Financial Abundance Guide

As 2007 comes to a close, now is the time to decide on strategies that can save on taxes, either now or in the future.

If 2007 has been a year in which your income is lower than your normal income and if you will have significant “Schedule A” income tax deductions, you may want to consider converting some of your traditional IRA funds to a Roth IRA .

Using your 2006 tax return as a guide, determine your approximate 2007 income. Reduce your income by contributions made to your Health Savings Account, IRA contributions, self employed health insurance and 1/2 of any self employment taxes paid. The remainder will be your approximate Adjusted Gross Income (AGI) for 2007.

If your AGI is over $100,000, you are not eligible to make a Roth conversion in 2007.

If your AGI is under $100,000, determine what your approximate “Schedule A” itemized tax deductions will be in 2007. Schedule A includes home mortgage payments, medical expenses, charitable gifts and state and local taxes plus any property taxes.

Your next step is calculate exemptions by multiplying your total number of claimed dependents (including yourself) by $3,400. Subtract both your approximate Schedule A deductions (or the Standard Deduction, if that is greater) and your exemptions from your estimated 2007 AGI. The remainder is your approximate 2007 taxable income.

As a single filer, subtract your taxable income from $31,850. The remainder is the approximate amount of your IRA holding that you can convert to a Roth IRA at a 15% tax rate.

As a joint tax filer, subtract your taxable income from $63,700. This is the approximate amount that you can convert to a Roth IRA at a 15% tax rate.

Once you have converted these funds, they will grow tax free until they are withdrawn. When they are withdrawn, the withdrawals will also be totally tax free. The small amount of taxes that you pay now will keep you from paying significantly more in taxes on these funds when you retire.

There is one caveat. This approach should only be used if you have adequate non-IRA savings to pay for the increased taxable amount. However, if you are able to pay for the increased taxes, your long term tax savings can be significant.

2007 Roth IRA conversions must occur before December 31, 2007. If this approach may work for you, do your homework now so the conversion can be completed before the end of the year.

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In the November 17th Wall Street Journal, Glenn Ruffenach has an excellent article entitled “The Baby Boomer’s Guide to Social Security.” In the article, he describes a little known plan for two earner baby boom couples to maximize their Social Security benefits. In this entry, I will describe the seldom used tactic and add another twist that Glenn does not cover in his article.

In my scenario, George is age 66 (his full retirement age) and has not yet filed for his Social Security benefits. He is planning on waiting until he is age 70 to file for Social Security, so he will receive “delayed retirement credits” that provide him with 132% of his full Social Security retirement benefit ($2,000 per month) for a total of $2,640 per month.

George’s wife, Barbara, has recently turned 62 and would like to start collecting her Social Security, which would also be $2,000 per month at her full retirement age of 66. Since Barbara is only 62, she will receive 75% of her full retirement benefit or $1,500 per month.

What George found out by reading Glenn Ruffenach’s WSJ article is that he may file for a spousal benefit at age 66 and receive 1/2 of Barbara’s full projected Social Security benefit or $1,000 per month. This allows George and Barbara to jointly receive $2,500 per month, until George turns 70.

When George turns 70, he will apply for Social Security benefits based on his earnings and begin to receive his delayed retirement benefit of $2,640. Thus, when George turns 70, the couple’s Social security benefit will increase from $2,500 per month to $4,140 per month.

The final advantage to this approach occurs if George dies before Barbara, a likely scenario since he is four years older and a male. If this occurs, Barbara may apply for “survivor benefits” and receive George’s full benefit of $2,640 per month instead of her $1,500 per month, for the rest of her life.

Assuming both George and Barbara live until they are age 80, by using this approach, they will receive $59,520 more in Social security benefits than if George had merely filed for his full benefit at age 66.

All of these numbers assume no inflation. On an inflation adjusted basis, the increases in the amount of additional Social Security collected would be even greater.

The above example does not mean that this is the best approach for you. It is only meant to demonstrate that Social Security is a very complex system and the decisions that you make on when and how to receive your benefits can have a major impact on the income that you will receive. Be sure to get expert advice on the vagaries of the system before you make your decision on when and how to take your Social Security benefits.

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As the end of the year draws near, mutual fund companies are required to distribute all of their capital gains and dividend income accumulated over the past year. If you have mutual funds, you likely reinvest these distributions into more shares of the mutual fund.

If you plan on selling a mutual fund soon, you might want to sell the fund before the year end distribution, to avoid paying taxes on this year’s distributions. If you are planning on buying a mutual fund, you may want to wait until after the yearly distribution is made, to avoid paying taxes on gains in which you did not participate.

