Bergerson Tax Services

The answers to the questions you have always had about your personal finances.

We will frequently address a personal finance, tax, or investment topic that personally affects you and your overall financial well-being.  These articles will be laid out in a way that everybody can understand and apply to their own real life finances.  We at Bergerson Tax Services, Inc can help you with all of your personal finance and tax related needs. Please fell free to contact us anytime. This month’s topic is

Should I Pay off My Debt Or Should I Invest For My Retirement?

By Jeff Bergerson, Bergerson Tax Services, Inc

In a perfect world you would be able to pay off all of your debt and also invest for your retirement.  Unfortunately, like most of us you probably do not have enough money to pay off all of your debt and invest for your retirement at the same time.  So what is the most financially savvy strategy to help you pay off your debt and fully fund a retirement account? Should you pay off all your debt before contributing to a retirement account; or should you keep certain debt and contribute to your retirement account.  In this article I will address the different types of debt that you might have, which debt is the best and worst to keep, and walk you through an illustration.

First of all, lets address the type of debt that you might currently have: Home mortgage, student loan, car loan, and credit card debt.  As I wrote in January’s article, To Pay Off My Home or Not to Pay of My Home, That is the Question, a home mortgage can be considered reasonably good debt to maintain.  Interest rates on home mortgages are generally lower than car loans or credit cards, plus the interest you pay is tax deductible. For example, if you have a interest rate of 6% on your mortgage and are in the 35% tax bracket, the after tax cost of your loan is only 3.9%.  Student loan interest is very similar in that the interest rates are reasonably low and the interest is tax deductible.  Up to $2,500 of student loan interest is deductible as long as your modified adjusted gross income is below $70,000 for single filers and under $140,000 for married filers. 

Car loans are a different story; depending on the terms of your car loan your interest rate may or may not be as low as your home mortgage or your student loan, but the interest you pay on it is not tax deductible.  Finally, the worst kind of debt that you can have is credit card debt.  The national average interest rate on credit cards is a staggering 15%, plus the interest you pay is not tax deductible.

When determining what debt to pay off first, it is clear that credit card debt and possibly car loans need to be paid off before your home mortgage and any student loans. The question of whether to even try to pay off your home mortgage or keep it is answered in January’s issue, To Pay Off My Home or Not to Pay of My Home, that is the Question.

It has been determined that credit card debt is the first debt that you should attempt to pay off, but what about investing for retirement? Should you pay off your credit card first, and then save for retirement, or should you just pay the minimum on your credit card and invest the rest into your retirement account?

Lets look at an example to help you decide.

Lets say you have a $5,000 credit card balance of which the interest rate is 14%.  At the same time your employer has a 401K plan and offers a 50% match (50 cents per every dollar you contribute) up to 6% of your salary.  At first glance it looks like a no-brainer, 50% vs.14% returns.  But consider the fact that the 50% match is a one-time gift while the 14% compounds yearly and eventually will overtake the 50%.  Now lets say you have $250 every month of which you have to pay your minimum credit card payment of $125, so you have $125 to either put toward the balance of your credit card or invest in your 401K. 

Example 1.  You pay just the minimum of $125 and invest the $125 (which is actually $174 because it will be contributed pre-tax) every month.  You will need 55 months to wipe out your credit card debt.  During that time if you earn 8% in your 401K and receive a 50% match you will accumulate $17,271 in your 401K.

Example 2.  You choose to put the entire $250 toward your credit card debt and hold off entirely on contributing to your 401K.  You will pay off your credit card in 23 months.  At that point you can begin contributing all $250 to your 401K.  By the end of 55 months you would have $18,515 in your 401K plan.

By focusing on paying off your credit card completely and then funding your 401K rather than splitting your money between the two you will have $18,515 rather than $17,271 over that 55- month period. You can see that paying off your credit card completely before funding your retirement plan is a more effective strategy. 

There are a couple caveats to the idea that paying off your credit card will produce more money in your pocket overall.  First, if you just have a small amount of credit card debt and would be able to pay off that debt in under a year’s time, go ahead and fund your retirement account and take advantage of that employer match.  In instances where you do not have any credit card debt I would always advise to contribute the maximum amount to your 401K up to your company match, its free money!  The other time where I would advise to contribute to your retirement account before paying off your credit card debt completely is if you do not contribute to your 401K at first it meant you never ended up doing it.  In this case I would say start contributing and get the ball rolling and then pay off your credit card.

Ideally the best financial strategy for most people who have credit card debt is to focus on paying off your entire credit card balance first before you begin investing into your retirement account. Once you pay off your credit card balance, begin investing into your retirement account.

