It is one of life’s conundrums: If we hate paying taxes, then why do we consistently overpay them, collectively lending Uncle Sam some $300 billion year after year—interest free?

This year, as in previous ones, about 75% of individual taxpayers will receive federal income-tax refunds, with the average refund totaling around $3,000. From a purely economic standpoint, this makes no sense.

“All a tax refund is, is the government saying to you, ‘You’ve overpaid and here’s your change,’ ” explains Charles Enis, an accounting professor at Penn State University.

The rational thing to do, he says, is to pay just enough taxes throughout the year—via withholding and quarterly estimated payments—to avoid owing a penalty at tax time, and then pay any balance due when you file your return. (The minimum required payment is typically the lesser of 90% of the current year’s tax or 100% of the preceding year’s tax.) That way, you get an interest-free loan from Uncle Sam instead of Uncle Sam getting an interest-free loan from you.

But that is not what most of us do. Why not?

One possibility is that we are indeed acting rationally because, with interest rates so low, there’s not much opportunity cost to parking some money with the government for a while; it wouldn’t have earned any interest to speak of anyway. History shows, however, that we overpay our taxes in both high interest rate environments and low ones.

Another theory is that we find it too confusing or difficult to “zero out” our tax bills by, for example, decreasing the amount we have withheld from our paychecks. But at least one study has shown that even when taxpayers believe they could adjust their withholding relatively easily, they are still hesitant to do so.

No, it turns out we may actually prefer getting tax refunds. Why? Because they pay emotional dividends.

For one thing, they free us from worry and uncertainty, according to Donna Bobek Schmitt of the University of Central Florida, who has studied the issue. It is never pleasant to have to write a check at tax time, but it is especially unpleasant if the bill is unexpected or unexpectedly large—and even more so if we don’t have the cash to pay it. So, to avoid any unpleasant surprises, we err on the side of caution and overpay throughout the year, engaging in a form of forced savings.

Apparently, we don’t trust ourselves to set aside money in advance to pay our taxes—with good reason. In a survey for Capital One Financial, only one-quarter of respondents who owe taxes this year had set aside cash specifically to cover the cost.

Then there is the rush we feel from getting a refund, an experience akin to putting on your spring jacket for the first time in a year and finding a $20 bill in the pocket. We frame it as income. A windfall. (Same goes for owing less tax than expected; we frame it as a gain.)

In fact, research by Mr. Enis shows taxpayers are so addicted to this adrenaline rush that those who discover during tax filing season that their refunds will be smaller than hoped (or their tax bills higher) are more likely to open traditional, tax-deductible IRAs or add to existing ones to goose their refunds (or lower their tax bills). Is it any wonder why most IRA contributions are made between Jan. 1 and April 15?

And what of taxpayers whose refunds end up being larger than expected? They are more likely to open savings accounts or certificates of deposit or to buy U.S. savings bonds, according to an ongoing study of low- to moderate-income taxpayers by J. Michael Collins and Nilton Porto at the University of Wisconsin.

No matter what their size, refunds clearly pay big dividends in the way of spending enjoyment. It seems we view money differently if it comes in a big chunk like a tax refund than if it is dribbled out in smaller amounts, as is the case when you decrease your withholding to give yourself more take-home pay each week.

According to Ms. Schmitt, we enjoy getting a tax refund more than having the extra money in our paychecks because we are more likely to spend the refund on a vacation or a new TV (Yay!) but more likely to use the extra money each week to pay bills (BOR-ing.).

What will you do with your tax refund this year? Email me your plans and I’ll share them, along with some suggestions, in my next column.

—
investingbasics.wsj@gmail.com

Article source: Wall Street Journal

 

Do you pay your fair share in taxes?

Even as President Barack Obama pitches the “Buffett rule” to ensure that millionaires pay at least a 30% tax rate, some commentators are decrying the fact that about half of U.S. taxpayers don’t pay any federal income tax.

But our tax system is more complex than any sound bite or simplistic headline can illustrate.

Some multimillionaires do pay a lower effective income-tax rate than some middle-income taxpayers; receiving a chunk of your income via long-term capital gains rather than a paycheck is just one reason that happens. But the top 20% of income earners paid 70% of federal taxes in 2007, according to the most recent data available from the Congressional Budget Office.

That group also pulled in 60% of total pretax income, according to the CBO.

Meanwhile, 46% of taxpayers don’t pay any federal income tax, but they often pay a hefty portion of their income to levies at the federal, state and local level.

Those include payroll taxes for Social Security and Medicare; state and local sales taxes on groceries, clothing and other purchases; and federal and state excise taxes on things such as gas, cigarettes, alcohol and airline tickets.

The payroll tax for Medicare is paid by all workers, but the Social Security tax isn’t levied on income over $110,100 (in 2012). So people with bigger six-figure salaries pay a lower portion of their income to Social Security taxes than those earning less.

Maybe you “forgot” about that one deduction. So how long should tax cheats to assume they are not going to be caught?

Yet wealthy people bear a bigger share of corporate income taxes, which are ultimately borne by individuals. “All taxes have to be paid by somebody at some point,” says Steve Wamhoff, legislative director at Citizens for Tax Justice, the liberal lobbying arm of the Institute on Taxation and Economic Policy, a research group. “The corporate tax is paid by the owners of corporate stock and business assets.”

In 2011, federal corporate income taxes ate up an estimated 7.7% of income for the top 1% of income earners, compared with a 0.4% bite for taxpayers in the lowest fifth of the income ladder, according to the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution.

