« February 2009 | Main | April 2009 »

March 31, 2009

Tax Planning as You Age

While tax planning should be a consideration through all phases of life, the nature of that planning changes as you approach retirement age. During your working years, your primary tax-planning objectives are to reduce your current income taxes while saving for retirement. After decades of accumulating money, you now need to ensure you withdraw and manage that money properly. Here are five tips you should consider:

Rolling out of a 401(k): If you don't want to leave your funds in your 401(k) plan, you should consider transferring your money to an individual retirement account (IRA). You can now transfer directly to a Roth IRA, provided your adjusted gross income does not exceed $100,000 in 2008 or 2009. Starting in 2010, there is no income requirement. While there are no income tax ramifications if you roll over from a 401(k) plan to a traditional IRA, you do have to pay taxes on the amounts that would be taxable when withdrawn when converting to a Roth IRA (i.e., contributions and earnings in deductible IRAs and earnings in nondeductible IRAs). However, if you pay the income taxes from funds outside the IRA, you have essentially increased the value of your IRA, since you won't have to pay income taxes on qualified withdrawals.

If you own stock in the company you work for in your 401(k) plan, consider those assets separately. There is a provision in the tax code that may save you a substantial amount of taxes. Instead of rolling over the company stock, have the shares distributed to you and put them in a taxable account. You will owe ordinary income taxes on the cost basis of those shares, which equals the price that was paid when the stock was purchased. (If you take the distribution prior to age 59 1/2, you may also owe the 10% federal penalty on the cost basis.) At this point, you do not pay taxes on any appreciation in the stock's value. When you sell the stock, provided you have held it for over one year, you will owe capital gains taxes at a maximum rate of 15% on the net unrealized appreciation, rather than ordinary income taxes that would be paid on other traditional IRA distributions. If you have substantial appreciation in your company stock and are in a high marginal tax bracket, this strategy can save you a substantial amount of taxes.

Handling an inherited IRA: IRAs are becoming an increasingly significant asset for many people due to 401(k) rollovers and asset growth. Thus, it is becoming more likely that you will inherit an IRA. Don't immediately cash out an inherited IRA, which requires the payment of income taxes on the distribution. If you inherit a traditional IRA from a spouse, you can delay distributions to age 70 1/2 and then take distributions over your life expectancy. No distributions are required during your life if it is a Roth IRA. If you inherit the IRA from someone other than your spouse, you must start taking distributions in the year following the owner's death, but you can take those distributions over your life expectancy. Make sure to investigate whether you are entitled to an income in respect of decedent deduction, which is available when federal estate taxes are paid on IRA assets. This deduction can help offset income taxes due on distributions.

Dealing with a second home: If you plan on moving after retirement, you might want to acquire a home in that location before retirement. But first, be aware of the 1031 exchange rules. These rules allow you to sell one property and purchase another of like kind, deferring any gains. For instance, this tax rule can be used to help acquire a retirement home. Start out purchasing a small investment property. You can sell it at a later date and purchase a more expensive property, deferring the gains. You can continue this process until you eventually purchase your retirement home. However, before living in the home, you must first rent it out to defer the gain. While there are no clear-cut rules on how long the home must be rented, the Internal Revenue Service has validated a two-year period. After that, you can move into your retirement home and use it as your principal residence. Currently, as long as you live in the home for two of the last five years before selling, you could then sell the home and exclude up to $250,000 of gain if you are single and up to $500,000 of gain if you are married filing jointly. However, the Housing Assistance Tax Act of 2008 will affect sales and exchanges after December 31, 2008. The home sales exclusion won't apply to the extent gain from the sale or exchange of a principal residence is allocated to periods of nonqualified use. Generally, nonqualified use is any period (other than the portion of any period before January 1, 2009) during which the property is not used as the principal residence of the taxpayer. The amount of gain allocated to periods of nonqualified use would reduce proportionately the home sale exclusion amount.

When purchasing the second home, be sure to get a mortgage on that property rather than a home-equity loan against your principal residence. Interest is only deductible on $100,000 of a home-equity loan, while the entire mortgage interest up to a $1,000,000 loan would be deductible.

Selling a business: Many business owners find that their business comprises a substantial portion of their net worth. Thus, when it comes time to sell that business, they naturally want to negotiate as large a selling price as possible. But keep in mind that there are many ways to structure a sale. You might want to consider an installment sale, so the gain is recognized over a period of years rather than a single year. You may want to consider including a consulting contract for a period of years. If you are selling the business to employees, an employee stock ownership plan may make sense.

