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Call All Bloggers! 2nd Annual 1% More Blogging Project

Nov 4th, 2013
by jblankenship.
1 comment
ceramic piggy bank

I’m sure that I’m not alone in the financial planning world with my concern about the rate of saving toward retirement across this great land.  Recent figures have shown that we Americans are not doing as this year as last, at a 4.6% rate versus 5% last year when we started this project. This is a dismal figure when you consider how most folks are coming up way short when they want to retire.  Just like last year in November, I thought maybe something could be done to encourage an increase in savings – if only by 1%, this can be a significant step for lots of folks.  November is the perfect time to do this, as most corporations are going through the annual benefit election cycle, so the 401(k) (or 403(b), 457, or other savings plan) is right at the forefront for many folks.

I’m proposing that all financially-oriented bloggers sharpen up their electronic pencils and write a column to encourage folks to increase their 401(k) savings by at least 1% more than last year.  I’d suggest taking a new look at this situation, perhaps suggesting ways that people can free up money to devote toward savings, for example.  I know you folks have a lot of great ideas, so don’t let my lame suggestions limit you!

In order to keep it oriented toward the benefits enrollment period for many companies, we should probably produce these articles between now and Thanksgiving.  Of course, most folks can make an increase to savings at any time, but while employees are looking at benefit options is a good time to strike while the iron’s hot.  If you’re interested in joining this action, send me a note at jim@blankenshipfinancial.com and let me know when you’ve posted your article.  I’ll keep a list of all of the articles with links on a blog post at my blog – this way anyone who’s looking for ideas on how to increase savings can find a multitude of ways to do so.

I have started things off this morning with my first post about saving more: Take a Small Step: Increase Your Savings by 1%.  I’ll continue to produce the list of articles every Monday and Friday during November – keep checking back!  I’ll also be tweeting about the project using the tag #1%more – keep it moving!

Thanks in advance for your help!

jb

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Take a Small Step: Increase Your Savings by 1%

Nov 4th, 2013
by jblankenship.
2 comments
saving and spending

saving and spending (Photo credit: 401(K) 2013)

As savers, we Americans are not doing a good job.  We’re improving (according to recent data), but still way behind what we should be saving.  But it doesn’t have to be that way – you can take small steps to increase your savings right away, and it doesn’t have to hurt.

The Bureau of Economic Analysis recently reported that we are saving at a rate of around 4.6% of disposable personal income, an increase of 0.1% over the prior month.  On a per-person basis, that works out to about $1,831 saved per month, or just short of $22,000 per year.  Since we know that very, very few people are exactly average (by definition most people are going to be something above or below the average), what concerns me is that even those who are a bit above the average are still not saving enough.  And woe to those who are saving at a rate far below the average.

The math works it out – say for example you’re a bit above average, saving 5% on a disposable income that is a bit above the average, say $60,000 per year (the simple average annual disposable income per person works out to just less than $40,000 per year).

Saving 5% over your working life of 40 years will result in a nest egg of $362,400 (inflation-corrected, earning a rate of 5% annually).  Even at the most optimistic of withdrawal rate of 6% per year, this amounts to $21,744 – not exactly the 80% of income most folks hope to have for retirement income.

Given that most likely more than half of all Americans are below the average savings rate, you can see my cause for concern.  If we don’t get started increasing our overall savings rates, it’s going to be a bleak existence in retirement (ask anyone who’s still working past age 65 because he or she has to how that feels).

I realize that saving more isn’t easy – after all, we have so many things we have to pay for, and the cost of all these things is increasing all the time.  The problem is that we need to make some decisions about what’s critical to pay for: is it really more important to have a membership at the gym that you only go to once a month, or would you like to be able to afford to pay for your accustomed meals when you’re retired?  Or do you really need the expanded satellite TV package?  If you pay attention to what you’re paying out each month and weigh that against paying for the basics in retirement, it’s not as hard of a decision.  If you’ve got other great ideas for reducing expenses and increasing savings, leave a comment below – I’d love to pass them along to everyone else.

Increasing savings just a bit – say 1% – would only result in decreasing the example above average person’s monthly net disposable income by $50.  Surely you can find somewhere in your budget to set aside an extra fifty bucks!  And the resulting 6% withdrawal could be increased to just over $26,000 – an increase of 18%.

Of course, that’s still a small portion of the current take-home of this above average person, but it’s an improvement! So take that small step – start saving an extra 1% more right now, there’s no time like the present!

Note: the figures I use above for the example are extremely over-simplified, using a simple average per-person income rate for all Americans (estimated at 317 million), and the reported figures from BEA (the Bureau of Economic Analysis) to build my example.

In case you’re wondering, in order to replace 80% of your income at the more sustainable 4% withdrawal rate, you’d need to set aside an average of approximately 17.5% of your disposable income over your 40-year working career.  This means every year, not just the later years of your career.  So if you’re late getting started, you need to save, save, save, with both hands, in order to catch up and have enough set aside to provide yourself with a retirement income that will keep you going. 

Of course, if you have a pension, that will factor into your available funds in retirement, as will Social Security.  But neither of these sources should be considered guaranteed, nor should they be your only source of income.  In today’s world, you have to fend for yourself!

Best wishes to you – if you have additional ideas on how to find money to put into savings, leave a comment below.  We’d love to hear your ideas.

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NUA Allocation Twist – Not as Easy as it Looks

Oct 30th, 2013
by jblankenship.
6 comments
NUA ALONE

NUA ALONE (Photo credit: NAPARAZZI)

I’ve written much about the Net Unrealized Appreciation (NUA) treatment for company stock in a 401(k) plan – this is the provision that allows you to pull out company stock as part of a full distribution from the plan and get favorable tax treatment for the gain on the stock.  More about NUA can be found in this article about Net Unrealized Appreciation Treatment.

One of the factors in that article speaks to a special way to allocate the basis (original cost) of the stock.  Specifically, if handled correctly, the ordinary income tax on the NUA move can be minimized or eliminated, and the capital gains treatment maximized.

However. (As you know, there’s always a however in life!)

The problem with this move is that you absolutely must get the 401(k) administrator to go along with your plan – in order to make sure that the 1099R generated by your distribution correctly describes how you’ve allocated the basis.  If not, the strategy depends entirely on your own word and record-keeping, which I personally would not want to have as my only basis if the IRS disagrees with you on the applicability of the law to your actions.

I’ve spoken to quite a few folks who have looked into this, hoping to take advantage of the way I’ve described it and minimize or avoid tax altogether.  It seems that, at least among all those I’ve heard about, 401(k) administrators as a group don’t like to take direction from their participants.

Either that or they don’t want to do anything out of the ordinary (this is the more likely reason, in my opinion).  I can’t say that I blame them – there’s no benefit in it to them.  Even when confronted with the rules and the law that allow this move, I’ve not heard from any that have gone along with it yet.  (If you have gone down this path successfully, please let me know – leave a comment below! I’d love to hear of successes with this component of the law.)

So, unfortunately if you’re hoping to use the special allocation of basis option, I’m in your court, but expect to run into some push-back.  Although the option seems to be completely valid, don’t count on getting to use it.

