A House panel has passed a bill that would temporarily expand the standard tax deduction used by the majority of taxpayers by $2,000 per person for the next two years.
The Tax Cuts for Working Families Act (H.R.3936) recently approved by the tax-writing House Ways and Means Committee would temporarily boost the standard deduction by $2,000 for single filers and $4,000 for married filers for 2024 and 2025. The deduction would start to phase out for single taxpayers with $200,000 in income, or $400,000 for joint filers. A financial advisor can help you optimize your tax strategy and make sense of tax code changes.
“The vast, vast majority of my constituents use the standard deduction on their taxes every year,” said Rep. Carol Miller, R-West Virginia, adding that the measure will increase economic activity in local economies. “The bonus $4,000 deduction is a $100 billion tax cut for the working families and will go a long way to make sure that my constituents can make ends meet.”
Potential Impact of Standard Deduction Increase
Nearly two-thirds of households would get a tax cut in 2024 under the proposal, according to research from the nonpartisan Penn Wharton Budget Model. However, since the standard deduction lowers the amount of income subject to tax, the deduction isn’t refundable and wouldn’t provide cash to lower-income taxpayers. In fact, only a small percentage of the bottom 20% of households have enough income to get a tax cut under the proposal, the researchers from Penn concluded.
But those at the very top of the income ladder also wouldn’t see significant tax savings if the bill becomes law. Not only does the higher deduction phase out for incomes of $200,000 or more (or $400,000 for married couples), but a larger proportion of high-income households use itemized deductions.
“The poorest fifth of Americans would receive just 2% of the benefits of this provision, and on average, that means a tax break of just $30 next year,” said Rep. Richard Neal of Massachusetts, the committee’s ranking Democrat.
The change would also cost approximately $96 billion over 10 years, the Penn researchers found.
The standard deduction for 2023 will be $13,850 for singles and $27,700 for couples. The deduction nearly doubled as part of the 2017 Tax Cuts and Jobs Act, which expires in 2026. An increasing number of taxpayers have opted to claim the standard deduction, rather than itemize deductions for mortgage interest, charitable donations, medical costs and a host of other deductible expenses. According to the IRS, 90% of taxpayers opted for the standard deduction for their 2021 taxes.
Will it Help Ease Inflation or Make it Worse?
Sponsors of the temporary increase said the measure was intended to provide relief from inflation, which soared to 9.1% last June before dropping to 4% in May. The target inflation rate for the Federal Reserve is 2%, which mirrors the historical average.
That reasoning was criticized in an analysis by the conservative-leaning American Enterprise Institute, which pointed out that increasing the disposable income of so many Americans tends to make inflation worse, and would contradict efforts by the Federal Reserve to slow consumer spending by raising interest rates.
Bottom Line
An increase in the standard deduction on federal income tax would benefit most U.S. households but only a small amount of lower-income taxpayers would see any cut to their tax bills. Since the increase of the standard deduction in 2017, fewer taxpayers have been itemizing deductions on their returns.
Tax Optimization Tips
When it comes to saving and investing for retirement, taxes are a significant and complicated consideration. Saving in a traditional IRA or 401(k) gives you an immediate tax break since contributions are made on a pre-tax basis. A Roth account, on the other hand, is funded with after-tax dollars so your money grows tax-free. Here’s some additional guidance for late-career savers deciding whether to switch to Roth contributions.
A financial advisor with tax expertise can help you optimize your tax strategy. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Most income taxes in the United States are paid by the people with the most income. That is in keeping with the generally progressive nature of the individual federal income tax, the primary source of government revenues, which applies higher tax rates to higher incomes. However, some taxes fall more heavily on people with less income, while the most affluent of all can sometimes pay little or no income tax. A financial advisor can help you plan to manage your taxes.
The Biggest Taxpayers
The biggest source of tax revenue in the United States is the federal individual income tax and the biggest source of individual income tax revenues consists of the nation’s highest earners. In 2023, according to an estimate of the Tax Policy Center, 67% of all federal income tax collected will come from the top 20% of earnings, who were bringing home more than $189,200 annually. The situation where a small minority of high earners pay most of the individual income taxes has remained steady for many years.
Beyond that, figuring out who pays the most total taxes in the United States is complicated by the fact that there are many types of taxes. Federal individual income taxes levied on earnings from working and investing is just one variety, albeit the most important.
Payroll taxes supporting Social Security, Medicare and unemployment benefits are the second-largest source of federal tax revenues. Employers deduct these Federal Insurance Contributions Act (FICA) taxes from workers’ paychecks.
Other taxes include corporate income taxes, estate taxes, gift taxes and customs duties. Excise taxes are assessed on gasoline, alcohol, gambling and some other products and services. These taxes land more or less heavily on different taxpayers. For example, lower-income workers pay a larger percentage of their incomes in payroll taxes than higher-income workers thanks to the cap on income subject to Social Security taxes.
The capital gains tax is a special tax imposed on certain types of investment income that is in lieu of and generally lower than the individual income tax rates. Capital gains taxes are mostly paid by people who have more assets, while people with few assets may pay little or no capital gains tax. Similarly, property taxes, which are the major source of revenue for state and local governments, are only levied on the owners of property such as real estate.
Factors Influencing Who Pays the Most Taxes
A number of factors determine how much someone pays in federal income tax. The interplay between these factors and taxpayers’ efforts to save on taxes while conforming to the tax law, is largely responsible for the complexity of tax planning and preparing tax returns. Here are some of the major considerations.
Taxable income: As your income rises, you move into a higher tax bracket, which means more of your income goes to taxes.
Filing status: Tax rates vary depending on whether you are filing as a single individual, a married couple filing jointly, a married couple filings separately or as a head of household.
Adjustments to income. Retirement plan contributions, student loan interest payments and some other outlays can reduce your taxable income and your taxes.
Exemptions: Taxpayers can further reduce income by claiming exemptions, including dependency exemptions for their children.
Deductions: Yet another way to reduce taxable income is by claiming deductions. In addition to the standard deduction, you may be able to claim deductions for medical expenses, charitable contributions, home mortgage interest and other costs.
Tax credits: Credits for education and energy conservation, among other categories, can not only reduce your taxes but result in the government sending you a check.
Managing your tax liability consists largely of working with these factors. For example, if you have an unusual amount of income in one year, you may be able to use averaging to spread the income among different taxable years, keeping you from moving into a higher tax bracket.
Using the capital gains tax to reduce income taxes is also important. If you have assets that have appreciated in value, you could be subject to a large capital gains tax bill when you sell them. On the other hand, if you never sell them, you may be able to pass them on to your heirs without ever paying any income tax on your increased wealth. Very affluent taxpayers can pay their bills while avoiding income and other taxes by a number of other means, including pledging their assets as collateral for loans, the proceeds of which are not taxable.
The Bottom Line
The people with the highest incomes generally pay the highest taxes in the United States, thanks to the generally progressive individual income tax system used by the federal government. There are some exceptions to this type of policy, as very wealthy individuals can find ways to reduce their taxes – sometimes paying none at all – by making the most of so-called loopholes in the tax code. However, as a rule, the top 20% of earners pay more income taxes than the rest of the tax-paying population put together.
Tax Tips
Managing and reducing the amount of taxes you pay can benefit from the assistance of a financial advisor. Finding a financial advisor doesn’t need to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
SmartAsset’s Federal Income Tax Calculator can help you break down your tax obligations including the total tax as well as the type of tax and your marginal and effective tax rates.
