of moving money because it's not only safe but also tax-free. The IRS prefers you to use it too but for a different reason-they tremble at the thought of your taking the money, failing to redeposit it, and not telling them. With a trustee-to-trustee transfer, the IRS is assured (as are you) that your funds arrived safely at their new destination.
