Advanced Personal Finance

I know a way to reduce a mortgage balance by nearly $30,000 in four years. We’ve done it. Since we refinanced our house in early 2003 (original mortgage $190,800), we’ve reduced the balance to $163,400. We did it by sending our mortgage holder additional money each month toward principal curtailment.

There are two schools of thought on prepaying the mortgage, and I’m solidly in the ‘do it’ category. Before anyone points it out, I concede had I put the additional $200 each month into an S&P index fund, I would have done better than the 6% interest on my mortgage.

I don’t care.

I believe the piece of mind that will come with owning my home outright outweighs the amount we’ll be ‘missing out on.’

So for those interested in doing so, there are three easy ways to pre-pay your mortgage:

• Send in an additional amount each month with your regular payment. This is the method we use and if you pay by ACH/electronically, it’s particularly easy. Just tell the servicing company what additional amount you want deducted from your checking account and it’s done automatically. Doing it this way eliminates the temptation to skip sending in the extra amount during those ‘tight’ months if you pay by check.

• Make thirteen payments a year instead of twelve. This isn’t possible with all mortgage servicing companies (including mine), but it’s particularly useful if you get paid biweekly like I do. Twice a year you get paid three times in one month. Send that money to the mortgage instead of spending it.

• Put bonuses and/or tax refunds toward the principal balance. This takes a good bit of self-discipline. It’s hard to pretend you didn’t get that $1,200 back from the IRS.

It’s not for everybody, but if you’re inclined to pay down your mortgage quickly like me, these are three ways to do it.

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A friend was depositing birthday money into his kids’ savings accounts the other day and asked me about taxes. I’m not a tax attorney by a long shot, so I did some investigating. I wanted to write about what I found so I’d kind of have it in my own ‘archives’ in case it ever comes up for me and my children.

The Kiddie Tax

There are basically three rules regarding children’s savings taxes:

1. Only unearned income is taxed this way. Unearned income is capital gains, dividends, and interest earned. Any earned income is taxed like an adult’s income.
2. It affects children under age 18. On the year of the child’s eighteenth birthday, the Kiddie tax no longer applies.
3. It only matters for unearned income above a certain threshold. In 2007, that number is $1,700. Kids don’t have to report unearned income under $1,700.

Filing Forms

The IRS form for the Kiddie tax is Form 8615 (Tax year 2006 form here). You use that to add to the child’s 1040 if it applies. You can also pay the tax on the parents’ return by filing Form 8814 (2006 form here), as long as the child’s unearned income is less than $8,500 (as of 2006).

‘Getting Around’ the Kiddie Tax

It’s possible to minimize the effects of the Kiddie tax.

First, the child can invest in stocks that pay little or no dividend income. He or she can also use municipal bond funds. The tax effect is the same. The capital gain at sale is the only thing to be concerned about.

Second, your kid doesn’t actually have to be eighteen for the tax treatment to change. It only has to be the year he or she turns eighteen. At that point, he or she is an adult for IRS purposes. This could come into play when paying for college.

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Mutual fund companies started marketing so-called ‘tax-managed’ funds in the 90s as a way for investors to save on taxes. You can use their techniques to manage (read minimize) taxes on your own.

Tax-managed funds are actively managed funds, with all the negatives that come with being actively managed, but they’re specifically geared to limit capital gains taxes that are passed from the fund to investors. At the end of the year, mutual funds are required to distribute capital gains to investors. Those investors, in turn, pay taxes on those gains. No one likes paying taxes, so a whole group of funds has sprung up to fill this niche.

Tax managed funds employ four main strategies to minimize taxes:

• Minimize taxes when selling by keeping your basis in mind. Assuming your fund purchase was not a one-time event, you own different amounts of shares purchased at different prices. When you sell, it makes sense to specify that the shares being sold be those with the highest purchase price. This way, your capital gain is minimized or you might even have a loss that can offset other taxable gains elsewhere. Doing this is somewhat complicated and records-intensive, however. You must tell the fund company specifically which shares (by date) you want sold. Moreover, once you utilize this method, you’re stuck with it. You can’t later go back to ‘average cost basis.’

