Idea$ 2014 - February: Retirement accounts

During the month of January, it seemed as if everyday I went to the mailbox or checked my email, there was some kind of document related to my finances waiting for me.  On Monday I got a 1099 from my bank for interest earned during the year.  On Tuesday American Express sent me my "Annual Summary" which shows how much money I spent during the year and in what categories (which can be a great tool to use when making a Budget).  Then on Wednesday, I got my W-2, Thursday brought my 1098 mortgage statement, and on Friday I got a Form 5498 showing contributions to my Roth IRA.  The irony is, the 5498 also discloses the fair market value of the account at the end of the year, to which I responded "hmm, I figured it would be more than that....I wonder what I still own in there?"  

Between packing up holiday decorations and getting together tax information, retirement accounts don't carry as much priority this time of year.  But, this is a great time to go over your retirement accounts and analyze contribution amounts and investment allocations.  

Investment allocations

The investment allocation of your retirement portfolio is simply how you have your portfolio diversified between different types of investments.  There is a wide array of investment options out there, including common stocks and exchange traded funds (ETFs), to mutual funds and bonds.  There are even different allocations within some of these families.  For example, a mutual fund can own large-cap growth stocks or small-cap international stocks.  Determining how to allocate your retirement portfolio between these different types of investments is usually tied to your age.  A 30-year-old worker will want to have their portfolio allocated more to higher-risk investments like growth and international stocks, whereas a 60-year-old worker will want to have more of their portfolio invested in less risky assets such as dividend stocks or bonds.  This is true for two reasons: 1) as an older worker nears retirement, their risk of loss of principal is greater because they will be withdrawing the funds in the near future, and 2) an older worker does not have as much time to make up for losses in a broad market decline as compared to a younger worker.  A simple Google search will produce a number of links to investment allocation calculators where you can input your age, how long until you retire, and the amount you expect to contribute, and the calculator will suggest an investment allocation for you.  One of my favorites is from CNN Money, and can be found here.

Contributions

Another aspect of a retirement account to consider is how much to contribute.  The common response to this is 10% of gross wages, but that figure is debatable given certain circumstances.  First, a young worker might not be able to contribute 10% because they have other liabilities such as student or car loans that must be serviced.  A young worker just starting out, living on their own and providing for themselves might also not have the cash flow to put away 10%.  In this case the worker should put away something that they are comfortable with.  On the other hand, take an older worker (55) that makes a very high wage, let's say $250,000/year.  The 2014 contribution limits to a 401(k) are $17,500, and workers over the age of 50 can defer an additional $5,500 as catch-up contributions.  In this case, if the older worker put away 10%, they would exceed the allowable amount of contributions.  One other consideration is the employer match.  If your employer matches all contributions made by the employee up to 3% of their income, then it is beneficial for the worker to defer at least 3%.  This way, the worker will be saving something, and will be getting full benefit from their employer.  The match is in effect free money and should not be passed up.    

Company stock

I live in Little Rock, and we have a handful of publicly traded companies located here, one of which is Windstream Communications.  Dividend investors love Windstream because, even with a stock price below $10, they pay a $1 per share annual dividend.  This is a pretty good return, especially on common stock.  But every once in a while I will hear a friend of mine that works at Windstream say "I dumped all of my 401(k) into Windstream stock...can't beat that dividend!"  Although this mindset seems smart, ("I work there, it's a great company, and it's a great dividend) it is a very risky move.  Several employees at Enron did the same thing, and ended up with no retirement savings after the company went belly-up.  I'm in no way suggesting that Windstream will have a similar fate, but the lesson is investing all of your retirement account in one asset, including company stock, is very risky.  The key to having a retirement account that grows and can weather the ups and downs of the market is diversification, and investing all of your contributions in one asset prevents even the smallest form of diversification.  

In conclusion, take some time this month to look over your retirement account statement.  Calculate how much you have invested in each asset class, and if there is too much or too little consider rebalancing the account.  Because the assets are in a retirement account, you won't be taxed on any gains or losses generated transferring funds between investments.  During this process, consider how much you have invested in stock of the company where you work, and take some off the table if it seems too high.  Also look at your contributions and see if they are too high or too low.  If you find yourself having excess funds each month, it might be wise to up your contributions, but if you are struggling to make ends meet or have other obligations it's okay to lower the contributions, as long as you don't sacrifice your company's matching provision in the process.  