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How Adding to Your Earnings Can Increase Your Social Security Benefits

Oct 23rd, 2013
by jblankenship.
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increaseGiven the way that Social Security benefits are calculated, it should come as no surprise that increasing your income over time will make a difference in your eventual Social Security retirement benefits.  But how much of a difference does it make when your income is increased?

Of course, this is going to depend upon what your current income is, and how many years you have left before you’ll begin receiving benefits.  Keep in mind how your benefits are calculated – see this article for information about Computing Your Social Security Monthly Benefit – it’s based on your average monthly income over your lifetime.  Increasing that average will increase your PIA, which will in turn increase your benefit.

It’s definitely not a simple calculation to figure out what difference each increased dollar of income will have on your benefit.  Let’s walk through a few examples to see how it plays out.

Example 1

Jane, age 32, has been earning an inflation-adjusted $2,000 per month during her working career, beginning at age 22.  If her income only keeps up with inflation between now and age 62, her average indexed monthly earnings (based on today’s dollars) would equal $2,000.  Running the numbers to determine her PIA, we use these equations (2013 figures):

90% of the first $791 = $711.90
32% of the next $1,209 = $386.88

Jane’s PIA is the sum of these two numbers, $1,098.78.  This is the amount that Jane would receive at Full Retirement Age (of course, adjusted by inflation at that time).

So what would happen if Jane can increase her average income by $100 per month, from now until she’s ready to retire?  Since she’s 32 now, she’s had 10 years at the average adjusted rate of $2,000 per month, so this means her income for the coming 30 years will need to be approximately $2,117.  Running the numbers on her new average monthly income of $2,100:

90% of the first $791 = $711.90
32% of the next $1,309 = $418.88

That brings Jane’s PIA to a total of $1,130.78, a monthly increase of $32 dollars.

What if the individual has a much lower current average income?  Intuitively you’d have to figure that the increase of $100 would have a higher percentage of impact on benefits, right?  It depends on where you are on the scale of bend points.  Let’s look at two individuals, Ed and Seth.

Example 2

Ed, age 37, has an average income of $1,000 per month over his lifetime. Seth is 42, and has a lower average income – only $500 per month.  Ed and Seth are thinking about starting a very small side-business which will bring in $100 a month each.  Neither fellow earns any more in his regular job (other than COLA increases) throughout the rest of his life.

As a result, without the side-business, Ed’s PIA at age 62 would be $778.78.  If he adds the side-business income, his average over his lifetime would increase, and so would his PIA – to $801.64, for an increase of $22.86 per month.  Seth, on the other hand, would have a PIA of $450 without the side-business.  Adding the additional $100 per month with the side-business would bring his PIA to $501.42 – an increase of $51!

Seth’s PIA increased by a larger amount for two reasons: first of all, the $100 represents a larger percentage increase versus Ed’s increase.  Secondly, since Seth’s average income is below the first bend point ($791) both before and after the increase, a much larger share of his increased average income applies to his PIA.  In this case, the $100 increase made a difference for each, just by appreciably different amounts.

What about higher incomes?

Example 3

Anna, age 42, has averaged $6,000 per month over her lifetime.  If she continues at that rate for the coming 20 years, her PIA would equate to $2,422.46.  If Anna receives an increase in her salary of $100 per month for the coming 20 years, her PIA would increase to $2,431.03.  This increase of $8.57 per month is due to the fact that Anna’s average income is above the second bend point, so each dollar of average income increase only has a 15% impact on her PIA.

These examples illustrate how the Social Security benefit calculation benefits lower income folks at a higher rate (proportionally) than folks at higher incomes.  One particular career where this can really make a huge difference is in the service industry – particularly waiters and waitresses.  Since cash tips are voluntarily reported, waiters and waitresses typically under-report these, to their own detriment, regarding Social Security benefits.  Since quite often waiters and waitresses are on the lower end of the wage spectrum, taking credit for the dollars earned in cash tips can have a lasting improvement in future Social Security benefits!

You’re Running Out of Time If You Want to Use These 13 Tax Provisions

Oct 21st, 2013
by jblankenship.
No comments yet
An assortment of United States coins, includin...

An assortment of United States coins, including quarters, dimes, nickels and pennies. (Photo credit: Wikipedia)

Every year we say goodbye to certain things that we’ve come to know and love, and certain provisions of the tax law are not excluded from this treatment.  Portions of the tax law are intentionally added with short life-spans, and others are retired from time to time as their intended use has either changed or been eliminated.

Listed below are the tax provisions (according to the Joint Committee on Taxation) that will be expiring at the end of the year – some we’ll be glad to see go, others we’ll wish would stay around a while.  Some will be extended by Congress, either at the last moment or on into the new year, as has happened in the past.

Note: This article is aimed toward individual taxpayers rather than businesses, so I’ve only listed those provisions that will have impact on individuals.  There are quite a few provisions expiring that will impact businesses and employers as well – see the link above for the complete list.

Tax Provisions Expiring at the End of 2013

  1. Credit for certain nonbusiness energy property – this provision allows individual taxpayers with a credit for the cost of “building envelope components”, which include windows, doors, insulation, some roofing, and heating and air conditioning units.  The credit has expired in the past (2011) and was extended.
  2. Credit for two- or three-wheeled plug-in electric vehicles – pretty self-explanatory, a credit that applies to the purchase of these vehicles is also expiring.  The four-wheeled variety continues to be in play.
  3. Credit for health insurance costs of eligible individuals – I believe this one is supplanted by the credits available via the Affordable Care Act.
  4. Determination of low-income housing credit rate for credit allocations with respect to nonfederally subsidized buildings – this is a credit amount that is set annually, presently at 9%, but will change in 2014.
  5. Credit for construction of new energy-efficient homes
  6. Deduction for certain expenses of elementary and secondary school teachers – this credit has been available “above the line” for educators to help reduce the costs of self-provided (out of pocket) materials and supplies for the classroom.
  7. Discharge of indebtedness on principal residence excluded from gross income of individuals – dating from the Great Recession, a qualified cancellation of indebtedness for a taxpayer’s primary home was excluded from income.  After the end of 2013, this exclusion from income provision expires.
  8. Commuter credit – extended before, this credit provides train commuters a parity with car commuters, allowing a pre-tax deferral of income to help pay the expense of transit commuting.
  9. Deductibility of mortgage insurance premiums – through the end of 2013, it is allowable to deduct these premiums along with your interest on your primary or secondary qualified residence.
  10. Deduction for state and local general sales tax – This credit is allowed to replace the state and local income tax paid by the individual if the sales taxes are greater.  Word is that this one will likely be extended, but who knows?
  11. Charitable contribution of conservation easements or property – for the rest of 2013, if a taxpayer contributes property or easement to a conservation organization, such as a local land trust, special enhanced tax breaks will be available.
  12. Deduction for qualified tuition and related expenses – This credit allows for the reduction in income, above the line, for qualified tuition payments within limits.  It has always been coordinated with the other education credits – the Lifetime Learning Credit and the American Opportunity Credit.  This one has been extended in the past as well, so maybe it will again?
  13. IRA Qualified Charitable Distributions – for individuals over age 70½ this credit allows for individuals to contribute up to $100,000 directly from an IRA to a qualified charity, and exclude the distribution from income.  This one has expired a few times in the past and has limited impact due to limited usage by taxpayers, so it’s hard to predict whether it will be extended again.

