Darwin's Finance » Taxes

Billion Dollar Inheritance: Heirs Pay NO Tax – Right or Wrong?

Darwin — Tue, 15 Jun 2010 02:51:40 +0000

There was an interesting new item the other day (here) on a Billionaire that was able to bequeath his entire fortune of 9 Billions dollars to his heirs and they got to keep it all – not one red cent went to the taxpayers. This is all possible by the “luck” (if you’d call it that) that he died during calendar year 2010. Since the Bush tax cuts had scaled changes to the inheritance tax threshold across multiple years with 2010 being an infinite amount allowed without taxation “sunset provision”, jokes about about the number of elderly that are going to “mysteriously” pass away this year or the number of plugs pulled on New Year’s Eve this year on breathing machines, etc. Jokes aside, 2010 is the optimal year to die from an estate planning standpoint. Since his estate would have been taxed at 45%, that’s $4 Billion that would have gone into federal coffers in the past that won’t this year. Starting in 2011, the exclusion reverts back to $1 Million again unless new legislation is enacted by then.

Regardless of whether the inheritance was Billions, Millions or barely enough to cover funeral expenses, without considering scale, how about considering the concept of taxing inheritance itself?

Pros and Cons of the Inheritance Tax

Caste Systems in the US – Many feel that by allowing families to continue to amass wealth and pass it on generation after generation, there will always be classes of haves and have-nots. Those in the elite class will always have virtually infinite funds to continue their domination while those borne to ordinary citizens will never have parity with the inheritance class. This is an extreme view and over-generalized but you get the point.

Many point to the impact this tax has on small businesses. If heirs inherit a small business with a sizable estate but little liquid assets, there’s no feasible way to pay the estate tax without liquidating the family business. This is in some cases an unfortunate side effect. While some make this claim about family farms as well, there is a provision to address family-owned farms specifically.

Double Taxation – Another common argument is that one’s wages, earnings, investment gains, (even a prior inheritance) were already taxed DURING one’s lifetime, and now it’s being taxed again. That’s true.

Loopholes - Like virtually everything in life tied to either legal or financial matters, there are myriad ways to avoid, mitigate or alter the intent of the estate tax. With crafty estate planning, gifting, actions leading up to death, etc., there is the routine cat and mouse game with the taxman which is probably a net loss to society and heirs and a boon to lawyers and financial planners. If the code were more clear or devoid of loopholes, perhaps money could be passed more efficiently, to both heirs and taxpayers.

You Didn’t Earn It – There’s just something different about earning money versus being given money just because of who you are or what situation you were in. Earning a $10,000 bonus for hard work just seems more “moral” or appropriate than knowing that you’re being gifted $10,000 by mom every year for the rest of your life, just because mom has some bucks. It’s akin to being entitled vs. having some skin in the game. This touches on some of the concepts above.

Where Do I Stand on the Inheritance Tax?

I don’t believe everything in life needs to be a binary decision – like either no tax whatsoever, or tax the heck out of everything over $500K or something along those lines. While the theory of basically usurping family money and redistributing it to taxpayers sounds unfair, at some point, you’ve gotta admit it becomes rather absurd to pass on Billions upon Billions of dollars to heirs creating generational wealth that seems rather ridiculous. Consider when Warren Buffett dies (he’s actually in favor of the estate tax), should Billions go to his children untaxed? Billions? I think it’s fair to impose a nominal tax on massive fortunes, but with a few provisions. At the lower levels, it should certainly be indexed to inflation, which pre-Bush was a problem, because the thresholds were relatively low, especially given inflation and home price appreciation. While I struggle a little bit with a redistribution of wealth earned by a particular family member just because they died, the estate tax is a rather common and accepted practice in other western societies and taxes are needed to fund the country’s needs after all. Something’s gotta give and since the estate tax has always been (ex-2010) and likely will always be at least some part of the tax system, if trying to abolish it, who pays for the loss in tax revenue? Where’s that money coming from? I’ve gotta lean toward being in favor of it, but perhaps with higher limits at the lower end.

Where Are You on the Inheritance Tax?

Should I Use the Energy Tax Credit for a New Central Air Unit?

