Don’t Feed the Alligators

A Personal Finance Blog from a Small-Scale Landlord’s Perspective

Archive for the 'taxes' Category

Irrational Bins

Creative Commons License photo figure credit: “Irrational Bins” by MousyBoyWithGlasses

I finished up the preparation of our tax return today, and as you know, we are getting a sizable return.  In fact, I can’t ever remember having to write a check to cover any unpaid taxes for the year.  What bothers me, though, is that the government has been getting free use of my money all year.

I like to preach that people should strive to break even at the end of the year, or even owe a little bit rather than getting a refund.  In this way you’re not leaving your own money on the table in the form of bank interest or investment returns that you could be seeing — or better yet, having free use of some of the government’s money all year long.  This advice tends to fall on many deaf ears.  It seems, shockingly, that people like to get tax refunds and hate having to write a check to the government.

Many people have told me that a tax refund at the beginning of the year is a form of forced savings for them.  I tell them that they should adjust their withholding and then set up an automatic monthly or semi-monthly deposit to their high interest savings account of choice.  They tell me that they fear they just don’t have the discipline to keep up with something like this and will simply squander the money over the course of the year and have little or nothing to show for it.

Up until recently I thought this line of reasoning showed some kind of character weakness on the part of the tax-refund-as-forced-savings-plan (TRAFSP) crowd.  But as I get the same answer from so many people, I’m starting to re-think my judgement.  We’re all human, and we need all the help we can get when it comes to doing what’s best for ourselves the better part of the time.  I read the other day that when Warren Buffet wanted to lose weight, he bet his children that he could by giving them each an unsigned check for $10,000.  Buffett is “someone who understands his irrationality and builds systems to cope with it.”

So while TRAFSPs may be choosing the default option rather than building a system, they still understand this aspect of their irrationality and continue to choose a system that seems to work for them.  Personal finance is the confluence of a rational philosophy and irrational participants.  If it were all about math, most of us would be rich by now.  Instead, we all do irrational things when it comes to money at some point or another.  Those of us who understand our own irrationalities and build systems to overcome or circumvent them are the ones who will ultimately be successful at this game.  This might mean that we don’t always make decisions based on math, but rather on which option is more likely to be successful for us. TRAFSPs are one example.  Another recent example that comes to mind is J.D. Roth at Get Rich Slowly’s decision to go with a longer term mortgage than he could afford.  Lastly, a classic example of this is Dave Ramsey’s debt snowball.  These are all cases where the math says to do something different, but the math doesn’t mean a thing if the concept doesn’t ever succeed.

With all this being said, I’ve put off taking my own advice for many years.  The main reason for this is that we’ve had major lifestyle changes in each of the last 5+ years that have made our tax situation rather uncertain: we’ve changed jobs several times between us, sold a house, bought a house, started renting out a portion of our house, had kids, etc.  But 2008 and 2009 look like they will eventually shape up to be very similar from a tax perspective, so I have gone ahead and changed my withholding amounts with my payroll department.  I took home almost 10% more in my first paycheck because of this change.  I already have set up a monthly automatic transfer to sweep this extra 10% into a medium term savings account for one of our financial goals.

03.22.2009
Money

Creative Commons License photo figure credit: borman818

I have just about wrapped up our tax return for 2008 and it looks like we’re getting a pretty sizable refund. This poses two questions: What should we do with the refund?

and

Should we change our withholding to avoid getting such a large return next year?

This post is about the first question, and the second will be covered in Part II.

ScrapperMom and I talked for a while about what to do with the refund. Given the current economic climate and the fact that our emergency fund only has about 3 months worth of expenses in it, we considered simply saving the money. It would add about another 1.5 months to our e-fund. This would give us some extra security, but would not help us to reduce our monthly obligations at all.

The other option is to use the refund to pay down some of our other debts. We’ve got a mortgage, car loan, and low interest, fixed rate credit card. Throwing it at the mortgage would be decidedly unsatisfying for two reasons: one is that it represents about 1.5% of our balance, so I’m not sure it would even qualify as a dent. The other is that it locks up our cash, at least until we sell our house — and we have no short term plans to do that. The credit card debt is the result of a renovation that we made to our rental property, and represents a deductible business expense. The tax refund will pay about 2/3 of this debt. With the low interest rate and the tax-deductibility making the effective rate even lower, low monthly payments, and the inability of this payment to provide relief from our monthly minimum obligation, this is also an unattractive option.