Stay tuned as we finish out the tax year, to hear which of these credits may or may not be extended.  I for one am going to be on the edge of my seat.

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So, What’s Going on at the IRS During the Shutdown?

Oct 14th, 2013
by jblankenship.
3 comments
English: Anti-United States Internal Revenue S...

(Photo credit: Wikipedia)

While the government is in hiatus, what’s going on at the IRS?

Well, not a lot.  As I understand it, none of the phone lines are being manned, so if you call in for any reason you wind up with the automatons handling your questions.  The website is still in operation as well (at least partly).  So, you may be able to do a few things, but you’re limited.

For example, if you need a transcript of a prior year’s return, I understand that you can request this for yourself – but you can’t ask your accountant or anyone else operating as POA for you to request a transcript.  I’ve experienced this myself in attempting to get a transcript for a client – I was shut down.  (The same individual had trouble getting a transcript for himself, as the IRS records of his address didn’t match what he was entering into the system – aren’t computers great?)

In addition, even though there’s no one working there, you’re still required to complete your necessary filings on time.  For folks that filed an extension of time to file their returns in April, that means by October 15 you need to file your final return, unless you’re in a combat zone or have been affected by the flooding in Colorado (no other exceptions!).

On the other hand, don’t expect for your refund to come right away: refunds are frozen until the funding issues are sorted out.  Your payments will be processed right away though, even though the returns themselves will not be processed until later.

Payroll tax deposits and quarterly filings normally due by the end of October must be done on time as well, regardless of whether the government is back in business by that time (let’s hope it is!).

Audits in progress are on hold, but the systems that generate automatic correspondence, such as delinquency notices, are still on-line and churning away.  So don’t be surprised if you receive mail from your friends at the IRS.

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Social Security Filing Strategies for Surviving Spouses

Oct 9th, 2013
by jblankenship.
12 comments
Social Security Poster: old man

Social Security Poster: old man (Photo credit: Wikipedia)

There are a couple of strategies for Social Security filing that surviving spouses can use to maximize benefits throughout their lifetimes.  The important factor to keep in mind for the surviving spouse is that filing for Survivor Benefits (based on your late spouse’s record) has no impact on filing for Social Security benefits based on your own record – other than the fact that you cannot file for both benefits at the same time.

Coordinating these two benefits (Surviving Spouse benefits and your own benefits) can take a couple of different paths: you could file for the Surviving Spouse benefit first, allowing your own benefit to accrue Delay Credits up to as late as age 70; or you could file for your own benefit first, and then later file for the Surviving Spouse benefit.

Sue’s husband Steve passed away when Sue was 61 years of age.  Steve had just turned 70 and had just begun receiving his Social Security benefit, which was increased to the maximum amount since he waited until age 70 to begin receiving benefits.  His monthly benefit was $3,300, an increase of 32% over his Primary Insurance Amount (PIA) of $2,500.

Sue’s PIA is $1,500 – meaning that if she waits until her own Full Retirement Age (FRA) of 66 to begin receiving benefits, she will receive $1,500 per month based upon her own record.  Sue has a couple of strategies available to her:

  • She could start receiving the Survivor Benefit now at a reduced rate (since she is less than Full Retirement Age but over age 60) – for a total benefit amount of $2,481.  This is still much greater than her own benefit, so she would continue with this amount for her lifetime.  Annual COLAs would increase this amount when applied.
  • Sue could start her own retirement benefit when she reaches age 62 (one year from now).  At this point her benefit would be reduced from $1,500 to $1,125 per month since she’s filing before she reaches FRA of 66.  Then she could wait until she reaches age 66 and file for the Survivor Benefit – which would not be reduced since she’s now at FRA.  She would then receive the $3,300 monthly benefit, Steve’s maximized amount, for the rest of her life, increasing by COLAs when applied.

The first option provides Sue with the highest benefit right away, but she is giving up the future increased benefit that could be available if she waits to FRA.  The second strategy results in the greater benefit for her as long as she lives more than 10 years beyond her own FRA.

Now, if the amount of benefits were switched and Sue’s PIA was $2,500 while Steve’s was $1,500 – his benefit at age 70 would have been $1,980.  At Steve’s passing, Sue has the following options available:

  • She could start receiving the Survivor Benefit now at the reduced rate of $1,489, and then begin her own benefit at FRA, for the full amount of $2,500 (plus intervening years’ COLAs).
  • Or, Sue could start the Survivor Benefit now and wait until she reaches age 70, when her own benefit would have increased to $3,300 per month (plus COLAs).
  • Another option would be for Sue to delay receiving the Survivor Benefit until she reaches age 66 (FRA), at which point the Survivor Benefit would be $1,980 per month plus the COLAs.  Then she could wait to age 70 to begin her own benefit, again at the increased $3,300 plus COLAs.
  • The last sort of option available to Sue is to begin her own benefit at age 62 at a reduced rate of $1,875.  Since her own benefit is greater than the reduced Survivor Benefit, there are two ways that she might take the Survivor Benefit: 1) right away now at age 61 at a reduced rate of $1,489; or wait until FRA and take the maximized Survivor Benefit of $1,980.

The last option provides Sue with a relatively level benefit either right now (one year of $1,489 then increased to $1,875 for the rest of her life) or when she reaches age 62 next year ($1,875 for four years and then increased to $1,980 for the rest of her life).

In all cases where Sue intends to delay her own benefit, the Survivor Benefit options should be considered.  The key to it all is that either benefit can begin first, followed by the other later if it results in an increase in benefits.  Also important to note is that you can’t start Survivor Benefits early, switch to your own, and then switch back to Survivor benefits (or vice versa).  Once you’ve switched between the two types of benefits once, you are not allowed to switch again.

There are many other ways that the benefit amounts and ages could be worked out for examples, but hopefully these examples have helped to explain the decision process.

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How the 3.8% Surtax Could Influence Roth Conversions

Oct 7th, 2013
by jblankenship.
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Note: This is a dust-off of an article written in April 2010 that dealt with the special two-year taxation of Roth Conversions that was available in that year.  An astute reader noted that the original was a bit dusty and not applicable to today’s decision-making (thanks S!). Income tax

One of the provisions of the Affordable Care Act is a new tax – a surtax on investment income over certain amounts.  This surtax has come into play this year, for tax returns filed in 2014 on 2013 income.  The income amounts are, admittedly, rather high, but nonetheless will likely impact a lot of folks.  What you may not realize is that, due to the application of this surtax, Roth IRA conversion strategies that you may have had in play may be impacted.  Depending upon your overall income, you may have to pay the surtax on some or all of your conversion amount. On the other hand, by converting, in the future you could avoid surtax, and likely reduce the bracket that you have to pay from for all income.

