Free Money Finance

An Example of Why to Give Appreciated Securities Rather than Cash

In their piece on end of year tax tips for the generous, Kiplinger gives an example why it's better to give appreciated securities (assuming you do not want to hold on to them any longer) rather than cash. Their thoughts:

When you give $1,000 in cash, you get to deduct $1,000, and that saves you $250 in the 25% bracket. (Any state-income-tax savings are gravy.) But let's say you have $1,000 worth of mutual fund shares that you bought more than a year ago for $500. If you sell the shares, you'll owe $75 in tax on the profit, even at the preferential 15% capital-gains rate. But if you donate the shares, the charity gets the full $1,000 (it doesn't have to pay tax on the profit when it sells), you avoid the $75 tax bill, and you still get to deduct the full grand. It's a win-win-win situation.

I used this strategy several years ago (before the market melt-down -- when I still had big gains on almost every fund) to consolidate funds/accounts. I knew I wanted to give a certain amount over the course of the year, so instead of taking it out of cash flow, I gave securities. After doing this for a few years, I had drastically decreased the number of investment accounts and funds I had to follow/track.

A word to the wise: giving this way can throw the charity for a loop since many aren’t used to receiving donations in this manner. I had to do some research (find the right person at the charity who knew how to receive the securities on their end) as well as fill out some specific paperwork from the mutual fund company to make these transactions work, but it was worth the effort.

Just wanted to give you a heads-up -- if you're thinking of giving this way, be sure to allow a few extra days to take the extra steps required. This is certainly not a strategy you can use at 11:59 pm on December 31st! ;-)

Managing Taxes in Taxable Accounts

The following is an excerpt from Personal Investing: The Missing Manual.

Sometimes, you have to put higher-taxed investments into taxable accounts. For example, if you're saving for a short-term goal, stocks may be too risky, so you put your money in bonds or bond funds, or in a savings account. Or you may be saving for a goal that doesn't have a tax-advantaged account option. Don't worry. Although you shouldn't make investment decisions purely to avoid paying taxes, you can keep your investment taxes low with the following tactics:

• Buy and hold individual stocks and bonds instead of stock or bond funds. You don't pay capital gains on individual stocks and bonds until you sell them; fund managers may trade within stock or bond funds frequently, and you pay taxes on any gains from those trades. Sell individual securities in taxable accounts only to rebalance your asset allocation or because an investment hasn't panned out as you hoped.

• Buy municipal-bond funds or municipal bonds. If you want more bonds in a taxable account, purchase municipal bond funds. The federal government doesn't tax municipal bond income. In addition, you don't pay state taxes on municipal bond income if you buy municipal bonds issued by your state.

• Delay selling until the capital gains are long term. If you sell an investment before you own it for a year, you earn a short-term capital gain, which is taxed at ordinary income rates (for someone in the 25% tax bracket, that rate is 25%, versus the 15% for long-term capital gains). If you're close to the 1-year mark and the investment isn't in mortal danger, hold off on the sale until you pass the 1-year mark.

• Wait until the next calendar year to sell. If the end of the year is close, delay a sale until January. That way, you don't pay tax on the capital gain until the following year, which means you have a full year to use that money, for example, to earn interest on savings or invest in something else.

• Offset capital gains with capital losses. If you have capital gains and also have some losers you want to unload, sell the losers in the same tax year as the winners. Your capital losses offset your capital gains. This tactic is particularly effective for short-term capital gains, taxed at higher, ordinary income rates.

Note: If you have more than $3,000 in long-term capital losses, you can use those losses to offset long-term capital gains. However, if you don't have enough long-term capital gains to offset all of your long-term capital losses, you can deduct no more than $3,000 of a long-term capital loss in one tax year and must carry the remaining loss over to future tax years.

Save Money by Donating Things You Were Going to Throw Away

As I noted in Update on Our Shopping List, we recently got a new door. We went through quite a process to shop for the door and the company to install it that we felt worked best for our family, home, and budget. It took us several months from start to finish, but in the end we completed the process with a door we love (and it makes the front of our home look so much better!)

When the installers were set to come and place the door, my wife got a brainstorm -- why not call Habitat for Humanity and see if they could use the door? It wasn't in the greatest shape, but it still had some life in it. In addition, it was a nice, glass, double door that someone could get for a steal because it was used.

Unfortunately, the local Habitat for Humanity chapter didn't even return our calls (my wife did finally speak to someone who said she'd have a contact call us, but we never heard from anyone.) But my wife talked to the guy we got the door from and he told her about a local charity that accepted and needed door donations. My wife called them, and the day after our old door was taken out, they stopped by our house and picked it up.

My wife asked for and they gave us a tax receipt for the contribution. She then asked our door person what he estimated as the value of our door since we had no clue. He said $400.

If we were, say, in the 28% tax bracket, the simple act of finding a charity that wanted, needed, and would take the door saved us $112 in federal income taxes. Not a fortune, of course, but it's $112 we didn't have before and that we earned for little effort. I'll take it!!!!

Lesson for today: before you throw anything out as trash, ask yourself if there's a charity that might want it. If so, make it a contribution, get a receipt, and save yourself some money by reducing your taxes.

Dorothy in Taxland: Tax Credits

The following is a guest post from Marotta Wealth Management.

Tax credits are much more valuable than tax deductions. Deductions only reduce the amount you are taxed on. One dollar of deduction might only be worth 35 cents. In contrast, tax credits are a dollar-for-dollar reduction in your tax bill. And a refundable tax credit could mean the government will owe you money you never paid in the first place.

The final tax formula is "Total tax minus payments equals the amount you owe or have overpaid." The critical part of this formula is that payments include not only the money you have given the government but also any tax credits you are eligible to receive.

But most people fail to claim all their legal tax credits and miss opportunities to gain some real wealth redistribution.

For example, if college students have earned income, they can receive the Making Work Pay tax credit. It's a refundable tax credit worth 6.2% of earned income with a maximum of $400 per person. This credit is phased out for middle-income families but not for their children. They are eligible as long as their parents don't claim them as dependents.

Even if these students pay no tax, they will still receive a check from the IRS for $400. That's the beauty of a refundable tax credit. Students who file a tax return can take advantage of several other tax credits.

As a parent of a college student, you could receive a Hope tax credit. Usually this is a $1,800 credit for the first $2,400 spent on a college education during the first two years. But for the past two years it has been enhanced for students in the Midwestern disaster area to be $3,600 on the first $4,800 spent. If you have saved in a College 529 plan, you cannot receive this credit for money disbursed from the 529.

But if you spend $24,800 on the University of Chicago, for example, you can reimburse yourself $20,000 from the 529 and still receive the full $3,600 Hope tax credit for having spent $4,800 out of pocket. Spending $1,200 outside the 529 allows you to keep an extra $3,600 inside the plan.

Alternatively you can get the American Opportunity credit, which gives you up to $2,500 on the first $4,000 of educational expenses. It isn't limited to the first two years of college and is partially refundable. You can also take advantage of the Lifetime Learning credit and get $2,000 on the first $10,000 spent. Even part-time students who only took a single class are eligible.

This year many adult children of millionaires will receive an $8,000 First-Time Home Buyer tax credit. Many wealthy families will receive a $6,500 Move-Up/Repeat Home Buyer tax credit. These credits were available for couples with incomes under $225,000 who purchased homes priced at $800,000 or less. It's good to know we are using our tax credits to support the truly needy.

