What Happens if the Bush Tax Cuts Expire?

These legislative initiatives created six tax brackets and cut taxes across the board for earned income, long-term capital gains and dividends. They also increased the child tax credit, eliminated the “marriage penalty” as well as many other changes, exemptions and adjustments to the tax code.

How soon could you see the impact if Congress does nothing? You could see it as early as January when your employer starts withholding more taxes from your paycheck. Any taxable income earned in which you are having federal taxes withheld prior to distribution, could be impacted.

Congress could address the tax cuts when they come back to Washington following the mid-term elections. But it is difficult to predict what the political environment will be in the Capital following this highly contested mid-term. It is unlikely that nothing will be done. Democrats and Republicans agree that the expiration of the current tax policy needs to be addressed. The question is whether or not they can come to a consensus on how to address it and for whom.

Most in Congress believe that increasing taxes during a recession will harm our chances for a continued recovery. However, there is still debate on how tax cuts across the board will impact the already stifling $1 trillion plus budget deficit.

Posted on November 1, 2010 Read More

Borrowing from Your 401(k)

While every 401(k) plan is different, most will let you borrow as much as 50% of your vested balance up to $50,000. The loan is paid back through your paycheck, with interest. Most plans have competitive interest rates and the loans can be carried for up to 5 years. If you use the proceeds of the loan to purchase a primary residence, that pay-off term may be extended.

When you are making payments back into the loan, you are paying yourself interest on the money you borrowed. This is where it gets a bit foggy. First, when you draw your paycheck, you pay taxes on the earnings. Then you pay the interest on the loan out of what remains. At a later date, say retirement, you begin drawing from the plan. Those distributions are taxable income, therefore taxed again. You are paying income taxes twice on the funds you use to pay interest on the loans. (Special tax rules apply to Roth 401(k) contributions).

There is an opportunity cost with taking a loan from your 401(k) as well. If those funds are not invested, they are not continuing to grow tax deferred. So, what is the opportunity cost? Well, you need to compare the interest you are paying yourself and the future tax implications previously discussed with the lost opportunities of tax deferred investment returns.

There are other considerations as well. For instance, if there is a separation from employment, the plan may require that the loan be immediately repaid. If you don’t have the funds to repay the loan, it is treated as a taxable distribution. If you are not age 59 ½ or more, a 10% early withdrawal penalty may also apply to the taxable balance.

Whether or not you can afford to pay back the loan and still make contributions to the plan should be carefully considered. Would the circumstances that have lead you to look at borrowing the funds as an option impair your ability to repay the loan? If so, this might not be considered a viable option.

The interest you pay on alternative financing options may be tax deductible. For example, the interest on a home mortgage often qualifies for a tax deduction. However, the interest on a plan loan repayment often is not. Be sure to weigh the comparisons of tax deductibility for both alternatives before making a decision.

Every plan is different and will have various restrictions. Consult with your plan administrator before deciding to borrow from your 401(k).

Posted on October 1, 2010 Read More

Is Your Mental Accounting Adding Up?

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The faulty stock market perception can be illustrated with the following equations.
If you were to ask people what the average of 3 and 5 is, they typically respond as follows: (3 + 5 = 8)/2=4. The average is 4.

If you were then to ask them for the average of a negative 50 and a positive 50 they would do the equation the same way. So the typical investors assume that if they are getting positive returns and negative returns that they are still doing fine.

So what if you were then to ask them, “What is the impact of losing 50 percent one year and gaining 50 percent the following year? Back to your starting amount, right?” Actually, that would work out like this:

• $10,000 down 50 percent is $5,000
• Then up 50 percent is $7,500
• This is a 25 percent loss (13 percent annualized) after “offsetting” years.

Let’s look at an example in which the gaining percentage is greater than the losing one. A return of +66 percent followed by -50 percent would seem to add up to an 8 percent return. But actually:

• $10,000 up 66 percent is $16,600
• Then down 50 percent is $8,300
• +66 percent followed by -50 percent produces a negative 9 percent annualized return.

But look at the compounding gain of two 8 percent years:
$10,000 x 1.08 = $10,800 x 1.08 = $11,664

So, many people wrongly think that if they are getting a greater return than a loss, then they are doing well. But obviously that’s not true. Another misperception is just how deep a hole is created by losses. A 100 percent return would be necessary to offset a 50 percent loss. But a 300 percent return is required to offset a 66 percent loss. And then 400 percent for a 75 percent loss.

So, the next time you’re thinking about taking a risk, make sure you are doing an accurate mental accounting.

Posted on September 1, 2010 Read More

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