Darwin — Thu, 15 Apr 2010 10:24:21 +0000

Since I’m always looking to make sound investments with a favorable return on investment to optimize our family’s cash flow, I’ve been considering having a new Central Air unit installed. There’s an energy tax credit (IRS Link) that expires at the end of this year that allows for a full 30% credit on the purchase and install of an energy efficient unit (max credit is $1500). I’ve confirmed that there are no income limits on the credit, so essentially, if I spend $4000 on this project, I’ll get $1200 back next spring. There are some key considerations that are driving this assessment:

Age of Existing Unit – Our house is about 15 years old. As I’ve found with many other things in the house, the builders didn’t exactly use the top of the line suppliers for anything – from cabinetry to water heaters – to the Central Air unit. Therefore, I don’t anticipate that this unit is going to last forever. If it dies in 2 years, I’m going to have to replace it at full cost with no credit, and likely pay more to have it replaced as an emergency install if I don’t want to wait 3 weeks in 100 degree weather to pay for a routine scheduled install.

Efficiency of Existing Unit – I’ve gotta run the numbers once I get some quotes on new units, but in essence, the units being manufactured today are vastly more efficient than the generic model we have now. The industry standard for efficiency is the SEER number. The basic premise is for a higher SEER number, you’re going to pay more up front but realize lower operational costs long the way. Conversely, if you pay less up front, you won’t save as much on energy costs. My preliminary research is pointing toward a 16 SEER unit and I may replace the furnace blower as well – same reasons – age and efficiency.

Net Present Value – Using NPV (see NPV model at work) to drive financial decisions is a personal favorite of mine. Once I have some models priced out and I can make some reasonable estimates on what my annual savings will be with say, 2-3 models, I can price out whether it’s worth the purchase and what my NPV will be over various time periods. For instance, if we are staying in the house 10 years or longer, there’s no doubt in my mind the NPV will be favorable, especially considering the assumption that I’ll likely have to buy a new unit in a few years either way. However, if we move in 3 years for whatever reason and we don’t anticipate a buyer paying a premium for a “new unit” per se, we may not break even. So, that’s another key consideration.

Which Company to Use – We have a trusted electrician/plumber (jack of all trades) we’ve used before that recommended a local company. He said he’s often done work along side them or after them on installs and people are always very happy with them. I’ve done the contractor haggling thing before, but sometimes when I’ve put price over recommendations, we weren’t totally happy with the results like our patio. Therefore, may just go with the recommended company and not try the haggling thing this time around. This company typically deals with Carrier units, which rank well in the reviews I’ve read.

While spending several thousand dollars this year is never appealing, part of being a homeowner, and a financial steward at that, is to make investments that will end up costing you less in the future. I think upon confirming our plans for staying put for a few years (we sometimes debate whether we want something a little different, but with this economy and housing market, it’s probably not the best time to move), the pricing will probably make sense. I’ll be sure to come back with a detailed analysis on the annual savings and the 5-yr, 10-yr NPV for the project.

Are You Taking Advantage of The Energy Tax Credit This Year?

My Effective Tax Rate is Under 5% – That’s Just Wrong

Darwin — Mon, 05 Apr 2010 10:46:37 +0000

So, my accountant finally wrapped up my various tax documents and for the prominent Federal Tax Return, I was surprised once again to see just how low my Effective Tax Rate is – under 5%. That’s my net tax rate after all deductions, credits, etc. Not that I’m complaining, but the tax system is so convoluted that someone that makes what I make pays less than 5% in Federal Taxes. I mean, we are a single income household and I’m not raking in huge bucks, but we’re solidly upper-middle class and paying just a fraction of our actual “tax bracket” amount. This just further illustrates that if I’m paying this little in Federal taxes, people closer to the national average income are pretty much paying nothing.

Why Is My Tax Rate So Low?

There are so many deductions available that with relative ease, one can get down to a virtually non-existent tax rate. Here are a few financial drivers for our family:

I’m a routine contributor to my company 401K plan. Any dollars contributed reduce your taxable income by an equivalent amount.
We just had our third child. That’s a $1000 tax credit for each child until you start to get phased out based on income limits.
We make various charitable contributions each year, which reduces taxable income.
We have a decent sized mortgage since we live in a relatively high cost area. Mortgage interest is deductible, as are real estate and school taxes. Even though I have an incredibly low mortgage rate at 4.625% for a conventional 30 year, it’s still a 5-figure amount lopped off income each year.
I established an LLC for my blogs. While I brought in a decent amount of money last year, it was still in the growth phase and I had expenses that were either fully or partially deductible.
I utilized a Flex Spending Account for health and medical expenses.
I took my lumps last year in my taxable trading account during the market meltdown. I had recognized some losses throughout the year (here’s my Current Portfolio which is doing remarkably well this year, even in the context of the 70% in the broad market from March last year).
There are probably a few other considerations I missed as well.

