Gross Income, Part 2, Module 2 of 5

Module 2: Gross Income, Part 2

            After introducing the concept of gross income and its significance and going through a variety of examples of gross income in Module one, we will now continue by discussing the rules of various other types of income.

Annuities, Pensions and Social Security

An annuity is a contract (which can take the form of an annuity contract, endowment contract or life insurance contract, among others) that provides for payments made at regular intervals (usually monthly, quarterly, semi-annually or annually) to the owner (“annuitant”) and/or a named beneficiary.[1] Annuities can take many forms. For example, an annuity may last for a fixed number of years or until the death of a single person or the last death of multiple people (such as husband and wife). The amounts of the payments may be fixed or variable and may or may not vary based on interest rates, cost of living adjustments and the performance of the portfolio in which the annuity funds are invested.

There are several types of annuities.[2] A “fixed period” annuity pays the annuitant a fixed monetary amount at a regular interval for a defined period of time. A “variable period” annuity pays the annuitant for a contingent period of time, such as for the annuitant’s life. A “single life” annuity pays a fixed monetary amount at a stated interval for the life of the annuitant ending on the annuitant’s date of death, while a “joint and survivor” annuity pays a fixed amount at regular intervals to the first annuitant for his or her lifetime. After the first annuitant dies, a second annuitant receives a fixed amount at regular intervals until death. The second annuitant may receive the same amount or a different amount than that paid to the first annuitant. A “qualified pension plan annuity” pays a fixed amount at regular intervals.  It must meet specific IRC requirements and be approved by the IRS. A “tax-sheltered” annuity is purchased by a public school or other tax-exempt organization for the employees of the organization.  It pays a fixed amount at regular intervals.

For annuity contracts purchased by the taxpayer, the amounts received from annuity contract payments must be divided into the shares of the payments that represent the return of the principal (called the “investment in the contract”) and the shares of the payments that represent interest. The interest is taxable income, while the return of principal is not. To calculate these percentages, one must figure out the amount of interest that will be paid under the annuity contract as a whole as a percentage of all of the payments that will be made under the contract.

For example, assume the taxpayer purchases an annuity contract for $10,000. The contract pays out $1,233.38 per year over the course of the next 10 years, for an effective interest rate of 5%. The total payments on the annuity contract will therefore amount to about $12,333. Of this, $10,000 is return of the principal and the remaining $2,333 is interest. Each year, therefore, of the roughly $1,233 the taxpayer receives, $1,000 constitutes return of principal, which is not taxed. The other $233 is taxable interest.[3]

For annuity contracts purchased by employers as part of qualified retirement plans, the rules are slightly different. Keep in mind that qualified retirement plans are generally funded with pre-tax money. Thus, the full amount of annuity payments received from a qualified retirement plan is generally included in the recipient’s gross income. However, if the contributor funded the retirement plan with any post-tax money (for example, if he made contributions beyond the maximum tax-deductible contributions allowed in a given year), then the return of that principle is not taxed. Moreover, many qualified retirement plans impose a 10% penalty for distributions made prior to age 59 ½, with certain exceptions.[4] In another course, will focus more on qualified retirement accounts and their rules.

Pensions and retirement benefits paid by a state government, the federal government or by private businesses are generally taxed as gross income. However, as with annuities, the portion of the pension benefit that represents return of contributions to the pension made with “after tax” dollars is not taxable.[5]

Social security benefits are taxed in a more complex manner. The general rule is that while social security income is subject to income tax, only part of the benefit is taxable. Social security includes monthly retirement benefits, survivor and disability benefits received from the Social Security Administration and survivor and disability benefits received as a tier 1 railroad retirement benefit.[6]             

For single taxpayers, if the taxpayer’s gross income is between $25,000 and $34,000, 50% of the social security income is subject to federal income tax. If the income (including the untaxed social security benefits) exceeds $34,000, 85% is taxable. For married taxpayers filing a joint return, the 50% rule applied to income between $34,000 and $44,000 and the 85% to income above $44,000.[7]

IRA Disbursements

Since contributions to a traditional IRA are deductible from gross income,[8] amounts distributed from the IRA are taxable income.[9] In addition, there is a 10% penalty if disbursements are made before the owner attains age 59 ½.

