Dear Liz: I’ve been contributing to a traditional individual retirement account for the last few years. Taking one of your recommendations, I would like to move the money to a Roth IRA. I understand that I’ll have to pay taxes on the conversion, but will there also be any penalties involved? If so, how much of a penalty? If there is no penalty and only taxes, what is the rate I should be expecting?
Answer: Roth IRAs offer tax-free withdrawals in retirement, which is why they’re a great deal for many savers, and conversions are about to become easier.
Currently there is no penalty for converting a traditional IRA to a Roth, but you will owe income taxes that are determined by your tax bracket. If you’re in the 25% federal tax bracket, for example, you’ll owe taxes equal to 25% of the amount you convert, assuming your contributions were all tax-deductible. (If you made nondeductible contributions, those will reduce the tax bill proportionately.) You’ll also need to factor in state and local income taxes.
You can convert to a Roth this year only if your modified adjustable gross income is $100,000 or less. Next year, however, the income limit on Roth conversions is scheduled to be removed. Also, for 2010 only, you can opt to have the taxable income from your conversion reported in two equal installments in 2011 and 2012, putting off the tax bill you owe.
Make sure you have enough cash to cover the taxes without raiding the IRA you’ll be converting. But being able to put off the tax bill, and paying it over two years, should lessen the burden. Talk to your tax pro for details.
Dear Liz: I am 74 and retired. Due to the economy I would like to cash out my retirement accounts. I have an individual retirement account, a Simple IRA and an annuity. Only other income is Social Security. How badly would this affect me?
Answer: That depends. How much do you love paying unnecessary taxes?
Cashing out any retirement account, other than a Roth IRA, typically triggers a significant income tax bill. Cashing in an annuity may also trigger surrender charges that can be substantial.
If you took too much risk with your investments, you can shift to safer options inside your retirement accounts. You would be smart to consult a fee-only financial planner first, so you can construct a portfolio that acknowledges your tolerance for risk while still giving you enough money to live on for the rest of your life.
Dear Liz: Since tax filing season is upon us, it’s a good time to get rid of statements and records we don’t need. How long should we keep such things as tax records, credit card statements, mortgage payment statements, utility bills, etc?
Answer: Most tax-related documents should be kept for seven years unless the paperwork concerns a potentially taxable investment or asset, such as your home or stocks bought outside a retirement account. In that case, keep the paperwork as long as you own the investment or asset, plus seven years.
For example, hang on to the paperwork created when you bought your home, such as sales contracts, deeds, mortgage paperwork, appraisals and surveys, as well as the costs of any home improvements, since they can help reduce any potential tax bill when you sell. You can dispose of all this documentation seven years after you sell the property.
Why seven years? Your greatest risk of audit is in the first three years after you file your return, but you can still be audited up to six years later if you substantially underreport your income. Since we file our returns in the following year — last year’s returns are due in April of this year, for example — adding seven years to the tax return year will give you the year that you can toss your return’s documentation. This year, for example, you can toss tax-related documents filed for the 2002 tax year.
You might want to hang on to the actual return, though. They typically don’t take up much room and may come in handy. One reader who discovered errors in her Social Security statements, for example, was able to get those corrected because she still had the tax returns for those years.
If it’s not tax-related, your holding times vary. You typically can ditch credit card statements and utility bills after a year, for example. Old insurance policies can be shredded after they’ve lapsed or been replaced, and there’s no chance you’ll file a claim against them.
You can dispose of your pay stubs after comparing them with your annual W-2 form. (Keep your year-end pay stub too, if it shows information that’s not on your W-2, such as tax-deductible union dues.)
Many people these days simply scan all their paperwork into their computers and discard the originals. The actual paper isn’t as important as the information on it, and most sources — including the IRS — accept electronic documents.
Just make sure to back up regularly and keep those backups in a safe place somewhere off site. A secure website or a safe deposit box are two options.
Dear Liz: I received the $7,500 first-time home buyer tax credit for the house I bought last year, but I understand I have to pay that back over 15 years. Under the new stimulus plan, the tax credit went up $8,000 and doesn’t have to be paid back. Is there a plan to relieve the people from paying back the $7,500 or is it a dead issue?
Answer: When Congress changed the credit, it didn’t go back and change the rules for last year. So as of this writing, you’re still required to pay back the $7,500, even though someone who buys a home this year and qualifies for the larger credit won’t face the same requirement.
Raise the issue with your congressional representatives. You can find them at www.house.gov and www.senate.gov.
Dear Liz: My daughter is trying to buy her first home with very little money available for a down payment, perhaps 3% of the total purchase price. What are your thoughts on the interest-free loan from the IRS for first-time home buyers? It seems too good to pass up. Is there a downside?
Answer: The IRS isn’t exactly handing out cash for down payments. What first-time home buyers can get after they buy a house is a tax credit worth up to $8,000. Before Congress passed the stimulus package, the tax credit was $7,500, and had to be back over time, which is why some referred to it as an â€œinterest-free loan.â€ Besides being slightly larger, the new version of the credit wonâ€™t have to be paid back.
With 3% down, your daughter may qualify for a Federal Housing Administration loan. She might want to discuss her situation with a housing counselor approved by the U.S. Department of Housing and Urban Development. She can find one at www.hud.gov.
But she also might consider waiting to build up her down payment and her cash reserves in general. Homeownership is expensive, and she should be reasonably sure she can afford all the costs before she dives in.
Dear Liz: No question here, just a suggestion. I think you should emphasize to your readers that they should avail themselves of retirement and financial planning seminars that may be offered by their employers early on in their careers.
That way, they’ll have the maximum time possible to make the right decisions and allow their investments to grow.