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More Tax Tips and Deductions

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For my state taxes, I’m actually getting a refund if you can believe it, because in our state, 529 plan contributions are deductible as well. So, that’s like beating the market by a few points each year in that college plan account for the kids as well. Not only does it grow tax-deferred, but I also get a refund back from the state up to something like $15K per year (I have to check that).

Who’s Paying the Taxes?

Well, most of the country isn’t. It’s pretty much the top percentage of earners. I get the notion that a family of four making $40,000 in a medium cost part of the country would struggle with a $5000 tax bill on top of the myriad state taxes and cost of living. But shouldn’t most families at least pay something? 1%? I mean, we’re all sharing in the services and expenditures of the federal government from Defense to social programs to now, healthcare, but the full burden is being borne by such a small portion of our constituency. With more tax increases on the way, this equation will only become more lopsided. It just begs that question as to how far it goes and the fairness of the whole system.

So, with a rather large tax deduction, some may question why I don’t run and adjust my W-2 immediately to make sure I’m not giving the government one of those free loans all year, but the reality is that it’s really not a big deal to me – Here’s Why.

What Was Your Effective Tax Rate?

Do You Feel It’s Too Low or Too High?

What’s wrong With THIS Health Care Reform

Darwin — Tue, 23 Mar 2010 01:01:44 +0000

With a major hurdle cleared this weekend in the Health Care Reform efforts, much attention has been focused on how it’s “historic” and how many people are now going to have healthcare and somehow topics of abortion and and other seemingly tangential issues became deciding factors in who would vote for it. There has been much praise and articles citing what’s in it for you but health care reform criticism articles have been few and far between. I’m not opposed to bringing America’s health care access and treatment in line with other western economies, but I can’t help but be dismayed and frustrated by the bill in its current state and how it was enacted. I wanted to step back and highlight the major flaws in the approach, what the indirect impact to America’s prosperity may be and why it’s just so difficult to please everyone.

What’s Wrong with the Health Care System?

Health Care Costs continue to skyrocket. In a year where annual inflation was virtually zero for most other major categories, health care premiums still rose 5% again through early 2009 (8% for year end). Why?

As you can see, not only are the costs of healthcare skyrocketing, but for a country with the largest GDP in the world, this segment continues to comprise the largest % of total GDP in the world as well.

One of the biggest flaws in the system (which cannot be easily addressed due to complexity) is that compensation is based on treatment, not outcomes. As much as we like to think that all medical professionals act SOLELY with the patients’ interest in mind, the reality is that they’re doing a job to support their family just like you are. And, since the way medical expenses get paid is rather nebulous, it’s very easy to overdo everything from MRIs to specialist recommendations to medications even with the best intentions in mind. The doctor figures “Well, maybe this is going to cost a ton, but if I hit this condition with these 6 approaches and one works, great! I’m trying to save a life here, not a dime”. Meanwhile, more doctors (specialists) are compensated, more hospital capacity is filled for expensive cost centers like MRIs, CAT Scans, etc., more drugs are prescribed and the patient may or may not improve. Perhaps they would have been better off with a different, less expensive treatment altogether or perhaps they shouldn’t be treated at all. In my article on how to value life for a terminal patient, does it make sense to spend six figures to extend someone’s life by a few months? If it’s your family member, you’d probably say yes – especially if you’re not paying for it. If you are paying for it, you may still say yes primarily from an emotional standpoint. If you’re analyzing the situation from an objective unemotional standpoint (someone sitting in Washington making this decision for you) and see just how unsustainable this model is, you’d certainly question it. In the absence of a methodical approach to treatment (rationing), this situation will continue to manifest itself and balloon further. Why? People are living longer, innovative companies continue to find new treatments and approaches to disease that didn’t exist previously (and they rightfully need to recoup their R&D costs lest we take away any incentive to innovate further and take financial risks to develop new approaches), and Americans are becoming LESS healthy primarily due to poor eating habits and an increasingly sedentary lifestyle. So, it’s a conundrum. I don’t think it’s fair to blame any one particular group – hospitals, health insurers, doctors, pharma, patients…it’s a massive problem shared by what is basically a flawed system.

The problem with trying to use say, a lean six-sigma approach to analyzing data, outcomes and recommending guidelines for treatment is this notion of “death panels” and “government bureaucrats” deciding what kind of treatment a patient will receive. There is certainly merit to this argument. Don’t you think your doctor who’s been seeing you for the past 5 years has better insight into how to treat you for your condition than a paper pusher in Washington? But conversely, that’s how we get into this situation of over-treatment. It’s come down to one of two choices – to ration or not to ration. Rationing would control costs but remove the flexibility and judgment of physicians to treat the way they see fit while no rationing allows costs to continue to run rampant.

