Deducting automobile expenses / I have my own business (an S corporation) that requires using my own car from time to time. Can I deduct my auto expenses on my tax returns?

Barry Dolowich for the Monterey Herald writes: Q: I have my own business (an S corporation) that requires using my own car from time to time. Can I deduct my auto expenses on my tax returns? 

Answer: Local transportation expenses are generally those incurred for the business use of a car. However, they also include the travel by train, bus or taxi. Businesses (including self-employed people and statutory employees) may deduct ordinary and necessary local transportation expenses from gross income. 

Commuting expenses for travel between a taxpayer's residence and a business location within the area of the taxpayer's home generally are not deductible; however, a deduction is allowed for expenses incurred in excess of ordinary commuting expenses for transporting job-related tools and materials.

An individual who works at two or more different places in a day may deduct the costs of getting from one workplace to the other. 

Expenses for gasoline, oil, tires, repairs, insurance, depreciation, parking fees and tolls, licenses and garage rent incurred for cars used in a trade or business are deductible. 

The deduction is allowed only for that part of the expense that is attributable to business usage. Also, you must take into account any employer reimbursements. 

Generally, an employee's unreimbursed expenses can be deducted only as a miscellaneous itemized deduction subject to the 2 percent adjusted gross income floor. 

A taxpayer can substantiate car expenses by keeping an exact record of the amount paid for gasoline, insurance and other costs along with detailed mileage records. The use of a preprinted car expense logbook, sold at most office supply stores, can be very helpful for tracking your expenses and mileage.

Under the standard mileage method, you can determine the amount of your allowable deduction by multiplying all the business miles drive during the year by the standard mileage rate. 

The standard mileage rate for 2013 is 56.5 cents per mile. The business portion of parking fees and tolls may be deducted in addition to the standard mileage rate. Since this method only requires you to track and substantiate your business miles driven and does not require you to keep track of your expenses (except for parking and tolls), you may find this method to be easier and more cost-effective. 

I recommend that you discuss this issue with your tax return preparer and consider having your corporation reimburse you for the business miles driven using the standard mileage rate discussed above.

Warning Clients On 401(k) Loans

• DAISY MAXEY for the Wall St Journal writes: Within the past few weeks, adviser Marc Shaffer has heard from two clients looking to tap their 401(k) plans, one for a family emergency and another to purchase land on which to build a home.

As the economy makes a painfully slow recovery, financial advisers like Mr. Shaffer continue to hear from cash-strapped clients who are considering borrowing from their retirement accounts to meet emergency needs or pay for major purchases, like land, homes or business expansions.
"I don't know if it's a result of the market being where it is or what," says Mr. Shaffer, a principal of Searcy Financial Services Inc. in Overland Park, Kan. "Some have taken [401(k) loans] because it's what their option is; others have taken home equity loans." 

In many cases, advisers say, they succeed in deterring clients by pointing out the drawbacks of 401(k) loans and laying out alternatives that are less disruptive to their retirement nest eggs.
But not always. 

In Mr. Shaffer's case, the client who needed the money for a family emergency--the adviser was never told what that emergency was--went ahead with the loan. He was a neonatalogist who had no other cash on hand, but felt he could pay it back quickly, the adviser says. 

The other client, who considered a loan to buy land, opted instead to refinance his home, partly on Mr. Shaffer's advice. The adviser laid out some of the drawbacks of a 401(k) loan, including the fact that the loan is paid back with after-tax money, which is taxed again when it's withdrawn in retirement.
Pam Dumonceau, president of Consistent Values Inc., in Greenwood Village, Colo., says borrowing from one's 401(k) is "a precarious last resort." She's convinced some clients not to tap into their retirement plans. 

"Most of the time, I brainstorm with them about every other possible solution first, then I inform them of the consequences," says Ms. Dumonceau, who's affiliated with Asset One LLC, which manages $348 million. "Sometimes it is the last resort and you've got to do it. It's still better than losing your house or having cars repossessed." 

Among 401(k) participants, 12.5% initiated new loans in 2012, down from 12.7% in 2011 and 13.9% in 2010, but still higher than the 10.6% level in 2008, says Aon Hewitt, which expects the loan-usage rate to remain flat this year. 

The fact that account holders who take out 401(k) loans are paying themselves back with interest may be blinding them to the far-reaching drawbacks, advisers say. 

There's the loss of compounded tax-deferred growth of the borrowed money. Also, contribution rates tend to be lower as the loans--which often range from 5 years to 20 years--are paid back. Worse yet, those who lose their jobs are generally given just 60 to 90 days to repay the loans. If they default, those younger than 59 1/2 years old face a 10% early withdrawal penalty in addition to income taxes. 

A recent study by New York Life Retirement Plan Services underscored the downside: The average contribution rate for a 401(k)-plan participant with a loan is 5.63% compared to 7.23% for those without a loan. In addition, more than two-thirds with an outstanding loan who leave their employer end up taking a distribution rather than paying back their loan. 

