The Roth conversion topic has certainly dominated headlines, articles, and blog posts in 2010, but part of the story may be missing. A Roth conversion may not be the wisest financial move for some. Most of the reports regarding this conversion have touted the benefits, and little has been written about the negative affects to a Roth conversion.
Roth Conversion and College Planning
An ill-timed Roth conversion can dampen financial aid prospects for some college bound students. The most important year for the financial aid process is the year the high school student is a junior. This is the base year for most financial aid formulas. If a parent converts during this year, the conversion can be viewed as income to the parent. The parent will then be viewed as having more income available to pay for college, and, since financial aid is based on the ability to pay, the parent can be seen as having the ability to fully pay the college bill. Depending on the level of assets and the amount of the conversion, a Roth conversion may be a deal breaker to receive financial aid for your college-bound teenager.
Conversion Income and Taxes
Tax planning is similar to college planning in that more income creates negative consequences. Taxes are a moving target for most people, and an unexpectedly large tax bill due to a Roth conversion would certainly be painful. Remember when an IRA is converted the amount converted is considered as income in the year of the conversion (although spreading out this income is possible). If a conversion is accomplished the year in which the taxpayer is in a high tax bracket, the converted amount will be taxed at that high tax rate. The marginal tax rate could actually increase due to the conversion as well. I generally don’t recommend Roth conversion for taxpayers who are in a high tax bracket.
Opportunity Costs
There are many calculators available that illuminate the tax savings generated by a Roth conversion, but these calculators fail to show opportunity cost lost to the tax due, which includes the cost of not having the money available for current needs. Ex. A conversion of a $100,000 IRA to a Roth will generate a $25,000 tax bill for someone in the 25% tax bracket. The opportunity cost of that $25,000 might be high. If the rationale of the conversion forces someone to eat rice and beans now so they can eat Fillet later, that rationale doesn’t fly with me. This will create financial dysfunction. This seems to be the case for younger couples. Younger couples implementing wise financial and tax strategies can leverage monies now when it is really needed. Most of the families I work with have children in private schools and college. They need money now and shouldn’t move backwards financially today to pay for their tomorrow.
Roth conversions can be a wonderful tax savings strategy, but these conversions should be carefully reviewed. By understanding the possible negative consequences, a mistake may be avoided. Just because Roth conversions are the topic de jour doesn’t make them right for everyone.
Wednesday, May 26, 2010
Tuesday, May 18, 2010
Financial Tips for any Economic Environment
It’s been more than 18 months since we first heard the utterance of the “R” word, recession. The funny thing about economic data is bad news travels much more quickly than good news. While we all heard about the economy’s struggles, many have no idea that we are technically out of a recession.
While the technical data points to some positive signs and the economy actually grew, the pulse of individuals still remains fearful. Economic gloom and doom doesn’t have a mortal enemy that clearly pronounces the proverbial all-clear. While the media loves to provide data illuminating every wrinkle in our economic system, good news remains sparse at best.
Are we still in a recession? Either way, what does it really matter? From a personal financial standpoint, it really doesn’t matter. Our habits and financial wherewithal should always remain diligent. I live in Nashville, the city that experienced an enormous flood that some experts claim to be a 500 or maybe a 1000 year flood. Does it matter to those flood victims if we are or aren’t in a recession? Of course not, but what does matter is sound financial planning and decisions.
Sound financial decisions transcend good and bad economic data or even disasters. The stock market is out of our control, and the ups and downs associated with our economy are beyond the reach of our hands. Focusing on something that is out of our control is not productive.
If we can’t control the market or the economy, what can we control?
The items listed below will allow you to focus on the things you can control, while participating in financial growth, buffering against economic downturns, and all while providing support during emergencies.
Have sufficient cash liquidity.
Liquidity is the keystone of the financial foundation. Emergency funds (cash) can provide liquidity to those in need during emergencies, large or small. This cash can prevent folks from going into debt for purchases that are necessary to return life to normal.
Live within your means.
Spend less than you make….save 10% of your income. These old adages will ensure that some money is set aside for tomorrow.
Dollar cost average.
Continue to be a buyer during economic downturns. Buying at regular intervals (such as into a 401k plan) will help buffer the ups and downs of the market.
Proactively manage your tax liability.
Proper tax and strategic planning can help reduce the single largest recurring expense that most Americans face.
Invest for the long term.
