Second chance on Rebate and Tax Increase?

Since the final legislation for the stimulus package and the rebates has been enacted, various news reports are indicating that it's in effect a prebate on 2008 taxes, except that payments this year are based on 2007 payments and in some circumstances don't have to be paid back.

The IRS is less forthcoming, and their web site does not indicate that there's a second chance at the rebate in 2009 when filing the tax return for 2008. And no indication whether the tax credit will be phased out for those with an AGI above $75000 this year, so I still don't know whether the Tax Rebate is a Tax Increase for Some.

If the phaseout is in effect based on 2008 AGI, and your income is just above the phase-out threshold, then it may be possible to get the rebate by increasing your 401(k) before-tax contributions, since this will lower your AGI.

Hopefully the IRS will soon update their web site, so that it won't be necessary to parse the language of the legislation to figure this out.

Tax Rebate = Tax Increase for Some

The title is counter intuitive, so let me explain. The tax rebate as proposed is phased out for "high" income, for example a single with an AGI of $75,000. The $600 rebate is phased out over the $12,000 of AGI between $75,000 and $87,000. For someone with an income in this range, this is effectively a marginal tax increase of 5%. With an original marginal tax rate that's probably 5% (assuming deductions near the standard value), the effective tax rate is now 30%.

I am caught in this. If I had known about the tax rebate terms last year, I could have adjusted the amount of tax-deferred savings I converted to a Roth IRA.

I can see some merit to the argument that the tax rebate is really the US government borrowing money from the Chinese so the poor can buy Chinese goods. Either the bill for the tax rebate will have to be paid, or interest will be paid in the mean time. Probably increasing the taxes I'll have to pay on tax-deferred savings withdrawn in retirement. So in the end the extra taxes I effectively paid on part of my Roth conversions may balance out in the end.

Psychology of Personal Finance

Investopedia has an interesting article on Behavioral Finance. While much of the article discusses behaviors particular to investors such as herd behavior, there are behaviors which can effect anyone's finances.

One behavior is mental accounting. This is treating money differently. "Found money" such as an income tax return can be splurged while money that was earned is more valuable.

Prospect theory is how we react to certain events, treating negative events as more significant than positive ones. For example, someone who gains $100 and then loses $50 is unhappy while someone who only gained $50 is happy, even though they're even in terms of results.

Check out the behavioral finance article and see if any of its concepts apply to you.

Future Programming for Analog TV: Snow

An acquaintance commented last night that her TV broke. When she went to buy a cheap one, there were none to be found. In the group conversation that developed, no one was aware that analog TV broadcasts stop in just 17 months, on Feb 17, 2009. Only digital TV broadcasting will remain after that date. Right now it is illegal to sell a new set that doesn't include a digital tuner.

So what do you do if you have an analog TV set? If your TV reception goes through the cable company, then the issue is up to them. Your existing converter box probably will continue to work. On the other hand, if you use an antenna then you will have to do something yourself.

There is a Digital-to-Analog Converter Box Coupon Program scheduled to begin next year. Under this program, all US households will be eligible to request two $40 coupons towards converter boxes. These boxes are expected to retail for approximately $60 each, but are still under development.

If you use an antenna and want to use your analog set, I recommend that sometime next year you take advantage of this program. You may want to wait a few months for prices to stabilize. Next summer may be the optimum time. If you use rabbit ears you may find that a roof-top antenna is necessary. That has been my experience with a digital TV as I'm in a fringe area. While analog TV degrades into snow and perhaps ghosts, digital TV is perfect and then with degraded signals you might see a bit of pixelization, and a dark screen. Don't wait until the last minute to sort this out.

Reasons For Not Participating in a 401(k) Plan

Occasionally the topic of retirement savings comes up at work. I'm amazed at some of the thinking.

One colleague made the comment that if he had $50,000 he could retire. Being an immigrant, I thought perhaps he was planning to return to his home country and live in a mud hut. But I didn't pursue the topic. Then a couple of years later, he was looking at needing to retire and told me that all he had was Social Security. When I asked about his 401(k) he said that he wasn't participating. When I asked why he said "It might go down". Well, with a 50% employer match and 100% match after 5 years, it has to go down a lot to lose money. And if afraid that "it might go down" the plan offers a money market fund. So he lost out on the employer match for 6 years at this employer. And with the relatively small amount he could have saved, he would pay very little if any taxes on his distributions if he spread it out over a number of years.

Another fellow employee told me that he wouldn't participate because he didn't want his money in our employer's stock. Yes, it's a good idea to diversify. But beginning last year, those who were vested had the option to sell their company stock and chose other investments. After the conversation, I got to thinking that maybe he thought his contribution had to be invested in company stock. Which was never the case, although that has always been an option.

Another colleague who is participating thought that the only way to get funds of the employer match out of the company stock was to pursue our unique option of being able to have up to a certain limit distributed each year -- he wasn't aware of the plan change last year allowing diversification.

Before making decisions about participating in your employer's 401(k) plan, get a copy of the Summary Plan Description and read up on the rules. And if it's been awhile since you've read yours, get a fresh copy because they can be amended periodically, and review the information there.

Any other excuses for not participating?

I Wonder if Ray Got a Letter Too

The Federal Trade Commission has published a press release "FTC Warns Mortgage Advertisers and Media That Ads May Be Deceptive". On this page is a link to a sample letter they sent out.

