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.
Q: My wife and I just owed a ton of money for taxes because we had to take the standard deduction. How in the world to people accumulate enough deductible expenses to be able to itemize? I refuse to believe that the average individual makes thousands of dollars of deductible purchases or donates thousands to charity.
A: Well, you’re right on that score. About two-thirds of the nation’s taxpayers take the standard deduction, typically because they don’t have enough deductible expenses to itemize.
What usually allows people to itemize is mortgage interest, often combined with property taxes and state and local taxes. (For years, only state and local income taxes qualified as deductible expenses, but now you can choose to deduct sales taxes instead.)
So it follows that people who live in areas where real estate is expensive and taxes are high are more likely to itemize than those who don’t. Someone who buys a house in Amarillo, Texas–where the median house price is $97,100, according to the National Association of Realtors, and there is no state income tax–may not have enough deductions to itemize, whereas someone who buys a home in Orange County, California–median home price $627,300–almost certainly does.
AmarilloÂ homeowners who put 10% down on median-priced homes would pay just $4,777 a year in interest during the first year of ownership, assuming a 30-year loan at 5.5%. That’s well short of the $9,700 standard deduction in 2004 for a married couple filing jointly.
San FranciscoÂ homeowners, by contrast, would pay $30,862 in mortgage interest during the first year.
Some commentators have used these differences to asset that folks in many parts of the Midwest and South are subsidizing those on the coasts and in the Northeast, thanks to the mortgage interest deduction. While that might be a bit of a stretch, it is true that the ability to itemize isn’t evenly distributed.
You may never have enough deductions to itemize, but you have a few other ways to avoid a big bill on April 15. Making contributions to a 401(k), if available, is one such way. If you’re not covered by a workplace retirement plan, or you are but your income is below certain limits, you can make deduction contributions to an individual retirement account.
You also should take time now to estimate your taxes for 2005 and adjust your withholding accordingly so you don’t face such a big bill next year. The IRS has a withholding calculator on its site,Â www.irs.gov, thatÂ can help.
Q: I just finished my taxes, and I know my refund would have been bigger if I had been able to find more of my tax-related receipts. You’ve talked about how to organize your records and when to get rid of old paperwork. Do you have any suggestions for tracking receipts?
A: Essentially, you need to figure out a way to separate your important receipts from all the other paperwork you carry around, and to be consistent with whatever system you set up.
Professional organizer Debbie Stanley has some great tips about handling receipts in her book, “Organize Your Personal Finances in No Time” (2004,Â Que). She notes that most receipts for purchases, ATM withdrawals and credit card transactions need to be retained for short periods of time only; typically three months or less, which is long enough to compare them against your statements or return an unwanted item.
So your first step is implementing a system in your wallet or purse that allows you to separate these short-term receipts from those you’ll need to retain longer, such as tax-related paperwork or sales slips for major purchases.
Some folks will have a third category: receipts that they need for reimbursement or rebates. If you’re an employee who regularly travels or entertains clients, you’ll want to include this category so you can get paid back for your expenditures.
Fortunately, many wallets have a number of different compartments where you can stow receipts of different types, or you might want to carry envelopes for this purpose in your backpack or purse.
Then, every night–or at least a few times a week–you can empty your receipts into an appropriate file folder or box: one labeled for short-term receipts, one for taxes and one for reimbursements or rebates.
The key to being able to find your important receipts when you need them is to put them in the same place every time–both when you receive them and when you get home. Don’t stuff them in your pants pocket or let clerks put them in the bags, and don’t let them linger in your wallet or purse.
StanleyÂ also has a pretty nifty idea for dealing with short-term receipts. Rather than waste much time sorting through them, she set up three file folders, labeled “This Month,” “Last Month” and “Two Months Ago.” She empties her short-term receipts from her wallet into the “This Month” folder; at the end of the month, she transfers the contents of that folder to the “Last Month” folder. The previous contents of the “Last Month” go into the “Two Months Ago” folder, and whatever’s in the “Two Months Ago” folder goes into the trash. After three months, her receipts have spent time in each folder and she’s had plenty of time to retrieve them if necessary.
Q: Last year, I briefly worked for a local school district that had a pension fund. Participation was mandatory. I contributed only $650 in the four months I worked there.
But when I tried to make my usual tax-deductible IRA contribution for the year, my bank said that brief participation was enough to prevent me from contributing. My income was more than $100,000 so I’m looking for ways to reduce my tax bill.
Is what the bank said true â€” am I out of luck?
A: Yes, if what you want is a tax deduction, said Nicholas Kaster, a senior analyst with tax research firm CCH Inc.
Anyone who is an “active participant” in a workplace retirement plan for any part of a tax year faces significant limits on how much of an IRA contribution, if any, may be deductible.
For single filers, the ability to deduct a contribution begins to phase out at $45,000 and disappears entirely at $55,000; for married filers, the phase-out range is $65,000 to $75,000. (These figures are for 2004 contributions, which can be made until April 15 of this year.)
That does not mean, however, that you can’t contribute to an individual retirement account â€” just that you can’t deduct your contribution. Anyone who has earned income can make a nondeductible contribution to an IRA.
If your income is below certain limits, you might consider contributing to a Roth IRA, which offers tax-free withdrawals in retirement. You can contribute as much as $3,000 for tax year 2004 if you are single and your income is less than $95,000 or if you are married and your income is less than $150,000. (Your ability to contribute to a Roth phases out as your income rises; singles with incomes of more than $110,000 and marrieds with incomes of more than $160,000 can’t contribute.)
With all IRAs, you can make an additional $500 “catch-up” contribution if you are 50 or older.
Q: You had a column last year about what documents to save, and for how long. I put it aside, but now I can’t find it. Would you mail me a copy?
A: Well, no. But with the idea that it’s better to teach a reader to fish than to mail her the fish wrap, here are a few ideas for better managing your paper flow.
The guidelines for keeping and discarding paperwork aren’tÂ all thatÂ complex. If it has to do with taxes, you’ll generally want to hang on to it for seven years. The exception is for assets that may incur tax when you sell, such as a home or an investment. In that case, you’ll want to keep the paperwork for as long as you own the asset, plus seven years.
If you make a nondeductible contribution to an individual retirement account or other retirement plan, keep the paperwork indefinitely. You can subtract a portion of those contributions from future withdrawals, which will save on taxes.
If you get a periodic summary of your transactions, you can generally discard the interim paperwork. In other words, you can toss your pay stubs once you’ve checked them against yourÂ W-2s,Â and your automated teller receipts once you’ve compared them against your monthly bank statement.
If you make a big purchase, keep the receipt for as long as you own the item. A receipt can help in the short run, when you need to return an item, and in the long run, by establishing its value for insurance purposes.
Old insurance policies and paperwork can be discarded once they’re replaced with new versions and there’s no longer a possibility of filing a claim.
Most people hang on to way too much paper, fearful that they’ll need it somehow, someday â€” when actually all it does is add to their clutter.
Professional organizer Debbie Stanley, author of “Organize Your Personal Finances in No Time” (Que, 2004), recommends an annual purge of your paper, and tax season is as good a time as any to tackle that.
Once you’re done, though, consider creating one new file â€” for helpful newspaper articles. Then you’ll be able to put your hands on the information right when you need it.