Ask The Expert
Richard Barrington, CFA, is the primary spokesperson and personal finance expert for MoneyRates. He is a 20-year veteran of the financial industry, including having served for over a dozen years as a member of the Executive Committee of Manning & Napier Advisors, Inc. He earned his Chartered Financial Analyst designation in 1991 with the Association for Investment Management and Research (AIMR). Richard has written extensively on investment topics, including investments, money market accounts, certificates of deposit, and personal finance as it relates to retirement.
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July 21, 2016
Q: Our mother recently passed away. She had some CDs [certificates of deposit] that our names were on that are part of our inheritance. Will we owe taxes on that money?
A: First of all, sorry for your loss. One of the challenges of dealing with estate issues is that they can bring up complicated and unfamiliar issues at a time when one is least prepared to deal with them.
In terms of your question, the specifics of any tax situation usually require individual attention from a qualified tax expert in order to definitively answer any questions. However, there are some general principles that might give you an idea of what to expect.
The three concepts you should focus on when determining if there is a potential tax liability here are possession, size and timing:
Possession: Who are the primary owners of the CD account?
You mention that your names were on the CDs prior to your mother's death, so it is important to understand whether you were already considered the primary owners of those accounts, or just had joint privileges. What you are really trying to get at here is to make sure that you did not already have responsibility for paying taxes on the interest earnings of those CD accounts.
You may want to check your mother's past tax returns to determine whether your mother had been paying taxes on the CD interest in prior years. If so, and she was still the primary owner of these accounts, then the past interest is not a concern but your primary focus should turn to estate tax. This is where size becomes a key issue.
Size: What is the amount when you have to worry about federal estate tax?
Besides the issue of taxes on the CD interest, there is the potential for estate taxes to be due on the total amount left to you and the other heirs.
While estates can be subject to taxes, there is a fairly sizable exclusion amount that results in most estates not having any tax liability.
For 2016, the federal estate tax exclusion is $5,450,000. So, if your mother's estate was fewer than this amount, you should not have any federal estate tax to worry about.
Timing: When was possession of the CD passed down?
If the CD term was still continuing when possession of the CDs passed to you and the other heirs, you will be subject to income tax on any interest earned from that point forward. Coordinate with the bank to make sure that their tax forms accurately reflect the timing of when possession formally passed to you.
Again, consult a tax adviser to see how these concepts of possession, size and timing apply to your situation. Also, please note that these concepts apply to federal taxes, so you should check to see if there are any state tax implications where you live.
Finally, when inheriting a CD, it is wise to check the maturity date so you can decide about rolling over into savings accounts, new CDs or other investments. For example, don't automatically roll the CD over at your mother's old bank because you might find better CD rates elsewhere.
Comment: Have you considered rolling over inherited CDs into other investments?
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July 5, 2016
Q: I am 60 years old, and plan to retire at age 62. Because Social Security won't be enough to live on, I am continuing to put money into a 401(k) for extra income. Can you recommend an investment product for me?
A: Naturally, you should start with income-producing products, since you are looking for something to supplement the annual income you will get from Social Security. As you start to look into the possibilities more closely, what you find should indicate whether you can afford a more diversified approach than one devoted to income production - and this process might even affect your retirement plans.
Retirement income and inflation
Low-risk investment options
Every 401(k) retirement savings plan offers a menu of investment options that represents a range of risk levels, and you should be focusing on the portion of your plan's menu dedicated to income-producing vehicles. Some of these are likely to be stable-value vehicles. Though as with savings accounts and other conservative investments these days, the main drawback of stable-value options is an extremely low income yield.
Bonds for a higher source of income
A higher-yielding source of income should be bonds. Your 401(k) likely has long-term bond options, and these should be offering a higher income yield than the stable value options. Just be advised that both the price and the yield of bond funds are variable, so you will be subject to market fluctuations. You can mitigate this risk somewhat over the long-term by choosing a fund dedicated to high-quality bonds only.
