Q&A: Lowering credit limits

Dear Liz: You recently answered a question about a woman who asked her credit card issuer to lower her credit limits. While it’s true that lowering your credit limit on a card can have a negative effect on your credit scores, it may be needed to leave credit room for new cards, as your total credit across cards vs. your annual income is considered. And of course your credit score won’t suffer when balances are paid down before the statement date.

Answer: Credit scoring formulas calculate your credit utilization based on the amount of credit you’re using on the day that the card issuer reports your account to the credit bureaus each month. That’s usually, but not always, the balance as of the statement closing date. Making a payment just before that date often lowers your credit utilization and can help your scores.

So yes, making a payment before the statement closing date can offset the negative impact of lowered limits. However, it would be rather foolish for an individual to request lower limits thinking that a credit card issuer might prefer them to have less credit. Typically, healthy credit limits are a sign you’re managing your credit well. Even if a credit card issuer might look askance at your available credit, you won’t know exactly where to draw that line. Credit card issuers have different policies on how they set credit limits, and they typically don’t broadcast how those decisions are made.

Q&A: Should you sell a house or let heirs deal with it? The taxes shake out differently

Dear Liz: My mother, who will be 101 later this year, is leaving me real estate in her trust. The value of it is $4.5 million. She has other assets that will put her estate over $5 million when she passes. I currently have an offer from someone who wants to buy the real estate. Is it better for her to sell it now and reduce the value of her estate? She has never exercised the option for the one-time sale of her primary residence tax free. What are the tax implications if it remains in her estate until she passes?

Answer: There’s no such thing as a one-time option to sell a home tax free. Decades ago, homeowners could defer the recognition of taxable gain if they bought another house, and homeowners 55 and older could exclude as much as $125,000 of gain. That was a one-time deal, so perhaps that’s what you’re remembering.

Since 1998, however, taxpayers have been able to exempt as much as $250,000 of capital gains from the sale of their primary residence as long as they owned and lived in the home at least two of the prior five years. Taxpayers can use this exemption as often as every two years.

Clearly, your mom needs to find a source of good tax advice, such as a CPA or other tax professional. If you have the authority to act on your mother’s behalf through a power of attorney or legal conservatorship, then you should seek the tax pro’s advice as her fiduciary.

Under current law, if she retains the real estate it would get a “step up” to the current market value as of her death. That means all the appreciation that happened during her lifetime would never be taxed. If she sells now, on the other hand, she probably would owe a substantial capital gains tax bill, even if she uses the exclusion. The tax pro will calculate how much that’s likely to be.

That tax bill has to be weighed against the possibility that her estate could owe taxes. The current estate tax exemption limit is $11.7 million, an amount that will continue to be adjusted by inflation until 2025. In 2026, the limit is scheduled to revert to the 2011 level of $5 million plus inflation. President Biden has proposed lowering the limit to $3.5 million and modifying the step up, but those ideas face stiff opposition in Congress.

An estate planning attorney could discuss other options for reducing her estate if she’s still with us as 2025 approaches. The tax pro probably can provide referrals.

Q&A: Why delaying Social Security is the smartest retirement play

Dear Liz: If someone delays applying for Social Security after their full retirement age, the common thought is that their benefit grows by 8% a year until the age of 70. It accrues by that much only if you continue to work, right? I was unceremoniously laid off during the pandemic and I am holding off as long as I can before applying. I will be 67 at the end of this month. But because I am not working, that 8% is not a reality, right?

Answer: Wrong. The 8% delayed retirement credits apply whether you’re working or not. Those credits will help you maximize the benefit you receive for the rest of your life and potentially the rest of your spouse’s life, if you are the higher earner in a marriage. This effect is so powerful that many financial planners recommend their clients tap other resources, such as retirement funds, if it allows them to put off claiming Social Security.

It may help to think of retiring as a separate event from claiming Social Security. Many people link the two, but you can work while claiming Social Security or retire but delay Social Security.

If you did continue to work, your benefit might be increased somewhat by the additional earnings. This typically happens if you had a low-earning year included in the 35 highest-earning years that Social Security uses to calculate your benefit. If you had earned more in 2020 than in one of those previous years, then your 2020 earnings would replace that past year’s earnings in the formula and boost your benefit.

The 8% delayed retirement credit probably will have a much bigger effect on what you ultimately get, though, so don’t fret about any missed opportunities. Just try to delay your application as long as you can.

Q&A: Different Roths, different rules

Dear Liz: I have a Roth 401(k). Are withdrawals from it the same as from a Roth IRA? And how do I move it to a Roth IRA?

