Taking Advantage of IRAs

With tax season here, it is a good time to consider IRAs. IRA stands for individual retirement account. They are a special type of account created by the government to encourage people to save by providing certain tax benefits. There are two types of accounts. One gives you a tax benefit now and the other gives you a tax benefit later.

Traditional IRA

In a traditional IRA, the government allows you to deduct the amount put into the IRA from the money you pay tax on. So if you owe tax on $50,000 for the year and put $4,000 in to a traditional IRA, the government would only tax you on $46,000. If you pay 30% taxes, that might be worth $1,200 to you.

Once the money goes into an IRA, you can’t take it out without paying penalties to the government. In addition to paying tax on the money when you take it out, you’ll pay an additional 10% penalty. There are certain provisions for hardship withdrawals that we won’t get into here.

When you retire and take money out of the IRA, you will pay tax on it then. Depending on your age there may be required to take a certain amount of money out each year.

Roth IRA

A Roth IRA is similar to a standard IRA, but it doesn’t give you the tax savings up front. You pay tax on all of your income now, but when you retire, you don’t have to pay any interest on the original amount (you already paid that tax) or on the amount it has grown. So if you put $4,000i into a Roth IRA and it grows to $12,000, you will pay the tax on the $4,000 up front, but you won’t have to pay any tax on the $8,000 in interest.

If you take an early withdrawal from a Roth IRA, you don’t have to pay tax or penalties on the original amount you put in. You do have to pay tax and penalties on any amount it has grown. The penalty is 10% just like it is for the Traditional IRA.

Exceptions

Certain exceptions may allow you to take money out of an IRA without paying the penalty. If you become disabled, have very large medical expenses, or if you use the money to purchase your first home you may be able to avoid the penalty.

Which Type of IRA

In general it makes sense to put money into a Roth when you are in a low tax bracket and a Traditional IRA when you are in a high tax bracket. Further, put money into a Roth when you expect it to grow significantly. Put money into a Traditional IRA when you need to shift the tax burden to a year that you will be in a lower tax bracket.

So following this advice a 20 year old with their first job would probably want to put as much into a Roth IRA as possible. This money will have the most time to grow and the 20 year old is probably not at the top of his salary curve. As the individual gets older it may make sense to switch to a traditional IRA. For example once the kids leave the house and no longer can count as dependents it might make sense to switch over to a Traditional IRA. This will probably happen when the individual is around 50. Also this money has less time to grow, so the future tax savings will not be as great. Also the individual is probably at the peak of the salary curve so it makes sense to try to minimize taxes now.

If an individual plans to make much more during retirement than now, it might make sense to stick with Roth IRAs the entire time.

One advantage of having both types of IRAs is that it gives you some flexibility to pull money from which ever one will have the least tax impact for that year. So during retirement you can take money out of the Traditional IRA when you have very little other income and your tax burden is low. You can take money out of the Roth IRA when you have a high income and don’t want to pay more taxes at your marginal rate.

Are US Income Taxes Illegal

You’ve probably seen programs advertised that say they can show you how to not pay anything in income tax. Many of these programs make statements that the US income tax is illegal and as such it is unenforceable. I’ve heard people claim that they don’t pay any taxes and that the IRS leaves them alone because the IRS knows it is legal for them to not pay tax.

For a moment, lets consider the possibility that income tax is illegal and the law doesn’t require anyone to pay income tax. Even if that was true, you have to look at how it is enforced. The IRS can take you to court and if you lose you can go to jail. It doesn’t matter if the income tax is invalid on a technicality, the truth is you can go to jail for not paying your taxes–regardless of how right you think you are.

If you do go to court and end up in a jury trial, you are going to be judged by average citizens. Since most of the people in the US pay the taxes that they owe, it is unlikely that they are going to be sympathetic to your claim that you shouldn’t have to pay anything. So even if it were true that you shouldn’t have to pay taxes, you still face the very likely possibility of going to jail.

When it comes down to the law, taxes are legal. Some people say that they aren’t legal because at one point in time they weren’t. The federal government didn’t always have the power to tax individuals directly. It could tax the states, but it had to be done proportional to their population. The idea of taxing citizens directly wasn’t legal. However the 16th amendment to the Constitution, specifically addresses this.