What’s Wrong with This Health Care Bill?

The biggest problem with the bill is that it probably won’t work, will be much more costly than initially projected and is likely just a foot in the door to broader, more sweeping government oversight of the country’s medical system. No different than the initial bailout that turned into more bailouts, the unemployment benefits that got extended once, but are now up to 99 weeks!, and the housing legislation that kept evolving into more ridiculous and inneffective modification programs like first paying people to stay in their house which evolved into paying people to leave their house??. Basically, once government gets an inch, they’ll take a foot. They make hasty decisions that are based on politics rather than effectiveness and then need continued band-aids, fixes and more money to fix what they screwed up the first time. This will be no different and anyone that thinks otherwise is naive and disconnected from reality.

Special Interests, Deals and Moral Hazard

Especially egregious was the contrast between Obama’s campaign promises of “no more special interests” and transparency which directly contradicts the entire process in which this bill evolved.

Votes were bought. Basically, savvy holdouts in the political spectrum gamed the political process to hold out and become one of the few deciding votes so they could essentially put their handout and demand a bribe for their vote. (See the Louisiana purchase which cost taxpayers $100 Million for 1 vote). Additionally, unions got a sweetheart deal that other Americans didn’t (See the Union Giveaway that the rest of America must fund through 2018). Why? Well, this just helps the agenda, right? Basically, at the expense of the rest of the country, the administration shamelessly enacted a special deal for a special interest group. There’s no way around it. As unions win favorable deals like this and people want these same benefits, marginal workers (those could care less whether or not they’re in a union or are slightly in favor or a non-unionized workplace) will continue to sway toward unionization or taking union jobs because of these “sweeteners” on the shoulders of taxpayers. The more attractive you make it, the more members you’ll get. Why provide this artificial incentive? More unions = more democrat votes each election. This seeks to ensure the cycle continues. Not good for American competitiveness. But good for Democrats.

Fuzzy Math. Politicians love to cite CBO statistic as gospel and tout that the CBO is a non-partisan group that can be trusted, etc. The problem is, when you talk to someone currently or previously at the CBO, they say that the numbers politicians drop are often total BS. The CBO makes statistical predictions and analyzes various scenarios (i.e. if assumptions x,y,z come to fruition, there is a 75% probability that it will cost ABC…). A politician latches on to an attractive sounding scenario and cost and starts touting that number. Meanwhile, that might have been the most optimistic scenario with the lowest cost which clearly will not be the actual scenario that plays out. Seriously, who can predict how many people are actually going to pay for health care vs. pay the “penalty” if you can call it that? Who can predict how this legislation will change coverage, prescribing habits, consumption of services and the other thousands of variables? The true cost will be nothing near what was projected. So, the question is whether it will be more or less expensive. Given our country’s history with large programs, I highly doubt it will be cheaper. We don’t exactly have a track record of coming in on time and under budget, do we? No, that’s only private industry that’s expected to do that since accountability exists there. Not here.

More Fuzzy Math. Additionally, the higher taxes and fees are front-loaded but the benefits don’t come for years until 2014. While people keep praising the cost per year as modest, what they keep forgetting to mention is that there are 4 full years of taxes up front and then 6 years (with 6 more years of taxes) of benefit, so the when looking at the rosy 10 year projection, the cost per year is really almost twice as much as is being touted.

Who Pays? Pretty much, the middle class and up. Most of the heaviest taxes fall on those darn “rich people”, which also happen to be many small business owners, who are primarily the ones that create real jobs. Not temporary census workers or more government jobs that don’t actually create anything, but real small business jobs. Is it fair that the top 5% percent earners in the country foot the fill for the bottom 50% of the country? I guess if you’re in that 50% you’d say sure. If you’re in the minority, it’s not fair. It just doesn’t seem right to me. The rest of the funding? Ah, just more debt. More tax increases.

