Archives for June 2009

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401k Overhaul: Yes, we really do need it!

People have been discussing the problems with 401k plans for decades. With all the media coverage of failed retirements and shattered dreams over the last year, the idea of revamping the system has now become particularly popular.

Earlier this week, however, Jeremy from GenXFinance provided a counter-argument, mentioning that–while the 401k system is not perfect–the larger problem is that most investors have:

  • Outlandish expectations, and
  • Poor investment strategies.

I absolutely agree. Those problems are bigger than the problems with 401k plans. However, I think that an overhaul of the system could go a long way toward solving both issues.

First, I agree with Kyle:

Solution Part 1: Eliminate 401k plans entirely.

Meanwhile, remove the income limits for IRA contributions, and increase the contribution limit to $20,000 per year–roughly equal to the current IRA contribution limit plus the current 401k contribution limit.

This way, investors will have the freedom to choose where to invest their money, rather than being stuck paying exorbitant fees to invest in mediocre funds.

While we’re at it, however, new regulations must be created that make it perfectly obvious what the costs of the plan are. Without good information, it’s difficult to make a good choice.

Of course, those two changes would only solve part of the problem. After all–as we can see from the existence of an entire industry of financial advisors–many people don’t want to choose on their own. Whether it’s due to lack of confidence, lack of interest, or lack of time, many people want help.

Further, it’s clear that–when left to their own–many investors don’t, well, invest.

So what could we do about both of those problems?

Solution Part 2: Expand the Thrift Savings Plan

What is the Thrift Savings Plan, you ask? The TSP is the retirement savings plan for Federal government employees. Its investment options are extremely low cost and very easy to understand:

  • A government bond fund. Expense Ratio: 0.018%
  • A fixed income index fund. Expense Ratio: 0.018%
  • An S&P 500 index fund. Expense Ratio: 0.019%
  • An index fund that tracks the Wilshire 4500. Expense Ratio: 0.019%
  • An international stock index fund. Expense Ratio: 0.019%
  • 5 “Lifecycle” funds that are just target date funds made up of the other 5 funds. Expense Ratio: 0.019%

My proposal is to expand access to the TSP to all investors in the U.S. Let us invest our new, $20k-contribution-limit IRAs the same way government employees can.

In fact, don’t just give everybody access, automatically sign people up for it (with contributions going to the appropriate lifecycle fund) when they get a new job. Of course, give people the chance to opt out at any time (including at the date of hire). This way:

  • Anybody who wants to try his hand at picking stocks, picking funds, or timing the market is free to do so, and
  • Everybody who doesn’t want to mess with any of that will have access to low-cost, low-maintenance, easily-understood investment options.

Haven’t we tried this already?

Yes. I’m aware that I have more or less recreated Social Security here. I’d say that there are two primary differences:

  1. An opt-out option for people who want to do it on their own.
  2. Everybody will have their own account rather than being reliant upon the government not spending the money on something else (including the retirement of workers from prior generations).

Sounds pretty good to me.

Do you have a portfolio or an investment collection?

coincollection

Coin Collection

One thing that I’ve seen time and again when looking at people’s investments is that they could more accurately be described as “collections” than as “portfolios.”

Often, people seem to accumulate investments rather haphazardly over the years. By the time an investor is in his 40s or 50s, he (and his spouse’s) investments might look something like this:

Taxable Accounts:

  • 100 shares of this stock
  • 100 shares of that stock
  • a $5,000 muni bond from a local government agency
  • a handful of assorted mutual funds

Retirement Accounts:

  • 3-6 different funds in his 401k
  • 3-6 more funds in his spouse’s 401k
  • 3-6 more funds in his IRA
  • 3-6 more funds in his spouse’s IRA

It’s essential to know what you own.

In my experience, when an investor has an investment collection like the one above, he can’t even tell you what his stock/bond allocation is. Naturally, it’s only made worse when the funds involved are actively-managed funds such that it’s impossible to know precisely what’s in them at any given point.

In case it’s not obvious: This is a serious problem because it can mean that the investor is exposed to more risk than he’s aware of.

Further, when you own actively-managed funds, your diversification may not be as thorough as you’d expect, as the funds’ holdings may overlap significantly.