Mark Henricks
Mark Henricks has reported on personal finance, investing, retirement, entrepreneurship and other topics for more than 30 years. His freelance byline has appeared on CNBC.com and in The Wall Street Journal, The New York Times, The Washington Post, Kiplinger’s Personal Finance and other leading publications. Mark has written books including, “Not Just A Living: The Complete Guide to Creating a Business That Gives You A Life.” His favorite reporting is the kind that helps ordinary people increase their personal wealth and life satisfaction. A graduate of the University of Texas journalism program, he lives in Austin, Texas. In his spare time he enjoys reading, volunteering, performing in an acoustic music duo, whitewater kayaking, wilderness backpacking and competing in triathlons.
Ultimately, retirement planning is like a math equation — you input several variables and estimate whether what you’ll have will pay for what you will need in retirement. The challenge is that many of the variables are future values that are unknowable today.
But that doesn’t mean you can’t make some educated guesses. So let’s examine the “what you’ll need” part of the equation — that is, how much the retired life will cost you each year — to see if we make the murky crystal ball any clearer.
How much do retirees need?
The standard rule of thumb is that retirees need 70 to 80 percent of their pre-retirement income. Fortunately, we can examine how spending changes as we age by looking at the Consumer Expenditure Survey that is produced every year by the U.S. Bureau of Labor Statistics. That can help us figure out if this 70-to-80-percent estimate has any basis in reality.
The following table highlights average income and expenditures of households led by people in different age groups. (I selected particular categories from the much larger Consumer Expenditure Survey.)
EXPENSE ITEMS
AGE 25-34
AGE 35-44
AGE 45-54
AGE 55-64
AGE 65-74
AGE 75+
Income before taxes
$59,613
$76,128
$79,589
$68,906
$49,711
$31,782
Avg. number of persons per household
2.9
3.3
2.8
2.2
1.9
1.6
Average annual expenditures
$46,617
$55,946
$57,788
$50,900
$41,434
$31,529
Food at home
$3,338
$4,255
$4,369
$3,681
$3,213
$2,643
Food away from home
$2,753
$3,227
$2,861
$2,387
$1,935
$1,230
Housing
$16,845
$20,041
$18,900
$16,673
$14,420
$11,421
Apparel and services
$2,087
$2,040
$1,966
$1,571
$1,186
$708
Transportation
$8,231
$8,763
$9,255
$8,111
$6,086
$4,288
Health care
$1,800
$2,583
$3,261
$3,859
$4,922
$4,754
Entertainment
$2,251
$3,058
$3,088
$2,683
$2,341
$1,374
Reading
$61
$80
$104
$126
$147
$135
Education
$839
$963
$2,094
$917
$240
$140
Pensions and Social Security
$5,151
$6,664
$7,227
$5,932
$2,261
$763
Personal taxes
$1,055
$1,992
$3,323
$2,295
$1,116
$144
Factors that reduce living expenses among retirees
As you study the table, you notice that expenditures peak somewhere between age 45 and 54 — then they gradually decline. Here are some of the reasons that drive the trend:
Fewer people under the roof. Eventually, kids leave the house and you wind up spending less money on food, utilities, education, and Febreze. Also — and this is the sad part — a spouse will pass away. When a two-person household goes down to a one-person household, expenses drop by approximately 30 percent.
We eat less as we age. As our metabolisms slow down, so does our need for calories. Another unfortunate reason some older people eat less is that they find it more difficult to go shopping and to cook meals.
The mortgage eventually gets paid off. Roughly 55 percent of households in the 45-to-54 age group have a mortgage, whereas just 13% of the 75-and-older group still have that monthly payment.
We just slow down. As we age, we spend less on entertainment, clothes, travel, and other semi-discretionary expenses. As a writer and former English teacher who is married to a writer, I was heartened to see that expenditures on reading generally increase as we age, with just a slight dip after age 75.
We don’t save for retirement forever. Once you retire, you’ll stop paying the 7.65 percent FICA tax that pays for Social Security and Medicare (15.3 percent if you’re self-employed) and you’ll stop contributing to your 401(k)s, IRAs, and other savings vehicles. This alone could shave 15 percent to 25 percent off your pre-retirement expenses.
Uncle Sam likes older people. Senior citizens pay much less in taxes, for several reasons: They receive a higher standard deduction, most Social Security is not taxed, and other sources of income — such as qualified dividends, municipal bond interest, and long-term capital gains — are taxed at lower rates than ordinary income. Plus, as you can see from the first row in the table above, income declines as we age, which puts most older people in the bottom two tax brackets.
Not every expense decreases as we age — notably, health care costs increase. Also, there’s a legitimate question about whether senior spending declines out of choice or necessity — i.e., retirees would spend more if they had more. However, for many of the categories, the spending declines are the logical result of getting older and not working anymore. Thus, on the whole, the evidence indicates that the old rule of thumb that you’ll need 70 percent to 80 percent of your pre-retirement income in retirement has its foundation in reality.
How to translate statistics to your retirement plans
However, while the average retiree spends less than the average 50-year-old, this is not the case for every retiree. Many spend quite a bit more, especially in the first few years of retirement, as they fill their newfound free time with travel, hobbies, classes, and other forms of recreation. Others see their income needs drop to half of their pre-retirement income. So when it comes to your own financial planning, especially once you’re within a decade of retirement, it’s important to look at and refine your budget, estimating how much you’ll actually need after you kiss the working world good-bye.
Donating to charity isn’t just a way to have a positive impact on society – it’s also a savvy approach to reducing your tax liability. Schwab suggests people who donate to charity on an annual basis may want to consider a tax-smart strategy known as “bunching,” which involves making at least two years’ worth of charitable contributions in one year. Doing so can allow you to itemize your deductions for that year and increase the size of your tax deduction over the two-period. Consider working with a financial advisor if you need help with tax planning or charitable giving.
Standard Deduction vs. Itemizing
Each year, tax filers must choose between taking the standard deduction or itemizing their deductions. If your individual tax deductions exceed the standard deduction in a given year, itemizing is likely the preferable approach. The opposite also rings true. If the total value of your itemized deductions is less than the standard deduction, you’ll want to claim the latter.
2023 Standard Deduction
Single filers and married couples filing separately: $13,850
Married couples filing jointly: $27,700
Heads of household: $20,800
2022 Standard Deduction
Single filers and married couples filing separately: $12,950
Married couples filing jointly: $25,900
Heads of household: $19,400
Choosing between taking the standard deduction or itemizing is key when determining how to best maximize the tax benefit of your charitable contributions.
When to Bunch Charitable Donations
If you regularly donate to charity but your total itemized deductions fall short of the standard deduction, you may want to consider bunching your contributions. Doing so means you’ll make multiple years’ worth of contributions in the current tax year, pushing your itemized deductions above the standard deduction threshold. You’ll then take the standard deduction in the following year(s) since you won’t be making any additional donations.
To illustrate the potential benefits of bunching, Schwab ran the numbers on a hypothetical couple with no children. Schwab assumed the couple made $10,000 in charitable donations in both 2022 and 2023. Their other deductions for both years total $13,000. By taking the standard deduction ($25,900 in 2022 and $27,700 in 2023) in both years, the couple’s two-year deduction adds up to $53,600 – more than would have been had they itemized in both years.
However, if the couple made two years’ worth of donations in 2022, their itemized deductions would have added up to $33,000. They could have then taken the standard deduction in 2023 and their two-year deduction would have added up to $60,700.
By bunching their charitable contributions, the couple would have lowered their combined taxable income in the two years by $7,100.
Bottom Line
Tax filers who regularly donate to charities should consider how to maximize the tax benefit of their goodwill. Schwab recommends making multiple years’ worth of donations in a single year, so your total itemized deductions exceed the standard deduction. This strategy, which is known as bunching, then calls for you to take advantage of the standard deduction in subsequent years when you won’t be making any donations. Doing so can increase the size of your total deductions over that two-year period and lower your taxable income.
