Archive

Posts Tagged ‘money management’

Tax Tip: Mortgage Interest Deduction

If you have a mortgage on your personal residence, you’re probably well aware of the mortgage interest deduction, but like many tax provisions, a simple rule can be complex.  There are many factors involving the deductibility of mortgage interest. 

Generally, you are able to deduct the interest associated with $1 million of acquisition indebtedness and $100,000 of home equity debt.  The interest can relate to your principal residence (as defined) and one other residence you select. 

Some of the requirements for deducting the interest associated with acquisition indebtedness are as follows.

  • Acquisition debt is associated with acquiring, constructing or substantially improving a qualified residence.
  • The debt must be secured by the residence.  Not a problem if you borrowed money from a financial institution, since they will definitely secure their mortgage.  However, if you borrowed money from a family member, your loan document may not state that the loan is secured by the property.
  • You must own the property on the debt you are paying and must personally make the payments. For example, if parents pay the mortgage for their children, the interest isn’t deductible by either of them.

The following are some of the rules related to deducting interest on a home equity loan.

  • The home equity loan can’t exceed the equity in your house.  You generally can’t borrow more than the value of your home, but this could be problematic given the recent decline in real estate prices.
  • The proceeds from a home equity can be used for any purpose, except to purchase tax-exempt securities. 
  • Interest associated with proceeds used for purposes other than for a residence may be subject to the alternative minimum tax.

Mortgage points are generally deductible when paid for an initial loan to purchase a property.  Points paid upon the refinance of a mortgage must be amortized over the life of the new loan.

The IRS is very strict in apply the $1 million acquisition and $100,000 home equity debt limits.  However, the Service issued a ruling in 2009 in which they stated that acquisition indebtedness in excess of $1 million to acquire, construct or substantially improve a residence could be considered home equity interest.  Thus, taxpayers could deduct interest on $1.1 million of acquisition indebtedness without having to take out a separate home equity loan.

As you can see, a simple deduction has rather complex requirements.  If you have an unusual situation or are unclear about the tax rules, you should consult a tax professional.  A mortgage interest deduction can drastically reduce your tax bill, but it can also be quite costly if your deduction is disallowed.

Tax Tip: Self-Employed Health Insurance

While the debate over health care and health insurance continues in the U.S., there is one thing we call agree on… health insurance is expensive.  If you are paying for health insurance, any tax benefits you receive will help reduce the effective cost of your coverage.

A majority of people in the U.S. receive their health insurance coverage as a tax-free employee fringe benefit.  You may contribute to the expense, but the portion your employer pays is typically tax-free to you.  In order to attain parity between an employer and someone who is self-employed, self-employed taxpayers are allowed to deduct 100% of their premiums in calculating their adjusted gross income.  While it may seem logical and fair, it was not always this way.

In order to take the deduction, you must have self-employment income equal to or greater than your health insurance premiums.  Your salary, wages, interest, dividends, pension and other income are not considered self-employment income.  Thus, the portion of insurance you are contributing to your employee benefits and premiums you are paying while unemployed do not count.  The premiums may be deductible as an itemized deduction, but they do not qualify for the self-employed health insurance deduction.

There are a couple of changes that can affect your 2010 tax liability.

  • Your health insurance premiums are treated as a deduction for calculating your net self-employment income, which will reduce the self-employment taxes you pay.  This benefit is only applicable for 2010, unless otherwise extended by Congress.
  • The IRS has determined that Medicare Part B premiums can be treated as self-employed health insurance premiums.  Thus, if you are over 65 and are having Medicare Part B premiums deducted from your Social Security check, you can deduct the premiums if you have net self-employment income greater than or equal to your Medicare Part B premiums.
  • After March 30, 2010, any premiums paid for a child who is under age 27 will qualify for the deduction.
  • After March 30, 2010, the deduction is not allowed for anyone who is eligible to participate in any subsidized health insurance plan for themselves, their spouse or dependent (i.e., you can’t deduct your portion of the premiums paid as part of a subsidized employer health plan).