Reviewing your estate plan: As you approach retirement, it's a good time to review your entire estate plan. While the estate tax exemption has increased (from $2,000,000 in 2008 to $3,500,000 in 2009) and the estate tax will be repealed in 2010, this amount will drop back to $1,000,000 in 2011 unless further legislation in enacted. Thus, individuals with estates over $1,000,000 still need to consider ways to use their exclusion amounts to minimize estate taxes. Those with large estates probably don't want to leave their entire estate to their spouse. While that will avoid estate taxes on the first spouse's death, estate taxes may be owed after the second spouse's death if the estate is larger than the estate tax exemption.

While increasing estate tax exemption amounts can make it more difficult to plan, you should still consider leaving part of your estate to other heirs. If you don't want to make outright distributions in case your spouse needs the assets, you can set up a trust (commonly referred to as a credit shelter or bypass trust) to hold those assets. Your spouse can then use the income and even some of the principal, with the remaining assets distributed to your heirs after his/her death. This preserves the use of your exclusion amount. You may also want to add a disclaimer provision to your estate planning documents, detailing what happens if one of your heirs disclaims his/her inheritance. With the estate tax exemption amount fluctuating over the next several years, this provides a way for heirs to decide after your death how much should be placed in various trusts.

March 23, 2009

Should You Buy Insurance If You're Renting a Car?

Before you fork over the money, you may want to first ask -- do you need insurance when renting a car? There are many reasons you may need or have to rent a car: you're traveling, you don't want to use your own car for long distance driving, your own car may be in the shop for repairs, or you don't own a car but must travel. Whatever your reason is for renting a car, carefully consider if you really need that extra insurance.

Types of Insurance Offered at Major Car Rentals

When deciding if you do need that extra insurance when renting a car, it would help to know and understand the different types of car insurance being offered by rental companies.

1. Collision damage or loss damage - This is essentially a form of waiver that relieves you of any responsibility to pay for loss or damage to the rented car in case of theft, vandalism or accident.

2. Liability insurance - The liability insurance sold through the car rental company will give you supplemental coverage if you own a car and have your own insurance policy.

3. Personal accident insurance - This will insure you and your passengers for medical expenses should you be injured if the rented car figures in a car crash.

4. Personal effects coverage - This offers insurance protection in case your personal items are stolen from the car you rented.

To Buy or Not to Buy Insurance When Renting a Car

Before finally deciding if you need insurance when renting a car, you should take a good look at your own car insurance policy and the insurance benefits you can get on your credit cards. If you are a car owner, you should have your own insurance policy already.

However, to make sure that you are amply protected, check with your insurance agent about the limitations of your policy and the type of additional insurance you will need if you rent a car. If what you have is a comprehensive insurance, you can rest assured that any car you drive, even a rental, is covered under your existing policy.

Major credit cards provide insurance benefits to their account holders. They usually include coverage for rentals of regular cars within the country. To be sure, call the card company to ask about the type of insurance they're giving you. Note that credit cards do not usually cover the cars you rent in foreign countries, as well as cars of expensive makes and models, SUVs, or RVs. Again, phone the card company to check on the details of your insurance benefits.

And if you have to bring along jewelry and electronic items like digital camera, cell phone, or laptop computer when you drive the rental car, you should consider buying a personal articles floater. The floater rides on your homeowner's insurance policy (or renter's insurance of you're not the homeowner) and covers your personal possessions at home or when you take them with you anywhere. This way, you can do away with the personal effects coverage when you rent a car.

Do remember that no matter how skillful or careful a driver you are, there are other vehicles you will encounter on the road and anything can happen. There is no doubt that you need insurance coverage but if you are already fully covered by your existing insurance policy, it will just be superfluous on your part. So, do you need insurance when renting a car? You should already know the answer by now.

March 20, 2009

Get to Know the Three Types of IRS Audits

The Internal Revenue Service (IRS) is not exactly the favorite government agency of many Americans. This can only be expected given that everyone thinks differently on how best to compute and pay their taxes. Nonetheless, you should have a working knowledge of the tax system to be prepared in case you get audited. It is reported that around 80% of American tax payers are subjected to an IRS audit at least once in their lifetime.

What is an Audit and Why Should You Care?

One of the basic duties of the IRS is the audit, a routine check on selected individuals and business entities to determine if they correctly declared their income and paid the proper taxes. The IRS does not randomly choose tax payers who are up for audit. The list of individuals up for an IRS audit is generated by the IRS computers and the list is based on information contained in the tax returns filed with them. The computers check the returns and claims for any likely errors and rank them accordingly. Tax payers that rank high in the list are more likely to be subjected to an audit.