But partly because taxpayers earn money in different ways, the top 1% of earners saw a smaller share of their income go to payroll taxes.

Then there are state and local taxes to add in. People in the lowest 20% of income earners paid about 17% of their income to federal, state and local taxes in 2011, versus about a 30% effective rate for the top earners, according to an estimate from the Institute on Taxation and Economic Policy. But the share of total taxes paid roughly matches the share of total income for each of the income groups.

Sales taxes can have an outsize effect on lower-income people. “After they buy basic necessities, they typically won’t have a lot of money left over to save or invest,” says Mr. Wamhoff. A wealthier family is “more likely to have a portion of their income that they can put to savings or investments that will never be subject to sales taxes.”

What about those 46% who don’t pay federal income tax?

Roberton Williams, a senior fellow at the Tax Policy Center, says 23% of U.S. taxpayers don’t make enough money to owe that tax once they take their personal exemption and standard deduction. Another 23% qualify for tax breaks that bring their bill to zero or provide a refund.

“They start off with relatively low income to begin with,” Mr. Williams says, “and therefore have low tax liability before claiming any breaks.”

Wealthier people face a tax rate as high as 35% on earnings, “but they get the biggest tax breaks,” he says. “They start off with such a high tax that the biggest tax breaks don’t bring them down to zero. They’re benefiting hugely from tax breaks—much more than the poor people—but because they start off at the high level, their tax bills stay positive.”

That said, 1,470 millionaires were among those who paid no federal income tax in 2009.

Write to Andrea Coombes at andrea.coombes@dowjones.com

—Andrea Coombes is a personal-finance editor for MarketWatch. Read more at marketwatch.com.

Article source: Wall Street Journal

 

Cash poured into mutual funds during the first week of February at the fastest pace in nearly two years, according to data from the Investment Company Institute, a trade group.

But not all fund investors are being treated equally. Two investors who buy into the same fund could end up with significantly different returns, due to a confusing array of share classes, each with a different fee structure.

As recently as 1989, the total number of share classes matched the number of funds: 2,262 in the U.S., not counting money-market funds, according to ICI data. By 2010 there were 6,928 U.S. funds available in 20,188 share classes.

“Most of these share classes weren’t designed to help investors,” says Mike Alfred, co-founder of Brightscope, which tracks retirement plans. “They were designed to pay someone else.”

For example, the Amcap Fund, offered by American Funds, is available in A and C shares for all buyers, F-1 and F-2 shares for those who go through certain advisers and a handful of separate classes for investors who buy through a 529 college-savings plan.

A spokeswoman for American Funds says the purpose of different share classes is to allow investors to choose how they pay their adviser.

Most A, B and C share classes impose sales commissions, or “loads,” based on the amount invested. Because loads pay salespeople, they are a needless expense for investors who choose their own funds or pay advisers directly, says Morningstar analyst Eric Jacobson.

One way to get financial advice without sales charges is to find a planner who is paid by a set fee based on assets rather than a commission. The Financial Planning Association has a tool for that at FPAnet.org. Fees of 1% a year are common.

Even 1% can add up. For a 25-year-old who saves 9% of his pay in a typical stock and bond portfolio, the difference between paying, say, 0.25% a year and paying 1.25% amounts to having $510,000 or $410,000 by age 65, according to a study by Vanguard Group. A cheaper choice might be a planner who charges an hourly fee.

Some firms have fund marketplaces that allow investors to choose among hundreds of funds with simplified pricing. “We seek to have one and only one class of each fund,” says Doug Hanson, who oversees the OneSource mutual-fund platform at Charles Schwab.

Some marketplaces offer investors the ability to dodge loads. For example, A shares of the Federated Capital Appreciation fund cost a maximum of 5.5% up front through some channels, but the fee is waived for Schwab customers.

Just don’t confuse “no load” with “bargain.” That same Federated fund has ongoing expenses of 1.25% of assets per year. Princeton economist Burton Malkiel recommends mutual-fund buyers pay no more than 0.5% a year for an actively managed domestic fund, whatever the share class.

For investors who want a fund that comes only in A, B and C shares, deciding which class to choose is like deciding whether to rent or buy a house. Total future costs depend on unknowns, like holding periods and yearly returns.

A-class shares usually have hefty upfront fees, often 4% to 5.75%, and lower annual ones. Many offer discounts for larger purchases.

B shares usually have no upfront fees but higher ongoing ones, and impose a charge on holders who sell in the early years (“contingent deferred sales charge”). Typically, B shares convert to A shares after several years, thus shifting to lower ongoing expenses.

Over the past decade, the Financial Industry Regulatory Authority, or Finra, has stepped up enforcement actions against brokers for big-ticket sales of B shares that would have qualified for A-share discounts. Some mutual-fund companies have phased out B shares, including Fidelity Investments, Franklin Templeton and American Funds.

C shares also have high ongoing expenses. Minimum holding periods are short and charges for early sellers are modest. But C shares rarely convert to A shares, and thus stay expensive indefinitely.

It is possible to simplify the math. Finra offers a side-by-side comparison tool at Finra.org/fundanalyzer. For example, it shows that $10,000 placed in the Invesco SP 500 Index fund, assuming it returns 5% a year for 10 years, will cost $1,269 with A shares and $1,630 with C shares.

The tool also shows that the similar Fidelity Spartan 500 Index fund, investor class, costs a good deal less: $115 under the same assumptions.

