Municipal Bond Investing Mistakes

Investing in municipal bonds can be a benefit due to the fact that the interest income they provide is generally tax-exempt. In order to realize the full tax benefits of municipal bonds, you have to be careful not to make the following mistakes.

Low Interest Rates: Interest income from municipal bonds is usually much lower than corporate bonds, but since municipal bond interest is generally tax-exempt, your returns may be higher when factoring in taxes. The problem arises when you would have received a greater return by investing in corporate bonds than municipal bonds when factoring in taxes. Generally, if you are in a low tax bracket, then municipal bonds may not make sense.

Purchasing Out of State Bonds: Municipal bonds are not subject to either Federal or state taxes if you purchase bonds from your home state. If you live in a high income tax state, such as California, New York, or New Jersey, then you should consider purchasing a bond from your state to reduce the overall tax exemption.

Alternative Minimum Tax: This dreaded tax, also known as the AMT, may make your tax-exempt municipal bonds taxable. If a bond is considered a private activity bond, then you may end up paying taxes on the bond interest.

You must be careful when selecting municipal bonds by doing your research. Otherwise, in your quest for tax-exempt income, you may end up overpaying taxes or unnecessarily receive a low interest rate.

Be Careful Who You Loan Money To

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A friend is in a pickle and asks you for a loan of $5,000 because they hit some hard times and have some bills to pay. Do you help out your friend and say yes, or simply say no.

If you say no, then your friend may get upset, get behind with bills, but hopefully they will respect your decision. I recommend to never loan money to friends or family, but in case you end up doing so you need to formalize the process. Better yet, give the money as a gift with no strings attached or expectation of being paid back.

If you do say yes, your friend is happy and you are happy to help out a friend. And your friend will pay you back . . . or will they? And when? Here are a few tips to make sure that you do not damage your relationship with your friend, which is probably much more valuable than the money in most cases. You can easily substitute family member or employee in the place of friend, which is a very common situation too. I am big believer in having things written down so there is a mutual understanding between everyone, and here are some important factors to have in writing and to consider:

Loan vs. Gift: Your agreement states that it is a loan, so there are no misunderstandings about this fact.

Amount of Loan: How much are you loaning.

Interest Rate: How much is the interest rate you will charge?

Length of Loan/Payment Schedule: Is the loan for a month, a year, five years? How much will the payments be? What about late fees?

These are some basic items to consider, and the most important is to have it in writing even if it is a very basic agreement. If your friend refuses to sign the agreement, then this is a sure sign that you will most likely not get paid and will lose both your money and your friend.  It is always wise to seek legal guidance when warranted.

Should You Buy a Home or Rent?

Several years back when the real estate market was red hot, it was almost a no-brainer to buy a home. A year or two later your home appreciated by thousands of dollars and was worth much more than you paid for it. We all know that this is not true now, so does it make sense to be a homeowner or a renter?

Let’s start with the benefits of owning a home. First, home prices are much more affordable than in the past. Combine this with historically low interest rates, and it makes home ownership much more enticing. Over time real estate does generally appreciate and over time it usually becomes one of the largest assets a person owns, especially for the middle class. Also, the interest paid on your mortgage and property taxes paid are generally tax deductible.

The drawbacks of owning a home are several. First, you must be able to afford and qualify for a mortgage. The combined mortgage and property tax payments are usually much higher than renting. Although, over time theoretically your rent will increase while your mortgage payment stays constant with hopefully only a small increase of property taxes. Also, you are responsible for all of the upkeep, improvements and repairs, utilities and all other expenses.

Renting can be beneficial for a variety of reasons. First, the payments are usually lower than a mortgage and property taxes. You do not need a large down payment, except for a security deposit. It is easier to move because you do not have to worry about selling a home and can take a job much farther than where you currently live. You also may be able to save more money because your housing costs are lower.

Renting can present a problem in the long-term though because it may prove to be more expensive over time. You also do not build any equity or have the benefit of real estate appreciation. Also, when you rent you obviously are more restricted by the rules of your landlord.

Many factors should be weighed before purchasing a home or choosing to continue renting. Home ownership is the American dream, but one thing to keep in mind is that you want to make sure that your monthly payments do not cause a financial strain. This even applies to existing homeowners.