In many very rich families, everyone got a new home this year. Money is being given to each child to help him or her buy a home and make payments. In three years all the homes can be sold for a profit. In the meantime everyone gets an $8,000 refundable tax credit.

If you install a new air conditioner, windows, doors, roofing, furnace or water heater, you can also qualify for tax credits. The replacements have to be more energy efficient. Nearly everything new qualifies. Even those with enough discretionary income to make improvements without any governmental incentives can get a $1,500 tax credit.

According to the IRS regulations, nearly every window sold today will qualify as more energy efficient than the older windows being replaced. But the window companies have lobbied for taxpayers who can't afford to replace their windows to subsidize wealthier individuals who can. Nearly anything can be justified these days by calling it green.

The geothermal heat pump manufacturers must have had an especially adept lobbyist. Their merchandise isn't subject to the $1,500 cap and is worth 30% of the cost. So are solar energy systems or small wind energy systems.

There's even a tax credit for contributing to your retirement account. Couples earning less than $50,000 can get a tax credit up to $2,000. They can get a tax deduction for the contribution and still receive the credit. Even students can qualify if they are part time and not claimed as a dependent.

Probably the largest of all is the Earned Income tax credit. It is intended as the primary way to help the working poor, defined as a family of four with an income less than $45,295. The maximum credit is $5,028 with two children.

If you choose to take your children as dependents, you may also qualify for the child tax credit. It provides a $1,000 tax credit for each child as long as couples earn less than $110,000.

Finally, there is still a federal energy tax credit if you buy a hybrid electric vehicle. Incredibly, the IRS has ruled that even golf carts qualify under the rules of the $700 billion bank bailout. Every golf cart manufacturer has applied to become a licensed motor vehicle dealer and modified its carts to be street legal and plug into the wall. Getting a $5,900 tax credit on buying a golf cart can't possibly be what legislators intended.

Most of these tax credits are just a percentage of what you have to spend to qualify. Because the poor don't have much discretionary income, these tax credits do not help them at all. Mostly they subsidize the upper middle class and the businesses in specific industries who have lobbied to qualify.

I've personally taken advantage of nearly every tax credit available. In fact, this year each of my children got refundable credits giving them thousands of dollars more than they actually paid. Tax planning and management is increasingly a crucial part of wealth management. But it is terrible public policy. I think it is every citizen's civic duty to vote against the hands that try to bribe special interest groups with tax credits.

Hundreds of other federal tax credits and a host of state tax credits are available as well. Simplifying the tax code is the easiest way to reduce or eliminate loopholes and bring sanity back to the process.

As always, the tax code is as easy to understand as a flying monkey. Perhaps this is another reason why most people leave hundreds or even thousands of dollars of refundable tax credits unclaimed. This is especially true of the poor who don't have tax professionals to help them decipher and access the multiple forms required.

The moral failing belongs to voters and politicians who support nearly every proposed tax credit and then are surprised at the consequences. Until our country comes to its senses, tax management will remain a way to build and protect your family's hard-earned wealth.

The Fragility of Freedom at 60%

The following is a guest post from Marotta Wealth Management.  I generally like to stay out of political discussions, but the topic of over-spending by our government has been on my mind recently and I thought this piece might generate some good discussion. It's not an anti-Republican or anti-Democrat piece, but rather one that makes us think about the consequences of our on-going (and getting worse) deficit spending.

In 1977 economist Milton Friedman wrote an article "The Line We Dare Not Cross: The Fragility of Freedom at '60%.'"

He predicted that as the percentage of society that owes a portion of their livelihood to government spending increases, the ability to limit the growth of government will decrease. At some tipping point, attempts to reduce the size and scope of government become too difficult. Welfare statism sets in as a permanent malaise and drags on the growth of the economy.

Friedman said, "We still have some ruin in us, but pretty soon we are going to be forced to face up to the issue." We did a good job of keeping government spending relatively constant as a percentage of gross domestic product (GDP) for the next 30 years. Total government spending was at 33% in 1977 and had risen to only 35% by 2007. But since 2007 we've expanded the scope of government from 35% of GDP to 45%.

This overspending is certainly severe, but the cumulative deficit spending is even more critical. When Friedman warned us about the fragility of freedom, the gross public debt was at 47% of GDP. After three decades of deficits it had risen to 81%. Today it is at 120%. In just three short years we've added more to the deficit as a percentage of GDP than in the three decades before.

We don't have much ruin left. We have to face up to the issue. We are in danger of crossing a line we dare not cross.

Every time government spends money to provide security to a few, it destabilizes the rest of society. Shore up one sector and you risk impoverishing other sectors. Soon catastrophes in those sectors that are left free of government support are perceived as further evidence of the failure of the free market. Each crisis becomes an opportunity to expand the scope and power of government.

Most government spending consists of benefits given to the few while the costs are borne by the many. Thus a small minority has a large vested interest in seeing the legislation passed, and for the large majority it isn't worth the time and effort to try and defeat it.

Imagine there are 100 people in society and each earns $100 a day. Now imagine for just $5 a day from each person you could support five people so their income was secure and they could do public good. For the five people involved, it is a great deal. Everyone else is too busy to organize and fight against funding them. After all, it is only worth $5 to fight against it, but it is worth $100 each for those five to organize and agitate for it.

Perhaps there are another 10 people who benefit most from the good being done. It will only cost them $5 a day, and they might get $20 a day worth of benefit. Under the free market they could have purchased the benefit directly, but it would have cost them more. Never mind that they are middle class and could have afforded it. Why should they be obliged to pay when they can vote for the government to provide it for "free"?

The other 85 people only get $1 worth of benefit and it costs them $5 in taxes, but it isn't worth fighting, so they end up paying it. The cost to society is $500, and the benefit to society is only $285. The rest is lost opportunity costs. Most people, had they kept their $5, would have spent it on exactly what they valued at $5, and there would have been no waste. But because society pooled its money, few got what they really wanted.

And now that everyone only has $95 left to spend, everyone's businesses will collect 5% less in revenue. Society as a whole will be poorer as a result. In our example the level of missed opportunity costs was only 40% of what was collected plus an additional 5% less in GDP. In reality, the level of waste is much higher. Compliance and collection are costly. Federal monopolies are rife with enormous inefficiencies.

Ultimately the five individuals who are on public support have secure jobs, better pay, superior benefits and guaranteed pensions. In fact, we are there already. A Bureau of Labor Statistics study this month showed that federal jobs paid better than the exact same job in the private sector 83% of the time.

The difference is striking. The average salary in the private sector is $60,046, whereas the average federal worker earns $67,691. That's 12.7% more pay for the public servant. And the difference was even more pronounced in benefits. Health, pension and other benefits total $40,785 per federal worker but only $9,882 per private worker. So the total compensation package for the federal worker is $108,476--a full 55% higher than the worker in private industry whose total compensation amounts to only $69,928.

There is also the inevitable building of government fiefdoms and use it or lose it budgeting. Government bureaucrats each serve their own private interests. Many are seeking to further their careers or salaries. Others are seeking to extend their power and prestige. The legislation and regulations they put in place uses force to implement their interests.

An example from Friedman describes the problem succinctly. In a political decision, if 51% vote for red neckties and 49% vote for green, 100% of the people get red neckties. Each individual vote counts for very little in the political process. Contrast that with the free market where every vote counts and people get exactly the color they want.