Now that we have determined paying off your entire credit card balance is the most financially savvy strategy, I will give you a couple of strategies to help you pay off your credit card debt in the most effective way. 

If you have more than one credit card and cannot pay them all off, the best bet is to try to consolidate all of your cards into the one that offers the lowest rate.  Most credit card companies make offers of lower interest rates, called balance transfer credit cards, in an attempt to attract you to consolidate your debt with their company.  Be careful, as sometimes there is small print that can boost up your rate after a certain period of time.  Read all the small print and research the credit cards thoroughly before making your decision where to transfer your debt.

If you own a home and have built up equity, it would be a good idea to take out a home equity loan to pay off your credit card debt.  You will get a much better interest rate and the interest you pay on a home equity loan is tax deductible.  Whichever route you choose the most important thing to do is pay off your credit card and the sooner you begin, the better.

Jeff Bergerson founded Bergerson Tax Services, Inc (BTS) eight years ago and pilots a rapidly growing practice in St. Paul, Minnesota. Jeff has written many articles offering tax related strategies, financial strategies, and business guidance. Bergerson Tax Services, Inc. provides individuals and small business tax preparation services, small business consulting, and tax planning.  He can be reached on the web at http://www.bergersontax.com/ or by email at info@bergersontax.com. 

The answers to the questions you have always had about your personal finances.

Throughout the year we will address a personal finance, tax, or investment topic that personally affects you and your overall financial well-being. These articles will be laid out in a way that everybody can understand and apply to their own real life finances.  We at Bergerson Tax Services, Inc can help you with all of your personal finance and tax related needs. Please fell free to contact us anytime.  This month’s topic is

To pay off my home, or not to pay off my home, that is the question.

By Jeff Bergerson, Bergerson Tax Services, Inc

This question is asked more than any other personal finance question.  You have probably heard a million different theories from a million different people.  But what is the right answer?  The simple truth is it depends upon your situation.  This article will clearly lay out all of the factors to help you decide which would be best for you.

Your home is one of the biggest investment decisions you will ever make.  Deciding to keep a mortgage or pay it off could affect your whole financial life and might mean earning or costing yourself hundreds of thousands of dollars. 

With extra money should you put it toward your mortgage or invest the money?  Or, if you had enough money to pay off your mortgage should you?

There are several factors that need to be considered:

1. Your time until retirement.
2. Your mortgage rate.
3. The rate of return you can achieve on your money invested rather than being put into your mortgage.
4. Your psychological capabilities and your self-disciple.

To start lets take a look at a real life example and assume the following:  You have just inherited $250,000 that you can use to either pay off your home or invest into an investment account. You have just purchased a house with a 6% 30-year mortgage with a balance of $250,000 and you are in the 25% tax bracket. 

Interest on your $250,000 mortgage is $15,000 of which you can deduct $3,750 on your taxes because your taxable income goes down $15,000 (your mortgage interest paid deduction).  Your after tax interest cost therefore is $11,250.

Lets say you use the $250,000 to pay off your mortgage.  You no longer have any debt and have saved $11,250 after taxes.  In comparison if you keep the mortgage and invest your $250,000, the rate of return (the 3^rd factor needed to consider) will be dependent on the type of investment you choose to put your money into and the amount of risk involved.  Historically a portfolio consisting of 80% stocks and 20% bonds has returned between 8-10%.  Lets assume an 8% return; you would gain $20,000 in the first year. You have to factor in taxes on that gain and the long-term capital gains and dividend rate is currently at a maximum 15%.  If you sold the investments after one year, that would leave you with after tax gains of $17,000.  We will use a taxable investment account for our purposes, but if you are able to invest your money in a tax deferred account such as a 401K, IRA, SEP, etc, your returns will be even greater.  By comparing what you save ($11,250) and what you would have earned had you invested the money ($17,000) you can see the difference for you is $5,750.

What makes this example even more powerful is when you factor in the power of compound interest over time on the money you invest.  Borrowing money at simple interest (as with your mortgage at 6%) and locking in the amount owed at today’s value can never balance with investing your present dollars to receive compounding returns for up to 30 years into the future.  The invested side of your balance sheet pulls ahead and leaves the debt side far behind.  Even if the interest rate paid on your mortgage and the interest rate received from your investment account are equal you are going to come out better financially with the investment.