Forget Something? Umm, Tort Reform? Why not confront the frivolous litigation and the costs that can’t even be estimated by over-treating for fear of litigation? Well, a decent portion of Congressional lawmakers is comprised of…none other than lawyers! Why would lawyers take an action to reign in their own kind? The trial lawyer association is a huge political donor and when tons of these pols are voted out of office next term, what do you think they’ll go back to? Practicing law. Having no tort reform is good for all types of attorneys. It keeps the gravy train going. The reason cited for not including tort reform was that it would “only” have saved a few billion dollars per year, as cited by the CBO of course. Well, again, it’s impossible to accurately estimate all the intangible costs of doctors thinking non-stop about lawsuits all day and why they take every measure possible no matter how ineffective it is from a cost standpoint. It was WRONG to exclude tort reform. Special interests again ruled the day.

Gaming the System – Fraud. First off, government does a terrible job of combating fraud. Why? Because it’s just taxpayer dollars being wasted, which are endless. Notice the large insurers aren’t defrauded at nearly the same rate? Why? They are beholden to shareholders and have an incentive to turn a profit – and reduce fraud. When you’re ineffective in private industry, you’re replaced with someone who will get the job done. When you work in the government, it’s virtually impossible to be fired. Ineptitude rules the day. Government workers don’t have much incentive to care. With Medicare being defrauded at a rate of $60 Billion per year, how many taxpayer dollars do you think are going to fund scammers by 2015?

Gaming the System – Americans. Americans will surely game the system in shameless fashion as well. We’ve seen it in virtually every aspect the government allows itself to be exploited like cash for clunkers and the mortgage modification programs. This one leaves the door wide open.

Get this: If you don’t buy health insurance, you’ll be assessed a “penalty”. What was started off as a reasonable couple thousand dollars per year, which would incentivise people to just go buy some insurance, has devolved into peanuts. In 2014, it’s $95. In 2015, it’s $325 and maxes out at $695 or 2% of income.

$95? Are you kidding me?

Here’s How the Government Will Take Over Health Care Completely:

Young people think they’re invincible. In general, if not already insured by a large company or their parents, they will just forgo coverage. Paying a few hundred bucks a year is a pittance and is much cheaper than paying a few thousand per year.
Here’s where it gets ridiculous: Since insurers will now be prohibited from denying anyone with a pre-existing condition (75 year old life long smoker shows up and says “I want insurance”, they have to cover his 6-figure treatment for lung cancer), said young person will now wait until they have some massive costly condition and say, “Well, I guess it’s time to get health insurance today”. Example: Cancer, infection, pregnancy, whatever.
It’s a free ride (close enough at these menial penalty rates) up until you get sick. Then you pay the going rate when you want to exploit the system. On that, who’s even going to pay? What are the penalties for not paying? Who enforces this? Are we really going to prosecute people for not paying the penalty while many challenge the constitutionality of forcing the issue to begin with? Mark my words. People will not pay. They will seek emergency treatment when they need it and they will be treated. It’s a joke.
This will destroy the insurers because the way the insurance business works is that the healthy people help fund the rare large bills incurred by the small number of unhealthy people. What you get here is the health insurers being forced to insure an increased number of unhealthy people and a smaller proportion of healthy people.
Premiums will need to rise or profits will tank, but alas – the government will impose restrictions on how much they can raise premiums. It is likely profits will tank, as the government won’t allow premiums to rise at this even more ridiculous rate to account for this ridiculous mandate.
As fewer and fewer insurers remain viable, and the ones that do are forced to provide a worsening level of service, people will become frustrated and demand action. The government takes an ever broadening swath of patients under their umbrella under…hello – Public Option.

On one hand, the private health insurers are so reviled because of their practices, most people don’t care right now. But what they will care about is the unintended consequences. The problem is, people are so enamored with “hope and change” and making history that they’re missing the likely implications of this problematic bill.

I think at the end of the day, there’s going to be buyer’s remorse.
I hope I’m wrong.

6 Reasons You Won’t Go to Finance Hell if You’re Getting a Tax Refund This Year

Darwin — Tue, 09 Mar 2010 13:01:52 +0000

There are a select few articles that get republished year in and year out that start to become “gospel” in the personal finance world. With tax time approaching, you’re going to see several writers and talking heads on television chastise you for the “free loan” you gave the US government this year if you’re receiving a tax refund. With the average tax refund estimate at around $2700 from the 2009 tax year, that’s roughly $50 per week you could have had in your account instead of on the government’s coffers, right?

Let’s consider the realistic reasons you don’t go to Hell. Not the hypothetical, but the pragmatic.