While the account holder need not start taking distributions immediately at age 59 ½, the tax code requires the account holder to start taking (taxable) “required minimum distributions” starting no later than April 1 of the year in which the IRA owner attained age 70 ½. This is called the “required beginning date.”

The amount of the annual required minimum distributions depends on the age (and, thus, life expectancy) and marital status of the account holder. If the owner of the IRA is unmarried, the owner must begin receiving required minimum distributions based on life expectancy tables provided by the IRS.[10] The required minimum distribution is the percentage of the account that is one divided by the remaining actuarial life expectancy of the account holder.

For example, assume Mary was born June 1, 1950 and so she attains 70 ½ years in 2020. She must begin receiving disbursements from her IRA by April 1, 2021. Assume her IRA account balance on December 30, 2020 was $50,000. Based on Table III in Appendix B of IRS Publication 590-B,[11] the life expectancy for someone her age is 26.5 years. Her required minimum distribution is $50,000 divided by 26.5, or $1,887. This amount must be distributed to her by April 1, 2021. On April 1, 2022, she is now 72 years old, making her life expectancy 24.7 years. Her minimum required distribution for that year is 1 divided by 24.7 times whatever the balance of the account is at that time.

When the IRA is payable over the joint lives of a husband and wife, the required minimum disbursement is based on their joint lives, the distribution periods for which are published as Table 2 of the same IRS document.[12]

For example, assume Mary was born June 1, 1950 and so attains 70 ½ years in 2020. Her husband, Sam, is 15 years younger than she and so is only 55 in 2020. The IRS provides a table that lists the distribution period based on their joint lives. Mary’s IRA account balance on December 30, 2020 was $50,000. Based on Table II in Appendix B of IRS Publication 590-B, the distribution period for a joint IRA for Mary (age 72) and Sam (age 56) is 30.0 years. Her required minimum distribution is $50,000 divided by 30.0, or $1,667. This is the amount distributed to her on April 1, 2021, her required beginning date.

Distributions from “Roth” IRAs, on the other hand, are not subject to income tax.  This is because contributions to Roth IRAs are not deductible and so are made with “after tax” dollars. The tax-free distributions from the Roth-IRA, which apply to both the contributions and all growth on the contributions, is what makes this one of the best tax planning retirement tools. There is no “required minimum distribution” from a Roth IRA and so no mandatory age when payments must begin.[13]

There is a 10% penalty if disbursements are made before the owner attains age 59 ½, with certain exceptions (most of which apply to the traditional IRA as well). However, withdrawals can be made from Roth IRA accounts before that age up to the total amount of the contributions.

            Almost all types of qualified retirement plans, including traditional and Roth IRAs, have limitations on contributions and many have income limitations on who can participate in these devices. The traditional and Roth IRAs are limited to annual contributions of $6,000 (total, between the two types of IRAs) per person per calendar year. If the owner is over 50 years old, the Code allows for a an additional “catch up” contribution of $1,000 per year to make up for years the full contribution limit was not met.

Roth-IRAs are subject to the following income limits. For 2019, an individual taxpayer can only contribute to a Roth IRA if that person earns less than $137,000 in modified adjusted gross income. Married taxpayers filing joint tax returns can contribute to a Roth IRA if they earn less than $203,000 of joint modified gross income.[14] 

There are no income limits for contributions to traditional IRAs. However, there are income limits for those who wish to take tax deductions for the contributions. Those income limits are similar to those of the Roth IRA. People who earn too much to contribute tax-free dollars to the traditional IRA can contribute post-tax dollars. This, at least, allows the money to grow tax-free until the monies are eventually withdrawn. Moreover, withdrawals up to the amount of post-tax contributions can be withdrawn tax-free.[15]

Miscellaneous Taxable Income

In the landmark decision of United States v. Kirby Lumber,[16] the Supreme Court ruled that debt that is cancelled or forgiven is taxable as income.  This decision has been codified in the Internal Revenue Code.[17] Thus, when a taxpayer settles a debt by paying less than its full value (such as, for example, an agreement with the bank to settle credit card debt by paying less than what is owed), the difference between the full value of the debt and the amount paid to satisfy the debt is taxable income to the taxpayer.  

