Getting Personal
Taxes Archives
The AMT
Question: Hi folks, We were just sitting here listening to Chris Farrell say that the AMT should be eliminated. We agree that changes need to be made to this tax, but don't understand why it should be totally eliminated. The problem it was originally designed to solve probably still exists. Chris said the reason the situation is bad now is because it was not indexed to inflation. So why not just make the change so that the income levels affected are in line with those originally targeted? Obviously, there would still need to be another source of revenue for the government. But why do away with it completely? Paul and Carol, Joelton, Tennessee
Answer: It's a good question. Now, I'm in the camp that believes the AMT or Alternative Minimum Tax came about for a good reason: Evidence in the late 1960s that some of the nation's wealthiest families weren't paying any tax thanks to shelters and deductions. I don't think it was good tax policy or public policy that these wealthy families escaped Uncle Sam's tax bill. And I certainly don't like it that once again Congress and the White House have just agreed on another "patch" to limit the reach of the AMT into the middle class rather than get rid of it through fundamental tax reform.
Anyway, why not just restore the AMT to its original purpose? The reason is that I am increasingly skeptical of targeted income taxes. The current tax system is an abomination. The federal income tax code is a legal maze riddled with exemptions, exclusions, deductions, credits, phase-ins and phase-outs--as well as the AMT. Taken altogether, billions of dollars are spent on accountants and lawyers every year. Billions of hours are spent struggling to fill out forms. Tax economist Joel Slemrod at the University of Michigan has estimated that it costs taxpayers some $100 billion a year to complete their returns. That's no chump change, even in a $14 trillion economy.
Instead of redesigning or overhauling the AMT, I favor radical tax simplification. The basic idea is simple: Lower marginal tax rates by broadening the tax base by limiting exemptions, deductions, and credits. For instance, economists have designed an income tax system that eliminates every loophole except for charitable giving and a home mortgage credit (as opposed to the current home mortgage deduction).
A White House appointed blue chip panel proposed a radically streamlined tax system several years ago; sadly, not enough attention was paid to its recommendation. A simpler, progressive tax code with lower rates would benefit all taxpayers and also ensure that the nation's wealthiest families pay taxes.
Trading Stocks and Taxes
Question: I'm a weekly listener via podcasts and thank you for all the good advice. So the question: My co-worker mentioned that I could trade my stocks in an IRA and not have to pay capital gains taxes with this type of account. Currently, I trade within a taxable account so my gains are taxed. Is there any drawbacks with trading stocks within an IRA and what is the best way to learn about the process. Thanks a bunch! David
Question: Your co-worker is right. You don't pay any capital gains taxes on trades within an IRA. If it is a traditional Individual Retirement Account, you will pay ordinary income taxes on the money when you withdraw it during your Golden Years.
Here's the main drawback to trading stocks in an IRA. When it comes to saving for the long haul there's no evidence that all that trading activity will line your pockets. There is abundant evidence that a disciplined, long-term approach with minimal trading and low fees will increase the odds that you'll reach your long-run financial goals. So, my response is restrain your trading impulses in an IRA--it's a hazardous habit for long-term wealth accumulation.
That said, I don't want to be a spoilsport. Picking stocks is fun. You get to match wits in the most competitive market in the world. But I think the tax code encourages you to do trades in a taxable account. Here's why: Let's say you make some unprofitable trades. The market goes against you. Uncle Sam limits your losses through the tax code. Now, let's say you have made some smart moves and share prices have moved up. You still get to decide when to trigger the capital gains tax rate. You could sell tomorrow--or 30 years from now. That's a powerful tax shelter. (There are a few complicated exceptions where you can take a tax loss on an investment in an IRA, but they're the exception, not the rule.)
One more point: Bill Gross, the investment guru and founder of the mutual fund giant Pimco, once suggested that investors play with no more than 10% of their portfolio. He reasoned that it's just enough to make a difference if you win on the upside, and not enough to make a difference if you are wrong on the downside. I've always found that sound advice. This way you're not putting your standard of living in retirement at risk.
01/11/08 by Chris FarrellTaxes and the Ex-dividend Date
Question: When selling a stock or bond mutual fund, is it better to: Wait a few days to the Ex-Dividend date, receive the dividend and sell at the lower Ex-Div price? Or Sell before the Ex-Div date, receive the higher pre-Ex-Div price and forego the dividend? Very thankful for your program and your advice. Phil
Answer: The ex-dividend date means that owners of record are eligible for all dividends and capital gains distributions. Even if you sell your shares on or after the ex-divident date you'll receive the distributions. The distribution of mutual fund dividends and capital gains has an impact on the share price of a mutual fund. On the ex-dividend date the share price drops by the amount of the distribution (that is, plus or minus change in the market). So, if the share price is $10 and the distribution is $1.00, the mutual fund's net asset value (NAV) should drop to $9.00 (the price will depart from that value depending on what happens in the market that day).
The main implication to keep in mind when buying and selling mutual fund shares around the ex-dividend date is taxes.
On selling: The key question is to look at the tax bill from the distribution (where the federal rate can climb as high as 35%) versus long-term capital gains if you've owned the mutual fund shares longer than a year (where the tax bill is 15% or less). It often pays to sell before the distribution if you qualify for the 15% federal capital gains tax rate--but not always. The hated phrase is "it all depends" is right it this case. It all depends on comparing the actual tax bills and see where you come out ahead.
On buying: The Wall Street jargon is that you don't want to "buy the tax liability." For instance, lets say you purchase some mutual fund shares just a few days before it goes ex-dividend. The new investor will then watch the value of their shares fall by the amount of the distribution and owe taxes on the distribution. Ouch.
Here's an example on buying courtesy of mutual fund giant Vanguard
Say you invest $5,000 on December 15 (record date), buying 250 shares for $20 each. If the fund pays a distribution of $1 per share on December 16, its share price will drop to $19 (not counting market change). You still have $5,000 in value (250 shares x $19 = $4,750 in share value, plus 250 shares x $1 = $250 in distributions), but you owe tax on the $250 distribution you received--even if you reinvest it in more shares.
In other words, the long-term investor enjoys the payoff from dividends and capital gains (and pays taxes on the gain). The short-term investor mostly gets to write a check to Uncle Sam.
01/16/08 by Chris Farrell
Fellowships and IRAs
Question: My husband and I are currently on National Research Council fellowships, working at a government lab. The nature of the fellowship is such that we are neither employed by NRC, nor by the lab we work in, yet we are not required to pay self-employment taxes. Someone told me that in that case, we cannot contribute to our Roth IRA accounts either. Is this true? I'm concerned because it's the only retirement saving vehicle we have right now, since we don't qualify for a 401(k). If we can't contribute to our Roth IRAs, do you think getting Treasury I-saving bonds are our best alternatives? Thanks! Nandita
Answer: As I understand it, IRS rules prevent scholars on fellowships like yours from technically counting the money as "earned" income. So, you can't contribute to your Roth if the fellowships are your only source of income. However, if you have any part-time work (I realize that's probably unlikely given your schedules) then you can use that money to fund the Roth-IRAs.
If that's not the case, I do like the idea of investing money in I-bonds, the inflation protected savings bond. You don't pay any commissions buying and selling them. Your money compounds tax free until you cash them in. And the dollar you put in today is worth a dolla--plus interest 10, 20 or 30 years from now. The other thing you can do is also direct some money into a broad-based equity index fund, like the S&P 500, the Russell 3000, or the Wilshire 5000. That will give you an exposure to the equity market in an investment that keeps fees razor thin and your annual tax liability low.
One advantage of this home-brewed retirement savings approach--bonds plus equity index fund--is that it's easier to pull money out early. Yes, you'll have to fork over capital gains tax and income taxes, but you won't have to pay Uncle Sam the 10% penalty imposed on early withdrawals from retirement savings plans like IRAs or 401(k)s.
01/30/08 by Chris Farrell
Tax rebate?
Question: Should I wait to file my tax return to see whether Congress passes the Bush tax rebates? Is that part of my tax return or something completely separate? Avery
Answer: You should go ahead and file your return. You don't want to get into trouble with Uncle Sam and the Internal Revenue Service. Even if the rebate is eventually attached to your tax filing, all of us will be in the same boat if Washington asks for revisions. But I doubt that will be the case.
To be sure, the centerpiece of the Washington's current economic stimulus package is tax credits. But the details are still being negotiated, especially now that the Senate has weighed in with its own ideas. Despite strong signs of bi-partisan accord, the bill could change in coming weeks. It could also fail to pass. I'd hold off counting on the rebate money until President Bush signs the final economic stimulus bill.
More importantly, I'd like to make a suggestion on what to do with the rebate assuming the check comes in the mail in late spring or early summer. Washington wants to get money into your hands on the theory that you'll go out and buy an I-phone, a flat panel TV, pay for a delayed car repair, and the like. The rebate is designed to fight the gathering forces of recession by boosting consumer spending. Yet I'd rather people use the money---if it comes--to shore up finances. If there is a rebate, put the money toward paying down debt or adding it to emergency savings.
