Mail Pouch

April 12, 2013
Let's play "Guess What's In My Pouch", a game popular with kids in each hemisphere

Let’s play “Guess What’s In My Pouch”, a game popular with kids in each hemisphere

We’d call it a mailbag, but it features only one question. Here it is, barely edited:

Believe it or not, this is a real question (unlike what you find twice a week in The Simple Dollar’s mailbags), and one I haven’t been able to find an answer to thus far.

The situation: my wife and I are pushing right up against it.  In 2012, we were below it. In 2013….I have no idea where we’ll end up, but it’ll be right near the limit.

So here’s my question: if I don’t know if I’ll be above or below the income limit, can I/do I contribute to the Roth IRA? Why isn’t this clearer, by, for example, setting your ability to contribute THIS year to LAST year’s MAGI? (Duh — stupid government making things far too complex.) What happens if I contribute the max to our Roth IRAs this year but we end up OVER the limit? Do we have to pull our money out of the Roth IRAs?

Thanks

Chad, Chicago

Even though Chad’s a lawyer, we’re answering his question during one of our non-billable hours. MAGI is Modified Adjusted Gross Income, which to our horror we discovered that we’ve never defined on this site. By the way, if you think the term is redundant because “modified” and “adjusted” are synonyms or close enough, then you’ve never worked for the IRS. MAGI refers to the amount of income that serves as the baseline from which you’re allowed to make IRA contributions that you’re allowed to deduct from your taxes. MAGI derives from Adjusted Gross Income, which itself is a prolix way of saying “taxable income.” AGI is income (from taxable sources) minus the amounts that IRS agents have deigned to let you deduct. You want your AGI to be as low as possible, relative to your true income. MAGI adds some items back in, including any income you made in another country, student loans you took out, and for Chad’s purposes, contributions to his IRA.

Assuming Chad is under 50, he could contribute up to $5000 to his IRA for 2012, and $5500 for 2013. The income limit he’s referring to is $178,000 for him and his wife for 2013. Up to that point, he can contribute the maximum of $5000. Beyond $188,000 (not a typo), he can’t contribute anything. Between $178,000 and $188,000 is where it gets tricky.

Here goes, and we’ll try our best to turn the IRS’s impenetrable jargon into English. However much Chad & wife’s MAGI is over $178,000 (up to $188,000), he divides it by $15,000, and then subtracts that from 1, which gives a number between ⅓ and 1. Then, take that number and multiply it by the maximum contribution limit – again, $5500 for 2013. That’s the amount that Chad is permitted to contribute, reduced because of his inability to make a particular amount of money that doesn’t fall within the prescribed limits.

So what do to if Chad’s 2013 income, a work in progress, exceeds the limit? The way around it is to open another IRA, a traditional one, with the same company that manages his Roth IRA. At the end of the year, should he have contributed “too much” money to the Roth IRA, Chad can move the excess to the traditional one. No fuss, no muss. Of course, this is assuming that (sigh) neither he nor his wife qualifies for a 401(k) (or a 403[b], or something similar) at work.

(God, no wonder most personal finance bloggers write about how to build emergency funds and sell their DVDs on eBay. It’s way easier than this.)

Upon further review, sure enough Chad and his wife both qualify for 401(k)s. If they didn’t have 401(k)s, they still qualify for them, and that’s as bad as being there. So Chad plans to wait until December, at which point he’ll put a trivial amount – $100 or so – into both his and his wife’s Roth IRAs. By then he’ll obviously have a better idea of what his 2013 modified adjusted gross income will be. He’ll have until the following Tax Day to make contributions to his Roth IRA, contributions that will be considered as being made in or for 2013. He’ll be able to max out his Roth IRAs as much as possible, regardless of what his and his wife’s MAGI are.

There’s one more way around this. Chad and wife can still contribute to their 401(k)s of course, without worrying about the Roth IRAs. Beyond that, if they want to shelter even more of their money, they can read Chapter VIII of The Greatest Personal Finance Book Ever Written and create an S corporation or a limited liability company. Doing so is more than just shuffling paper – the business would have to be generate some form of income. But that doesn’t mean Chad would have to operate a hot dog cart on nights and weekends: said income can derive from investments. Then, he can shelter that income in a separate IRA, or a defined benefit plan. This is more complex than Chinese differential calculus, but the more money you make, the more you want to keep it from the taxman (and the harder Congress makes it for you to do so.)

Remember, the biggest difference between an IRA and a 401(k) is that the limits for the former are set by the IRS, those for the latter by your employer. We here at CYC prefer IRAs only because we hate having regular jobs.

Send your questions, masochistic or otherwise, to info @ ControlYourCash.com.

Filed Under: Investments, Taxes Tagged With: , , ,

H&R Block? What The Hell For?

February 8, 2013
They say this as if proud of it.

They say this as if proud of it.