Tips for Reducing Your Tax Bill
A financial advisor can help you assess your tax situation and potentially limit how much you end up owing Uncle Sam. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
Capital gains can increase the amount of money you ended up owing the government each year. However, harvesting tax losses can help offset those gains. And if your tax losses exceed your capital gains, the IRS permits you to deduct up to $3,000 worth of excess losses from your total income for that year.
If you’re approaching retirement and thinking about moving to a new state, consider the tax environment for retirees in that state. SmartAsset’s retirement tax friendliness tool provides an in-depth look at the places with the best and worst tax environments for retirees.
Patrick Villanova, CEPF®
Patrick Villanova is a writer for SmartAsset, covering a variety of personal finance topics, including retirement and investing. Before joining SmartAsset, Patrick worked as an editor at The Jersey Journal. His work has also appeared on NJ.com and in The Star-Ledger. Patrick is a graduate of the University of New Hampshire, where he studied English and developed his love of writing. In his free time, he enjoys hiking, trying out new recipes in the kitchen and watching his beloved New York sports teams. A New Jersey native, he currently lives in Jersey City.
Tax law is complicated. There’s no doubt about it. But oddly enough, a lot of the tax mistakes people make are for shockingly simple things that could easily be avoided. (Some examples include missing the tax deadline, failing to report all your income, and not taking the right tax breaks, just to name a few).
Understanding these mistakes can help you avoid them in the future, since none of us really want to deal with the IRS more than we have to.
What’s Ahead:
1. Not paying required estimated taxes
If you’re a freelancer, small business owner, side hustler, or anyone else earning income where taxes aren’t withheld, you’re required to make quarterly estimated tax payments to the Internal Revenue Service (IRS).
Not paying required estimated taxes or paying them late has two major outcomes:
Your tax bill will be a lot larger than anticipated.
You’ll pay penalties and interest charges on your unpaid tax liability.
Either way you dice it, it’s not good. Work those quarterly payments into your schedule so you can breeze into tax season knowing you won’t be in trouble with Uncle Sam.
Read more: 7 Side Hustle Accounting Mistakes To Avoid
Who has to pay quarterly estimated taxes?
Generally speaking, if you owe $1,000 or more in federal taxes for the year, then you’ll need to pay quarterly estimated tax payments. This could include any income earned through:
Self-employment
Interest
Dividends
Alimony
Capital gains
Prizes and awards
Read more: Quarterly Estimated Tax Payments: Who Needs to Pay Them, When, and Why
2. Failing to keep necessary tax records
No matter how simple or complex your tax situation is, you’re going to need to collect receipts, income statements, and other things throughout the year to make sure you have everything you need to file your return.
So, what documents do tax preparers need to keep? In general, you should hang onto:
Income statements such as W2s and 1099s.
Bank statements.
Any tax forms you receive electronically or by snail mail.
Receipts for purchases and charitable donations you plan on writing off.
Copies of your signed return and all supporting documents, so you have proof if you’re audited or need to file an amended return.
If this sounds like a lot, don’t panic. You can use our tax document checklist to keep it all organized.
3. Failing to report all of your income
The IRS knows how much money you make each year — and they also know when you fail to report it all. (They’re kind of like that parent who knows their kid broke their favorite vase but they ask them about it anyway just to give them a chance to come clean and tell the truth).
If you accidentally or purposefully leave something off your return, the IRS will know about it, and there will be consequences to pay. It could be as simple as paying a penalty fee or as extreme as being audited or facing tax fraud charges. Either way, it’s best to avoid it all together.
The easiest way to make sure you’re reporting all your income for the year is to hang onto all your W2s and 1099s. This will help you make sure nothing falls through the cracks when you sit down to prepare your return.
MU30 Tip: If you file your taxes and later realize you forgot to report something, file an amended return as soon as you can to fix it. Learn how in our piece – Tax Return Error? Here’s How To Amend Your Return.
4. Not using accounts that have tax advantages
One of the easiest ways to lower your tax bill is by maxing out any tax-advantaged accounts you have at your disposal. This includes:
Employer-sponsored retirement accounts, such as a 401(k), 403(b), 457 plan, or a federal Thrift Savings Plan (TSP).
Traditional IRAs.
Health savings accounts (HSAs), which you qualify for if you have a high deductible healthcare plan (HDHP).
So, why should use tax-advantaged accounts to lower your taxes? Here’s a scenario to show you why. (It involves some math, so put your nerdy glasses on with me for a second).
A real-life example of why you should use tax-advantaged accounts
Meet Cleo. She’s a single, 28-year-old financial analyst who made $80,000 in 2022. Cleo’s big into saving, so she maxed out her company’s 401(k) ($20,500), her traditional IRA ($6,000), and her HSA ($3,650). This brings her taxable income down to $50,900.
Based on current marginal tax rates, her federal tax liability comes out to $3,650 for the year. Without the tax-advantaged accounts, Cleo would’ve been on the hook for $10,368 — A LOT more money.
Note that this is a simplified scenario that uses the standard deduction but doesn’t take into account other credits or expenses.
5. Filing with incorrect information
Another common tax mistake is filing a return that’s incomplete or inaccurate. This can result in delays in getting your refund, as well as additional penalties and interest charges from the IRS.
To avoid this, be sure to:
Double-check your bank account and routing numbers if you’re getting a tax refund via direct deposit.
Review your name, Social Security number, address, and other personal information.
Make sure your filing status is correct.
Confirm that your income matches the W2s and other income statements you have on hand.
Review your deductions and credits to see if they make sense for your situation.
6. Filing under the wrong status
Your filing status can have a huge impact on how much you owe in taxes for the year. It can also determine if you even need to file a return in the first place.
So, what happens if you file under the wrong tax status?
The most common downside is that it could result in a larger tax bill than necessary. And if the IRS suspects you were intentionally deceptive, you could be audited or hit with a tax fraud penalty.
What are your tax status filing options?
Tax filers have five filing statuses to choose from:
Single – Applies to anyone who isn’t married, including those who are divorced or legally separated.
Married filing jointly – Applies to anyone who’s married and wants to file taxes together.
Married filing separately – Applies to married couples who want to file taxes separately. This could be advantageous if you only want to be responsible for your own taxes. Or, if filing under this status will save you more money.
Head of household – Mostly for those who are single, but it can also be used if you pay for more than 50% of the costs for you and a qualifying person.
Qualifying widow(er) with dependent child – For anyone whose spouse has recently died and has at least one child dependent. Special rules apply, though.
If you’re stuck between two filing statuses, the IRS recommends preparing your return both ways to see which saves you the most money.
Read more: How To Know When You Should File Your Taxes Jointly or Separately
7. Not taking the right tax breaks
There are HUNDREDS of tax deductions and credits out there. Some are quite common — like the earned income tax credit, child tax credit, and property tax deduction.
Others are super obscure — like how you can write off student loan interest paid by your parents. Or, how you can write off taxes paid to the Social Security Administration if you’re self-employed.
Read more: Tax Benefits For College Students: How To Pay Less And Get More Back
One of the best ways to reduce your taxes is to take advantage of every tax break you qualify for. The good news is, if you file your taxes online, the tax software you use will automatically maximize these deductions and credits for you.
Check out a few of our recommended tax software options here: Best Tax Software Compared
8. Missing the tax deadline
The tax filing deadline is April 15 (almost) every year (or October 15 if you file an extension). But in 2023, it’s April 18 due to a state holiday. One of the most common tax mistakes people make is missing this deadline.
So, what happens if you miss a tax deadline?
If you’re set to receive a refund: the short answer is nothing. You can file your tax return at any time and get your money. You won’t pay any penalties or fees.
If you owe the IRS money: you’ll pay a penalty for filing a late return and for not paying your taxes on time. This penalty gets larger the longer you wait, so file your return ASAP if you can.