UGMA
Question: Years ago, we bought zero-coupon bonds for our son's college fund. They were timed to mature as he went through college, which has worked out great. They were purchased under the Uniform Gifts to Minors and are held in a custodial account. The last one has recently been called early, which is great because our son is graduating this May. I have just stuck it in a Money market account for now. My question is this: after I pay the last semester's tuition, there will be about $15,000 left. Can my husband and I keep it? Are there tax consequences for us or for our son? (More detail: our son will be entering the Navy's officer training program to be a nuclear engineer and will not be in need of the money. We have another son who's 8--would it make any difference if we keep the money or put it in a 529 for son #2?)
Answer: You did really well by your son. But now it's your son's money. You gave up ownership of the money when you put it into a custodial account. I'm sure he'll find some use for it down the road, like a car loan or a down payment on a home later on. For your other son, a 529 is good way to save for college.
The Tax rebate
Question: I have heard that this new rebate check that was just passed by Congress and now the White House is nothing more than an advance on our 2008 tax return. Is that true? Graham
Answer: I just pulled this comment from Graham. We've got several similar questions.The tax rebate is the same as a 2008 tax cut. But you get the money this year (most likely late Spring/early summer) after filing your 2007 tax return.
How much of a rebate you get--if any--will be based on your 2007 return. For instance, singles with no children and earn over $87,000 in gross income don't get a rebate. The same holds for childless couples with over $174,000 in income.
02/15/08 by Chris Farrell
The Tax Rebate, Again
Question: My parents are receiving social security and do not file income tax. Do they have to file an income tax return for 2007 in order to receive the tax rebate? Thank you. Chan
Answer: The simple answer is, yes. To get that rebate check you need to file a tax return. That includes people who normally don't file, such as retirees like your parents and disabled veterans. The reason is that the rebate amount (as well as the phase-outs) are calculated off 2007 returns.
By the way, in the 2008 tax year the IRS will refigure your rebate based on your 2008 tax return. It's a heads you win, tails you win calculation. You get to keep the money without penalty if it turns out the government gave you a too big a rebate check. But if your rebate check was too small the IRS will send you the difference.
Yes, File 2007 Taxes
Question: My 27-year-old daughter is developmentally disabled, lives at home and works for a sheltered workshop. Her last years' earnings were $1646, no federal or state taxes withheld, just social security and medicare. She also receives around $1000 in SSI per month. 1) Does she need to file taxes? 2) Is she eligible for the up to $600 "rebate"? Thanks for your time. Sincerely, Tina
Answer: Yes, everyone must file 2007 taxes to get a rebate.
02/25/08 by Chris FarrellDownsizing
Question: My wife and both turn 50 this year. Our son is graduating college and our daughter enters college this fall. We are downsizing into a smaller home, purchasing with cash. We'll then sell our current home. I've looked forward to being "mortgage-free" for some time, but several of our friends suggest losing the tax advantage is a bad financial move. Chris, what is your opinion? Tom, Charlotte, NC.
Answer: First of all, from a financial point of view it's really smart to make a downsizing move while you're still working. You'll save a lot of money--no mortgage, lower property taxes, cheaper utility bills, and so forth--and you can salt away at least some of that money for later on. In a sense, it's a smart savings strategy. Secondly, I don't think the mortgage deduction is all that important to your bottom line. Sure, it helps. But it's far better to enter your Golden Years owning a home without a mortgage. This way you have a solid equity foundation for your overall portfolio. Go for it
A Rollover IRA
Question: I was recently hired for a job in the public sector, working for the state of New York. My previous job was in the private sector. My 401(k) from my previous job is still being administered by my former employer, and it's now worth about $108,000.
The benefits administrator of my present employer has told me that I am not allowed to roll my 401(k) into any pension or savings plans that my employer offers. What are my options for doing something productive with my 401(k), instead of just letting it sit there? Tim, NY, NY
Answer: A rollover IRA (Individual retirement Account) is designed for circumstances just like yours. It's a routine transaction. First, figure out what financial institution offers the mutual fund options and services you'd like. They'll have the forms online for making a rollover IRA, but I always recommend calling the 1-800 number and ask for a human being to walk you through the process. The reason is that you want to make sure that your retirement savings are transferred institution to institution. In other words, you don't touch the money. It goes from your 401(k) to the financial institution you've picked for your IRA. This way you preserve the pension's tax shelter.
Gifts
Question: My parents are really excited for my wife and I to buy a house, as is my grandmother. So much so that between them they'd like to give us $30K to help with a down payment. Would this gift become "income" and therefore be subject to taxes? If so, are there any clever ways to make this money non-taxable? Thanks! David, Walla Walla WA
Answer: There's no need to be clever. In 2008 you can gift up to $12,000 to a person without paying taxes on it. Your parents and your grandmother could gift you $12,000 each for a total of $36,000 without tax consequences. They could double that sum by gifting the same amount to your wife.
08/06/08 by Chris FarrellA 0% Capital Gains Tax Rate?
Question: I have been told that in 2009, if my income is under $65,000, I do not have to pay capital gains tax on some stocks that I would like to sell. My husband and I make less than that, if we don't count our dividends and real estate investments. Could you please clarify the situation for me? Janet, Columbiaville, MI.
Answer: Ah, taxes. I'm sure you won't be surprised if I tell you the answer isn't simple! Most importantly--and this is not just boilerplate--you should work with a professional in figuring out your actual tax liability. But this question is coming up more and more, so here is a brief introduction. It's a tax benefit well worth knowing about for some middle class families.
Under certain circumstances between 2008 and 2010, the long-term capital gains rate for some investors will drop to zero. That's right 0%. The same goes for dividends. It's a genuine opportunity to sell some highly appreciated assets with a zero capital gain tax liability. You've heard right.
That said, don't sell your taxable portfolio just yet. (Withdrawals from a 401(k), 403(b), and comparable retirement savings plans are still taxed at your ordinary income tax rate.)
The long-term capital gains tax break is limited to those in the 10% and 15% income tax brackets (which is a lot of people, although far fewer have sizeable taxable stock, bond, and mutual fund portfolios). These folks have been paying a long-term capital gains tax rate of 5% in recent years.
Looking it up, in 2008 a single filer is in the 10% bracket with an income cutoff of $8,025. The single filer jumps into the 15% bracket after that with an income up to $32,550. The comparable 10% and 15% income bracket limits for a married couple filing jointly are $16,050 and $65,100, respectively. Of course, your actual income could be much higher. These numbers represent taxable income after deductions and exemptions.
Still, the capital gains from the sale of stocks or mutual funds are added to your income. That additional money could push you into a higher bracket. For instance, let's say you earned as a couple filing jointly $40,000 (after all deductions but before capital gains and dividends). You sell sold $20,000 worth of stocks eligible for long-term capital gains treatment. The gain would not be subject to capital taxes.
But if you earned $65,000 and sold $20,000 worth of stock, almost all the stock profit is subject to the 15% capital gains tax treatment.
This is only one example, and there are other permutations that can affect the capital gains taxes of those living on Social Security, children that want to gift stock to their parents, and so on. The capital gains tax treatment could change in a new administration, too.
The bottom line: It pays to investigate this short-term capital gains wrinkle in the tax code for anyone in the 10% and 15% tax bracket.
A Merger
Question: I own about 400 shares of Anheuser Busch common stock. I have been accumulating the stock slowly since 1976 mostly through a DRIP program. So my tax basis is relatively low. A company, I think it is "In Bev" is offering to buy out Anheuser Busch stock holders for about $70 per share. I would like to avoid paying taxes on the gain by putting the proceeds from the sale into some vehicle where the principle and interest will be available for my 8-ear-old child in the future, say college or high school expenses. Do you have any suggestions? Thank you. Brian, Brooklyn, NY
Answer: Yes, it's the Belgium multinational InBev that is buying Busch. You won the stock-owners lottery. . The price tag for your good fortune is that Uncle Sam will take part of your gain. Most of the tax bite should be long-term capital gains, which is currently at 15%. One time-honored method of limiting the tax take is to comb through your portfolio and see if there are any stocks or mutual fund you'd like to get rid of at a loss. You can use a capital loss to offset a capital gain. You may be able to avoid paying capital gains altogether. The long-term capital gains rate for investors in the 10% and 15% income tax bracket will drop to zero between 2008 and 2010. The same zero rate holds for dividends.
My tax reactions are just quick ideas. It is well worth your while to work with a professional accountant to delve into the details of your portfolio to see how to best handle the gain.
In terms of taking the gain and saving for your 8 year olds college education, I'd vote for putting at least some money into a 529 college savings plan. The contribution must be in cash, and it's made with after-tax dollars. But the money compounds free of taxes. The gain is also tax free when the money is withdrawn to pay for qualified educational expenses. A 529 plan is treated favorably when it comes to the basic financial aid formula.
08/21/08 by Chris Farrell
Capital Gains
Question: Hello! I'm 39 years old and was gifted a large amount of shares of Weyerhaeuser stock when my dad died 38 years ago. I recently got married and my husband and I started working with a financial planner. He was reviewing my individual portfolio and he pointed out that I have a large amount of Weyerhaeuser stock. He strongly advised me to sell the shares and diversify. I don't know the cost basis of the Weyerhaeuser stock off hand, but I am sure if I sold the stock, it would be a significant capital gain.