A costly mistake, that many people make, is not keeping track of their yearly distributions from mutual funds. Each year, you will pay taxes on the capital gains and dividend distributions from a mutual fund. If you reinvest your capital gains and dividends, when you decide to sell the mutual fund, these distributions should be included in your cost (basis) of the fund. If you forget to do this, you will end up paying taxes twice on these distributions.

As an example, suppose that you bought a mutual fund five years ago for $10,000. Each year you reinvest your $1,000 capital gains and dividend distribution. At the end of five years, your mutual fund holdings are valued at $17,000. What is your capital gain if you sell?

If you forget that you have already paid taxes on $5,000 of capital gains and dividend distributions, you might report a capital gain of $7,000. However, since you have already paid taxes on $5,000 of capital gains and dividends, your cost/basis is $15,000 and your capital gain is only $2,000.

If you buy and hold mutual funds, be sure to keep track of the reinvested gains that you receive and pay taxes on each year. This will keep you from paying Uncle Sam more than you should when you sell the fund.

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Thanks to the present financial crisis that began with the proliferation of “sub-prime” mortgages, housing prices are dropping and mortgages are getting harder to obtain, even for people with a good credit history. If you are wondering if you will ever be able to buy your first home, you may want to consider the benefits of saving for it by using a Roth IRA.

If you are single, with an Adjusted Gross Income (AGI) of under $99,000, or married (filing jointly) with an AGI of under $156,000, you may contribute up to $4,000 of your income to a Roth IRA. In 2008, the maximum Roth IRA contribution will be $5,000. While your contribution does not lower your immediate taxes owed, it can literally open the door to owning your first home.

Let’s assume that you would like to buy a house in the next 5 years. In 2007, you contribute $4,000 to a Roth IRA. In 2008 -2011, you contribute $5,000 each year. At the end of 5 years, assuming an 8% return on your Roth IRA investments, the $24,000 that you have invested will have grown to over $30,000.

With a Roth IRA that has been established for at least five years, you are allowed to withdraw up to $10,000, in income and growth, plus all of your contributions, when the proceeds are used to buy a first home. In the example above, all $30,000 can be withdrawn to purchase a first home, without any income tax or penalties.

This approach will allow you to make a 10% down payment on a $300,000 house. If the remaining $270,000 is financed with a 30 year mortgage with a 6% annual interest rate, your monthly payments would be approximately $1,620 (plus taxes and insurance). While this approach takes patience, it may allow you to become a home owner, building up equity in your future, while your friends are still renting.

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I am often asked whether it is better to contribute to a traditional, deductible IRA or to a Roth IRA. As with most personal finance questions, my answer is typically “it depends.” In this entry, I will provide some guidelines to help you decide which is best for you. When I use the term “IRA,” I am only addressing deductible IRAs. In a future entry I will discuss why I believe that it is seldom wise to fund a non-deductible IRA.

Let’s first look at the rules:

With a traditional IRA, you must be under 70½ years old plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you are covered by a retirement plan, you can only deduct the full amount contributed to your IRA if your Modified Adjusted Gross Income (MAGI) is no more than $52,000 as a single tax payer or $83,000 as a joint filer.

With a Roth IRA, your Adjusted Gross Income (AGI) must be less than $99,000 as a single filer or $156,000 as a joint tax filer plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you make any deductible IRA contributions, the amount that you can contribute to a Roth IRA is further reduced by the amount that you contributed to the deductible IRA.

Based on these rules, the decision on which IRA to use is sometimes obvious:

1. If you are a single filer with an AGI over $99,000 or a joint filer with an AGI over $156,000 and you are not covered by a retirement plan, you can only fund an IRA.
2. If you are covered by a company retirement plan and your MAGI is over $83,000 but less than $156,000 as a joint filer or $56,000 but less than $99,000 as a single filer, you cannot receive full IRA deductibility, but you are able to fully fund your Roth IRA.
3. If you are over 70 ½ and have earned income, you can only fund a Roth IRA.
4. If you are saving to buy your first home, up to $10,000 of growth and income from a Roth IRA, plus all of the contributions may withdrawn, tax and penalty free.

Now let’s look at the more subtle differences between the IRA plans:

1. If you are under 40, the tax free growth combined with the tax free withdrawal of the funds (when you are over 59½) often make the Roth IRA a better, after-tax investment strategy.
2. If you may need some of the funds before you turn 59½, with a Roth IRA you can typically withdraw all of your contributions and pay no taxes or penalty on the withdrawal.
3. If you are over 40 and wish to pass some of your estate to your children, a Roth IRA is an excellent way to pass funds to younger generations.

When none of the above apply, the decision of funding a Roth IRA or a traditional, deductible IRA must be made by analyzing your current tax bracket, what you believe will be your future (retirement years) tax bracket and whether you expect to consume the retirement funds or pass them to future generations. This is never easy and often comes down to whether you want the tax reduction now or you can wait to get it later.

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