The strategy for building a politically powerful coalition is to find a dozen such minorities who are willing to support you if you vote for their pet project regardless of what else you may do. This aggregate spending may be burdensome to society as a whole, but each item by itself will have a strong advocate. Although there may be popular support for cutting government spending in general, people will be reluctant to cut any specific programs because of the vehement support by an emotionally vested minority.

Friedman asked this very important question: Is there anybody in the vast American electorate who would take his or her vote away from a representative because that person voted to keep some small special-interest project? We need people like that. We need people who are against society specifying tie color even if they want red ties.

We need government employees who are willing to vote for limited government. We need middle-class families who are willing to let entitlement programs stop after funding the truly needy. And we need liberals who are willing to join with libertarians to say "Enough."

Holding the line on the growth of government is challenging, but there is a line we dare not cross. Just because something is good for most people doesn't mean it is good for everyone. Society is interconnected. We must cooperate in nearly every component of the economy.

We can either allow that cooperation to be voluntary or coerce behaviors through force. The first spreads a multitude of small benefits over many people. The second gives larger benefits to a privileged minority. One leads to freedom and prosperity. The other leads to tyranny and misery.

Are You Getting a Tax Refund? What are You Doing with It?

Well, it's tax day -- so why not a tax-related post and discussion?

Consumer Reports says that the average tax refund this year (through March) is $3,036, up almost 10% versus last year. They then offer some ideas for how to spend a refund as follows:

• Pay down debt
• Build up an emergency fund
• Fund your IRA
• Save for or finance home improvements
• Add to college savings
• Have some fun

CNN Money offers its own suggestions on how to spend a tax refund as follows:

• Pay down debt
• Save for a rainy day
• Save for retirement
• Invest in yourself
• Buy something you need
• Have a little fun

Lists look similar, huh? ;-)

So what will people do with their tax refunds? MSNBC says most will use them to pay down debt or save. A survey they cite notes "84 percent of Americans receiving refunds intend to pay down debt, save or invest their windfall or use it for everyday necessities." BTW, 7% plan to spend it on something "fun."

Each year I try as hard as possible not to get a refund since I'd rather have my money as I earn it instead of four months into the next year. However, I have one big wild-card I can't seem to work around: my annual bonus. If I get a small bonus or none at all, I'm close to being on target with what I have taken out of my taxes. But if I receive a larger-than-average bonus (which I did this year), it blows everything out of the water because they take a HUGE percentage of the bonus out and send it to the government. So needless to say, I'm getting a good-sized refund this year.

What do I plan to do with it? I'll spend it on some things we need and probably save the rest. I know, boring... :-)

How about you? Are you getting a refund? If so, what do you plan to do with it: pay down debt, save it, or spend it?

Overtaxed Homeowners Fighting Back

Here's a piece from MSNBC that talks about people appealing their real estate taxes because they are too high compared to current home valuations. The details:

Now that the housing bubble has burst, up to 60 percent of the nation's taxable property may be overassessed, meaning owners are paying thousands of dollars more in taxes than they need to, experts say.

That is leading to a flood of appeals in many markets from homeowners eager to cut their taxes and speed the process of aligning tax valuations with reality.

While home prices have fallen by 30 percent on average since their 2007 peak, according to the Case-Shiller Home Price Index, many counties only reassess every three to five years and have little incentive to move faster considering how important property taxes are to funding local government operations.

So homeowners are increasingly appealing the valuations, although the number is still a tiny fraction of the total — 2 to 4 percent, according to the National Taxpayers Union.

“People forget they need to appeal,” said Barbara Payne, executive director of the Fulton County Taxpayers Foundation in Georgia. “Everyone should have appealed more than once in the last five years or you’re paying too much.”

Those who appeal are getting mixed results. Only 20 to 40 percent of those who challenge their assessment walk away with a victory, the NTU said.

You may remember last year when I tried to get my assessment lowered. I did get it reduced, but not by much. This year when I got my assessment notice it was much more realistic -- down 14.2% -- and at a level I feel is a true reflection of the value of our home. Now I just have to see what this does to the actual amount of taxes we pay.

One big downside to this: since the township is reflecting actual values for homes, I assume tax revenues are down big-time. As such, they're now asking voters to approve an additional millage to pay for needed police and fire workers. I guess if they can't get it one way, they'll get it another. But if my taxes aren't going to pay for the proper level of police and fire protection, what are they going towards?

Any of you seen changes in your real estate assessments?

Five Tax Rules You Should Consider Implementing

The following is an excerpt from The Financial Crossroads.

Now that we have tackled the major tax myths of which you should be wary, we’ll provide some beneficial tax rules to consider implementing in your financial life.

Rule #1: Take advantage of a 401k or other retirement plan.

The most effective way for most people to minimize taxes is through the use of a pension plan, such as a 401k, 403b, or Simple IRA.  These are corporate retirement plans that allow you to make pre-tax contributions to an account that will grow tax-deferred until you take distributions in retirement.  In 2009, an individual can contribute $16,500 to a 401k; if over age 50, an additional $5,500 “catch-up” contribution is allowed.  If you make $66,000 per year and contribute $16,000 to your 401k, your taxable income is reduced to $50,000, and you keep the investment.  After someone has parted service from a company and reached age 55, distributions can be taken from a 401k without penalty, but the distribution will be treated as taxable income in the year in which it was taken.

Rule #2: Take advantage of a Roth IRA.

A Traditional IRA functions similarly to a 401k or other corporate retirement plan.  Contributions up to $5,000, for those with income under $55,000 for a single individual or $89,000 for a married couple, are deductible and will reduce taxable income.  As it is in a 401k, the growth in a Traditional IRA will also be tax-deferred, but distributions——in this case, after age 59 ½——are subject to full taxation.  For individuals age 50 and over, an additional $1,000 “catch-up” contribution is allowed. 

A Roth IRA, however, is a different animal.  With a Roth, you do not receive a tax deduction on the front end, but the money grows and is distributed tax-free.  You don’t need to get your eyes checked; I did say tax-free, and those opportunities are few.  The limitations are that you may only contribute $5,000——if 50 or over, $6,000——and make less than $105,000 for an individual or $166,000 as a married couple to be able to contribute the full $5,000 in 2009. 

The argument historically has been that if you are young and in a low tax bracket, you should contribute to a Roth; if you’re older and in a high tax bracket, contribute to a Traditional IRA because by the time you take distributions from your Roth IRA, your bracket will likely be lower.  But, I suggest that anyone who is eligible to contribute to a Roth should do so.  The reason my suggestion can be so broad is that almost all of us will have the bulk of our retirement savings in vehicles like a 401k——all of which will be taxed upon distribution.  In retirement, if we need income, we’ll be forced to take it from our 401k or Traditional IRA “buckets” and thereby be forced to pay tax on it. 

It is beneficial for anyone planning for retirement or financial independence to have at least one bucket from which they can take distributions without paying any tax.  Oh, and by the way, with Social Security, Medicare and Medicaid in troublesome financial shape; global, perpetual military activity on the part of the U.S.; trillions (with a “t”) in “Great Recession” stimulus packages; and over one trillion planned for a healthcare overhaul, the chances are good that we are all seeing the lowest tax rates that we’ll see in our lifetimes.  That makes for an even stronger case for the Roth.

Rule #3: Create a liquid investment account.