The New 3.8% Surtax

Here’s how the new 3.8% surtax is applied:  a tax will be imposed for each taxable year, equal to 3.8% of the lesser of 1) net investment income; or 2) the excess of Modified Adjusted Gross Income over the threshold amount. So, in order to understand what this means, we need to define a few things.

Net Investment Income – this is the total of all interest, dividends, annuities, rents, royalties, income from passive activities, and net capital gains from disposition of capital property not held in an active trade or business.  The IRS has specifically excluded the following from Net Investment Income:

  • Income (including self-employment income)
  • Distributions from IRAs or other qualified plans
  • Gain on the sale of an active interest in an S Corporation or partnership
  • Items that are otherwise excluded from income, such as interest from tax-exempt bonds

Modified Adjusted Gross Income – for the purpose of the surtax, this is simply your Adjusted Gross Income (Form 1040 line 37) plus the net amount related to the foreign earned income exclusion.

NOTE:  THIS IS NOT THE SAME AS THE MAGI THAT YOU USE TO DETERMINE YOUR ELIGIBILITY FOR VARIOUS IRA DEDUCTIONS OR CONTRIBUTIONS.  You can find that calculation by reading “Determining Your MAGI”.  Don’t confuse the two, as they are completely different calculations – thanks, IRS!  To keep the confusion at a minimum, I will explicitly refer to this Modified Adjusted Gross Income as Modified AGI within this surtax context.

Thresholds – the thresholds for applying the surtax are as follows:

  • $250,000 for filing status of Married Filing Jointly
  • $125,000 for filing status of Married Filing Separately
  • $200,000 for filing status of Single or Head of Household (yes, Virginia, it is more tax efficient to be single)

Examples

Now that we know the definitions, let’s look at a couple of examples to see how the surtax would be applied:

Example 1. Joe and Mary, a married couple filing jointly, have net investment income of $50,000 and pension income of $125,000.  They are also strategically converting distributions from their IRA to Roth annually in the amount of $100,000, which brings their Modified AGI to $275,000.  So in 2013 Joe and Mary will be subject to the surtax on the lesser of their net investment income ($50,000) or the amount of their Modified AGI over the threshold ($275,000 minus $250,000 equals $25,000).

In this case, the amount of the Modified AGI over the threshold is the lesser amount, and so Joe and Mary will have to pay the surtax on $25,000, or $950 in surtax.

Example 2. Les, a single taxpayer, also has net investment income of $50,000, and pension and other income of $155,000.  Les also is converting amounts each year from his IRA to Roth, in the amount of $50,000 annually.  Les’s Modified AGI, combining of all of this income, is $255,000, which is over the threshold.  Applying the calculation, Les will owe the surtax on $50,000 – which is the lesser of his two amounts (Modified AGI of $255,000 minus $200,000 threshold equals $55,000, which is greater than his net investment income of $50,000).  The surtax will be $1,900.

How a Roth IRA Conversion Strategy Could Be Impacted

You’ve undoubtedly heard about Roth IRA conversions – where you move money from a traditional IRA or 401(k) plan to a Roth IRA, paying income tax on the pre-tax amount moved.  This overall concept should be considered by all folks who have IRAs, especially folks with higher incomes.  This is especially true if future (taxable) distributions from traditional IRAs will have an impact on your tax bracket – and potentially cause the surtax to be applied.

When the money is moved to a Roth IRA, there are no future Required Minimum Distributions (RMDs) from the Roth IRA account during your lifetime, whereas if the money is in a traditional IRA when you reach age 70½ you will be forced to withdraw funds (via RMDs) from your IRA and pay tax on it in that year.  Plus, any amount that you withdraw from the Roth IRA in the future will not be taxed, and therefore will not impact the calculations for the surtax.

In Example 1 above, the only reason the surtax was applied at all was because of the IRA distribution for conversion.  If Joe and Mary had completed the conversion of the $500,000 in IRAs to Roth IRA in prior years, they would have paid tax on the conversion in each year of conversion.  This would mean that for 2013 they would not have Modified AGI above the threshold, so they would not owe the surtax.

If they waited until 2013 to do a total conversion, they’d have Modified AGI of $675,000 – with a pretty hefty income tax and surcharge applied.  However, if they adjusted their conversion amounts to only $75,000 for 2013 their Modified AGI would be exactly $250,000, so they wouldn’t owe the surtax.  Keeping up at the rate of $75,000 per year, they’d have their IRAs converted to Roth within the coming 7 years, eliminating RMDs from their future income – but since they wouldn’t be subject to the surtax from future RMDs, they might opt to discontinue Roth Conversions at this stage and opt to take future RMDs at a much smaller pace.  This could result in lower overall taxes for the couple.

In Example 2, Les was already going to be subject to the surtax even without the IRA distribution.  If we assume that Les also had $500,000 in his IRA account, converting that amount to a Roth IRA would result in a Modified AGI of $705,000, again with a hefty tax bill and surtax.  Unlike the Example 1 couple, Les can’t make an adjustment to his Roth Conversion amounts to eliminate the surtax.  But he might want to continue with his conversion activity nonetheless in order to eventually eliminate the additional amounts being withdrawn via RMDs.  Like most Roth Conversions, a decision must be made as to whether or not you believe future taxes will be more or less than the current rates.

Conclusion

While the surtax on its own should not be a reason to enact a Roth IRA conversion strategy, one of the tenets that we’ve talked about in the past that can cause the conversion to work in your favor is a future increase in tax rates.   If you believe that future taxes are likely to be higher (and let’s face it, who doesn’t believe this?) then any amounts that you can afford to convert should be considered now.  The surtax just gives you more reason to consider it.

Photo by alancleaver_2000

How Your Average Indexed Monthly Earnings is Determined

Oct 2nd, 2013
by jblankenship.
2 comments
Image courtesy of nuchylee at FreeDigitalPhotos.net

Image courtesy of nuchylee at FreeDigitalPhotos.net

In order to calculate your Social Security benefit you need to know what your PIA (Primary Insurance Amount) is.  In order to calculate the PIA, you need to know what your Average Indexed Monthly Earnings (AIME) factor is.  So how is your AIME determined?

During your working career, your Social Security-covered earnings were reported to the Social Security Administration.  When you reach age 60, an index factor is applied to each year of your earnings in order to adjust each year’s earnings for inflation.  After the index factor is applied, the top 35 years of earnings are totaled and then divided by 420 (the number of months in 35 years).  This produces an average… indexed… monthly… earnings… factor.

If you haven’t had a full 35 years of Social Security-covered earnings, the AIME is still calculated using 35 years as the divisor.  This can result in a much lower benefit as compared to your average earnings in the years that are in your record.  For example, if you earned the “average” wage during at least 35 years of your working life, your AIME would work out to $3,582.  However, if you only had 30 years of reported earnings during your working life, having taken time off for college or to raise your family, your AIME would only work out to $3,070.

And this makes a real difference – the PIA that results from the first example (with 35 years of earnings) is $1,605 per month, versus $1,441 per month when you have only 30 years of the exact same earnings.  That’s a difference of nearly $2,000 per year.