The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.

That makes it pretty clear that the government has the ability to tax individual income. If someone tells you otherwise, they are either making money by telling people what they want and paying taxes on that money or they are operating illegally and will potentially face very serious consequences in the future.

How to Make $82,400 Tax Free

The US taxation system is generally designed to tax everyone on money they make from any source inside or outside of the US. In some cases you can end up paying double tax on foreign source income because it is taxed in the foreign country and again in the US. However, there is a provision that will allow you to earn $80,000 without paying tax to the US government.

This provision is designed to minimize the tax burden on people who are no longer living in the US and make their income from a foreign source. It allows the exception if you are a resident of another country and have lived there for a full year or if you have spent at least 330 days of the last year outside of the USA.

Residency Test

Proving that you are a resident of a foreign country isn’t as simple as it seems it would be. There are many people who have homes outside of the US, but are still US residents. Basically you will need to do all the things you would normally do when establishing a residency in a foreign country. Getting a local drivers license, utility bills, property lease, etc. Just as important is how you handle your property in the US. If you move all of your belongings to your foreign residence it is easy to prove that you don’t reside in the US. Short of that, selling or renting out your home, placing your car in storage and other such actions will help establish your foreign location as your true residence.

Claiming to be a foreign residence, but keeping a house, vehicles, and other possessions easily accessible in the US will make it difficult to believe that you are truly a residence of another country.

Here is an example from the IRS.

For several years, you were a marketing executive with a producer of machine tools in Toledo, Ohio. In November of last year, your employer transferred you to London, England, for a minimum of 18 months to set up a sales operation for Europe. Before you left, you distributed business cards showing your business and home addresses in London. You kept ownership of your home in Toledo but rented it to another family. You placed your car in storage. In November of last year, you moved your spouse, children, furniture, and family pets to a home your employer rented for you in London.

Shortly after moving, you leased a car and you and your spouse got British driving licenses. Your entire family got library cards for the local public library. You and your spouse opened bank accounts with a London bank and secured consumer credit. You joined a local business league and both you and your spouse became active in the neighborhood civic association and worked with a local charity. Your abode is in London for the time you live there. You satisfy the tax home test in the foreign country.

Under the residence test, you are allowed to return to the US. It doesn’t appear that there is any certain amount of time that you are required to be outside the country. However, if you claim to live in Belize, but you spend 95% of your time in the US, you will likely fail the residency test.

Physical Presence Test

The other way to qualify for the $82,400 exclusion by calculating the number of days you intend to spend in the US each year. Even if you don’t establish a residency in a foreign country, but you are only in the US for 35 days in a given 12 month period, you will qualify for the exemption. This is particularly useful if you plan to travel around and not spend much time in any one place.

The IRS will also allow you to overlap 12 month periods to calculate the time you were out of the country. Here is one of their examples:

You work in New Zealand for a 20-month period from January 1, 2005, through August 31, 2006, except that you spend 28 days in February 2005 and 28 days in February 2006 on vacation in the United States. You are present in New Zealand 330 full days during each of the following two 12-month periods: January 1, 2005 - December 31, 2005, and September 1, 2005 - August 31, 2006. By overlapping the 12-month periods in this way, you meet the physical presence test for the whole 20-month period.

Form 2555

The form to file for this exemption is Form 2555 from the IRS. Keep in mind that it only helps you out if you have income from a foreign source, so you have to be working for a foreign business. You can’t simply take your salary from a US company and claim an $82,400 exemption just because you’ve been traveling around the world. The IRS states that you don’t have to be in the foreign countries for employment–you can be traveling around on vacation.

It is important to note that Form 2555 only applies to earned income. Basically that refers to income you earn for doing work. It does not apply to income you earn for investments.

Form 2555 isn’t likely to help the average individual, however it is very worth keeping in mind as people spend more time traveling with an increasingly mobile workforce that crosses borders.