If you are self-employed or have self-employed income, the self-employed health insurance deduction may help reduce the cost of maintaining health insurance coverage.  The tax savings may not make get you over the affordability hump, but if you are paying, you might as well take advantage of whatever tax breaks you can.

A Financial Resolution for 2011

Happy New Year!  New Year’s resolutions often accompany the celebrations and revelry.  A majority of resolutions are related to personal health and fitness, which is understandable following a season dominated by parties and indulgent eating.  Christmas is also the time of year when people spend more money than expected.  The stress of the bills coming due can also lead to financial resolutions. 

January 1 is a great time to lose weight, get in shape and stop smoking.  It’s also a fantastic time to get your financial affairs in order.  What is one financial objective that you would like to achieve for 2011?

I won’t be surprised if your answer involves reducing debt, saving more money or living by a budget.  While these are common financial goals, they are not an exclusive list.  You can also include things like giving more money away, drafting a will, reviewing your insurance policies or buying a new home.

Whatever your objective, here are a few principles that will help to ensure your success.

  • Be Reasonable: If the goal is unreasonable, you’ll quickly become frustrated and discouraged.  It may not be reasonable to get out of debt in one year.  Instead, set a goal to reduce your debt by $__ or pay off certain credit cards.
  • Be Specific:  Vague goals like eating healthier or being a better money manager are hard to evaluate.  Your goals should be quantifiable and measurable.
  • Develop a Plan: Whatever you want to achieve isn’t going to miraculously happen.  Think about the steps needed to accomplish your goal. Your plan should also include a timetable.  Identify the actions and the dates for completion.
  • Write it Down: It’s easy for the urgent things of the day to overtake the important. Writing down your goals and plan will help keep you on track.
  • Measure Progress:  Don’t wait until December 31 to determine success or failure.  Periodically evaluate your advancement.  You may need to adjust your plan in order to still achieve your goals.
  • Be Accountable: Behavioral changes are not easy, and being accountable to someone can be the difference between success and failure.  You must have enough of a relationship to trust the person, be honest with them, and listen to their feedback.  They must also be willing to ask you the tough questions.
  • Reward Yourself: Develop appropriate rewards as you accomplish your interim goals.  It doesn’t have to be big or lavish.  It just needs to be something that motivates you.

I know it’s kind of morbid, but by December 31, 2011 you’ll either be dead or one year older. Assuming that you expect to be alive, would you rather have accomplished your financial goal or not?  If so, then develop a plan and have the resolve to see it through to completion.

If you do… it will truly be a Happy New Year… for the entire year and not just one day.

Paying for Christmas

The most wonderful time of the year is quickly followed by the most miserable time of the year. Not because of the winter doldrums, but because of the credit card bills appearing in your mailbox.  If you’re like many Americans who used credit cards to purchase gifts for the holidays, financial stress quickly replaces the joy and happiness of Christmas.

You may have the unfortunate realization that it’s going to take you months to pay off your Christmas gifts.  Don’t feel alone.  According to Consumer Reports, 13 million Americans (nearly 6% of the population) are still paying off last Christmas.   If you’re only making minimum monthly payments on your credit cards, chances are you’ll be paying it off for several more years.

Do you know that there is another way to pay for Christmas?  I will even go so far as to say that it’s a better way.

The best time to start paying for Christmas 2011 is right now.  I’m not talking about taking advantage of all those after-Christmas sales to stock up on gifts.  Instead, you can start saving money now to pay for your Christmas shopping next year. 

The first step is deciding how much you want to spend for Christmas.  If you’re married, you need to discuss this with your spouse and come to some reasonable agreement.  You may have different families, traditions and expectations, so expect to compromise.

Let’s assume that you decide you want to spend $2,000 for Christmas gifts next year.  Starting in January, take $200 and save it (that’s $50 per week). Open a separate savings account if you need to, or find a bank that offers Christmas Club savings accounts just for this purpose.  With meager interest rates and bank fees, you might just stuff the cash under your mattress.  The key is that you save it the money and don’t touch it until Christmas.  It’s not an emergency fund or quick spending money; it’s for Christmas.  If you put $200 aside each month, you’ll have $2,000 in cash by the end of October just waiting to be spent on great Christmas bargains.