The IRS’ Failure to File Penalty is 5% each month for any unpaid taxes owed. This fee maxes out after five months for a total of 25%. There’s also a Failure to Pay Penalty that keeps accruing each month even after the Failure To File Penalty stops. It can all add up in a hurry.
MU30 Tip: A tax extension gives you more time to file your return, but it does not give you more time to pay any taxes you owe. So, if you have a bill this tax year, set up a payment plan by the deadline even if you haven’t filed a return yet.
9. Filing your tax return too early
If you’re anything like me, you may be in a hurry to file your taxes as soon as possible each year. Especially if you’re set to get a refund.
Side story: I remember so many times in college when I treated the first day of tax season like my birthday or Christmas. I’d wake up and file my return as quickly as I could because I was so excited to see what my return would be. Weird, I know.
But here’s the catch — another easy tax mistake people make is filing their return too soon. Sounds odd, right?
When you file your return too soon, you run the risk of not having all the proper tax documents you need to file a complete and accurate return. You could also miss out on valuable deductions and credits and that could maximize your refund even more.
What you should do if you make a mistake on your tax return
Okay, so what happens if you file your return and then realize, “Crap! I’ve made a mistake!”? Calm down and take a deep breath. We’re gonna get through this.
In most cases, all you need to do is file Form 1040X, which is an amended tax return, to correct any mistakes you made.
You can typically amend your return using the same tax software or company you used to file it the first time. Or, you can download this form from the IRS and fill it out by hand (although this is a lot more tedious).
Summary
These are just a few of the most common tax mistakes people make each year. The IRS doesn’t always make things easy for us, so there are some things that are just honest mistakes.
One easy way to minimize these mistakes is to file electronically using tax software or a tax professional.
This is another guest post from JoeTaxpayer. On my blog, I’ve shared several articles that discussed the Roth IRA conversion event of 2010 in great length and detail. While this is can be a great opportunity for many, there are several instances that a conversion does not. I looked to JoeTaxpayer to share some pros and cons of the Roth IRA conversion and for unforeseen consequences that could result.
There’s been much hype regarding the ability for anyone to convert their retire money to Roth regardless of their income. Many professional planners and writers of financial blogs have offered compelling reasons why one should convert. Today, I’d like to share some scenarios where you might regret that decision.
You don’t have a crystal ball
All signs point to higher marginal rates, this is one factor that prompts the advice to convert, but who exactly would that impact, and by how much? Let’s look at the first risk of regret. You are single, and an above average wage earner, just barely in the 28% bracket. (This simply means your taxable income is above $82,400 but less than $171,850, quite a range). Any conversion you make now is taxed at 28%, by definition. You get married, and start a family quickly, your spouse staying home. That same income can easily drop you into the 15% bracket as you now have three exemptions, and instead of a standard deduction, you have a mortgage, property tax and state tax which all put you into Schedule A territory and a taxable income of less than $68,000. Now is when you should use the conversion or Roth deposits to take advantage of that 15% bracket, before your spouse returns to work and you find yourself in the 25 or 28% bracket again. It’s then that you should convert enough (or use Roth in lieu of traditional IRA) to ‘top off’ your current bracket.
Life isn’t linear
It’s human nature to expect the next years to be very similar to the past few. Yet, life doesn’t work quite that way. The person who makes more money year on year, from their first job right through retirement is the exception. For more people, there are layoffs, company closings, major changes in family status, disability, and even death. Except for permanent disability or death, the other situations can be considered opportunities to take advantage of a full or partial Roth conversion. If one should become disabled, the ability to withdraw that pretax money at the lowest rates is certainly preferable to having paid tax on it all at your marginal rate.
Transferring your 401(k)
The Roth conversion is available for holders of 401(k) (and other) retirement accounts as well as holders of traditional IRA accounts. Back in October 07, I cautioned my readers on a somewhat obscure topic they need to be aware of when considering a transfer from the 401(k) to their IRA and the same caution exists for conversion to a Roth. Net Unrealized Appreciation refers to the gains on company stock held within your 401(k). The rules surrounding this allow you to take the stock from the 401(k) and transfer it to a regular brokerage account. Taxes are due only on the cost of that stock, not the current market value. The difference up to the market value at time of sale (thus the term Net Unrealized Appreciation) is treated as a long term capital gain. Current tax law offers a top LT Cap Gain rate of 15%. A loss of 10% or more if you are in the 25% bracket or higher and convert that company stock to a Roth.
Taking Money At Retirement
Given the low saving rate of the past decades, all projections point to fewer than the top 10% of retirees coming close to ‘retiring in a higher bracket.’ Consider how much taxable income it would take to be at the top of the 15% bracket in 2010. For a couple, the taxable income needs to exceed $68,000. Add to this two exemptions, $3,650 ea, and an $11,400 standard deduction. This totals $86,700. Using a 4% withdrawal rate, it would take $2,167,500 in pretax money to generate this annual withdrawal. What a shame it would be to pay tax at 25% to convert only to find yourself with a mix of pre and post-tax money that puts you toward the bottom of that bracket. Whose marginal rates do you believe will rise? Couples making less than $70,000? I doubt it. What’s the risk? That you should be in the 25% bracket at retirement? That’s still break even in the worst scenario.
What About Your Beneficiaries
While a tax-free inheritance might be great for the kids, a properly inherited, properly titled Beneficiary IRA can provide them a lifetime of income. Consider, if you leave a portion of your traditional IRA to your grandchild, a 13 year old, his first year RMD (required minimum distribution) will only be about 1.43% of the account balance. For a $100,000 account left to him, this RMD falls shy of the current $1900/yr limit before he is subject to the kiddie tax. To insure that he doesn’t withdraw the full remaining amount at 18 or 21, consult a trust attorney to set up the right account for this purpose. If left to your own adult children, the advantage can go either way depending on their income and savings level.
Are You a Philanthropist?
If you don’t have individual heirs you wish to leave your assets to, the ultimate poke at Uncle Sam is to leave your money to charity. No taxes at all are due. Leaving Roth money to charity just means that our government already got its piece of the pie.
Avoiding Roth IRA Conversion Regrets
Today, I’ve shared with you some scenarios that are cause for regretting a conversion. As I always caution my readers, your situation may differ from anything I addressed here, and your unique needs are all that matters. If you have any questions on when or if a conversion makes sense for you, post a comment and we’ll be happy to discuss.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Please see a tax professional before implementing any sort of IRA conversion. Joe TaxPayer is not affiliate or endorse by LPL Financial.
Americans donate billions of dollars each year to nonprofits — both at home and abroad. That money is essential to helping those nonprofits carry out their missions.
But how do you know that money will be used the way you want?
If you’re donating money to a charity, take a minute to make sure you know where your money is going first.
3 Things to Consider Before Donating Money to a Charity
If you have the money to make donations — or even if you don’t, but feel strongly about a certain cause — it’s important to evaluate the charity first.
Are donation dollars helping support a worthy cause — or supporting high administrative costs?
You want to get the most out of your donation dollars. Here are some tips to help.
1. Make Sure You’re Donating to a Legitimate Organization
It never hurts to check out the charity’s profile on a watchdog site such as Charity Watch or Charity Navigator.
You can search the organization and find its address, mission statement, tax filing status and total expenses vs. total contributions.
Charity Watch will also tell you how much it cost the charity to raise $100, which can be a sign of the organization’s efficiency (or lack thereof).
Charity Watch gives organizations a letter grade, like A, B or C. Charity Navigator rates organizations on a scale of one to four.
2. Know Where Your Money Is Actually Going
You don’t want your hard-earned money to go into someone else’s pockets — unless that’s who you donated it to.
The number that can help you understand where your money is going is called the program efficiency or expense ratio.
