Volunteers Wanted For NPR Article About Taxes

Here’s an e-mail I got yesterday from a reporter from National Public Radio, looking for some volunteers for a story that requires someone who is both willing to be open about their finances and who also keeps a close accounting of things.

Jonathan – I am working on a story for National Public Radio about taxes. [...] We want to track all of the taxes paid by one average American. All the taxes. Property tax, income tax, sales tax (as best we can), hotel taxes, airline taxes, capital gains taxes…

We just want to give listeners a sense of all the taxes we pay. The theory is that we might be surprised at how much we pay in non-income taxes. [...] Perhaps one of your readers would fit the bill.

I’m still trying to be anonymous, but if you’re interested, please e-mail Tamara Keith directly at tkeith -@t- npr.org.

Mortgage Loan Refinance Breakeven Points

Sometimes saving money just involves being lucky. I don’t really keep up with mortgage rates anymore, but last week an e-mail subject line just happened to catch my eye that mortgage rates are at “record lows”. I always figured that my 5.125% rate was so low that another refinance or loan modification probably would never be worth it, but it turns out that rates are so low they just might. Here’s a quick snapshot of rates from a Wall Street Journal article on 7/16/10:

The 30-year fixed-rate mortgage averaged 4.57% in the week ended Thursday, unchanged from a week earlier and down from 5.14% a year earlier. Rates on 15-year fixed-rate mortgages were 4.06%, extending the lowest point since Freddie started tracking it in 1991, and down from 4.07% last week and 4.63% a year earlier. [...] To obtain the rates, the mortgages required payment of an average 0.7 point. A point is 1% of the mortgage amount, charged as prepaid interest.

has ads now for 4.25% fixed for 30 years and 3.75% for 15 years. As for me, I might be able to get my interest rate below 4.75% and have a “breakeven” period of less than 3 years. I’m awaiting official paperwork. Ask your loan servicer and/or mortgage broker what they can do for you. Can’t hurt to ask!

Meanwhile, I was playing with the Refinance Breakeven calculator over at DinkyTown and found out that there are multiple definitions of “breakeven period”. Before, I simply figured that a refinance would cost X dollars upfront in fees and closing costs, but would save me Y dollars per month. Divide X by Y, and you’d have a breakeven point. For example, if it cost you $2,400 in fees but saved you $100 per month, you’d break even in 24 months. Past that, you’re saving $100 every month. In this case, if you plan to keep your mortgage for longer than 24 months, then refinancing makes sense.

However, there are actually four possible breakeven methods presented:

  1. Monthly payment savings. The simple formula described above. The number of months it will take for your monthly payment reduction to be greater then your closing costs. Doesn’t take into account that you may be making more monthly payments.
  2. Interest savings (plus PMI if applicable). The number of months it will take for your interest and PMI savings to exceed your closing costs.
  3. After-tax interest savings (plus PMI if applicable). The number of months it will take for the after-tax interest and PMI savings to exceed your closing costs. This takes into account that the interest and PMI being paid may be tax-deductible, while the closing costs are paid with after-tax money only. Depends on your income tax rate.
  4. Total after-tax interest savings vs. prepayment. This is the most conservative breakeven measure, and will result in the longest breakeven time period. This method considers that you could take the amount spent on refi closing costs and instead make a large prepayment on your existing mortgage. Then, it calculates the number of months it will take for the after-tax interest and PMI savings to exceed both the closing costs and any interest savings from prepaying your mortgage.

Which method is best?

First, I should add that you could complicate things even further by assuming any money not paid out immediately could earn a rate of return (savings accounts, CD, etc.) But that would make my head explode, so I won’t. The calculator suggests that methods #2 and #3 are most commonly accepted, and I would tend to agree. If you are sure that your interest is 100% tax-deductible (you exceed the standard deduction provided by the IRS without it), then you should use the value from #3. Otherwise, something in between #2 and #3 is probably the most accurate.

Method #4 compares with another theoretical situation that only applies if you really want to make a lump-sum prepayment and keep the higher monthly mortgage payment over a shorter mortgage term. For many people, the goal is to lower the monthly outlay and improve cashflow as well as save money on interest.

