Tax Archives - Page 3 of 3 - The Free Financial Advisor

The Roth IRA–Playing Games with Tax Brackets

March 23, 2012 by Joe Saul-Sehy 11 Comments

Our normal Friday Blog Post of the Week! segment will return next week.

The Roth IRA is a Swiss Army knife for financial success.

In our past wildly exciting posts about the Roth IRA here and here, some of the commenters on these stories have discussed the efficacy of the strategies presented by the Other Guy.

In short: is it worth all the trouble jumping through hoops to get as much money into the Roth IRA as possible?

In a word: indubitably (I’ve wanted to use that word since I heard it in Mary Poppins. 10 points!)

While I’ll agree that if the only upside to these strategies are immediate returns on a few exotic Roth IRA gyrations, you’ll only gain a few extra dollars in your pocket for what seems like a lot of work.

…and I get exhausted switching television channels, so let’s not talk about work.

I prefer easy and exciting.

The Roth IRA has one exciting feature beyond those we’ve listed previously—flexibility later in your planning.

The problem with financial planning

When I read well-meaning blog posts about retirement or education planning (including my own), the writer always discusses assumptions.

You know what happens when you assume…but what choice do we have?

We’ll have to assume that the tax rate will go up/down/stay level.

We have to project inflation rates.

Finally, we have to decide when we’re going to die. (Well, at least you do…I’ve got my cryogenic tank next to Walt Disney ready to go. I’m gonna live forever.)

Back on point: Roth IRA plans, for those of you uncomfortable with this type of tax shelter, give you no tax break today but offers tax free income down the line. Many (yawn) dissenters say that tax treatment of a Roth IRA is irrelevant. You’ll pay the tax today or tomorrow. It’s all the same.

No it isn’t.

We’re working for maximum tax flexibility, not a few random bucks. Because I can’t predict income tax rates, capital gains rates, or estate tax rates, I’m going to create a financial future that is as flexible as possible, as soon as two current criteria are met:

– I’ve done what I can to maximize deductions today. I know what tax rates are right now, so I’ll take my tax break, thank you.

– I’m not locking up money unnecessarily for down the road when I’m experiencing short term needs for cash.

Here’s the Roth IRA Game

When you reach retirement, let’s pretend you want to live on $60,000. Tax brackets in America are tiered, meaning that you’ll pay 10 percent on the first dollars you make, until you hit the 15 percent bracket, which is what you’ll pay beginning with the first dollar in that bracket, until you reach the 25 percent bracket…..

Because we don’t know what tax brackets will be in the future, let’s pretend the 25 percent line will be at $50,000.

You Have Two Pots of Money

Most people have a pre-tax retirement plan. As I mentioned, I like my current pretax deductions, so I’ve maximum funded those. Therefore, I have monster amounts of money (otherwise known as oodles) inside of them. These dollars must come out of the plan and get taxed.

I’ll remove $50,000 per year from this plan. Some of it will be taxed at the 15 percent bracket and some at the 10 percent bracket.

Here’s Where the Roth IRA Comes In

Finally, I remove $10,000 from my Roth IRA. Now I’m living in the 25 percent tax bracket but the government is taxing us at the top of the 15 percent bracket.

Lots of Work for Big Payoffs

Now, I’ve avoided a 25 percent tax each year (or whatever my top tax rate would be….) on $10,000, or $2,500 in taxes. Of course, I paid those taxes already, but remember, if I’m worried about the HUGE AMOUNT OF WORK this takes, I’m only investing money after I’ve already secured current tax breaks.

(photo credit: Swiss Army Knife: IK’s World Trip, Flickr; License Plate: Gamma Man, Flickr)

Joe Saul-Sehy

Joe is a former financial advisor and media representative for American Express and Ameriprise. He was the “Money Man” at Detroit television WXYZ-TV, appearing twice weekly. He’s also appeared in Bride, Best Life, and Child magazines, the Los Angeles Times, Chicago Sun-Times, Detroit News and Baltimore Sun newspapers and numerous other media outlets. Joe holds B.A Degrees from The Citadel and Michigan State University.

joesaulsehy.com/

Unplug Grandma’s Life Support…Quick! Inherited IRA rules changing?