A liquid investment account is just a regular individual or joint investment account in which you pay typical taxes.  In this account, if you own income producing bonds, you’ll pay ordinary income tax (which means the interest will be treated as taxable income) in the year in which it’s paid.  If you own stocks, you don’t pay any taxes on the growth until you sell the stocks, and when you do, you’ll pay capital gains tax (on any stock held over one year), which is currently 15% (with very few exceptions).  If you lose money on stocks, when you sell them you can take a “tax loss.”  When you do your taxes, tax losses can be set against gains, neutralizing the taxable event.  Dividends that come from stocks are taxed in the year in which they are received at the dividend rate, which is also currently 15%——but probably not for long.  Mutual funds, which own stocks and bonds inside of them, pass on the taxable impact of capital gains and income to the mutual fund shareholders.

With all this taxation to keep track of, why would I suggest that you maintain a liquid investment account as a tax strategy?  If a portion of your portfolio is focused on investing in stocks, long-term capital gains taxation is preferable to ordinary income tax treatment.  If you invest in a stock in your IRA, it will grow tax-deferred, and if you sell it in the future and take a distribution from the IRA, you’ll pay ordinary income tax rates, the highest of which is 35% (and climbing) in 2009.

If you bought the same stock in a taxable, liquid investment account, your gains would be deferred until you sell the stock in the future.  When you sell the stock years later, it will be considered a capital gain and, based on today’s rate, you’d pay 15% on the gain.  If you are in a high tax bracket, the difference between that 35% tax in the IRA and 15% tax in the liquid investment account is significant.  Some even orchestrate a strategy where they do their fixed income investing inside of their IRA and their growth investing in their taxable account, but remember, too much time focused on a strategy of this nature begins to look like the tax tail wagging the dog.  The primary focus in investing should be making wise investment decisions.

Rule #4: Do long term investing for college in a 529 plan.

The 529 college savings plans offer a tax-privileged way to save for college, but this rule comes with a caveat.  From a tax perspective, the 529 functions much like a Roth IRA.  Dollars invested in the plan receive no special tax treatment initially, but they grow tax-deferred and are distributed——if used for qualifying education expenses——tax free.  The caveat is that one’s time horizon must be fairly long to withstand the volatility of the investment vehicles that are likely to net a meaningful gain.  Our next chapter will discuss in greater detail the benefits and drawbacks to 529 education plans.

Rule #5 Utilize a Health Savings Account.

You heard us sing the praises of the Health Savings Account in Chapter Nine, but we need to mention it here again, because the HSA may be the multi-use investment vehicle with the most tax privilege allowed by the IRS.  Whether you’re talking about a 401k, a Traditional IRA, or a Roth IRA, the IRS only allows you to get a tax break on one side of the timeline——either your contribution is tax privileged or your distributions, but not both.  The HSA, however, allows both the front and the back end tax break.  Every dollar contributed to an HSA is a deduction.  If your employer contributes, they get the deduction; if you contribute, you get it.  The money grows tax-deferred, and if you take a distribution to pay for qualified health expenses, the distribution is tax-free!  That’s the best deal on the street.

Five Tax Myths

The following is an excerpt from The Financial Crossroads.

In the remainder of this chapter, we will address the most common myths in personal financial planning regarding taxes and also share the tax strategies of which you should be taking advantage.

Myth #1: “I need a mortgage for the tax deduction.”

It is not a myth that most homeowners are able to deduct all or most of the interest that they pay on a mortgage.  That is true, and the deduction has the impact of reducing our taxable income each year, and that is a good thing.  But, it is the pursuit of indebtedness for the primary purpose of having a tax deduction that is financial foolishness.

For example, when you have a mortgage at 7%, any interest that you pay will be deductible.  If you’re in a 25% tax bracket, that means that your effective interest rate——after taking the deduction into account——would be 5.25%.  But you’re still paying 5.25%!  It’s as if you’re paying the bank one dollar to save 25 cents.  Many have made the mistake of purchasing a car with home equity because of the income tax deduction.  You may be paying less interest per year, but when you take 15 years to pay off a car, you’d be much better off to take an auto loan with your credit union, or better yet, buy with cash.

Further complicating matters with deducting mortgage interest, is that your mortgage comes with an amortization schedule that front-end loads the interest portion of your payment.  So when you have just taken out a 30 year mortgage, almost 100% of your mortgage payment in that first year will be interest.  By the time you have only 10 years left, most of your payment will be going towards principal repayment.

Remember, you don’t get a deduction for your entire mortgage payment; it’s only the interest part of your payment.  So if you’re about to retire and you only have 10 years left on your mortgage——and you have the money to pay the mortgage off——and someone advises you to keep the mortgage because you’ll keep the deduction, recognize that you’re not even getting much of a deduction at that point anyway.  You would be better served to pay the mortgage off and be free from the payment in retirement.

The Truth: You should never carry a mortgage for the primary purpose of having a tax deduction.

Myth #2: “I can’t sell this stock——I’ll have to pay the capital gains tax!”

From Thanksgiving in 1999 through the Super Bowl in 2000, the above quote was mentioned at festive gatherings as much as lines from the Chevy Chase movie, Christmas Vacation, along with this other holiday favorite, “Oh, I think I ate too much.”  Cisco, the beloved darling of the technology stock boom of the late 1990s, tells an interesting capital gain story. 

In October of 1998, you purchased 1,000 shares of Cisco for around $12,000.  You bragged over eggnog in December of 1999 how much of a stock trading genius you were sitting pretty with a Cisco position worth over $50,000, and your crotchety Uncle Pervis said, “That stock’s way overvalued!  You’d be stupid not to sell at least half of that stock now.”  You retorted, “That’s crazy!  I read in a magazine that it’s different this time, and besides, I’d have a huge capital gain tax bill if I sold now.”  You called Uncle Pervis to rub it his face in March of 2000 as you were sitting on an $80,000 position, but Uncle Pervis would have the last laugh.  By September of 2001, your position was back where you started; down from $80,000 back to $12,000.  You no longer had to worry about capital gains tax because your gain had evaporated.

In this example, you had gained 566% or $68,000 on a $12,000 investment.  The federal capital gain tax required, had you sold the stock in March of 2000, would have been $13,600.  That’s a lot of money, but it’s not nearly as much as the $54,400 of pure, after-tax gains that you left on the table by holding the stock even after the economic, valuation, and cyclical factors all pointed towards a red neon SELL sign.  Certainly, with the benefit of hindsight, it’s easy to say you should have sold, but it was the tax consequences that made it hard to sell.  The best investment decision was to take your gain and pay the tax.

The Truth: You should never hold an investment with the avoidance of taxes being the primary determinant.

Myth #3: “I’m buying this investment to lower my taxes.”

In the 1980s, Limited Partnerships were a red hot investment.  While they did have a bona fide investment component to them, they were sold largely on their seemingly magical ability to create a tax loss——and accompanying deduction——while the investment somehow made money.  A change for the worst regarding tax preference and the incredible illiquidity of these vehicles resulted in painful losses for investors who had been sold shares in Limited Partnerships.

Annuities, also, have been touted by salesmen for many years with the primary pitch that they defer the taxation of gains.  As discussed in Chapter Twelve on annuities, many annuities have high expenses, sub-par or limited investment choices, and look less attractive from a tax perspective as laws and times change.

Another investment often sold primarily on the basis of tax privilege is municipal bonds.  Income from the bonds of a state or local municipality is exempt from federal income tax (and state tax, if you purchase bonds of a municipality in the state in which you live).  While carefully purchased municipal bonds can be a wise investment for an individual in a high tax bracket, they make very little sense for individuals in lower brackets. 