For clients who can be convinced to leave their accounts alone and are in position to secure money via other sources, Ms. Dumonceau of Consistent Values recommends that they borrow on a home-equity line of credit or take an unsecured, low-interest personal loan. Even applying for a credit card with 0% interest may be a better option, she says. 

Still, she says, for those with no real choice, a 401(k) loan may work. It can work well, for example, for a small-business owner who wants to expand by purchasing a piece of equipment or real estate and who's certain he can make the payments, she says. However, Ms. Dumonceau would still rather see such an investor take a small-business loan secured by the real estate, which can be had at reasonable cost if the borrower has good credit, she says. 

Last year, one of her clients borrowed from his 401(k) to pay off credit-card debt with interest of 12% to 21%. He had a secure government job and no home equity, she says. "You must not run up those credit cards again," she warned him. 

Gil Armour, an adviser with SagePoint Financial Inc. in San Diego, says he's had more clients suggesting 401(k) loans since 2008, as spouses have been laid off, income has diminished and debts have been called. Clients are also more likely to take a distribution when leaving a job rather than rolling over their 401(k) assets, he says. 

The privilege of 401(k) loans is often abused, he says. Some investors consider such loans "found money" to be used when the car breaks down or their credit cards build up, he says. Instead, they should be setting money aside for an emergency. 

"I generally caution people against doing it," he says. Sometimes, a client is able to borrow from a family member instead, he says.

529 Tax Credit or Deduction: Which Is More Valuable? / The answer is more complicated than you might think.

Adam Zoll for Morningstar writes:  Question: My state offers a tax deduction for 529 contributions made to our state's plan, but my sister's state offers a tax credit for 529 contributions. Which is better and why?

Answer: Typically an income tax credit of any type is better--meaning that it saves the taxpayer more money--than an income tax deduction. That's because a tax credit is an off-the-top reduction in the amount of taxes paid whereas a tax deduction is a reduction in the amount of income subject to taxes.
For example, someone who receives a $500 tax credit pays $500 less in taxes than they otherwise would have, whereas someone who gets a $500 tax deduction merely avoids paying taxes on that amount. So if the person receiving the deduction lives in a state with a 5% income tax rate, he saves an amount equal to 5% of $500, or $25, in taxes (assuming no other state tax breaks are affected by taking the deduction). That's obviously a far cry from the $500 he or she would save with a tax credit. Thus, the short answer is that a tax credit is generally more valuable.

However, given the way tax breaks for 529 contributions are structured by the states, not to mention the broad range of state income tax rates, merely looking at whether a state offers a credit or a deduction doesn't tell the whole story. For one thing, states typically impose limits on the amount of 529 contributions subject to a tax credit or deduction. The limit is often imposed on a per-taxpayer basis, but some states impose limits per 529 beneficiary. (Some states also allow deductions or credits for funds transferred from out-of-state 529 plans.) Residents of states with generous deduction limits can pocket significant tax savings by making very large contributions to 529s, but it's a different story for states with tax credits. 

Giving Tax Credits Where Credits Are Due
Only Indiana, Vermont, and Utah currently offer tax credits for 529 contributions. Indiana offers a 20% tax credit per year on the first $5,000 contributed to its plans, for a maximum credit of $1,000 per account owner. Vermont's tax credit covers 10% of contributions up to $2,500 for a maximum credit of $250 per beneficiary for single filers or $500 per beneficiary for taxpayers filing jointly. Utah's tax credit covers 5% of contributions up to $1,840, or $92 per beneficiary for single filers or $184 per beneficiary for taxpayers filing jointly.

Eligible contributions in the three states that offer credits are capped at fairly low levels, so generally speaking, tax credits are most beneficial to people who aren't making significant 529 contributions. Although these tax credits amount to a nice bonus for families saving for college, residents of some states that offer tax deductions on 529 contributions can potentially save even more because their states have higher limits on the amounts subject to tax breaks.

For example, Colorado essentially places no limit on the amount of contributions a 529 account owner can deduct in a year as long as it's not more than the account owner's taxable income. (However, the annual federal gift tax exclusion of $14,000 may apply, and the state does limit the amount of contributions that can be made to a single beneficiary's 529 account to $350,000). Given the state's 4.63% income tax rate, a 529 account holder who contributes $50,000 in a given year to the state's plan might receive a $2,315 break on state income taxes. 


Another interesting example is Pennsylvania, which is one of a handful of states that allows residents to deduct contributions to any 529 plan, even out-of-state plans. (It's a good thing, too, given that their state's plan receives only a Neutral rating from Morningstar's 529 analyst team because of its high fees.) The state's relatively generous 529 deduction limit of $14,000 for single taxpayers or $28,000 for couples filing jointly, and the state's flat income tax rate of 3.07%, means that a couple that contributes the full $28,000 to any 529 plan could come out $860 ahead on their taxes.
 
