Many of us grow up hearing various sayings about money. Some of them are passed down as wise quotes, while others may be pieces of advice given to us by by someone trying to help us out. A small number of these things turn out to be good, sound advice; however, the majority of them are really nothing more than money myths!  

Recently, Investopedia posted an article giving 10 “bank-breaking” money myths. Because I love reading and analyzing these ideas, I thought it would be good for us to take a look at them here.

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First we will look at housing and tax money myths, and then we will look at investment and credit-related financial misconceptions!  

Money Myths About Housing And Taxes

If I Get A Raise That Bumps Me Into A Higher Tax Bracket, I’ll Actually Take Home Less Money

Since I have clients that come to me for tax preparation, I hear this one all the time. It is completely false to assume that you will actually take home less (or even the same amount) money because a raise or annual bonus has pushed you into a higher tax bracket.  

The reason for this is that our tax system is set up in such a way, that your income is taxed in tiers. When you move into a higher tax bracket, what really happens is that the rate of tax that you pay on the last dollars you earn increases. This is known as your marginal tax rate – which is broken out on these income tax rate tables.  

In short, only the amount that pushed you over your former threshold will be taxed at the higher rate. All other dollars earned up to that point will be taxed at lower rates (again, this is broken out in detail in the linked tables).  

Renting Is Like Throwing Away Money

This is probably the one that I hear most often – because I am renting. People always tell me that I’m throwing my money away, and that I should go out and borrow hundreds of thousands of dollars in order to put a stop to this (even when I tell them that I am trying to pay off debt, they still insist)! But, does this money myth really make sense? Of course not (which is why I asked the question )!  

Here is how you can tell if you are throwing your money away as a renter: When you pay your rent each month, do you get anything in return? If not, then you are being ripped off and indeed throwing your money away. However, if you are getting anything in return (such as A PLACE TO LIVE!!!), then don’t worry, you aren’t lighting dollar bills on fire!  

Of course, if you are paying too much for your rent, that’s a different story.  

The Investopedia article made a good analogy:  

Do you consider the money you spend on food to be thrown away? What about the cash you spend on gas? Both of these expenses are for items you purchase regularly that get used up and appear to have no lasting value, but which are necessary to carry about daily activities. Rent falls into the same category.  

I won’t go into all of the other reasons why this thought doesn’t make sense, or how you “throw away money” (by using the same logic) as a homeowner, because that will take up the entire article. I believe that simply focusing on just how illogical this money myth actually is, will show that it’s wrong.  

Paying for a service, experience, or even a temporary possession are all valid ways of spending your money, and they should be evaluated just like all other expenses. You want to avoid paying more for something than the value that it holds for you.  

Income Tax Is Illegal

This is a funny one that I hope is finally dying down. I know that there are many reasons given for this. I have heard the two mentioned in the original article – the tax code states that paying taxes is voluntary, and the IRS is not an agency of the United States.  

Without going into all the detail – thankfully, the IRS addresses most of the common myths here – these statements are all false! You have to pay whatever taxes you owe according to the tax code.  

Home Ownership Is A Surefire Investment Strategy

I guess this is why renting equates to throwing your money away! Even after almost four years with the housing market being in the tank, and many “investors” left holding onto multiple mortgages on properties in various counties/states, begging the government and the banks for a bailout; you can still hear people holding on to this myth.  

I won’t write about how housing performed as an “investment” before 2002 – because I would only receive comments about that one point, and everything else would be ignored (I’m not sure why housing is such an emotional topic).  

Let me just state that the housing market is just like any other market in which people invest. There will be people who make money no matter what the economy is doing, and there will be people losing money at all times as well.  

There is risk in all types of investments, we will always face trade-offs, and whether you are investing in your education, housing, stocks, or even your own business, you can’t avoid it!  

One of the major advantages of home ownership is being able to deduct your mortgage interest

So many people justify borrowing tons of money for a place to live, by talking about deducting the interest on their mortgage. Unfortunately, they believe this because there are a few things about this deduction that they probably don’t realize.  

First, this benefit is usually not available to homeowners who claim the standard deduction. That means that millions of people will see no benefit at all based on their current tax situation.  

Also, because of the nature of a deduction (read our complete explanation of tax deductions and credits), they will only receive a partial (probably around 25% or less) savings on their tax bill.  

It is nice that they government decides to partially subsidize home ownership by offering tax benefits, but this really shouldn’t be considered when you are deciding to take out a mortgage!  

Reader Questions

1. How many of these money myths have you believed at some point in the past?
2. Which ones do you still think may be true?
3. How do myths that have been proven wrong time and time again, continue to stay popular across generations?

For as long as I can remember, people in the so-called middle and lower classes (as far as income is concerned) have always felt that the “rich” have far too many tax breaks. They point toward those wealthy individuals who are able to retain a significant portion of their income through various income tax deductions and credits (which serve to reduce your taxes).