 

 

Meet Ana Maria Costanza, part of H&R Block’s attempt to show that tax preparers can be beautiful at any size. And with any face.

 

 

Ana Maria claims to have read all 900 pages of the ObamaCare Act, the single defining law that forever modifies the relationship between government and citizen to one of lord and serf. But without getting into the costs of a law that won’t do a thing to improve the average American’s health*, what about the law’s impact on your taxes, anyway? Ana Maria spent weeks figuring out the answer. Can we do it in a couple of hours?

Looking exclusively at the tax implications of the law, you’ll pay a 40% penalty for having an expensive health insurance plan. (The $4800 annual plan your non-smoking, teetotaling, drug-free, childless and physically fit blogger with no chronic illnesses nor birth defects has doesn’t count as “expensive” for these purposes, but enough digression.) Your individual medical expenses deduction might change. You won’t be allowed to contribute as much to your flexible spending account. Your 26-year-old child can still count as a dependent, which means Kevin Durant’s parents can keep him on their plan. And lots more.

So Ana Maria read the whole thing cover-to-cover. We’re impressed. What we’re not impressed with is the idea that she can do your taxes better than you can. Why? TurboTax, that’s why.

H&R Block management might be surprised by this, but the people at Intuit (makers of TurboTax) incorporate every year’s tax code changes into their software. So do their competitors, including TaxSlayer, TaxAct, etc.

NOTE: This is not a paid post, although it should be. We just hate the idea of you throwing your money away to use an obsolete in-person service that should have been rendered defunct by now.

But I like seeing the person who’s doing my taxes face-to-face.

Do you like the sound the needle makes when it hits the record, too? How about the unmitigated thrill of paying your bills with a checkbook, an envelope, a stamp and a trip to the mailbox? Hey, you know what else is awesome? Paying by the minute every time you want to communicate with someone who lives in a different country.

Formal tax preparers like H&R Block, Jackson Hewitt etc. had a nice long run, but it’s over. Put them on the rural landfill next to bookstores, music stores, and travel agencies. TurboTax isn’t just more efficient than a seasonally employed human preparer, it’s cheaper. The Deluxe version costs $30. You’ll pay an additional $37 if you’re one of the 82% of Americans who live in a state that levies its own income tax, plus you’ll have the pleasure of paying said income tax itself.

If your return is simple enough that you need a cheaper version of TurboTax than the Deluxe, you don’t need a cheaper version than the Deluxe. In that case you can calculate your taxes yourself, probably in less time than it’d take you to order the appropriate stripped-down version of TurboTax.

So is TurboTax for everyone? Not at all. In fact, hopefully it isn’t for you. How can we contradict ourselves within the space of one blog post and still have any credibility? Read on.

If you’ve taken the lessons in The Greatest Personal Finance Book Ever Written (Len Penzo’s words, not ours) to heart, you know that you’re never going to build wealth if you restrict yourself to the money that derives from a W-2. You need to start embracing those other sources of income:

  • from any limited liability company that you set up, funneled your personal income through and thus likely qualified for lower taxes on.
  • from any S-corporation you set up, same thing.
  • K-1s. Do you have a partnership requiring distributions to be handled on yet another form? If not, why not? Otherwise you’re stuck in your pathetic little tax bracket, at the whim of legislators who design the tax code specifically to keep you in its clutches. God, you really need to read our book. Especially Chapter 9, the one on taxes. Here’s the link again.
  • foreign income. Did you know you can get paid by people in other countries, too? Most people don’t, which is a contributing factor to why they’re still less rich than they could be. But yeah, keep contributing to that emergency fund.
  • trusts, private placement income, etc.

If you’ve got at least one of these, Ana Maria or her local equivalent will stare at you, stare at your documentation, cock her head at a 30º angle, open her mouth a little, and call for a supervisor who will then do the same things in the same order.

So if you’re deriving any kind of passive income, find a professional: a Certified Public Accountant who can find the complex deductions and credits that few mall tax preparers know the first thing about. You’ll pay considerably less, too.

Wait. A CPA charges less than an H&R Block preparer?

No, of course not. That’s absurd. They can charge 10 times as much, and should. And do. But that’s still just a fraction of what you’ll save in taxes.

From a taxpayer’s standpoint (that’s you), you either want to be safe on shore with TurboTax, or out past the breakers with a CPA who sends you Christmas cards and itemized bills. It’s in the middle, dealing with a preparer who barely knows more about taxes than a lay person does, where you get clobbered.

*But it will:

  • Regulate insurers’ business models, forbidding them from taking more than 15% of revenue as profit.
  • Phase out annual spending caps by next year.
  • Prohibit you from using a Health Savings Account to buy any over-the-counter drug other than insulin.
  • Designate domestic violence counseling as a medical treatment, for some reason.
  • Set caps on premia, the inevitable result of which will be the federal government becoming the default health insurance provider.
Filed Under: Taxes Tagged With: , , , , , ,

Ordinary Income. Extraordinary taxes.