Let’s assume an investor is faced with a decision to invest in either a highly rated corporate bond yielding 5.5% or a highly rated municipal bond yielding 4%.  The corporate bond interest will be taxable and the municipal bond interest would be tax free.  Which is the best investment?  It depends on the prospective owner’s tax rate.  If the buyer is in a high income tax bracket, like 35%, the 4% tax-free municipal bond gives the buyer an equivalent taxable yield of 6.15%.  Since that 6.15% equivalent taxable yield on the muni is higher than the corporate taxable yield of 5.5%, the municipal bond appears to be the wise decision.  If, however, the owner of the bond is in a lower tax bracket——let’s say 15%——the tax equivalent yield is only 4.7%, making the 5.5% corporate bond more attractive.

The Truth: You should never purchase an investment for the primary reason that it will benefit you from a tax perspective.

Myth #4: “The bigger the tax refund, the better!”

When winter begins to turn into spring, we all start thinking about taxes——or, at least, we should.  It is that time of year when we’d rather be receiving a check instead of writing one, but we are missing the point.  The point isn’t to give Uncle Sam a free loan so that we can feel an imaginary sense of surplus when we receive a refund; nor is the point to be so aggressive in our tax planning that we end up having to write a big check, or paying a penalty for having held on to too much of the U.S. Government’s income.  Neither should we judge our accountant on his or her performance by how much of a refund we receive.

An objective of an informed taxpayer should be to regulate your withholding exemptions——the amount of tax that you pay the government throughout the year——such that you’re not writing or receiving a huge check come tax time.  Taxpayers must also be aware that it is you, not your accountant alone, who is responsible for the accuracy and fidelity of your return.  You are signing on the dotted line and the Internal Revenue Service is not a forgiving creditor. 

One of the more painful examples that I’ve seen is that of an individual who changed tax preparers several years ago.  The year of the change, he received a dramatically higher tax refund than he was accustomed to.  It wasn’t until I reviewed three years of his tax returns that I realized the accountant had fashioned fraudulent deductions in an effort to boost the refund.  The taxpayer, originally referred to the accountant by a family member, was so pleased that he had referred friends and family himself.  Now that he had realized that the accountant had materialized $15,000 in fraudulent refunds, he’d have to report the news to friends and family, and their lives would be negatively impacted as well.

The Truth: The amount of a tax refund has absolutely no bearing on whether or not the taxes were optimally computed.  Take full advantage of the tax law and adjust your withholdings so that you neither write nor receive a huge check at tax time.

Myth #5: “This stuff is easy; anyone can do it!”

Helpful software tools and low-cost tax preparation services leave the impression that tax planning can be done in a matter of minutes by people who have little or no training.  There is a major difference between tax preparation and tax planning.  The former can be done by a computer program or tax preparer, but the latter requires the help of a professional Certified Public Accountant working in tandem with you. 

Your tax preparation software is only as good as the preparer, and don’t forget that our own Secretary of the Treasury, Tim Geithner, couldn’t get Turbo Tax to work properly!  Even if you think yours is a situation that is easy enough to be handled on your own, you should visit with a CPA every few years to ensure you’re not missing something significant. 

The Truth: Most people would be best served by having a professional Certified Public Accountant prepare their taxes. 

H&R Block At Home 2010 Federal and State Tax Software Review

Since I use a CPA to do my taxes, the past two years I've had a friend do a write-up of TaxCut software for me (here's 2008's review and here's 2009's review). We did the same thing again this year (except the software is now called H&R Block At Home), and here is his review.

This is my third year reviewing H&R Block’s TaxCut (now H&R Block At Home) tax program. The past two years I have printed the returns but I had not e-filed because the machine that I used in my basement office was not hooked to the internet. This year I thought I would try e-filing for the first time.

Last year I had a problem trying to download the updates on a computer with an internet connection and then transferring the updates to my basement computer. So, to avoid a 3 hour hassle again I ended loading the program on a laptop with an internet connection. I then proceeded to get the large updates and then downloaded the state forms. I then copied last year’s tax return file from the non-internet basement machine onto the laptop with the help of a thumb drive so that I could import last year’s data into the program.

At Home brought over the previous year’s tax information without a hitch and then it started to ask me if there were any changes to my family member’s data. I was then able to start responding to the orderly questions by logging in my income. The program showed the previous year’s 1099int, 1099div accounts, and bank accounts. You can add or delete the accounts as needed and then change the amounts. The same thing happened for the deduction section. It assumed that I was giving to the same charitable organizations and that my mortgage was with the same mortgage company.  I just added and deleted as with the income accounts.  This year I had purchased a vehicle that would qualify for a $1300 alternative fuel tax credit. I couldn’t find much information about the forms that needed to be filled out last year, but At Home filled in the proper forms like a trooper.  I was already well organized with my receipts so it only took about a half hour of answering questions before I was done with the 1040 federal return.

One gripe is that I am not a fan of the way that it prints the tax forms. I wish they would work on this function so that at any time you can just take a “draft” look at the 1040 form.  Maybe there is a way to do this, but it is not very intuitive. 

I then went to the state form and answered the questions and plugged in the numbers and was done with that form in about 15 minutes.  The State of Michigan hardly gives you any tax breaks so there is not much to fill out. (Unless you are some obscure wild rice farmer that uses homemade bio fuels to drive his 1809 machinery and make less than $15,000 per year. Then there are a bunch of tax breaks.)

I then printed out the forms with the schedules and worksheets, and reviewed all 60 pages of them.  I then preceded to e-file the tax federal tax return. I set up pass words and filled in the banking information for a direct deposit of the refund and sent it off. I got an email back from H&R Block stating that they will send me an email when the federal government acknowledges that they have received my tax return. (As of writing this I have not receive that acknowledgement which can take a day or two.)

I then turned to e-filing the state return. As I was going through the motions I found out that it wanted to charge me $9.95 to e-file the state return. I wondered about this and then looked at the fine print on the box. The software only includes free filing for federal returns and not state returns. What’s up with that! You pay good money for the program and yet they only include federal e-filing in the price?  No problem since I owed money. So I just backed out of the e-filing section, printed the form, attached a check, and popped it into an envelope.

Here are my findings:
 
Likes: 

• Easy to use.
• Putting income in accordance with the boxes that are on the w-2 and 1099’s.
• Checking the boxes of sections that you need to fill out and avoid wading though unwanted tax questions.

Dislikes:

• Print preview functions.
• No state e-filing included in the price.
• Price of the software.

At Home does a nice job a methodically moving you through the federal tax maze and takes a lot of the time out of researching the tax guide books on what forms and schedules that need to be filled out. This is truly the benefit of using the program.

However, I basically have the same beef as I did last year. Why is tax software so expensive? This beef is not against just At Home but all the major software vendors.  It seems that one should be able to buy the original software for $45 and then each year download any new updates and forms for a nominal $10 -$15. The architecture of the software has hardly changed from one year to another and you are already downloading the new federal and state forms from the internet. So why should we consumers have to buy a totally new package each year? I believe that the first software package to come up with an easy to use and accurate tax program with nominal upgrade charges each year will get the majority of the business.  Then again, maybe we should scrap the whole tax code and just do a straight flat tax on a post card and make all of our lives simpler.

Saving a Bundle on Your Taxes with an Unrelated Dependent

The following is a guest post from Harvey J. Poorbaugh, Editor of Fidelity Select Fundranker.