Interest Rates are a Joke. This is the primary reason this “loan” issue is bunk. With savings rates paying less than 1% for the most part, save for some top online savings rates you can find, how much are you really lending? Note that inflation is virtually non-existent as well. Conservatively, by “lending” $2,700 at 1.3%, you forgo a whopping $35 in interest. I say conservatively because a) 1.3% is the top rate you’ll find virtually anywhere and b) because this assumes a 1 time payment made a full year back. However, you’re making gradual $50 payments throughout an entire year, so that December payment for instance, earned a couple pennies only. So, in reality, you’re losing out on LESS THAN $35 by getting a refund this year. While you could cite last year’s stock market performance and how much you “could have made”, this isn’t a good proxy. You won’t see massive returns like that again (save for following the next financial crisis) and by that logic, you could LOSE much more than just lending it to the government in a down year in the future (aren’t you happy you loaned the Feds money in 2008?).
Most Americans spend what they make – or more. The tax refund is at least one autopilot program that virtually guarantees a few thousand dollars coming in at a set time each year. Most people would simply spend the additional $50 each week instead of say, investing that exact amount. This is reality over theory speaking, but sometimes, you’ve gotta recognize and accept human behavior over spreadsheets and assumptions.
Tax Refunds Act as a Special Savings Account – many people use the annual refund to pay for anything from this summer’s vacation to making a final investment into the prior year’s IRA allowance. There are few mini-windfalls in life, but this is an annual one that lends some routine stability to a family budget. Even an annual bonus isn’t guaranteed to those that were used to them in prior years.
Many Americans Don’t have an Emergency Fund – for those that don’t, an annual refund could be used to pay for an unforeseen medical emergency, help with monthly payments following a recent layoff, or pay for that water heater that just busted. It may be the only time per year that one of these mini-windfalls ever comes around.
A Better Strategy for Funds Allocation – Many people don’t really have a good “plan” for what to do with $50 weekly. Perhaps disciplined investors do set up that automatic monthly withdrawal into an investment account, but with a single 4-figure payment coming in once per year, there’s plenty of time to plan and think about how to best deploy that cash. Perhaps with that money, you ‘ll want to make a high ROI investment in your house under the cash for caulkers plan that is just being finalized now. Perhaps you’ll want to buy a few thousand dollars of shares in a particular stock which you can’t do with $50 generally (DRIP plans perhaps but they have their drawbacks). Basically, with some time and planning and a one-time payment, many people will put that money to work better than ongoing micropayments weekly.
You May OWE Money! – Nobody ever gets it exactly right when toying with projected deductions, projected income and adjusting dependents. Depending on how your year went, what the latest tax law changes were that you may have missed and how much you actually made, let’s say you end up owing $500 come April. Is that where you want to be? You had those extra $50 each week last year, but now you’ve gotta come up with an unplanned tax payment within a month!

So, there is something to be said for maximizing returns in the long-term, beating inflation and optimizing cash flow. In the corporate world, cashflow management is gospel and accounts payable/accounts receivable should be optimized to squeeze every penny out of the timing of transactions. However, you’ve also got to realistically assess what the impact would be to having no tax refund vs. a few thousand dollars each year. Ask yourself (since most of you ARE getting a refund this year) – Do you wish you weren’t getting that refund and had the money weekly last year? Or are you relieved and pleased that it’s coming?

If your annual refund is enormous, like over $10,000 each year, perhaps it’s worth reconsidering whether that’s too high and your money could be put to better use throughout the year. If you carry revolving credit card debt and for whatever reason haven’t bounced that into a 0% balance transfer, perhaps the money could be better utilized paying down debt monthly (with requisite discipline). But if it’s say, $1,500 or even the national average tax refund estimate at $2,700, perhaps for your given budget, you’re better off each year just leaving it alone.

I’m interested in your thoughts:

For 2009, Did You: Lend it or Leave it?

401K Loan Rules – Taxes, Interest, Pros and Cons

Darwin — Wed, 03 Mar 2010 13:12:24 +0000

401k Loan Rules allow for easy access to retirement funds, but is that a good thing? Many employees are unaware that they can take a loan from their 401k account for basically any personal need with very little hassle. There are clear negative attributes to this route, but some situations may warrant considering this option, depending on the need and other options at your disposal. One major misunderstanding is how the loan works and how it is administered.

How Much Can You Borrow From Your 401K?

Most 401k plans allow you to borrow up to 50% of your vested account balance or $50,000, whichever is less. Many plans allow immediate vesting, but if not, you’ll want to ensure you understand what your vested amount is. You usually have up to five years to repay the loan, unless you are borrowing for a first home, which allows a longer payback. You can basically use the funds for whatever you want. If you adhere to the confines of these rules, you don’t need to pay the 10% early withdrawal distribution penalty since you’re paying it back within the confines of the plan.

