Fantasy Tax Choices

Most of these blogs are helpful hints to think through financial issues that impact you.  This one is not that applicable to most readers.  It’s certainly not political, but may give food for thought about the negotiations that go into tax legislation.  As the national debt limit is being debated, there’s governmental discussion over tax cuts and tax increases as opposed to tax reform.  The tax code is certainly more complicated than it should be, as are other government funding issues.  Some of the most simple solutions may never get serious consideration because they are, in fact, so simple.  Here are a couple that will probably never off the ground.

 Flat Tax

A true flat tax would be exactly that.  Everyone would pay the same percentage of every dollar they get from anything  that’s income.  So wages, dividends, interest, capital gains, sales – everything – would be taxed at the same rate.  Deductions would either be minimal (alimony paid, the cost of items sold for profit, etc.) or non-existent.  So if you make $15,000, you’d pay the same percentage of you income that someone who makes $500,000.  Those with higher income pay more dollars, but you’d each pay the same percentage.  To have our current system – the more you make the higher percentage you pay may seem fair in the sense that those who make more have more disposable income.  But the deductions always end up debated and making things complicated.  Shouldn’t we encourage home ownership by giving people a tax break for their home mortgage?  Maybe so, but what about all those innovations that could save the environment?  Shouldn’t they get a break?  How about farmers?  They feed our nation and should be able to pay less in taxes.  Right?  And so it begins.  What the “flat” tax is and how it’s structured has as much potential for interpretation and complication as our current tax system once it gets started.

National Sales Tax

This is so simple it wouldn’t even require filing a tax return.  The government could impose taxes for anything purchased in the country.  They could even set different rates for different purchases to help out lower income households.  So food purchased at a grocery store could be at a low tax rate or no tax, but food purchased at a restaurant could have a higher tax.  We all have to eat, but those who don’t make a social occasion of it pay less to eat than those who do.  Cars could have a higher tax rate, maybe even much higher for vehicles in a higher price range.  Houses could have the same structure as cars and the tax could be part of what we’re able to finance with a mortgage.  But how do people get to claim their deductions? And so a national sales tax falls apart, too.

Sigh…

And so it all ends up with the same concerns about having a system that generates income for government, attempts to tax those who can afford it, and gives breaks to those who are doing things that society wants to reward.  To be clear, my descriptions of these two alternatives aren’t the ones that have been put forth for public debate.  They describe a basic concept and how it might work.  Unfortunately it seems that none of the systems – including the one we currently have – work for everyone.

To Roth or Not To Roth

Congress lifted the income ceiling in 2010 for conversion of a traditional IRA to a Roth IRA. So lots of people are wondering if a conversion is a good idea.  The answer is – as it so often the case – that it depends. 

What’s the difference between the two types of IRAs?  Contributions to a traditional IRA might be partially or fully tax deductable, so this type of retirement account has some or all of the balance subject to tax when the money is withdrawn.  Also, with a traditional IRA, you are required to withdraw a portion of the account every year beginning when you turn 70½ and those withdrawals are taxable.  Contributions to a Roth IRA are never tax deductible, but withdrawals aren’t subject to tax.  Also, you are never required to withdraw the money from a Roth.  Both types of IRAs have a 10% penalty if you take money out prior to your age 59½, with a few exceptions. 

Converting from traditional IRA to Roth means that the taxes need to be paid on the taxable portion of the traditional IRA, which sometimes means the entire amount.  During 2010, that converted amount can be taxed partially in 2010 and partially in 2011.  But unless you know you’re going to drop into a lower bracket in 2011 due to a life event – retirement, quitting a job to go to school full time, taking a big pay cut – spreading the tax over two years probably doesn’t make sense.  We know the tax brackets in effect for 2010 and it’s likely that they’ll be higher in 2011.

It’s important to remember that you don’t have to convert your entire IRA.  You could decide to convert just part of it.  So if the top IRS tax bracket you are subject to is 28%, you could convert enough of your IRA to a Roth that you wouldn’t have income pushed into the next tax bracket and leave the rest in your traditional IRA in place.  That Roth balance will now be available in your retirement years to be withdrawn only if you want to withdraw it and will be tax free if you do use it. 