Personal Health Insurance

For many people, the primary reason they work for someone else is because of health insurance. The fear of not being able to afford medical care, keeps people from starting their own business, retiring, or doing what they really want to with their life.

The reason for this concern is because of the high cost of insurance. Most people who look into getting their own health insurance get a quote, discover that the fees are very high, and stop looking. In this article we are going to examine several ways to get insurance that is less expensive.

High Deductible

Insurance companies charge you more if they expect to have to pay more. By choosing a high deductible (particularly if you are in good health) you can lower your payment.

Even if the high deductible means you are paying more out of your own pocket, insurance companies can still save you money if you are able to use their contracted rate for services. For example, if you schedule an appointment with a doctor and just pay for it yourself, you may be charged $300. However, the same visit may be listed as a $60 service based on the contract your insurance company has with the doctor. So even if you end up paying the entire cost yourself, you can still benefit from the lower negotiated rate from the insurance company.

Group Insurance

If you try to buy personal insurance, you will be charged based on the risk you pose. If you have pre-existing conditions or are older, your rates will be significantly higher. However, in some states there are limits to how much more an insurance company can charge if you are part of a group plan.

Group insurance is what most companies get for their employees. If your state regulates how high premiums can be for group insurance, you may be able to get a better deal by getting group insurance instead of an individual policy.

Usually group insurance will require at least two members and will need to be purchased by a company not an individual.

Health Saving Plans

Another option that goes along with high deductible health insurance is health savings plans. These are savings accounts where you (or your company) can put money tax free and then u se it for medical expenses. The account follows you, so you still keep the money even if you move to a different employer.

Health savings plans can be a valuable way to prepare for going into business for yourself. If you set aside money into a health savings plan while you are working for another employer, you’ll have a reserve setup to use for medical expenses when you start your own business. When you start your own business you can get an insurance plan with a very high deductible to keep your monthly expenses as low as possible and use the health savings plan to cover any expenses not covered by the insurance plan.

Income and Quality of Life

Salary should be part of what you look for in a job, but if you just focus on how much you will be making you are setting yourself up for problems. If you make $60,000 per year, but live in an area where the average house costs $500,000 per year you may be better off taking a job for $30,000 per year where you can buy the same size house for $80,000. Most people tend to look at their yearly income, but forget to pay any attention to their living expenses. You’ll be able to pay off a $80,000 house off much quicker on a $30,000 per year salary than trying to pay off a $500,000 house on a $60,000 salary. On top of that if the real estate market takes a dive, the $500,000 is likely to lose a whole lot more value than the less expensive house.

There are a host of other expenses to consider as well. If you take an expensive job somewhere that requires a two-hour commute each way the cost is really going to add up. Even more important than the cost of gas and mileage, is the amount of your life that you’ll be giving away. If you end up in traffic for 4 hours each day, you could just as easily take a lower paying job near your home and spend your reclaimed commute time working at McDonalds 20 hours per week. By the time you consider all the expenses it is quit possible you’d come out ahead from a financial standpoint.

It isn’t just about the money. You need consider how taking a particular job will impact your financial situation and entire quality of life. Money is an important ingredient in the quality of life mix, but it isn’t the only part. Many people think they are rich because they are making a lot of money when in reality they are poorer than people with much lower income living elsewhere.

You cannot just focus on your income you have to look at both your income and expenses in order to be able to make a good decision. You also cannot focus just on the money; you have to look at your entire life holistically. If you just look at one segment you can easily convince yourself that you are making a good decision, when in fact you are setting yourself up for poverty.

It isn’t how much you make that matters. What is more important is whether or not you are getting to live your life in a way that you are happy with. If you just focus on the money, you can convince yourself that you are happy with a situation that really amounts to living in poverty. Look at your life as a whole. Think about your free time, your family, your friends, etc. If you don’t you’ll get to retirement age and wonder where all the years went and why you didn’t spend them on things that were more important.

Benefits of using Credit Cards

Credit cards can get a lot of people in trouble. The interest rates are high and undisciplined shoppers can acquire a huge amount of debt very quickly. However there are many benefits in using a credit card for your purchases. For example: credit cards can be one of the most useful tools in tracking your expenses. They way they work is beautiful and simple. You make a purchase on your credit card, the charge is sent to the bank, the bank approves the transaction, and the bank posts it on a website or makes it available for you to download into your personal financial software.

