Marketplace

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.

12/20/07 by Chris Farrell

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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 Farrell

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Taxes 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

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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

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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.

02/04/08 by Chris Farrell

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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.

02/11/08 by Chris Farrell

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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

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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.

02/19/08 by Chris Farrell

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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 Farrell

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Downsizing

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

04/15/08 by Chris Farrell

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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.

04/16/08 by Chris Farrell

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