Answer: Roth 401(k)s are a type of workplace retirement plan that, like Roth IRAs, allow tax-free withdrawals. But the rules for Roth 401(k)s are somewhat different from those governing Roth IRAs.

For example, a Roth IRA allows you to withdraw an amount equal to your contributions free of taxes and penalties anytime, regardless of your age. Earnings can be withdrawn from a Roth IRA tax- and penalty-free once you’re 59½ and the account is at least 5 years old. The clock starts on Jan. 1 of the year you make your first contribution.

To withdraw money tax- and penalty-free from a Roth 401(k), you typically must be 59½ or older and the account must be at least 5 years old.

In addition, Roth 401(k)s — like regular 401(k)s and traditional IRAs — are subject to required minimum distribution rules that require you to start taking money out at age 72. Roth IRAs aren’t subject to those rules.

Many people roll their Roth 401(k)s into Roth IRAs to avoid the required minimum distribution rules or to have more investment choices. Such a rollover resets the five-year clock that determines whether a withdrawal incurs taxes and penalties, however. If you wait until you retire to roll over your Roth 401(k) and need access to the money, that waiting period could be problematic.

You can roll over your Roth 401(k) after leaving the employer that offers the plan. But you also could ask if your plan allows “in service” rollovers — in other words, rollovers while you’re still working for the employer. Some Roth 401(k)s allow these, although they may be restricted to people 59½ and older.

Q&A: Finding a fee-only advisor

Dear Liz: I need help locating a fee-only financial advisor. My search only comes up with advisors with investments.

Answer: It’s not clear what you mean by “advisors with investments.” Some fee-only planners charge a percentage of the assets they manage and often require you to invest a minimum amount with them. Others charge a monthly retainer (check XY Planning Network) or by the hour (visit Garrett Planning Network).

If you’re primarily looking for help with issues other than investing, such as budgeting or debt management, you could consider hiring an accredited financial counselor or accredited financial coach. Visit the Assn. for Financial Counseling & Planning Education. Another resource is nonprofit credit counseling agencies affiliated with the National Foundation for Credit Counseling at www.nfcc.org.

Q&A: Here’s how taxes work on estates and inherited money

Dear Liz: Are all assets entitled to a stepped-up basis upon the death of the owner? My father died about a year ago, leaving my sister and me an estate of a little over $1 million. He had a Thrift Savings Plan that is apparently like a 401(k) for federal government employees. This is getting taxed at 37%. Also he had U.S. Savings Bonds and the interest on those is apparently taxable. I was under the impression all assets in an estate under $11 million were not taxable. Is this not correct?

Answer: That’s not correct. You’re confusing a few different types of taxes.

Estate taxes are levied on certain large estates when the owner dies, and those taxes are typically paid out of the estate. The current estate tax exemption limit is $11.7 million, up from $11.58 million last year. After 2025, the limit is scheduled to drop to $3.5 million, but even then very few estates will owe the tax.

Another type of tax is the capital gains tax. This essentially taxes the profit someone makes when they sell a stock or other asset. Capital gains tax rates are typically 15%, but they can be as low as zero or as high as 20%, depending on the seller’s income.

Inherited assets that qualify for capital gains tax treatment also can qualify for the “step up in basis” that may reduce the tax bill, sometimes dramatically. If your dad paid $10 for a stock that was worth $100 when he died, you could sell it for $105 and owe taxes only on the $5 in appreciation since his death. The $90 appreciation that occurred during his lifetime would never be taxed.

Not all assets qualify for capital gains treatment, however. Retirement accounts, including 401(k)s and IRAs, are a good example.

People usually get tax breaks when they contribute and the accounts grow tax deferred. When the money comes out, however, the withdrawals are taxed as income regardless of whether it’s the original owner getting the money or the heir. Whoever makes the withdrawal pays the taxes.

Federal income rates currently range from zero to 37%. The 37% rate applies for singles with taxable income of $523,601 or more and married couples filing jointly with taxable incomes of $628,301 or more.

Q&A: Finding your real credit score

Dear Liz: I’ve been thinking of buying a house, and I want to get a good deal on the mortgage. To do this, I’ve been working on getting my credit score high. I only have one credit card and have had it for less than two years. This credit card has gotten my FICO score to 788. I’ve never had a loan. Would you recommend getting a credit builder loan, to try to increase my score and get a better mortgage deal? Or is 788 good enough?

Answer: Mortgage lenders typically use older versions of the FICO scoring formula. The resulting scores can be quite different from the free scores you can find online, or even the FICO 8 or FICO 9 scores that your bank and credit card companies may show you.