I do have another investment portfolio (mutual funds) and a 401k. I am a shareholder-employee of my family business, which is an S-corp. My 2007 salary was $90,000 and my 2007 AGI was about 67,000. However, I received a pay increase as of May 15th 2008, I am now earning a $120,00 annual salary.
I am worried about selling the stock and the resulting tax implications of the capital gains tax on the sale of the stock, my increase in income and corporate profits..
Furthermore, if the Democrats are elected to the White House in 2009, the capital gains tax is going to rise. Even diversifying my porfolio, I still am incurring risk. What would be the advantages/disadvantages if I held on to it. I know I will eventually have to pay the capital gain tax, but I want to minimize my overall taxes owed. I'm frozen by my indecision, please help if you can!! First Name: Jenifer, Seattle, WA
Answer: I don't have enough information on your portfolio and Weyerhaeuser to get into detailed specifics, but I do have strong thoughts about the idea that you should diversify at least a portion of your portfolio. I agree.
Remember Enron? Bear Stearns? How about Fannie Mae and Freddie Mac? These companies expose the risk of having too much of your portfolio in any one stock.
For instance, with Enron, not only did some 4,000 workers lose their jobs, but many more watched their retirement savings decimated by the energy company's collapse. Enron's employees had invested a big chunk of their tax-deferred retirement savings in Enron stock. The employees at Bear Stearns had invested a big chunk of their income into the well-regarded Wall Street firm, considered one of the savviest risk managers among investment banks. Yet the government ended up engineering a bailout of the firm, and employees lost much of their savings. Until recently, mortgage giant Fannie Mae was among the bluest of blue chip corporations in the world. Yet it has been caught up in the credit crunch and its stock price has cratered. According to a recent article in the New York Times, Fannie Mae "workers had $116 million in the employee stock ownership plan at the end of 2006. Today, it's more like $17.5 million. Ouch."
I could multiply the examples, but you get the point. This doesn't mean you have to get out of Weyerhaeuser completely, but that you should consider making one stock a smaller portion of your overall portfolio. I'd add that my philosophy is that while it's sensible to minimize the tax take, no one with a profit has gone broke paying taxes.
That said, there is a lot you can do to save on taxes. For instance, you may have some long-term capital losses to offset the gain. You may also try and time the sales to spread out the tax hit. But this is the kind of tax strategy a professional can help you engineer.
Hiring a Caregiver?
Question: On your show on 9/6/08, two families got together to hire a child care provider. Do these families need to pay social security tax and what about health insurance for that employee? I would like to do something similar regarding caregivers for a disabled brother. Lawrence, City: Oriskany, NY.
Answer: You can listen to the story here.
In essence, you're a small employer if you find and hire a person to take care of your disabled brother. Like all employers, you need to make sure the caregiver isn't an illegal immigrant. You're responsible for paying Social Security and Medicare taxes (assuming your wages are more than $1,600 a year in 2008). In many cases, you'll pay federal unemployment tax (in 2008 that's required if you paid total cash wages of $1,000 or more in any calendar quarter to the caregiver.) There might be state employment taxes, as well as a requirement to meet workman's comp and short-term disability insurance.
However, just as a small business isn't required to offer its employees health insurance you don't need to provide that benefit. One reason many families turn to an agency for a caregiver is to avoid all the small employer paperwork and filing requirements. It can be overwhelming
Stockholders and a failed bank
Question: I know WaMu depositors are insured, but what can WaMu stock holders do now? I’m relatively new to investing, and this is the first time I’ve seen my stock drop to $0.16! Andy, Ankeny, IA
Answer: The FDIC engineered takeover of Washington Mutual by JPMorgan Chase protects depositors, not shareholders. Shareholders are essentially wiped out. At this point, the real value of your WaMu stock could come on your tax bill, using the loss to shelter capital gains or ordinary income from Uncle Sam.
09/29/08 by Chris FarrellHarvesting capital losses
Question: My portfolio contains some stocks that have cratered -- and I don't expect them to turn around soon in this economy. Might it be beneficial to take a long-term loss on them this year, with an eye toward lowering current taxes and trimming some dead wood? Thanks, Dave, Reston, VA.
Answer: The answer is "yes" to both questions. You will have a lot of company taking capital losses this year, especially with the stock market down about 35% year-to-date. It's also a good time to harvest some dead wood. However, when evaluating investments remember that the underlying fundamentals trump tax strategies.
That said, the capital gain section of the tax code is a fertile area for tax-savvy financial planning. You need to sell in order to get the capital loss or losses, defined as selling an investment at less than the price you bought it for or its adjusted basis. (The expenses you incur selling the investment are deducted from the proceeds and added to the loss.) And, of course, we're looking at stocks, bonds, or other investment in a taxable account. For instance, you can't deduct losses in a tax-deferred retirement savings account, such as a 401(k).
Of course, since we're dealing with taxes the calculation isn't simple. You'll want to familiarize yourself with Schedule D, as well as the differences between short-term and long-term losses and gains. Computer-based programs like Turbotax are helpful or you can hire an accountant to do it for you. If you have a capital loss remaining after offsetting any capital gains you've realized, you can still deduct $3,000 from your income taxes. If the loss is greater than $3,000 you can carry the leftover portion to the following year, and the year after that, and so on.
File taxes now--or wait?
Question: For the first time in my life, I actually did my taxes earlier than usual. All this talk of stimulus packages, however, has me wondering: should I hold off on mailing my tax return? Are there any plans you know of in the house or senate that might affect typical 2008 tax returns? After not procrastinating on my taxes, I would hate to have to file an amendment at the last minute. Thanks. Ben, Madison, WI
Answer: Well, you're way ahead of me. Hopefully, you're getting a refund. If that's the case, file and get the money back fast from Uncle Sam.
The fiscal stimulus package is still being negotiated and much could change between now and the President signing legislation. Still, it looks like most of the individual tax changes kick in for 2009 and after. If you're interested in (a lot) more detail, check out this analysis by the tax specialists at CCH, http://tax.cchgroup.com/Legislation/2009-Recovery-Act.pdf.
By the way, filing an amended return to get even more money back? It's easy and well worth it.
Freelancers and unemployment insurance
Question: i am a self- employed artist. all of the news about record numbers of people collecting unemployment benefits has me wondering if these benefits are also available to self-employed people whose incomes dry up. i am currently managing to pay all of my bills and even save little bit of money but am concerned about what i will do in the future if i am unable to earn enough money/find a job. thanks, jenny, minneapolis, MN
Answer: One of the drawbacks of being self-employed is that you're usually ineligible for unemployment insurance once work dries up. The most common reason why artists operating as a freelance sole proprietor are excluded is that they file their income on a Schedule FC tax form. Yes, you get to take tax deductions as an operating business, but in most cases you can't claim unemployment insurance.
I want to emphasize the phrase, "in most cases." The rules surrounding unemployment insurance are complicated. So, if you ever do find yourself in need of filing, check with a professional. You can get good information at online resources geared toward artists in most major metropolitan areas.
Deduct 401(k) losses?
Question: Can I deduct the losses in my 401K on my tax return? I am 26 years old. Thanks, Leena, Dallas, TN
Answer: Most of us (almost all of us? Just about everyone?) have losses in their retirement savings plan at work. That's behind all the jokes about 201(k)s. No, you can't deduct those losses on your income taxes. It doesn't matter whether they are paper losses or realized losses. You're funding the 401(k) with pretax dollars and it's compounding (or losing) money sheltered from Uncle Sam. When you do withdraw the money some 40 years from now, you'll pay your federal income tax rate on it. Hopefully by then it will have grown a lot over the decades.
Tax credit and tax rebate
Question: We've heard about the $13 a paycheck 'tax credit'. What exactly is a 'tax credit' as opposed to the 'tax rebate'? Will we have to pay the credit back to the IRS come April? Should we adjust our withholding so we pay enough tax and avoid paying penalties? Lisa, Pinckney, MI
Answer: I thought I knew the difference between a tax credit and a tax rebate, but I wasn't quite sure. So I put your question to the financial advisor and professional polymath Scott Gislason at North Star Resource Group in Minneapolis. He's a lawyer, a CPA (certified public accountant), a CLU (chartered life underwriter) and ChFC (chartered financial consultant).
Here what he says: "There's an often overlooked difference between "tax credits" and "tax rebates". Generally speaking, tax credits only offset tax balances due - meaning if you have low income and owe nothing in tax, you get no benefit from a credit. Whereas, tax rebates are paid to a taxpayer regardless whether a tax is payable. There is an exception to this rule - the earned income tax credit which operates like a rebate."
Another exception: The new $8,000 credit for first time homebuyers. It's a "refundable tax credit." That means you can get a refund of the full $8,000 even if your total tax bill is less than that.
So, that's the difference between a credit and a rebate. He adds: "Neither credits nor rebates should generate additional taxable income necessitating a change in withholdings or estimates."
By the way, the change in withholding for the "Making Work Pay" credit is being done by your employer. You don't need to do anything.