There is one last choice for people put off by share complexity: Buy individual stocks and bonds instead.

That is best left to experienced investors. But someone who can learn to analyze a contingent deferred sales charge probably has a head for telling whether Coca-Cola can keep paying its dividend.

—Jack Hough is a columnist at SmartMoney.com. Email: jack.hough@dowjones.com

Article source: Wall Street Journal

 

Throughout the lexicon of financial advice in the marketplace, there are many different views regarding the role of debt in our lives.  The traditional view is that debt causes us to make interest payments that deplete our wealth and erode our ability to build wealth.  In the case of the current mortgage crisis, many lending institutions and government agencies encouraged excessive lending to borrowers that were in very high risk of default.  This has even prompted some financial authors to proclaim that all debt is bad, regardless of what it is used to finance, and regardless of how it is structured.

It is certainly true that using debt to finance consumption purchases is fraught with danger.  (This is what people typically refer to as ‘consumer’ debt)  The problem you run into is that when consumption is financed with debt, you end up paying for something that either doesn’t exist anymore such as food & drinks or something that is currently worth less than what you paid for it.  (The overwhelming majority of consumer purchases decline in value after they are purchased)  Automobiles also fall into this category, but are frequently financed because most people do not posses enough cash to purchase them outright.  Many of these items are necessities or highly sought after luxuries.  The thing that we need to keep in mind is that these expenditures should be made with our current income … if we allow ourselves to pay interest on the purchase of something that is consumed or that depreciates in value, we will quickly be consumed.

Conversely, you can also use debt to purchase something that increases in value such as your home.  This type of transaction provides a double-benefit because the value of the dollars you use to repay your loan are eroded by inflation while the value of your home increases.  The difficulty in this strategy is that you can’t spend the increase in your home equity until you sell the house and realize the gains.  One way to get around this crunch is to use debt for purchasing rental/income investments where the income collected is used to pay the interest on the loan and you benefit from the increase in the asset value.  Generally speaking, the fundamental basis of all capitalistic wealth creation stems from the notion that you invest capital at a higher rate of return than its current use.  This process systematically directs capital toward its highest and best use … it also benefits the investor / entrepreneur by generating a rate of return on money that has been borrowed.  The important factor to consider is that debt used to finance investments is like a magnifying glass … it will amplify both good and bad results.  When debt is used prudently, it can create tremendous value.  When debt is used foolishly, it can destroy tremendous value.

A third option has generated considerable attention in recent years, and this is the notion of living with no debt at all.  The advantages are quite clear, since you will have total ownership of your assets, and will not owe interest to anybody.  This desire stems from a view on the part of many people that debt is inherently bad.  The truth is that debt is neither good nor bad, it is simply a tool.  It is a tool that can create great benefits or create great problems … the difference is all in how the debt is used. Debt that is used to finance a prudent investment or business can generate returns that exceed the cost of carrying that debt by a considerable margin.

Consider the common advice to pay extra principal each month on a mortgage.  The rate of return that you will earn by following this advice is equal to the interest rate that you pay on your mortgage.  For example, if you pay 5% interest on your mortgage loan, paying extra principal each month will generate a 5% internal rate of return for your additional principal payments.  If you consider 5% to be an exceptional rate of return, than this may represent a highly prudent decision.  If you are able to earn considerably more than 5%, it may represent systematically trapping capital in home equity when it could have been put to another more productive use.

In the end, the way that we use, view, and live with debt doesn’t have anything to do with the debt itself.  Like all tools, debt can be used for both constructive and destructive purposes.  It is our responsibility to ensure that we use debt prudently so that it generates value.  If we are going to use debt as a tool in our lives, it is critical to ensure that the things this tool is being used to purchase are of high value.  This is the best way to avoid the “bad debt” trap that ensnares millions of people each year.

 

When your banker says no, your 401(k) says yes.

New data show that employee borrowing from 401(k) plans in 2010 was way up over the previous year, in some cases in the high double digits. Jason Zweig examines the causes–and the consequences.

That is what many employees nationwide seem to think. This week, publicly traded companies have been disclosing how much their workers have borrowed from their retirement accounts—and loans from 401(k)s are way up. In a society already drunk on debt and an economy struggling to recover, people are even hocking their own retirement funds. Most of them are making a mistake.

But, crazy though it might seem, there is a case to be made for borrowing from your 401(k) account, at least in certain circumstances.

As of Dec. 31, at the retailer Target, total borrowings by employees from their 401(k)s were up 23% over the year before; at grocery chain Whole Foods Market, 34%; at the home builder PulteGroup, 51%; at Heritage Financial, a community-bank holding company in Olympia, Wash., 98%.

Altogether, according to retirement analyst Pamela Hess at Aon Hewitt, a consulting firm, 28% of participating workers had borrowed from their 401(k)s as of the end of 2010, up from 26% in 2009 and an average of around 22% earlier in the decade.

It isn’t just lower-income workers who are taking these loans. According to Aon Hewitt, 23% of employees earning between $80,000 and $100,000 have borrowed from their 401(k)s—along with 16% of those earning at least $100,000, up from 13% in 2005.

Traditionally, financial advisers have admonished workers never to borrow from a 401(k) account. That partly is because the money you invest in your 401(k) is sheltered from income tax, while you must use after-tax dollars to pay back whatever you borrow from the 401(k).

