Penny Wise, Dollar Foolish
Imagine realizing that as you bent over to pick up a quarter, you’d dropped and lost your full wallet in the process. Rabbi Leib Porush felt this way when he learned that he’d lost a $6000 Earned Income Tax Credit (EITC) because he’d earned too much investment income last year. Reb Leib counted on his tax credit (refund) to cover Pesach expenses, and it would be hard to get by without this annual “bonus”. Adding salt to this financial wound was the knowledge that he had caused the damage himself. Though the Porush family had $40,000 invested in mutual funds, Leib could not see how or why this would disqualify him. In fact, in prior years these investments had never been a problem, so why now? More importantly, what could he do to avoid losing his EITC next year?
EITC Explained
The EITC is the unique government program which political conservatives and liberals both support. What is different about the EITC? Most social programs pay the highest aid amounts at incomes of zero and lower grants as income rises until benefits are cut off entirely, often abruptly. This structure of drastically reducing programs as earnings go up creates “welfare cliff” scenarios, where a welfare recipient’s raise in salary makes them worse off. Poor people obviously dislike and can’t afford such “raises” and therefore may remain on the dole permanently to everyone’s detriment. The EITC however, requires recipients to work, and the credited amount initially goes up as they earn higher salaries. This arrangement helps people move up the employment ladder and improve their financial lives. The EITC is also phased out gradually which enables people to work toward self-sufficiency, the ultimate goal of government assistance.
Although the EITC is shrewdly designed, it also includes a steep cliff for excessive “unearned income”. Unearned income is profit gained from savings and investments such as interest, rental payments, dividends and capital (investment) gains. Regardless of the value of someone’s savings and investments, if they bring in even a dollar more than $3,500 in a tax year than the entire EITC is forfeit. The Government assumes that anyone with profitable investments isn’t needy enough to qualify for this assistance. While the Porush’s modest portfolio had risen for years, it had kicked off little income, and their gains had been just on paper. But Leib had recently sold off some mutual funds to lock in years of impressive gains. By selling, and thereby formalizing his investment profits, he had reached the $3,500 “unearned income” limit and lost his EITC for that year.
A Few Easy Solutions
Leib really did shoot himself in the foot because whatever he hoped to gain by investing was lost to tax error and then some. His loss was also unnecessary because with a bit of financial planning he could have invested the funds and also kept the EITC. One option would have been for Leib to use the $40,000 to pay down his mortgage where his investment returns are the savings in interest payments. Lowering his interest bill is not considered income, and although the investment “return” is not very high, unlike mutual fund investments, they are guaranteed and tax-free. Alternatively, he could have kept the funds invested via retirement accounts and college savings plans which are tax deferred and not counted toward current income. Finally balanced mutual funds would have kept his stock investments in a reasonable ratio, avoiding the need to sell and lock in his gains. Going forward to avoid additional unearned income, these ideas should be considered. But what could he do with the funds which he still owns which have capital gains? He doesn’t want to risk losing the EITC again.
Kiddie Trust?
Another tax efficient way for the Porush family to invest their money without jeopardizing their EITC is to use minor custodial accounts. Within these accounts, each child can earn over $2,000 tax-free and without risking their parents EITC. Since they plan on using these saving for their kids’ weddings anyways, Leib can gift the investments to his children now and grow them with excellent tax efficiency. The catch here is that the transfer to his kids is permanent and Leib will become a custodian of the funds rather than an owner. Money invested in minor trust accounts funds have to be used to benefit the child, although the custodian broad discretion to decide what is beneficial. At age 18, the child takes legal control of the accounts to be used as they see fit. This also can turn into a negative arrangement when it comes time for college scholarships. As long as the Porush’s are comfortable with this arrangement and will seek help closer to college application time, custodial accounts may be a very effective way to maximize family’s earnings without jeopardizing government benefits.
Lesson Learned
Whatever he does, he also needs to use this $6,000 loss as an expensive lesson: “What you don’t know can hurt you, ” and Leib needs to get better educated financially. Even now that he is aware of the EITC rules, the fixes he uses to lower his unearned income (selling out, switching mutual funds or gifting to his kids) can themselves cause unearned income if not done properly, losing him another year $6,000. Leib should consider spending more time getting the guidance of his accountant and financial advisors. The cost of those consultations will usually be money well spent. Reading a few books on basic personal finances over Bain Hazemanim is probably a good idea too.