The index factor that I mentioned earlier is determined in your 60th year, and it’s based on the national average wage during that year, compared with the average wage in prior years.  This is known as the Average Wage Index (AWI), and you can learn more about it in detail on the Social Security website.

Book Review: Winning the Loser’s Game

Sep 30th, 2013
by jblankenship.
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winning the losers game

Timeless Strategies for Successful Investing

Charles D. Ellis, the author of this book (in it’s Sixth Edition), has definitely hit the nail on the head with his subtitle.  The strategies outlined in this book are good for any investor in any economic/investing climate.

Time and again throughout the book, Mr. Ellis points out that the real key to investment success has nothing to do with finding the right stock, bond, mutual fund or ETF – and everything to do with developing a sound strategy for investing and sticking to it.

The strategy requires you to develop an understanding of your own personal tolerance for risk and your need for returns.  This can be a difficult undertaking, as it requires the investor to answer difficult questions about what kinds of losses he can stomach with his investments, as well as what sort of return you require for your investments over the long term.  It takes careful planning to develop this strategy – because you have to be truthful with yourself about your own reactions to market losses.  Losing your nerve at the wrong time can derail the process altogether.

Sometimes it is necessary to have help in the process – a financial advisor who is not vested in your investment choices can really help with building the strategy.  Look for a fee-only advisor to help with the process.

Another recommendation made throughout the book is to use indexed mutual funds as the basis for your investments.  As you’ve heard from me before, indexed mutual funds are really the best, smartest option in the marketplace.  Mr. Ellis puts it best with these three bullets, his conclusion to the book:

  • The number of brilliant, hardworking investment professionals is not going to decrease enough to convert investing back into the winner’s game of the 1950’s and 1960’s.
  • The proportion of transactions controlled by institutions – and the splendid professionals who lead them – will not decline.  Investing, therefore, will stay dangerous for the most gifted amateur.
  • Maybe some day so many investors will agree to index that the “last stock pickers standing” will have the field all to themselves.  Maybe.  But that’ll be the day.  So, be sure to call me.  Meanwhile, I’ve got better things to do – and so do you, where we can play to win with both my time and our money.

If all of this sounds eerily familiar, it’s because this is another author who I agree with completely – and I believe this book provides an excellent guide for the average investor.  It’s no wonder that this book has had such a successful run, and this latest edition just carries on the great tradition.  Go get it!

What You Can Do If Your 401(k) Has High Fees

Sep 25th, 2013
by jblankenship.
2 comments
Image courtesy of anankkml at FreeDigitalPhotos.net

Image courtesy of anankkml at FreeDigitalPhotos.net

Now that we’ve all been receiving 401(k) plan statements that include information about the fees associated with our accounts, what should you do with that information?  Some 401(k) plans have fees that are upwards of 2% annually, and these fees can introduce a tremendous drag on your investment returns over a long period of time.

There are two components to the overall cost of your 401(k) plan.  The first, and the easiest to find, is the internal expense ratios of the investments in the plan.  Recent information shows that, on average, these investment fees are something on the order of 1% to 1.4% or more.  The second part of the costs is the part that has recently begun to be disclosed: the plan-level fees.  These are the fees that the plan administrator has negotiated with the brokerage or third-party administrator to manage the plan.  These fees can average from 1% up to around 1.5%.  When added together, these fees can amount to nearly 3% for some smaller 401(k) plans.  Larger employers’ plan fees average about 1% less, at approximately 2% per year.

For example, if average investment returns are 8% you should be doubling your investments (on average) every 9 years.  However, if there is just a 1% fee deducted from the average investment return (so that now you’re only earning 7% annually) the doubling will take a bit more than 10 years.  A 2% fee brings you down to a 6% net average return, and so now your account won’t be doubled until 12 years has passed.  If you started our with $10,000 in your account, this would result in a differential of more than $42,000 over the course of 30 years – at 8% your account could grow to $100,627, while at a 6% return would only grow to $57,435.

The information about fees used to be kept pretty much secret, but beginning in 2012 the plan-level fees have begun to be disclosed to participants in the plans.  Now you know more about the overall fees that are charged to your plan and thereby reduce your overall investment returns.

What Can You Do?

So, now that you know what your expenses are in your 401(k) account, there are a few things that you might do to improve the situation.  While it’s unlikely that you can have an impact on the plan-level fees, you may be able to control some of your exposure to investment fees.  Listed below are a few things you can do to reduce your overall expenses in your 401(k) account.

  1. Lobby for lower fees.  Talk to your HR representatives and request that your plan has lower-cost options made available.  Index funds can be used within a 401(k) plan to produce the same kinds of investment results as the (often) high-cost managed mutual funds, with much lower expense ratios.
  2. Take in-service distributions, if available.  If your plan allows for distributions from the plan while you’re still employed, you can rollover some or all of your account to an IRA, and then choose lower-cost investment options at that time.  Typically a 401(k) plan may offer this option only to employees who are at least 59½ years of age – but not all plans offer in-service distributions.
  3. Balance the high-fee options with lower-cost options outside the plan.  If your 401(k) plan is unusually high-cost, if available do the bulk of your retirement investing in accounts outside the 401(k) plan, such as an IRA or Roth IRA, if you are eligible to make contributions.  Review the investment options in your 401(k) plan for the “diamonds in the rough” – such as certain institutional funds with very low expenses – that can be desirable to hold.  Then complete your allocations using the open marketplace of your IRA or Roth IRA account.

Don’t forget that there are sometimes very good reasons to leave your money in a 401(k) plan, even if the expenses are high.  See the article Not So Fast! 9 Special Considerations Before Rolling Over Your 401(k) for more information on why you wouldn’t want to make a move.

Uncertainty Abounds With ACA Implementation

Sep 24th, 2013
by jblankenship.
1 comment
English: President Barack Obama's signature on...

President Barack Obama’s signature on the health insurance reform bill at the White House, March 23, 2010. The President signed the bill with 22 different pens. (Photo credit: Wikipedia)

Several high-profile companies have recently made known that they will be directing retirees and in some cases employees to the Health Exchanges with the implementation of the Affordable Care Act (aka “Obamacare”).  How this will wind up affecting us as taxpayers is uncertain, to say the least (See the article at this link: Workers Nudged to Health Exchanges Seen Costing U.S. Taxpayers).

Since participation in the Exchanges carries the possibility of taxpayer subsidy to those with lower incomes, adding more folks to the rolls of the Exchanges will likely drive up the cost of these subsidies.  And of course, that will mean increased taxes to pay for the subsidies.

It makes sense for IBM, Time Warner and others to send the retirees to the Exchanges with a stipend, since the stipend will be less (presumably) than the cost to the company for health coverage in the long run.  Many of the retirees will (likely) fit into the subsidized categories since they are in retirement and likely have lower incomes, so a portion of the cost will certainly be subsidized.

What do you think – is this a trend?  And what if the Exchanges become the dominant method of health insurance delivery? Would the law of large numbers eventually begin to bring down the overall costs, or will the costs spiral out of control?

