Don’t Do This

There is one financial transaction that I strongly discourage clients from doing and here’s why . . .

Do not withdraw from your retirement accounts early! Here are the reasons why I hear most people want to withdraw from their retirement accounts:

  1. Purchase a house
  2. Pay for expenses while unemployed
  3. As a temporary loan, with the intentions of replacing the money
  4. To pay for unforeseen expenses
  5. You need the money for (fill in the blanks)

The main reason to not do this is because it is one of the major reasons for tax problems. Aside from early withdrawal penalties, additional income taxes are accessed  on the balance, withholdings are not usually taken or not enough, and you may end up increasing your income, which sometimes pushes you into an even higher tax bracket. Once you add up all of the penalties and taxes, then the amount withdrawn can disappear by half for some.

What are some other options as you are most likely withdrawing your retirement funds because you desperately need the money and do not have a cash cushion? If you are employed, you may be able to obtain a retirement plan loan from your employer, which is not a taxable event. Alternatively, you might be able to borrow the money from your home’s equity. In some cases, you may be able to delay what you need the money for if not needed for emergency purposes.

Over the long-term, this is why I stress slowly building up a cash emergency fund. Yes, it’s boring and unexciting, but you will be glad you did when the time comes.

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Deadline Approaching: Should You Make a Retirement Plan Contribution?

The due date for your tax return is fast approaching and so is the deadline to make a contribution to your IRA or a SEP-IRA if you own a business. Should you make the contribution, save the cash, or pay off some debt?

Reasons to Make the Contribution: Let’s assume that you have the extra cash. If you are looking for an extra deduction and you are able to make a deductible contribution then this is a great last minute strategy. You may have also maxed out your retirement plans at work and are looking for additional retirement savings. A non-deductible IRA contribution can also be advantageous too and may be able to be converted to a Roth IRA with no tax consequence, depending upon your situation.

Save the Cash: You may need the cash to start a business or expand your business. Start-ups need every bit of cash so saving for retirement may need to be put on hold for now. Additionally, the returns of starting or expanding a business can be many times greater than a retirement plan contribution.

Pay Off Debt: If you have very high interest rate debt, then paying down your debt will help you to pay off the debt faster and decrease your liabilities, which will in turn strengthen your finances. However, I do not recommend not contributing to a retirement plan to make extra payments towards your mortgage.

Other factors to consider are: large expenses that you may need to fund in the near future, your health, job and business stability, emergency fund balances, and your overall financial goals.

Is it Better if I File Separately from My Spouse and Other Common Tax Questions Answered

We receive a lot of questions pertaining to tax and financial matters. Here is a sample of commonly asked questions:

Q: Is it better if I file separately from my spouse?

A: Usually the answer is no, and the only way to know for certain is to perform an analysis when preparing the tax return to split income and deductions between spouses to see if there is a benefit. However, you may want to file separately from your spouse if there are tax or legal issues.

Q: Is social security taxable?

A: That depends. If you are only receiving social security and do not have other income, then the answer will probably be no. A quick way of checking is to add one half of your social security plus your other income to see if it is greater than your base amount, which varies based upon your filing status (currently it is $32,000 for married filers).

Q: Does my son or daughter need to file a tax return?

A: Generally, if your dependent child has more than $6,300 of earned income or $1,050 of unearned income, such as from dividends, then they need to file a return.

Q: If I file an extension, will it extend the amount of time that I have to pay my taxes.

A: No, the extension only grants you additional time to file your return and all payments must be made by the original due date, otherwise additional interest and penalties may be incurred.

Q: Can the IRS levy my IRA?

A: Yes, the IRS has the power to levy almost all of your income and assets, with few exceptions, such as workers’ compensation.

Q: Are legal fees for a divorce deductible?

A: Many of the legal fees for a divorce are not tax-deductible, except for the portion relating to taxable income.

Strange Tax Benefits

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The tax laws are written with a purpose in mind, but at times, it may be used (loopholes) to receive unintended benefits.

  • You may be able to rent out your home or vacation home tax-free if rented for less than two weeks during the year
  • If you have a home office, you may be able to deduct the cost of building a gym or swimming pool if it is for the benefit of your employees and their dependents (especially if your wife is your employee)
  • Through your IRA you can own a business and any income will not be subject to taxes. This one can be difficult to implement, and you must follow all the rules exactly.
  • If your children work for your business you may be able to deduct their wages and they may not have to pay taxes on them either.
  • Your dog if you are hearing or visually impaired. This includes dog food and training too.

There are many strange, creative, and at times aggressive tax strategies that can be employed to help you to save taxes. This is just a list to show that we think outside of the box. If you have any questions, please let us know.

Pay Less Tax on Your Investments

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It’s great to accumulate wealth by investing and saving you money, but did you know that taxes can take a large bite from your investments? Every investor, including those with 401(k)’s, IRA’s, and traditional brokerage accounts need to be aware of the impact of taxes. Here are a few tips and items to watch out for:

401(k)’s: A 401(k) can be a great way to save money for retirement as it is automatically deducted from your paycheck every time you get paid. If you are in the 25% tax bracket, every $1,000 you contribute saves $250 in taxes, plus savings for state taxes as well. You want to contribute as much as possible to reduce your taxes and save for retirement, especially if your employer has a matching contribution.

There is one common mistake that I do see often with 401(k) accounts and that is withdrawing money before retiring. It could be because you really need the money or you switched jobs and cashed out your account. You must resist the temptation to do this! Generally, there is a 10% early withdrawal penalty plus you will owe income taxes on the money withdrawn. This can easily add up to a third or even half of the money lost to taxes that you have withdrawn!