The last option is the car loan, which has about the same balance as the credit card. This loan is through our credit union. We bought our van a few years back and stretched a bit for it. We did save a lot of money by buying lightly used, but we took a 6 year loan on it to keep the payments manageable. Since then we have been pre-paying by about 10% each payment, as well as throwing some extra money at it here and there. So far we have shaved over a year off the loan. An interesting thing about this loan that I have not noticed on other loans is that as we pre-pay, our next payment due date keeps getting pushed out. So according to our latest statement, our next payment isn’t due until next year. The nice thing about this is that if we find ourselves in a position where we can’t make the minimum payment on this loan, we can skip it for quite a while by pre-paying now. The same is not true for the mortgage or credit card: if we pre-pay, we’re still obligated to make the minimum payment EVERY month.

ScrapperMom and I have decided, therefore, that the best option for the bulk of our refund is to pay down our car loan. This will cut another year off of our loan, reduce the number of payments left at our present paydown rate to just over 6, and still preserve the security of knowing that, if we lose some or all of our income, the obligation to pay this loan is pushed back far enough to help keep us solvent while we find ways to replace that lost income.

What do you think? Is this the best of both worlds? Are you getting a refund? How will you spend or save your refund? Share your thoughts in the comments section below!

401k tip jar

Creative Commons License photo figure credit: _e.t

A reader writes:

“Due to current economic trends I have suffered a rather costly loss and one of my 401K’s dropped below the minimum of what they need to be to stay open.  I got a letter in the mail with options of what I can do with it. I was wondering what you would do in this situation?”

While the loss of value in your 401k is unfortunate, this situation forces you into a beneficial situation.  Generally 401k plans have fewer investment options and sometimes more restrictions on how frequently you can move into and out of those options.  Moving your retirement money to an Individual Retirement Account (IRA) opens up a lot of investment options.

The major question is what type of IRA to use: Traditional or Roth.  A Traditional IRA is very much like a 401k in that money is put into it pre-tax.  Money and earnings in a TIRA grow untaxed as well, and only withdrawals are eventually taxed.  A Roth IRA uses post-tax money.  Earnings and withdrawals from a Roth are non-taxable, and you can also withdraw principal (but not earnings) from a Roth IRA at any time without penalty (though this practice is not recommended by this blogger).

The question of choosing one type of IRA over the other can be very complicated, but the general rule of thumb is to consider whether or not you have yet reached your full earning potential, and therefore whether you are yet at your highest tax burden.  If the answer is “yes”, then a TIRA is probably your best bet, since you will likely have a lower tax burden in retirement, and therefore you want your earnings taxed then.  If the answer is “no”, then a Roth is probably a good choice because your retirement earnings will likely be higher than they are now, so you want your contributions taxed now.

With all that said, I think there are a few questions that you have to ask yourself to make the best choice:

1. How much money is in the 401k that you are about to roll over? My presumption is that it’s not that much, otherwise the plan custodian would not be closing your account.  In the grand scheme of things, this probably means that it will not make that much difference one way or another which option you choose.  However, the amount you have to invest may have some effect on what fund options are available to you in the particular option you choose.

2. Are you currently contributing to an IRA and/or do you plan to contribute to one soon? Related to Question 1 above is the issue of how much money you have to invest.  The fund option availability issue can be mitigated very quickly if you’re already contributing to an IRA or plan to do so soon.

3. How much money do you make? Your income determines your eligibility for TIRA and Roth IRA contributions, which relates directly to Question 2 above.  If you’re covered by a 401k plan at your current employer, then your Adjusted Gross Income (AGI — income after tax exempt deductions such as 401k contributions and Health Savings Accounts) has to be less than $53,000 if filing singly or $85,000 if filing jointly (there’s another pesky marriage penalty…) to be eligible to contribute to a Traditional IRA.  The AGI limits are $99,000 for single filers and $156,000 for joint filers for Roth IRA contributions.  Both types of IRAs allow up to $5,000 per person in contributions in 2008.  There are a number of little nuances to these rules, so you should check the link at the top of this paragraph to see the relevant tables pertaining to your particular situation.