But wait… what about the debt from this year?  Wouldn’t I be better off using the $200 each month to pay off my credit cards? 

That may sound like a good idea, but I say don’t do it.  Reducing your existing debt and paying off your credit cards is a different discussion.  Chances are this is the cycle you’ve been operating under for years.  You charge it.  You work all year to pay it off.  When Christmas rolls around again, you haven’t saved any money for Christmas, so you charge it again.  If you want to break the cycle, you’ve got to do something different.

I’m all for paying off credit cards and getting out of debt. However, you probably won’t achieve either of these without learning how to live within a budget and saving money to pay for future purchases.   Even if you’re still paying for this Christmas next year, think of how great you’ll feel next year when Christmas is fully paid before Christmas.  The stress and agony of opening bills in January will be history.

When it comes to paying for Christmas, you can pay now or pay later.  If you start paying for next Christmas now, I think you’ll experience a lot more peace, joy and holiday cheer next year.

Repeating History: The Predictability of Economic Indicators

Baseball is a sport that relies heavily upon history.  Managers make decisions about pitchers, hitters, runners, etc. based upon historical statistics.  If a certain batter has a lower batting average against a left or right-handed pitcher, the manager may make a pitching change.  The batter may still hit a homerun, but statistically it’s less likely.

Much like baseball, leading economic indicators are based upon the premise that economic history will repeat itself. Leading economic indicators are various statistics or observations that are intended to give an indication of the future direction of the economy.  As written in a previous article, they can be a nationally publicized economic statistic or someone’s instinct of what’s coming next.

Ben Bernanke, the current Federal Reserve Chairman, is considered to be a leading authority of the Great Depression.  He has dedicated a lot of his career studying the causes and remedial measures of the Great Depression.  His intent… to learn from history and avoid making similar mistakes.

The assumption is that economic output will react the same way to similar measures.  As a simple example, raising the discount rate will slow the economy and curtail inflation, and lowering the rate will encourage lending and growth.   The same principle was the basis for passing the $787 billion Stimulus Bill in February 2009.  The premise goes all the way back to President Roosevelt’s plan for ending the Great Depression with the passage of the New Deal.  The ultimate effect of the New Deal and the Stimulus Bill will be debated for years, but the assumption is that if it worked in the past, it will work again.

This theory influences the way economists, investors, politicians and policy-makers approach the economy.  The historical economic results of certain changes in economic indicators form the basis for how they make current decisions.

The difficulty arises when the economy reacts differently.  Economic conditions are as unique and unpredictable as people.  Although statistics may point a certain reaction, the economy doesn’t always function as expected.

Oil prices are a great example of this.  When oil prices spiked in the early 1970’s and 1980’s the economic effects were staggering.  The economy fell into a great recession and inflation took off.  From the beginning of 2007 to the middle of 2008, oil went from $61 per barrel to over $140, a 130% increase.  Although people grumbled and businesses scrambled, the economy didn’t fall into a great recession.  A major recession started in the third quarter of 2008, but it was more a result of imploding real estate and financial markets, than the price of oil.

In this case, history didn’t repeat itself.  Yes… oil prices may have been a contributing factor, but I don’t believe it was the primary cause, like it was in the 70’s and 80’s. 

I’m not suggesting that there is no value to leading economic indicators, but their utility in predicting future economic results is limited.  To the extent you study economic indicators and listen to pundits espouse their opinions of the implications of economic measures, keep this one principle in mind – leading economic indicators assume history will repeat itself, but the economy is like people… it is unpredictable.

Budget Basics #10 – Creating Margin

In business and financial terms, margin is typically defined as the difference between income and expenses.  For your personal finances, it can be thought of living below your means.

It’s easy to look at someone who is successful and wealthy and think that they are successful because they never have problems.  The reality is that sooner or later, every person and business will experience struggles and challenges.  Success is often the result of surviving problems, not the absence of problems.