Undo a Roth IRA Conversion For Profit – Tips & Tricks

Did you know that if you do a Traditional to Roth IRA conversion, that you can undo it? This “do-over” process is called recharacterization, and can come in very handy if the value of your investments drop significantly after your conversion since you owe income taxes based on the value of the IRA at the time of conversion. With the recent market volatility, this may apply to many investors as it did previously in 2008/2009.

Take the example below, from a 2009 CNN Money article but still applicable. Let’s say you had a Traditional IRA valued $150,000 at conversion, which later on drops to $100,000. At the end of the year, you’d have to pay taxes on $150k of income and also be stuck with the lower account value. By performing an “undo” and “redo” the conversion, you could pay income taxes on only $100,000 of income instead of $150,000 – a savings of $14,000 at the 28% tax rate. (Find your 2010 tax bracket.)

There are some ground rules, however. The IRS says you can perform a recharacterization until October 15th of the year following the year you converted. So if you converted in April 2010, you have until October 15, 2011. If you want to re-convert, you have to wait either 30 days after the recharacterization or until the tax year after the conversion year, whichever is later. Again, if you converted in April 2010, you’d have to wait until January 1st, 2011 to reconvert. If you wait too long in between, it is possible your account value might be even higher than before. Still, something I’ll be keeping an eye on.

(You must still meet the Roth conversion eligibility rules, previously based upon your modified adjusted gross income. In 2010, there are no income limits. In 2011 and beyond, there currently are no income limits either, but it is unknown if this will remain the case. Also, only for 2010 conversions are you allowed to split the income over 2011 and 2012, which can lower your overall tax bill based on tax brackets.)

More Advanced: Multiple Roth IRAs

How can you set yourself up to best take advantage of this “redo” opportunity? I recently read in a sample issue of Kiplinger’s Retirement Report that you should split your Traditional-to-Roth conversion into multiple IRAs for each asset class you own.

For example, you might split a $200,000 IRA into $100k of stocks and $100k of bonds. If the stocks go down to $80k while the bonds go up to $120k, just to a “redo” on the stock IRA and leave the bonds IRA alone. Assuming the values stay the same upon re-conversion, that would save you income taxes on $20,000 ($5,600 at a 28% tax rate) as compared to not splitting up the IRA since if you just converted it a single IRA, the total value remained $200,000 ($80k+$120k). Tricky!

Traditional to Roth IRA Conversion at Vanguard

So, you’ve done your research, read the articles, crunched the numbers, and you want to convert your Traditional IRA held at Vanguard into a Roth IRA. But, how do you actually do it at Vanguard.com? There is no explicit “Convert” button or link to run this conversion. After some fumbling around, I managed to figure it out. But why not just share it here in mind-numbing detail and hopefully save folks some time.

You’ll need to have both a Traditional and Roth IRA set up at Vanguard first (mutual fund only). If you don’t have the Roth yet, click on the “Open an Account” link on the black bar on the top of every page and open an account first. Be sure to indicate that the funds you’ll use to open the new account are “At Vanguard”.

After you already have both a Vanguard Traditional IRA and a Vanguard Roth IRA:

  1. Log in to your account online. Click on “My Portfolio” so that you can view all your accounts.
  2. Under your Traditional IRA section, click on “Buy & Sell”.
  3. Next, click on “Exchange” on any of your funds.
  4. Now, you can choose to Exchange from all your Traditional IRA funds, to funds in your Roth IRA. You may need to add a new fund.
  5. For the exchange amount, if you are doing a complete conversion, chose All. You may be asked to verify and accept any redemption fees.
  6. You’ll also need to choose your tax withholding options. In order to maximize my balances in these tax-deferred accounts, I chose not to withhold and to pay the taxes separately myself later from a taxable account. Also, I can spread the taxes due for a 2010 conversion over two years.
  7. At the end of the next available business day, your mutual funds will be exchanged into your Roth at their net asset values. Your Traditional IRA will still show up with zero balances, which you can hide from displaying.
  8. Your conversion is complete! Keep your transaction confirmations for tax time.