The biggest risk: If you leave your job, you must promptly pay off any 401(k) loan—usually within 60 days—or you will owe ordinary-income tax on the remaining principal amount, plus a 10% penalty.

Christophe Vorlet

While about 15% of 401(k) loan balances tend to go into default, at least 75% of the workers who leave their jobs with a 401(k) loan outstanding end up defaulting, estimates Brigitte Madrian, an economist at the John F. Kennedy School of Government at Harvard University.

One of the most dangerous temptations: There are generally no restrictions on what you can use a 401(k) loan for. Some 22% of borrowers use the money to pay for college or medical expenses, and 39% use it to consolidate or pay off higher-cost debt, according to research by Stephen Utkus, director of the Vanguard Center for Retirement Research.

But there is nothing to stop you from spending it on a binge in Cancún, a week at Canyon Ranch or a pedigreed Tibetan mastiff with a diamond-studded collar.

Still, if you have urgent legitimate spending needs or high-cost debt you want to erase, tapping your 401(k) might make sense. Although a few retirement plans charge interest rates of 10% or more on loans, the most common rate is currently just 4.25%—compared with 11% on personal bank loans and 13.4% on credit cards, according to the Federal Reserve.

Even Mr. Utkus has borrowed from his 401(k). “I’ve used it for cars, I’ve used it for housing improvements,” he says.

From your portfolio’s perspective, taking out a 401(k) loan is like adding a bond position: you are plunking down a chunk of cash in order to receive a steady stream of interest income. The difference is that the interest comes out of your paycheck, rather than from the issuer of the bond.

Borrowing from your 401(k) at 4.25% to pay down credit-card debt at 13.4% gives you a return of more than 9%, points out Ms. Hess of Aon Hewitt, even if stocks or bonds go down in value. That return is virtually risk-free, unless you leave your job before you have paid off the loan.

Say you borrow $10,000 from your 401(k) at 4.25% for a one-year loan to pay down a credit-card balance carrying an interest rate of 13.4%. If you had left the money intact in your 401(k), you might have earned a 5% return on a 50/50 mix of stock and bond funds, giving you $10,500 after a year. With the loan, your interest payments go back into your 401(k), so when it matures in a year you will have returned $10,425 to yourself.

In exchange, you have not only eliminated $1,340 in credit-card interest charges, but prevented them from continuing to mushroom. Here, taxes don’t matter, since paying off either loan requires after-tax dollars.

If this is making sense to you, please remember: Debt is always risky. And this debt carries the extra risk that you could have to pay it off at the very time when you aren’t earning a salary. If you leave or lose your job you must have a feasible means of immediately paying off the loan.

“Take only the minimum you need, not the maximum you can get,” says Ms. Hess. Your loan should fund an asset of enduring value, advises Prof. Madrian: “If you have to leave your job, you can’t sell the vacation to pay off your loan.” Don’t take a loan of last resort to splurge at a resort.

Article source: Wall Street Journal

 

When planning for retirement, many Americans think about their pay the way they used to think about the value of real estate or stocks: that it will always go up.

Tim Foley

From SmartMoney

Use our new Retirement Planner to challenge your own assumptions.

They are mistaken. It turns out that the average person’s pay plateaus in his 40s, according to the latest data from the U.S. Census Bureau. Many people also assume they will be gainfully employed until the day they turn 65, or 62, or whichever age they plan to retire—but if they lose a job in their 50s, finding another at the same salary is difficult.

Americans are an optimistic lot—but when it comes to important financial goals such as retirement, caution is warranted. During the past few years, people who put all their money into stocks hoping for big gains or assumed their houses were piggy banks paid a steep price for their exuberance. Wages should be treated with similar skepticism: What is here today could be gone tomorrow.

If you are among those who have been assuming too rosy a future, you need to rethink virtually every aspect of your retirement plan, from the amount you can sock away each month and your investment allocations to the year you can realistically expect to retire and even the amount of Social Security you are likely to receive. What would happen if you suffered a 30% pay cut or found yourself out of work at, say, 60—five years earlier than you expected? Would you be prepared?

“You have to be wary of building in lofty expectations,” says Paul Palazzo, managing director of New York-based Altfest Personal Wealth Management. He urges clients to assume the only salary increases they will win are cost-of-living adjustments.

The numbers bear him out. Data from 2009, the most recent available from the Current Population Survey, a joint effort between the Bureau of Labor Statistics and the Census Bureau, show that income grows at a steady rate for people in their 20s and 30s. No surprise there. But once people hit midlife, the good times are over. The 40s are the peak earning years for most, when the median income for men working full-time hovers between $52,000 in their early 40s and about $54,000 in their late 40s. After that, median income barely budges—it’s still $54,000 for men aged 50 to 54. In other words, there is a 15-year plateau.

“Cost-of-living adjustments are about all they can count on after they enter their 40s, and a lot of people aren’t even getting those,” says Cheryl Russell, a demographer and editorial director for New Strategist Publications, a demographic data and analysis firm. Indeed, according to government statistics, the median earnings of men who work full-time fall 10% as they move from their peak earning years toward their retirement years. “So even if you continue to work long after you’re eligible for Social Security, you can’t count on a rise in your earnings,” Ms. Russell says.

It is tempting to think this is mainly a problem for lower-wage workers, but it also is a fact of life for higher-income managers and other professionals, say financial planners.

“The stagnation in salaries has hit all varieties of workers, from executives to middle managers,” says Brandon Ross, senior vice president at Dallas-based Peak Capital Investment Services. “That makes retirement planning more difficult.”