03/04/09 by Chris FarrellA loss on selling home
Question: Hello, I sold my house last year and lost 30K. Can I claim any capital loss on my tax returns? Rozario, Nashua, NH
Answer: No, when you sell a home at a loss you can't turn to Uncle Sam to lesson the financial hit. A home enjoys enormous benefits when you have a profit at sale. A single filer gets to exclude $250,000 from capital gains tax and a joint filer a $500,000 gain. (There are some restrictions surrounding this capital gains exclusion.) But on the downside the loss is all yours.
What to do with a tax refund?
Question: We are getting a hefty tax return this year (and yes, I had our tax accountant double check it three times!)-- due to capital gains losses, losses on rental properties we have and loss of income for my husband. It's a hefty 5 figure refund. I just don't know what to do with it. Invest it? But where? Slit that mattress of ours? Money market? Savings? Any suggestions? Nancy, Berwyn, PA
Answer: Please, not in the mattress! It's distressing enough that home safe sales are up during this financial crisis.
Seriously, if I were in your position I'd put the money right into an online savings account (FDIC insured), or some kind of comparable savings account backed by the full faith and credit of the federal government. This way you preserve the value of your unexpected "windfall" while you and your husband figure out the best use of the money. In light of all the economic uncertainty--and the losses you've suffered this past year--you may decide to keep it in a safe place in case you need it. On the other hand, you might want to pay down debt (always a good idea), invest in more education and skills for the job market, upgrade some aspect of your rental properties, or simply spend it in a way that adds to your life experiences.
But while you two talk it over, I would put it in a very safe place like a bank savings account or certificate of deposit--nothing fancy.
Hybrid tax credits
Question: My car is on its last legs. Its engine is slowly dying. I know I am going to need to buy a new (which to me usually means used) car this year. I am confused about all the offers currently around. I understand there's a tax deduction for new car purchases, which basically makes the purchase "tax free." I'm considering purchasing a new car to take advantage of the tax benefits, but also realize that a used car might still make more financial sense. Are hybrid tax benefits still around? The sub $20,000 Honda Insight is looking quite appealing... Alex, San Diego, CA
Answer: The credit is only for new cars. The hybrid tax benefits still exist. They're available for four kinds of vehicles: fuel cell, advanced lean burn technology, hybrid, and alternative fuel. That's the good news.
The bad news--aarrrgggghhhhh--is that rules are stunningly complex. I know I shouldn't be surprised at this point, but it's ridiculous. No, it's stupid. For instance, the credit varies significantly by car. According to tables published by Cars.com, the tax credit attached to the 2009 BMW 335d is $900 while the credit on a 2009 Ford Escape Hybrid is $3,000 (for the two-wheel drive version). The credit also runs out. There is a limit of 60,000 cars per automaker, and then the credits are phased out. As I understand it you already can't get a claim the full credit (or even get a credit) on Toyota and Honda alternative cars. For the life of me I can't figure out how all these tax credit twists-and-turns, phase-ins and phase-outs are good public policy.
You're right about the ability to deduct state and local taxes on a new car purchase. (Again, not for used cars.) Of course, there are wrinkles to this tax perk. You can deduct local sales and state taxes on a new car purchase if you file jointly and make less than $250,000 or if you earn less than $125,000 for a single filer. The car, motorcycle, RV or light truck must cost less than $49,500.
You can read a good explanation of the rules at Cars.com The hybrid tax credit section is here.
Home buying tax credit
Question: Is there an income cap for single first-time homebuyers to be eligible for the $8,000 tax credit? Is there a sliding scale of eligibility amount? Sandra, New York, NY
Answer: This is the U.S. tax code. Why make it simple? Yes, there is an income cap and a sliding scale. The home buying credit is for 10% of the purchase price of the home or $8,000--whichever figure is lower. For a single filer, the credit starts getting phased out with a modified adjusted gross income of more than $75,000, and it's eliminated once your income is $95,000 or more. For a married couple, the phase starts with a modified adjusted gross income of more than $150,000 and the credit ends if your income is above $170,000 (married).
Remember, the $8,000 credit applies to homes bought between January 1, 2009 and November 30, 2009. You must keep the home for three years, and you cannot have owned a home for the past 3 years to qualify.
Clearly, considering the volume of questions we're getting the home buying credit has grabbed the attention of potential home owners. I'll be curious to see how much the interest in the credit translates into actual purchases this year.
03/27/09 by Chris FarrellWithholding taxes
Question: Is it better to owe the federal/state government tax, or receive a refund? How much money should one aim to owe/receive when deciding how many exemptions to take on a W-4 form? In anticipation of buying a house last year, my husband and I took more exemptions, and now owe quite a bit more than we have in previous years. We found our home late in 2008, and closed at the end of January. Now we are trying to plan for 2009 taxes. Thank you for your help, Jeannine, San Diego, CA
Answer: Congratulations on getting a jump on your tax filings for next year. Many people haven't even filled out this year's return. (And you know who you are.)
Ideally, you won't owe anything and you won't get anything back either. It's always nice to get a refund rather taking out the check book in April. Still, if the refund you are used to is over a few hundred dollars I would adjust your withholding. The reason is that the government doesn't pay you any interest while holding on to your money. In essence, you're making an interest free loan to Uncle Sam. On the other hand you can also make an adjustment if you will owe more than you're comfortable with come April. Remember, your withholding has been reduced slightly because of the Making Work Pay Credit that was part of the Obama Administration's fiscal stimulus package.
The IRS has a withholding calculator here.
It reflects the new withholding tables. The IRS recommends that any employee use the calculator if they work two jobs, are a two-income couple (that's you), and if you can be claimed as a dependent to make sure that the amount being withheld is what you want--and so that you don't owe more than you expect next year.
Getting rid of escrow
Question: My mortgage (with GMAC) has an escrow element tied to it. Every year, the amount collected exceeds the amount needed for the tax payment, but when the annual Escrow Analysis statement comes in, the mortgage company declares there is a shortage, and the amount of my mortgage payment will go up whether I pay the shortage or not.
First of all, what is up with that? If I paid in more, how is there a shortage?
And secondly, can I remove the escrow from this mortgage without refinancing? I know I can easily save for this tax payment throughout the year, and collect interest for myself. Thanks very much. Diane, Milwaukee WI
Answer: I wish you luck. The money that goes into an escrow account is used to pay for expenses such as real estate taxes, property taxes, and homeowners insurance. Lenders require an escrow account if you put less than 20% down. That's a lot of people in the 2000s when a 20% down payment became the exception. The fluctuating payments could reflect a number of factors, ranging from higher bills to changes in the amount the lender requires as a cushion. Whatever the reason, some homeowners love escrow for its convenience and others can't stand it.
Here's the thing: If you have 20% or more equity in your home you can approach your lender. They may waive it for a fee. But lenders like escrow accounts so they aren't eager to make the change. That's why many homeowners with 20% or more in equity in their house end up refinancing to eliminate escrow (or perhaps more accurately, getting rid of escrow is an additional benefit to refinancing).
I-bonds for Roth?
Question: I was told by my bank that it is not possible to put I-Bonds in my Roth IRA. If not, why not? I want to make a contribution that will not shrink like my mutual funds. Suzanne, Los Angeles, CA
Answer: That's right. There are technical and legal reasons why it's almost impossible to do. For instance, the U.S. Treasury rules say you can't open an account to buy savings bonds electronically through Treasury Direct in the name of an IRA.
Here's the thing: I don't think you should do it anyway. It isn't a good idea even if you could convince a bank to go through contortions to do this transaction for you. In essence, you're wasting a valuable tax shelter with the I-bond. You buy an I-bond with after-tax money. The savings compounds tax free. That is, until you cash it in and then you pay ordinary income tax rates on the gain. The I-bond is like a non-deductible IRA.
By the way, I-bonds are a terrific fixed income investment for most people. I like owning I-bonds, just not in an IRA.
Another inflation-indexed security is the Treasury Inflation Protected Securities, better known as TIPS. These default-free securities are also designed to hedge the value of your money against the ravages of inflation. The big drawback with TIPS is that Uncle Sam requires owners of TIPS in a taxable account to pay income taxes on the inflation-adjusted gains before getting any of the inflation-adjusted money at maturity. That's why TIPS work best in a tax-sheltered account, like an IRA or Roth-IRA.
It would be a better idea to use TIPS in your Roth.
You do need to go through a broker if you want to own the TIPS directly. A number of brand-name mutual fund companies sell funds made up exclusively of TIPS, too.
You could also buy short-term CDs insured by the FDIC at your bank for your Roth. You wouldn't have any credit risk with the FDIC insurance. You'd earn a decent rate of interest. And by keeping the CD terms short you could always be earnings something around the prevailing rate of market interest rates.
I-bonds vs TIPS
Question: I have the opportunity to buy $10,000 worth of I-bonds this year, or $10,000 worth of TIPS in an IRA account. Which is better--or is it more or less the same risk and return? Is it better to by a TIPS bond directly, or in a bond fund?
PS: Your book was great and I enjoy hearing you on public radio. Ken, Swarthmore, PA
Answer: Thanks a lot. Just a quick definition: TIPS are Treasury Inflation Protected Securities. These inflation-indexed bonds come in 5, 10 and 20 year maturities. TIPS offer a fixed interest rate above inflation, as measured by the consumer price index. TIPS are designed to protect the value of an investment dollar against the ravages of inflation (as measured by the CPI). Uncle Sam levies income taxes on the inflation-adjusted gains before you get any of the inflation-adjusted money at maturity. That's why you're right to see TIPS as the better investment in a tax-sheltered account, like your IRA.