Keep on reading below for some of the warnings and notifications that you’ll encounter during the conversion process.

A conversion is a taxable event. Generally, you’ll owe taxes on the amount you convert from your traditional, SEP-, or rollover IRA into a Roth IRA.

When you convert to a Roth IRA, you may elect to withhold Federal and certain state taxes. You can get the most benefit from the conversion if you don’t have taxes withheld and instead pay taxes from a separate nonretirement account. Keep in mind that the money withheld for taxes isn’t part of the conversion, and, if you’re under age 59½, you may have to pay a 10% federal penalty tax on it. You also can’t “recharacterize”, or restore to a traditional IRA, the amount you withhold. If you choose not to withhold, you may need to make estimated tax payments to avoid an underpayment penalty.

We encourage you to consult a tax advisor about your individual situation. For 2010 conversions only, you have the option of postponing the tax due and paying it off over two years. If you choose this option, taxable income from the conversion gets split evenly between 2011 and 2012. Alternatively, you can choose to pay all the conversion income in 2010.

Moving money out of a retirement account is a distribution, and all or a portion of your distribution may be subject to federal or state tax. You can elect to have either no federal income taxes withheld from your Vanguard IRA® distribution or a percentage between 10 and 100. If you don’t elect to have income taxes withheld from your IRA distribution, you’ll remain liable for income taxes. Tax penalties may also apply if your estimated income tax payments or income tax withholdings are insufficient under federal or state rules.

Inflation As a Hidden Tax Increase

With all of the current government spending, future promised spending, and the huge trillion-dollar budget deficit, there is a lot of talk about impending inflation. Many people are convinced that there is going to be a tax increase as a result, regardless of your political affiliation. However, this reminded me that we shouldn’t forget that the government can increase taxes without ever passing a bill, making you a new line on your IRS 1040 form, or even telling you about it. It simply has to keep pumping more money into the system.

The Wikipedia entry on “inflation tax” focuses on the idea of increasing prices and devalued currency as a increasing burden on people. But rising inflation itself is a hidden tax increase.

Let’s take a simple investment like a savings account or a bond earning an interest rate of 2% a year, but there is no inflation. Income tax is 25%. So you grumble about your low interest rates, pay your 2 x 0.25 = 0.5% in taxes, and keep the other 1.5% as your after-tax “real” return.

What if inflation is 3%, but you are slightly happier because you’re earning 2% above that for a total of 5%. Income tax stays the same, 25%. But now you’re paying 5% x 0.25% = 1.25% a year in taxes, and after 3% inflation you are left with 0.75% as your after-tax real return. Even worse.

Finally let’s say that inflation is now 6%, and you are still earning 2% above inflation. Income tax again is based on your nominal income, so you’re stuck paying 25% of that 8% interest. This leaves you earning 2% above inflation pre-tax, and then going and paying 8 x 0.25 = 2% in taxes. Your after-tax real return is now zero. You’re not making any money, it all went towards taxes.

All this could happen without ever raising the official income tax rate. This fact is sometimes brought up when talking about inflation-indexed bonds, but applies the same to all investment returns.

Infographic: Overall Tax Rates For Single, Married Filers

VisualizingEconomics has a nice series of infographics that explore how various income-based taxes change with your adjusted gross incomes. It uses 2009 IRS numbers, but should still remain relevant to today. Below is a snapshot of a married filing jointly couple with two kids and one income (click to enlarge):

Not you? Check out also:

Death and Taxes 2011: Visual Guide to the Federal Budget

The 2011 edition of the Death and Taxes poster is out, which outlines in spectacular detail how the United States federal budget spends its (your?) tax dollars. View the huge image online, or buy it as a 2 ft. x 3 ft poster. If you haven’t seen it before, you really should check it out.

Due to what the creator deems complexity and size constraints, the poster focuses on the $1 Trillion discretionary portion of the budget. Discretionary spending refers to the portion of the budget which goes through the annual Congressional debates every year, and amounts to about 1/3rd of the total budget. Currently, the biggest chunk goes to defense spending. Want to know how much the V-22 Osprey gets? It’s on the poster ($2.2B).