• Keep turnover low. Buying and selling generates taxes. Period. Keeping trades to a minimum lowers your tax bill.

• Match losses with gains. As alluded to above, capital gains are offset by capital losses. In other words, if one investment lost money upon sale, you can use that loss to lower your capital gains elsewhere.

• Buy stocks with low or no dividends. Dividends are taxed at 15% for most people. You don’t pay that 15% if you have no dividends to begin with.

You can employ each of the above techniques on your own to limit your tax bill. It depends on your situation, but for most people, only the first technique results in a sizable benefit. You shouldn’t make buy/sell decisions based on taxes, so gain matching and turnover are unlikely to help much.

There’s an important caveat to using the first technique, however. By employing this technique, you’re ‘back loading’ all your capital gains. So when you ultimately sell the last shares, they will be the absolute cheapest and your gain could be huge.

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This post appeared earlier this week on Money, Matter, and More Musings. Thanks to Golbguru for the opportunity to guest post at his blog.

When investors talk about diversification, they’re typically referring to diversification. But there’s another kind of diversification. It’s called tax diversification and you might be practicing it without knowing it.

Tax diversification is the idea that you should have investments subject to each of the various tax treatments. The idea applies not only to U.S. citizens, but those of other countries as well. There are three types of tax treatments for our purposes - tax-deferred, tax-free, and taxable.

The three account types

• Tax-deferred. Tax-deferred accounts are those that grow tax free until they are liquidated, at which time full taxes are due. Examples are the 401(k) and traditional(”deductible”) IRA. You invest pre-tax dollars. The full amount of money goes to work for you, compounding until withdrawn. At the time of liquidation, the entire amount withdrawn is taxed as ordinary income.

• Tax-free. Tax-free accounts use after-tax money to buy investments that then grow without ever being taxed again. Examples are the Roth 401(k) and Roth IRA and municipal bonds. In these types of account, you purchase the investment with after-tax income. The investment then grows over time. When liquidated, the total account balance is tax-free.

• Taxable. These accounts invest after-tax income. When the investment is liquidated, the earnings are taxed again. An example is a regular brokerage account.

How tax diversification works
In short, you use tax diversification when you split your investable dollars between the three types of accounts. Tax rates and treatments are moving targets. By using tax diversification, you’re hedging.

Why use it?
You simply cannot know what the tax brackets will look like at retirement (unless you’re within a year of retirement, I suppose). Using this technique, you’re spreading the risk of using any one type of account.

For example, if the bulk of your retirement investments are in a combination of traditional IRA and 401(k), at retirement all of that money is fully taxable. As of today, it’s taxed as ordinary income. If your tax bracket is lower in retirement, you made a shrewd move. If it is instead higher, you lost money by using only the tax-deferred accounts. So whether you think Roths are bad or good, it makes sense to have at least a portion of your retirement savings there.

I personally use this technique in my investments. Currently, I have 8% pre-tax going to my traditional 401(k) and 11% going to a Roth 401(k). We also have a taxable account we fund each month.

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I came across a study done published in the Journal of Financial Planning that provides a quick way to tell if you’re saving enough for retirement. The article, National Savings Rate Guidelines for Individuals, uses a more nuanced approach than many retirement calculators.

The authors calculate retirement income needs based on net pre-retirement income. Most calculators have you input your current gross income. This is important because in retirement, you’ll obviously not be saving for retirement. They also use Monte Carlo simulation and data from Ibbotson Associates in their calculations (one of the authors is Roger Ibbotson).

So here’s the quick method. The table below shows what you need to save now to replace 80% of your net income at retirement. Simply find your age and income. You can adjust the number for savings you already have.

For example, let’s say you’re 35 years old, make $60,000, and have saved $40,000 for retirement. Your base savings rate is 16.4% and you adjust it down by 0.55% x 4 = 2.2%. To replace 80% of your net income at retirement, you need to save 14.2% of your current gross income.

How easy is that?

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