Higher efficiency ratios are a good thing. They illustrate a charity’s productivity in providing services in line with its mission.
A general rule of thumb: The most efficient organizations spend at least 75% of their budgets on programs and services, with the rest going toward administration and fundraising costs.
Finding the spending ratio is super simple. Go to Charity Watch and search for an organization. You’ll see a “program expense ratio” that reflects the total expenses a charity spent on programs relative to overhead.
3. Take Note of the Group’s Nonprofit Status for Your Taxes
When you make a donation, check to see if it’s tax deductible. This is important to some donors because donation dollars can be deducted from taxable income. That means it won’t be taxed.
To determine the status of your monetary contribution, look for the charity’s tax status.
You can find an organization’s tax status on Charity Watch or Charity Navigator. Or simply go to the organization’s website, the IRS or GuideStar.
The two most common tax statuses for charities are 501(c)(3) and 501(c)(4).
A 501(c)(4) donation is generally not tax deductible, while donations to 501(c)(3)s are.
As a result, if you’re trying to get a tax break, look for a 501(c)(3) organization before you make your donation.
The IRS has a great resource about charitable donation deductions for those looking to save money at tax time. Read up!
But remember: You can only claim charitable donations if you itemize your taxes. And most Americans don’t itemize.
According to The Tax Foundation, about 87% of Americans took the standard deduction in 2019 instead.
For the 2022 tax year, the standard deduction is $12,950 for an individual, $25,900 for married couples and $19,400 for heads of household.
That means your deductible expenses — including your charitable donations — will need to equal more than $12,950 (or $25,900, if you’re married and filing jointly) to be able to take advantage of a charity tax benefit.
For many of us, that will not be the case.
Rachel Christian is a Certified Educator in Personal Finance and a senior writer for The Penny Hoarder. Carson Kohler is a former staff writer.
It’s that time of the year again, when presidential hopefuls lay out their plans to save America and get the nation back on its feet.
While a lot of it is just noise, I do enjoy reading about the candidates’ housing policies to see what they think about real estate, mortgages, and so on.
It was especially important in the previous election, but has barely been mentioned this time around thanks to a resurgent housing market.
This week, Bernie Sanders weighed in with a piece titled, “Fighting for Affordable Housing.”
It has a number of proposals along with six main areas of interest, including:
– Expand affordable housing – Promoting homeownership – Helping underwater homeowners – Preventing homelessness – Getting lead out of our homes – Addressing housing and environmental justice
First, Sanders wants to expand affordable housing by building more affordable rental housing units for extremely low-income households.
Along with that, he wants to raise the minimum wage to $15 an hour by the year 2020, while also reinvigorating federal housing programs, repairing public housing, and defending the Fair Housing Act.
When it comes to promoting homeownership, Sanders promises to fight to support first-time home buyer programs, including expanded HUD and USDA offerings, as well as pre-purchase housing counseling.
Credit Score Reform?
He also wants to enact some kind of “credit score reform,” which is confusing to say the least. The proposal points out that a “prime score” before the housing crisis was 640, and that it’s now 740.
I can’t really get behind this because 640 back then was still 640, just slightly above subprime. Today, it’s the same, but you can still get a mortgage with very little down and a score that low.
Additionally, he notes that those with low scores had their credit ruined by foreclosures. Unfortunately, your credit score takes a hit when you stop paying your mortgage, even if the mortgage was destined to fail.
The upside is that there are already programs in existence for those with a foreclosure in recent history that wasn’t really their fault, and even some if it was your fault. It’s also been long enough that many boomerang buyers are now eligible for mortgages again.
He also backs the CFPB and ostensibly the Qualified Mortgage rule, but warned that Republicans are attempting to undermine the agency’s efforts. There’s certainly a lot of controversy there with many lenders feeling the need to walk on eggshells.
But all in all, the new forms should be easier for consumers to read (and to compare to other offers they receive), and the QM rule should limit the number of toxic mortgages doled out in coming years.
Mortgage Interest Deduction for All
Perhaps most interestingly, Sanders wants to extend the mortgage interest deduction to all taxpayers, not just those who itemize their taxes.
Many have argued that the deduction only benefits wealthier taxpayers with larger amounts of mortgage interest paid, many whom tend to itemize. With mortgage rates low and the standard deduction already quite high, many homeowners actually see no tax benefit.
He claims they could close the second home and yacht interest deduction “loophole” and direct the money to some 19 million homeowners who would otherwise benefit if they itemized.
I’m not sure how it would work, but I’m guessing it would be a flat dollar amount that would level the playing field between rich and less rich.
Sanders may have a point because a lot of homeowners probably think they’ll save more money than they actually do once they file their taxes, despite being told beforehand that they’ll save lots of money on taxes. And this can affect the rent vs. buy decision.
Sanders also wants to reinvigorate the Home Affordable Refinance Program (HARP), which is odd seeing that it has been around for some seven years and is winding down at the end of this year. Loan volume is already super low because most who could benefit already took advantage.
Additionally, home prices have risen markedly, so it’s importance has diminished tremendously in recent years.
A more useful idea he’s also touting would expand foreclosure mitigation counseling, with studies showing better outcomes for underwater homeowners who receive counseling.
All in all, there are some hits and misses with Bernie’s housing plan, but expanding the mortgage interest deduction could certainly be a game changer. It just probably won’t happen.
Government officials can’t predict exactly when inflation will go down, but representatives of the International Monetary Fund expect the U.S. inflation rate to reach its 2 percent target by the end of 2023.
The information provided on this website does not, and is not intended to, act as legal, financial or credit advice. See Lexington Law’s editorial disclosure for more information.
Consumers around the world are currently grappling with rising costs, making many people wonder how long this high rate of inflation is going to last. Although the U.S. inflation rate has nearly quadrupled since 2020, inflation is even worse in other countries. In Israel, for example, the inflation rate has increased by 25 times in the last two years.
When inflation is high, consumers have less purchasing power, making it more difficult to afford housing, food, utilities and other necessities. Some consumers have even changed their spending habits to account for rising costs. So, how long will inflation last? No one knows for sure, but it’s possible to make an educated guess based on what the Federal Reserve is currently doing to reduce spending.
What is inflation, and how does it work?
The Federal Reserve defines inflation as an increase in the overall price level of an economy’s products and services. This refers to a general increase in prices, not an increase in a single product or service category. For example, it’s possible for the cost of dairy products to increase without the rate of inflation increasing.
When inflation is high, many consumers have less purchasing power. This is because their income doesn’t buy as many products and services as it did when inflation was low. Inflation also has a negative impact on banks that loan money at fixed interest rates. If a bank makes a loan at 6 percent interest, an inflation rate of 7 percent would reduce its real income, or the amount of money it earns after taking inflation into account.
In the United States, the Consumer Price Index (CPI) helps estimate inflation by tracking the average change of prices over time. This index doesn’t include the price of every good or service. Instead, it uses a market basket of goods and services typically purchased by consumers in urban and metropolitan areas. In July 2022, the U.S. Bureau of Labor Statistics reported that the CPI rose by 1.3 percent in June, bringing the total increase for the last 12 months to 9.1 percent.
Why is inflation so high right now?
Although many Americans are feeling the pinch of higher prices, inflation is a global problem. In response to the COVID-19 pandemic, government officials around the world implemented mandatory lockdowns to prevent the spread of the disease. With so many businesses closed, the demand for goods and services declined.
Once businesses started reopening, demand soared. With the unemployment rate falling to 3.5 percent in July 2022, job seekers have more bargaining power, driving up wages and giving many consumers more money to spend on goods and services. Consumers also saved more money than usual in 2021 due to concerns over how the ongoing pandemic would affect their finances.