Don’t try to time the market. Timing the market most often results in disappointment. By focusing on the long term, the short term ups and downs become blips on the radar screen.
What we do behaviorally (controlling the things we can control) is much more important that what the market is doing or how the economy is holding up. So whether we are in a recession or not, the 5 tips above are simple to implement, yet extremely effective.
While the technical data points to some positive signs and the economy actually grew, the pulse of individuals still remains fearful. Economic gloom and doom doesn’t have a mortal enemy that clearly pronounces the proverbial all-clear. While the media loves to provide data illuminating every wrinkle in our economic system, good news remains sparse at best.
Are we still in a recession? Either way, what does it really matter? From a personal financial standpoint, it really doesn’t matter. Our habits and financial wherewithal should always remain diligent. I live in Nashville, the city that experienced an enormous flood that some experts claim to be a 500 or maybe a 1000 year flood. Does it matter to those flood victims if we are or aren’t in a recession? Of course not, but what does matter is sound financial planning and decisions.
Sound financial decisions transcend good and bad economic data or even disasters. The stock market is out of our control, and the ups and downs associated with our economy are beyond the reach of our hands. Focusing on something that is out of our control is not productive.
If we can’t control the market or the economy, what can we control?
The items listed below will allow you to focus on the things you can control, while participating in financial growth, buffering against economic downturns, and all while providing support during emergencies.
Have sufficient cash liquidity.
Liquidity is the keystone of the financial foundation. Emergency funds (cash) can provide liquidity to those in need during emergencies, large or small. This cash can prevent folks from going into debt for purchases that are necessary to return life to normal.
Live within your means.
Spend less than you make….save 10% of your income. These old adages will ensure that some money is set aside for tomorrow.
Dollar cost average.
Continue to be a buyer during economic downturns. Buying at regular intervals (such as into a 401k plan) will help buffer the ups and downs of the market.
Proactively manage your tax liability.
Proper tax and strategic planning can help reduce the single largest recurring expense that most Americans face.
Invest for the long term.
Don’t try to time the market. Timing the market most often results in disappointment. By focusing on the long term, the short term ups and downs become blips on the radar screen.
What we do behaviorally (controlling the things we can control) is much more important that what the market is doing or how the economy is holding up. So whether we are in a recession or not, the 5 tips above are simple to implement, yet extremely effective.
Friday, May 14, 2010
Casualty Losses for Flood Victims
There has been much discussion regarding the tax benefits available to flood victims here in middle Tennessee. The discussions have also created a good bit of confusion. While the information provided has delivered general guidance, this guidance can lead to costly confusion.
The tax benefits available are through a provision titled Casually and Theft Losses. A casualty loss is generally taken as an itemized deduction, but can be utilized without itemizing for tax year 2009. The loss is not equal to a tax credit. The loss will reduce taxable income; therefore, the amount of loss will generally create a savings equal to the loss amount times the taxpayers marginal tax rate. Example, a taxpayer in the 25% bracket showing a $1000 casualty loss will produce $250.00 in tax savings. While the tax savings can be beneficial and even substantial, casualty losses are not easy to understand for most people.
The Nuts and Bolts of Casualty Losses
The IRS definition of a casualty loss is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual. Here in Middle TN, the identifiable event was the flood of May 2nd. Losses attributable to the flood can be considered for tax purposes, but the valuation of the loss is complicated.
Caution- technical content follows!
To determine the loss the IRS states there are three steps:
1. Determine the adjusted basis in the property before the casualty or theft.
2. Determine the decrease in the fair market value (FMV) of the property as a result of the casualty or theft.
3. Use the smaller of #1 or #2 and then reduce that by any insurance or other reimbursement received or expected to be received.
Got it? Clear as mud, right? Let’s use an example to break this down.
If a taxpayer loses a car due to a flood, the taxpayer must use the lower of the adjusted basis (what was paid) or the decrease in the fair market value of the car. If the taxpayer originally purchased the car for $20,000 in 2008 but the fair market value (the value of an identical used car) is now $10,000, the taxpayer will use the $10,000 value for the casualty loss. NOTE: Remember the value of the loss is either adjusted basis or the decrease in the FMV…..not replacement cost. In the example above, the taxpayer cannot use the purchase price of a new car as the casualty loss value! Again, a casualty loss should not spur the taxpayer to over purchase with the thought of increasing the casualty loss.
The loss must then be reduced by any reimbursements. If the taxpayer received $6000 from an insurance claim on the car, the casualty loss is now down to $4000.