Taxes aren't an issue with I-Bonds, a savings bond that is the federal government's other inflation-protected security. There are no commission costs when you buy or sell savings bonds, and your savings compound tax deferred. I-bonds redeemed before the 5 year mark forfeit the 3 most recent months' interest, but after 5 years that there is no penalty at redemption.
The key to answering this question is when do you need the money? It's advantage I-bond if you might tap the savings at some point in the future but before retirement. You can sell the I-bonds without incurring a penalty even if you're under 59 ½. You just pay Uncle Sam whatever you owe in taxes after the sale (and I'm assuming you'll own them for 5 years).
In sharp contrast, if you buy TIPS in your IRA, you can't get at that money without paying taxes on it plus a 10% early withdrawal penalty if you're under 59 ½. You'll have to pay a broker a fee to purchase the TIPS for you in an IRA (although the charge should be very small.) If you're okay with the extra work and monitoring the bonds then I would lean slightly toward owning individual TIPS. This way you know what you have and when the bond will mature. You could care less about fluctuations in the bond market. But a very low cost TIPS mutual fund is just fine for those who favor its convenience.
The education IRA
Question: My wife and I had our first baby in January of 2009 and are looking into saving for her education. I have heard a lot about 529 plans but very little about Coverdell accounts. So far I have learned that both 529s and Coverdell's allow money to grow and be withdrawn to pay for the education of the beneficiary tax-free. While the Coverdell does have a $2k/year contribution limit, contributions are also tax deductible while 529 contributions are not (at least in California). Why haven't I heard more about Coverdell accounts? Is there a reason why I would not max-out my Coverdell contribution and then put additional money into a 529? My wife and I make a combined taxable income of about $150k. Hans, Sherman Oaks, CA
Answer: The Coverdell Education Savings Account is one of the least understood ways to save for college. It used to be known as the Education IRA. In essence, it acts much like a Roth-IRA. You contribute up to a maximum of $2,000 in after-tax dollars--contributions are not tax-deductible--at a financial institution of your choice. There income phase outs and limits to the Coverdell. Joint filers with $190,000 or less in modified adjusted gross income qualify for the full $2,000 contribution. The income limit for single filers is $95,000 for single filers. For joint filers the contribution amounts is reduced for modified adjusted gross income between $190,000 and $220,000--after that you're out of luck. The comparable figures for single filers are $95,000 and $110,000.
The money compounds tax free. If it is used to pay for qualified educational expenses withdrawals are tax free too. Unlike a 529 plan, the account can be tapped tax-free to cover qualified education expenses at primary and secondary schools as well college.
Here's the rub: The annual contribution limit is $2,000 until 2010, when the figure drops to $500. A number of other college savings attractions attached to the Coverdell will end that year, too. I'm not sure why Congress liberalized the rules surrounding the 529 college savings plan in 2006 but left the Coverdell vulnerable to changes in its treatment in 2010. After 2010, the Coverdell will be a much less attractive way to save for college compared to the 529. That's why I favor the 529 plan.
But there is no reason why you couldn't contribute to the Coverdale to the maximum for now, in addition opening up a 529 plan. You can learn much more about the details of the Coverdell at savingforcollege.com.
File taxes
Question: I have not filed a return this year because the preparer told me that I did not have enough taxable income that I needed to file. Comment, please. James, Hastings, NE
Answer: You're probably fine. Some people don't have to file if they make under a certain sum of money and can't take advantage of any refunds, credits, deductibles and the like. (An exception was the tax year 2007 when you had to file to get your tax rebate.) "Many people will file a 2008 Federal income tax return even though the income on the return was below the filing requirement," according to the IRS
Here's how to make sure: The IRS has a section of its website that asks a series of questions to help you determine if you need to file a federal income tax return. Check it out.
04/21/09 by Chris FarrellA Roth-IRA conversion in 2010
Question: As I understand it, Congress has lifted the income limits for Roth IRA roll-overs starting in 2010. How likely do you think it is that Congress will leave that tax change in place? Paul, Seattle, WA
Answer: My best guess--and it's just that, a guess--is the shift in the Roth-IRA conversion rule will hold for 2010. After that it all depends on whether the Obama Administration pursues dramatic tax reform and manages to get Congress to agree to a major overhaul of our Byzantine tax code. The Administration has appointed a tax reform commission headed up by former Federal Reserve Board chairman Paul Volcker, but with everything that is going on in the economy and markets it hasn't had much traction.
For the moment it looks like 2010 is fast becoming the equivalent of a conversion gold rush. Here's why: Up until now, you could only convert a traditional IRA into a Roth-IRA if your modified gross adjusted income was under $100,000. The income limit lifts in 2010. What's more, when you convert from an IRA to a Roth you owe income taxes on the amount converted. The reason is a traditional IRA is funded with pretax dollars while a Roth is funded with after-tax dollars but withdrawals are tax free in retirement. Well, the 2010 conversion amount may be included as taxable income in 2011 and 2012. That helps spread out the tax bite. It's a one-time perk.
To convert or not to convert, that is the question. There are many factors to consider, but for many people the answer will be yes. The benefit of tax free withdrawal is huge. The argument for converting strengthens the longer your money can compound after conversion and before retirement. It's also important to have other savings on hand to pay the tax bill. Another advantage of the Roth is there is no required minimum distribution at age 70 ½ as there is with a regular IRA. For those with substantial assets converting to a Roth may make financial sense simply from an estate planning perspective.
There are many twists and turns to this conversion story. For instance, should you pay the tax tab in 2010 or spread it out depend on whether you believe the money you make off the delayed payment will offset the risk of a higher tax bill. What will happen to your income in 2012? Maybe your income will plunge in which case you'd probably elect to pay the tax over two years. But if there's a chance of a big bonus in 2012 you'd get rid of the tax liability in 2010.
One place to get started researching the economics of conversion for your household is at web-based calculator, like this one.
04/28/09 by Chris FarrellHome equity and credit cards
Question: I have a $16,000.00 credit card balance with Chase at 3.99 % until balance is paid off. I also have a home equity credit line that would support paying this balance off. The home equity interest rate is currently at 4.12%.
My question is would I be better off paying off my credit card and putting it into my home equity line of credit where I could deduct the interest on my taxes even though the interest is slightly higher or stay the course and continue to make monthly payments on my credit card. Some one told me it is not a good idea to put your credit card balance against your mortgage. What do you think? Roger, Minneapolis, MN
Answer: I am against using home equity to pay down credit card debt. Yes, you get to deduct the interest. But you're hardly paying much of an interest rate anyway.
Far more important, once all your debt is home-based you risk losing the house if you suffer a setback. If you look at the credit problems of recent years a common mistake was homeowners tapping into their home equity to consolidate debts for the tax break. Then they got into financial trouble--lost their job, suffered a major medical illness, got divorced--and suddenly they couldn't make their mortgage and home equity payments. Results: Foreclosure, a short sale or extreme stress holding on to the property.
Yet there are a number of ways to get financial relief on auto loans, credit cards and similar consumer debts. For instance, you can make minimum payments for a while, go into debt counseling, and even declare bankruptcy. And you get to keep the home. The bottom line: I don't like the risk-to-reward ratio.
I would just focus on paying off the credit card and leave your home equity al
Estate taxes
Question: My elderly parents (82 & 88 years old) own a large (2000 sq ft) completely renovated 1805 farm house and 100 acres in SC - all paid for. My brother and I will inherit this property upon the death of our parents. It is vital to my parents that they leave this property as a gift to their children; they are proud that they have it to give to us. However my parents think that there won't be many estate taxes on this property since it is no longer an active farm and the local property taxes list the value at $200,000. My brother and I are concerned that the estates taxes will take away most of this inheritance. As a solution to this problem, my understanding is that if our parents sell us this property now, with a codicil that they will stay in the house until their deaths, there won't be any inheritance taxes to us. We would be responsible for the yearly property taxes. Also, who decides, upon my parents' deaths, the value of the property in order to calculate the amount of inheritance tax? Any input is gratefully accepted. Thank you. Ellen, Willow Spring, NC
Answer: I doubt if you need to worry about the estate tax. Most people don't need to be concerned about it because the amount exempted from the tax is so large.
To be sure, estate tax law is extremely bizarre at the moment, and that's putting it kindly. Here's the rub: Congress and the White House cut a deal in the negotiations for the 2001 income tax cut that increased the amount that individuals can leave to heir's tax free. It also lowered the estate tax rate on any money owed to Uncle Sam. In 2009, an individual could leave her heirs $3.5 million free of taxes. That's $7 million for couples. For sums above that the estate tax rate starts at 13% and tops out at 45%. Yet in 2001 to make the budget projections work and to satisfy opponents of the "death tax" the estate tax was slated to disappear completely in 2010 and then return in 2011. Go figure. I can't.
But it looks like the estate tax disappearance and reappearance act won't happen. The Administration's current budget blueprint makes the 2009 rules permanent. In other words, individuals with estates of $3.5 million or less would be exempt from the top 45 percent estate tax rate, and married couples could end up sheltering a combined $7 million for their heirs from tax (depending on how marital assets are titled).