Income Tax Rates Also Come Into Play
Tax deductions for 529 contributions also tend to be slightly more valuable for high earners in states with graduated income tax structures. For example, New York allows couples filing jointly to deduct up to $10,000 in contributions to its state 529 plans. A couple making $100,000 a year, and thus falling in the 6.65% tax bracket, would save $665 in taxes if they hit the full deduction amount. But for a couple paying the top rate of 8.82% (starting at more than $2 million in income) the tax savings on the same size contribution would amount to $882.

Not all states offer tax incentives for families saving for college. In fact, more than a dozen don't. However, for residents of those that do, tax savings can be among the biggest advantages of using a 529 as a way to save to send a family member to college.

What is the biggest mistake investors make when evaluating a fund?

The Wall St. Journal, Journal Reports,THE EXPERTS write:   Avoiding errors when selecting a fund is no simple task, especially when there's more than meets the performance data.  So we asked The Experts: What is the biggest mistake investors make when evaluating a fund?
 
This discussion relates to a recent Journal Report article on mutual-fund performance figures that don't tell the whole story and formed the basis of a discussion on The Experts blog on Aug. 8.

Mike Piper: Don't Judge a Fund By Its Cover

Two mistakes I see frequently when it comes to mutual-fund selection are picking funds based on their past performance and ignoring funds' expense ratios. But I think an even bigger mistake (one that I'm seeing more and more often as target-date funds grow in popularity) is to invest in a mutual fund without having the slightest idea what's inside it.
It's all too common these days for people to invest in a target-date fund based solely on the fact that the date in the fund's name is close to the date at which they plan to retire. For some investors, this will lead to a nasty surprise during the next bear market when they find out that their target-date fund's asset allocation is far too aggressive for their personal risk tolerance. (Of course, the opposite can happen, too. Upon taking the time to check, some investors might find that the target-date funds generally intended for people their age are too conservative for their tastes.)
When evaluating a mutual fund (target-date or otherwise), the very first step should be to look at what's actually in the fund—what is its asset allocation? By taking the time to do this, you can avoid finding yourself in a position in which you learn (too late, as many investors did in 2008 and early 2009) that your portfolio has a much larger allocation to risky assets than you thought it had.

Fortunately, it's quite easy to look up a mutual fund's asset allocation. For most retail mutual funds, in less than 60 seconds you can find the fund on Morningstar's website (hint: put the fund's ticker symbol in the "quote" search box), click over to the "portfolio" tab, and look at the handy pie chart and accompanying figures explaining what the fund holds.
Mike Piper (@michaelrpiper) is a Missouri-licensed CPA and the author of the blog ObliviousInvestor.com. He is also the author of several personal finance books, including his latest, "Social Security Made Simple."
 

Eleanor Blayney: It's More Than Just a Ratings Game

They get stars in their eyes, and can't see much else. If the fund rates five stars, they will buy or keep; if just one or two, they sell.

I am talking about the Morningstar "stars," used by the investment research and data company to rank funds in similar style categories on their past risk-adjusted performance.
I happen to think that Morningstar is a great company, which transformed the mutual-fund industry through the "democratization of data," to use a term coined by head of research Don Phillips. What Mr. Phillips and his team did, back in the 1980s, was to open the black box of mutual funds, and enable the investing public to see and analyze what the funds were investing in, how the funds were governed and performing, and what they cost in terms of fees and risk. They also adopted the star-rating system to give investors a way to evaluate the fund's track record relative to other similar funds, in terms of return and risk.
This star-rating system has been explained and refined over the years, and Morningstar has always been the first to qualify its limitations in predicting future performance.
Many investors, however, fail to consider all the other data that Morningstar publishes on funds, and make their decisions entirely based on the stars. This, to my mind, is pure astrology and not prudent investing.

Eleanor Blayney (@EleanorBlayney) is consumer advocate of the Certified Financial Planner Board of Standards.
 

Charles Rotblut: Know When You're Better Off Playing RouletteI'm going to put a few numbers behind what I'm assuming several of my fellow experts will be saying: Investors too often focus on recent performance when selecting funds. Funds with good recent performance are viewed in a favorable light, and funds with lousy recent performance are frowned upon.

S&P Dow Jones Indices maintains a scorecard of how often top-performing funds remain top-performing funds. According to the latest Persistence Scorecard, which was released just a few weeks ago, only 4.69% of all domestic funds kept their top-quartile rankings for the three consecutive 12-month periods ended March 2013. Put another away, there was a 95% chance the top performing fund you picked three years ago didn't keep on being a top-performing fund. Hardly favorable odds.

Let's go out even further. Less than half of the large-cap funds tracked by AAII's annual mutual fund guide had higher 10-year annualized rates of return than the S&P 500. Plus, many of those that did beat the large-cap index only did so by a small margin—a sign investors weren't adequately compensated for incurring the risk of active management.
Simply put, your odds of correctly determining whether a roulette ball will land on a red or a black number are better than your odds of picking an actively managed fund that will outperform over the next five or 10 years.