November 28, 2012

 

Manna wasn’t legal tender, but that doesn’t mean the IRS wouldn’t have tallied it.

 

A couple of days ago we pointed out how money doesn’t care where it came from. Some people think that their regular salaries should go towards daily expenses, while windfalls (inheritances, stock appreciation, house appreciation, etc.) can go towards less vital stuff like vacations and ATVs.

That’s an idiotic perception. If you have an asset to buy, defining “asset” as we do here at CYC (something that’ll build wealth), buy it. With your paycheck, or with a handout from Grandma. Or even a loan from Grandma, depending on what interest she charges. Otherwise, it shouldn’t matter. Regardless of its origins, money goes where it goes.

Well, that’s not entirely true. The only entity that cares how you came by your money is the Internal Revenue Service. Receive money one way, it’s taxed at a certain rate. Receive it another way, it’s taxed at a higher rate. Seeing as the IRS has the power of deadly force*, soon for the crime of not doing your duty for the Motherland and buying health insurance, it makes sense for us peons to accede to the agency’s capricious demands.

As far as the IRS is concerned, there are 2 ways you can receive income:

  1. ordinary income and short-term capital gains
  2. long-term capital gains.

This is simplified, obviously. A full accounting of every exception would take us years to write about.

Ordinary income? That’s:

  • Wages, salaries, tips, commissions, bonuses
  • Interest, dividends, and net income from a business that you own a piece of
  • Gambling winnings
  • Royalties
  • Rents
  • Pensions, assuming you’re one of the few people who collects one.

Meanwhile, capital gains are:

  • Money from the sale of a “capital asset”, like shares of a publicly traded company, or a house that you sold. Unless you’re a land developer and the house is your stock in trade, that kind of thing. The difference between short- and long-term capital gains is arbitrary but defined: hold on to an asset for a year before selling, that’s long-term.

We’ll spare you the numbers, but regardless of what tax bracket you’re in, long-term capital gains are always taxed at a lower rate than short-term capital gains and ordinary income are. There’s a good reason for this, too. Ordinary income (and to a lesser extent, short-term capital gains) carries little risk. If you punch a clock, you’re legally entitled to wages and can sue if you don’t receive them. If you wait tables, society expects that customers will tip you as part of (if not the bulk of) your income.

Long-term capital gains involve tons of risk. There’s no guarantee that that stock you bought years ago might ever result in a payoff. Contrast that with the biweekly checks you get after entering into a standard work agreement. By taxing long-term capital gains at a lower rate than ordinary income (and short-term capital gains), the IRS encourages people to hold onto their investments. If all income was taxed at the same rate, there’d be no incentive for anyone to defer spending (synonyms for which are “save”, “invest”, and “build wealth”.) We’d only chop trees down, never planting any.

So is this just an accounting curiosity, something for you to pass the time reading about on a boring Wednesday? Heck and no. Control Your Cash don’t play that game. If it didn’t apply to your life, we wouldn’t be spending time on it.

The more of your income you can derive via long-term capital gains, the less you’ll have to fork over to the IRS. We devote an entire chapter of the book to this. Chapter IX, the longest and most detailed one. (By far. Although it’s still easy to read, certainly no more difficult than our posts.)

Unless you want to move to Antigua – and before you do, remember that it’s easy to go stir-crazy on a 109-square mile island – you’re going to have to play the IRS’s arbitrary game. Both Wonderland croquet and Calvinball have more consistent rules. This wasn’t always the way, but America’s descent from beacon of freedom to patchwork of statism is a topic for another day.

Maximizing your long-term capital gains is the inevitable result of buying assets and selling liabilities, our 2-pronged guaranteed way to wealth. It means purchasing vehicles for passive, non-sweat income, no matter how modest or expensive: a $25 mutual fund contribution here, a real estate investment trust there. Anything that creates an income stream for you, or that should appreciate (such as a house). Hold onto it for at least a year, and you’ll pay less in taxes that you would if you’d earned similar income via more direct means. Hold onto it indefinitely, and…

You can defer capital gains, too. Sometimes indefinitely. Methods for doing this include structured sales, charitable trusts and 1031 exchanges, which we touch on in the book and will expand upon in future posts. Really we will.

The point is, don’t go to H&R Block with your W-2s and say, “Fix this for me.” And really don’t get a refund anticipation loan. You’ve got a few months to make this work for 2012, and to figure out how to not get burned in future years. Do it now. (By “do” we mean “buy”, and by “it” we mean click the link above. Which is also this link.)

 

*This is not an exaggeration. To quote P.J. O’Rourke, “If you don’t pay your taxes, you get fined. If you don’t pay the fine, you get thrown in prison. If you try to escape from prison, they shoot you.”

Filed Under: Capitalism, Economics, Making Smart Choices, Taxes Tagged With: , , ,
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