One of the cases that can raise red flags is a low declaration of income that is accompanied by a huge claim for deductions (expenses). Therefore, if you have been spending more than what you earn, you can almost expect the IRS to be knocking at your door anytime soon.

Do not panic in case you receive notice of an IRS audit. It does not imply that the IRS suspects you of being a fraud or a tax evader. The IRS only wants to verify your claims and check the accuracy of its records to spare you of any future problems. There are three kinds of IRS audits, and what you will be subjected to depends on your income declaration.

Correspondence Audit

The IRS notifies you by mail that you are under audit and explains the reasons behind the examination. You will be requested to send them specific documents to support the information you included in your tax return. The usual grounds for this type of audit are brokered transactions like stock deals or real estate matters.

Office Audit

If your notice is for an office audit, you will be scheduled for a meeting with a tax auditor at the local IRS office. You will also be asked to bring along certain documents to substantiate your tax return. At the meeting, the auditor will examine your tax return and review your documents while interviewing you on the notable items in your return.

If you are not able to answer all the auditor's questions during an office audit, you may be scheduled for a second meeting. It is to your advantage if you seek the advice of a certified public accountant or tax attorney before attending the meeting. That way, you will be briefed on what to expect and how to respond satisfactorily to any questions that might be raised.

Field Audit

With a field audit, the IRS agent personally visits you at home or at work to perform the audit. It is usually the big businesses and individuals earning six figures or more that are audited in this manner. If you are up for a field audit, ask a tax professional to be around during the audit to represent you and facilitate the whole process.

March 16, 2009

Pension Plan Decisions

In the past, a retiree typically received a monthly pension check and Social Security benefits. Now, it's not uncommon for a retiree to have a pension plan, a couple of 401(k) plans, some individual retirement accounts (IRAs), personal savings, possibly some deferred compensation, and maybe an annuity. Deciding how to handle all of those different income sources in the most advantageous manner is a daunting task. In many cases, decisions regarding pension plans are irrevocable, so proper choices are imperative. Before making those decisions, consider the following:

Prepare a list of all of your retirement assets, by type of plan. Indicate the expected monthly income as well as the earliest and latest date you can start taking benefits. Review the payment options available to see if some assets should be used before others. For instance, defined-benefit plans and deferred compensation plans generally require you to take benefits when you retire, whether you want the money or not. Other plans, such as 401(k)s and IRAs, allow you to start withdrawals between the ages of 59 ½ and 70 ½, providing flexibility regarding the amount withdrawn. Thus, if you can, it is typically advantageous to leave that money in the plan to grow tax deferred until a later date. You must begin taking minimum distributions from traditional IRAs (not Roth IRAs), 401(k) plans (unless you are still working), and other qualified plans by the time you are 70 ½.

Decide whether you want to take a lump-sum distribution or receive an annuity. This option is generally offered with 401(k) plans, profit-sharing plans, and some defined-contribution plans. Your decision should be based on the income tax ramifications of the different options, your personal needs, and your financial ability to handle the money.

If you opt for an annuity, you must decide among various payment options, including life only, which pays you a certain amount until your death; joint and survivor, which will also pay a certain amount to your spouse after your death; and life and period certain, which pays a certain amount for your life or a specific time period, whichever is longer. Your payments are generally taxed as ordinary income when received.

You may like the peace of mind that comes with annuities, since you are assured of a monthly income without having to worry about investment decisions. However, annuity amounts are typically fixed, so inflation can seriously erode the purchasing power of this income over the years.

A lump-sum distribution gives you the opportunity to invest your retirement funds. Thus, you receive the rewards of smart investment decisions, but you can also suffer from poor decisions. Since you own the funds, proceeds can be left to your heirs after death.

The tax treatment of a lump-sum distribution depends on how you handle the distribution. The least favorable alternative is to include all the proceeds in your taxable income in the current year, subjecting the proceeds to your top tax rate, and possibly the 10% tax penalty if you are under age 59 ½.

As an alternative, any portion of your account balance in a qualified plan can be rolled over into an IRA within 60 days. This rollover defers the tax on the distribution and allows it to grow tax deferred until withdrawn. Keep in mind that if you take possession of the funds, your employer must withhold 20% of the proceeds, even if you plan to roll over the entire balance. You can avoid this provision by having your employer directly transfer the distribution to your IRA. If you are between the ages of 59 ½ and 70 ½, you can access the funds as you need them, penalty free, paying ordinary income taxes only as you withdraw funds.

Determine how to withdraw money from your plans. After going through this analysis, you can decide when to start taking distributions. These decisions will take into account your life expectancy, your tax situation, your current income needs, the expected inflation rate, and your expected rate of return on retirement assets. The calculations can become very complex if you need to evaluate several different plans under several different payment scenarios. Should this occur, you may want to consult with an investment advisor for guidance.