I'd see what the law becomes first. Then, if you want you can get some additional peace of mind by having an independent appraiser value the home and property for you. And I'm sure your parents have other assets as well that should be considered. I'd also with a reputable estate attorney. But I wouldn't do anything without good evidence that you and your brother are among the estimated 0.2% of all estates this year that might be subject to the tax. Most people who worry about the estate tax aren't subject to it.
The $8,000 home buying credit
Question: My husband and I are looking to buy our first home. Since our annual income is around $34,000, we tend to get all of our tax money back at the end of the year (at least until I'm out of college). Is the tax credit a wash for us? Thank you for your help, Leslie, Lemon Grove, CA
Answer: No, it should be a real financial help for you. The tax credit is for qualified first-time home buyers that purchase a primary residence between January 1, 2009 and before December 1, 2009. The tax credit is equal to 10% of the home's purchase price up to a maximum of $8,000. You should qualify for the credit since you're a first time homebuyer and you come in under the income limits. (For instance, the income limit for married taxpayers is $150,000, and it phases out at modified adjusted gross income of $170,000.)
Like most tax law changes, the $8,000 homebuyer credit has created a lot of confusion. The National Association of Home Builders offers up detailed information on the tax credit here. I've also answered a number of other question on the credit on the Getting Personal blog.
Your question is about the tax implications. You have a choice when it comes to filing for the credit. You can amend your 2008 tax return to get the money quicker or you can elect to file for the credit on your 2009 return. However, you must have purchased the home before filling for the credit.
There is additional news this week on the $8,000 tax credit front: The Federal Housing Administration (FHA) has come up with new rules that allow new home buyers using an FHA-insured mortgage to tap the credit to pay for closing costs and the down payment. The lender must be FHA approved. You can find a list of qualified FHA lenders by tapping into this database. New home buyers still need to come up with an initial 3.5% down payment before taking advantage of the credit money.
You can read the official FHA statement on the program here.
06/02/09 by Chris FarrellA loss on a closed Roth
Question: I recently closed a ROTH account, feeling that the money could best be used elsewhere, since I still have a fair amount in other retirement funds, even after all the recent market trouble. I had been contributing $100 per month for about seven years, yet the cash out value, even before 10% government withholding and surrender fees, was less than the total of my contributions by several hundred dollars. What is my tax liability? Can I claim a loss on this year's taxes? Can I expect to get my 10% withholding back at some point? Thanks! Joe, Milwaukee, WI
Answer: There is nothing simple about Roth-IRAs and taxes. Yes, under certain conditions can claim a tax deduction for the loss from closing the Roth-IRA account. But there are a number of twists and turns in the tax code about liquidating a Roth. My best advice is to strongly urge you to consult a professional advisor.
That said, if you're in a similar position as Joe in Milwaukee you can stop reading this post right now. Go get professional help.
Here's a brief overview of the basic rules for those of you that remain curious. In order qualify for a tax loss from closing a Roth you must liquidate all your Roth-IRAs. The amount of money you have at liquidation must be less than your "basis." A basis is defined as the amount of money you contributed to the Roth; plus any money you may have added to it by converting a traditional IRA into a Roth; and subtract any sums of money you've withdrawn. (From Joe's email it looks like he has a loss by this definition.) You must itemize on your taxes to claim the loss. The amount that can deducted is limited to 2% of adjusted gross income. By the way, the 10% penalty doesn't apply if the Roth is made up from annual contributions.
There are a few more wrinkles, but you get the basic idea. And you see why I say work with a tax pro.
06/05/09 by Chris FarrellInflation and an IRA
Question: I'm interested in finding a good investment for inflationary times. This would be about 7% of my retirement portfolio; around 10,000 in cash languishing in 2 different IRA accounts. I am 42, and will probably have to work until I croak. I am guessing I'll retire at 75 or so. I considered purchasing some I Bonds in an IRA account. I'd like to be able to sweep the proceeds of a dividend-yielding investment into the bonds once a year. I contacted my stock-trading account - no dice on holding I Bonds in my account there. I contacted Treasury Direct and they told me I needed to find a bank that would hold the bonds in an IRA and also contact the IRS. Do I need to call all the banks in town to see if anyone will do this? Is there a kind of bank that I should focus on? A directory that would help? Am I trying to do something completely wacko and ill-advised? Jill, Northfield, MN
Answer: I wouldn't say "wacko". But ill-advised? Yes. For a number of technical and legal reasons you can't get I-bonds into an IRA. More importantly, you wouldn't want to do that anyway. In a sense, an I-bond acts like an IRA. The money you put into an I-bond compounds tax deferred until you cash it in. At that point you owe ordinary income taxes on the gain. With an IRA, your investment grows tax deferred until you pull it out in retirement and pay ordinary incomes taxes on the withdrawal. You'd be wasting the tax shelter if you could invest it in an IRA.
That said, I like I-bonds. I would just buy them directly from the Treasury.
Inflation isn't much of a problem right now. The government reported this morning that the Consumer Price Index for the 12 months ending in May was down 1.3%, the biggest decline since 1950. I'm not very concerned that the Federal Reserve extraordinary actions to shore up the economy will end in a bout of hyperinflation, either. The formidable combination of an intensely competitive global economy and a competent central bank will keep inflation around its target level of 1% to 2%.
Of course, that forecast could be horribly wrong and a reprise of the inflationary '70s awaits us. Even if I am right low levels of inflation erode the value of a dollar over time. Long-term savers should worry about inflation a lot. That's why I like Treasury Inflation Protected Securities or TIPS. It's an ideal security for an IRA, although you'll have to buy them from a broker. I've written a fair amount about TIPS elsewhere on the Getting Personal site. The best overall source of information for investing in TIPS and similar securities for safety and security is Worry Free Investing by Zvi Bodie, finance professor at Boston University. You can check it out here.
06/17/09 by Chris FarrellIRA withdrawal
Question: If I borrowed amount $x from my IRA and invest it and make $x + 10% and return $x back into my IRA within the 60 day limit, what is the status and treatment of the 10% profit? Treated as ordinary income? Paul, Bethesda, MD.
Answer: Yes, short-term gains are taxed at your ordinary income tax rate. But for a whole host of reasons it's a really bad idea to take money out of your IRA and try this strategy.
08/06/09 by Chris FarrellMedium-term savings
Question: I am a 24 year old engineer who has been extremely fortunate in this economic downturn. My wife and I have no college or credit card debt and a combined income of 100k. Up to this point the majority of our savings has been in retirement accounts, such as 401(k)'s and our Roth IRAs. We also have begun to build an emergency fund in a money market account for short-term savings. The glaring weakness I see currently is medium-term savings, such as for our next house or car in 5-10 years. My hunch is that some low-cost index funds are the way to go right now. Is this the right overall investment strategy to be taking in the short, medium, and long-terms? Adam, Hamilton, OH
Answer: You're smart with your money and you have a good savings strategy. Here's a suggestion for your medium term savings. I like the idea of investing in a low-cost broad-based equity index fund in a taxable account. Your annual tax liability is fairly small, most reflecting dividends payments. The capital gains impact is minimal since index funds mostly don't sell their holdings unless it's to take into account changes in the underlying index. You'll face the capital gains tax hit when you sell shares, assuming the investment has appreciated in value over the years. I like the idea of setting up an automatic investment plan so that every month a small sum of money goes out of your checking account and into the index fund.
You can complement this risky slice of your savings portfolio with an investment in I-bonds. It's an inflation-protected savings bond. There are no commission costs to buy and sell I-bonds. You can buy $5,000 online in electronic I-bonds directly from the U.S. Treasury and another $5,000 in paper I-bonds from your bank or credit union. Your money compounds tax-deferred and you don't pay Uncle Sam at your ordinary income tax rate until you cash them in. If you sell the I-bonds before 5 years you'll lose three months interest as a redemption penalty. There is no penalty after 5 years. To be sure, I-bonds aren't in favor right now because the rate is zero. That's right, 0%. The rate reflects the steep decline in the consumer price index during the Great Recession. The reason it doesn't bother me is what if inflation surges in a year, three years, or five years from now? The dollars you put aside today will be protected against inflation, at least as it is measured by the consumer price index.
By the way, I look at this approach as a 5+ years strategy, especially with the index fund. If your time horizon is less than 5 years the stock market is simply too volatile a place for savings. .
Retirement savings and taxes
Question: Hi Chris - my husband and I are in our 50's and trying to plan well for retirement, including how to protect our retirement money from being "taxed to death" when the time comes for us to take distributions. I have recently heard lots of "caution" about the inevitability of everyone's tax liabilities increasing greatly in the coming years in order to deal with our national budget deficit, health care reform, etc. What is your advice for how we can best protect our 401-k and IRA money so it isn't taxed to exhaustion when the time comes for us to take distributions? Currently our retirement accounts are invested in index mutual funds linked to the S&P 500. Thanks for your time and expertise, Chris. Helene, Watsonville, CA
Answer: I have a middle-of-the-road position when it comes to future tax rates. In light of the government's obligations that you mention, such as national defense, Social Security, health care, and the budget deficit it's likely that taxes will go up. I agree with Tyler Cowen, the libertarian economist at George Mason University, who argues that the tax cuts from the Bush years were really deferred tax increases. That said, I don't buy the scare stories that taxes will go so high that our savings will be wiped out. My own guess is that the pressure for revenue without pushing rates too high will lead to major tax reform. The deal would be to offer everyone lower rates in return for closing many loopholes. But that's just a guess.