So what is an investor to do? Stop looking at performance first. Rather, figure out what asset classes you need exposure to and then seek out the lowest cost funds that target those assets. Only after doing this should you consider a fund's long-term performance (at least five years, preferably 10 years). And once you buy a fund, compare its performance with that of its peers; a fund's performance will primarily be determined by the rules governing what the manager can and cannot invest in.

Charles Rotblut (@charlesrotblut) is a vice president with the American Association of Individual Investors.
 

Christian Magoon: Don't Put Too Much Focus on Expenses

Investors are often too focused on a fund's cost rather than the performance of the fund. While a fund's cost is an important detail, ultimately the purpose of investing is to make money, not to save it. Investors should incorporate the cost of a fund into their selection process by reviewing performance net of all fees and expenses. Only then will investors avoid the premature elimination of funds that may have a higher expense ratio but ultimately produce superior performance.
Christian Magoon (@ChristianMagoon) is founder and chief executive of YieldShares, an income-focused ETF sponsor. 
 

Larry Zimpleman: Today's Allocation May Not Be Tomorrow's

First of all, I always encourage even experienced investors to seek opinions on funds from advisers before you make a final decision to invest. I think the mistake that investors often make when evaluating a fund is not understanding how much latitude the fund's portfolio manager has to change the fund's asset allocation. For example, an investor might look at a fund today and see that it's invested 60% in U.S. equities and 40% in U.S. fixed income. But—can the fund go to 100% equities? Or 100% fixed income? Can it be fixed income or equities outside the U.S.? Don't make the mistake of thinking that the investment portfolio will always look like it looks today—understand how much discretion the portfolio manager has to make asset allocation changes.
Larry D. Zimpleman is chairman, president and chief executive of Principal Financial Group.
 

Terrance Odean: Think About Today's Fees, Not Yesterday's Results

Focusing on past performance rather than fees.
Terrance Odean is the Rudd Family Foundation professor and chair of the finance group at the Haas School of Business at the University of California, Berkeley.
 

Michelle Perry Higgins: Follow My ABCs

While there are many ways to evaluate funds, the biggest mistake I see is that most people tend to overcomplicate things. My advice is to keep it simple and follow Michelle's ABCs of evaluating funds to avoid costly mistakes.
A—Always check the fund's expense ratios. Your goal should be to keep your costs as low as possible. Expense ratios are an important component and a simple measurement to keep costs in check. Although it sounds like a no-brainer, many investors often fail to review this figure.
B—Be clear on the fund's objectives. The prospectus is an often-underused reference tool that contains valuable information. If you read nothing else in it, be sure to find out what the fund's objectives are. This gives you a clear path to track its performance relative to the appropriate peer group and benchmark.
C—Chasing returns is a losing game. This is an easy trap to fall into for the investor without a solid game plan in place. You've got to look at the big picture. Don't jump into a fund only because of past performance. You run the risk of buying high with the rest of the herd.
Disclosure: This is just the ABCs. Every investor should have a thorough plan when evaluating funds.
Michelle Perry Higgins (@RetirementMPH) is a financial planner and principal at California Financial Advisors.

George Papadopoulos: Stop Chasing Performance!

Investors make many mistakes when evaluating funds. These include
• Only considering funds that make it to "Top 10 Funds to buy now" lists that regularly appear in the media
• Judging the funds only based on past performance and/or Morningstar star ratings
• Selling the funds too fast when a manager hits a rough spot (it should be expected)
• Not giving high enough importance to the fund's expenses
• Not looking into how a particular manager fared in both bull and bear markets
• Not looking to see if the current manager was at the helm for the entire 10-year stellar record
But by far the biggest mistake investors make when evaluating a fund, in my humble opinion, is performance chasing!
George Papadopoulos (@feeonlyplanner) is a fee-only wealth manager in Novi, Mich., serving affluent individuals and families.

 

Greg McBride: Keep the Past Where It Belongs

As every fund prospectus says, "Past performance is no guarantee of future results." Yet investors routinely look to past performance as a harbinger of what returns they can expect going forward. This mistake can manifest itself in a couple of ways: chasing performance and buying into sectors or asset classes that are overvalued; and disrupting a proper allocation by overweighting hot sectors and asset classes at the expense of those that have been underperforming, but may well be poised to rebound. When looking at past performance, focus instead on how the fund has performed relative to its benchmark index and peers. But even then, this is no guarantee of future results.
Greg McBride (@BankrateGreg) is a senior financial analyst and vice president for Bankrate.com, providing analysis and advice on personal finance.