February 29, 2012 by The Other Guy 21 Comments

Why You Might Have the Awful Hope That Grandma Dies This Year.

According to this Wall Street Journal article, Congress is toying with the idea of getting rid of (or at least seriously modifying) Inherited IRAs.

Here’s why you should care: getting an inherited IRA is like winning the lifetime income lottery.

What is an Inherited IRA?

An inherited IRA is just what it sounds like – it’s an IRA that you didn’t start, i.e., you inherited it. In most cases, when someone passes away, they’ll leave retirement accounts to their spouse, but sometimes those spouses are pre-deceased. In this case IRA assets fall down to the next (or sometimes the third) generation.

When you inherit a spouse’s IRA, the IRS allows you to convert it to your own, delaying any and all taxes until at least age 70 ½ (assuming you don’t remove the money to spend). If your spouse is substantially younger than you, couples are allowed to treat it as an inherited IRA for tax purposes.

What are the Current Benefits of an Inherited IRA?

The major benefit is the ability for non-spouse beneficiaries to distribute those taxable dollars over the lifetime of the beneficiary.

Grandma is 68 and goes to what crazy uncle Jim called “that big tax shelter in the sky,” but leaves her $500,000 IRA to her 4 year old grandson. Because the distribution is based on his life expectancy…around 80 years or so… if structured correctly it would provide him income for the rest of his life.

Apparently, the IRS and Congress think it’s too long to wait another 80 years or so to wring all the tax money from Granny’s IRA, so thye’re thinking about changing the law to require distributions from an inherited IRA within 5 years of the original account holder’s death.

Yikes.

That’s a change.

Thankfully, this isn’t anywhere near the President’s desk yet, but I wanted to put it on your radar screen…in case…you know…someone has a little “slip and fall.”

Don’t quote me later.

– TheOtherGuy

How to Pay an Ugly Overdue Tax Bill

December 6, 2011 by Joe Saul-Sehy 6 Comments

I just read that Christie Brinkley owes over $500,000 in back taxes. That’s an ugly place to be. Sadly, I’ve been there before (not $500,000, but still a sizeable chunk of money). I’d like to share that story here.

When I began advising people about money, my background was similar to the many professional athletes who become financial advisors: I had no training. I was exactly “that guy” the pros and financial books warn you about when they say “don’t hire the new advisor.” Sure, I’d passed a few tests and took classes sponsored by the company I was going to work for, but I’d been an English major in college with an emphasis in creative writing. Talk about “not in Kansas anymore.” I wasn’t even on the same planet.

Why I’m An Expert In This Area

So, there I was, learning quickly. My paranoia about my lack of knowledge and the ability to “dumb down” difficult financial concepts helped me with early success in my new field—probably because I was coming at those concepts from a similar non-finance point of view. I hauled in a nice income. I had a great relationship with my clients. If I didn’t know something (which was often), I said “I don’t know, but I’ll find out.” That happened a ton.

Here’s the bad part of the story. I was a 1099 independent contractor. (For those of you unfamiliar with “1099”, it means that I didn’t actually work for the company. Because I was technically independent, zero taxes were taken out of my compensation. Without an knowledge of the full impact of not paying taxes, this was a financial meltdown ready to burst.)

Near the end of my first awesome year a friend said, “Who is your accountant?”

Me (thinking): “Dude, I should get one of those!”

So, I did. I found a guy named Tom. He was a great number-cruncher, but a horrible financial coach.

Tax guy Tom: “You owe $26,000.”

Me: “WTF?”

Tax Guy Tom (clueless): “Do you want to attach a check to the return?”