Although demand has increased, many companies are unable to fill orders due to manufacturing and shipping backlogs associated with the pandemic. When demand exceeds supply, firms increase their prices, contributing to higher rates of inflation.
Finally, many consumers are spending more on services than goods, increasing demand in the service sector. As a result, it now costs more to rent an apartment, dine at a restaurant or hire someone to perform housekeeping or landscaping services.
The government’s response to inflation
The Federal Reserve is currently implementing contractionary monetary policy to reduce demand and give the economy a chance to cool off. This involves raising interest rates to decrease consumer spending and business-related investment spending.
The Biden-Harris administration is also focused on lowering costs for low-income and middle-class families. President Biden signed the Inflation Reduction Act of 2022 into law on August 16, 2022, and this act aims to reduce energy costs and make healthcare more affordable for Americans.
Because the current inflation rate is associated with high levels of demand, there isn’t much more the federal government can do to bring prices down. The plan is to continue raising rates until the inflation rate returns to 2 percent.
When will inflation go down?
Government officials can’t predict exactly when inflation will go down, but representatives of the International Monetary Fund expect the U.S. inflation rate to reach its 2 percent target by the end of 2023. To reach this target, analysts believe the Federal Reserve will need to raise rates by another 2 to 2.5 percent before then.
Are we in a recession?
Although government officials, consumers and business owners are concerned about the prospect of a recession, the United States hasn’t entered a true recession yet. A recession is characterized by rising levels of unemployment, lower retail sales and negative growth of the gross domestic product (GDP), among other factors.
In July 2022, the Bureau of Economic Analysis reported that the U.S. GDP declined by 1.6 percent in the first quarter of the year and 0.9 percent in the second quarter. Although GDP declined, retail sales increased by 1 percent between May and June 2022. The unemployment rate also fell from 5.4 percent in July 2021 to 3.5 percent in 2022. Therefore, the United States doesn’t yet meet all the criteria for an economic recession.
Where is inflation the worst in the United States?
In the United States, cities tend to have higher inflation rates than suburbs and rural areas, due in part to their higher housing costs. On July 13, 2022, Bloomberg reported that several American cities had crossed the 10 percent mark. Urban Alaska is at 12.4 percent, the Phoenix-Mesa-Scottsdale metro area in Arizona is at 12.3 percent and the Atlanta-Sandy Springs-Roswell metro area in Georgia is at 11.5 percent. Baltimore, Seattle, Houston and Miami also have inflation rates above 10 percent.
Inflation isn’t quite as bad in the New York-Newark-Jersey City metropolitan area, which had a 6.7 percent inflation rate in June 2022. Overall, inflation tends to be higher in the South and Midwest regions than it is in the Northeast region of the United States.
How will inflation affect my 2022 and 2023 taxes?
Take a look at the top ways your upcoming taxes might be affected by inflation.
Taxable income
Federal tax brackets are adjusted for inflation, which means you may drop to a lower tax bracket in 2022 even if your income doesn’t decrease. If high rates of inflation persist, you may get the same tax benefit when you file your 2023 return.
The standard deduction is also adjusted for inflation, so high inflation rates may help you reduce your taxable income even more than in previous years. In 2021, the standard deduction for a single filer was $12,550; for the 2022 tax year, it’s $12,950. If the economy doesn’t cool down quickly, the standard deduction may be even higher in 2023.
Health savings accounts
The annual HSA contribution limit is adjusted for inflation, so high rates of inflation allow you to put aside more money for medical expenses each year. The limits have already been increased for 2022, allowing individuals to contribute $3,650 per year and families to contribute $7,300 per year. In 2023, the limits will increase even more, to $3,850 for individuals and $7,750 for families.
HSA contributions are deducted on a pre-tax basis, so higher contribution limits may leave you with less taxable income, reducing your tax burden.
Retirement contributions
High levels of inflation can even help you save a little more money for your retirement. The contribution limits for 401(k) accounts and individual retirement arrangements (IRAs) are adjusted for inflation, so you can typically save more when inflation is high. For 2022, the 401(k) contribution limit is $20,500, an increase from the $19,500 limit for 2021. The IRA contribution limit didn’t increase for 2022, but it may go up in 2023 if the inflation rate continues to be high.
Although you can’t save more in your IRA this year, the income limit for 2022 was increased to keep up with inflation. As a result, you can now participate in a Roth IRA if your income doesn’t exceed $144,000 ($214,000 for married couples filing jointly).
Social Security
If you have combined income of more than $25,000 in a year as a single filer, your Social Security benefits are subject to federal income taxes; the limit increases to $32,000 for married couples filing jointly. Combined income includes half your Social Security benefits, your adjusted gross income and your tax-exempt interest income. These income limits aren’t adjusted for inflation, but Social Security benefits are.
For 2022, the federal government implemented a 5.9 percent cost-of-living increase for Social Security beneficiaries, and the 2023 adjustment could be as high as 10 percent, or even slightly more—we’ll know for sure in October 2022. This increase could push your combined income above the $25,000/$32,000 limit, making your Social Security benefits taxable for the first time.
Capital gains taxes
When you sell certain assets, you must pay capital gains tax on your profit. If you sell when inflation is high, you could end up with a profit on paper even if the sale results in a real loss. This typically happens when high rates of inflation erode your purchasing power over time.
If you made a $100,000 investment in 1980 and sold it for $200,000 today, it would look like you made a profit of $100,000. The truth is that $100,000 in 1980 dollars is equivalent to about $359,600 today. Although you made a profit on paper, you really lost a significant amount of purchasing power. Unless you qualified for some type of exemption, you’d have to pay capital gains tax since the purchase price of assets isn’t adjusted for inflation.
How can I save money while inflation is high?
You can’t control the national economy, but there are a few things you can do to strengthen your financial position while inflation is high.
Eat more meatless meals. Meat, poultry and eggs are among the food products with the highest price increases in 2022. To lessen the effects of rising costs on your budget, try adding a few meatless meals to your weekly menu.
Track your spending. If you don’t keep track of your spending, it’s easy to spend much more than you realize. Keep a record of how much you spend on necessities as well as extras like streaming subscriptions and movie tickets.
Start meal planning. If you spot a good deal at the grocery store, you can take advantage by planning several meals around that ingredient. For example, if a store is advertising chicken for $2.49 per pound, you may want to plan on eating chicken salad sandwiches for lunch each day that week.
Cancel unused subscriptions: In June 2022, Sarah O’Brien of CNBC reported that more than 40 percent of consumers were paying for at least one subscription they didn’t use. Unused subscriptions leave you with less money in your pocket, so canceling them can help you weather this period of high inflation.
Maintain a high credit score. When you have good credit, you typically qualify for lower interest rates and other favorable loan terms. If you have to borrow money while inflation is high, maintaining a healthy score can help you save money.
Keep the faith
Inflation makes it a little tougher to meet your financial goals, but that doesn’t mean you should give up on managing your finances responsibly. You can save money by tracking your spending, canceling unused subscriptions and planning your meals according to what foods are on sale each week.
Maintaining good credit can help you save money in the long run if you have to take out a loan or otherwise buy on credit. If your credit is lower than you’d like it to be, work with the credit repair consultants at Lexington Law to identify inaccurate negative items on your credit reports and make sure outdated information isn’t being held against you.
Note: Articles have only been reviewed by the indicated attorney, not written by them. The information provided on this website does not, and is not intended to, act as legal, financial or credit advice; instead, it is for general informational purposes only. Use of, and access to, this website or any of the links or resources contained within the site do not create an attorney-client or fiduciary relationship between the reader, user, or browser and website owner, authors, reviewers, contributors, contributing firms, or their respective agents or employers.
Reviewed By
Brittany Sifontes
Attorney
Prior to joining Lexington, Brittany practiced a mix of criminal law and family law.