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Selling Your Home? Be Aware of These Half-Truths

Sep 23rd, 2013
by jblankenship.
2 comments
Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

Since selling a home is one of those events that many folks only do a few times in their lives, there is much uncertainty about what kinds of potential rules and laws may trip you up.  Recent data suggests that the average American will buy and sell their primary home something like 10 times in their lifetimes – for many that number will be far less.  There is a lot of information about the tax impacts of selling a home out there flying about on the internet, and some of it is mostly bunk.  And much of what’s not bunk is limited in applicability.

Below are a few half-truths about home sales that you want to understand before you sell your home, along with the explanation of the facts behind them, including how they may apply to your situation if at all.

1. If I sell my house I need to buy another one with the proceeds or owe tax.  Not true, as long as you lived in the home as your primary residence for two of the preceding five years.  There is an exemption of the tax on such a residence sale, of up to $250,000 ($500,000 for a married couple) of gain in value over the original purchase price plus improvements to the property.  In other words, if you purchased a home for $100,000, updated the kitchen for $10,000, lived in the house for three years and then sold it for $120,000, you’d have a gain of $10,000 on the sale.  This sale is exempt from tax since you lived in the home as your primary residence for at least two of the preceding five years.

The truth to this one has roots in the olden days – long ago it used to be the law that when you sold your primary home you needed to purchase a new one with any gains from the sale within two years. This rule expired in 1996, so it doesn’t apply any more.  Many folks think it still applies since they haven’t sold a home in a very long time and they recall this rule.

2. Beginning in 2013 if you sell your home you’ll owe an extra 3.8% surtax on the proceeds due to Obamacare.  Not true, except in some limited cases.  This one has gotten its traction via emails and internet postings, and has enjoyed a rather long life.  I’ve written about this specific myth in the past in the article The “Tax on the Sale of Your Home” Email Myth.

Here’s the deal: Following the information presented in #1 above, if you wind up with a non-exempt gain on the sale of your primary home – either because you didn’t live in the home for 2 of the previous 5 years, OR the gain was more than the exempted limit – AND your other income (Modified Adjusted Gross Income) is greater than $200,000 for single folks or $250,000 for marrieds, then you might owe the additional 3.8% surtax on the gain.

3. Loss on the sale of my home can be written off against income.  Not true, for a primary or secondary home.  You (generally) don’t have to pay capital gains tax on a gain when you sell your home, and likewise you cannot take a capital loss if the sale results in a loss.  This is the same for all personal property not held for investment purposes.

If you sold a property that you had held for rental purposes at a loss, this loss would be eligible to be written off against other investment gains, but losses on personal property, including your main home, doesn’t allow this option.

Unintended Result From Obamacare?

Sep 19th, 2013
by jblankenship.
4 comments
Image courtesy of stockimages at FreeDigitalPhotos.net

Image courtesy of stockimages at FreeDigitalPhotos.net

One of the primary tenets of the Affordable Care Act legislation (Obamacare) is guaranteed healthcare insurance for all Americans.  This insurance is expected to have lower premium rates than individually-purchased healthcare insurance policies – although the jury is still out on exactly what those rates will be.  When the Health Insurance Marketplaces begin operation next month we’ll learn more about how this new health insurance delivery will be priced, compared with employer-provided health insurance or individually-purchased policies.

If the rates are dramatically lower than the individually-purchased policy, an unintended result may occur: early retirement for many. (For more on this phenomenon, see “Obamacare could encourage more early retirements from baby boomers”.)

Think about it – everyone knows at least one successful self-employed individual, and probably several, whose spouse works in a position with a large local employer (around here it’s likely the state, or a hospital or insurance company) – solely so that the couple can get health insurance at a reasonable rate.

In addition, I believe there are lots of folks out there who have the resources to retire but are (for example) only 62 years old.  This leaves them in a pickle for insurance for three years, since Medicare is not available until you hit 65.

How many times have you heard this:

John is ready to retire, but keeps his full-time job at Acme so that we can have health insurance.  If it wasn’t for health insurance, we’d be retired and travelling to spend time with our grandkids.

Similarly, I’ve heard this one as well:

I’ve been building this company of mine up for several years, and someday I’ll drop my old job to do this full-time.  It’s hard to give up the health insurance though!

How will this impact the economy?  If we have lots of folks making the leap from work at large businesses to either established small businesses, starting new sole proprietorships or retiring, I think a couple of things will happen:

  1. The old position that was left will be open, providing a job for some of the unemployed
  2. The addition of manpower into an established small business could spur additional economic growth

On the other hand, as we all know, a very high percentage of new small business enterprises fail within the first couple of years, so the economic gains might turn out to be nil.  When you add in the costs that Obamacare is expected to cause many small- to medium-sized businesses to incur (via the required insurance coverage or pay a penalty provisions), the overall result may wind up being a drag on the economy.  It’s going to be interesting to see how everything shakes out…

What do you think?  Will Obamacare be a positive influence on the economy, or a drag?  Or will it have no positive or negative effect?  I’d like to hear your opinions – leave a comment below!

When Rolling Over a 401(k) to an IRA Isn’t a No-Brainer

Sep 18th, 2013
by jblankenship.
6 comments
Stibnite-121128

Stibnite-121128 (Photo credit: Wikipedia)

Oftentimes when folks are considering leaving employment, the decision to rollover 401(k) to an IRA is a no-brainer.  After all, why would you leave your retirement funds at the mercy of the constricted, expensive investment choices and other restrictions of your old company’s 401(k) administrator, when you can be free to invest in any (well, most any) investment you choose, keeping costs down, and completely within your own control in an IRA?

Well, for some folks this decision isn’t the straightforward choice that it seems to be, for the very important reason of access to the funds before reaching age 59½ (see this article for more info about The Post-55 Exception to the 10% Penalty for Withdrawals from 401(k)).  Since only within a 401(k) (or other employer-sponsored plans) can you take advantage of this early withdrawal exception, it might be in your best interests to think about your rollover choice before automatically rolling over into an IRA.  This is only important if you are under age 59½, of course – and much more important if you’re under age 55 when you leave your old employer.

Why it’s important

If you are under age 59½ and you have a sudden need for the funds that you’ve saved over the years in your old 401(k), and you’ve rolled over the funds into an IRA, you will have to pay a 10% penalty in addition to the ordinary income tax on your withdrawal, unless you meet one of the other exceptions to the early withdrawal penalty.

However, if you rollover the old 401(k) into another 401(k) (or 403(b), et al), you will preserve your opportunity to withdraw those funds if you leave employment at the job associated with the new 401(k) plan after you’ve reached age 55.

How can this work in your favor?

If you start work with another employer, as long as the new employer offers a 401(k) plan that accepts “roll-in” of 401(k) plan money and IRAs, you can rollover those old plans into the new plan, which will keep your options for access open should you need them upon leaving employment after age 55.

That’s not really under your control so much, is it? How about this: as you’re leaving employment at the old employers, if you have the opportunity to start your own business – such as consulting, or perhaps some part-time business – you can start your own Solo 401(k) plan and rollover the funds from your old plan(s) and IRAs if you have them.  Then, on the chance that you’d need the money later on after you’re at least age 55 (but not yet 59½), assuming that you can end your employment in your consultancy or other self-employment activity, you can then have access to those funds in your Solo 401(k) plan without penalty.