With the US economy in the toilet for the last few years, these talks of unfair tax breaks for the wealthy have been getting much more prominent.

However, what many people fail to recognize is the fact that many of these same deductions and credits are available to taxpayers of all income levels. Here are a few ways in which you can reduce your taxes, just like the rich!

So let’s look at how to reduce your taxes like the wealthy!

Giving To Charity

Donating money to a charitable organization is one of the most common ways that the wealthy reduce their tax bill. You don’t have to make it on the cover of the next Philanthropy magazine in order to make an impact. Just be sure to receive a receipt for any donations that you make to your local church, or food bank and deduct those amounts from your taxable income. Even if you are just giving to the poor – as long as it’s through a charitable organization – will give you an additional tax deduction!

Also, include any donations which you may have made to disaster relief efforts and other 501(c)(3) organizations (such as foundations connected to educational institutions, medical research, etc). In this case, you are able to reduce your taxes by helping others!

Owning A Home

There are two ways in which you can benefit from “owning” a home.

Take Out A Mortgage

I think it’s becoming a pretty well-known fact that I hate mortgages. However, they do carry tax benefits to them. If you have a mortgage, then you are allowed to deduct both the interest paid against the loan and the property taxes paid during the tax year, from your income. For those of you who have looked at your statements, you know that these amounts can be quite large (especially if you live in New Jersey)!

Own Rental Property

Another way in which the “wealthy” are able to mitigate some of their tax liability is to purchase rental property. All expenses that are incurred in both the improvement/renovation and maintenance of your rental property can be deducted from your income. Don’t forget to include the costs for advertising, property management, legal fees, and even travel related to your rental property!

If you take out a mortgage on your rental property, then you are able to deduct both the interest and property taxes as well, and reduce your taxes even further.

Start A Business

This is probably how the majority of non-celebrity wealthy people established themselves. For most people reading this article, quitting your job to start a business is probably not feasible (it surely isn’t for me)! However, you can easily take a hobby and turn it into a side business.

You can give lessons, offer services, or even create various products, and all without turning your life upside down! You may even want to create a website or start a blog as part of your business.

No matter what you choose to do, any expense related to this business will be tax deductible. With the ability to capitalize certain expenses, starting a business would be a great way to manage your tax situation. If you decide to pay yourself, make sure you are aware of the self employment tax rate.

Invest In Tax-Friendly Accounts

The key here is to get to a point where you can gain a significant portion of your income from income from your investments. Most municipal bonds are exempt from both state and local taxes, and so they are a favorable investment – especially in states that have high tax rates!

If you are looking to save on your tax bill today, then look no further than either a Traditional Individual Retirement Arrangement (IRA), or a 401(k). Both of these accounts allow you to defer your taxes until the time in which you begin to take distributions (up to age 70 1/2). This means that the money you put into these accounts today will not be taxable (up to the limit).

If you desire to gain huge tax savings in the future, you can look into either the Roth IRAs or Roth 401(k)s. What’s special about these accounts is that unlike their “traditional” counterparts discussed above, you pay taxes on the contributions in the year that you make them. However, once you are ready to take your distributions, no taxes are owed.

If you are able to take large enough distributions in order to support yourself, then you will greatly diminish your tax liability.

Take a look at the IRA contribution limits and 401k contribution limits and reduce your taxes!

Nothing Special

As you can see, all of the items listed above can be accomplished by taxpayers of most income levels. You will also notice that these are not earth-shattering, secret financial gems known only to a few!

On the contrary, these are situations that millions of Americans find themselves in every day. The only difference is that many of us don’t realize what a huge difference these overlooked tax deductions can make in our tax liability. If you have not yet completed your tax preparation, then take a look at your finances to see if you are already taking advantage of some of these techniques.

photo by Arvind Balaraman

Reader Questions

1. What situation in your life gives you the largest tax benefit (mortgage, marriage, children, business, retirement accounts, etc)?
2. Do you consider your tax situation before making certain financial decisions?
3. What is the one tax code you would change?

Almost everyone complains about paying taxes, wouldn’t you agree?. In fact, many people go to great (sometimes) illegal lengths to avoid paying them.

However, the IRS estimates that millions of taxpayers fail to claim these overlooked tax deductions, thereby overpaying their taxes each year!

Here is a list of a few of the more common tax deductions that people fail to consider.

Overlooked Tax Deductions

Medical Expenses

This is a category that I see overlooked all the time! Most people don’t know that you can deduct a portion of your medical expenses on your tax return. Even those who do know (because I tell them every year when I prepare their taxes), tend to forget throughout the year.