What is myRA?

After President Obama's State of the Union address this past week, there has been quite a buzz about "myRA" accounts.  More details were released in a press release from the White House the following day.  But, with 401(k)'s, 403(b)'s, and IRA's already in existence, why do we need another retirement savings vehicle?

In simple terms, the myRA is essentially a Roth IRA offered by an employer that has very low initial investment requirements and where the principal is guaranteed.  Here's how it would work in practice: an employer that does not currently have a plan in place can offer a myRA to their employees.  The employees make after-tax contributions to the account, as low as $5 to $25.  These contributions are deposited to the same government securities investment fund that only federal employees had access to before, meaning the principal is backed by the US Treasury.  The employer has no cost because they will not administer or contribute to the accounts.  

Married couples making up to $191,000/year and single individuals making up to $129,000/year can contribute to a myRA account.  Fittingly, these are the same income limits to make contributions to a Roth IRA for 2014.  Another catch is that the account only exists for a finite amount of time - the earlier of when contributions reach $15,000, or 30 years.  Once these are reached, the account holder will be required to roll their money to a "private sector retirement account", i.e. a real IRA.  

The pros of this approach are 1) employees that work somewhere without a retirement plan now will have an option, 2) contributions are guaranteed by the US government, which eliminates the majority of the investment risk, and 3) with very low initial investments, people in middle and lower income brackets will find it easier to participate.  The cons are, well, only one: the 1-year return on the government securities investment fund last year was 1.47%.  

The President has urged the Treasury to start making these accounts available to the public by December 31, 2014.  

Fed to AR tax differences

All but seven states in the USA have their own form of individual income tax separate from Federal reporting required to the IRS.  Unlike the Federal system, which applies a uniform tax system to everyone regardless of what state they live in, states with an income tax all have their own way of doing things.  For example, some states start with Federal adjusted gross income (AGI) and work down to state AGI.  Other states require taxpayers to start from the beginning and calculate their state AGI on its own.  Still other states calculate income tax based on other factors, like Tennessee, which only taxes interest and dividends over a certain amount.

Arkansas has its own individual income tax system.  It is similar to the Federal system, but has intricacies that taxpayers should be aware of so that they don't over- or under-pay.

Married filing separately on same return

This is a filing status available to married Arkansas residents.  This form has two columns, one for the taxpayer and one for the spouse.  Joint income is divided between the two columns, but income allocated to one or the other goes in its respective column.  This is beneficial to married taxpayers where the taxpayer or spouse has a higher income than the other, because tax is calculated by taxpayer and spouse separately, then added together.  The tax is usually lower than if calculated on joint income, like a Federal return.

Income differences

There are several types of income that are taxed differently by Arkansas than at the Federal level:

• Social security benefits - not taxable to Arkansas
• Distributions from qualified retirement plans - if they are taxable, Arkansas allows a $6,000 reduction in the taxable amount, both for taxpayer and spouse.
• Capital gains - only 70% of net capital gains are reported on the Arkansas tax return.  However, up to $3,000 of losses can still be taken.
• Tax exempt interest - interest earned from municipal bonds is not taxable at the Federal level.  However, in Arkansas it is taxable unless it is from an Arkansas source.  For example, interest received from a New Orleans, Louisiana municipal bond is taxable in Arkansas, but interest received from a Little Rock, Arkansas municipal bond is not.  Neither is taxable on the Federal return.
• Depreciation differences - Federal depreciation benefits such as Section 179 and bonus are different at the Arkansas level.  Arkansas does not recognize bonus depreciation, and the Section 179 limits are much lower.  Therefore, income from S-corps, partnerships, or farms could be different for Arkansas than Federal.  Taxpayers should refer to an Arkansas-equivalent Form K-1 received from these entities.