If you find a bond fund that produces enough income to meet your projected needs, you might consider putting any excess 401(k) balance into a stock fund, to give you some element of inflation protection. Retirement is likely to be just the beginning of a long period in which you will be living off your investments. This means some inflation protection for the long run would not be out of place, if you can afford it after you have taken care of your income needs.
Use time to your advantage for retirement savings
Choosing an investment vehicle could be an instructive exercise, not just for the present but for the future. Looking at how much income current yields would provide will allow you to gauge the extent to which your current 401(k) balance is sufficient to meet your income needs.
Why delay retirement to boost retirement income
If it is not sufficient, you might want to consider delaying retirement long enough to build more savings and increase your Social Security benefit. That may not be what you want to hear, but if you you don't feel physically or mentally ready to continue working past the age of 62, at least consider downshifting to part-time work. Even that may be sufficient to buy you enough time to improve your retirement income.
In summary, income investments should be a central part of the answer if you are looking to supplement Social Security income. Just how much of your 401(k) should be devoted to income investments, and how soon you should access it, depend on the extent to which your income needs would be met by current yields.
Comment: How do you plan to supplement your Social Security income?
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June 28, 2016
Q: What is the best way to pay for stuff online?
A: As commonplace as online commerce has become, it does not pay to get complacent, and you are correct to raise concerns about security. There are also financial differences in the different methods of payment.
Broadly speaking, you have three options: credit cards, debit cards and online payment services like PayPal.
Purchases protected from fraud
From a security standpoint, credit cards offer consumers excellent protection against unauthorized transactions, if they are reported on a timely basis. Financially, credit cards allow people to use the money interest-free until the bill is due, during which time their money could be earning a little extra interest in their savings accounts. Another advantage of credit cards is that many offer rewards programs, so you can get a little something back on your purchases.
Easy to accumulate debt
On the other hand, there are two major problems with credit cards. Credit lines make it easy to spend more than you have, which can lead to racking up an uncontrollable debt balance. And, with credit card interest rates running in excess of 13 percent, that debt costs much more than any potential extra interest on savings accounts. So, use this method only if you are diligent about limiting your spending and paying your balances off in full every month.
Debit cards make it easier to limit your spending to what you have in your checking account, and thereby avoid overspending and onerous credit card interest.
Less protection than credit cards
On the other hand, debit cards provide less protection against fraudulent purchases. This is a particular concern because they provide direct access to your checking account. Also, whether the transaction is legitimate or not, directly drawing on your checking account can result in expensive overdraft fees. Finally, while debit cards rewards programs once were commonplace, they have largely disappeared in recent years.
Online payment services
Reduce security risks
Using an online payment service like PayPal can allow you to create a buffer between various online vendors and your actual accounts, so this can limit your security exposure.
Unable to earn interest
At the same time, balances kept with these services do not earn interest, nor are they protected by FDIC insurance. So, be sure to transfer just what you need into these payment accounts, and make your purchases with that money shortly after it is available.
Credit, debit or online payments: Which will you choose?
Face it - all e-commerce is a trade-off between security and convenience. Each vendor you deal with, and each transaction you enter into, is a potential security risk. To the extent you can limit how many vendors you transact with online and consolidate purchases into fewer transactions, you can help rein in the risk you are taking.
Ultimately though, if technology is the source of this security problem, it is also part of the solution. Use technology, such as transaction alerts and online account monitoring, to keep closer track of all activity in your accounts. No approach is completely safe from cyber threats, but vigilance can help you monitor the size of any potential problem.
Comment: How do you prefer to pay for your online shopping purchases?
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June 22, 2016
Q: Do you have any tips for buying a home on a low income?
A: Often, being able to afford a home is not so much a question of income as of expenses. If you are good at managing your expenses and can find the right property, you may well be able to afford a home on a modest income. In fact, the low level of current mortgage rates makes homeownership unusually accessible.