However, you still have time to not only gather up all of your receipts, but to plan any office visits or medical procedures for 2010! Here is a list of qualifying medical expenses. Of course, there are a couple of things to consider about this deduction (taken directly from IRS Publication 502)…

• You can include only the medical and dental expenses you paid this year, regardless of when the services were provided.
• You can deduct on Schedule A (Form 1040) only the amount of your medical and dental expenses that is more than 7.5% of your AGI (Form 1040, line 38).

Example:

Your AGI is $40,000, 7.5% of which is $3,000. You paid medical expenses of $2,500. You cannot deduct any of your medical expenses because they are not more than 7.5% of your AGI.

In the example above, if your medical expenses rise to $3,500, you will be able to deduct $500 (i.e. the amount above 7.5% of your AGI). Start saving all of your medical receipts and cross this off of your list of overlooked tax deductions.

Mileage

Many people forget that they can deduct mileage for various purposes. If you have to drive for business purposes during the year, then you are allowed to claim a certain amount (changes every year) per mile on your tax return. This is not only true if you own your own business, but also if you have to drive outside of your normal commute for your employer, and you are not reimbursed.

You are also able to claim the miles that you drive for medical purposes. This includes driving to a regular check up at your doctor, picking up a prescription, seeing a specialist, etc.

Another overlooked tax deduction is mileage while in the service of a charitable organization.

The IRS has this to say regarding using the standard mileage rate:

Taxpayers always have the option of calculating the actual costs of using their vehicle rather than using the standard mileage rates.

Keep in mind that if you choose to claim tax deductions based on actual costs, you must keep all receipts related to maintenance and fuel.

IRA Contribution

This isn’t make the list as an overlooked tax deduction because people don’t know about it; but rather because many taxpayers ignore it! The easiest way to take advantage of this tax deduction is to use a bonus or even your tax refund!

Making a contribution to an IRA happens to be one of the few things that you can do after the tax year ends. You have until the standard tax return deadline (usually April 15) to contribute for the previous tax year! This means that people are choosing to overlook this tax deduction more than once each year!

Take a look at the IRA contribution limits for both last year and this year, and then create an account.

Job Hunting Costs

Since unemployment is still a large problem in this country, many taxpayers should be able to claim this tax deduction. However, many people fail to keep track of these expenses, and are unable to claim them on their return.

If you itemize your taxes you will be able to include your job hunting expenses as miscellaneous expenses. The one thing that you must note is that if your miscellaneous expenses are not more than 2% of your AGI, you will not be able to claim the deduction (and even then, you are only allowed to claim the amount over 2%).

There are a few other rules that you need to know for your job hunting expenses, so click that link to see all of the guidelines.

Jury Duty Pay Paid To Your Employer

I was just talking to a friend at church about this one – she is actually a tax accountant, but didn’t know about this deduction.

When you have to serve on jury duty, your are paid a jury fee for each day that you serve. Some employers will then reduce your daily pay by the amount of your jury fee. However, many employers will just continue to pay you your full salary instead of making an adjustment.

In these cases, they (your employer) will require that you turn over your jury fee to them. At the end of the year, your employer will report your full salary to the IRS as income, and the municipality for which you served will report your jury fees as income as well – even though you turned them over to your employer.

Well, the IRS allows you to claim a deduction for these jury fees, so that you are not taxed on income that you did not receive.

I can go on with all of the overlooked tax deductions, but I’m sure that Jason doesn’t want me writing a book on his site ! If you have any questions, please leave them in the comments section.

photo by renjith krishnan

Reader Questions

1. What are some of the tax deductions which you overlooked in the past, but are now aware of?
2. Were any of these overlooked tax deductions new to you? If so, which ones?
3. Are there any tax deductions which you know you can claim, but you still fail to keep the proper documentation?

Ever since I became a tax preparer, I’ve noticed how little people actually pay attention to their finances…especially their taxes!

Most people simply throw their receipts into a shoebox, grab a bunch of unopened envelopes (which they believe contains their various tax documents) from employers, banks, and mortgage companies, and dump all of this paperwork on their preparer’s desk when it comes time for tax preparation!

Being this unorganized with your financial data can only lead to trouble. At the very least, it can cause you to miss out on tax credits and deductions to which you are entitled. However, this can also cause you to overlook payments that are due, or to fail to realize that certain paperwork is missing.

Here are four tips that can help make filing your taxes a much easier process:

File And Organize All Of Your Tax Documents

You should have already received all of your tax documents. This includes a W-2 from your employers, 1099-MISC from any company (except for your employers) that paid you more than $600 (maybe for consulting or contractor work), 1099-DIV if you earned interest, etc.

Also, keep in mind any expenses that you may have that should be included on your tax return. You should receive documentation for your mortgage interest and property taxes (1098), student loan interest (1098), and tuition payments (1098).