Me: “WTFFF????” I’m pretty sure I yelled. Yeah, I screamed. I should have been screaming at myself. It didn’t matter. He couldn’t believe I was dumb enough to spend every penny of the money I’d made. The funny part now is that I had used all that money to pay down debt.

I’d committed every stupid mistake in the book.

So, what did I do? I made the brilliant decision not to file my taxes, thinking that I’d find a way to catch up.

Note to the world: It doesn’t work that way. You can’t catch up.

So, Christie, I understand an overdue tax bill. I know that today you say that it’ll all be paid quickly. That’s good. If you can’t, or if any other reader is in a similar situation, here’s what to do. This is what I should have done:

Joe’s Awesome 7 Step “Get Your Overdue Tax Bill Paid” Plan (or “Here’s What I Did”)

1) Find good tax advisors. My advisor helped me file back taxes and face the music. By avoiding the overdue tax bill, it was becoming bigger and more difficult to pay. I thought I was finding a “good” advisor when I met Tom. ….but, had I known how to ask questions, it would have gone smoother. AND I should have known to interview more than one person. I found a guy with lots of pretty letters after his name and hired the first one. I needed someone who could walk a beginner through the process of receipts and “what’s deductible and what ain’t.”

2) Communicate with the IRS. You need to face the music sooner or later. What surprised me is how easy the IRS people were to talk with. I was ashamed of my overdue tax bill, but they deal with people that have late taxes all day, every day.

Here’s a tip: the IRS phone line gets busy, so if you’re going to call, do it right after they open. You should get right through (I now call whenever I have questions or am feeling lonely). In my case, they knew promptly what programs to point me toward. Why did I call the IRS? My tax advisor told me to call them. She said it would help me stay on top of the situation. She also talked to them from time to time. (I had to sign a paper giving her the limited power to discuss my personal tax situation with the IRS first.)

3) Decide which method works best. There are two general directions you can decide between if you can’t pay the entire overdue tax at once. First, you can opt for an offer-in-compromise. This is a settlement with the IRS to pay less than your bill. I couldn’t go this route because (as my tax advisor explained), I had a high income stream and there was a good probability—in the IRS’ eyes—that they’d be able to collect the whole amount sooner or later (it was going to take me 30 years, but they don’t care. They may be nice, but those IRS zombies live forever, apparently.—I HAD to have one IRS joke in this piece….). If you owe less than $25,000, you can apply for an installment agreement, and will usually be accepted as long as you haven’t been a repeat offender. For amounts more than $25,000, the IRS is a little more like a nervous loanshark. You’ll have to fill out some extra paperwork.

4) Fill out the appropriate paperwork. Here’s a link to the IRS page describing all the appropriate tools. Before anything, you need to file the appropriate tax forms, if you haven’t already. Once that’s done, if you owe more than $25,000 on your overdue tax bill (like I did), you’ll need to fill out Form 433F, the Collection Information Statement. If you’re pursuing an installment agreement, complete Form 9465, Request for Installment Agreement. For an Offer in compromise, read IRS Booklet 646. It explains thoroughly the process of applying to reduce the amount you owe the government.

5) Be prepared to pay a fee to set up the agreement. As of this writing, direct debit and online payment plans cost $52, while payroll deduction plans run $105.

6) Wait for an answer from the IRS. They’ll respond in writing. If you called the IRS as I recommend above, you may receive an answer while you’re on the phone with the agent.

7) Realize that speed is your friend. Confronting the pain today is better than waiting. If you’ve managed to accumulate $500k in debt, you’ll owe interest and may owe penalties if you didn’t communicate effectively with the IRS.

Forms Needed:

IRS Collection Information Statement, Form 433F

IRS Installment Agreement Request, Form 9465

IRS Offer in Compromise booklet 646

Have a tax issue you’d like to discuss? While AverageJoe and TheOtherGuy aren’t tax advisors, we can point you toward resources and strategies. Use the comment section below or email me at joe (at) thefreefinancialadvisor (dot) com.

Joe Saul-Sehy

joesaulsehy.com/