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Disability – An Abundance Risk

November 13th, 2007 at 11:22 pm

Disability is a risk that many people underestimate. While most people have life insurance, health insurance and property/casualty insurance, many people fail to carry adequate disability insurance. Some people believe that the risk of becoming disabled is so small that they can afford to ignore it. Others believe that they will get enough through Social Security, if they become disabled. If you believe either of these to be true, you might want to reconsider.

A U.S. worker, under the age of 65, has a considerably higher risk of being fully disabled for over six months than she does of dying. Why is it that many more workers have life insurance than have disability insurance? Can you financially afford the consequences if disability occurs?

Perhaps you are planning to rely on Social Security if you become disabled. The Social Security administration states that “you can receive disability benefits after six months if you have a physical or mental impairment that’s expected to prevent you from doing substantial work for a year or more or result in death.”

However, virtually no one begins collecting Social Security benefits before they have been disabled for at least one year. Combining the long “lead time” to begin collecting Social Security benefits, with the relatively low monthly payments is a recipe for financial disaster. Just as you are not planning on receiving 100% of your retirement benefits from Social Security, you should not depend on Social Security alone to take care of you if you become disabled.

If your employer does not provide you with long term disability coverage, you should seriously consider buying a personal disability policy. If you pay for the policy, the disability income will be tax free. Combining the tax free disability payments with Social Security payments will allow you to buy a policy that covers less than your current total income.

There are many decisions to make with a disability policy such as a “noncancelable” policy in which payments never rise versus a “guaranteed renewable” policy where the insurer may increase premiums over time. Before buying any disability insurance policy, find a trustworthy insurance agent who will explain the costs and benefits of all of the policy options. Choose the policy with the coverage amount, benefit period and policy options that meets your current financial

Avoid Paying Double Taxes on Mutual Funds

November 11th, 2007 at 06:58 pm

As the end of the year draws near, mutual fund companies are required to distribute all of their capital gains and dividend income accumulated over the past year. If you have mutual funds, you likely reinvest these distributions into more shares of the mutual fund.

If you plan on selling a mutual fund soon, you might want to sell the fund before the year end distribution, to avoid paying taxes on this year's distributions. If you are planning on buying a mutual fund, you may want to wait until after the yearly distribution is made, to avoid paying taxes on gains in which you did not participate.

A costly mistake, that many people make, is not keeping track of their yearly distributions from mutual funds. Each year, you will pay taxes on the capital gains and dividend distributions from a mutual fund. If you reinvest your capital gains and dividends, when you decide to sell the mutual fund, these distributions should be included in your cost (basis) of the fund. If you forget to do this, you will end up paying taxes twice on these distributions.

As an example, suppose that you bought a mutual fund five years ago for $10,000. Each year you reinvest your $1,000 capital gains and dividend distribution. At the end of five years, your mutual fund holdings are valued at $17,000. What is your capital gain if you sell?

If you forget that you have already paid taxes on $5,000 of capital gains and dividend distributions, you might report a capital gain of $7,000. However, since you have already paid taxes on $5,000 of capital gains and dividends, your cost/basis is $15,000 and your capital gain is only $2,000.

If you buy and hold mutual funds, be sure to keep track of the reinvested gains that you receive and pay taxes on each year. This will keep you from paying Uncle Sam more than you should when you sell the fund.

Choose the High Deductible Health Plan

November 8th, 2007 at 11:34 pm


Many companies are now offering the choice of a “traditional” health care plan or a high deductible health plan (HDHP). Often, the employees are only told that the HDHP costs less (usually by 20% - 30%) and has a higher deductible. The deductible for a family “traditional” plan is often at least $500 per individual and $1,000 for the family. For a HDHP the family deductible is often as much as $3,000.

If your traditional plan costs $200 per month and the HDHP costs $160 per month (20% less) you might be believe that the $40 per month ($480 per year) savings is not worth the risk of possibly paying $2,000 more in deductible expenses. This would be true, if you do not take advantage of the tax free Health Savings Account (HSA) that can be matched with the HDHP.