Once you receive these documents in the mail – or hopefully online (this is 2011!) – put them away in a file marked “2010 Tax Return”. Actually, I recommend scanning each of these documents into PDFs, and storing them on your computer. Separate your income and expense documents to make things easier when you go to file.

If you are missing any of these documents, then call whatever company owes them to you and request them – be sure to double check the address they have on file for you.

Collect And Organize Your Receipts

The same principle that we discussed above regarding your tax documents applies here as well. Go get your shoebox (or plastic bag) full of receipts and separate them.

If you own a small business, then be sure to keep those receipts separate from your personal expenses. Any receipts that you have for day care expenses, charitable donations, medical expenses (including copays), and property taxes – if you pay them directly – should be separated by those categories.

At this point, don’t forget to calculate all of your eligible miles driven using the standard mileage rates. If you have used your car for business or medical purposes (even something as small as picking up a prescription), or in service of a charitable organization, then you are eligible to claim those miles on your tax return.

The key here is to have everything organized by type of expense in order to make your tax preparation that much smoother!

Know Your Filing Options

There are a few different ways that you can prepare and file your tax return. First you must decide if you are going to prepare your own taxes, or if you are going to hire a professional. If you decide to file your own return, then you still have a few options to consider.

If your AGI is less than $58,000, you can go through the IRS’ free file option. You just have to answer a few questions and they can pair you together with a service that will file your federal tax return for free. Keep in mind that there is usually a charge for filing your state return with this option (actually that charge is usually higher than if you pay for the service as a bundle).

You also have a number of low-cost options online (such as Tax Slayer and Tax Act). Also, you still have the option of downloading software to your desktop and preparing your return offline.

This leads us to our next tip…

Find A Reliable Preparer

With the level of complexity involved in preparing a tax return growing each year, it is becoming much more difficult for an individual to prepare their own return. Rather than let your pride or miserly ways cause you trouble, it would be better to pay for professional tax preparation, then to risk making a huge mistake on your tax return!

I’ve actually had conversations with friends and family members who file their own taxes because it seems so easy to do with the latest software. What I find over and over again is that they have missed serious deductions and credits because they don’t understand tax basics.

Tax software is getting better at including questions that will prompt you to remember certain deductions; however, they still function on the information that you enter in…no matter how flawed or incomplete.

photo by Arvind Balaraman

Reader Questions:

1. What do you do to ensure that you are organized for tax preparation?
2. Do you hire a tax preparer? If so, how do you make your choice?

The White House issued a fact sheet that explained the benefits of the tax cut extension in more detail.

Here’s a broad overview of the four main benefits as outlined by the White House:

1. Payroll Tax Cut for Workers

This would include a 2% payroll tax cut for employees, which would result in tax relief of an estimated $120 billion for workers.

This means you’ll get more in your pocket with each paycheck, which lawmakers hope you will go out and spend to spur consumption, growth, and get the economy humming again.

Here’s a line from the release:

This tax cut will have a major impact on jobs and growth – creating substantial numbers of jobs. It is widely recognized by economists across the political spectrum as a high bang for the buck way to boost growth and was cited by both major deficit reduction commissions as consistent with long term fiscal discipline.

2. High Impact Credits for Workers

Here’s a very interesting quote from the release:

Economic studies consistently find that lower-income households are the most likely to spend additional money, creating jobs and helping overall growth. That’s why the Congressional Budget Office, for instance, has concluded that “policies aimed at lower-income households tend to have greater stimulative effects.

So, lets give the cuts to lower-income families because they’ll go out and spend the money…those rich folk will just save it! 

What they are proposing:

1. Child Tax Credit – extend the $1,000 child credit for two years.
2. Earned Income Tax Credit – extend the extra $600 in tax relief for qualifying families with three or more children.
3. American Opportunity Tax Credit – extend the (up to) $2,500 tax credit for families with students who qualify.

3. Unemployment Benefits Extension

The bill would extend the unemployment benefits for another 13 months, through the end of 2011.  This would provide relief for those still looking or work.

4. Business Tax Cuts to Spur Growth

Here’s what the release states:

In September, the President called for temporarily allowing businesses to expense all of their investments in 2011. This growth-oriented tax cut was included in the framework agreement.

•  
  • According to the Treasury Department, complete expensing could generate more than $50 billion in additional investment in the U.S. in 2011.
  • The provision will provide a crucial incentive to 2 million businesses to invest and create jobs in the U.S and would be the largest temporary investment incentive in American history.
  • The framework agreement also includes a 2-year extension of the R&D tax credit and other tax incentives to support business expansion

Another deduction to consider is the 2011 home improvement tax credit, which provides a max up to $500 for home improvements.

What Are Your Thoughts?

Do you like the proposal? 

What would you add or take away?