Penny Wise, Pound Foolish

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What do I mean by penny wise, pound foolish? Saving a penny, but it costs you a dollar. Here are a few examples:

Extreme Couponing: I watched an episode of extreme couponing years ago and the first thought that came to my mind, aside from obsessive, is that the coupon clippers spend way too much time trying to save money. If an average family spends around $200 to $250 on groceries weekly, but they spend 30 hours a week couponing, aren’t they missing out on actually earning money? Multiply 30 hours by a minimum of $20/hour working and the result is $600. Even if $200 out of that goes towards taxes, it makes sense to try to earn more money than trying to save $200 by cutting coupons all day. The net result of working would increase your cash flow by around $10,000.

Not Investing in Yourself or Your Business: Aside from retirees, most individuals make the most income from earnings as a business owner or an employee. Don’t hesitate to intelligently invest money to further your career to produce more income, or to invest money into your business to produce more profits. Investing can be in the form of items designed to produce more income, such as marketing, or to reduce expenses, such as updating your equipment and use of technology.

Spending Too Much on Items That Are Tax Deductible: Just because you can save taxes by paying loan interest, or by purchasing a new vehicle and equipment for your business, does it really make economic sense to do so? Spending a dollar to save a quarter is definitely penny wise, pound foolish.

Doing It Yourself or On the Cheap: Should you really do your own plumbing if you have never done it before just to save some money? It may end up costing you more when a real plumber has to fix your mess! I also see this with tax and accounting matters, but I am biased in this area, of course.

I still remember the first time I heard the penny wise, pound foolish saying (actually it was a partner at a large public accounting firm, and he said, “penny wise, dollar dumb,” but it still means the same thing). Think before trying to save!

I Received a Notice from the IRS – Now What?!

If you receive a letter in the mail from the IRS, the first thing you should do is open it! It might not be as bad as you think. The most common notice I see is that a client forgot to include interest, dividends, or wages from a W-2 on their income tax return and now they owe additional taxes, interest, and penalties.

Just because you receive a notice that you owe money doesn’t mean the notice is correct. You want to see why there is an increase, and compare the figures in the letter to your tax return. Then you want to see what the proposed changes are. I have seen notices that have actually showed incorrect W-2 wages.

Usually you have 30 days to respond to the notice before additional interest and penalties will be assessed. There are several options to take at this point.

The first option, if the notice is correct and the additional penalties and interest are very insignificant, should be to pay the amount due as soon as possible. If the notice is correct and you have a valid reason for not including a portion of income, you should then include payment of the taxes and interest on those taxes only. Additionally, you will need to respond to the notice to state why the penalties should be removed. The IRS will remove penalties if you have a justifiable reason. As a caveat, if the penalties are not removed then you will owe not only penalties, but possible interest on the penalties as well. The cost/benefit has to be weighed carefully. If the notice is completely wrong, then you should not send any payment, but include an explanation in your written response to the IRS, along with any supporting documents to show why you do not owe additional taxes, interest, and penalties.

As you can see there are several options when receiving a notice from the IRS or one of the state taxing authorities. Do not hesitate to contact our office if you receive a notice. We can clearly explain it to you and guide you through the next step to take.

An Overview of IRS Audits

There are different types of IRS audits. The first and least complex is the correspondence audit, next is the office audit, and lastly and most complex, the field examination. I highly recommend to anyone who receives a letter from the IRS, or even the State of NJ, to contact their tax advisor as soon as possible.

The correspondence audit is the most commonly used audit of all three types of audits. It starts with a letter issued from the IRS stating that a change has been made to your tax return, such as for investment income that you failed to report. Assuming in this case the IRS is correct, you will need to submit the additional tax assessed on the unreported income, along with interest to the IRS. If the IRS is not correct and you disagree then you will need to provide an explanation to prove that you do not owe additional taxes. Sometimes the notice is partly right, and the best course of action may be to file an amended return or complete the appropriate forms.

Since correspondence audits are very cost effective for the IRS, they also send letters for specific deductions, such as charitable contributions, to request substantiation for your deductions. This is why it is extremely important to keep all receipts for your deductions, because without any proof that you made donations, your deduction will be disallowed and additional taxes and interest will be assessed.

The next audit, the office examination, takes place at one of the field offices of the IRS by a local agent. Although more complex than a correspondence audit, the agent usually focuses on a select number of items. It is very important to be very prepared for this type of audit because it can lead to the agent broadening the scope of the audit.

Lastly, and most in-depth, is the field examination. This involves an IRS agent visiting your place of business or possibly your home. The agent requests much more information and asks a lot more questions. Again, it is very important to be well-prepared for this audit. It is also crucial to communicate with and work closely with your tax advisor.

After completion of an audit, there can be several outcomes. The first is an assessment of additional taxes, interest, and/or penalties, the second is no change to your tax liability, and third you may actually be due a refund (not likely, but that would be a great outcome)!