Brittany began her legal career at the Maricopa County Public Defender’s Office, and then moved into private practice. Brittany represented clients with charges ranging from drug sales, to sexual related offenses, to homicides. Brittany appeared in several hundred criminal court hearings, including felony and misdemeanor trials, evidentiary hearings, and pretrial hearings. In addition to criminal cases, Brittany also represented persons and families in a variety of family court matters including dissolution of marriage, legal separation, child support, paternity, parenting time, legal decision-making (formerly “custody”), spousal maintenance, modifications and enforcement of existing orders, relocation, and orders of protection. As a result, Brittany has extensive courtroom experience. Brittany attended the University of Colorado at Boulder for her undergraduate degree and attended Arizona Summit Law School for her law degree. At Arizona Summit Law school, Brittany graduated Summa Cum Laude and ranked 11th in her graduating class.
Have you ever thought about doing a cash-out refinance on your home for investment?
A lot of people have.
I received exactly this question from a reader.
Reader Question
Hi Jeff,
Thanks for your videos and educational websites!
I know you are very busy and this may a simple answer so thank you if can take the time to answer!
Would you ever consider approving someone to taking a cash-out refi on the equity in their house to invest?
I have been approved for a VA 100% LTV cash-out refi at 4% and would give me 100k to play with.
With average ROI on peer to peer, Betterment, Fundrise, and S&P 500 index funds being 6-8%, it seems like this type of leveraging would work. However, this is my primary residence and there is an obvious risk. I could also use the 100k to help buy another property here in Las Vegas, using some of the 100k for a down and rent out the property.
BTW, I would be debt free other than the mortgage, have 50k available from a 401k loan if needed for an emergency, but with no savings. I have been told this is crazy, but some articles on leveraging seem otherwise as mortgages at low rates are good at fighting inflation, so I guess I am not sure how crazy this really is.
I would greatly appreciate a response and maybe an article or video covering this topic as I am sure there are others out there who may have the same questions.
My Thoughts
But rather than answering the question directly, I’m going to present the pros and cons of the strategy.
At the end, I’ll give my opinion.
The Pros of a Cash-Out Refinance on Your Home For Investment Purposes
The reader reports he’s been told the idea is crazy.
But it’s not without a few definite advantages.
Locking in a Very Low-Interest Rate
The 4% interest rate is certainly attractive.
It will be very difficult for the reader to borrow money at such a low rate from virtually any other source. And with rate inching up, he may be locking into the best rates for a very long time.
Even better, a home mortgage is very stable debt. He can lock in both the rate and the monthly payment for the length of the loan – presumably 30 years. A $100,000 loan at 4% would produce a payment of just $477 per month. That’s little more than a car payment. And it would give him access to $100,000 investment capital.
As long as he has both the income and job stability needed to carry the payment, the loan itself will be fairly low risk.
So far, so good!
The Leverage Factor
Let’s use an S&P 500 index fund as an example here.
The average annual rate of return on the index has been right around 10%.
Now that’s not the return year in, year out. But it is the average based on nearly 100 years.
If the reader can borrow $100,000 at 4%, and invest it and an average rate of return of 10%, he’ll have a net annual return of 6%.
(Actually, the spread is better than that, because as the loan amortizes, the interest being paid on it disappears.)
If the reader invests $100,000 in an S&P 500 index fund averaging 10% per year for the next 30 years, he’ll have $1,744,937.That gives the reader a better than 17 to 1 return on his borrowed investment.
If everything goes as planned, he’ll be a millionaire using the cash-out equity strategy.
That’s hard to argue against.
Rising Investment, Declining Debt
This adds an entire dimension to the strategy. Not only can the reader invest his way into millionaire status by doing a cash-out refinance for investment purposes, but at the end of 30 years, his mortgage is paid in full, and he’s once again in a debt-free home.
Not only does his investment grow to over $1 million, but over the 30 year term of the mortgage, the loan self-amortizes down to zero.
What could possibly go wrong?
That’s what we’re going to talk about next.
The Cons of a Cash-out Refinance on Your Home
This is where the prospect of doing a cash-out refinance on your home for investment purposes gets interesting.
Or more to the point, where it gets downright risky.
There are several risk factors the strategy creates.
Closing Costs and the VA Funding Fee
One of the major disadvantages with taking a new first mortgage are the closing costs involved.
Whenever you do a refinance, you’ll typically pay anywhere from 2% to 4% of the loan amount in closing costs.
This will include:
origination fees
application fee
attorney fee
appraisal
title search
title insurance
mortgage taxes
and about a dozen other expenses.
If the reader were to do a refinance for $100,000, he would only receive between $96,000 and $98,000 in cash.
Then there’s the VA Funding Fee.
This is a mortgage insurance premium charged on most VA loans at the time of closing. It’s usually added on top of the new loan amount.
The VA funding fee is between 2.15% to 3.30% of the new mortgage amount.
Were the reader to take a $100,000 mortgage, and the VA funding fee set at 2.5%, he’d owe $102,500.
Now… let’s combine the effects of both the closing costs in the VA funding fee. Let’s assume the closing costs are 3%.
The borrower will receive a net of $97,000 in cash. But he will owe $102,500. That is, he will pay $102,500 for the privilege of borrowing $97,000. That’s $5,500, which is nearly 5.7% of the cash proceeds!
Even if the reader gets a very low-interest rate on the new mortgage, he’s still paid a steep price for the loan.
From an investment standpoint, he’s starting out with a nearly 6% loss on his money!
I can’t recommend taking a guaranteed loss – upfront – for the purpose of pursuing uncertain returns.
It means you’re in a losing position from the very beginning.
The Interest on the Mortgage May No Longer be Tax Deductible
The Tax Cuts and Jobs Act was passed in December 2017, and applies to all activity from January 1, 2018, forward.
There are some changes in the tax law which were not favorable to real estate lending.
Under the previous tax law, a homeowner could deduct the interest paid on a mortgage of up to $1 million, if that money was used to build, acquire or renovate the home. They can also deduct interest on up to $100,000 of cash-out proceeds used for purposes unrelated to the home.
That could include paying off high interest credit card debts, paying for a child’s college education, investing, or even buying a new car.
But it looks like that’s changed under the new tax law.
Borrowing up $100,000 for purposes unrelated to your home, and deducting the interest looks to have been specifically eliminated by the new law.
It’s now widely assumed that cash-out equity on a new first mortgage is also no longer deductible.
Now the law is still brand-new and subject to both interpretation and even revision. But that’s where it stands right now.
There may be an even bigger obstacle that makes the cash-out interest deduction meaningless, anyway.
Under the new tax law, the standard deduction increases to $12,000 (from $6,350 under the previous law) for single taxpayers, and to $24,000 (up from $12,700 under the previous law) for married couples filing jointly. (Don’t get too excited – personal exemptions are eliminated, and combined with the standard deduction to create a higher limit.)
The long and short of it is with the higher standard deduction levels, it’s much less likely mortgage interest will be deductible anyway. Especially on the loan amount as low as $100,000, and no more than $4,000 in interest paid.
Using the Funds to Invest in Robo-advisors, the S&P 500 or Peer-to-Peer Investments (P2P)
The reader is correct that these investments have been providing steady returns, well in excess of the 4% he’ll be paying on a cash-out refinance.
In theory at least, if he can borrow at 4%, and invest at say, 10%, it’s a no-brainer. He’ll be getting a 6% annual return for doing virtually nothing. It sounds absolutely perfect.
But as the saying goes, if it looks too good to be true, it probably is.
I often recommend all of these investments, but not when debt is used to acquire them.
That changes the whole game.
Whenever you’re thinking about investing, you always must consider the risks involved.
The last nine years have somewhat distorted the traditional view of risk.