In the course of preparing tax returns over the last few years, I have heard people confuse the concepts of tax credits and tax deductions.

What’s worse is that I’ve even seen various financial writers and bloggers misuse the terms when performing various types of analysis involving taxes.

Let’s take a look at the difference.

Tax Deductions

A deduction is basically an expense that the IRS (really the tax code) allows you to “deduct” from your gross income. This will serve to lower your taxable income by the amount of the deduction.

For instance, if your gross income is $100,000 and you have no other adjustments, then you will be taxed on $100,000 (minus the standard deduction). Now add $10,000 in deductible charitable contributions (and no other adjustments), you will be taxed as if you only earned $90,000.

So, as you can see, having deductions can be pretty valuable because they reduce the amount of your taxable income.

Standard Deduction

For each taxpayer, the IRS applies a standard deduction. This is an amount that they automatically deduct from a taxpayer’s gross income.

For tax year 2010 it is $5,700. Basically, if your deductions added up to less than $5,700, then you would deduct $5,700.

However, if your deductions were more than the standard deduction, you have the option of claiming that higher amount (if it’s worth it to you) or going with the standard deduction.

Tax Credits

A credit is an expense that the IRS allows to you “credit” against the amount of tax that you owe. In other words, if you owe $3,000 in taxes and also have an education credit of $1,500, you now only owe $1,500!

There are two basic types of tax credits:

Non-Refundable Tax Credit

In the example above, the amount you owed in taxes was larger than the amount of your credit; but what if that wasn’t the case? Let’s say that you owe $1,000 in taxes and you have a non-refundable credit of $1,500. In this case, your tax liability is brought down to $0, but you are not entitled to a refund.

While these types of credits still come in handy when you owe money, they are pretty much worthless if you are already getting a refund!

Refundable Tax Credit

These are the fun ones! Let’s say you still owe $1,000 but now your $1,500 credit is refundable; this means that you will receive a $500 refund!

A refundable credit allows you to apply the full amount of the credit against what you owe in taxes. So, even if you are slated to get a refund (which really is simply owing a negative amount), the credit will just add to it!

Why is This Important?

When you want to decide if a particular move makes financial sense, it’s important to consider the tax implications. The first step in doing this (after figuring out if you qualify) is to determine if you are eligible for a credit or a deduction.

For instance, many people will purchase a home in the near future and be told about all of the wonderful tax benefits of their decision. Maybe you’re considering purchasing a home but can’t imagine paying a huge sum of money each year for your home. Usually, someone will say, “but you’re forgetting the tax ‘write-off’”!

Let’s take a look at some numbers to see how great this benefit will be. The first thing to note is that the IRS will allow you to take a deduction for mortgage interest and for property taxes paid during the tax year.

If you purchase a home and need to take out a $350,000 mortgage, at 5%, for 30 years, you will pay approximately $22,546 each year! In the first year of the mortgage, approximately $17,383 of that will go toward interest!

It is [very] wrong to assume that you will reduce the amount of tax you owe by $17,383! However, I see many people make this type of assumption when arguing in favor of a certain expense (buying a house, business expenses, etc)!

In order to figure out what your true tax benefit will be, just multiply it by your marginal tax rate. For tax year 2010, a single person making $65,000 a year would have a marginal tax rate of 25%. That means that you will owe $4,346 less in taxes if you applied this deduction.

However, since it is less than your standard deduction (see above), there is really no benefit at all – unless you have other deduction (like property taxes, for instance).

As we mentioned above, if this were a tax credit, then the entire $17k would be used toward reducing your tax bill. And if it’s refundable, then you’ll actually get a refund once your full tax due has been covered.

As you can see, this is a very simple, yet very important concept that you must understand if you are going to evaluate most major financial decisions properly.

Khaleef writes about personal finance from a biblical perspective for KNS Financial’s “Faithful With A Few” blog. KNS Financial provides Personal Financial advice, Budgeting Assistance, Tax Preparation and Advice, Debt Management, and Economic Commentary, through personal consultations, writing, seminars, and workshops

Tax Free Exchange (1031 Exchange) Explained

Normally, when you sell investment property, and realize a gain, you must pay taxes on that gain.

However, if you are replacing that property with another one of equal or greater value, you may be able to classify it as a tax free exchange, otherwise known as a 1031 exchange.

Be sure you understand the rules of a 1031 exchange.  Let’s take a look:

Tax Free Property Exchange

A 1031 exchange is so named because it is governed by section 1031 of the IRS tax code. Here is what the IRS has to say about this arrangement:

Generally, if you exchange business or investment property solely for business or investment property of a like-kind, no gain or loss is recognized under Internal Revenue Code Section 1031.

This strategy can be useful to any business owner looking to expand operations. Keep in mind that this does not apply to just any type of asset:

Section 1031 does not apply to exchanges of inventory, stocks, bonds, notes, other securities or evidence of indebtedness, or certain other assets.