With all that said, here is how I see your options:

1. Roll your 401k straight to a Traditional IRA.  This is the most common and straightforward move you can make.  The biggest problem that you could run into is not being able to meet the minimum amount required to buy into a particular mutual fund.  I’ll talk more about this in my next post on this subject.

2. Roll your 401k to a TIRA and then recharacterize it to a Roth IRA.  This may be a good option if your AGI is less than $100,000.  The downside to this option is that you will have to pay taxes on the money you have invested as if it were income, and you will have to file some additional paperwork with your tax return next spring.  Since it’s not a lot of money, the taxes won’t be that great.  You can pay the taxes out of the principal or out of pocket.  The latter option is preferred so that you keep the greatest amount of money working for you, but means you may have to come up with the cash in April if you’re expecting a refund but it doesn’t cover the taxes owed on the conversion.  Example: If you have $3,000 in the plan and you’re in the 25% tax bracket, then you’ll owe $750 in taxes.  You can reduce your principal balance to $2,250 to cover this, or you can come up with $750 on your own.  The bonus to the 2nd option is that you get to keep that extra $750 in the plan and growing tax free for the next 30-40 years.

3. You can take a distribution on the money.  This is probably the worst option (I like nuance, otherwise I would have said, “This is, by far, the absolute worst thing you can possibly do with this money.)  If, for example, you happen to have a credit card that is currently charging an exorbitant interest rate, like in the 30% range, then it may be in your best interest to use this money to help get out of that pickle before refocusing on retirement.  The downside to this option is that not only will you have to pay taxes as in Option 2, but you will also face a 10% penalty on the early withdrawal of 401k funds if you are under 59 1/2.  So that $3,000 turns into $1,950 just like that (imagine fingers snapping).  Just to be clear: Option 3 is nearly always a bad idea.

In my next post on this topic I will cover how to pick a new custodian for this money, how to set up an IRA, how to move the money from the 401k to the IRA without incurring expenses or taxes, and some thoughts on good fund options to get you started.

What would you do if you found yourself in this reader’s shoes?  Do you prefer to use Traditional or Roth IRAs for your non-401k retirement investing?  Let’s hear your thoughts in the Comment Section!

08.23.2008
Hay is for Horses!

Creative Commons License photo figure credit: law_keven

It’s been a few weeks since I’ve had a chance to compile some of the best things I’ve read lately.  The list below is pretty long, so let’s jump right into it:

I participated in the Carnival of Financial Goals earlier this month with my post on declaring a Financial Independence Day.

NCN wrote about a major motivation for keeping his financial house in order.  As the parent of a young daughter myself, my perspectives on what really is important have changed a lot in the last 2 years, and I certainly can empathize.  It’s great that NCN is in a position that frees him up from having to worry about anything other than family at this time. I hope Baby Girl is doing well.

The Freak-est Links points us to a website run by the Maine State government on how to calculate the value of your public library.  I calculated a $260 annual value of our local library.  Not bad!

Living Almost Large writes about Dreading the Envelope — you know, the one that gets passed at work when someone has a baby or something like that?  This article really changed my perspective on this practice.  I work in a relatively small office (~20 people).  A few months back a co-worker’s house burned to the ground.  He lost everything.  This was the only time that the envelope has been passed in the 3 years I’ve worked in this office.  I was torn on if and how much to give.  On the one hand, I can’t even begin to understand how devastating a loss this must have been.  But on the other hand, we’re responsible and have insurance (and so did he), so why should we need to give any money at all?  In any event, this situation is a true need compared to a birthday or baby shower, and in that light I will not hesitate to give more should the occasion ever present itself again.

Glbl asks for reader input on whether money earmarked for college should be given in one lump sum or allocated over time.  Many argue that young adults are still too immature to handle large sums of money responsibly (ie not blow it all in Vegas instead of using it for tuition…).  My argument, however, was that most young adults are “too immature” because they haven’t had the proper training on how to handle money.  So use this opportunity as a chance to educate the recipient on how to be financially responsible, budget, etc.  Otherwise you’re putting the cart before the horse.