March 12, 2009

How to Determine a Reasonable Rate of Return

How do you know if you're saving enough for a future goal? You must get three factors right: how much do you need; when do you need the money; and, how much you'll earn on your investments. You can then calculate how much you should save on an annual basis.

The typical approach to estimating a rate of return is to look at average annual returns for some historical period. For instance, from 1926 to 2007 (82 years), the average return for the stock market as measured by the Standard & Poor's 500 (S&P 500) was 10.4%. Change the period to 1958 to 2007 (50 years) and the return changes to 11.0%, 12.7% from 1983 to 2007 (25 years), and 5.9% from 1998 to 2007 (10 years).* Assume you want to save $1,000,000 in 30 years. To reach that goal, you need to save $5,635 annually at 10.4%, $5,025 at 11.0%, $3,616 at 12.7%, and $12,873 at 5.9%.

It's tempting to use the highest return possible, since that results in the lowest savings amount. But consider using a conservative estimate. If you save too much, you can always reduce savings in later years or spend more in retirement. The alternatives are far less attractive if you don't save enough. Consider the following points:

Your investing time frame will probably encompass decades. Thus, consider using an historical rate of return that covers a very long time frame, making adjustments from there.

Factor in inflation. When estimating inflation, factor in a long time period. For instance, inflation, as measured by the consumer price index, averaged 3.1% since 1926 (Source: Bureau of Labor Statistics, 2008).

Watch your pattern of returns. Even if you get the average rate of return exactly right, your portfolio's balance will depend on the pattern of actual returns during that period. Some years will experience higher-than-average returns, while other years will have lower or even negative returns. If you experience higher returns in the early years, your portfolio balance will be lower than if those returns occurred in the later years. If you encounter negative returns in the early years, you will have a higher balance than if those negative returns came in the later years. Assess your portfolio's progress every year so you can make adjustments along the way.

What is a reasonable long-term rate of return to use for stock investments? Starting with the average return from 1926 to 2007 of 10.4% and subtracting 3.1% inflation would result in a return of 7.3%. You may even want to use a more conservative return if you feel the stock market may encounter an extended period of below-average returns. Sure, that means you'll need to save more every year, but learning to live within your means and saving significant portions of your income aren't bad things.

* Source: 2008 Ibbotson Stocks, Bonds, Bills, and Inflation Classic Yearbook. The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.

March 9, 2009

Assisting Your Parent With their Finances

Discussing financial matters with your parents can be difficult. You don't want to seem concerned about how much money they may eventually leave you, while they may fear you are interfering in their lives. Yet, without discussing these matters beforehand, you may have trouble finding financial records or determining their wishes if you need to take over their finances.

Consider discussing financial matters with your parents when they are in their early 60s. Include all immediate family members to prevent future misunderstandings, making sure to cover the following:

Where are personal records kept? You don't need to know specifics, but you should find out where important records are located. Determine where details about insurance policies, investments, deeds, birth and marriage certificates, pension information, bank statements, estate planning documents, credit card information, and outstanding debts are kept.

Who are their advisors? Ask for a list with names, addresses, and phone numbers of all advisors and physicians. Get details about medical conditions and medications being taken.

What are their monthly income and expenses? This will help you determine whether they have sufficient income to pay bills. If they don't, you may be able to help them change investment selections or find ways to increase income.

Do they have adequate insurance? Make sure your parents have adequate insurance coverage and have made provisions for long-term-care needs. Have them investigate long-term-care insurance when they are still healthy and young enough to qualify for reasonable premiums. If they aren't interested in coverage but you fear the burden of long-term care will fall on you, you may want to obtain the insurance for them.

Do they have up-to-date estate planning documents? Don't ask for specifics, just make sure documents are in place so their wishes can be carried out. Find out if they have a durable power of attorney and health-care proxy. With a durable power of attorney, they designate someone to control their financial affairs if they become incapacitated. If your parents are concerned that this person may assume control prematurely, suggest leaving the document with their attorney, who can deliver it to the appropriate person when necessary. A health-care proxy delegates health-care decisions to a third person when your parent is unable to make those decisions. Usually, this document also outlines procedures to be used to prolong life.

What are their preferences for the future? Find out where your parents would like to live if they're not physically able to live in their current home. Do they want to move in with relatives or live in an assisted-living facility? Discuss in detail what procedures they want performed to prolong life in the event of a terminal illness. Determine their preferences for funeral arrangements.