To demonstrate the power of compounding, follow the example below:

There are two women, age 30, who both inherited $250,000 and they both decide to buy new homes priced at $250,000.  Both woman have full time jobs and have a steady salary.  The first woman, Priscilla Payoff has always been told that paying off your mortgage is the best solution so she did just that and paid cash for her home and does not have a mortgage.  She uses her salary to buy luxuries like an SUV and speedboat.

The next woman, Samantha Savvy has been talking with her financial and tax advisors and decides to invest her money rather than paying off her mortgage immediately.  Samantha put $50,000 down on the house and invested $200,000 in an investment account. Samantha uses her salary to make her interest only payments and lets her investment account appreciate in value.  At the time of purchase:

Now that you can see the power of compounding and the power of investing money as opposed to paying off your mortgage, you will probably conclude that the no-brainer choice is to maintain a mortgage and invest your money.  I would like to touch up on a couple of factors that I mentioned earlier that may argue for paying off your mortgage.  Factor #1, Your time until retirement. If you are approaching retirement (5-10 years) you will most likely not be able to invest your money where you can achieve 8-10% Typically 8-10% gains come from stocks, which should not be the majority of your portfolio if the money will be needed in the short run.  The types of investments more reasonable for individuals near retirement would usually only yield between 4-5% (treasury bonds, money market, etc) making the strategy not as effective.  Also in the short run the power of compounding interest is not nearly as powerful as if you have a thirty-year time frame.

As for Factor #2 your mortgage rate and Factor #3 the rate of return on your investment account, if your rate of return that you achieve on your investment account is significantly lower than the rate you pay on your mortgage, this strategy will not be successful.

The other factor is Factor #4, which are your psychological capabilities and your self- discipline.  If you cannot sleep at night and you are completely stressed out by the idea of having your money invested in the stock market and more specifically in the types of investments needed to yield 8-10% you should not be in it.  If you cannot tolerate the sometimes-large fluctuations that the stock market sometimes produces go ahead and put your money into your house. If you constantly worry about debt on your house or think not having a monthly mortgage bill is your personal heaven, then pay off your mortgage.

Do consider a couple of additional things. Over time the stock market has proven to produce positive gains near 8-10%, but you need to wait out the bad times and just let the market work for you.  Next consider that home equity is relatively illiquid meaning if you suddenly need money for unforeseen circumstances and emergencies it is easier to sell a mutual fund in your investment account than it is to pull cash out of your home.

That leads me to my final point.  It is absolutely essential that if you choose to not pay off your mortgage and go the route of investing that money, you must, must, must actually invest it.  If you do not have the self-discipline to invest every penny and think your desire to buy a new S.U.V or luxury boat will be to great than you need to put your money into your home.

In summary, if you have a long-term time frame (over ten years) until retirement and you have the psychological capabilities and disciple to invest all of the money that would have gone into your home and your rate of return on your investment account is equal to or greater than your mortgage rate, you will be better off investing your money than paying off your mortgage. You will need that long-term time frame to absorb the market fluctuations and achieve the time tested market yield of 8-10%.  So take all of the previous information, factors, and illustrations and apply them to your situation and decide which avenue is best for you.

Jeff Bergerson founded Bergerson Tax Services, Inc (BTS) eight years ago and pilots a rapidly growing practice in St. Paul, Minnesota. Jeff has written many articles offering tax related strategies, financial strategies, and business guidance. Bergerson Tax Services, Inc. provides individuals and small business tax preparation services, small business consulting, and tax planning. He can be reached on the web at http://www.bergersontax.com/ or by email at info@bergersontax.com. 

For 2007 income tax purposes, investment income over $1,700 earned by a child under age 18 is taxed at the child’s parent’s tax rate. The kiddie tax only applies to investment income such as interest, dividends, rents, royalties, and profits on the sale of property. As the child’s parent you generally must use form 8615 to report their income.  On the form 8615, the kiddie tax rules are applied and the tax is reported on the child’s income tax return. The 8615 computation has no effect on the treatment of items on your own return or on your tax computation.

If you use the married filing seperatly filing status, the parent with the larger amount of taxable income is responsible for the kiddie tax computation. If parents are divorced or separated, the parent who has custody of the child for the greater part of the year computes the tax.

Attention: Starting in 2008, the kiddie tax will apply to investment income of over $1,800 for children in the following categories:

1.  children under the age of 18.

2. children who are age 18 who do not have earned income exceeding 50% of their support.

3. children age 19-23 who are full-time students and who do not have earned income exceeding 50% of their support.

This is an easy way to reduce your future estate tax bill. You can give up to $12,000 each year free of gift tax to anyone you want. If you are married and your spouse concurs, even if the entire amount of the gift comes from your seperate assets. There is also an unlimited break for tuition that donors pay directly to schools. It does not count toward the $12,000. This applies to medical expenses that donors pay for donees.