So, if you have property used for investment and you sell that property in order to purchase another of equal or greater value then you are able to avoid paying taxes on any gain realized in the sale.

At this point your sale and purchase of investment properties are no longer looked upon as two separate transactions, but they are considered to be part of an “exchange”.

Like-Kind Property

In order for your transactions to be considered a tax free exchange, they must be “like-kind” property.

What is like-kind property?

The IRS explains it as follows:

Properties are of like-kind, if they are of the same nature or character, even if they differ in grade or quality. Personal properties of a like class are like-kind properties. However, livestock of different sexes are not like-kind properties. Also, personal property used predominantly in the United States and personal property used predominantly outside the United States are not like-kind properties.

Real properties generally are of like-kind, regardless of whether the properties are improved or unimproved. However, real property in the United States and real property outside the United States are not like-kind properties.

This is something very important to keep in mind as you consider taking advantage of a 1031 Exchange. Although, two pieces of investment property are usually “exchangeable”, you still need to be sure.

Boot

It is possible to do a tax free exchange of like-kind properties, but also have property that is not considered like-kind as a part of the deal; however, the IRS has special rules to deal with this:

If, as part of the exchange, you also receive other (not like-kind) property or money, gain is recognized to the extent of the other property and money received, but a loss is not recognized.

Any money or property received that is not like-kind is typically referred to as “boot“. If your transaction includes boot, then you are responsible for paying taxes on your gain, up to the amount of the boot.

For example, if you sell a property with a larger mortgage balance than the property that you buy, you will have to pay taxes on the difference between the two mortgages. You must also consider boot if the seller of the property that you are buying makes repairs to the property as part of the deal. The cost of the repairs may be treated as cash received.

Time restrictions

An investor only has 45 days from the date that the “original” property is transferred to identify potential replacement properties.

He then has up to 180 days (or the due date of the federal tax return – whichever is earlier) from the original transfer date to complete the exchange.

Restrictions on Replacement Property

There are three rules that govern what can be considered as replacement property in a 1031 Exchange:

1. The Three-Property Rule – You are allowed to identify up to 3 potential replacements, regardless of value.
2. The 200% Rule – You can identify any number of potential replacements, but their total Fair Market Value (FMV) cannot be more than double the value of the relinquished property.
3. The 95% Rule – Again, no limit to the amount of potential replacements. However, you must purchase replacement properties with a combined FMV of at least 95% of the FMV of all identified properties, before the end of the exchange period.

There is one thing to keep in mind when determining if a tax free property exchange, or 1031 exchange, is right for you.

This is not a way for you to permanently avoid paying taxes, but simply a way to defer them.

Khaleef writes about personal finance from a biblical perspective for KNS Financial’s “Faithful With A Few” blog. KNS Financial provides Personal Financial advice, Budgeting Assistance, Tax Preparation and Advice, Debt Management, and Economic Commentary, through personal consultations, writing, seminars, and workshops

Reader Questions:

Have you ever taken advantage of a 1031 exchange?

Does this sound like something you will look into in the future?

Do you think that there is too much risk involved given the time restrictions?

photo by woodleywonderworks

So we are about halfway through 2010!  Hard to believe isn’t it?

Although some of the buzz has seemingly died down about the year of the Roth IRA Conversion, there is still some controversy regarding whether folks should convert their Traditional IRAs to a Roth.

For those of you wondering what exactly is a Roth IRA,  Well, here are the basics:

A Roth IRA is funded with after-tax contributions; the money grows tax-deferred; and withdrawals are TAX FREE!

In other words, you use money you’ve already paid taxes on to fund the Roth, and provided you meet certain qualifications you never have to pay taxes on that money again!

What is a Roth IRA Conversion?

A Roth IRA conversion then is withdrawing money from a Traditional IRA and putting it into a Roth IRA where it will grow tax free.

Sounds good right? 

Well, the problem is that whenever you do this you have to pay taxes on the amount you withdraw from your Traditional IRA. 

So, let’s say you are converting $5,000 from your Traditional IRA — you would have to tack on 5G’s to your income for the year and pay tax at whatever rate you are at.  It’s as if you earned an additional $5,000 of income for the year.

As many of you already know, one big change for 2010 is that anyone can convert to a Roth regardless of income level. Previously, if you made over $100,000 you could not convert to a Roth.

If you convert in 2010, you now have a choice to pay all of your taxes in 2010 or average the taxes owed on the conversion over two years (i.e. pay in 2011 and 2012).  Uncle Sam is giving you a choice on when you pay your taxes.