 

Manisha Thakor: Find the Hard-to-Find Fees

The biggest mistake I routinely see is not paying attention to fees. The difference between a low-cost index-oriented fund with a 0.25% expense ratio and an actively managed fund with a 1.25% ratio may not seem such a big deal on the surface. Yet assuming 7% returns, over a 25-year time period, that incremental 1% in fees will eat up over 25% of your return.
Think about that for a minute. Two funds. Both generate returns of 7% a year on average for 25 years. Yet investors in the fund that has the 1.25% fee only have $3 to spend for every $4 the investor in the .25% fund has to spend.
It's understandable that investors often don't focus on fees as the financial-services industry doesn't exactly make it easy to see what you are paying. Between management fees, 12b-1 fees, other expenses, and my least favorite fee of all—"the load"—it can be hard to get the full picture. While not exactly scintillating reading, the fund prospectus is the best place to look as all fees are required to be disclosed here.
Manisha Thakor (@ManishaThakor) is founder and chief executive of Santa Fe, N.M.-based MoneyZen Wealth Management LLC.

 

Tom Brakke: Stop Looking in the Rearview mirror

Chasing performance.
Investors tend to invest in what has done well, without regard to the inherent risks that may have built up during the run of historical performance that catches the eye.
That goes for asset classes, specific strategies fund families, and individual funds. They become popular when performance has been good and unpopular when it hasn't been good.
But you can't buy historical performance. You get what is coming down the road, not what is in the rearview mirror, so the numbers you see there are mostly distractions.
Tom Brakke (@researchpuzzler) is a consultant, writer and investment adviser who specializes in the analysis of investment decision making and the communication of investment ideas.

 

Rick Ferri: Low Fees Beat Star Ratings

Investors put too much emphasis on past performance and that can hurt. A better selection method is to find low-fee funds, preferably index funds, that track the markets.
Morningstar has been tracking and rating mutual-fund performance for over two decades. Funds are ranked from five-star to one-star based on past three-, five- and 10-year performance.

According to the Morningstar 2012: Annual Global Flows Report, only 10% of funds receive the coveted five-star rating, yet investors flocked to these funds. Net new assets into five-star funds overwhelmed the other four categories. There was some asset flow into four-star funds and net outflows from three-star, two-star and one-star funds. 

Are investors setting themselves up for a fall by chasing top funds? They may well be, according to the newly released S&P Persistence Scorecard. Published twice per year, S&P tracks the performance consistency of mutual funds over consecutive 3- and 5-year periods.
The Scorecard released in July shows that a U.S. equity fund in the top quartile of performance three years ago had only a 24% chance of staying there over the next three years. Funds in the top half for five years ending in March 2008 had only a 46% chance of being in the top half for the five year period ending in March 2013. Past performance is not a good predictor of future return.

If past performance doesn't work, what does? Morningstar analyst Russel Kinnal wrote in How Expense Ratios and Star Ratings Predict Success, "If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help you make a better decision." Fees beat star ratings as a predictor of returns. And which funds have the lowest fee? Index funds.

Rick Ferri is founder of Portfolio Solutions LLC and the author of six books on low-cost index fund and ETF investing. His blog is RickFerri.com.
 

Michael Kitces: Don't Confuse an Asset Class With an Active Manager

Asset allocation and effective diversification have been long-standing tenets of portfolio construction. In fact, while long credited as a key outcome of modern portfolio theory, the truth is that the benefits of diversification extend back even further. In his seminal paper "Portfolio Selection" from 1952, Harry Markowitz stated, "Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim." In other words, diversification wasn't actually an outcome of modern portfolio theory, it was a fundamental assumption used in creating it in the first place.

What modern portfolio theory did show, however, was that the benefits of diversification and their impact on reducing portfolio volatility and enhancing risk-adjusted return could be quantified, through the measure of correlation. The caveat, however, is that determining the benefits required an accurate estimate of what correlation would be in the first place. Though many assumed that correlation would be stable, it has been revealed otherwise, especially in the 2008-2009 financial crisis (and in fact, many other high volatility periods in history) when correlations rose together at the worst possible time.

In the search for new alternatives to low correlation, though, investors have begun to move down a dangerous path—one that fails to recognize the underlying factors that lead to a low correlation in the first place. After all, there are many different ways to generate a low or negative correlation, and still much debate about what constitutes an alternative asset class in the first place. Adding an investment with low correlation can be done by investing in a completely new, different asset class. It can be done by investing in something very illiquid (though in truth what is perceived as "low correlation" may actually be little more than a lack of price transparency). It can be done by buying a well-diversified portfolio (as almost by definition, buying a well-diversified basket of investments will show a reduced correlation to any one of them in particular). And it can be done by buying an active manager whose investments will continually be changing, such that the correlation to anything else will be low and/or won't sustain for long.