On a practical what-can-I-do-today level, one of the best moves anyone can make is diversify the tax treatment of their retirement savings. When you withdraw money from your 401(k) and traditional IRA it will be taxed at your ordinary income rate. I would also save in a Roth-IRA. Your contributions are with after-tax dollars but your withdrawals will be tax free. That could be a huge benefit in retirement.
The other thing is to consider converting money from a traditional IRA into a Roth-IRA in 2010 (or after). You could only convert an IRA into a Roth if your modified gross adjusted income was under $100,000. But the income limit lifts in 2010. The argument for converting strengthens the longer your money can compound. There is also a one-time perk for anyone who converts in 2010. You can pay any taxes owed on the conversion in one year or spread it out over the following two years.
However, if you have to use tax-deferred savings to pay the tax bill it doesn't pay to convert under most scenarios. You can begin exploring whether conversion makes sense for you at such online sites as rothretirement.com. Amy Feldman of BusinessWeek has a nice story on this: Is a Roth IRA Right for You?
Mortgage and taxes
Question: I always enjoy listening to your comments and hope that you have a moment to settle a discussion a friend and I are having. Is the "benefit" of the itemized tax deduction on one's income tax worth retaining a mortgage if one is able to satisfy that debt? In this case, we are discussion someone who has about fifty thousand dollars on the mortgage and is of retirement age, no children and few other itemized deductions. There is no other debt. Thank you for your thoughts on this matter. Judith, Reading, OH
Answer: Sure, I'd love to weigh in on your discussion. The short answer is that any financial benefit you get from the mortgage deduction is swamped by the cost of paying interest on the loan. My guess is that the value of your mortgage interest deduction is not only minimal, but it's below what you can get by simply taking the standard deduction. (It's worth finding out.)
The main reason not to pay off the mortgage has to do with your personal financial safety net. You don't want to put all your savings into one asset, like a home. But if you have a well-diversified portfolio and adequate savings why not get rid of the mortgage. And that sounds like you or your friend.
Early withdrawal from 401(k)
Question: Is it possible to move the majority of my balance in my company's 401k to a self-directed IRA without penalty (or quitting my job)? I'm not happy with the investment alternatives available in my company's 401k plan. David, Lewis Center, OH
Answer: In most cases the answer is no. The general rule is that employers aren't supposed to let you take money out of the 401(k) and roll it over into an IRA. You can only do that when you leave the company--voluntarily or involuntarily.
However, there is one important wrinkle (hey, legislators can't make saving for retirement simple, can they?). By law, companies can offer their employees 59 ½ or older the option of rolling over their contributions into an IRA. It's called an "in-service" distribution. In other words, you're still working for the company, you're 59 ½ or older, and you can roll the money over into an IRA. It's legal, but it's up to management whether they offer the option. A majority of large companies seem to allow it.
To learn more about the twists-and-turns in the in-service distribution world, check out this detailed article in Forbes: The Great 401(k) Escape.
Too much in retirement savings?
Question: This may be an odd question in this economy. I've always tried to max out my pre-tax retirement savings. However, I'm wondering if this philosophy still holds true when your employer's contribution is significant (i.e. it's over 10%)? This is a *contribution*, not a *match*.
This puts me at pretty much 25% pre-tax retirement savings. I'm 35. Am I better off taking some of my money and putting it into something post tax for more diversification? Or should I still contribute the maximum because of the pre-tax benefits?
Basically, is there such a thing as putting too much into pre-tax retirement? Renee, Minneapolis, MN
Answer: You're right--you are in a different situation than most people. It's a nice place to be, too. But yes, I do think it's possible to put too much into a particular tax-sheltered retirement savings plan. The reason is that you can't get access to the money without paying a steep 10% penalty as well as ordinary income taxes if you withdraw the money before 59 ½.
I have two suggestions for you to consider. Both assume that reducing the amount going into your pre-tax retirement plan doesn't affect the company's contribution, which is incredibly valuable. First, if you come under the income restrictions I would set up a Roth IRA. The contributions are funded with after-tax dollars, but the gains are tax-free on withdrawal in retirement. An additional benefit is that you can always withdraw the contributions without penalty or tax if you need the money.
The other is to set up a long-term savings plan that minimizes your annual tax hit. But you can always access the money. For instance, you could set up an automatic savings program--a set some of money is invested every month. Some of your savings could be regularly invested in a broad-based stock index fund, such as the Wilshire 5000, the Russell 3,000, or the Standard & Poor's 500. Uncle Sam annual levy is minimal since there isn't a lot of trading activity with an index fund and when you sell stocks much of the gain will come under the lower capital gains tax rate. You could also load up on tax-deferred inflation-protected I-bonds for the fixed income portion of your portfolio (or Treasury bills, certificates of deposit, and other safe investments). It provides an anchor to your savings.
A regular monthly investment into a mix of secure and riskier savings in taxable accounts accumulates with time. It may be tapped to fund a career change, a medical emergency, a home, or retirement. This approach is a simple strategy that gives you a lot of flexibility.
$7,500 homebuyer credit
Question: I bought a house in 2008 and received the $7500 first-time home buyer credit (the first one not the $8000 giveaway). I lost my job and sold my house at a lost in spring of 2009. Do I still have to payback that $7500 credit? If so how soon? If I kept my house I would have to repay it over a 15 year period. Sean, Camden, AR
Answer: The $7,500 homebuyer "credit" was truly misnamed. It wasn't a credit. It was a 15-year interest-free loan from the government for first-time homebuyers. You got the "credit" upfront and then you paid it back in equal installments over 15 years. (The $8,000 first-time homebuyer for 2009 that expires on November 30 is a pure tax credit. You simply pocket the money. You don't owe anything so long as the home is your principal residence for at least 36 months after purchasing it.)
The balance of the $7,500 loan is paid off in full if you sell your home at a profit before the 15 year term is up. The amount paid back to the government, however, can't exceed the amount of the gain. When a home is sold at a loss--as in your case--the balance of the loan is forgiven.
By the way, I find it intriguing that even the IRS on its website suggests checking with a tax professional if you sell a home bought with the $7,500 "credit/loan" with no gain or a loss. The agency knows it's a confusing piece of legislation. So, who am I to argue with the IRS? Check with a tax pro first.
Rollover IRA
Question: I was recently laid off and told that because my 401k balance was below 5k I would need to move the money. I do not want to cash out and would like to avoid paying any taxes on the funds. I currently have 3 other 401k accounts with previous employers. What are some of my options for these investments? Natalie, West Chester, OH
Answer: You'll want to do what's called a "rollover IRA." There are no tax consequences or penalties so long as the money is transferred from your former employer directly into the rollover IRA account. Check with human resources before you do anything to make sure you understand any requirement the company may have about a rollover. The same goes with the company you've chosen to place your rollover IRA. And if you put the money into a comparable investment you shouldn't take much of a hit on the transfer, either.
Now, as to your other 401(k) accounts at 3 previous employers, why are you keeping the money there? If it's because you really like the plan options offered by these employers, fine. But my bias is for you to take control of the money through a rollover IRA. "It's great anytime you can take control of your money and take it out of your company plan," says Ed Slott, head of his eponymous company and a leading IRA expert.
You're no longer working for these companies. It's your money and if it's under your control you'll watch it carefully. Plus, you get to chose the investment company and investment options, not your former employer.
10/21/09 by Chris FarrellRoth conversion
Question: My wife has a combined income that is over the limit for a traditional IRA tax deduction or for contributing to Roth directly. We both also have employer sponsored retirement plans. Since there is no income limit for conversion from a traditional IRA to a Roth in 2010, I want to establish a traditional IRA now so that I can convert it to Roth next year. My question is, because I will be contributing to my traditional IRA after tax (or without any tax deduction), how I will be taxed when I convert my traditional IRA to a Roth coming 2010? Thanks. Andrew, Norman, OK
Answer: What you're planning on doing can be a smart move. Let me just give a bit of the background behind your question.
The Roth-IRA is a terrific retirement savings vehicle, probably the best available. The main reason is that all accumulated investment gains are free from Uncle Sam's clutches when withdrawn during retirement. The other attraction of the Roth is that it offers unusual flexibility for managing finances. For instance, there is no required minimum distribution at age 70 ½ with a Roth as there is with a 401(k) or a traditional IRA.
In the past, you could convert money stashed in a traditional IRA into a Roth, but you could only do it if your adjusted gross income was under $100,000. That earnings cap on conversion disappears next year. That's why the Roth conversion equivalent of a gold rush is about to be unleashed in 2010. Conversion calculators have sprung up all over the web. (The contribution limits to a Roth and the income phase-outs all remain essentially the same in 2010 and on. What have changed are the rules with conversion.) There are a lot of twists and turns to the Roth conversion question in 2010 and after. But it's an issue well worth researching.