Government entities, banks and other entities engaged in the business of lending money are required to report to the IRS cancelled debt worth $600 or more.[18]

A partnership does not pay federal income tax. The income and deductions are “passed through” to the partners based on their percentage ownership in the partnership.[19] The partnership files an informational return with the IRS (Form 1065). The return includes a Schedule K-1 for each partner that lists the “distributive share” of the taxable income and deductions allocated to each partner based on that partner’s percentage of ownership in the partnership.[20] The amounts listed on each partner’s Schedule K-1[21] must be listed on the partner’s personal federal income tax return.

The income a deceased taxpayer would have received had the taxpayer not died is “income in respect of a decedent” and is taxable income to whoever does receive it. This includes unpaid salary, wages, deferred compensation, commissions, stock options, vacation pay, sick pay, accrued interest and dividends, uncollected rent, accounts receivable owed to the decedent and sale proceeds from the sale of property that occurred before death, but the proceeds were not collected until after death.[22]

Taxpayers who typically report income in respect of a decedent may include the decedent’s estate, which itself becomes a taxable entity, or the decedent’s beneficiaries, if the assets have already been allocated and distributed.

A decedent’s estate and an irrevocable trust are considered their own independent taxpayers for federal income tax purposes. Estates and trusts receive the same types of taxable income as individuals and corporations and are required to file  federal income tax returns in years in which they earn at least $600 in gross income.[23] They file their own income tax returns (Form 1041) and pay their own income taxes on money that they retained. They can deduct any amounts of income that were distributed to beneficiaries, in which case they distribute schedule K-1s to the beneficiaries and the beneficiaries are then taxed on that income.

For example, assume an estate had interest income of $2,000 for a taxable year. The estate distributes $500 each to beneficiaries A, B, and C. The estate must distribute schedule K-1’s to A, B and C, who will then each report $500 of income. The remaining $500 is subject to income tax of the estate, though, since it’s under the $600 exemption, the estate will not pay income tax.

Constructive Receipt of Income

The constructive income rule mandates that taxpayers “realize” income- even though it has not been physically received- when the taxpayer controls or can use the funds or property or is guaranteed to be able to access it in the future.[24] For example, income is “constructively received” when it is added to the taxpayer’s bank account or made available for withdrawal or when the taxpayer is notified that she can withdraw the funds at any time.[25] 

For example, if an employee receives a paycheck on December 15 but does not cash or deposit it until January, that paycheck is still taxed to the employee as income of the first year because it could have been cashed or deposited in December.

There is no constructive receipt when the taxpayer’s receipt is restricted or subject to substantial risk of forfeiture[26]. Property is subject to a substantial risk of forfeiture if the receipt is contingent on a future event.[27] For example, an employee’s year-end bonus would not be considered constructively received if it is contingent on certain revenue goals being accomplished, when those goals won’t be measured until January.

Note that life insurance premiums paid by the employer are taxable to the employee when the employee has the right to transfer ownership of the life insurance or when the ownership of the policy is not subject to the performance of future services.

Nontaxable Income

Gross income is taxable unless excluded by a section of the Internal Revenue Code. Sections 101 through 140 list items that are excluded from gross income. Let’s look at some of the most important of these.

Section 101 excludes from gross income proceeds of life insurance contracts that are paid upon death. To qualify, the recipient must have an “insurable interest” in the life of the deceased person, which typically means a close familial or business relationship. If, for example, an investor purchases a life insurance policy on an unrelated person, the death benefits are taxable to the extent that they exceed the investor’s purchase price because the investor doesn’t have an insurable interest in the deceased person.

Section 102 exempts gifts and inheritances from income tax,[28] though they may be subject to gift or estate taxes under other sections of the Code. Gifts given by employers to employees are considered taxable even if they are nominally called gifts, a rule that prevents disguising wages or benefits as gifts to avoid income tax.[29]

Other common items of income excluded from taxable gross income include:

-       compensation for injuries or sickness, usually won in lawsuits or settlements[30]

-       payments received under accident or health insurance plans; [31]

-       contributions by employers to accident or health insurance plans;[32]

-       the rental value of a parsonage in which a clergy member lives, even though it is part of the compensation for his services as clergy; [33]

-       a discharge of debt that occurs as part of a bankruptcy case that occurs when the taxpayer is insolvent or in certain other cases. This constitutes an exception to the general rule we discussed earlier that debt discharge is generally considered taxable income; [34] and

-       tuition scholarships or fellowship grants that reduce tuition at qualified schools. [35]

In our next module, we will turn to deductions, by looking at income tax deductions that are available to individual taxpayers.