However, if you are in at least the 25% federal income tax bracket and deposit the family policy maximum of $5,650 into your HSA, the cost of an HDHP will always be less than a the cost of using a traditional plan.

If you are in the 25% federal tax bracket, the $5,650 HSA deposit will provide a federal income tax savings of ($5,650 *25%) = $1,412.50.

Next, using your HSA for medical expenses lets you pay for them with tax-free dollars. The $3,000 deductible can be paid with these tax-free funds. This reduces the $3,000 cost by your 25% tax bracket to a cost of $2,250 on an after tax basis.

Let’s add up the after tax costs of each plan. The traditional plan costs $480 more and saves you ($2,250 - $1,000) = $1,250 on after tax deductible costs, for a net “savings” of ($1,250 - $480) = $700

However, the HSA deposit of $5,650 has an income tax saving of $1,412.50. When the income tax savings is included, the HDHP plan costs ($1,412.50 - $770) = $642.50 less than the “traditional plan, even when your health care costs “max” out the $3,000 deductible.

If you only use $1,000 in medical expenses for the year, the savings with the HDHP is $2,142.50. This represents the sum of the insurance savings ($480), the HSA tax savings ($1412.50) and the savings from paying the deductible with funds that are never taxed ($250).

If you are in a higher tax bracket and/or if you pay state income taxes, your savings with an HDHP are even greater. Plus, the funds remaining in the HSA continue to grow tax free and can be used for future medical expenses tax free.

The bottom line is that, if you are in at least the 25% federal income tax bracket and your company offers an HDHP, you will come out ahead with the HDHP, as long as you contribute the maximum amount allowed to your HSA.

Buy Your First Home with a Roth IRA

November 7th, 2007 at 06:15 pm

Thanks to the present financial crisis that began with the proliferation of “sub-prime” mortgages, housing prices are dropping and mortgages are getting harder to obtain, even for people with a good credit history. If you are wondering if you will ever be able to buy your first home, you may want to consider the benefits of saving for it by using a Roth IRA.

If you are single, with an Adjusted Gross Income (AGI) of under $99,000, or married (filing jointly) with an AGI of under $156,000, you may contribute up to $4,000 of your income to a Roth IRA. In 2008, the maximum Roth IRA contribution will be $5,000. While your contribution does not lower your immediate taxes owed, it can literally open the door to owning your first home.

Let’s assume that you would like to buy a house in the next 5 years. In 2007, you contribute $4,000 to a Roth IRA. In 2008 -2011, you contribute $5,000 each year. At the end of 5 years, assuming an 8% return on your Roth IRA investments, the $24,000 that you have invested will have grown to over $30,000.

With a Roth IRA that has been established for at least five years, you are allowed to withdraw up to $10,000, in income and growth, plus all of your contributions, when the proceeds are used to buy a first home. In the example above, all $30,000 can be withdrawn to purchase a first home, without any income tax or penalties.

This approach will allow you to make a 10% down payment on a $300,000 house. If the remaining $270,000 is financed with a 30 year mortgage with a 6% annual interest rate, your monthly payments would be approximately $1,620 (plus taxes and insurance). While this approach takes patience, it may allow you to become a home owner, building up equity in your future, while your friends are still renting.

IRAs: Roth or Traditional

November 1st, 2007 at 10:59 pm

I am often asked whether it is better to contribute to a traditional, deductible IRA or to a Roth IRA. As with most personal finance questions, my answer is typically “it depends.” In this entry, I will provide some guidelines to help you decide which is best for you.

When I use the term “IRA,” I am only addressing deductible IRAs. In a future entry I will discuss why I believe that it is seldom wise to fund a non-deductible IRA.

Let’s first look at the rules:

With a traditional IRA, you must be under 70½ years old plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you are covered by a retirement plan, you can only deduct the full amount contributed to your IRA if your Modified Adjusted Gross Income (MAGI) is no more than $52,000 as a single tax payer or $83,000 as a joint filer.