You can’t beat the ease of use for record keeping. It almost happens automatically. For people who pay the balance at the end of each month there is no expense for this service. In fact with the reward programs available on most cards, banks basically pay you to use the card.

Of course this only works because many people do not pay their balance at the end of the month. If no one carried a balance, the banks would start losing money and they definitely would not have any of those programs that give you free sky miles or points toward buying books and electronics.

The average amount owed by an American with a credit card is over $8,000. For the banks this is a windfall. The interest rate on credit cards is very high–much higher than other types of loans. Banks make a tremendous amount of money of people carrying balances.

If you have the financial discipline to pay off your balance at the end of each month and track your credit card expenses just like a checking account, you will basically get the credit card services for free–paid for by people who do not pay off their balance each month.

You get free record keeping, free reward points, and many other features. Many credit cards offer some type of insurance if your purchase is stolen. Others offer extra life insurance policies for air travel booked on their cards or free rental car insurance. Some credit card companies offer extended warrantees on certain types of items purchased with their credit card.

One of the most important benefits of a credit card company is the fact that they will usually stand up for a good customer that is being charged incorrectly. For example, assume you cancel an order with a merchant and they ship you the goods anyway. When you try to return the items, the merchant says that you can’t. A quick call to your credit card company will probably be all that is necessary to resolve the situation. Credit card companies can revoke money from merchants and this is exactly what they will do if you complain that you were shipped an item that was canceled. That means instead of you spending hours on the phone trying to resolve the situation, your credit card company will call the merchant and tell them that you didn’t want the item and that they are revoking payment. Naturally the company is going to let you return the item so they don’t lose the item and the payment.

There are many benefits you can obtain by using a credit card–all for free as long as you pay off your balance at the end of each month. Other people aren’t going to pay off the balance and they are paying for you to get free service. Many of these benefits are found in the fine print of your statement or in the paperwork that came with the card in the first place. Make sure you understand how everything works because the benefits differ from card to card.

Keeping Track of Your Finances

One of the most important steps in controlling your finances is simply tracking where your money goes. You can’t manage your money unless you understand where it is going. Many people don’t track their expenses unless they are under financial strain. When finances are tight people tend to allocated money to different categories and then try to stay within the amount allocated. This is commonly called a budget.

Keeping track of your finances when you are not in a financial bind has many benefits. For one you can get a good view of your spending as it is instead of trying to control it. Understanding your spending habits can be very insightful. You may find that you are happy with how you spend your money. It is also possible that you’ll find some areas where you are spending more than you really feel is necessary. For example, many people find that they spend much more on eating out than they realize. Once they realize this, they may decide that investing in a grill for their home is better use of their resources and more in line with their priorities. It is also possible to discover that you aren’t spending as much as you’d like in certain areas. Savings and charitable giving are two areas that come to mind, but you may find that your spending doesn’t reflect your true interests and want to allocate more money to certain activities.

By keeping a record of where your money goes, you are better able to understand yourself. It is much easier to start this discipline when you aren’t hurting financially because there is no pressure. You don’t have to change your behavior; you just want to understand it.

Tax Free Retirement

The government wants you to save for retirement. To encourage this, they offer you special tax incentives to save. There are several savings methods that allow you to put money into savings for retirement without requiring you to pay tax on that money. As an example, consider $2,000 that you earn and stick in your checking account. When you earn $2,000 the government will take about 30% in taxes. Most of this money is taken out before it goes to your paycheck, so you never see it. So when you earn $2,000 you actually only get $1,400.

If you put $2,000 in certain retirement accounts however, the government doesn’t take their 30%. So when you earn $2,000 you get to keep put the entire $2,000 into savings. When you go to take it out at retirement, you have to pay taxes on it, but since your are likely to be in a lower tax bracket when retired, you’ll pay much less in taxes. Also, by putting the entire $2,000 into a savings account now, you get the benefits of compounding interest on an extra $600 which is pretty significant.