Ask Liz Weston

Get smart with your money

Liz Weston

Thursday’s need-to know-money news

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College studentAvoiding health care scams, improving your credit mix, and navigating the rocky roads of inheritance.

How to Avoid Healthcare Fraud
Don’t let yourself be scammed.

Rules of the Road for Improving Your Credit Mix
Taking on new credit could make it easier to get a mortgage.

Stop Family Feuds Over Inheritances Before They Start
Few things can tear a family apart worse than a will.

7 Huge Mistakes Back to School Shoppers Make
How to avoid overspending during the chaos of back to school shopping.

How to Buy Maternity and Kids Clothes on the Cheap
Don’t spend a fortune on clothes everyone will outgrow.

The young and the foolish

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Stop-watchLifehacker’s post today “How Much You Should Save for Retirement, Based on 139 Years of Data” is a nice summary of Professor Wade Pfau’s research on “safe savings rates.” But some of the comments made me groan.

The reasons people gave for not saving for retirement aren’t unusual: some can’t imagine ever getting old (you will) and some think there are more important things to do than save for retirement (there aren’t). The most frustrating come from people who are obviously young and thus obviously wasting their most precious asset—time.

Just look at the chart provided with the post. The longer you wait to save for retirement, the more you have to put aside to “catch up”—until catching up becomes all but impossible. Someone aiming for a replacement rate of 70% of her final salary needs to save about 12% of her income if she starts in her 20s (with 40 years until retirement). If she waits until her 40s, with 20 years left, she has to save half of her income. Half. How many 40-somethings will manage that? Sure, you may have student loan debt now, and you want to save for a down payment, and maybe get a better car, but trust me—it won’t be any easier to save down the road when you have even more obligations than you do now.

In the meantime, you will have wasted all those opportunities to get tax breaks and tax-deferred gains. You’ll have given up company matches you can’t get back. Most important, though, you’ll have blown the opportunity to let compounding–that miracle of math–work for you. Your money can’t earn returns that will earn returns that will earn returns if you don’t get it into your retirement accounts in the first place. The earlier you get it in there, the longer it has to work for you, and the more money you’ll ultimately have.

So sign up for that 401(k) or IRA. Set up automatic transfers now, and boost your contributions regularly. Do it before you do anything else, including paying down debt or working on your emergency fund. Let time be on your side, because it won’t be for long.

Money advice for the self-employed

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Dog walkerIf you’re self-employed, you’ve probably noticed that standard money advice often falls short.

A lot of what you read assumes you receive regular, predictable paychecks with taxes already withheld and benefits covered. Just try finding advice to deal with the following:

  • A major customer abruptly changes payment policies, so that five-figure check you’re counting on to pay the bills lands weeks later than you expected.
  • Your health insurer announces your premiums will increase 39%, and your insurance broker tells you that no other company will cover you for less…or at all.
  • Congress dithers on renewing a key tax break, so your CPA advises (at Christmastime) that you’ll need to cough up thousands more dollars to make yourself “penalty proof.”

These aren’t hypotheticals. Each has happened to me as a small business owner. Predicting income and expenses when you run your own show is often as much art as science. When you’re providing your own benefits, handling your own taxes and doing your own billing, your financial life becomes complex in a way that would confound most of the W-2 world.

This is what has helped me:

A business line of credit. Excellent credit scores helped me land a low-rate line of credit when I opened my business checking and savings accounts. I relied on it heavily when I was getting started to cover those inevitable gaps in cash flow (translation: slow-paying customers). I still use it occasionally to deal with unexpected expenses; I don’t carry a balance for a day longer than necessary, but I’d rather pay a few bucks in tax-deductible interest for a few days than keep a huge wad sitting idle in a business savings account.

A tax pro. I don’t write about taxes often, and almost never about business taxes. So why would I waste time trying to keep abreast of business tax law and struggling to do my own taxes when I can hire someone? Especially since that someone lives and breathes taxes, and can be counted on to represent me in an audit. We small business owners often have trouble delegating, but we’re far better off spending our time making money than wrestling with tax forms.