For example, the young manager who reaches $150,000 a year by age 45 might think his pay will keep zooming—and set his retirement strategy accordingly. But it’s likely only to keep pace with inflation thereafter.

What’s more, if he loses his job while in his 50s, it will be increasingly difficult to find another. The unemployment rate for persons 55 and older increased sharply since the beginning of the recession in December 2007, and reached record-high levels in 2009, Bureau of Labor Statistics data show. And once jobless, older workers remain unemployed longer, according to BLS data.

It’s especially difficult to find a high-paying job these days. According to a February analysis by the National Employment Law Project, a New York-based advocacy organization, only 14% of the job gains in the 12 months since the recession’s end were in higher-wage industries, compared with 49% for lower-wage industries.

The simplest way to prepare for lower pay later in life is to save more, spend less or both right now. If you behave as though your income has dropped by 20%, you can set aside the rest for retirement.

‘I Never Expected This’

Vern Pope, an engineer, always assumed he was on the path to a comfortable retirement. Two years ago, the computer-manufacturing company in Rapid City, S.D., where he had worked for 30 years closed down. Unable to find a job for a year, Mr. Pope, 55 years old, settled on a position last year that pays 25% less and forces him to live away from his wife during the week.

“I always thought that my salary would continue to rise,” Mr. Pope says. “I never expected this.”

Such tales are common. According to a May survey of older workers by AARP, 36% have stopped or cut back on their saving since the recession began, while 25% have exhausted their retirement savings.

Several factors are driving the trend toward older people earning and working less, from the sour economy to downsizing and the fact that employers have been moved to more “performance-based” pay, which often translates into smaller pay increases, as well as pay freezes.

While the financial crisis and recession have exacerbated the trend, it isn’t new. IRS filings for pension plans show that a decade ago, large employers assumed steep drops in the rate of salary growth as employees aged. Boeing Co., Hershey Co., Sears Holdings Corp. and Xerox Corp., for example, assumed salaries for a 25-year-old would increase by 7% to 13% a year, but that the rate of increase would fall steadily thereafter, generally reaching the 3% range by age 50. With inflation, this means that salaries remain flat in one’s final decade or two on the job.

Greg Scott, a senior executive at telecommunications giant Verizon Inc. with 30 years at the company, saw his salary plateau in his early 50s. In 2007, when his pension was frozen, he opted for a buyout, figuring it was certain compensation in an uncertain economy. Now working as a senior vice president of marketing at a credit union, Mr. Scott, 57, who lives in Grapevine, Texas, is making roughly half of what he earned in his old job.

“The things that were certain before the recession are just not certain anymore,” Mr. Scott says.

‘Flawed Notion’

Popular retirement-planning software often reinforces people’s lofty expectations. A 2009 study by the Pension Policy Center, a Washington-based nonprofit, examined 12 popular Web-based retirement-planning tools, including those offered by Fidelity Investments, AARP and MetLife Inc., and found that “none of them assume wages might decline,” says John Turner, who heads the nonprofit. “That is a flawed notion.”

One of Fidelity’s calculators, for example, assumes that salary will rise by 3.8% a year until retirement but that inflation will be only 2.3% a year. It is modeled on data from the 1980s to the 2000s, says Chris McDermott, Fidelity’s senior vice president for retirement and financial planning.

The tools do allow investors to tinker with the assumptions manually, Mr. McDermott says, but pay growth can’t turn negative. “It’s a default assumption,” Mr. McDermott says. “We want people to be able to play around on their own. It’s about engaging them in the conversation.”

A surprise pay cut later in life also can lead to lower Social Security benefits. If someone who turned 66 in January 2011 had earned the maximum amount covered by Social Security since 1975 ($14,000, rising to $106,800 today), he would get the maximum benefit, about $28,400 a year. If his earnings in the final 10 years fell to $50,000, the person would receive $26,300. And if he made the maximum amount for 30 years, then lost his job and didn’t work the final five years, the benefit would be $26,240.

These drops may not seem drastic, but when combined with lower savings rates they can squeeze retirement spending more than many people expect, says Jean Fullerton, a financial adviser in Bedford, N.H., who ran these calculations.

For people who earned a decent wage during their early working years, Social Security might not be affected much by a late-career pay swoon. That is because the benefit is based on one’s 35 highest-earning years, inflation adjusted. So the $14,100 earned in 1975 counts as $58,238 in today’s dollars credited toward your benefit, says Ms. Fullerton—which means that recent years at little or no earnings could be filled in with earnings from your 20s.

On the other hand, people who worked their way through college or graduate school before landing their first professional job, toiled for years at low wages before striking it big in their 30s and 40s, worked overseas for long periods for non-U.S. employers or dropped out of the work force to raise families won’t gain as much from those early working efforts.

How to Plan for Lower Pay

For many people, their current retirement-savings strategy is merely a best-case scenario. You should also identify a worst-case scenario—such as a 20% pay cut during your final 10 years in the work force. Then, you could try to live on that lower income and put the rest into savings. If your disaster scenario plays out, you will be prepared—and if it doesn’t, you will be sitting on a bigger pot of gold come retirement time.

Of course, this approach might require you to forgo such dreams as footing your kids’ college bills. One alternative: Tell your kids to take out student loans, and promise to pay them off if you are able to make it to retirement unscathed.