For example, the stock market has been up nine years in a row, without so much as a correction of greater than 10%. It’s easy to see why people might think the returns are automatic.
But they’re not.
Yes, it may have been, for the past nine years. But if you look back further, that certainly hasn’t been the case.
The market has gone up and down, and while it’s true that you come out ahead as long as you hold out for the long term, the debt situation changes the picture.
Matching a Certain Liability with Uncertain Investment Returns
Since he’ll be investing in the market with 100% borrowed funds, any losses will be magnified.
Something on the order of a 50% crash in stock prices, like what happened during the Dot.com Bust and the Financial Meltdown, could see the reader lose $50,000 in a similar crash.
But he’ll still owe $100,000 on his home.
This is where human emotion comes into the picture. Since he’s playing with borrowed money, there’s a good chance he’ll panic-sell his investments after taking that kind of loss.
If he does, his loss becomes permanent – and so does his debt.
The same will be true if he invests with a robo-advisor, or in P2P loans.
Robo-advisor returns are every bit as tied to the stock market as an S&P 500 index fund is. And P2P loan investments are not risk-free.
In fact, since most P2P investing and lending has taken place only since the Financial Meltdown, it’s not certain how they’ll perform should a similar crisis take place.
None of this is nearly as much a problem with straight-up investing based on saved capital.
But if your investment capital is coming from debt – especially 100% – it can’t be ignored.
It doesn’t make sense to match a certain liability with uncertain investment gains.
Using the Funds to Buy Investment Property in Las Vegas
In a lot of ways, this looks like the most risky investment play offered by the reader.
On the surface, it sounds almost logical – the reader will be borrowing against real estate, to buy more real estate. That seems to make a lot of sense.
But if we dig a little deeper, the Las Vegas market in particular was one of the worst hit in the last recession.
Peak-to-trough, property values fell on the order of 50%, between 2008 in 2012. Las Vegas was often referred to as the “foreclosure capital of America”.
I’m not implying the Las Vegas market is doomed to see this outcome again.
But the chart below from Zillow.com shows a potentially scary development:
The upside down U formation of the chart shows that current property values have once again reached peak levels.
That brings the question – which we cannot answer – what’s different this time? If prices collapsed after the last peak, there’s no guarantee it can’t happen again.
Once again, I’m not predicting that outcome.
But if you’re planning to invest in the Las Vegas market with 100% debt, it can’t be ignored either. In the last market crash, property values didn’t just decline – a lot of properties became downright unsalable at any price.
The nightmare scenario here would be a repeat of the 2009-2012 downturn, with the reader losing 100% of his investment. At the same time, he’ll still have the 100% loan on his home. Which at that point, might be more than the house is worth, creating a double jeopardy trap.
Once again, the idea sounds good in theory, and certainly makes sense against the recent run-up in prices.
But the “doomsday scenario” has to be considered, especially when you’re investing with that much leverage.
Putting Your Home at Risk
While I generally recommend against using debt for investment purposes, I have an even bigger problem when the source of the debt is the family homestead.
Borrowing money for investment purposes is always risky.
But when your home is the collateral for the loan, the risk is double. You not only have the risk that the investments you’re making may go sour, but also that you’ll put your home at risk in a losing venture.
Let’s say he invests the full $100,000. But due to leverage, the net value of that investment has declined to $25,000 in five years. That’s bad enough. But he’ll still owe $100,000 on his home.
And since it’s a 100% loan, his home is 100% at risk. The investment strategy didn’t pan out, but he’s still stuck with the liability.
It’ll be a double whammy if the money is used for the purchase of an investment property in your home market.
For example, should the Las Vegas market take a hit similar to what it did during the Financial Meltdown, he’ll not only lose equity in the investment property, but also in his home.
He could end up in a situation where he has negative equity in both the investment property and his home. That’s not just a bad investment – that’s a certified nightmare!
It could even lead him into bankruptcy court, or foreclosures on two properties – the primary residence and the investment property. The reader’s credit would pretty much be toast for the next 10 years.
Right now, he has zero risk on his home.
But if he does the 100% cash out, he’ll convert that zero risk to 100% risk. Given that the house is needed as a place to live, this is not a risk worth taking.
Final Thoughs
Can you tell that I don’t have a warm, fuzzy feeling about the strategy? I think you figure it out by the greater emphasis on Cons than on Pros where I come down on this question.
I think it’s an excellent idea in theory, but there’s just too much that can go wrong with it.
There are three other factors that lead me to believe this is probably not a good idea:
1. The Lack of Other Savings
The reader reports that he has “…50k available from a 401k loan if needed for emergency, but with no savings.”For me, that’s an instant red flag. Kudos to him for having no other debt, but the absence of savings – other than what he can borrow against his 401(k) plan – is setting off alarm bells.
To take on this kind of high risk investment scheme without a source of ready cash, exaggerates all of the risks.
Sure, he may be able to take a loan against his 401(k), but that creates yet another liability.
That that will need to be repaid, and it will become a lien against his only remaining unencumbered asset (the 401k).
If he has to borrow money to stay liquid during a crisis, it’s just a question of time before the strategy collapses.
2. The Reader’s Risk Tolerance
We have no idea what the reader’s risk tolerance is.
That’s important, especially when you’re constructing a complex investment strategy.
While it might seem the very fact he’s contemplating this is an indication he has a high risk tolerance, we can’t be certain. He’s basing his projections on optimistic outcomes – that the investments he makes with the borrowed money will produce positive returns.
What we don’t know, and what I ask the reader to consider, is how he would handle a big reversal.
For example, if he goes ahead with the loan, invests the money, and finds himself down 20% or 30% within the first couple of years, will he be able to sleep at night? Or will he instead contemplate an early exit strategy, that will leave him in a permanent weakened financial state?
These are real risks that investors face in the real world. At times, you will lose money. And how you react to that outcome can determine the success or failure of the strategy.
This is definitely a high risk/high reward plan. Unless he has the risk tolerance to handle it, it’s best not to even start.
On the flip side, just because you have the risk tolerance, doesn’t guarantee success.
3. Buying at a Market Peak
I don’t know who said it, but when asked where the market would go, his response was “The market will go up. And the market will go down”.
That’s a fact, and one that every investor has to accept.
This isn’t about market timing strategies, but about recognizing reality.
Here’s the problem: both the financial markets and real estate have been moving up steadily for the past nine years (but maybe a little bit less for real estate).
Sooner or later, all markets reverse. These markets will too.
I’m worried that the reader might be borrowing money to leverage investing at what could turn out to be the absolute worst time.
Ironically, a borrow-to-invest strategy is a lot less risky after market crashes.
But at that point, everyone’s too scared, and no one wants to do it. It’s only at market peaks, when people believe there’s no risk in the investment markets, that they think seriously about things like 100% home loans for investments.
In the end, the reader’s strategy could be a very good idea, but with very bad timing.
Worst Case Scenario: The Reader Loses His Home in Foreclosure
This is the one that seals the deal against for me. Doing a cash out refinance on your home for investment is definitely a high-risk strategy.
Heads you’re a millionaire, tails you’re homeless.
That’s not just risk, it’s serious risk. We don’t know if the reader also has a family.
I couldn’t recommend anyone with a family putting themselves in that position, even if the payoff were that high.
Based on the facts supplied by the reader, we’re looking at 100+% leverage – the 100% loan on his house, then additional (401k) debt if he runs into cash flow problems. That’s the kind of debt that will either make you rich, or lead you to the poor house.
Given that the reader has a debt-free home, no non-housing debt, and we can guess at least $100,000 in his 401(k), he’s in a pretty solid situation right now. Taking a 100% loan against his house, and relying on a 401(k) loan for emergencies, could change that situation in no more than a year or two.