The press release included the following:

For example, some ads touted rates as low as “1%” but failed to disclose adequately:

* that the stated rate was a “payment rate” – not the interest rate – that applied only during the loan’s initial period;
* that low advertised payments applied for only a short period; and
* the loan’s Annual Percentage Rate, the uniform measure of the cost of credit that enables consumers to shop for and compare mortgage offerings.

Some ads promoted only incredibly low monthly payments but failed to disclose adequately the terms of repayment, including payment increases and a final balloon payment.

I wonder if Ray Vinson got one about his "No-Spin Mortgage". Perhaps so -- I haven't heard any such ads from him or Bill O'Reilly recently. I was never able to find out any details about his loans on his web site, just an application form. What do you think the chances are that I would have found out if I'd taken the trouble to apply?

While over at the FTC website, you might want to check out their page with links to articles with consumer information about mortgages.

How and Why I Rolled Over 401(k) Funds to a Roth IRA

Actually I didn’t do this exactly as I’ll explain later. First I’ll discuss the “why”.

As I discussed in this post, you should have some of your retirement funds in tax-deferred savings such as traditional IRA or 401(k) funds. This is because some taxable income is not actually taxed. The taxable income on which you pay no taxes at all is that which is less than your personal exemption and standard deduction. The standard deduction amount is increased slightly for someone 65 or older. This adds up to almost $10,000 for a single person over 65 in 2007, and this amount is indexed annually for inflation.

However, the effective tax rates for a retiree can quickly escalate once taxes are paid. If other income including withdrawals from tax-deferred savings added to 50% of your Social Security benefit exceeds $25000 for a single person, you begin paying taxes on $.50 of Social Security for each $1 of additional other income. With even more income, you pay taxes on $.85 of Social Security for each $1 of additional other income. This can effectively turn a 15% tax bracket into 22.5% or 27.75%, and a 25% bracket into 37.5% or 46.25%. It would be terrible to pay 46.25% taxes on money you deferred at 25%. Also, the $25,000 threshold for testing whether or not some of your Social Security is not indexed for inflation which will result in more and more people paying more taxes on Social Security benefits.

Once you reach the age of 70 ½, the IRS expects you to take Required Minimum Distributions (RMDs) from your tax-deferred accounts. Failure to take your RMDs can result in punishing penalties -- 50% of the amount you were supposed to have distributed but did not.

I have sufficient tax-deferred savings that I’m concerned about ending up in an effectively higher tax bracket due to taxation of my Social Security benefits. I am also concerned that tax rates will increase in the future as right now they are at historic lows. So I am converting 401(k) funds to a Roth IRA, but as I stated earlier I couldn’t do this exactly, or at least not directly. First I had to rollover the 401(k) funds to a rollover traditional IRA and then I converted funds from the rollover IRA to a Roth IRA.

My employer’s 401(k) plan rules allow me to distribute up to $25,000 per year of the company match. Most people probably don’t have this option, but I did. However, you may have funds from prior employers that you’ve either left with them or have already rolled over to an IRA. (If you spent them – shame on you.)

Last year, I created a rollover account at Vanguard which initially was unfunded. Then I contacted my 401(k) plan administrator and asked for a partial distribution with the check made out to Vanguard as the custodian of my rollover account. By having it made out to my IRA custodian I avoided having taxes withheld from the distribution. The check was mailed to me. I then placed it in an envelope with a form I downloaded from Vanguard’s site and filled out with my personal and account information to fund the rollover IRA account I had setup previously.

Later on and before the end of 2006, I converted part of my rollover account to a Roth IRA account which I had previously set up and funded with normal IRA contributions. The part I didn’t convert is still in my rollover IRA. The amount that I converted to Roth added to my tax bill. In order to avoid penalties for underpayment of taxes, I made sure to increase tax withholdings from my salary to exceed the amount I had paid in taxes the prior year, and I went ahead and had enough withheld to cover the taxes on the amount I converted to Roth. I estimated this with a spreadsheet and actually ended up with a small refund due to the telephone tax refund.

In retrospect, I should not have done this with my current employer’s 401(k). I have funds left in a prior employer’s 401(k) plan. I should have started my conversion with those funds. The reason is that if I leave my current employer during or after the year I turn 55, then I can withdraw plan without penalty from my 401(k) sponsored by that employer. I don’t have that option for employer’s I’ve left at a younger age until I reach 59 ½. I also don’t have that option with funds that I’ve rolled over. While taking and spending distributions from my 401(k) is not currently in my plans – well, life happens and it’s good to have options.

I want to reiterate a few points for someone contemplating doing this.
(1) Make sure that you have enough tax-deferred savings or a taxable pension so that when in retirement you use up the standard deduction and personal exemption amount on which you wouldn’t pay taxes anyway.
(2) Make sure the distribution is directly to your rollover account custodian to avoid withholdings.
(3) Plan your income tax withholdings and/or estimated tax payments so that you don’t get hit with a large tax bill and possible penalties the following April.
(4) If you have funds in any traditional IRA which are after-tax, the complexity of your tax returne will increase. Those funds are “non-deductible contributions” to a traditional IRA, see IRS form 8606 that will need to be filed if you do a conversion.
Another consideration is that the funds I’ve converted must remain in my Roth IRA for 5 years or I will pay a penalty.

This year I plan to rollover funds from my prior employer's 401(k) plan and convert them to Roth. I understand that beginning in 2008 that the "two step" won't be required and that 401(k) funds can be directly converted into a Roth IRA. While my employer offers a 401(k) plan with some great funds, I hope they make it even greater by adding a Roth 401(k) option.