I finally went to one of my employer’s retirement seminars at age 40, after working for the company for 16 years. Although I found out that I was not too far off track, there were definitely things I could have done differently to maximize my retirement benefits. As you know, timing is everything in investing.
Answer: Actually, “time” is everything in investing. The earlier you start and the longer you stay invested, the better as you now know.
Your point about attending employers’ education seminars is well taken. Many people put off investing for retirement or aren’t comfortable making decisions about how to invest, and those seminars can help them get over those barriers. A few hours invested in one of those seminars can pay huge dividends.
Dear Liz: You recently advised an entertainment industry executive about some of the pitfalls of using a credit card provided by his company.
I’m the tax director for a Midwestern company, and I believe that you overlooked a crucial statement in the questioner’s inquiry. He said the company would be paying the bill directly, eliminating the need for him to submit reimbursement requests.
If that’s the case, then the employer’s payments to the credit card company would be considered taxable income to the executive, subject to all withholding and payroll taxes.
He is then responsible for deducting his business expenses on his personal return, probably subject to the 2% limitation on itemized deductions. This is a terrible plan for more than the reasons you identified.
Answer: You just panicked a whole bunch ofÂ HollywoodÂ executives unnecessarily.
Although these arrangements may not be common in theÂ Midwest, they are par for the course in the entertainment industry. Fortunately for these high-living folks, direct reimbursement does not result in taxable income to the executive if the arrangement is part of an “accountableÂ plan,” said Mark Luscombe, principal analyst for tax research firm CCH.
Luscombe cited two private-letter Internal Revenue Service rulings (200304002,Â Aug. 6, 2002; and 200235006,Â May 17, 2002, if you’re interested) in which the IRS laid out the rules for what constitutes anÂ accountableplan.
“In reviewing these rulings, it appears that the card is to be used only for business purposes, cash advances on the card should not be allowed in most cases and the credit card bill provides adequate information for the employer to determine the business purpose of the charge,” Luscombe said.
If the bill isn’t adequate, the employer must require the employee to provide “any additional documentation necessary to support an expense where its validity cannot be established from the credit card bill,” Luscombe said.
Q: My son has owned his home for 25 years. He rents out three of his rooms, charging $300 to $500 a month. He doesn’t take checks, only cash, which he does not report on his tax form. I told him that he’s wrong and could face a heavy fine. Isn’t that right?
A: We’ll assume you tried to teach your boy right from wrong, so that particular ship has sailed. What often motivates people with, shall we say, “challenged” ethical systems is fear of getting caught.
Your son is probably counting on the Internal Revenue Service’s low audit rate to prevent his little scheme from being uncovered. But all it takes is one disgruntled renter willing to call the feds, and his moneymaking scheme could be exposed. Then he would have to pay taxes and penalties on the undeclared income.
If he has underreported his income by 25% or more, he could be in twice as much trouble. Normally, the risk of an IRS audit essentially ends three years after a tax return is due. But if you’ve underreported your income by more than 25%, the IRS can reach back six years.
If the IRS is successful in arguing that your son intended to commit fraud by filing a false tax return, there is no statute of limitations at all, said tax analyst MarkÂ LuscomeÂ of CCH Inc., a tax research firm. The IRS could audit and assess taxes for the entire 25-year period he’s been collecting rents under the table.
In any case, your son might discover that declaring the income is a better deal than he thought. Once the rent is on the books, he can start deducting plenty of expenses that otherwise wouldn’t be write-offs, such as a portion of the utilities, insurance and home-maintenance costs. Combine that with the depreciation he could take on the rented portion of a house, and he may find himself ahead financially.
He would have a tax issue when he sells the house, though. Typically, he would be able to exclude up to $250,000 of home sale profit from his income when he sells. But he would have to pay a 25% “recapture” tax on the depreciation he took afterÂ May 6, 1997. That’s still no reason not to declare the income, though, because the recapture tax is just a return of some of the deduction he took in earlier years.
ear Liz: I wanted to pass on a suggestion for other readers who might be in the same situation I was: working for a small business that refused to make payroll tax contributions to the Internal Revenue Service, Social Security or the state.
A business’ failure to pay affects employees’ future Social Security benefits, as well as causes problems for them at income tax time.
I reported the fraud by filling out Form SS-8 for the IRS and by contacting our state unemployment office.
Crooked business owners who don’t pay payroll taxes on their employees are short-changing the whole of society.
A: Business owners who pocket their employees’ income tax, Social Security, Medicare and other withholdings are crooks indeed. But so too are the deluded few who insist that they’re not required to withhold anything from employee paychecks.
The arguments of these tax protesters have been thoroughly refuted in the courts, but until the IRS and state tax agencies catch up with them, their employees pay the price.
If you have any question about whether your employer is properly making payroll tax contributions, check the wage and benefit statement you should be getting annually from the Social Security Administration. If the amount for any year is lower than it should be or â€” worse yet â€” zero, contact the administration immediately.
You might also want to check your pay stubs carefully against your year-end W-2 forms. If your employer didn’t issue W-2s, contact the IRS.
Dear Liz: Your column on tracking receipts was quite interesting, but it still appeared to be a lot of work.
The method that I use is to enter data from my credit card statements when they arrive, and enter information from cash receipts two or three times a week, into my Quicken personal finance software.
At tax time it is easy to create reports for my accountant. (The information can also be exported directly into TurboTax, for those masochists who want to do their own returns.)
A: Personal finance software like Quicken or Microsoft Money is indeed a huge time saver and a great way to track your finances. But most people haven’t gone to the trouble of buying and using such software, which is why it’s important to discuss other paper-handling methods.
By the way, you probably could save even more time by setting your software to download your transactions directly from your credit card companies. You could update your records as often as daily, rather than having to wait until the end of the month, and you wouldn’t have to do all that tedious typing.