Are you working long hours, possibly more than one job, and supporting your significant other while she’s out of work?  Is your unemployed college buddy mooching off you during a long and unsuccessful job hunt?  Have you taken in your daughter’s soccer team buddy because her home life wasn’t working?  It’s not obvious, and it may surprise you, but you may be able to claim an unrelated person as a dependent on your 2009 federal tax return.

There are several tests to determine whether an unrelated person is your dependent.  If you and your potential dependent pass all of these tests, get ready to save a bundle on your taxes:

• Is your potential dependent a qualifying relative? It’s easy to jump to the conclusion that she isn’t a qualifying relative, because, well, she’s not related to you in any form or fashion. Take a close look at the IRA definition of a qualifying relative, however, and you’ll see that it includes, in addition to various real relatives, any other person who lived with you all year as a member of your household if your relationship did not violate local law. Note that the 2009 Form 1040 instructions list some exceptions that still count as living with you, such as going to school or on vacation. So if your potential dependent lived with you for all of 2009, and your relationship did not violate local law, you pass this test.
• Is your potential dependent a qualifying child of any taxpayer for 2009? Because she is not related to you, she’s not your qualifying child, and if she lived with you the entire year, then she can’t be a qualifying child of anybody else, either. You easily pass this test.
• Did your potential dependent have gross income of less than $3,650 in 2009? If so, you pass this test.
• Did you provide over half of your potential dependent’s support in 2009? Well, does she have some other means of support? Is the support you provide more than her other means of support? If so, you pass this test.
• Was your potential dependent a U.S. citizen, a U.S. national, a U.S. resident alien, or a resident of Canada or Mexico? If so, you pass this test.
• Was your potential dependent married? If not, you pass this test.
• Can you yourself be claimed as a dependent on someone else’s 2009 tax return? If you are providing half of your potential dependent’s support, it’s unlikely someone else is providing half of your support. You should pass this test easily.

So if you pass the above tests, just how much can you save on your taxes?  An additional dependent allows you an extra exemption, which, for 2009, shaves $3,650 off your taxable income.  If you are in the 25% tax bracket, that amounts to tax savings of over $900.  If you also are paying education expenses for your unrelated dependent, you can save big with an education tax credit. To top it off, you probably will save money on your state income tax, as well.

Why I Report My Daughter's Babysitting Income to the IRS

The following is a guest post from Carol Topp, CPA. She is the mother of two teenage daughters and runs Teens and Taxes.

Typically, income from babysitting does not mean a teenager must file a tax return.  Income from babysitting is typically too low to pay income tax (the threshold in 2009 was $5,700). Additionally, teenage babysitters are considered household employees, not business owners, so they avoid paying self-employment tax. Neither does an employer have to pay employer taxes (Social Security and Medicare) on a teenage babysitter, if these three conditions exist:

• the employee is under age 18 at any time during the year and
• the work is in or around a private residence as an employee and
• the employee's main occupation is not providing house hold services. (For a teenager, their primary occupation is to be a student, not a babysitter.)

All three things must be true to be exempt from employer and self-employment taxes. See IRS Publication 926 Household Employer’s Tax Guide.

For example, when my daughter, Emily, was 16, she went to a neighbor’s house and babysat their three children several times a month and in the summer. In one year she made $1,200. She was a teenage household employee. Emily did not owe self-employment tax on her babysitting income. Since she earned less than $5,700 (in 2009), she did not owe federal income tax either.

But I filed a tax return for her even though Emily did not owe any income tax nor self-employment tax. Why?  I wanted to open a Roth IRA for her and contribute up to the amount of her earned income. Babysitting income is considered earned income even though it is essentially tax free for the amounts Emily made. The tax return is a way to officially report her earned income. 

Perhaps I am overly cautious. After all, the brokerage where I opened her Roth IRA did not ask for income verification. The IRS is not cross checking Roth IRA contributions with earned income (as far as we know). I wanted to create a paper trail. Since I am a CPA with a tax preparation practice, my daughter's 1040 was easy to prepare. I was careful to mark her earned income from babysitting as household income. The IRS instructs household employees (babysitters, lawn mowers, maids, etc) to write “HSH” on the line where wages are reported. My tax software took care of this when I checked a box for household employees.

Consider filing a tax return for your teenager to report her babysitting income and then open a Roth IRA for her. My hope is that someday Emily will cash in her Roth for a down payment on a house (you can use a Roth IRA for your first home purchase and avoid the 10% early withdrawal) and she will fondly remember her babysitting days. Maybe she will consider her mom fondly, too!

Tax Filing Stats

TurboTax offers up this "infographic" about filing your taxes online that has some rather interesting numbers in it. For instance:

• 67% of people file electronically versus 33% who filed paper
• 95 million out of 141 million tax returns were filed electronically
• 78% of filers received a tax refund
• The average tax refund was $2,753
• Top e-filing states are what you'd expect -- the most populous states (My state, Michigan, is #8)

A few thoughts here:

• What once was unusual, e-filing is now the norm. I wonder how long it will be until virtually everyone e-files.
• 78% of people get a tax refund and the average refund is $2,753? Ouch! I wonder how much money is lost (not earning interest or not being able to pay off a debt charging you interest) by Americans that are lending the US government $2,753 each. If there are 141 million filers, that means 110 million get a refund. And at $2,753 each, that's $302 billion in refunds. That's a boatload of money that could have gone to pay credit card debt and the like to save people a TON of money last year.
• I've been e-filing for as long as I can remember. My CPA does it for me.

How about you? Any e-filers out there? Anyone refuse to use e-filing? Anyone expecting a huge refund this year? Why?

Two Tax Credits that Could Save You a Bundle

The following is a guest post from Harvey J. Poorbaugh, Editor of Fidelity Select Fundranker. It's actually a combination of two pieses he sent me, and I thought they worked best under the unified title above.

Making Work Pay Tax Credit for 2009 and 2010

The Making Work Pay tax credit for tax years 2009 and 2010 came about as part of the American Recovery and Reinvestment Act of 2009, which was signed into law by President Obama in February, 2009, to help stimulate the economy in the depths of the Great Recession.

Under the Making Work Pay tax credit, working people are supposed to receive up to $400 per year ($800 for married taxpayers filing jointly) of a refundable credit against their federal taxes.  Refundable means that if any remains after it is applied against your tax, it will result in a tax refund.  The Making Work Pay credit begins being phased out for single taxpayers at an AGI of $75,000 and for married taxpayers filing jointly at an AGI $150,000.

The whole idea of this tax credit was to get money in the hands of working people as soon as possible so they could spend it and stimulate the economy, so withholding tax tables were changed as of April 1, 2009, and workers started receiving a little bit more take home pay for the remainder of the year.  Those little bits, over the last nine months of 2009, as well as over the entire 12 months of 2010, should add up to about $400 ($800 for married taxpayers filing jointly).

When you fill out your 2009 federal tax return, and you get down to the Payments section of your Form 1040, you’ll put down your withholding, which should be about $400 ($800 for married taxpayers filing jointly) less than it would have been had the tax credit not existed, and then you’ll also put down $400 ($800 for married taxpayers filing jointly) for the tax credit.  So your tax payments should add up to about the same amount as they would have had the tax credit not existed, but Uncle Sam contributed $400 ($800 for married taxpayers filing jointly) of it for you.  He just gave the credit to you a little at a time during the year instead of giving it to you all at once when you file your tax return.