Another way to build savings as long as possible is to delay retiring, even if it means working for lower pay. The longer you remain in the work force, the longer your savings will last and the higher your Social Security payments will be. Someone receiving $1,700 a month at age 62 might receive $2,400 a month at 66. If he delayed taking Social Security until age 70, he would receive delayed retirement credits that would boost the monthly payments to $3,200 a month.

This year, the Social Security Administration stopped issuing annual statements of estimated earnings, but it provides an online tool at www.ssa.gov/estimator that lets you see the benefit you have earned thus far and plug in estimated retirement ages and various scenarios for your future earnings, whether greater or lower.

When you turn 50 or so, you should assess your employability. If you anticipate difficulty keeping a job in your industry, you might even consider getting into a second profession. “Changing careers, almost anyone would take a financial hit, so they either need savings or a working spouse to make the transition,” Ms. Fullerton says.

Ms. Fullerton took that calculated risk at age 50. She had a comfortable job as a software engineer at Digital Equipment Corp., but worried that it couldn’t last. “The workload was doubling as the company cut back, and more jobs were being outsourced to India,” she says. So while working, she took courses at night and became a financial adviser. She now is financially as well-off as she was before, and has greater job security.

For the same reason, you should delay taking a monthly pension until your company’s full retirement age, advisers say. And when you do begin taking it, make sure your employer isn’t shortchanging you.

Many large companies estimate what you will receive in Social Security benefits and subtract half that amount from your pension. But they may overestimate what you will receive from Social Security, reducing your pension too much. That is because they assume their current and former employees work 35 years and that their pay grows at a certain rate. You have the right to have your employer calculate your pension using your actual earnings history.

Such strategies might seem like a radical departure from the classic “save 10% of your income” strategy financial advisers used to push. Then again, “all the maxims of retirement have totally changed,” says Mr. Scott. “You can’t play by the same old rules.”

By ELLEN E. SCHULTZ And JESSICA SILVER-GREENBERG

Article source: Wall Street Journal

 

The outlook for summer jobs for young people remains cloudy. Although the unemployment rate of 17.3% for workers ages 16 to 24 was down slightly in May compared with the 18% rate of a year ago, it was still far higher than the pre-recession level of 9.9% in May 2007, according to the Department of Labor.

The good news, for those who can find—or invent—jobs for themselves this summer, is that Uncle Sam’s tax rules may offer opportunities for savings.

The most favored young workers are children under 18 who are hired by parents to work for sole proprietorships or husband-and-wife partnerships. Both the children and the parents can skip Social Security or Medicare tax on the child’s pay, which this year comes to 13.3%. There is no limit on this exemption, and the workers also aren’t liable for federal unemployment tax.

What’s more, the business owner can take a deduction for the child’s pay, and the teen usually won’t owe taxes on income up to the standard deduction, which is $5,800 for individuals this year. Total tax-free income swells to $10,800 if the child puts the next $5,000 of pay into a tax-deductible individual retirement account, says Don Williamson, a tax expert with American University’s Kogod Tax Center in Washington. Mr. Williamson has helped several families take advantage of this boon.

There are ground rules, of course. Compensation has to be fair enough to escape an Internal Revenue Service agent’s scrutiny, so be prepared to provide examples of comparable pay. But if Junior has whiz-bang skills in Web design or programming, he or she can be paid at the going rate or a bit more.

Summer workers who are older or who can’t work for a family business may reap other tax benefits. But there are traps for the unwary. Here are tips from tax experts:

• Know your status. Young workers often don’t know whether they are employees or independent contractors, says Robert Gard, an Atlanta-area CPA with Gard LaFreniere LLC. There’s a big difference: Unlike employees, contractors don’t have income or payroll taxes withheld, so they (or their parents) may have an unpleasant surprise when a 1099 form arrives and taxes are due the following spring. While income taxes don’t usually kick in until $5,800, the payroll-tax threshold is $400.

Mr. Gard and others also suggest independent contractors track deductible expenses such as mileage or uniforms while working, because they can be hard to reconstruct later.

• Pay attention to the W-4 form. If the worker is an employee whose total earnings for the year won’t incur income taxes, he or she should file a W-4 form claiming exemption for withholding. That avoids having to file a return to reclaim tax payments the following year. Appropriate payroll taxes will still be withheld.

• Take advantage of IRA options. Workers may contribute earned income up to $5,000 to traditional or Roth IRAs, which offer tax-free growth. Contributions to a traditional IRA are tax-deductible but withdrawals are taxable, whereas Roth contributions aren’t deductible but withdrawals are often tax-free. Given that young workers usually have low tax rates, a Roth IRA is often the better long-term deal.

Experts say funding an IRA can be a terrific gift by a loved one to a young worker. “It provides tax shelter and teaches something about savings as well,” says Joe Kristan of Roth Co. in Des Moines, Iowa. Deborah Fox, of Fox College Funding in San Diego, says that for financial-aid purposes, a gift used by a young worker to fund an IRA is considered student income in the year it is given. After that, IRA assets are off-limits.

• Keep “kiddie tax” effects in mind. “Unearned” income such as interest, dividends or capital gains greater than $1,900 received by children is often taxed at the parents’ rate, and this can continue up to age 24 if the child is a full-time student. But this provision doesn’t apply if the child is between 18 and 24 and has earnings that are more than half of his or her support.

In addition, a child liable for this tax who also earns income must file a separate tax return. If the child has no earnings from work, the parents often have the option of claiming the income on their own returns.

Experts say it often is better to file a separate return for the child anyway, because that avoids raising the parents’ adjusted gross income, which can clip other benefits.