So who is a Roth conversion most appealing to?  If you are in a lower tax bracket this year than normal, you might want to consider it.  Maybe you just retired or you’ve been laid off or had a pay cut in your household.  If you are ten or more years away from retirement and don’t expect your tax bracket to go down much when you leave the workforce, that’s another favorable thing.  So if you’ll have a pension that will pay you when you stop working or your IRA is really large, you might want to look at a conversion.  Ironically, the people who haven’t been eligible this year – high income earners – often have the hardest time justifying a conversion.  I recommend doing a Roth conversion prior to age 59½ only if you have enough cash outside the IRA to pay the tax.  So paying between 28% to 35% to the IRS (on top of any state income tax) to move into a tax free instrument is a difficult pill to swallow at just about any time.  But to do it during a recession when it’s especially important to keep lots of funds liquid in case of a loss of income or another financial emergency is too aggressive for some of these folks.  For people already in retirement, a low stock market can be a good time to do the conversion.  If you account values are down, moving some money to the Roth will allow that money to grow tax free.  Assuming growth on the account of 8%, it takes about three to five years to get back what was paid in taxes.  From then on, all the growth I  the Roth puts you ahead in the tax game on your retirement funds. 

Still undecided?  Make an appointment with a financial planner to see if your particular situation could make sense for a conversion.  Your situation is unique and one of the factors that can’t be quantified is whether or not you’re comfortable with the transaction.

Revisiting Your Divorce During the Recession

When a divorce is final, the spouses or a third party like a judge or arbiter have made decisions about how assets, debts, and cash flow will be handled.  It’s common to have requirements to sell a home and divide the proceeds, refinance debt to remove one spouse from a loan or credit card, or have alimony (also known as spousal maintenance) paid by the spouse who was the primary earner.  I’ve said that there are few things in life as final as Final Orders in a divorce.  But that’s not always the case.

These “final” decisions are based on many factors – how long a couple was married, what the financial resources are to both parties going forward, and what’s deemed fair in that particular state and courthouse.  These factors usually incorporate what has happened historically in the economy, which is assumed to be a foundation for what will happen in the future. 

In the midst of the worst recession since the Great Depression, some people are exploring reopening their financial settlement.  Maybe the house that was to be sold when the kids moved out is now underwater.  Maybe the credit card to be refinanced can’t be.  Maybe one of the former spouses has lost a job or has had earnings reduced. 

So when is it reasonable to restructure a divorce settlement from several years ago?  Ethical, intelligent people in the family law arena struggle with how to address this in the current environment.  Answers and outcomes vary widely.  There is a long list of considerations, but here are a few.

–         The first and biggest is whether or not the divorce decree allows for changes.  If alimony was part of the settlement and specified as non-modifiable, that is probably not worth pursuing. 

–         If the reasons you want to revisit your settlement are factors that impact your ex as well as you, think carefully about why your divorce would be worth modifying after the fact.  For instance, if your income is down, but your ex has also lost earnings, it might not make sense to revisit alimony.

–         If the factors that negatively impact you are outside the control of your spouse, a judge might not rule in your favor.  For instance, if the house was to be sold and proceeds divided, but more is owed on the house than it would sell for, forcing a sale won’t get either of you a great outcome.  But if the house could be sold for less than originally anticipated and you’d each get some money and you’d now be off the mortgage, that’s worth approaching your ex about.

–         If you want to make a change because you believe in your heart that your long term well being will always be the responsibility of your former spouse, think again.  This is true in any economy.  Unless you are disabled, it’s probably in the best interest of you, your ex, and your kids that you assume that you are responsible for making your financial future a good one.  When people tie their futures to each other through a marriage, they agree to weather storms together.  When they untie their futures through a divorce, they can each assume the autonomy to make their own choices and live with the consequences of their life decisions.  Looking to someone else to solve your problems is seldom healthy emotionally or financially.

Truly Resolved

I’m not anyone’s idea of an athlete, but I generally manage to stay on a pretty good year round schedule of walking.  During the months when the weather is reasonably pleasant, I walk outside.  During the winter, I spend most of my walking time at a gym the family belongs to.  Right before January 1, I asked one of the gym employees how long it usually takes for the New Years Resolution crowd to stop coming.  He said it’s usually in early February.  I love seeing new faces – and shapes – coming to the gym and enthusiastically attacking their fresh goals.  But that crowd does thin out every year and it’s depressingly early in the year. 