There are cycles to the economy and to most businesses.  Success comes to those who can persevere through the downturns and hold on until things get better.  Margin helps to buy you time until things improve, and it gives you flexibility to make adjustments to handle your situation.

Like many people, I had a lot of margin a couple of years ago.  I was giving away nearly 30% of my income; taxes consumed another 25-30%; and I saved/invested another 10%.  As a result, I was living on about 30-40% of what I made.  Within a matter of months, things changed dramatically.

In addition to the economic recession, Lady M and I decided to relocate from Vermont to the great State of Texas.  Within a six-month period of time, we went from three sources of income to one.  Including employer-provided benefits, our income dropped by about 45% in a matter of months.  Having margin allowed us to make that move.

We had to make some adjustments in our giving, savings and spending to reflect the reduction in our income.  Too bad we couldn’t adjust our taxes as well.  Our margin shrunk, but thankfully, we have weathered the storm so far.  We are working towards increasing our income, expanding our margin and restoring our level of giving. It’s taking time, but we’ll get there.

How big of a margin should you have?  There is no universal formula.  It all depends upon your income, lifestyle and ability to make changes.  Margin is a lot like an emergency fund.  It won’t solve all problems or keep you from experiencing challenges, but it will increase the likelihood you will survive a challenge when it arises.

Want a few tips on how to create margin.  Here are a couple of articles you can read which may give you a few ideas.

18 Means for Living Below Your Means by Mark and Angel Hack Life.

10 Smartest Ways to Live Beneath Your Means by Dumb Little Man.

Budget Basics #9 – Saving for an Emergency Fund

What is an emergency fund?

Businessdictionary.com defines an emergency fund as this: Money which is set aside for an emergency situation, such as unexpected unemployment or injury, or a natural disaster which destroys one’s home and belongings.

Get Rich Slowly has a great blog with several links to articles by notable authors’ regarding an emergency fund.  Rather than try to duplicate all of that content, just click here and check out the resources yourself.

I personally like Dave Ramsey’s approach to an emergency fund.    He recommends you target $1,000 as your emergency fund, which should cover a lot of unexpected expenses and repairs.  While it may be good to have an emergency fund that would cover 3-6 months of you expenses, it will take years for most people to save that amount of money. It’s hard to get started and motivated towards and impossible goal, but everyone has the ability to save $1,000 over time.

As most of the material written about emergency funds states, there is no universal formula to follow.  Each person and situation is different.   Keep in mind that few people can save enough to cover every potential emergency and crisis.  Just like insurance, there are too many catastrophes to protect against.  All you can do is cover the most likely risks and have faith that everything else will be okay.

One of the most important things about an emergency fund is tapping it only for genuine emergencies.  What’s an emergency?  Once again… that’s going to be your call.  When drawing down your emergency fund, a key thing to remember is the amount of time it will take you to replenish it.  If it takes you 6 months to save the same amount of money again, how will you cover another emergency during that period?

The following is an illustration of determining an emergency.  Every vehicle needs regular maintenance which includes brakes and tires.  Depending upon vehicle, 4 tires can easily cost $400-800.  Tires generally last about 25,000-35,000 miles.  If you drive 12,000 miles per year, you know that you’ll need tires in 2-3 years.  Is it an emergency when you have to replace them after 3 years of driving?  Is that different than having a blowout 6 months after you purchased new tires?

Why do so many people reference 3-6 months of expenses?  Assuming that you have disability insurance, you’ll find that many policies have a 13 week waiting period (i.e., 3 months).  The other principle is that 3-6 months gives you time to make adjustments.  During this time you hope to be able to find another job, relocate, trade cars, sell certain assets, etc.  It won’t be easy or pleasant, but in many areas of financial planning, time can be your best friend.

So… if you don’t have an emergency fund, start one this week.  Even a few dollars a week will eventually compound into an amount that can make a difference.  If you currently have an emergency fund, take a few minutes to evaluate your current situation and determine if it’s sufficient for your present level of spending, debt and peace of mind.