IRA’s: An IRA (individual retirement account) has similar tax characteristics of a 401(k). A strategy to maximize the tax-efficiency of your IRA may be to convert some or all to a Roth IRA. A Roth IRA has more favorable tax aspects as there are no taxes when you make a qualified withdrawal. Before making this decision, a thorough analysis should be done to make certain this strategy is beneficial for your situation.

Traditional Brokerage Account: A regular taxable investment account needs to be monitored closely to make sure you are not unnecessarily paying taxes. There are three straightforward ways to do this:

  • Invest in tax-efficient mutual funds, ETF’s, and reduce the number of times you trade in your account. Every time stocks or bonds are sold, it may result in additional taxes
  • Hold your investments for longer than one year to pay lower capital gains tax rates. This strategy compliments the first point.
  • Compare the returns of tax-free municipal bonds to regular bonds to see which produces the higher overall rate of return.

Traditional IRA vs. Roth IRA

Traditional IRA:

An individual retirement account that allows individuals to contribute pretax money to investments. The investments grow tax-deferred until the amounts are withdrawn at retirement, generally age 59 1/2. The maximum amount you can contribute for 2015 is the lesser of your taxable compensation or $5,500 ($6,500 if you are 50 or older). There are phase-outs for tax deductible contributions if you or your spouse are covered by a retirement plan at work and your income exceeds certain levels.

Roth IRA:

An individual retirement account that allows individuals to contribute after-tax money to investments. The investments grow tax free and there are no taxes when withdrawn at retirement, generally age 59 ½. The maximum amount you can contribute for 2015 is the lesser of your taxable compensation or $5,500 ($6,500 if you are 50 or older). The eligibility to contribute starts to phase-out once your modified adjusted gross income reaches $183,000 if your filing status is married filing jointly and $116,000 if single or head of household.

Your IRA is a Tax Time Bomb

Individual retirement accounts, also commonly referred to as IRA’s, are a great way to save for retirement and potentially reduce your current taxes. Although these benefits are great, there is a tremendous downside that can impact you if you make a wrong move.

Early Withdrawal Penalty: If you need to withdraw money from your IRA before you are 59 ½ or if you do not meet the exceptions to withdrawing early, then you will owe a 10% penalty, plus income taxes on the amount withdrawn. Depending upon your tax bracket and when considering state taxes, the taxes and penalties for an early withdrawal can equal about 50% of the amount withdrawn.

Required Minimum Distributions: Once you reach age 70 ½ you must start withdrawing from your IRA the following year. If you do not take the required minimum distribution then you will be subject to an excise tax of 50% of the amount you should have taken.

Improper Rollover: You can rollover your IRA to another IRA or a qualified retirement, such as a 401(k) plan without penalty. The problem arises if you withdraw funds from your IRA and do not place them in another IRA or qualified plan within 60 days. If this happens then the amount distributed will be considered taxable distribution and may even be subject to the 10% early withdrawal penalty.

There are other mistakes that can easily be made, such as not choosing a beneficiary or not making contributions to your IRA. The good thing is that there are tremendous benefits that an IRA offers, which we can save for another article.

What is a Self-Directed IRA?

Individual retirement arrangement or IRA’s are very common and well-known. Normally when someone owns an IRA they invest in stocks, bonds, and mutual funds, but did you know that there is alternative arrangement, called a self-directed IRA?

A self-directed IRA allows an individual to invest in a wide array of assets, including real estate, private equity, and to make private loans. There are prohibited transactions though, such as living in a property owned by the self-directed IRA, so you must be careful to comply with the rules.

Why Use a Self-Directed IRA? Because of the ability to invest in non-traditional assets, you have the ability to earn a higher rate of return and to diversify your investments from traditional stock and bond portfolios.

Traps to Be Aware of: The easiest mistake to make is to not be aware of the tax traps of investing in private equity or real estate. For example, if you invest in a restaurant that is formed as an LLC, then the income from the LLC will be “passed-through” to the IRA. Although this is allowed, the income is considered “unrelated business taxable income” and would trigger tax on the income. A way of getting around this is to invest in a company organized as a c-corporation and receive dividend income.

Other Traps: These traps are called prohibited transactions and if you engage in them then the IRS will tax all of your IRA assets as a distribution as ordinary income plus penalties, when applicable. A sample of prohibited transactions includes borrowing money from your IRA, selling property to it, using it as security for a loan, and many other self-dealing transactions.

Despite the traps that need to be avoided, a self-directed IRA may be appropriate for your portfolio. As with any investments you need to perform your due diligence to choose the right investments, IRA custodian, and advisors.

Don’t Make These Mistakes

With all of the financial and tax laws, changes to the laws, and life changes it is almost impossible to stay on top of everything. We have to constantly assess our situation all of the time. Here are a few things to consider:

Wills, Beneficiaries and Estate Matters: Did you recently get married, have children, or get divorced? If so, then you need to make sure that your will is up to date, along with your beneficiaries of life insurance, retirement, and other financial accounts.

Required Minimum Distributions: Once you turn age 70 ½, you need to start taking distributions from your IRA’s the following year; the first one by April 1st and the next by December 31st. If you don’t do this then you may be subject to a 50% excise tax on the amount that should have been withdrawn.

Retirement Accounts: Are you contributing to your retirement accounts at work or through your business? If not, then what are you waiting for? You may be losing out on employer matches and also tax savings. The simplest way to start is to contribute a small amount, such as 1% of your income and then increase the percentage over time. If you are already contributing to a retirement account, then try to increase your contributions.

Social Security: The biggest mistake with social security is the temptation to start receiving your benefits at age 62. Unless you have known health issues, the biggest risk is actually living too long and receiving a small benefit for the rest of your life. Let us know if you need us to talk you out of this!

No Action: This applies to absolutely everything and not just financial matters. By far, the largest mistake is not taking any action to help your financial situation. Don’t let this happen to you!