A few taxpayers may find that their employers cut their withholding too much during 2009.  If you have more than one job, or you and your spouse both work, remember that your different employers are unaware of your income from the others.  They simply look up your payroll withholding according to the number of allowances on your W-4 form. It was up to you to make sure that you claimed the appropriate number of allowances on your 2009 Form W-4 so that your employers didn’t cut your withholding too much during the year.  If you are unpleasantly surprised at how this works out on your 2009 tax return, make sure you update your 2010 Form W-4 right away.

Education Tax Credits for 2009

If you, your spouse, or one or more dependents had qualifying postsecondary education expenses in 2009, don’t miss claiming your education tax credit on federal Form 8863.  The American Opportunity credit is new for 2009, and the Hope and Lifetime Learning credits are still available, as well, although the Hope credit is useful now only if you need to claim qualifying educational expenses for a student who attended a school in a Midwestern disaster area.  Instead of the above education credits, you also still can claim the tuition and fees deduction on federal Form 8917 for 2009.  It is limited to $2,000 or $4,000 depending on your gross income less other deductions, is deducted from your gross income, and lowers your AGI.  As such, it hardly ever lowers your federal tax as much as the above credits, and we won’t discuss it any further.  As an aside, you may be able to reduce your state income tax for 2009 by claiming qualifying education expenses, as well.

The American Opportunity education credit, new for 2009, allows you to claim a tax credit of 100% of the first $2,000 and 25% of the next $2,000 of qualified education expenses for each student, for up to a maximum $2,500 tax credit per student, for the first four years of postsecondary education.  Even better, if you are at least 24 years old (see Form 8863 instructions if you were younger than 24 at the end of 2009), 40% of each student’s tax credit is refundable, meaning it will increase your tax refund, even if you don’t owe that much tax.  If you claim the American Opportunity credit for any student, you cannot claim the Hope credit for other students, but you can claim the Lifetime Learning credit for other students.  The American Opportunity credit is phased out beginning at $80,000 AGI for single taxpayers and $160,000 AGI for married taxpayers who file jointly.

If you have a student who attended school in a Midwestern disaster area, the Hope education credit allows you to claim a tax credit of 100% of the first $2,400 and 50% of the next $2,400 of qualified education expenses for each student, for up to a maximum $3,600 tax credit per student, for the first two years of postsecondary education.  If you have other students who did not attend school in a Midwestern disaster area, the Hope education credit allows you to claim a tax credit of 100% of the first $1,200 and 50% of the next $1,200 of qualified education expenses for each student, for up to a maximum $1,800 tax credit per student, for the first two years of postsecondary education.  If you claim the Hope credit for any student, you cannot claim the American Opportunity credit for other students, but you can claim the Lifetime Learning credit for other students.  None of the Hope credit is refundable, and it is phased out beginning at $60,000 AGI for single taxpayers and $120,000 AGI for married taxpayers who file jointly.

The Lifetime Learning education credit allows you to claim a tax credit of 20% (or 40%, if your student attended school in a Midwestern disaster area) of the first $10,000 of qualified education expenses for all students together, for up to a maximum $2,000 (or $4,000) tax credit.  This credit can be used for any number of years of postsecondary education.  None of it is refundable, and it is phased out beginning at $60,000 AGI for single taxpayers and $120,000 AGI for married taxpayers who file jointly.

Check various combinations of the three credits to see which is best for you.  For example, if you have only one student, she attended school in a Midwestern disaster area, and she had $10,000 of qualifying expenses, you could claim a $2,500 American Opportunity credit, a $3,600 Hope credit, or a $4,000 Lifetime Learning credit.  If you have two students, neither attended school in a Midwestern disaster area, and they each had $5,000 of qualifying expenses, you could claim a $5,000 American Opportunity credit, a $2,500 American Opportunity credit along with a $1,000 Lifetime Learning credit, or a $2,000 Lifetime Learning credit.  If you have two students, one attended school in a Midwestern disaster area and had $10,000 of qualifying expenses, and the other had $4,000 of qualifying expenses, you could claim a $5,000 American Opportunity credit for both students, a $5,400 Hope credit for both students, a $4,000 Lifetime Learning Credit for both students, or a $4,000 Lifetime Learning credit for the student who attended school in a Midwestern disaster area along with a $2,500 American Opportunity credit for the student who didn’t.

When you are figuring out which option is best for your situation, remember that, if the nonrefundable portion of your education credit is limited by the amount of your income tax, it’s possible a smaller American Opportunity credit, which is partly refundable, may be better than a larger Hope or Lifetime Learning credit.

Last Chance for a Segregated Roth Conversion

The following is a guest post from Marotta Wealth Management. For more thoughts on this topic see 2010 Roth Conversion: Factors to Consider Before Making a Decision.

A tax tsunami is coming at the end of this year. The higher your adjusted gross income (AGI), the closer you live to the coast where the tsunami will hit. This is the last chance you will have to put your assets in a lifeboat and avoid getting swamped with taxes.

At the end of 2010, the Bush tax cuts will expire. The Obama administration is not expected to alter the rates significantly before then. They don't want to be held accountable for raising taxes before the midterm elections. And they would rather blame the previous administration for a crazy expiring tax law.

Right now, tax rates are at a historic low. But after 2010, counting all the tax changes, top marginal tax rates may rise from 44.6% to 62.4%. Thus you will only have to pay a maximum of 44.6% on income you can take before 2011, but after that you may have to pay 17.8% more in tax.

If you have an income over $100,000, this is the first year you can take money from your traditional IRA, pay tax as though that money is ordinary income and convert it to a Roth IRA. This procedure is called a "Roth conversion."

Roth IRA accounts are to your advantage if your tax rate will be higher in retirement when you withdraw the money than it was when you contributed. With a Roth IRA, you pay tax on the acorn. With a traditional IRA, you get a bigger acorn to start with, but you pay tax on the oak. Many families have actually lost money by investing in their traditional IRA when they were young and in a lower tax bracket, only to find themselves in a much higher bracket during their retirement. A year from now, we will all be in a higher tax bracket.

If you execute a Roth conversion this month, January 2010, you do not have to pay the tax on that conversion until April 15, 2011. You also may change your mind. If you decide the conversion wasn't worth it, you can move the money from the Roth account back to a traditional IRA account. This is called a "Roth recharacterization."

Recharacterizing a Roth conversion can be done any time before you file your taxes, including the filing extension. So if you file an extension you can change your mind any time before October 15, 2011. And you can decide to recharacterize part or all of what you converted.

The upside is that you can use all these laws and changes to maximize your after-tax investments. During the next few years, tax planning and management will be a significant part of wealth management. But it needs to be put together as part of a larger plan.

Here's the timeline of how to use a Roth conversion to maximize your investments. Now is the time to do five Roth conversions of equal amounts into five separate accounts. You aren't going to keep them all, so you can convert five times as much as you want to end up keeping and actually paying tax on. Invest each Roth account in a different asset class (e.g., large-cap U.S. stock, small-cap U.S. stock, foreign stock, emerging markets and hard asset stocks).

The five accounts will appreciate differently, but the entire portfolio will be fairly well balanced. Before April 15, 2011, decide if you will be keeping only one account or more than one. If more than one has appreciated significantly, you may want to keep more than one account's conversion. Compute your tax liability for the year and pay the tax, but instead of filing your return, file an extension.

