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Tax-Free Income (Part 1)

Appeared in the Columbia Daily Tribune on 4/13/19

Tax-Free Income is the best kind. When I mention tax-free income, you may think about municipal bonds. The purpose of this article is to enlighten you to the many types of tax-free income currently available. Here are common types of tax-free income:

1. Muni bonds

2. Life insurance proceeds

3. Nonqualified retirements accounts

4. Charitable Remainder Trusts

5. Per diem deductions

6. Mileage deductions

The US Constitution prohibits all government entities from taxing each other. The federal government is not allowed to tax state or local governments and vice versa. As an incentive to invest in the bonds of your resident state, most states provide an exclusion for residents who purchase those bonds. So, if you purchase a bond issued by the State of Missouri or any taxing authority in Missouri, it will be completely tax-free, not subject to federal, state or local income taxes.

Generally, proceeds from a life insurance policy paid to a beneficiary are tax free. Some people are unaware that life insurance proceeds can be taxed. If you pay for life (or disability) insurance pre-tax through your employer, then the benefit, when paid, would be subject to income tax. If you list your estate as the beneficiary of your file insurance policy, it can be taxed. The best way to ensure that life insurance proceeds avoid taxation is to set up an Irrevocable Life Insurance Trust (ILIT). My common sense suggestion would be to list several contingent beneficiaries in case you outlive your primary beneficiaries.

The nonqualified retirement account with which I am most familiar is the Sect. 7702 plan. Through the specialized design of a life insurance vehicle, it turns after-tax dollars into a tax-free juggernaut. All subsequent withdrawals are tax-free. It can be used to pay for college, fund retirement, even act as your own bank. Instead of going to your credit union for an auto loan, you can borrow from your 7702 Plan by charging the current IRS AFR rate. This often saves more than 50% in interest and you avoid all the meddlesome paperwork like submitting copies of paystubs, tax returns, W-2s, etc.

Section 662 of the Internal Revenue Code describes the requirements of the two types of Charitable Remainder Trusts (CRTs), which are the Charitable Remainder Annuity Trust (CRAT) and the Charitable Remainder Unitrust (CRUT). I will describe the process and the benefit. The grantor (you) forms a CRT, then donates a highly appreciated asset. The gift to the CRT is a nontaxable event. As a charitable entity the CRT records the asset at fair market value and later sells the asset. The potential tax on the long-term capital gain disappears. The funds received from the sale of the asset are invested by the trustee of the CRT and those earnings are reported to the recipient (usually the grantor) who pays tax on the earnings. But, the capital gains tax on the appreciation of the donated asset has been avoided completely. This sounds like tax-free income to me.

Many people, including small-business owners are not familiar with the concept of per diem allowances. For decades, the Government Services Administration (GSA) has developed daily rates for lodging and meals and incidentals (M & I) by location. This seems fair because it costs more to eat a meal in Chicago, IL than it does in Boonville, MO. The same applies to lodging. Just Google “Per Diem” and select the GSA option. You will find the per diem rates for every state and most big cities. If a city is not listed, then you must use the standard rate of $94 per night for lodging and $55 per day for meals and incidentals. There are even published rates for foreign countries. Here is a point of caution. The standard lodging rate cannot be used by self-employed business owners. They can only deduct their actual hotel expenses. However, an employer may pay employees the applicable per diem rate and avoid the time and expense of accounting for numerous small expenditures.

Using Per Diem is a theoretical reimbursement. That is why I have included this as a type of tax-free income. An employer may send a staff member to St. Louis for training and pay them the published combined per diem rate. If that employee has friends for family in St. Louis who are willing to let them crash for a few nights, they could pocket $500 of tax-free money. The employer incurs a deductible business expense and the staff member enjoys tax-free income from the difference between the per diem and what they really spent. 

Every year, the IRS determines and publishes several mileage rates. The business mileage rate for 2019 is 58 cents per mile. You need to keep a timely record of your business travel. There are cell phone apps that can do this. Or, you can do it the old way and keep a pad by your car seat. I have included this in the discussion of tax-free income because many people like me make money when they drive their car for business. I drive a 2001 Benz for which I paid cash a few years ago. With the current gas prices my cost is only $0.125/gallon. Add another few pennies per gallon for insurance and an occasional repair and I have computed that it costs me about twenty cents per mile to drive my car. I make 38 cents per mile in tax-free income when I use my car for business. The key to tax-free income obviously is to keep your actual cost per mile down by driving older, fuel-efficient automobiles.

Aric Schreiner, CPA, PFS, CTP is the Senior Tax Reduction Strategist and founder of Columbia CPA Group, who helps successful professionals and small business owners strategize to reduce taxes while reducing audit risk.


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