Once the valuation of the loss is determined there are additional steps to take
to finalize this tax benefit. Based on the current tax picture there are two years (2009 and 2010) in which the losses can be applied, and each year creates different tax situations. 2009, based on current tax law, offers a better bang for the buck, at least in most situations. The difference is in the details.
Most casualty losses are subject to a 10% of Adjusted Gross Income (AGI) floor, as well as an additional reduction. For 2009 the reduction is $500, but in 2010 the reduction is only $100. Example, a family with an AGI of $100,000 will normally have a $10,000 threshold to overcome, along with the subtraction amount, before any losses can be used. But often disaster area victims receive a nice break from Congress by removing the 10% of AGI threshold. As of this writing, the 10% of AGI floor is removed for folks in federally declared disaster areas for the tax year 2009….BUT NOT FOR 2010. Pretty confusing, right?
Let’s pick up the example from above. The taxpayer has a choice to amend their 2009 return or capture the loss in 2010. By amending the 2009 tax return, the taxpayer will not have the 10% of AGI floor, but will be subject to a $500 reduction. In 2010, the taxpayer will be subject to a 10% AGI floor and a $100 reduction. Let’s continue through this example assuming the taxpayer is in the 25% tax bracket with $100,000 of AGI.
2009
Loss from car = $4000.00
AGI threshold= none
Reduction= $500
Total Loss Applicable=$3500 ($4000 -$500)
Tax savings created = $875 ($3500 x 25%)
2010
Loss from car = $4000.00
AGI Threshold = $10,000
Reduction = $100
Tax Loss Applicable = $0 (loss doesn’t cross threshold)
Tax Savings created = $0
Why it might be wise to be patient
In the above example it’s quite clear which is the best choice, but patience MAY add another option. Congress usually makes changes in the tax code later in the year. One change that could make a difference would be AGI threshold removal for 2010. I am certainly not suggesting they will…only stating it might be possible. If this does occur it gives the taxpayer an option. The taxpayer could then choose to take the loss in the year it which it makes the most sense. This would be extremely valuable for a taxpayer whose tax bracket is different in the two years. The taxpayer would choose the year of the higher tax bracket. Therefore, a larger percentage of the loss ends back in the pocket of the taxpayer. The benefit of waiting may present options. These options will become clear over time.
What to do in the meantime
Some of the most important steps that a flood victim can do at this time in regards to casualty losses are:
1. Take pictures of damaged property, as well as find pictures prior to the flood.
2. Store those pictures in a safe place…maybe even electronically store them
3. Document losses- take notes and create a very detailed inventory (remember items such as trees are applicable as well)
4. Don’t make purchase decision based misconceptions (replacement value does not create a tax deduction).
5. Be patient – the deadline to file this particular amended return is April 2011, so there is no rush. Make sure that all losses are accounted for.
While the tax code creates an opportunity for those of us that have been impacted by the flood, this opportunity is very detailed and confusing. A rushed or hurried decision could be the wrong one. If a taxpayer is in real need of funding to rebuild, the amended 2009 return may be the only choice. Whatever decision is made, the tax payer should consult a tax professional to assist with the details.
The opinions expressed in this article are intended as general guidance only and are not intended as recommendations for specific situations. Internal Revenue Service (IRS) rules of practice require me to inform you that any tax advice included in this communication is not intended to be used, and cannot be used, for the purpose of avoiding any tax penalties imposed by the IRS.
The tax benefits available are through a provision titled Casually and Theft Losses. A casualty loss is generally taken as an itemized deduction, but can be utilized without itemizing for tax year 2009. The loss is not equal to a tax credit. The loss will reduce taxable income; therefore, the amount of loss will generally create a savings equal to the loss amount times the taxpayers marginal tax rate. Example, a taxpayer in the 25% bracket showing a $1000 casualty loss will produce $250.00 in tax savings. While the tax savings can be beneficial and even substantial, casualty losses are not easy to understand for most people.
The Nuts and Bolts of Casualty Losses
The IRS definition of a casualty loss is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual. Here in Middle TN, the identifiable event was the flood of May 2nd. Losses attributable to the flood can be considered for tax purposes, but the valuation of the loss is complicated.
Caution- technical content follows!