Complexity doesn’t increase return.

Of course, if you own 20 different mutual funds, it can be hard to keep tabs on what each of them own. The solution: Simplify.

Here’s a guideline I like to use: Outside of your 401k, if you own more than 6 mutual funds, you’re making things unnecessarily complicated. 6 funds should be plenty to provide you with sufficient diversification both among and within the major asset classes.

Moving from “collection” to “portfolio.”

If the bulk of your investable assets are in tax-sheltered retirement accounts, creating a cohesive portfolio is easy:

If a significant portion of your holdings are in taxable accounts, however, things can be a bit trickier, as the “sell everything” step could result in sizable capital gains, thereby taking a significant bite out of your portfolio.

Often, a reasonable approach is to keep your taxable investments more or less in place, while adjusting the allocation in your retirement accounts around them. (Example: If your taxable account is primarily invested in domestic stock funds, consider keeping it there and using your retirement accounts to fill out the bond and international stock components of your portfolio.)

I would, however, caution strongly against putting tax considerations ahead of asset allocation considerations. (Example: If an emerging markets stock fund makes up an extremely oversized portion of your portfolio, it’s probably a good idea to sell some of it even if that means incurring capital gains.)

How to Fill Out Form 8829 (Claiming the Home Office Deduction)

Form 8829 is the form used by sole proprietors to calculate and report Expenses for Business Use of Home (aka “The Home Office Deduction“).

Step 1: Download the Form and the Instructions.

Step 2: Fill-in your name and SSN.

Step 3: Fill-in “Part I – Part of Your Home Used for Business”

(Click to enlarge.)

  • On Line 1, enter the total square footage that you use regularly and exclusively for your business. [Note: When they say “exslusively” here, they really mean exclusively. If you use the space for anything else, you can’t count it for your Home Office Deduction.]
  • On Line 2, enter the total square footage of your home.
  • Divide the square feet used for business by the total square feet of your home, and enter the resulting percentage on Line 3. Also, as long as your business is not a Daycare facility, skip to Line 7, and enter the same percentage that you entered on Line 3. This percentage is the “Business Percentage” of your home. It will be used later in the calculations for determining how much of certain expenses you’ll be able to deduct.

Step 4: Fill-in “Part II – Figure Your Allowable Deduction”

  • On Line 8, enter the total profit from your business. (This can be taken from Line 29 of Schedule C.)
  • For lines 8-35, simply follow the instructions printed on the form. It may not intuitively make sense while you’re filling it out, but here’s what’s happening:
    • In column A, you’re entering and totaling all the expenses that relate only to the business-use portion of your home. (For instance, if you repainted your home office, the costs for the paint job would go here.)
    • In column B, you’re entering costs that relate to your entire home (rent, home mortgage interest, homeowners’ insurance, ultilities, etc.). Then you end up multiplying all of these “indirect expenses” by the Business Percentage of your home (from Line 7), thus giving you the portion of these expenses that relates to your home office.

Step 5: Fill-in “Part III – Depreciation of Your Home”

If you own your home, you can include an expense known as depreciation in your Home Office Deduction. Here’s how it’s calculated:

  • On Line 36, enter the smaller of the home’s fair market value or it’s adjusted cost basis (the amount you paid for it, minus any amount that you’ve already deducted as depreciation in prior years).
  • On Line 37, enter the value of the land that your home is located on.
  • Subtract Line 37 from Line 36. The difference (entered on Line 38) is known as the basis for the building.
  • Multiply Line 38 by Line 7 (Business Percentage of Home). Enter the product on Line 39. This is known as the Business Basis of Building. This is the amount that you will be allowed to deduct, spread out over a period of several years.
  • For Line 40, you’ll enter the percentage of the Business Basis of the Building that you’re allowed to deduct this year. (See the chart on Page 3 of the instructions.)
  • Multiply Line 40 by Line 39. This is the amount of depreciation for your home that you can include in your Home Office Deduction this year. (Also enter this amount on Line 29.)