The other 2/3rds of the federal budget is mandatory spending, which includes programs which are funded by eligibility rules or payment rules. An example is welfare. If you’re eligible, you get it. The only way to change how much is spent is by changing the eligibility rules.

The poster does include a little chart on the bottom right about the total federal budget, but I think it tries to convey too much information in a very small space. Here’s a simpler breakdown from the 2007 budget, courtesy of PerotCharts. As you can see, entitlement programs like Social Security and Medicare are also huge expenses.

And here’s another breakdown of the 2009 total spending via Wikipedia.

As long as take all of this into perspective, this graphic does a great job of making a complex subject accessible. Not sure how long this will last, but right now with code BOGO you can get two posters for $24 + $1.50 shipping.

How Much Did Your Tax Return Cost? U.S. Average $229

As CPAs everywhere are burning the midnight oil, the National Society of Accountants (NSA) released the results of their 2009-2010 Fee Survey of nearly 8,000 tax preparers, which showed the average tax preparation fee for an itemized Form 1040 with Schedule A and a state tax return to be $229. The average cost to prepare a Form 1040 and state return without itemized deductions is only $129.

Here’s a link to the full press release. The costs varied by geographic region, with the highest being the Pacific (AK, CA, HI, OR, WA).

They also listed the average fees for preparing other tax forms:

• $212 for a Form 1040 Schedule C (profit or loss from business)
• $551 for Form 1065 (partnership)
• $692 for Form 1120 (corporation)
• $665 for Form 1120S (S corporation)
• $415 for Form 1041 (fiduciary)
• $2,044 for Form 706 (estates)
• $584 for Form 990 (tax exempt)
• $58 for Form 940 (Federal unemployment)

If you used an accountant, how do you compare?

2010 Non-Deductible Traditional IRA Contribution Made

I talked about taking some “action” in my last net worth update. We both contributed $5,000 each to a non-deductible Traditional IRA earlier this week. In doing so, I was reminded of how some folks can be intimidated by the amount of IRS fine print you must read every time you try to achieve some tax savings. Perhaps it is a small minority, especially of people reading this, but still significant.

Just to figure out if we were allowed to contribute took some searching. Per this IRS flowchart, because we are married filing jointly and will most likely have a modified adjusted gross income (MAGI) over $177,000, we are unable to contribute to a Roth IRA. How many people know what their MAGI is? In this world of spiraling credit card debt, how many people are willing to try to figure it out?

However, anyone can contribute to a Traditional IRA, even though it doesn’t explicitly state that anywhere. Then the question is whether it is tax-deductible. From this other IRS flowchart, because we are married filing jointly, covered by a retirement plan at work, and have an MAGI of over $109,000, I figure out that our contribution is not tax-deductible.

Finally, I happen to know in 2010, there is no income limit on the conversion from a Traditional IRA to Roth IRA. I must rely on the many mentions from financial media and investment brokers to know this. Even so, there are even more catches in terms of pre-tax and post-tax bits of the IRA to be converted.

I personally don’t mind all of this. But there must be a study somewhere that shows that every time a person has to walk themselves through an IRS flowchart, the overall IRA participation rate drops something like 5%.

Changing 401k Contribution Rates During Year, Catch-Up Contributions

401k company matches are great ways to boost your retirement savings, but sometimes you have to be careful in order to capture it all. My wife’s company offers a 3% match, but only up to 3% of whatever you contributed that pay period. What if you contribute less than 3% for some period, and then a much larger amount a later period, with the overall total being much more than 3%? With some plans, you are simply out of luck and have missed out on potential money. Other plans offer what is called a “catch-up” or “true-up” contribution. Do you know which one you have?

I wrote about 401k true-up contributions and maxing out 401ks earlier, but finally got my hands on the employer’s Summary Plan Description which addresses it explicitly. Luckily, my OCR software was working, and I scanned it in below:

Is a year-end Matching Contribution provided if I changed my saving percentage during the year?