A simple rule of thumb. Early on, a CPA said he could bill me to make some elaborate projections, but he suggested a simpler way: save half. If I put aside half of every check that came in, I’d be able to cover my taxes and expenses. Ten years later I have a much better handle on cash flow, but it still pretty much boils down to saving half of what comes in.

If you’re an entrepreneur, I highly recommend “The Money Book for Freelancers, Part-Timers, and the Self-Employed: The Only Personal Finance System for People with Not-So-Regular Jobs Paperback” by Joseph D’Agnese and Denise Kiernan, two freelancers who through trial-and-error figured out a money system that really works.

Wednesday’s need-to-know money news

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bad creditLearning how to take advice, cleaning up your credit report, and why working an extra year or two could be a good thing.

Why Can’t We Follow Simple, Good Money Advice?
Why is it so hard to adhere to the basics?

10 Steps to Help Erase Errors on Your Credit Report
Tips on removing errors from you all-important credit report.

8 Costs to Consider When Buying a Rental Property
Rental properties can be a great investment, but there are things you need to watch out for.

Is That Credit Card Surcharge Illegal?
Depending on where you live, that fee to use your card could be against the law.

When Should You Delay Retirement?
Could delaying your retirement pay off in the end?

Tuesday’s need-to-know money news

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Car crashWhy students are a prime target for identity thieves, an easy way to save money on homeowners insurance, mistakes to avoid when buying a house and how cell-using drivers set themselves up for disaster.

The ABCs of Back-to-School Identity Theft Protection
Students of all ages are easy targets for identity theft.

Simple Tip Can Save You Big on Homeowners Insurance
Your deductible could be the key to savings.

The IRS Filed a Tax Lein on Your Home—Now What?
Don’t let your panic become a distraction. Buying a House? Don’t make these mistakes.
Things not to be overlooked while house hunting.

25% of Car Crashes Involved Cel Phones
Drivers using cellphones fail to see up to 50% of the information in their environment.

Don’t rush to pay taxes

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Dear Liz: I am a CPA and fairly knowledgeable about investing, but I have a question about my IRAs. I am 58 and my husband is in his mid-80s. We both are retired with federal pensions and no debt other than a mortgage. My plan is to start taking money annually from my traditional IRA in two or three years. I want to reduce the required minimum distribution I will need to start taking at age 701/2 and lessen the tax impact at that time. Should I put these annual withdrawals in my regular investment account or should I put them in the Roth IRA? My goal is to lessen the tax impact on my only child when he ultimately inherits this money. Does my plan make sense?

Answer: Your letter is proof that our tax code is too complex if it can stymie even a CPA. Still, it’s hard to imagine any scenario where you’d be better off accelerating withdrawals from an IRA and putting them in a taxable account.

A required minimum distribution “is merely a requirement to take the money out anyway,” said Certified Financial Planner Michael Kitces, an expert in taxation. “All you’re doing by taking money out early to ‘avoid’ an RMD [required minimum distribution] is voluntarily inflicting an even more severe and earlier RMD on yourself.”

In other words, you’d be giving up future tax-advantaged growth of your money for no good reason.

What might make sense, in some circumstances, is moving the money to a Roth. You can’t make contributions to a Roth if you’re not working, because Roths require contributions be made from “earned income.” What you can do is convert your traditional IRA to a Roth, either all at once or over time. You have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions. Whether you should convert depends on a number of factors, including your current and future tax rates and those of your child.

“In other words, if your tax rate is 25% and your child’s is 15%, just let them inherit the [traditional IRA] account and pay the lower tax burden,” said Kitces, who has blogged about the Roth vs. traditional IRA decision at http://www.kitces.com. “In reverse, though, if the parents’ tax rate is lower … then yes, it’s absolutely better to convert at the parents’ rates than the child’s. In either scenario, the fundamental goal remains the same — get the money out when the tax rate is lowest.”

If you do decide to convert, remember that the conversion itself could put you in a higher tax bracket.

“It will be important not to convert so much that it drives up the tax rate to the point where it defeats the value in the first place,” Kitces said. “Which means the optimal strategy, if it’s to convert anything at all, will be to do partial Roth conversions to fill lower tax brackets but avoid being pushed into the upper ones.”