Essential but Confusing Tax Terms and Definitions

Excerpted from
The Retirement Savings Time Bomb: How to Defuse It
By Ed Slott

You don't have to become a CPA to understand tax lingo (Pm 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 any other information you may come across on the topic of retirement distribution planning and savings protection.

Rather than do the standard type of 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 along the way, I've created a primer right here at the beginning, where it'll be more useful and convenient for you (and require no Band-Aids).

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 not only will help you to avoid such potentially expensive misinterpretations but will take much of the mystery out of all that follows in the coming chapters.

Adjusted Gross Income (AGI) vs. Taxable Income

AGI is your gross income before any exemptions, deductions, or tax credits. It's an important term to know because many provisions in the tax code are based on AGI, not the income on which you are actually taxed.

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 to 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 tax money you've already paid. Also, the IRS requires you and your plan to keep track of after-tax and pre-tax funds so that it knows how much is taxable when you begin withdrawals.

Basis vs. Cost

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 that you have already paid tax on, 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. When the dust settles, and you completely distribute your IRAs, if you do not recover your basis you may have a deductible loss.

The basis concept is needed to figure out how much of your IRA distribution will be taxable under the pro rate rule (see Chapter 3) when you withdraw from an IRA and you have made nondeductible contributions to your IRA or 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 will not be taxed again upon withdrawal, but to make sure that happens you must keep track of your IRA basis. Beneficiary vs. Designated Beneficiary

Beneficiary vs. Designated Beneficiary

In everyday English these two terms are interchangeable, but in tax language designated beneficiary has special meaning under the retirement distribution rules. It's the named beneficiary 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 or "other" column suitable only for "beneficiary" status-for example, a trust (although beneficiaries of trusts can also be designated beneficiaries if the trust meets certain requirements; see Chapter 8), an estate, a charity, or any other nonperson in your life, including pets, imaginary friends such as Peter Pan, Spiderman, Darth Vader, and all the characters on the TV show Friends (my daughter thinks they are 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 do not name a beneficiary for your IRA on the IRA beneficiary designation form before you die. But after your will is probated, and the loving but greedy family is finally through slugging it out, your son (whom you would have named as beneficiary if you'd gotten around to filling out the form) winds up inheriting your IRA anyway.

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); he is instead a "beneficiary." On the surface, this may seem like a lot of tortuous nuancing since the outcome in our example is the same either way. But the distribution rules for a "beneficiary" and a "designated beneficiary" can be different, and there may be significant tax consequences, depending upon which you have.

Capital Gain 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 anything 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 35 percent tax bracket, you would pay 35 percent on ordinary income, whereas a capital gain would be taxed at a maximum of 15 percent if the property was held more than one year before it was sold.

Conversion vs. Recharacterization

What language are we speaking here? This is an example of the IRS using two words to describe the same thing-the transfer of assets to and/or from a traditional IRA and a Roth IRA-and stumping spell check once again. In IRS jive, a conversion is not when you undergo a spiritual change but when you transfer funds from a traditional IRA to a Roth IRA. A recharacterization is when you transfer funds back to where they originally came from, thereby annulling the conversion (and thus any liability if it was a taxable conversion). Conversions can be accomplished through a rollover or a trustee-to-trustee transfer; a recharacterization can only be accomplished via a trustee-to-trustee transfer.

Deductible IRA vs. Nondeductible IRA

A contribution to a deductible IRA can be taken as a current tax deduction, and becomes taxable only when withdrawn. A contribution to a nondeductible 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.