From what I hear, most new years resolutions deal with either health and fitness or personal finance.  That makes the fact that too many people drop their resolutions a few weeks into the year all the more distressing, because those are both areas that are important.  So what can people do to stay on track?  Let’s look specifically at financial resolutions.

First, make the goal achievable.  For instance, this might not be the right year to double your income.  Second, approach your goal in bite size bits.  So you might not want to completely eliminate your dining out budget.   But maybe you can have eating out be a reward for some other goal you’re working on or you can start by going to places that are a bit less expensive than you usually do.  Third, allow the new goal to become natural and habitual in your life.  If you want to monitor your spending more, make sure your system isn’t too hard to keep going. 

So do what you must to make your financial goals for 2010 achievable.  If you need some help, send your financial resolution to linda@brightleitz.com .  If your goal is one that would benefit more people than just you, the action plan will be part of this blog in coming weeks.

Giving Thanks

During a recession, there may be some who are wondering what they have to give thanks for during this Thanksgiving week.  “Are we grateful for the good already received?  Then we shall avail ourselves of the blessings we have, and thus be fitted to receive more.  Gratitude is much more than a verbal expression of thanks. Action expresses more gratitude than speech.”  (Mary Baker Eddy)

So during this time that is set aside in the United States every year for gratitude, find the things that you appreciate.  Even in the midst of dire circumstances, there are aspects of every life worthy of gratitude.  If our thoughts and lives are driven by what we’re missing, we’re not making room for the good that can come our way.  And once you’ve realized what you have to be grateful for, do something that will bless someone else.  The return on that investment is huge.

Holiday Spending During a Recession

The holidays are upon us and many people are saying “Bah Humbug!”  There is a way to enjoy the holidays without overspending.  Here are a few tips:

–         Plan your shopping.  Don’t go out shopping without a list of what you’re looking for and the price range you have for each purchase.  No impulse purchases!

–         Make gifts.  Take a little time to put together gifts with materials you already have or are inexpensive.  It can be a knitted scarf, a photo collage, homemade bread, or a bird house.  The personal touch is better than anything money can buy.

–         Make personal gift certificates.  We’ve done this with family for everything from an extended curfew for our teenagers to a home cooked dinner to doing a chore for someone.  The gift is appreciated and you can make it more festive by printing the certificate on nice stationery.

While economic indicators say that we’re on the way out of the recession, many are still feeling the pinch.  It’s not a time to burrow back into debt.  The holidays are a great time to give yourself the gift of making financially responsible decisions.

The Right Time Without Timing

Many financial planners – including me – will tell you that market timing is not a good idea.  But that doesn’t mean that we should all bury our heads in the sand and ignore opportunities.  It’s a fine line, but there is a difference.

One example is the current mortgage rate environment.  Look at whether it makes sense to refinance your mortgage while rates are still low.  Whether you want to lower your payment, stretch out your payments over a longer time, or let a lower rate so you can get the mortgage paid off more quickly, now is a time to explore that.  But be careful.  There are mortgage lenders who will refinance anyone who asks without looking at whether you improve your situation with a refinance or not.  So get some good referrals on who to work with.

It’s also a good time to buy up in terms of housing.  Yes, you may get less for your little house than you feel it’s worth.  But all factors being equal, you lose less on selling your small house than what you save on buying a bigger house.  In other words, let’s say you get 10% less on your $200,000 house (lose $20,000), but you save 10% on a $350,000 house (save $35,000).  You’ve come out ahead.  Once again, having a realtor who can tell you if that’s the case is vital.  So don’t just pull out the phone book and start shopping.  Get a good referral.

If you think it’s time to change your portfolio approach, this may be the perfect time to do it.  If you took a bath on your individual stock portfolio and want to move to mutual funds and ETFs, this is probably a great time.  That portfolio change might have cost you big bucks in taxes a year or two ago.  But you might actually get some tax losses if you make that move now.  And – at the risk of sounding like a broken record – talk to a good financial advisor about it.  This is definitely a time when you want a fee-only and not a commission or fee-based professional.  If someone makes big bucks over making the changes, you may never know if the change was in your financial interest or theirs.  The good ones are still alive and well in this economy.  Look at http://www.acaplanners.org/Advisors.aspx  or http://findanadvisor.napfa.org/Home.aspx  to find one.