• Know the rules on paying children for work at home. What if Junior can’t find a summer job but you want to pay him or her to paint the house or do other work? According to IRS spokesman Eric Smith, there is a break here for children under 21: No federal payroll taxes or unemployment taxes are due on the payments.

Here the parent can’t take a deduction for the pay, as would be possible if the child were working in the parent’s trade or business, but the child could skip income tax at least up to the standard deduction and would be eligible for an IRA. For more information, especially about required record keeping, consult a tax professional or see IRS Publication 15.

By LAURA SAUNDERS

Article source: Wall Street Journal

 

With recent news overwhelmed by the financial difficulties of US state and national budget deficits, along with the continued financial difficulties in Greece, Spain, Portugal, and Italy there is a renewed focus on the impact of debt on national wellbeing.  This is especially important because most of the developed world is not far behind the major problems of these European nations.  The most important thing to understand about debt is exactly what it is, and by extension, what it is not.

Fundamentally, debt is a financial magnifying glass.  It will amplify whatever your current financial situation happens to be by the extent of your leverage.  For profitable endeavors, debt makes them more profitable by allowing the investor to expand the reach of his capital.  For example, if you can borrow $1,000,000 at 5% and earn an 8% return you would create $80,000 in returns while incurring $50,000 in expenses.  The $30,000 net profit would belong to you as the investor.  (So what’s the problem?)

But what happens if your forecasts are inaccurate?  If the same $1,000,000 that you borrowed at 5% only produces an income of 2%, you now have $20,000 of income and $50,000 of expenses.  This leaves you with $30,000 in losses.  Now let’s assume that you don’t have $30,000 available to pay for upholding your contract?  Who is going to come up with the difference?  (OK, now we see the problem)

If your name is AIG (and by extension Goldman Sachs, who was the #2 holder of AIG contracts) then the answer is simple . . . the taxpayer will pay for the debt.  However, the taxpayer does not have any money, since the government is running massive deficits.  Again, the answer is simple . . . create the money out of thin air.  In political circles, this is referred to as “quantitative easing’.

This begs the natural question of why anybody would be stupid enough to lend out to a borrower who cannot pay their bills.  The only way such an idiotic thing could happen is if a string of politicians create web of foolish laws that effectively forced the market into these bad decisions.  Only the most hardened of partisans could avoid the conclusion that rational people do not make loans of this nature unless the government steps in to assume all of the risk.  (The terms Fannie Mae and Freddie Mac should be coming to mind)

Getting back to the notion of creating pretend money, whenever the Federal Reserve ‘eases’ the money supply, it pushes more currency into circulation and devalues the currency already in the economy.  Thus, by a feat of financial magic a government that is so incompetent it cannot even pay its own bills can mystically satisfy its debts by reducing the purchasing power of every dollar in circulation throughout the economy.  This feat of financial magic is known in economic circles as ‘inflation’.

Now we come back to debt.  People who have borrowed prudently will find that inflation actually makes them wealthy by increasing the nominal value of what they own while the nominal value of what they owe to the bank remains fixed.  This phenomenon is especially powerful if the asset produces income from rents or dividends.  The most frequent example of this principal is rental property.  It is typically financed with fixed rate debt and produces rents for its owner.  As inflation rolls through the economy, its value grows, its rents grow, but the mortgage payment remains fixed.

Ultimately, what we see is that debt in and of itself is not inherently good or bad.  It is simply a magnifying glass that intensifies the current situation.  When used prudently and intelligently, it can amplify investment returns and protect investors from inflation.  When used foolishly, it can plunge a person into inescapable debt and perpetual servitude to interest payments.  When used by governments it is an implement of massive financial destruction that lays waste to entire generations for the simple purpose of satisfying the egotistical caprices of those in power who wish to be re-elected by spending public resources.

Debt has uncovered the great hubris of people, business, and government as each assumed that their ability to pay would perpetually expand.  This induced them to spend in excess of what they produced under the assumption that there would be a better future that allows them to make good on their obligations.  For some, this fictitious salvation has seemed to be achieved in the form of a ‘bailout’.  However, there is a finite limit to how many bailouts can be undertaken.  When the ability of government(s) to subsidize irresponsibility reaches its ultimate limit, the harsh side of reality will come to bear.  This reality is that many people and countries across the globe have been spending in excess of what they produce for many years.  Some have attempted to save themselves by asking their ‘rich uncle’ (frequently named Sam) to rescue them from their own idiocy.  The fundamental problem with this fantasy is that the rich uncle cannot rescue everybody.

For those of us who wish to enjoy a life of personal, professional, and financial success it should be obvious that nobody will deliver it except for ourselves.  The government can make all the promises in the world, but none of those promises can be kept without resources.  (Incidentally, attempting to defy the laws of economics by granting entitlements in the midst of deficits is akin to creating a law that declares gravity illegal.  Regardless of what a self-obsessed plutocrat writes down on a piece of paper, reality cannot be legislated away.)  The great promise of government has been little more than a great lie to lure unsuspecting fools into sheepish support of self-important politicians.

The only future that awaits is the one we create for ourselves.  The world is splitting into those who create their future and those who depend on somebody else for their well being.  The lot of those in the dependent class cannot go anywhere but down.  The prospects of those who create their own prosperity are fueled by historic opportunities that unfold on a daily basis.  The only question that lies before each of us is which path we will take.  One is easy and one requires disciplined work.  One will create economic bondage while the other creates financial freedom.  The choice is ultimately up to you.  Which path will you take?