Where Does 401K Loan Interest Go?

This is an oft-misunderstood and misrepresented question depending on which site you hit on the internet. Based on personal experience (more on that below), the interest paid actually goes back into your own 401k account – so you’re paying it back to yourself. You are NOT paying to the administrator, to the government or to anyone other than yourself. You might question why there’s an interest rate at all then. It’s basically to deter complete abuse of the provision to borrow money interest-free that was already exempted from income tax when you contributed to your account. Suze Orman and others have also purported that borrowing from your 401K creates some sort of “double-taxation”. While it’s a rather complex consideration of ifs, thens, and competing scenarios, perhaps it’s better stated that the interest is not tax-deductible like other options such as a HELOC, but I don’t agree that the amount borrowed is “double-taxation” by any means. Depending on your frame of reference, one may consider the interest portion as double-taxed because you’re paying back that interest to yourself in a tax-deferred account with after tax money, and then it will be taxed in retirement – But…But – the interest portion is a marginal amount of money compared to the amount borrowed since it is often offered at below market borrowing rates.

So, let’s consider the context. If you borrow $20,000 at 4% and pay if back over a couple years, the total interest is a few hundred dollars. Tax on a few hundred dollars is approaching a measley $100. Is this really worth micro-analyzing if you actually need the $20,000 for something important? It’s less than 1% of the total amount borrowed, so it’s less than a typical annual expense ratio on many funds you’re in, or certainly less than the fees/interest on ANY conventional loan you’ll ever come across.

Where else could you borrow $20,000 for $100 and pick the payback term?

The Case FOR 401k Loans

It’s Your Money! If you need it for an emergency or some compelling reason, you can stop the clock on your retirement funding, withdraw it and pay it back.
The interest rate is usually quite low generally at around 5% or less during the past several years. And you pay the interest back to yourself. The net loss due to the “double taxation” of interest is marginal.
There is no credit check required (see why credit score is critical) and the transaction can usually executed within a week or two. This is much faster than most other loan options.

The Case AGAINST 401k Loans

It’s Too Easy! The ease of which one can withdraw the funds lends itself to bad behavior. If people are already reckless with their personal finances by spending more than they take in by financing a lifestyle with credit card debt, what’s to stop them from drawing down the 401k in similar fashion?
You may miss out on a great market run. While you’re spending that money, it could have been growing your account principal.
If you are unable to pay back the loan, it is considered a premature 401k plan distribution. If you are laid off or leave your job, you may have to pay back the loan in full immediately as well. Otherwise, you will owe federal and state income taxes in addition to the 10% penalty if you are under age 59 1/2.
Sporadically tapping the 401k could seriously impede your retirement goals. Doing this under extremely rare circumstances throughout an entire career is one thing. But taking a loan for each summer vacation and paying it back over the next year is likely to be detrimental to your long term returns.

Why Would You EVER Borrow from your 401k?

There are certain life situations that may warrant tapping your 401k account because the alternative is even less desirable. These circumstances may include being laid off or an unforeseen medical emergency that consumed your emergency funds. If your options are to stop paying the mortgage and face eviction, embrace payday loans, or take a 401k loan, it’s an obvious choice. From another angle, what if a once in a lifetime investment opportunity came along? Example – great real estate investment opportunity or a friend is selling a successful business for health reasons/retirement. If it’s a low risk/high reward opportunity, and you’re confident you could handle the payback over time regardless of what happens to the initial funding, perhaps it’s a worthwhile endeavor.

Disclosure: I Took Out a 401K Loan Myself

In my early 20’s, I took out a 401k loan. I was newly employed and was getting engaged the same year I bought a house a year out of school. I was making pretty good money for my age, as I had one of the highest paying degrees out of school and I employed sound money habits (I drove a piece of junk for years, had no other debt and all I did was work long hours). I knew I could pay the loan back easily but I just hadn’t been working long enough to rebuild a large fund. I had just purchased a home after all. So, in looking at the pros and cons, I decided that rather than either a) propose to my would-be wife with a very meager stone or b) put off getting engaged/married for another year, I opted to fund a diamond I’d be proud to present with partial funding from a 401K loan. While some may scoff at this as a “frivolous” or irresponsible use of 401K funds, I weighed the risks and given the modest amount I borrowed and the outcome, I don’t have any regrets. As expected, I paid it back in a year, paid myself the interest, and as I recall, the market was roughly flat during the period, so I didn’t miss out on a spectacular stock market run.