Before the October 15, 2011, extension deadline, decide which of the five accounts you are going to keep. By now, nearly a year and three quarters has elapsed. You can easily determine which account has appreciated the most. Keep that one, and recharacterize the other four. Because you only have to pay taxes on the amount you originally converted, it's like betting on the horse race after the winner has already been determined. After recharacterizing the accounts, file your tax return before October 15.

If all of the accounts decrease in value, recharacterize them all and pay no tax. Financially, you are none the worse for having filled out a stack of paperwork. If only one account appreciates significantly, you only keep one conversion. But you have increased the odds of your Roth account appreciating by five times.

The average return of the S&P 500 is about 11%, but the standard deviation is about 19%. All of the other asset classes have an even higher standard deviation. It is likely, for example, that emerging markets will be either the best or the worst performing asset class over any two-year period. Using this technique you can guarantee that the Roth conversion you keep will have been invested in the best asset class during that year and three quarters.

Segregating each of the five conversions into a separate account allows you to decide to recharacterize or let each account stand separately. The difference in returns between the average and the best account is liable to be 20% or more over the year and a half before you have to choose which accounts to keep. Coupling the 17.8% tax savings and this Roth segregation technique could boost your returns by 30% or more.

In the quite likely event that all five accounts have appreciated significantly, you may decide to keep them all. Once you have reached the maximum tax rate, the top marginal rate does not increase from there. Those most fearful of expectations of higher tax rates soaking the rich after 2010 would be those most likely to benefit from converting everything.

You are a good candidate for a Roth conversion in 2010 if you have the following characteristics. You have an AGI more than $100,000 and so have not been able to convert previously. You have a large IRA that could be converted. You expect your tax bill to be higher in the future. You have sufficient taxable assets to pay the tax. You would like to reduce the value of your gross estate and leave a tax-free asset to your heirs. You are willing to pay estimated taxes and increased tax preparation fees.

Even thought this technique could boost your after-tax returns, be careful. Executing a Roth segregation account requires professional assistance. Such a technique should be just one small part of a larger comprehensive financial plan. And you should seek the guidance of a personal fee-only financial planner and certified public accountant (CPA) who have a legal obligation to act in your best interests. The laws are changing annually, and as a result so is the optimum path.

What Makes You Think You Can Do Your Own Taxes?

Ha! I'm sure the title of this post will irk a few people from the get-go, but I like it and I'm going to stick with it. ;-)

As you know, I'm generally a personal finance do-it-yourselfer. But in the area of taxes, I don't do them myself. I use a CPA for some very good reasons.

Recently I posted When You Should and Shouldn't Do Your Own Taxes. It listed some things we all should consider when deciding whether or not to do our own taxes. In particular, I highlighted the story of Flexo from Consumerism Commentary, no financial lightweight, who hired an accountant and ended up saving $15,000. If Flexo needed help to save more, don't you think maybe you and I might need some help too?

Now many of you will say "I use TaxCut/TurboTax/some other software and it does what I need it to." Oh yeah? How do you know that?

The reason I ask is this story from Generation X Finance. He notes that when his taxes were simple, he did them himself and things were fine (as far as he knew). Then life (and finances) started getting a bit more complicated. That's when this happened:

One year after putting in all of my data the tax software said I owed the IRS nearly $4,000. That’s impossible, I thought. We had as much taken out of our paychecks as possible through work, I was paying estimated quarterly taxes, and was itemizing deductions so that we could deduct as much as possible. There had to be a glitch in the software or I was missing so I plugged the numbers in over and over for about a week straight only to come to the same result.

With that, I knew it was time to seek professional help. We asked around with some friends and co-workers about CPAs that specialize in small businesses and self-employed taxpayers, and I made a few calls around and interviewed a few of them. We eventually found one not too far down the road and their name came up a few different times from the people we asked. So, I set up an appointment. After sitting down with the accountant for about an hour discussing our situation, looking over some numbers, and doing some calculations she knew she could help me. A few days later I was thrilled when I received a call stating that I now only owed somewhere in the neighborhood of $2,500. Wow, that phone call and meeting just saved me about $1,500. Sure, the cost of having my taxes done increased compared to doing it myself, but at around $300 it was some of the best money I ever spent.

Now this isn't coming from some bum off the street. Jeremy is a pretty sharp guy. So if he needed help, do you think maybe some of us do too (even if we don't know it)?

Now I'm not saying that everyone needs tax help (BTW, Jeremy notes that there's a BIG difference between a tax preparer and a CPA -- something I agree with completely.) If your taxes are simple and rather straight-forward, then you're probably fine doing them yourself. It's when life's complications start to set in that you'll probably need help. And the more complications, the more likely that you'll need some advice. (For the record, I said this four years ago when I posted Why I Use a CPA to Do My Taxes -- I'm not just making it up now.)

What sort of complications? Jeremy lists these three:

1. You own a business.
2. Going through a major life change.
3. Real estate or taxable investment dealings.

If nothing else, I'd suggest you contact a CPA in your area (get recommendations from successful friends), set up and informational meeting or lunch (most will do this for free), and see if they think they can help you (have them be specific in how they can do this.) What is there to lose? Nothing really. But in the end, you could end up saving yourself a good chunk of change.

When You Should and Shouldn't Do Your Own Taxes

Long-time readers know that I have several reasons for using a CPA to do my taxes. Now MSN Money weighs in on the issue of whether or not you should use a tax preparer by saying you should ask yourself these three questions when deciding if you should do them yourself or seek professional advice:

1. Are you prepared to give your taxes your time? In 2007, the IRS estimated that the average taxpayer needed 24.2 hours to do his or her 2006 tax return, 52.2 hours if a Schedule C for business or a Schedule E for rental properties was filed.

2. Are you prepared to put up cash to hire a preparer? Getting someone to do your taxes can cost $50 to $100 at the low end -- assuming a simple return -– or up to several thousand dollars for a complicated return. The average for an itemized return is more than $200. Any fee you pay may be deductible on your 2009 return if you itemize.

3. Are you prepared to deal with the complexity of the federal code? Because the tax code is so complicated, more than 60% of Americans have professionals do their tax returns.

Here's where I net out on these questions:

1. I do have a small business and I am NOT prepared to spend 52.2 hours (not to mention the frustration) to prepare my takes. I still do have to do the summary info for my accountant (which probably takes five hours), so I'm gaining 47 hours for my money. It's a good trade for me.

2. I spend about $800 on taxes, but they are deductible (business expense). This works out to about $17 per hour for the 47 hours I save. Again, worth it to me! (FYI, this includes both federal and state filings.)

3. I am not prepared to deal with either the complexity of the federal code or the frustration of learning about it. Not only is my accountant saving me 47 hours, but she's saving me 47 painful hours.

Ok, so maybe 47 hours is a bit of a stretch. Even if it would take me 20 hours to complete everything, the cost is still worth it to me. There are not many worse ways to spend 20 hours than working on taxes (other than babysitting several two-year-olds), and it's worth a lot for me to avoid the pain altogether.

And while I'm fairly financially savvy and up-to-speed on the tax code, even people with a good level of financial expertise can get over their heads when complicated tax issues are involved. Case-in-point: Flexo recently hired an accountant who re-did his past taxes and saved him $15,000. Now Flexo is a pretty good money manager, and if he was missing $15k, just think what you and I might be passing up.

How about you? Do you use a tax preparer or do you do it yourself?