Now, to your question. Many financial planners I've talked to are advising folks that earn too much to contribute to a Roth and a traditional IRA to open up what is called a non-deductible IRA. This is what you're planning to do. The non-deductible IRA is funded with after-tax dollars. The gain is tax-sheltered over the years and the earnings are taxed at your ordinary income tax rate on withdrawal during retirement.
But you're not going to wait that long. You'll convert the non-deductible IRA into a Roth in 2010. The only tax you will owe on conversion is on whatever gain you've earned in the meantime--in other words, not much. You won't owe anything on the contribution since you've already paid the tax tab on that money. And, of course, with this maneuver you won't pay any taxes on the investment earnings when you withdraw the money in your retirement years.
As I said, it can be a savvy move.
10/22/09 by Chris Farrell
Investment taxes
Question: Hi Chris, I have listening to Market place Money for the past several years and love to hear your views on the economy and your Q&A. Last year I bought some Municipal Bonds (MICHIGAN ST BLDG AUTH REV BDS CUSIP 594614W54) when the financial world was coming to an end (:((). I just did this as an experiment. (The post tax yield equivalent on these bonds were attractive at that time) If I were to sell these bonds after a year of holding them - what are the tax implications? Thank you and look forward to hearing your views in these historic times. Guru, Farmington Hills, MI
Answer: With the scenario you've laid out you would come under the capital gain and capital loss rules. You say you've owned the bonds for more than a year. Let's assume for illustration purposes that you paid $10,000 and you can sell the bonds for $10,400. You would have a capital gain of $400 with a maximum rate of 15%. (A long-term capital gain requires that the security be held for more than 12 months; the maximum rate on short-term capital gains is 35%.)
However, if you sold the bonds and could only get $9,800 for them you would have a capital loss of $200 that can be used to offset, first, a long-term capital gain and, second, if there is any loss left over any short-term capital gains.
Of course, there are a few other wrinkles, such as adjusting for selling costs and whether the bonds were sold at a discount. But that's the basic idea.
Thanks for listening.
Military thrift plan
Question: Hi, I recently left active duty military service and am trying to decide what to do with my Thrift Savings Plan. I've got about $40k saved in it right now.
When I look at the options for withdrawing, it seems like I'll be paying either 10 or 20 percent penalty fee.
I was thinking about starting a ROTH IRA. Should I take the penalty and roll it over into a ROTH IRA? Or am I better off just letting the money sit in the TSP until I retire? Thanks, Spencer, Humble, TX
Answer: You have a number of good options to think through. And you shouldn't pay a penalty or taxes with them. The one exception on taxes is the Roth option. I'll explain in a moment.
First of all, the Thrift Savings Plan is a really good, low-fee plan. It's hard to beat. You might want to simply leave your retirement savings in the plan.
If you still want to move your savings out of the Thrift Savings Plan you can roll it over into another tax sheltered plan. For instance, if your current employer's savings plan allows it you could transfer the money into your new 401(k). Alternatively, you could roll it over into an IRA. In both cases you don't take the money out. You'll make an institution to institution transfer of the money, preserving its tax-sheltered status. No penalties will be imposed, either.
You could put the money into a Roth-IRA. Since the Thrift Savings Plan was funded with pre-tax dollars and a Roth is funded with after-tax dollars you'll owe taxes on the money your transfer into the Roth. However, when you pull the money out during retirement the gain is free of Uncle Sam's levy. By the way, in most cases it does not make sense to Roth if you have to use your retirement savings money to pay the tax levy. It reduces the amount that can grow, free of tax, in the Roth.
I'm not sure which branch of the military you served in. But the Navy offers a clear brief explanation of your choices.
Inflation indexed bonds
Question: Is there a way I can buy "I" series treasury bonds with pre-tax money? I would like to hedge a little bit against inflation with these bonds, but don't like buying them with after tax dollars. Does this make sense? I am open to suggestions. Jeff, Sparta, TN
Answer: Let me clarify the choices. In an IRA or comparable retirement savings plan you can't buy Treasury Inflation Protected Securities directly from the U.S. government. However, you can purchase them through a broker with pretax dollars in an IRA, 401(k), and the like. (And commission costs are low.) You can also buy mutual funds that invest in TIPS with pretax money.
The I-bond is a savings bond that also offers investors an inflation hedge. It is purchased with after-tax dollars. But the money compounds tax free until you cash them. You don't want to buy I-bonds with pretax dollars since it's already a tax-sheltered form of savings.
Both TIPS and I-bonds are good long-term investments for savers.
The $6,500 tax credit
Question: I have a question about the recent federal tax credit for 1st time home buyer extension to cover move-up / repeat buyers.
All news and discussions talk about $6,500 for qualified move-up / repeat buyers. I moved from an old house to a new one in April. I lived in my old house for more than 5 years. Am I qualified for the credit? My realtor said yes but, when I checked the federal housing web site, it says only purchase after November 6 is qualified. I meet all qualifications except for my purchase date. Is there a date limit for the qualification??? Thanks, Joseph, Carrollton, TX
Answer: I don't like it. The $6,500 tax credit has several twists and turns, including income limits. Here is a good review of all the rules.
Anyway, to your question: The $6,500 credit applies to existing home owners "purchasing a principal residence after November 6, 2009 and on or before April 30, 2010 (or purchased by June 30, 2010 with a binding sales contract signed by April 30, 2010). " Sorry.
11/10/09 by Chris FarrellTaxes and short sale
Question: I'm trying to find out the tax implications of selling our house in a short sale. Basically, our house was on the market for 2years and after the real estate downturn, it appraised for 70,000 less that what we owed on our mortgage. We weren't in a position to keep the house and "ride it out" so we did a short sale and the bank accepted an offer of 70,000 less than we owed. I'm hoping you can tell me how this figures into our taxes. I heard that in the past, when a lender forgives a debt, it is considered income. But then more recently I heard that the government changed that tax policy for short sales. I just don't know how to find out more. Thanks for your help! Jen, Salisbury, CT
Answer: You should be okay on the tax front. Thanks to the Mortgage Relief Act of 2007 signed by President Bush you shouldn't owe taxes on the amount forgiven on a short sale of your primary home between 2007 and 2012. But the best advice I can give is for you to consult with a tax expert.
Here's the background. It used to be that the IRS would treat the amount forgiven by the bank in a short sale as income. You'd get a 1099 on the "gain." But in response to the housing crisis the tax treatment of a short sale was suspended until 2012. The IRS has a discussion of the tax treatment of debt relief here.
Gift stock to Mom
Question: What are the tax implications of giving a gift of appreciated stock to parents? I have some stock which has appreciated over the last couple of years and would like to gift some of it to my mother. Does her cost basis become zero when she sells it? Would it be better for me to sell it, pay the capital gains taxes, and have her rebuy it with the proceeds? Jim, Cincinnati, OH
Answer: When it comes to taxes there are always two phrases I have to write. The first is, "it all depends." The second is "check with a tax professional." I'm certainly not a CPA.
That said, gifting appreciated stock to your parents could be a savvy move depending on several moving parts.
Here's an example with several assumptions: You say you bought the stock several years ago and it appreciated in value. Let's assume you bought the stock for $10 a share and when you gift it the value is $20 a share. The total value of your gift is below the current $13,000 gift tax exclusion. Your Mom is in a lower tax bracket than you're in.
Okay, you gift her stock at $20 a share. She turns the stock into cash by selling it immediately at $20. Now, her cost basis for figuring out her tax liability is $10 a share--the price you bought it at. However, she also gets to take advantage of the low capital gains tax rate since you owned the stock for more than a year. Better yet, if she's in a low tax bracket her capital gains tax rate could be below yours. For instance, the long-term capital gains tax rate for folks in the 10% and 15% tax brackets is zero. That's right, 0%. The long-term capital gains rate for everyone else is 15%. (These rates only hold through 2010. They change in 2011.)
As you can see the devil is in the details. Change one assumption and the tax implications shift. Still, the idea is worth pursuing. It could be a very cost effective way to get money to your Mom. And that's always a nice thing to do.
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Latest Comments
- The $6,500 tax credit (4)
- Scott Kraz wrote: Nope. After November 6 is a direct quote from several sites ( <a href="http://www.irs.gov/newsroom/a... [read]
- Anne R wrote: Same here. We closed on 11-2-09. Wondering the same thing about the signing date.... [read]
- Roth conversion (2)
- Eric wrote: More info on the "non-deductible IRA", please!... [read]
- Jeremy wrote: Be careful if you do a partial conversion of your IRA's... Say you have a rollover IRA from an old ... [read]
- Rollover IRA (1)
- Scott K wrote: It's quite possible that the plan providers from your 3 old jobs have been charging you above marke... [read]
- Mortgage and taxes (1)
- Kelly Miller wrote: The income tax deduction on mortgage interest lowers your effective your interest rate, because it g... [read]
- Retirement savings and taxes (4)
- Andrew Latour wrote: Yes, yes. Indeed, how can we best avoid our responsibilities as citizens? In fact, perhaps the gover... [read]
- Scott Kraz wrote: The government created retirement accounts to encourage personal savings as opposed to reliance on S... [read]
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