With a Roth IRA, your Adjusted Gross Income (AGI) must be less than $99,000 as a single filer or $156,000 as a joint tax filer plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you make any deductible IRA contributions, the amount that you can contribute to a Roth IRA is further reduced by the amount that you contributed to the deductible IRA.

Based on these rules, the decision on which IRA to use is sometimes obvious:

1. If you are a single filer with an AGI over $99,000 or a joint filer with an AGI over $156,000 and you are not covered by a retirement plan, you can only fund an IRA.
2. If you are covered by a company retirement plan and your MAGI is over $83,000 but less than $156,000 as a joint filer or $56,000 but less than $99,000 as a single filer, you cannot receive full IRA deductibility, but you are able to fully fund your Roth IRA.
3. If you are over 70 ½ and have earned income, you can only fund a Roth IRA.
4. If you are saving to buy your first home, up to $10,000 of growth and income from a Roth IRA, plus all of the contributions may withdrawn, tax and penalty free.

Now let’s look at the more subtle differences between the IRA plans:

1. If you are under 40, the tax free growth combined with the tax free withdrawal of the funds (when you are over 59½) often make the Roth IRA a better, after-tax investment strategy.
2. If you may need some of the funds before you turn 59½, with a Roth IRA you can typically withdraw all of your contributions and pay no taxes or penalty on the withdrawal.
3. If you are over 40 and wish to pass some of your estate to your children, a Roth IRA is an excellent way to pass funds to younger generations.

When none of the above apply, the decision of funding a Roth IRA or a traditional, deductible IRA must be made by analyzing your current tax bracket, what you believe will be your future (retirement years) tax bracket and whether you expect to consume the retirement funds or pass them to future generations. This is never easy and often comes down to whether you want the tax reduction now or you can wait to get it later.

Taxing Times for Your Home

October 31st, 2007 at 11:40 pm

Congress is looking for ways to raise taxes and your homes are in their line of fire.

On September 27, the Wall Street Journal reported that the House’s Ways and Means Committee has approved a bill under which homeowners facing foreclosure will not get a tax bill, if part of their debt is forgiven by lenders. Presently, forgiven debt is treated as taxable income to the borrower.

To pay for this tax break, the committee decided to eliminate the ability to sell your second home and pay no capital gains taxes on up to $500,000 in profits, when the home is your primary residence for two out of the last five years. A full explanation of this tax break is found on page 106 of the Financial Abundance Guide.

With the proposed tax policy, the capital gains tax break for a second home would be based on the number of years that the house has been your primary residence. The longer your second home has been your primary residence, the larger will be your capital gains tax break when it is sold.

If your second home has been your primary residence for two of the past five years and you are trying to avoid capital gains taxes on its sale, sell it quickly and hope that Congress does not make this change retroactive.

The second way that your home’s tax deductions may come under congressional fire was discussed in a Wall Street Journal editorial on October 6. As part of a tax bill to reduce CO2 emissions, John Dingle, chairman of the House’s Energy and Commerce Committee, is proposing to eliminate the mortgage deduction on homes over 3,000 square feet in size.

While the probability of this measure passing is low, it portends that large, “energy wasting” homes will be a future tax “target” for Congress. If you are in the market for a new home, consider a smaller, “energy efficient” one.

Living In Financial Abundance

October 31st, 2007 at 11:34 pm

Are you interested in living from a position of financial abundance?

Meeting current financial obligations, saving for your family’s education and retirement expenses while increasing charitable giving are the outcomes of living in financial abundance.

I will be publishing blog entries to provide information that may help you increase your sense of financial abundance. These entries are meant to supplement the material contained in Financial Abundance Guide. If you have questions or comments on the information provided, please add to my blog.

Over time, my goal is to have a blog where people can increase their personal financial knowledge and learn to live from a sense of financial abundance.


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