The reason why these distinctions matter, though, is because they are all present to varying degrees in mutual funds, and while the first represents true diversification, and arguably the second might as well, the last two do not. The third option actually is diversification, not an alternative to be added to create diversification. And the fourth is perhaps the most concerning option. Because the reality is that while an active manager may or may not deliver value, the outcome is not dependent upon what the low-correlation diversification benefits of the asset class(es) that the active manager invests in (especially if they change over time), but the effectiveness of that manager to make the trades at the right time. Which means, for better or for worse, the opportunity of an active manager is not about having more diversification, but simply about picking a good manager that makes good active decisions, and the manager should be scrutinized accordingly. 

So the next time you're considering a mutual fund to add, be certain that you've really considered whether you're investing in an asset class or an active manager; one of those relies on being a low-correlation diversifier, while the other relies on the effectiveness of the manager to make good decisions, and it's crucial to evaluate the investment accordingly!

IRS Proposes To Permanently Ease Restrictions For Innocent Spouse Relief

Kelly Phillips Erb for Forbes writes: Mary (not her real name) was married to a man who abused her for years. When things were good, she said, they were really good. But her husband had a temper and he was physically intimidating: as their financial situation got worse, he would increasingly become violent. She stayed, she said, because she wasn’t sure what else to do. She feared for her children – her daughter was exhibiting signs of mental stress and had developed an eating disorder – but Mary had no real income of her own to support them. She had no assets, no savings, nothing to fall back on. She had thoughts of leaving but she couldn’t bring herself to do it. She didn’t have to: one day, her husband simply walked out, leaving her, she thought, with nothing.

Mary didn’t have time to think about how terrible her situation was: she needed to provide for her children. She found housing and a job. She relied on the kindness of others for a bit, including a local church, who helped her get back on her feet. Eventually, it seemed, things were looking up. She was making enough to pay most of her bills and more importantly, her children had a safe home.

It turned out, however, that her husband, hadn’t exactly left her with nothing. One day, she received a notice from the Internal Revenue Service advising her that she owed taxes. A lot of taxes.
As Mary investigated further, she found that while her husband had filed for most years, he had not remitted payment for most of those years. She had no idea. She had dutifully signed the returns – without ever reviewing them – and had assumed that they were being taken care of. When I later asked her why she never followed up, she became quiet. Most of their fights, she said, were about money. And it made him angry if she questioned how he handled the money. So she simply stopped asking.

She landed on the IRS’ radar screen because she was now earning a paycheck. Since she had previously filed her tax returns as married filing jointly, the IRS took the position that it could collect all of the debt from her wages. That, she told me, wasn’t fair. It was, however, the law.
She filed an application for innocent spouse relief with mixed results. The IRS was inclined to grant her application but her now ex-husband had other ideas. He waltzed back into Mary’s life for just a moment: to file objections for her request for relief. I met him and could understand how she would be frightened. He was a hulk of a man, looming far over my own 5’2″ frame. Mary was so scared of him that she was shaking and found it hard to tell her story; the attorney for the IRS graciously put him in one room and Mary in another during the proceedings.

In the end, Mary won most of her argument. It was, at the time, a rare victory: proving entitlement to innocent spouse relief has traditionally been a fairly steep burden for taxpayers.
Over the past two years, however, the IRS has made marked progress in how it treats taxpayers claiming innocent spouse relief. Last year, the IRS gave many taxpayers cause for hope when it released Notice 2012-8 (downloads as pdf), which “significantly lowered the bar for innocent spouse relief.” Among the issues address in the Notice is the issue of abuse, which had been treated unevenly by the IRS in absence of firm evidence of physical abuse. Now, the IRS acknowledges that:

Abuse comes in many forms and can include physical, psychological, sexual, or emotional abuse, including efforts to control, isolate, humiliate and intimidate the requesting spouse, or to undermine the requesting spouse’s ability to reason independently and be able to do what is required under the tax laws. All the facts and circumstances are considered in determining whether a requesting spouse was abused.

But not all taxpayers who are entitled to innocent spouse are victims of abuse. A number of other factors are taken into consideration when determining innocent spouse relief including the omissions of income by a spouse or overstating and fabricating deductions. Each taxpayer is supposed to review the tax return for accuracy before signing the return so the assumption is that you knew or had an obligation to know what information is on the return. Further, each taxpayer has an obligation to ensure that tax obligations are satisfied. By law, when you file a joint tax return, both taxpayers are jointly and individually responsible for the tax and any interest or penalty due on the joint return even if they later divorce.

You can imagine, then, that timing, in particular, could be a problem. The IRS has ten years to collect a debt after it is assessed (this is in addition to the time frame for audit and exam) but under prior rules, spouses had a much shorter deadline in which to claim relief. Specifically, the IRS had only allowed taxpayers two years to file for innocent spouse relief.

This week, the IRS proposed to make permanent rules to extend the amount of time taxpayers can apply for equitable relief through an innocent spouse application. Under the proposed rules, taxpayers would have up to ten years – or generally, the same time frame as IRS has to collect – to file for equitable relief. If the taxpayer is making a claim for refund, the statute of limitations for refund would apply.