Some Cautions

If you go the self-employment route, you need to make sure that the business that you’ve created is valid and legitimate.  The IRS doesn’t at all take this lightly – if your business isn’t making money (or at least validly attempting to make money), your actions in creating a 401(k) plan and everything else associated with the business can be considered fraud.

This also applies to the dissolution of the business in order to have access to the retirement funds.  If it’s deemed that the only reason you did this was simply to have access, this action could be considered fraud as well.  This could come about if you dissolved the original business and then shortly afterward started a similar business again, for example.

The Downside

Of course, as with attempts to “work the system” in your favor, there are usually downsides to the matters.  In addition to the concerns about fraud mentioned before, there is the matter of control.  If you roll-in your funds from the old employer to another 401(k) plan and you remain employed with that new job past age 59½ you will give up access to those funds unless the new plan allows in-service distributions.

Say for example you left an old company at age 50 and started work with a new company, rolling over your money from old employer’s 401(k) plan to the new plan.  Then you work until age 65 at the new employer.  Unless the new employer’s 401(k) plan allows in-service distributions, you can’t get to the funds until you retire at age 65.  Had you left the money at the old employer (or rolled it over to an IRA) you would have had access to the money from the old plan free of penalty or restriction once you reached age 59½.

What do you think?  Do you see any other downsides to this type of plan?  How about other ways to use these rules to your advantage? I’d love to see your thoughts on the subject – leave a comment below.

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Did the Advent of 401(k) Plans Hurt Americans?

Sep 17th, 2013
by jblankenship.
2 comments
The 87-vehicle pile up on September 3, 1999

The 87-vehicle pile up on September 3, 1999 (Photo credit: Wikipedia)

There’s been quite a bit of press lately about the recent Economic Policy Institute study (see this article “Rise of 401(k)s Hurt More Americans Than It Helped” for more), which indicates that the 401(k) plan itself is the cause of American’s lack of retirement resources.  I think it has more to do with the fact that the 401(k) plan (and other defined contribution plans) were expected to be a replacement for the old-style defined benefit pension plans, and the fact that those administering the retirement plans did little to ensure success for the employees.

Traditional defined benefit pension plans didn’t ask the employee to make a decision about how much to set aside – this was determined by actuaries.  Then the company made sure that the money was set aside (in most cases) so that the promised benefit would be there when the employee retires.  In the world of 401(k) plans, the employee has free choice to decide how much and whether or not to fund the retirement plan at all.  Human nature kicks in, and the nearer term needs of the employee win out over long term needs – of course the long-term requirements get short shrift!

It’s the same as when we turn over the car keys car to a 16-year-old.  Up to this point, the child has just ridden along, not having to know anything about rules of the road, car maintenance, or paying attention.  You wouldn’t just toss Johnny the keys and say “You know where you want to be. Do your best to get there!”  Of course you’re going to make sure that he has all the training necessary to operate the vehicle safely, and that he knows when to put fuel in the car, as well as that he knows how to navigate to his destination on time.

If the playing field had been level – that is, if when 401(k)-type plans were introduced as replacements for pension plans that there was no choice regarding participation and funding level, we’d see a much different picture.  I don’t think education alone is the answer, because the importance of continual funding is so difficult to comprehend.  Forced participation runs counter to the “American Way”, but that would have changed our outlook dramatically.

The problem isn’t the 401(k) plan itself – it’s that when companies dropped pension plans in favor of 401(k) plans they didn’t provide employees with the correct message about the importance of participation.  Free will is a good thing, don’t get me wrong.  But I think employers could have done much, much more to emphasize the importance of participation, of making long-term investment decisions, and of providing for your future with today’s earnings.

It wasn’t the account that is the problem, it’s in the implementation.

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Increase Your Income Tax Knowledge

Sep 16th, 2013
by jblankenship.
4 comments
Image courtesy of debspoons / FreeDigitalPhotos.net

Image courtesy of debspoons / FreeDigitalPhotos.net

If you find yourself stymied by the Income Tax Code (more power to you if you don’t!) and you’d like to get a better understanding of this very important area of your financial life, the IRS has many resources to help you improve your knowledge of taxes.  At the risk of sounding churlish, I suggest that if you’re an incurable insomniac these resources can also be used in lieu of the strongest over-the-counter sleep aid drug with satisfactory results and few (if any) side-effects.

The IRS recently published their Summertime Tax Tip 2013-21, which describes several of the resources available to help you gain a better understanding of income taxes.  The text of the Tip follows, in its entirety:

Explore a Quick and Simple Way of Understanding Taxes

If you’re a student or teacher, the summer months may be a nice break from class, but they’re also a good time to learn something new. A quick and simple way to learn about taxes is by using the IRS Understanding Taxes program.
The program is a free online tool designed in partnership with teachers for classroom use. The interactive tool is a great resource for middle, high school or community college students. However, anyone can use it to learn about the history, theory and application of taxes in the U.S.

Here are seven reasons why you should consider exploring the Understanding Taxes program:

1. Understanding Taxes makes learning about federal taxes easy, relevant and fun. It features 38 lessons that help students understand the American tax system. Best of all, it’s free!

2. The site map helps users quickly navigate through all parts of the program and skip to different lessons and interactive activities.

3. A series of tax tutorials guide students through the basics of tax preparation. Other features include a glossary of tax terms and a chance to test your knowledge through tax trivia. Interactive activities encourage students to apply their knowledge using real world simulations.

4. Understanding Taxes makes teaching taxes as easy as ABC:

  • Accessible (web-based)
  • Brings learning to life
  • Comprehensive

5. It’s easy to add to a school’s curriculum. Teachers can customize the program to fit their own personal style with lesson plans and activities for the classroom. They will also find links to state and national educational standards.
6. The program is available 24 hours a day. All you have to do is access the IRS website and type “Understanding Taxes” in the search box.

7. There are no registration or login requirements to access the program. That means people can take a break and return to a lesson at any time.

You can use the Understanding Taxes anytime during the year. The IRS usually updates the program each fall to reflect current tax law and new tax forms.

Additional IRS Resources:

Who Will Be The Biggest Benefactors of Obamacare?

Sep 9th, 2013
by jblankenship.
1 comment
Insurance

Insurance (Photo credit: Christopher S. Penn)

According to data cited in a recent WSJ article (The Health-Care Overhaul: What You Need to Know), there is a specific demographic that should benefit the most from the up-coming institution of the Affordable Care Act’s changes to the healthcare system.  If you’re wondering why this writing seems a bit smug, it’s because I’m one of these projected benefactors: folks between age 50 and 64.

Why is this group deemed the most likely to benefit?

It has to do with some current realities about our nation’s health and the way that the (current and proposed) health insurance marketplace works.  First of all, folks in this age group who are not covered by an employer plan, or are not covered by Medicaid, must find insurance in the private marketplace. And the reality is that folks who’ve seen half a century of life or more are typically in poorer health than younger people, thus having greater need for health insurance coverage. Plus, if you’re in that age group and you find yourself unemployed, whether by early retirement or layoff, AND you have a pre-existing condition, finding health insurance at all can be nearly impossible.  According to the WSJ article, in 2012 20% of this group had no health insurance at all, and up to 29% had been rejected for insurance (2008 figures).