J.D. writes about how to support your favorite bloggers (cough, cough).  While I don’t have any ads on Don’t Feed the Alligators at this time, most of the suggestions are still apt:

  • Participate in the discussion — really, please do! You can do so anonymously, and I never share or reveal email addresses, even if I know who you are.
  • Tell your friends — word of mouth, or email both work great!
  • Click on ads that truly interest you — not applicable here, but works well elsewhere
  • Link to stories that you like — if you’ve got your own blog or website and see a story you like, how about a linkback?

Madison writes about how to earn free money using the US Mint.  While this scheme is not for everyone, it certainly piqued my interest.

A spirited discussion follow David’s post on the large percentage of American corporations that pay no federal income taxes.  The biggest point that I would like to make here is that if you’re going to argue with someone and cite a fact, you have to be able to back up the fact with something other than the equivalent of saying, “It’s true, look it up!”  I never took debate classes, but it seems to me that it is the arguer’s job to look it up, not the audience he is trying to convince.  At the very best case, it doesn’t make for a very compelling argument.

Lastly and just for fun, J.D. links to a video made by two average guys who “compete” in a number of Olympic events and compare their results to those of Olympic caliber athletes.  This really underscores how incredible Olympic athletes are.  Hats off to all competitors and especially to US Gold Medal winners!

Tune in next time for a very special blognouncement!

Piggy Banks

Creative Commons License photo figure credit: Jeff Kubina

Our daughter was born in early 2007. Knowing what I know about the power of compounding interest, I knew it was important to start a college savings fund early with something, even if it wasn’t much.  We definitely subscribe to the belief that saving for retirement and debt reduction come first in the savings plan and that college savings has to take a back seat to these higher priority expenses.  Still, it’s difficult to be a parent and not try to put something away for your kids.

With that in mind, we opened a 529 savings account for our daughter when she was almost a year old.  A 529 plan is very much like a Roth IRA — except it’s for kids and their family and friends who are saving for their future college expenses.  Money put into a 529 plan grows tax free, and withdrawals are tax free as well.  529 plans are administered by individual states, and some states also offer an income tax exemption on contributions made to your home state’s 529 plan.  It’s interesting to note that many states now offer more than one plan.

With so many plans available, opening a 529 plan can be a daunting task.  Luckily the folks over at SavingforCollege.com have made the task a bit more manageable with a search function to find the characteristics of a 529 plan that you want.  We started with this list of wants:

  • low fees — no point in having high fees eat up a large portion of the gains
  • a variety of investment options — age based, index funds, etc.
  • low startup costs — we wanted to be able to contribute small amounts at irregular intervals
  • state tax exemption — your gains only get better if you can deduct the contributions on your state taxes

Another great resource at the time we set up the account was Nickel who did a lot of the homework for us.  My search did seem to concur with his assessment.  We got 3 out of 4 of our wishes in this search.  Unfortunately our state does not have any kind of income tax exemption for contributions made to 529 plans.

We decided on the Ohio College Advantage Plan to get started.  This plan offers very low contribution amounts at $15 per contribution.  It offers a range of investment options including portfolio blends, index funds, CDs, age based funds, etc.  Most of the fees for these options are low.  The Vanguard options, for example, start with an expense ratio of 0.23%, and there are no other management fees of any kind.

One nice feature of 529 plans, however, is that you can generally switch from one plan to another with little trouble (the one great exception being after you just got a state tax exemption…). So it’s not only possible, but probably quite likely, that you may pick a plan today but change to a different plan at sometime in the future.

It took until nearly her first birthday, but we finally managed to open an account with $1,100 that we had saved over the course of her first year.  Most of this was her money in the form of gifts that she had received.  We have since made a couple of additional contributions.  Our plan for the near term is to use the cash back from our Chase Freedom Card, as well as any additional birthday, Christmas, or any other kinds of gifts she receives (at least until she’s old enough to understand money…) to fund this account.  We don’t expect it to grow like gangbusters, but we expect that every little bit that we are able to save will help.  If we get to a point where we are saving 20% or more of our income for our retirement, then we will consider contributing more towards this 529 plan as a savings plan item.

For Part II of this article, we’ll look at Pre-Paid Tuition plans.

The cost of education is already scary, and it feels good to be contributing something to help our daughter’s future, even if it eventually amounts to just a drop in the bucket.  Are you saving for your kids’ education(s)?  How are you doing with it?