Step 6: Fill-in “Part IV – Carryover of Unallowed Expenses”

Every year, your Home Office Deduction is limited to your profit from your business. If your expenses for the business use of your home exceed the profit from your business, you’ll have to fill out Part IV of Form 8829. (What ends up happening is that the remaining expenses end up being carried forward, and you can add them to your Home Office Deduction in the following year.)

Step 7: Go Outside and Play.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

How to Fill Out Form 1040: Preparing Your Tax Return

Many people opt to pay a pro to prepare their tax returns for them. Others like to use software. Call me old-fashioned, but I think that preparing one’s own return using the actual forms is an excellent experience for most people. If you’ve never done it before, you can’t help but learn something in the process. Here, I take a look at preparing a Form 1040:

Step 1: Download the Form.

Step 2: Fill-in your personal information.

(Click on any of the images to enlarge.)

The top of the form simply asks for some basic information such as your name, SSN, address, etc. It also asks for your filing status. For the majority of people, this is either “Single” or “Married Filing Jointly.” If you’re unmarried and paying to support a dependent, you may be able to file as “Head of Household,” which will give you some additional benefits.

Step 3: Determine How Many Exemptions You’re Eligible For.

Generally, you are entitled to one exemption for yourself, one for your spouse, and one for each of your dependents. In 2010, each exemption reduces your taxable income by $3,650.

Step 4: Lines 7-22: (Income)


  • For Lines 7-21, list each of your types of income on the appropriate line. Most of this information can be gathered from documents that have already been provided to you. For example, Line 7: Wages, Salaries, and Tips is taken from the W-2 provided to you by your employer.
  • Sum up all of the amounts entered on Lines 7-21, and enter the total on Line 22. This is your “Total Income.”

Step 5: Lines 23-37 (Deductions to Arrive at Your “Adjusted Gross Income”)

  • On Lines 23-35, you’ll enter any of your “above the line” deductions. (Common above the line deductions include the deduction for contributions to a Traditional IRA, the Tuition and Fees Deduction, and the deduction for contributions to a Health Savings Account.)
  • These above the line deductions are particularly valuable, because they save you money regardless of whether or not you choose to itemize your deductions. (More on this in the next section.)
  • On Line 36, enter the sum of all amounts entered on Lines 23-35.
  • Subtract Line 36 from Line 22. Enter the difference on Line 37. This is known as your Adjusted Gross Income. (When people reference above the line and below the line deductions, Line 37–Adjusted Gross Income is “the line” that they’re referring to.)

Step 6: Lines 38-55 (Tax and Credits)

  • For Line 38 (at the top of Page 2) just carry over your Adjusted Gross Income from Line 37.
  • On Line 40, enter the greater of the sum of your itemized deductions (such as home mortgage interest and charitable contributions) or your standard deduction. (The amount for your standard deduction depends upon your Filing Status and is listed in the left margin of the form.)
  • Subtract the amount on Line 410 from the amount on Line 38. Enter the difference on Line 41.
  • Multiply the amount of exemptions you claimed (on Line 6d) by $3,650. Enter the total on Line 42.
  • Subtract Line 42 from Line 41. Enter the difference on Line 43. This amount is known as your Taxable Income.
  • You then use the tax tables in the instruction booklet to determine the corresponding amount of tax for your taxable income. Enter this amount on Line 44.
  • If you’re subject to the Alternative Minimum Tax, enter your AMT amount on Line 45.
  • On Lines 47-53, enter any credits for which you’re eligible. Common credits include the education credits (specifically, the Hope Credit and Lifetime Learning Credit), the Retirement Savings Contribution Credit, and the Credit for child or dependent care expenses.
  • Total your credits, and enter the amount on Line 54.
  • Now subtract Line 54 (Total Credits) from Line 46 (Total Tax). This is the total amount of income tax that you’re responsible for over the course of the year. [Note: As you can see, credits are particularly valuable because they reduce your tax on a dollar-for-dollar basis.]

Step 7: Lines 56-60 (Other Taxes)

In this section, you enter any other taxes for which you’re responsible. (Things such as Self-Employment Tax and the additional 10% tax for early withdrawals from an IRA go here.)