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Don’t forget though that 2010 is the last year for the current low income tax rates. The current law plans for higher tax rates in 2011 — so, if you chose to average your tax payments over the two year period in 2011 and 2012, you might get hit with higher tax rates.   That Uncle Sam – he’s always got an angle doesn’t he?

Should You Do a Roth IRA Conversion?

Back to the question at hand.  Should you perform a Roth IRA Conversion in 2010? 

Usually the answer to such questions is “it depends”.  This might be a great year to convert your money to a Roth and potentially pay lower taxes than you would normally if you are in a lower bracket due to retirement or a layoff and you’ve got some cash on hand to cover your taxes! 

This is important because if you are under 59 1/2 and use your IRA to pay the taxes on the conversion you’ll get whacked with a 10% penalty on top of the taxes!

Let’s take a look at some things to consider:

Factors to Consider for Your Roth IRA Conversion

• Do you have money to cover your tax liability?  Having cash on hand to cover your taxes will help soften the blow, and you certainly don’t want to pay taxes with the money you are converting.
• Will the money you convert push you into a higher tax bracket?  If so, you probably don’t want to do it.
• Do you have non-deductible contributions in your IRA?  No taxes are due on the non-deductible portion.  *There are some additional factors about non-deductible IRAs that I covered in a post at Bible Money Matters.
• Are you planning on applying for financial aid for yourself, your spouse or your child?  Better think twice about the conversion – conversion income counts on your application.

Ultimately, whether you convert your Traditional IRA to a Roth will not determine your retirement success, there certainly are other things to consider to help you make a great run at retirement. 

So which retirement account is right for you?  Consider the above  factors, your overall situation and the Roth IRA conversion rules to determine whether the Roth IRA conversion makes sense for you in 2010.

This was a post I originally wrote for ChristianPF.com and adapted here for my site.

“Mr. Jones, we appreciate your work for us, but unfortunately there’s just not enough room in our budget for you.

Here’s a packet of information regarding your retirement account.  Please look this over and have a decision made about your 401k plan by the 31st.”

Ever hear these words?

Maybe your company didn’t sound as nice, but the result was the same.

Or – perhaps you left on your own terms and are embarking on a retirement journey or looking for a new career path.

Any way you slice it, there is one question that remains:

“What should you do with your 401k plan?”

Let’s take a look at four options to help you make an informed decision on what you should do with your 401k plan upon retirement or separation from service whether you have a million dollars or several thousand.

Leave Your 401k Plan With the Current Company

Generally, you can leave your 401k with your current company – or should I say your previous employer.

But this isn’t always the case.  Many times, companies want you to get those funds out of there because of costs to them.

If your company does allow you to leave it – then you can just keep your 401k plan with the same custodian, use the same investments and keep things as is.

Advantage:

It’s easy, generally cost effective and doesn’t require much thinking on your part.  Just keep the status quo.

Disadvantage:

You have your money with your former employer’s custodian.  That could possibly make for some discomfort – even though your employer legally can’t do anything with your money, some folks would rather cut ties completely.

Your money is invested with whatever custodian your company chooses – and they can change whenever they want, to whomever they want.  That means your funds could change simply because your former company wants to change.

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Take a Distribution From Your 401k Plan

You could take money out of your plan, have a check cut and sent directly to you.  Perhaps you need the cash and are more worried about making ends meet with the loss of your job than you are about preserving your retirement future.

Advantage

Access to cash if you need it within a relatively short period of time.

Disadvantage

If you are under age 55 when you retire or separate from service there is a 10% penalty for early distribution.  

If you are over 55 that is waived.  Yes, you read that right – age 55. This is called the age 55 Exception where the IRS allows you to take a distribution from a 401k provided that you are age 55 at the time of your separation from service and that you leave your 401k at your company – in other words you cannot roll it to an IRA first and then take distributions and expect to avoid the penalty.

There is also a mandatory 20% tax withholding from your custodian, which they will send to the IRS for you.

Take Your 401k Plan With You to Your Next Employer

One option you may have is to take your 401k plan with you to your next job.  You’ll have to check with your new employer to find out if this is allowable, but generally speaking many plans will let you transfer that old 401k into the new plan.

Advantage

Easy.  Combining your funds helps with compounding interest earned on that 401k balance.  There are no tax consequences.

Disadvantage

The new company may not have the greatest 401k plan available.  There may not be a good variety of funds.  Again, the custodian can be changed at the employer’s discretion, which means you still don’t have much control over your funds.

Roll Your 401k Plan Over to an IRA

You can do a direct rollover to an Individual Retirement Arrangement or IRA.

Advantage

You are in the driver’s seat.  The money is in your own account which you have discretion.  You can make changes, you can make the investment choices, you can pick the custodian or brokerage company that you feel most comfortable.

You don’t have the company limiting your investment options.  You can invest into pretty much anything you want.