 

Recent news of growth in the Gross Domestic product, and the appearance of home price stabilization have led many to proclaim that the economy has entered into the greatly desired ‘recovery’ that many in the government and news media are fancifully searching for.  This appraisal of the current economic situation is based on past experience with brief and shallow recessions that were immediately followed by a sharp recovery and expansion.  However, there is a fundamental difference between those events and the current situation.

The fundamentals of a market economy are based on the aggregation of many people making independent decisions.  For example, the housing market relies heavily on people buying and selling homes for liquidity . . . but this buying and selling can only take place if there are people that can legitimately afford to pay their mortgage.  The unique aspect of this recession is that it was precipitated by a massive influx of people purchasing homes who could NOT legitimately afford to pay for them.  Thus, there is a tremendous inventory of homes for sale, and a desperate shortage of people who can afford to pay for their mortgage.  Because of this, it is not reasonable to assume that any real housing recovery will occur until there is an increase in the number of people who can afford to pay their mortgage.

Similarly, there can be no real economic recovery until there is an increase in the amount of people who can afford to pay for their lifestyle.  Put another way, more people must produce enough to pay for what they consume.  Currently, a large amount of spending is being financed with private borrowing, government borrowing, or government subsidy.  None of these represents anything remotely approaching an improvement in market fundamentals.  It is simply borrowing from future production to try and create the appearance of recovery.

In the end, there will be no easy way out of this recession.  Most recessions occur because of a misalignment in market prices that cause a disruption in output.  The current situation was caused by a misalignment in basic economic fundamentals.  Furthermore, the government is actively working to prevent these fundamental from realigning, because of the short-term fallout from economic adjustment.

No Shortcut Home

It has already been established that the root cause of our current economic situation is a misalignment of market fundamentals and a shortage of people who produce enough to pay for what they consume.  In order to improve these fundamentals, three things must happen:

1. Market prices for assets such as real estate must be allowed to fall sufficient low so that they attract investors.
2. The top producers must be incentivized to create more opportunities by removing regulatory barriers and lowering taxes.
3. People whose productive capacity is sitting idle must be incentivized to go out and produce by finding employment.

The unfortunate truth is that current government policy is oriented in the exact opposite direction of the things that must happen for a fundamental recovery.  By expanding entitlements and perpetually extending unemployment benefits, the government is creating a culture of dependence by conditioning a permanent ‘underclass’ of the population who relies on subsidies for their existence.

It is certainly true that initiating a market recovery would be painful.  It will involve many people experiencing uncertainty about their financial situation and settling for much lower compensation than they have become accustomed to receiving.  It will also result in a sharp reduction in the standard of living for the people who have been living beyond their ability to produce.

However, in the long-run it will return the nation to a sustainable growth trajectory that is built on market fundamentals, instead of government subsidy and borrowing.  If this culture of debt and dependence continues, it will eventually result in massive inflation as the government turns to printing money as a last resort for financing its entitlement promises.  If this occurs, it will have the effect of permanently impoverishing the dependent class by slashing the real value of their entitlement payments and leaving them without any of the market skills that are necessary to create real output or build real wealth.

For people who are looking to escape this trap, it is critical to avoid the culture of dependence, develop the skills necessary create real value in a global marketplace, and invest in opportunities that create real wealth and place them in control of real assets.  This is what will separate the productive wealth owners from the dependent consumption class.

 

A survey of millionaires conducted by Thomas J. Stanley and William D. Danko for their book “The Millionaire Next Door” found that taxes are their single highest expense item.  Because of this, tax reduction is one of the highest impact items that can increase your net personal income.  It is also worth mentioning that taxes work differently for employees and business owners.

As an employee, you must pay taxes on my wages before you can spend them for the necessities and luxuries of life.  There are limited deductions and credits available to employees, and these tend to be a political football that is pushed back & forth depending on who happens to be in power during the current session of congress.  This is the category that the overwhelming majority of people fit into.

Another thing to consider is that the US Tax code is based on progressive tax bracketing.  What this means is that the tax rate you pay on each additional dollar of earned income goes up as your income increases into higher ‘tax brackets.’  Thus, as you work harder to earn more money you get to keep less of it because of taxes.  In addition to this, there is a separate tax schedule for gains that are realized on the sale of capital assets such as stocks or real estate.  This rate schedule generally tends to be equal or lower than ordinary income taxes for earned income, and you don’t need to pay the taxes until you sell the asset.  (Meaning that you get to control when the tax man gets paid)

As a business owner, the legitimate expenses of running your business are deducted from the revenue realized by your business before any taxes are paid.  If your business produces a loss, you can use that loss to reduce taxes on any wage income.  (Subject to certain limitations)  Business expenses are a much more expansive category than deductions and credits, thus giving business owners much more influence over their tax situation.  In addition to this, business owners are able to deduct many ‘fun’ activities from their income, so long as those activities are pursued for the purpose of conducting business.

What all of this means is that the most advantageous tax situations are (legally) attained by minimizing the amount of earned income you pay taxes on by taking advantage of deductions & credits and maximizing business deductions (if applicable).  The impact of this is compounded if the result of this earned income minimization places you into a lower tax bracket.  Furthermore, it is also important to shift as much of your earning activity as reasonably possible from earned income to investment income.  This carries the benefit of a lower tax rate, and gives you control over when the taxes are paid.