I use the phrase “to make permanent” since the IRS was already generally extending the deadline as announced in 2011 as part of Notice 2011-70 (downloads as a pdf). That Notice was issued after a series of cases, the most famous being Lantz v. Commissioner, 607 F.3d 479 (7th Cir. 2010), which challenged the two year deadline. The IRS won some and lost some when it came to those cases, but eventually acquiesced, issuing the Notice to extend the deadline in most cases.
Now, the IRS has issued proposed regulations, REG-132251-11 (downloads as a pdf) which would permanently adopt those deadlines. If approved, the regulations will be considered effective as of the date of Notice 2011-70 which means that they would apply to applications for innocent spouse relief filed on or after July 25, 2011.

The proposed regulations – which are 25 pages long – also address issues raised in community property states as well as clarifying what constitutes “collection activity” for purposes of starting the deadline for relief.

If you think these rules apply to you – or if you want to re-apply under the new rules – you submit an application by filing federal form 8857, Request for Innocent Spouse Relief (downloads as a pdf). For more information, contact your tax professional or call the IRS at 1.800.829.1040.
But be careful: this is not the same form you use if you are an injured spouse. You are an injured spouse if your share of your tax refund as shown on your joint return was, or is expected to be, applied against your spouse’s past-due federal debts, state taxes, or child or spousal support payments. If you are an injured spouse, you may be entitled to get your share of the refund released to you. To apply for injured spouse relief, file a federal form 8379, Injured Spouse Allocation. (downloads as a pdf)

One final word – and this is the point where I sound like your mother. Everyone is entitled to dignity and self respect. No one ever deserves to be intimidated, humiliated, threatened or hurt. While financial security is important, personal security is more important. If you are the victim of domestic abuse, help is available. Please call 1-800-799-SAFE (7233). It can and does get better. You just have to have the courage to say, “Enough.”

Should you pay off your mortgage? Pursue the tactic that offers the highest return on investment

Robert Powell for Market Watch writes:  Which is better: To retire without a mortgage or keep the mortgage and retire with a bigger nest egg?  More Americans approaching retiring face what some describe as worrisome levels of debt, especially mortgage and credit card debt. 

Consider: More than half (55%) of the American population age 55 to 64 carry a home mortgage, and about the same fraction (50%) have credit card debt, according to a paper presented at the 15th Annual Joint Meeting of the Retirement Research Consortium held earlier this month in Washington, D.C. 

What’s more, that debt isn’t going away after retirement. Among people age 65 to 74, almost half had mortgages or other loans on their primary residences, and more than a third held credit card debt according to the paper, Debt and Debt Management among Older Adults. 

And that debt can be a problem, especially for those who are less financially literate, according to the authors of the paper, Annamaria Lusardi, a professor at The George Washington School of Business, and Olivia Mitchell, a professor at The Wharton School, University of Pennsylvania. 

Such debt can be hard to pay off during retirement, especially in the absence of earned income. Plus, in the worst of cases, such debt can lead to bankruptcy according to Lusardi, who, along with Mitchell, is the co-author of “Financial Literacy: Implications for Retirement Security and the Financial Marketplace.” 

Given the problems that debt can cause in retirement, we thought it worth asking the following questions: What’s the better tactic? To aggressively pay down one’s mortgage down before retirement and stop or perhaps reduce one’s savings for retirement? To keep saving for retirement and retire with mortgage debt? Or should you split the difference—save a bit less for retirement and pay down one’s mortgage a bit more aggressively? 

It depends

Well, as with most things having to do with money, the answer depends on your personal situation. “My answer would be that it depends on the facts and circumstances,” said Mitchell. 

Not surprisingly, many agree with Mitchell that it’s impossible to decide without crunching the numbers whether it’s wise to pay down your mortgage before retiring at the expense of saving less retirement. “I do not think there is a general advice to give without knowing more about personal circumstances,” said Lusardi. 

And Kathleen Mealey, a financial counselor with Cabot Money Management, is in the same camp. To begin to answer the question, she said you need to assess how ready you are for retirement today given your current savings and your goals and plans for the future. 

Others share that point of view. “The question is not a simple one to answer as there are a number of variables that would come into play,” said Mike Kenney, a consultant with Nationwide Financial. 

Those variables include current income, current savings, current tax rates, your Schedule A itemization before and during retirement, whether you have access to a Health Savings Account, your retirement income needs with and without a mortgage, your mortgage balance, the number of years remaining on your mortgage, and interest rates and opportunities to refinance—among many other factors. 

Earlier this year, a survey showed that most people think paying off their mortgage was among the smartest financial decisions they ever made—along with starting to save when they were young.

 

Tax consequences must be weighed

The tax consequences of pursuing one tactic or the other must also be considered. “They are tax advantages to pension contributions and interest payments on mortgages are tax deductible so one has to compare these advantages,” Lusardi said. 