You can even open a Roth IRA and do a Roth IRA Conversion on the money if you wanted to – you are making decisions, not your employer any more.

There are no tax consequences to performing a direct rollover.

Disadvantage

This requires a bit more work on your part.  For example, you’ll need to research a custodian, research investments – whether it is stocks, mutual funds or ETF’s.   You’ll need to essentially manage your own account unless you hire a professional to help you, which of course you’ll have to pay fees to do so.

The 401k generally allows for creditor protection in a bankruptcy or by plaintiffs in a civil lawsuit. IRA funds, however, are limited in their protection and the rules differ from state to state.

What Are Your Thoughts?

As you can see, there are some decisions to make once you leave your job. Some of these are more advantageous than others, so be sure you do your homework and figure out what’s best for you for your retirement.

Readers, what would you do – or what have you done in this situation?

This was a post I originally did on ChristianPF.com. I’ve adapted it some for my site, but you can check out the original here.

It seems there are more and more people becoming self employed these days - or at the very least, many folks are starting a side business, turning a hobby into some extra income or doing some type of independent contractor work.

In my day job, I am actually an independent contractor so I know quite well there are some things to remember if you’re self employed.

Whether you’ve decided to turn your blog into a business, sell a multi-level marketing product or rent a storefront to start selling your homemade jewelry there are some mistakes you will definitely want to avoid.

Not Having Your Small Business Set Aside Money for Taxes

This seems simple enough, but is probably one of the biggest tax mistakes people make .  The number of people I talk to that haven’t set aside money for taxes is pretty high. 

If you are a 1099 contractor, the company you are contracted with does not pull out small business taxes for you. 

At first, this feels great because your paycheck is higher – then reality sets in when it’s time to file your taxes.

Uncle Sam requires you to make quarterly estimated tax payments.  If you don’t have enough paid in for your estimated taxes you could face some penalties. 

I recently talked to someone who didn’t think they really needed to set money aside for his independent contractor work and figured he could just use his savings to pay the taxes.

He ended up making a little more than he thought by the end of the year and couldn’t pay all the tax liability.  He got whacked with some stiff penalties and is now making recurring payments to the IRS until his debt is wiped out.

Another thing people fail to realize is the self-employment tax that’s due.  This was a kick in the gut to me after my first year of self-employment.

Uncle Sam charges 15.3% tax for small business in addition to your regular income tax!  This is equivalent to the FICA tax on a regular paycheck.  The good news is that you can deduct half of your self-employment tax, but you still have to pay this small business tax! 

What I do to help me throughout the year is any time I get paid, I set aside a certain percentage of my money right away into a separate bank account, which is labeled Uncle Sam’s.  Then each quarter I take that money and make a quarterly estimated tax payment.

In the fourth quarter I do a quick assessment of where I am in terms of income and tax payments and adjust accordingly.  This has worked well for me the last few years.

Small business taxes are an annoying part of being self employed, but it’s a must.

Not Considering Incorporating a Business

Many self-employed folks start out as a sole proprietor.  They themselves are the business and everything (income, expenses and liabilities) gets funneled through their own personal account.

To set the record straight, not everyone should incorporate a business. 

If you’re not planning on going “big time” with your small business or you’ve decided you just want your hobby to make enough to cover expenses, it probably doesn’t make sense to pay the fees associated with incorporation.

It does make sense, however, to at least consider whether incorporating a business is right for you.  One benefit of incorporating is that you can get around the self-employment tax.

The biggest benefit however is limited liability.  This means that the business - not the owner - is personally responsible for its obligations. 

In other words, if the business gets sued, only the business assets are at risk, not all of your own personal assets like in a sole proprietorship.

So incorporating a business can be a pretty big advantage – definitely one worth considering.

Not Keeping Track of Income and Expenses

This is one of those mundane tasks that most owners hate, but every business must do in order to maximize deductions as well as protect themselves from an IRS audit.

A business owner should really be organized when it comes to keeping track of income and expenses.  Don’t write down your mileage on a napkin each time you travel.  

Your bookkeeper will thank you for that.  Or, if you are acting as bookkeeper you’ll appreciate your organization as your business grows.

Get a notebook, use a spreadsheet or some budgeting or personal finance software to track the amount of your expenses, the category (i.e. office supplies) and a brief explanation of what you purchased etc.

Don’t rely on your memory to come through for you when you need to report an expense.  Keep your receipts, develop a system and keep up to date.

I typically store all my receipts in one place for the week and then each Friday I pay bills, track my expenses in a spreadsheet, review my income and take a look at profit and loss statements. 

This may be a bit much depending on what type of business you are in, so just be sure you come up with a system that works for you.

Avoiding these mistakes as a self-employed person will help free up time, save you money and protect your business so you can maintain a long and profitable career.

What are some other mistakes you would avoid?