When To or When NOT To is the Question

With that being said, I don’t think people should take this 401k loan option lightly. Because it’s so easy to do, people are most certainly tempted to tap into those retirement funds for routine spending or frivolous reasons. I mean, is tapping into the 401K any worse than carrying credit card debt? At least with the 401K loan, the interest rate is generally 5% or under and the interest gets paid back directly to you. With credit cards, you can pay upwards of 20% if you’re not in a 0% percent balance transfer. Now, I’m not condoning both/either, but given the lesser of two undesirable sources of temporary income, the 401K loan isn’t looking so bad.

Do You Think It’s EVER Prudent to Take Out a 401K Loan?

$3,000 Cash for Caulkers Details Revealed

Darwin — Tue, 02 Mar 2010 15:20:35 +0000

Cash for Caulkers has been rumored to be coming for some time now, but this week, the administration finally unveiled more details on the rebate plan meant to further stimulate the economy. Following the much maligned and fraud-ridden new home buyer tax credits, cash for clunkers and the impending cash for appliances programs, the administration has formally released details of “cash for caulkers“. Regardless of whether you think one-time jobs such as home upgrades and weather-proofing have any discernible long-term employment benefit for this country, homeowners interested in pursuing these initiatives for their own energy efficiency efforts might as well participate in the program.

Cash for Caulkers Tax Deduction Rules:

Consumers would be eligible for between $1,000 and $1,500 for simple home upgrades such as insulation, duct sealing, water heaters, air conditioning units, windows, roofing and doors.
Homeowners looking for more comprehensive energy retrofits would be eligible for a $3,000 rebate if the efficiency measures lead to a 20 percent energy savings.
According to Obama, these rebates would come instantly from the hardware store, from the contractor
There will be limits of course, but these details still need to be worked out in Congress
Estimates surmise 2-3 Million households will participate

The program is envisioned to cost $23 Billion over 2 years, with $3 Billion set aside for retailers and contractors to promote it, similar to cash for clunkers and dealers.

With basic energy savings tips including a home thermostat and piping insulation, more expensive and complex jobs include energy audits, more extensive insulation, and heating equipment. There is certainly no shortage of ideas and improvements that the typical American household could implement to improve energy efficiency. There is a question of course, over the efficiency of the program itself as currently envisioned.

From a conceptual standpoint, it sounds great to reduce energy costs and energy consumption in the US. After all, we’re sending money to countries that are set on our demise whenever we import oil. High energy prices contribute to inflation, increase our trade deficit and shift money away from other stuff we could be buying to stimulate the economy since Americans don’t save. However, whenever the government tries to solve a problem with a hastily planned program, it’s wrought with waste and fraud and the net outcome is generally a horribly inefficient use of funds and unintended consequences which are never fully understood until the program has run its course.

Take the cash for clunkers program: While it stimulated buyers to trade in older cars for new ones, the American taxpayer paid $24,000 per vehicle to execute the program – what a horrible use of funds! Other initiatives could have distributed funds much more efficiently with both a better ROI and a more widely spread benefit. This was just another case of the government rewarding people for bad behavior at the expense of those with good behavior (those of use that already had fuel-efficient cars and didn’t have a clunker to trade in for a massive discount).

An invite for fraud? Based on what we saw in the new home buyer tax credit, in looking at the sheer number of taxpayers that have already fraudulently claimed the new home buyer tax credit on their returns without even qualifying, it will certainly be a challenge for the administration to put ample safeguards in place to prevent taxpayer/contractor fraud in this program.

At What Cost? What we’ve been seeing with the bailouts and cash-for-whatever programs is that once a program runs out of money or an automaker/AIG says “we need more”, even though the initial legislation was tied to an initial amount, that agreed sum immediately goes out the window and is extended for some period of time with a new limit attached to it. As such, this planned $23 Billion program will likely become much larger. Look at the recent unemployment benefit bill that causes so much contraversy this week. While it would be horrible to be unemployed and lose benefits after said period, are these extensions going to continue forever without actually cutting spending somewhere else in the budget? Each $10 Billion is more debt on our progeny.

So, with that in mind, I will certainly keep you informed as more details emerge, but for now, Cash for Caulkers is in the conceptual stage.

Expect more soon though. Perhaps the prospect of more free stuff will keep the public’s mind off the health care debate, right? If waiting until next year is too long and you want to do something about your energy prices this winter, you should also consider hedging your own energy prices.

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