Deduction differences

There are also several types of deductions that are different for Arkansas than on a Federal return:

• 529 plans - taxpayers that contribute to an Arkansas 529 plan for college savings are allowed an adjustment to income of up to $5,000 each for taxpayer and spouse.  The contributions have to be made during the tax year, and they must be to an Arkansas 529 plan (not just any 529 plan).
• State tax deduction - unlike the itemized deduction schedule for Federal returns, Arkansas taxpayers cannot deduct state tax payments on their Arkansas income tax return as an itemized deduction.  They can still deduct personal property and real estate taxes, but not estimated tax payments or withholding.
• Foreign taxes paid - instead of calculating the foreign tax credit like on the Federal return, all foreign taxes paid can be added in total as an itemized deduction on the Arkansas return.

Each state is different, so taxpayers should consult their tax advisor or their state department of revenue website for more information.

Idea$ 2014

Each month during 2014, the Ruggnotes will dedicate one article to a financial topic. These topics are are designed to give readers resources to address various parts of their finances.

Posts are now published for the following months:

January - Budgeting

February - Retirement accounts

March - Taxes

April - Spring cleaning

May - Wills, Trusts and the Zombie Apocalypse

June - Tax efficient investments

Check back in July for the next topic in the Idea$ 2014 series.

Am I a dependent?

Pop quiz: I am married and live with my wife and 2 children, ages 28 and 14, along with my elderly mother-in-law who has no income and my brother who has been unemployed for 2 years, draws $7,500/yr in unemployment yet never offers to pay for anything.  How many dependents can I claim on my Form 1040 individual income tax return?  The answer might surprise you.

Determining the correct number of dependents to claim on a 1040 for most families is simple. For example, a married couple with two children under the age of 18 has two dependents (the two children).  But, in family situations like the one laid out above, the number of dependents is not so obvious.  Claiming the correct dependents is important to the taxpayer because it gives them the opportunity to take advantage of tax benefits tied to those dependents, such as personal exemptions, the child tax credit, the child and dependent care credit, education expense deductions and credits, and the earned income credit.  Claiming the correct dependents is also important to the IRS, because they will match the social security numbers listed on the 1040 to their system to make sure the dependency claim is valid.

So who qualifies as a dependent?  Let's start with children first.

Dependent children

To qualify as a dependent, the child must meet the following criteria:

• Must be your son, daughter, stepchild, foster child,  brother (biological, half, or step), sister (biological, half, or step), or a descendant of any of these (grandchild, niece, etc.).  Adopted children are always treated as your own children.
• Their age at the end of the tax year must be 1) under 19, 2) under 24 if a student, and 3) younger than you (and your spouse if filing a joint return). However if the child is permanently or totally disabled, their age does not matter.
• The child must have lived with you for half of the tax year
• The child must not have provided more than half of their own financial support
• The child is not filing a joint return for the tax year

If the child meets these criteria for the tax year, they are a dependent child.  If the dependent child has to file their own tax return in the same year that they are claimed as a dependent, they cannot claim a personal exemption for themselves.

One note on this topic: mentioned above are brothers and sisters.  In the event that the taxpayer has a much younger sibling, and the taxpayer provides the siblings care (in the event of the death, disability, or absence of the parents), then it is possible for a sibling to be a dependent child.

Dependent relative

In some cases, a relative can qualify as a dependent on someone else's tax return.  To qualify as a dependent, the relative must meet the following criteria:

• The person cannot be a qualifying child or the qualifying child of another taxpayer (a child that meets the criteria in the section listed above)
• The person lived in the home for the entire year and is not a relative, or is a relative (brother, sister, father, mother, niece, nephew, uncle, aunt, or any of these as half, step, grand, or in-law)
• The person's gross income for the year must be less than $3,900 (because that is the amount of the personal exemption).
• The person does not provide more than half of their own support for the tax year.

Just like for children, if a dependent relative files their own tax return in the same year that they are claimed as a dependent, they cannot claim a personal exemption for themselves.

Now back to the example from the beginning.  The correct number of dependents is two.  Here's how:

The 14-year-old child is a dependent, but the 28-year-old is not, because they are over 24 and not a full-time student.

The mother-in-law is a dependent relative because she had no income and she did not provide over half of her own support.

The brother is not a dependent relative because the unemployment he draws makes his gross income above the threshold, even though he did not provide more than half of his own support.

In unique family situations, determining dependency exemptions can be complex.  Taxpayers should consult the IRS website or their tax professional for additional guidance.