To determine the loss the IRS states there are three steps:
1. Determine the adjusted basis in the property before the casualty or theft.
2. Determine the decrease in the fair market value (FMV) of the property as a result of the casualty or theft.
3. Use the smaller of #1 or #2 and then reduce that by any insurance or other reimbursement received or expected to be received.
Got it? Clear as mud, right? Let’s use an example to break this down.
If a taxpayer loses a car due to a flood, the taxpayer must use the lower of the adjusted basis (what was paid) or the decrease in the fair market value of the car. If the taxpayer originally purchased the car for $20,000 in 2008 but the fair market value (the value of an identical used car) is now $10,000, the taxpayer will use the $10,000 value for the casualty loss. NOTE: Remember the value of the loss is either adjusted basis or the decrease in the FMV…..not replacement cost. In the example above, the taxpayer cannot use the purchase price of a new car as the casualty loss value! Again, a casualty loss should not spur the taxpayer to over purchase with the thought of increasing the casualty loss.
The loss must then be reduced by any reimbursements. If the taxpayer received $6000 from an insurance claim on the car, the casualty loss is now down to $4000.
Once the valuation of the loss is determined there are additional steps to take
to finalize this tax benefit. Based on the current tax picture there are two years (2009 and 2010) in which the losses can be applied, and each year creates different tax situations. 2009, based on current tax law, offers a better bang for the buck, at least in most situations. The difference is in the details.
Most casualty losses are subject to a 10% of Adjusted Gross Income (AGI) floor, as well as an additional reduction. For 2009 the reduction is $500, but in 2010 the reduction is only $100. Example, a family with an AGI of $100,000 will normally have a $10,000 threshold to overcome, along with the subtraction amount, before any losses can be used. But often disaster area victims receive a nice break from Congress by removing the 10% of AGI threshold. As of this writing, the 10% of AGI floor is removed for folks in federally declared disaster areas for the tax year 2009….BUT NOT FOR 2010. Pretty confusing, right?
Let’s pick up the example from above. The taxpayer has a choice to amend their 2009 return or capture the loss in 2010. By amending the 2009 tax return, the taxpayer will not have the 10% of AGI floor, but will be subject to a $500 reduction. In 2010, the taxpayer will be subject to a 10% AGI floor and a $100 reduction. Let’s continue through this example assuming the taxpayer is in the 25% tax bracket with $100,000 of AGI.
2009
Loss from car = $4000.00
AGI threshold= none
Reduction= $500
Total Loss Applicable=$3500 ($4000 -$500)
Tax savings created = $875 ($3500 x 25%)
2010
Loss from car = $4000.00
AGI Threshold = $10,000
Reduction = $100
Tax Loss Applicable = $0 (loss doesn’t cross threshold)
Tax Savings created = $0
Why it might be wise to be patient
In the above example it’s quite clear which is the best choice, but patience MAY add another option. Congress usually makes changes in the tax code later in the year. One change that could make a difference would be AGI threshold removal for 2010. I am certainly not suggesting they will…only stating it might be possible. If this does occur it gives the taxpayer an option. The taxpayer could then choose to take the loss in the year it which it makes the most sense. This would be extremely valuable for a taxpayer whose tax bracket is different in the two years. The taxpayer would choose the year of the higher tax bracket. Therefore, a larger percentage of the loss ends back in the pocket of the taxpayer. The benefit of waiting may present options. These options will become clear over time.
What to do in the meantime
Some of the most important steps that a flood victim can do at this time in regards to casualty losses are:
1. Take pictures of damaged property, as well as find pictures prior to the flood.
2. Store those pictures in a safe place…maybe even electronically store them
3. Document losses- take notes and create a very detailed inventory (remember items such as trees are applicable as well)
4. Don’t make purchase decision based misconceptions (replacement value does not create a tax deduction).
5. Be patient – the deadline to file this particular amended return is April 2011, so there is no rush. Make sure that all losses are accounted for.
While the tax code creates an opportunity for those of us that have been impacted by the flood, this opportunity is very detailed and confusing. A rushed or hurried decision could be the wrong one. If a taxpayer is in real need of funding to rebuild, the amended 2009 return may be the only choice. Whatever decision is made, the tax payer should consult a tax professional to assist with the details.
The opinions expressed in this article are intended as general guidance only and are not intended as recommendations for specific situations. Internal Revenue Service (IRS) rules of practice require me to inform you that any tax advice included in this communication is not intended to be used, and cannot be used, for the purpose of avoiding any tax penalties imposed by the IRS.
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