March 6, 2009

The Balance Between Risk and Return

One of the most basic investment principles is that returns reward you for the risks that you take. While investors are often uncomfortable with the concept of risk, it is this uncertainty that makes higher rates of return possible. Below are some basic investment principles related to risk and return:

• Returns on specific investments are not known in advance. Investors can review historical rates of return, but there is no guarantee that past returns will be indicative of future returns.

• With most investments, there is the possibility that the investment will not meet your return expectations.

• The uncertainty regarding your actual return creates risk. Greater uncertainties typically lead to greater risk.

• Investments are subject to many different types of risk. Cash is primarily subject to purchasing power risk, or the risk that its purchasing power will decrease due to inflation. In addition to purchasing power risk, bonds are subject to interest rate risk, or the risk that interest rates will increase and cause the bond's value to decrease, and default risk, or the risk that the issuer will not repay the principal or interest on the bonds. Stocks are primarily subject to nonmarket risk, or the risk that events specific to a company or its industry will adversely affect a stock's price, and market risk, or the risk that a particular stock will be affected by overall stock market movements.

• There is generally a tradeoff between risk and return. Low levels of risk are the most desirable and typically have lower return potential; while higher levels of risk are typically undesirable, so they must offer higher return potential to encourage investors to invest. Be cautious of claims of high returns with low risk.

There are strategies that can be used to reduce the total risk in your investment portfolio:

Diversify your portfolio. You should diversify among several different investment categories, including cash, bonds, and stocks, as well as within investment categories, such as owning several types of stocks. A properly diversified portfolio should contain a mix of asset types whose values have historically moved in different directions or in the same direction with different magnitudes. By owning several investments rather than just one, a downturn in any one should not have a significant impact on your total return.

Stay in the market through different market cycles. Remaining in the market over the long term helps to reduce the risk of receiving a lower return than expected, especially for more volatile investments, such as stocks.

Use dollar cost averaging to invest. Rather than accumulating cash so you have a large sum to invest, invest small amounts regularly. Dollar cost averaging involves investing a certain sum of money in set amounts at regular intervals. This spreads your purchases over a period of time, preventing you from making one major purchase at high prices. Since you are investing a set amount, you purchase more shares when prices are lower and fewer shares when prices are higher. While a valuable investment strategy, dollar cost averaging does not ensure a profit or protect against losses in declining markets. Before starting a program, consider your ability to continue purchases during periods of low price levels.

March 4, 2009

Does the Buy and Hold Strategy Still Make Sense?

We all know the basics -- design an asset allocation plan, ignore market fluctuations, and stick with the plan for the long term. In other words, become a buy-and-hold investor. But in an era where everything seems to change overnight, is it realistic to expect to find investments you'll be comfortable owning for years or even decades?

Before you answer that question, you need to consider whether it's possible to reliably time the market. Unfortunately, it's a difficult strategy to implement for a couple of reasons:

No one has been able to consistently predict where the stock market is headed. Many try, but so many factors affect the market that even professionals watching the market full-time find it difficult to time the market with any degree of accuracy. In retrospect, everything seems crystal clear. Are you still upset you didn't get out of technology stocks in 2000? While we now know that was the market top for technology stocks, very few recognized that in 2000. Also, significant market gains can occur in a matter of days, making it risky to be out of the market for any length of time.

Frequent trading seems to reduce, rather than increase, returns. Several studies of investor trading found that investors who trade more frequently have lower portfolio returns than those who trade less frequently. A recent study found that for the 20 years ending in 2007, the average equity fund investor earned an annualized return of 4.5%, compared to an annualized return of 11.8% for the Standard & Poor's 500 (Source: Fortune, November 10, 2008).* Why? Investors tend to buy hot sectors and sell underperforming investments -- the opposite of a buy-low-and-sell-high strategy. Also, trading results in a taxable event. Even with capital gains rates at 15% and the highest ordinary income tax rate at 35%, taxes significantly reduce your portfolio's return.

Rather than trying to time the market, devise an asset allocation strategy you'll be comfortable with for years and then purchase investments for that strategy. That doesn't mean you'll never sell an investment, but selling should be an infrequent part of your investment strategy.

* The S&P 500 is an unmanaged index generally considered representative of the U.S. stock market. Investors cannot invest directly in an index. Past performance is not a guarantee of future results. Returns are presented for illustrative purposes only and are not intended to project the performance of a specific investment.

 

Seeking Alpha Certified
Creative Commons License
This weblog is licensed under a Creative Commons License.

Privacy Policy - Terms and Conditions - Site Map - About Company - Contact Us
Link to Us - Partners - Advertiser Center - Newsroom

© ManagingMoney.com. All Rights Reserved.
Image Domain - Las Vegas Web Design Services