Step 8: Lines 61-76 (Payments, and Refund/Amount Owed)

  • On Lines 61-70, you’ll enter any payments you have already made toward your tax liability for the year. (Most commonly, these payments are in the form of withholding from your wages, or in the form of quarterly estimated tax payments.)
  • If you qualify for the Earned Income Credit, enter your EIC on Line 64a.
  • Sum all of your payments, and enter the total on Line 71.
  • If the sum of your payments was greater than your total tax, enter the difference on Lines 72 and 73a. This will be the amount of your refund.
  • If the sum of your payments was less than your total tax, write the difference on Line 75. This is the amount you still owe. (So go ahead and get out the checkbook. There’s no sense in waiting.)

Step 9: Sign Your Return

Now just sign your return, and you’re all done! Nice job.

For More Information, See My Related Book:

Book3Cover

Taxes Made Simple: Income Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • The difference between deductions and credits,
  • Itemized deductions vs. the standard deduction,
  • Several money-saving deductions and credits and how to make sure you qualify for them,
  • Click here to see the full list.

A testimonial from a reader on Amazon:

"Very easy to read and is a perfect introduction for learning how to do your own taxes. Mike Piper does an excellent job of demystifying complex tax sections and he presents them in an enjoyable and easy to understand way. Highly recommended!"

1099 Income: Am I an Independent Contractor?

Jessica (realtor) asks:

Michael, this year I started working part-time as a realtor. I have been told that I will be receiving “1099 income.” I think this means I will be an independent contractor. Is this right?

Answer:

Hi Jessica. You’re absolutely right. You are now considered an independent contractor, meaning you are self-employed for Federal income tax purposes. This will impact your tax situation in many ways:

  • You will, most likely, have to make estimated tax payments at four (approximately quarterly) intervals throughout the year.
  • You will have to fill out at least two additional pieces of paperwork (Schedule C and Schedule SE). Don’t worry though, if you do some homework ahead of time, you’ll be able to tackle these on your own.
  • You will be subject to Self-Employment tax. (This is really just a different name for a tax that you and your employer would be paying if you were an employee.)
  • You’ll be able to deduct many expenses that would otherwise be nondeductible.

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."

Tax Forms for Independent Contractors | How to Report Independent Contractor Income

Mark (independent contractor/Cutco sales rep) asks:

Hi Mike. I’m a college student, and I work part-time as a Cutco sales rep in an independent contractor role. What tax forms do independent contractors have to fill out? Am I going to need to hire an accountant this year? In other years my Dad has helped me to file my tax returns.

Answer:

Hi Mark.

There are a few different forms you’ll have to fill out this year that you haven’t seen before: Schedule C, Schedule SE, and possibly a Form 4562 or 1040-ES. Don’t worry though–you should be able to manage on your own. As an aside, anything called a “Schedule” is simply an attachment to a “Form.”

Schedule C: This piece of paperwork, an attachment to your regular Form 1040, details the revenues and expenses from your business. It’s fairly straight-forward, as most of your expenses will fall very clearly into one of the categories given.

Schedule SE: Another attachment to your Form 1040, this is where your Self-Employment tax gets calculated. After completing your Schedule C, Schedule SE is very easy and will probably take you only a few minutes.

Form 4562: If you purchased some equipment (a PDA/Blackberry for instance) for use in your business, this is the form that you’ll be using to determine how much you can deduct. This form is easily the most complicated of the ones here, so if you think you’re going to be using it, be sure to save plenty of time to work on it.

Form 1040-ES: If you’re going to have to make estimated tax payments, this is the form you’ll use to calculate how much to send in. (Generally, the amount you send in each quarter is simply equal to 1/4 of the total tax you paid last year.)

Best of luck with your sales!

For More Information, See My Related Book:

Independent Contractor, Sole Proprietor, and LLC Taxes Explained in 100 Pages or Less

Topics Covered in the Book:
  • Estimated tax payments: When and how to pay them, as well as an easy way to calculate each payment,
  • Self-employment tax: What it is, why it exists, and how to calculate it,
  • Business retirement plans: What the different types are, and which one is best for you,
  • Click here to see the full list.
A testimonial from a reader on Amazon:
"Quick and easy read. No fluff, just straight to the point and gives you more helpful information that you might imagine. If you are looking to get the bottom line information you need to start your business right then this book is a must have."
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