Mealey agreed, saying that contributing to a 401(k) and deducting interest payments from a mortgage could be beneficial, especially if it puts you in a lower tax bracket. “If the answer will be a combination of both 401(k) contributions and paying off mortgage, work at keeping tax brackets low,” Mealey said. 

A word of warning: You are likely to lose much of the benefits of deducting mortgage interest payments the closer you are to paying it off in full. Also, consider this fact: You do get a tax deduction with your 401(k) contribution. But the deduction only defers your taxes, noted Michael Kitces, publisher of Nerd’s Eye View, partner and director of research for Pinnacle Advisory Group, and a RetireMentor at MarketWatch. 

What’s the higher return on investment?

Mealey and others also suggested that you pursue the tactic that offers the highest return on your investment. “What is the mortgage interest rate and length of time remaining?” she asked. “Compare this with the 401(k) investment options. If the long-term rate of return on the 401(k) plan will be higher than the mortgage and there is a comfort level with the risk involved, it may not be advantageous to pay off the mortgage.” 

For some, this is a no-brainer. “With current low interest rates that are fixed for a number of years, a retiree can possibly have a better return on the money in a long-term objective portfolio than the 3 or 4% interest payment,” said Michael Callahan, president of Edu4Retirement. 

On the other hand, if you aren’t earning much on your retirement investments, if you have low or negative returns, it might make sense to pay down your mortgage, Mitchell said.

“If one is holding assets in a money market mutual fund earning 0.5% while paying 5% on his or her mortgage, paying down that mortgage may be a clever strategy,” said Lusardi.

Kitces notes the following in an upcoming issue of MarketWatch’s Retirement Weekly subscription newsletter: “At the margin, choosing to not pay down your mortgage and invest in your 401(k) instead is the equivalent of choosing to invest with leverage since you’re keeping a loan and buying stocks.”

 

Reasons to not pay down mortgage

That said, there are some general rules to follow.

For instance, Kenney suggests that you not pay down your mortgage unless you already have has ample assets to cover all retirement income needs and/or are making the full allowable contribution to their 401(k). “The likely outcome of paying off a mortgage early is increased taxation on earned income now, though this would not apply with a Roth 401(k), and increased taxation due to the loss of a potential deduction later,” Kenney said.

Mitchell suggested that one’s house is a nondiversified, and potentially quite risky, asset. “In this light, hastening to pay off the mortgage may be the wrong thing to do,” she said. 

Reasons to pay down mortgage

In some cases, however, it might make sense to pay down your mortgage. For instance, if your mortgage rate is variable and you think interest rates are rising, that makes paying the mortgage off more appealing, Mitchell said. 

And some people, including Mitchell’s husband, believe that the “right thing to do” is to pay off the mortgage since it helps them sleep better at night, she said.

Others share that opinion. “The answer to the question will change with each person based on their current status, time frame, and risk tolerance,” said Mealey. “No matter what the numbers may show, a critical piece to is to understand (your) view on debt. Sometimes no matter how strong the math, the true answer is what allows (you) to sleep well at night.” 

Besides being able to sleep better at night, having your mortgage paid off pays off in other ways. You’ll be able to qualify for a reverse mortgage, said Callahan. 

Reasons to keep saving for retirement

There’s one big reason to keep saving for retirement, advisers said. If you employer matches your contribution to your 401(k) in some form or fashion, that’s “automatic return right away,” Mitchell said. What’s more, since many employers take the contribution out of your paycheck, “if you don’t see it, you won’t spend it, making that relatively easy,” said Mitchell. 

Another expert, meanwhile, is fond of having cash in the bank or money in the market rather than a paid-off mortgage. “To me, cash is king,” said Callahan. “If you can amortize the payment of the mortgage you have options by having the retirement savings on hand. You can always pay off the mortgage if the cash is available.” 

Plus, he said, it forces a better financial plan while working since past decisions need to be completed while future decisions need planning and commitments. And, Callahan said, having a mortgage “may keep people working longer so that they won’t overestimate the value of their retirement savings.”

Paying down your mortgage before retirement will also help you lower your expenses in retirement. And that’s especially important since housing represents more than 30% of the expenses for average American 65 and older. 

Lowering expenses is a really critical issue in retirement. “With finite resources, keeping expenses low is essential,” said Callahan. “Owning a home is very expensive. Upkeep…is not cheap.”

Are you financially literate enough to retire with debt?

According to Lusardi and Mitchell’s research, early boomers, as compared with previous generations at the same age, bought more expensive homes and got close to retirement with higher mortgage debt than other generations. Plus, they also have higher credit card debt.

“This means that, in addition to decide how to decumulate their wealth, this generation will also have to manage their debt well into retirement and these decisions are not that easy and do require some basic financial literacy,” Lusardi said. 

What’s the answer for you?

The bottom line, at least for Mitchell however, is this: “I’d say do both—and keep working longer.”