You can get your mortgage credit scores, along with FICO scores used for auto lending and credit cards, for $19.95 per credit bureau at MyFico.com. (Be sure to click on the tab that says “one time reports,” because otherwise you’re signing up for a subscription service.) Be sure to get all three bureaus’ scores, because mortgage lenders use the middle of the three numbers to determine your interest rate. If your scores are 800, 740 and 720, for example, the lender would use 740 to determine your rate and terms.

If the middle of your three mortgage scores is 740 or higher, you should get a mortgage lender’s best deal. If it’s not, the MyFico.com report should give you some clues how to get it higher.

Q&A: Credit scores and card limits

Dear Liz: I have a 780 credit score but noted that one of my cards doesn’t count in the percent of credit used. I have had this card for 44 years and I could charge a couple hundred thousand dollars on a single purchase if I chose to, yet credit scoring formulas don’t figure in the “credit I have available” from Amex. Seems unfair?

Answer: As credit cards with six-figure limits are rare, what you’re describing is probably a charge card. Unlike credit cards, charge cards don’t have preset spending limits. They also don’t allow you to carry a balance from month to month, typically.

The “percent of credit used” you mention is called credit utilization, and it’s a large factor in credit scoring formulas. Credit utilization measures how much of your available credit you’re using, and the bigger the gap between your credit limits and your balances, the better.

But the credit utilization calculation can’t be made if one of the numbers — the credit limit — is missing. The only way the formulas would be able to calculate credit utilization in that case would be to assume that whatever amount you charged is equal to your credit limit, and that would be disastrous for your scores.

Q&A: Withdrawals from an inherited 401(k)

Dear Liz: A relative inherited a 401(k) as a listed beneficiary, and it was simply rolled over into an IRA in her name. Now another family member wants some of the money. The relative keeps trying to explain that if she pulls out any or all of the money, it will be taxed and reduce the amount available if she did want to share it. She is already retired and doesn’t need to use the money. She wants to keep it as part of her joint estate with her spouse, who could possibly use it later to pay off their mortgage. Wouldn’t she be foolish to pull the money out just because another family member thinks he should get some of it?

Answer: Your relative needs to talk to a tax professional.

Required minimum distribution rules prevent people from keeping money in retirement accounts indefinitely, and the rules recently changed regarding inherited retirement accounts. Your relative needs to understand the rules that apply to her, since failing to follow those rules can incur hefty penalties. Exactly how those rules apply depends on when she inherited the money and her relationship to the deceased.

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 eliminated the so-called stretch IRA, which allowed non-spouse beneficiaries to minimize distributions so that inherited retirement accounts could continue to grow tax deferred for decades. Now, non-spouse beneficiaries are typically required to drain the account within 10 years of the original owner’s death. These rules apply to retirement accounts inherited after Dec. 31, 2019. Even if she inherited the money earlier, she would still need to begin distributions at some point. Failing to make these required distributions incurs a tax penalty equal to 50% of the amount that should have been withdrawn but wasn’t.

Of course, just because she has to withdraw the money and pay taxes on it does not mean she has to cave to the family member. The withdrawals are hers to spend, invest, share or save as she wishes.

Q&A: What you need to do when free health insurance for unemployed people ends Sept. 30

Dear Liz: My husband lost his job and we are on COBRA continuation coverage for our health insurance. We won’t have to pay the premiums through Sept. 30, thanks to the American Rescue Plan, which passed in March. Is there anything we can take advantage of Oct. 1 if my husband is not back to work? I understand that there’s a special enrollment period right now for Affordable Care Act coverage that ends Aug. 15. My husband’s 18 months of COBRA coverage ends in December but it’s very expensive and we’d like something cheaper.

Answer: The two of you should be allowed to switch to an Affordable Care Act policy once your free COBRA coverage ends.

COBRA allows people to extend their workplace health insurance for up to 18 months after losing their job, but as you’ve noted, the costs can be high. COBRA coverage requires paying the entire premium that was once subsidized by the employer, plus an administrative fee. ACA policies, by contrast, are typically subsidized with tax credits that make the coverage more affordable.

The American Rescue Plan requires employers to pay COBRA premiums for eligible former employees for April through September. The employers will be reimbursed through a tax credit. (The subsidy may last fewer than six months if someone’s COBRA eligibility ends before September, or if they become eligible for group coverage through their job or their spouse’s job.)

When the premium-free coverage ends, your husband would be qualified for a special enrollment period that allows him to switch to an Affordable Care Act policy.

Not only that, but anyone who is unemployed at any point during 2021 will qualify for a premium-free comprehensive policy through the ACA for the rest of the year. HealthCare.gov will have details later this month.