Ask Liz Weston

Get smart with your money

Taxes

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have to pay taxes on amounts you convert, but then the money can grow tax-free inside the Roth and doesn’t have to be withdrawn again during your lifetime, since Roths don’t have required minimum distributions.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.”

Estate taxes no longer a worry for most people

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Dear Liz: My father passed away two years ago and my mother recently died as well. I will be getting about $50,000 from the sale of their house. Everyone tells me the tax on this will be very high, so I need advice about how not to give my parents’ money to the government. Their grandchildren should be able to see a legacy of their grandparents.

Answer: You need to stop listening to “everyone,” since these people clearly don’t know what they’re talking about.

You have to be pretty rich to worry about estate taxes these days. The money you inherit wouldn’t be subject to federal estate taxes unless your parents’ estates exceeded the federal exemption limit (which is currently more than $5 million per person). Some states have lower limits and a few have “inheritance taxes,” which base the tax rate on who is inheriting (spouses are typically exempt, and lineal descendants such as children pay a lower rate than others).

The vast majority of inheritors, however, won’t face any of these taxes. You should check with a tax pro, but chances are good your inheritance won’t incur a tax bill and you’ll be able to pass the entire amount along to your children without taxes as well if you wish.

401(k) loans can get really expensive

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Dear Liz: I bought my condo in 2009. I took out a loan on my 401(k) account to use for the down payment. I left my job in early 2012, and at the time didn’t have the money to pay back the loan, so the balance was treated as a distribution. I now owe the IRS $10,000 and don’t have the money to pay them, nor can I afford monthly payments beyond about $50. I can’t borrow any money from a family member or friend. My tax guy suggested (another) 401(k) loan, but I’m really reluctant to go deeper into debt. Any suggestions?

Answer: Thank you for providing a vivid example of why people should think twice before dipping into retirement funds to buy a house. Not only are you facing a steep tax bill, but the money you withdrew can’t be restored to your account, so you’re losing all the tax-deferred gains that cash could have earned over the coming decades. You can figure that every $10,000 withdrawn costs you at least $100,000 in lost future retirement funds, assuming an 8% average annual return on investment over 30 years. If you’re 40 years from retirement, the toll can be twice as large.

So it would be good, if at all possible, to leave your retirement funds alone from now on. That means you need to come up with the cash to pay what you owe, and $50 a month doesn’t cut it. To use an IRS payment plan, you’ll need to come up with about $140 a month to pay your bill off within the required 72 months.

Fortunately, there are plenty of ways to trim your spending so you can free up more money to pay this bill. These ways include, but aren’t limited to: ending your pay TV subscription, preparing meals at home instead of eating out, trading your smartphone for a dumber one or at least switching to a prepaid plan, selling or storing your car and using public transportation, or selling your condo and moving to a cheaper place.

When people have virtually no discretionary income left after paying bills, and they’re employed, the culprits are often their housing or transportation costs, or both. Reducing these can be painful but may be necessary if you want to get on more solid financial footing.

Should you borrow to pay a tax bill?

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Dear Liz: Help! We’ve just received devastating news from our accountant that we owe around $11,000 to the IRS and the state for 2012 taxes. The reason for the huge bill is that we cleaned out my husband’s IRA to pay for our son’s college expenses. My husband is almost 65 and working part time after being laid off, and I’m 61 with a full-time job. What is the best way to pay this bill? Here are the options I can think of: 1) Cash out my three-month emergency certificate of deposit of $12,000 that I’ve saved to cover expenses in case I get laid off. 2) Take money out of my IRA. 3) Use a credit card check that will be at zero percent for the first 12 months and then will slide to 8.9%. 4) Arrange a payment loan with the IRS. 5) Sell our house in which we have 70% equity. Which is best?

Answer: Let’s take No. 2 off the table, shall we? If you learn nothing else from this experience, it should be that tapping retirement funds can trigger a big (and often unnecessary) tax bill.

Selling your house over an $11,000 bill is overkill, so let’s eliminate that option as well. Which leads us to three remaining possibilities: Use cash, borrow from a credit card or borrow from the IRS.

Borrowing incurs costs. That zero percent credit offer almost certainly comes with a fee, which is usually 3% to 5% of the total. If you can’t pay the balance within a year, you start incurring interest charges.

The short-term rate the IRS charges for installment loans is pretty low — lately it’s been around 3% — but you also typically incur late-payment penalties. The penalty typically is one-half of 1% of the tax you owe each month or part of a month until the bill is paid in full. If you file by the return due date, that rate drops to one-quarter of 1% for any month in which an installment agreement is in effect. The maximum penalty is 25% of the tax due.

How much either option will cost you depends on how long you take to pay the bill. The cost for cashing out the CD is, by contrast, almost zero. Whatever tiny amount of interest you’re getting is far less than what borrowing would cost you. If you should get laid off before you rebuild your emergency fund, your access to cheap credit could come in handy.

Going forward, let your son pay for his college expenses and conserve what’s left of your resources for retirement.

Avoid tax refund ripoffs, and think twice about getting married

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Tax refundMy recent MSN Money columns, in case you missed them:

How to avoid tax-return rip-offs Beware of promises to get your refund faster. Refund anticipation loans are gone, and what’s replaced them isn’t worth the cost.

Gay marriage can muddle finances Gay and in love? You might want to wait to marry.

‘Boomerang’ kids: Moving out again Household formation is on the rise and the kids who moved into their parents’ basements are finally able to move out on their own. Here’s what they, and their parents, need to know to avoid future boomerangs.

Simple retirement can be satisfying If you haven’t saved much for retirement, all is not lost as long as you’re willing to pursue a much simpler lifestyle than what you’re probably living now. One man who lives just such a life is happy he does.