Under the Affordable Care Act (aka, Obamacare), these folks will have access to health insurance without the possibility of denial due to health or any other reason.

Secondly, given the income caps that have been legislated and the tax credits associated, the insurance is expected to be much more affordable in the brave new world.  Premiums for older adults are to be capped at no more than 3x the rate of younger policyholders.

One way that this might not work out as intended is if the younger folks (not covered by an employer plan or Medicaid) opt out of policies in favor of the tax penalty (which will eventually be the greater of $695/year or 2.5% of income).  If that were to happen, the overall cost of health coverage under “marketplace” plans could skyrocket.  If younger, healthier folks are opting out of insurance coverage, all that would be left in the plans would be young, unhealthy folks and the other non-covered group up to age 64 – and the cost of covering this group could be enormous.

Honestly, I don’t know what will happen, and whether anyone will actually benefit from the implementation of the Affordable Care Act.  I expect that many folks will have health insurance coverage when before they didn’t, but how the costs will work out is up in the air.

What do you think?  Share your thoughts in the comments section below.

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Review Tax Withholding In Time to Fix Problems

Sep 9th, 2013
by jblankenship.
No comments yet
Income Tax Sappy

Income Tax Sappy (Photo credit: Wikipedia)

At this time of year, with a few months remaining on the calendar, it can be a good time to review your income and withholding to ensure that you will have enough in tax payments to ensure that you don’t get hit with underpayment penalties next year when you file your return.  This can be a relatively simple activity – all you need to do is gather your most recent pay-stubs and all of your other income information together and produce an estimate of your tax burden.  You’ll then compare the estimated tax with the amount of withholding and estimated tax payments that you’ve made up to date.

To do the estimates, you can use the worksheets available within Form 1040-ES, as well as the IRS’s Withholding Calculator online tool. (click the links to go to the tool or form)

If your withholding is significantly less than the estimated tax on your income, you have a few months remaining in the year to make an adjustment to your withholding or make an estimated tax payment (by September 16 for income through the end of August), in order to make up the difference.

On the other hand, if your withholding is significantly more than the expected tax, you can make adjustment to your withholding, decreasing the amount withheld.  This effectively gives you a raise in take-home pay for the remainder of the year.

Either way, it’s a good idea to try to bring your withholding very close to the amount of tax you’ll owe – the best of all circumstances would be for you to owe nothing and receive no refund, since you won’t have to come up with extra money to pay tax, and you also aren’t giving the IRS a free loan of your money.

The IRS recently produced their Summertime Tax Tip 2013-25, detailing the important facts about how to review your withholding.  The actual text of the Tip follows:

Give Withholding and Payments a Check-up to Avoid a Tax Surprise

Some people are surprised to learn they’re due a large federal income tax refund when they file their taxes. Others are surprised that they owe more taxes than they expected. When this happens, it’s a good idea to check your federal tax withholding or payments. Doing so now can help avoid a tax surprise when you file your 2013 tax return next year.

Here are some tips to help you bring the tax you pay during the year closer to what you’ll actually owe.

Wages and Income Tax Withholding

  • New Job.   Your employer will ask you to complete a Form W-4, Employee’s Withholding Allowance Certificate. Complete it accurately to figure the amount of federal income tax to withhold from your paychecks.
  • Life Event.  Change your Form W-4 when certain life events take place. A change in marital status, birth of a child, getting or losing a job, or purchasing a home, for example, can all change the amount of taxes you owe. You can typically submit a new Form W–4 anytime.
  • IRS Withholding Calculator. This handy online tool will help you figure the correct amount of tax to withhold based on your situation. If a change is necessary, the tool will help you complete a new Form W-4.

Self-Employment and Other Income

  • Estimated tax. This is how you pay tax on income that’s not subject to withholding. Examples include income from self-employment, interest, dividends, alimony, rent and gains from the sale of assets. You also may need to pay estimated tax if the amount of income tax withheld from your wages, pension or other income is not enough. If you expect to owe a thousand dollars or more in taxes and meet other conditions, you may need to make estimated tax payments.
  • Form 1040-ES.  Use the worksheet in Form 1040-ES, Estimated Tax for Individuals, to find out if you need to pay estimated taxes on a quarterly basis.
  • Change in Estimated Tax. After you make an estimated tax payment, some life events or financial changes may affect your future payments. Changes in your income, adjustments, deductions, credits or exemptions may make it necessary for you to refigure your estimated tax.
  • Additional Medicare Tax. A new Additional Medicare Tax went into effect on Jan. 1, 2013. The 0.9 percent Additional Medicare Tax applies to an individual’s wages, Railroad Retirement Tax Act compensation and self-employment income that exceeds a threshold amount based on the individual’s filing status. For additional information on the Additional Medicare Tax, see our questions and answers.
  • • Net Investment Income Tax.  A new Net Investment Income Tax went into effect on Jan. 1, 2013. The 3.8 percent Net Investment Income Tax applies to individuals, estates and trusts that have certain investment income above certain threshold amounts. For additional information on the Net Investment Income Tax, see our questions and answers.

See Publication 505, Tax Withholding and Estimated Tax, for more on this topic. You can get it at IRS.gov or by calling 1-800-TAX-FORM (1-800-829-3676).

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Can Both Spouses File a Restricted Application for Spousal Benefits Only?

Sep 4th, 2013
by jblankenship.
3 comments
Couple married in a shinto ceremony in Takayam...

Couple married in a shinto ceremony in Takayama, Gifu prefecture (Photo credit: Wikipedia)

Note: with the passage of the Bipartisan Budget Bill of 2015 into law, File & Suspend and Restricted Application have been effectively eliminated for anyone born in 1954 or later. If born before 1954 there are some options still available, but these are limited as well. Please see the article The Death of File & Suspend and Restricted Application for more details.

In the wake of my post last week, Can Both Spouses File and Suspend?, I received multiple iterations of the same question, which is the topic of today’s post: Can Both Spouses File a Restricted Application for Spousal Benefits Only?

Unlike the original situation where technically it is possible to undertake but the results would not be optimal, in this situation it’s not technically possible. (The one exception is in the case of a divorced couple. For the details on how it works for divorcees, see this article: A Social Security Option Strictly for Divorced Folks.)

The way the restricted application for spousal benefits works is that there are three rules that must be met:

  1. You must be at or older than Full Retirement Age (FRA)
  2. Your spouse must have filed for his or her own retirement benefit – does not have to be actively receiving benefits, he or she could have filed and suspended
  3. You must not have filed for your own retirement benefit

As you can see, #2 & #3 cannot both be done by the same person in the couple.  It is not possible to (#2) file for your own benefit, enabling your spouse to file a restricted application and (#3) not file for your own benefit, enabling you to file a restricted application.

Therefore, only one of the members of a currently-married couple can file a restricted application for spousal benefits.

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