The standard deduction for taxpayers who do not itemize a deduction(s) on Schedule A of Form 1040 is, in most cases, higher for 2008 than it was for 2007. The amount of the deduction depends on your filing status, whether you are 65 or older or blind, and whether an exemption can be claimed for you by another taxpayer.
The basic standard deduction amounts for 2008 are:

• Head of household deduction is $8,000
• Married taxpayers filing jointly and qualifying widow(er)s deduction is $10,900
• Married taxpayers filing a seperate deduction is $5,450
• Single deduction is $5,450

The standard deduction amount for an individual who may be claimed as a dependent by another taxpayer may not exceed the greater of $900 or the sum of $300 and the individual’s earned income.

For 2008, the additional standard deduction amount for a person who is age 65 or older or blind is $1,050. If you are single and not a surviving spouse, the additional standard deduction amount is $1,350.

Exemption Amount Increased

The amount of the deduction for each exemption has increased from $3,400 in 2007 to a deduction of $3,500 in 2008.

To learn more about tax deduction information contact Bergerson Tax Services.

You can sell your primary residence at a tax-free gain of up to $250,000 ($500,000 on a joint return). You just need to have lived in it for 2 of the prior 5 years. These time requirements can be relaxed in certain situations.

Partial Federal Income Tax Exclusion. If a sale occurs prior to satisfying the two-year test, a partial federal income tax exclusion can be claimed if the sale was because of a change in work, health reasons, or an unforeseen circumstance. For example, a federal taxpayer who sold his home in order to acquire the space needed to care for his disabled mother was entitled to a partial federal income tax exclusion.

The IRS ruled that the sale in this case was because of the health of a qualifying individual. IRS Federal Regulations contain several situations that constitute unforeseen circumstances, including divorce, casualty, or multiple births from the same pregnancy. The IRS continues to expand the definition of unforeseen circumstance in regards to federal income tax exclusion.

More recently, the IRS has held that a move caused by crime in the neighborhood was an unforeseen circumstance, allowing the homeowner to claim a partial federal income tax exclusion. One such case involved a homeowner who was held up at gunpoint while leaving his residence and forced to drive an assailant to ATM machines. The homeowner moved from the residence, renting it out and subsequently selling it, because of the traumatic and violent nature of the crime.

A partial federal income tax exclusion is figured by multiplying the dollar limit (ex:$500,000 for a married couple) by a fraction, the numerator of which is the number of days of ownership and use (ex:365) and the denominator of which is 730 days.

To learn more about federal tax laws with selling your home or federal tax regulation changes, contact the Bergerson Federal Income Tax Preparation Offices at info@bergersontax.com.

Beginning January 1, 2008, the IRS allowable deductions for the standard mileage rate are as follows:

• Business miles. The standard IRS mileage rate for the cost of operating your car increases to 50.5 cents a mile for all business miles driven between January 1, 2008 and June 30, 2008 and 58.5 cents a mile for all business miles driven between July 1, 2008 and December 31, 2008.
• Charitable services. The standard IRS mileage rate allowed for use of your car when you use your car to provide charitable services to a charitable organization remains at 14 cents a mile.
• Medical reasons. The standard IRS mileage rate allowed for use of your car for medical reasons is 19 cents a mile for miles driven between January 1, 2008 and June 30, 2008 and 27 cents a mile for miles driven between July 1, 2008 and December 31, 2008.
• Moving. The standard IRS mileage rate for determining moving expenses is 19 cents a mile for miles driven between January 1, 2008 and June 30, 2008 and 27 cents per mile for miles driven between July 1, 2008 and December 31, 2008.

This rule disallows a deduction for losses on a stock, if you purchase the same stock within 30 days before or after a sale. Any losses suspended by this rule are added to the tax basis of the replacement stock.

Long term capital gains (held 1 year or more) are now taxed at a maximum rate of 15%. People in the 10% and 15% brackets get a 5% return rate on long term gains up to the point that their gains lift their income beyond the 15% bracket.

For complete tax return filing preparation questions, please contact Bergerson Tax today!

This is an excellent tax saving strategy. If you have owned stock more than 1 year, you can deduct the full value of your donation and escape paying any income tax on the appreciation. That is a double tax break.

Giving appreciated stock is also a good way to make gifts to your children. If the child is 14 or older when the gift stock is sold and more than a year has passed since you acquired the stock, the gain would likely be at 5%.