To take advantage of this opportunity, here are three steps to consider:
Master your household budget
Not getting in over your head with a home purchase depends greatly on being able to predict your income and expenses. The income side of this comes down to the stability and security of your job. You should not contemplate homeownership unless you are confident that you have a steady job, and marketable skills in case you need to change jobs.
On the expense side, you can only know what you are getting into with a mortgage if you learn to predict expenses reliably. This means laying out a budget that accurately captures all your upcoming expenses, and then having the discipline to stick to that budget. Saving for a down payment in a savings account can be a great exercise in implementing this kind of strict budget discipline, and the money you save up should also help with your home purchase.
Concentrate on home values, not price
While you are working on your budget and saving for a down payment, get to know the area real estate markets. This will give you an idea of where the best values might be found, and give you enough of a sense of local prices that you will know a good deal when you see it.
The key word here is value, rather than price. The cheapest home might not be the best buy, if it is in a bad neighborhood or not in sound condition. You should be looking for something you can live with long-term that is reasonably priced.
Secure an FHA or VA loan
With a limited income, a possibility you should look into is a mortgage through the U.S. Federal Housing Administration (FHA). The FHA is a department of the federal government that arranges mortgage insurance in order to give lenders confidence to make loans to homebuyers with relatively low incomes or minimal credit histories. They also provide loans with low down payments, though saving up for a larger down payment should earn you better terms on your loan.
If you are a U.S. military veteran or service member, you should also look into a loan with the U.S. Department of Veteran Affairs. This is another federally-backed program, with even more favorable terms than FHA loans.
If you choose an FHA or VA mortgage, keep in mind that while these are government programs, they are offered by private lenders. Even though the level of current mortgage rates is generally low, actual rates will vary from lender to lender. So, shopping around for the best rate will help your income go farther toward affording a house.
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June 16, 2016
Q: My husband is 34. He is debating whether to use an old 401(k) from a previous employer to pay off the house. He has a new 401(k) that has about $15,000 in it and plans to leave it alone and continue to contribute to it. The 401(k) in question has about $130,000 in it. We owe $81,000 on the house and have 24 years left on the mortgage. So, after early withdrawal penalties and taxes, we'll have enough to pay off the house, which will save us like $62,000 in interest over the life of the loan and free up about $600 a month. But is the cost of cashing that out worth it? Any advice would be greatly appreciated.
A: Saving $62,000 in interest over the life of your mortgage sounds tempting. However, the other side of the equation is what you would have to give up to obtain those savings. When it comes to early withdrawals from a 401(k) plan, the price is generally not worth it. This may be especially true in your case because there may be alternatives to withdrawing from this fund that could save you a substantial amount of interest expense on your mortgage without causing you to take a hit to your 401(k) retirement savings.
Tax penalties vs. mortgage interest savings
Since your husband is younger than 59½, taking money out of his 401(k) to pay off your mortgage will mean first having to pay a 10 percent tax penalty for the early withdrawal, plus whatever tax rate you normally pay on income since the income tax was deferred when the money went into the plan.
Future investment earnings in danger
As a result, you are going to have to take out considerably more than $81,000 in order to have $81,000 left over after taxes to pay off your mortgage. Now think about the future investment earnings you will miss on the amount you take out. Even at a very modest rate of return, these earnings could very easily exceed the interest you would save on your mortgage. To find out how much your retirement fund will be worth in the future, use a retirement savings calculator to better inform your financial decisions.
Alternative to early withdrawals: Refinancing mortgage
Since you are six years into your mortgage, there is a good chance that the original loan was at a substantially higher interest rate than current mortgage rates. In this case, refinancing could save you a fair amount of interest, without you having to pay the tax penalty or give up future earnings on your current 401(k) balance.
Better yet, with six years of your loan paid off and refinance rates much lower these days, you could consider refinancing to a 15-year loan. In the long run, this would save you money in two ways. Rates on shorter mortgages are much lower than on 30-year home loans, plus you would save by paying interest over fewer years. In the near term, you would probably have to cope with a higher monthly payment, but you might find that the lower interest rate means this is affordable and well worth the long-term savings.
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