If you are employed by the Employer on the last day of the Plan Year, a true-up calculation is made so that your Matching Contributions will be maximized even if you changed the percentage of your Compensation that you elected to contribute during the Plan Year. The amount, if any, of the true-up Matching Contribution is the excess of (i) 100% of your Employee Contributions for the entire Plan Year that do not exceed 3% of your Compensation for the entire Plan Year that was paid to you while you were eligible for Matching Contributions, over (ii) the total amount of Matching Contributions already contributed to your Account for the Plan Year.

For example, John was eligible for Matching Contributions for all of 2010. John, who earned $40,000 evenly throughout the year, did not elect to contribute to the Plan from January 1 to June 30, 2010. From July 1 through December 31, 2010, John made Employee Contributions of 12% of his Compensation (12% of $20,000 = $2,400), and received Matching Contributions of $600. His year-end Matching Contribution is calculated as (i) minus (ii), as follows:

(i) 100% of John’s Employee Contributions to the Plan for the entire year that do not exceed 3% of his Compensation for the entire year. 100% x 3% x $40,000 = $1,200

(ii) The total amount of Matching Contributions already contributed to his Account for the year = $600

Year-end Matching Contribution to John’s Account for 2010 = 1,200 – 600 = $600

The year-end Matching Contribution generally is contributed to the Plan within a few months after the end of the Plan Year. hi some cases, IRS rules limit or reduce the amount of Matching Contributions the Employer can make on your behalf if you are Highly Compensated, as defined in Question 1, above. You will be notified if you are affected by this limit or reduction.

An important note here is that, at least for this plan, you must be employed on the last day of the Plan Year in order to be eligible for this catch-up contribution.

E-File Your Federal Tax Return Extension For Free

April 15th is only a month away, and you haven’t started your taxes yet. Time to file an extension! The IRS automatically grants a 6-month extension to anyone who asks. Asking a search engine will often direct you towards websites like FileLater.com that charge upwards of $20 to file the form, but here are two ways that anybody can e-File for free. Apparently, the only thing keeping these sites in business is lack of education!

Method #1: TaxACT
This is how I did my extension last year. Just sign up with TaxACT and e-file your extension for free through them. It’s quick. It’s easy.

You don’t even need to actually use them to file your taxes later, although TaxACT is also free for federal taxes with e-File included regardless of income, and is only $14.95 for state returns including free e-File. That’s cheaper than TurboTax or TaxCut, although if you’re already familiar with those programs it may be worth the extra bucks to stick with them.

Method #2: Free File Fillable Forms
This one’s a little harder to find, but here are some step-by-step instructions. Go to the Free File Fillable Forms site (say that 5 times fast) and click on “Start Free File Fillable Forms”. Click “Sign-in” on the top left, and create a new account.

After you’re signed in, click on “Continue” and pick your form. Go with 1040. On the top right, you should see an icon with the label “File an Extension”.

This will bring up Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return, a long title for a really short form. You’ll need to estimate your total tax liability for 2009. This form only extends the time to file, not the time allowed to pay. Overestimate your tax liability to avoid penalties. Here is how I estimated my tax liability.

You can even request your estimated tax payment to be withdrawn electronically by supplying your bank’s routing and account numbers. For identification purposes, you’ll need your adjusted gross income (AGI) from your 2008 tax return.

Got state income taxes as well? Here is a helpful page on manually requesting state-specific tax extensions.

Giveaway: QuickTax Platinum Tax Software For Canadians

I don’t know how many Canadian readers I have, but I do have one free copy of QuickTax Platinum ($69.99 value, download version) available to give away.

The Platinum version is the most fully-featured “personal” edition, and includes assistance with investment gains/losses and rental property, as well as RRSP guidance. Other than that, I don’t know much about QuickTax, other than it is made by Intuit and thus looks a lot like TurboTax in the US. However, there doesn’t seem to a similar product by H&R Block for the Canadian market. Who is their biggest competitor then?

To enter, simply leave a comment with a valid e-mail in the proper field below by Midnight Pacific on Sunday, 2/21. Real name not necessary, you can even leave the actual comment box blank. One entry per reader. I’ll randomly pick one winner. Thanks!