A Financial Primer for First-Time Homebuyers

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You’ve learned plenty of consumer lessons haggling with automobile dealers to buy a car, reckoning with rental apartment leases and landlords, and dealing with college loan debt. But as instructive and enlightening (and at turns, frustrating) as these experiences can be, in all likelihood they will not fully prepare you for the highly involved and often stressful process of purchasing your first home.

For first-time homebuyers

The more you understand about the entire process, from the financial steps to take in preparing for the purchase, to shopping for and securing a mortgage, to the choices you make you officially become a homeowner, the more positive the experience is likely to be. Here the personal finance experts at the Financial Planning Association offer suggestions to help first-timers minimize their stress and maximize their investment.

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To make yourself more attractive to lenders:

Banks and other mortgage lenders don’t hand out home loans to just anyone. To secure a mortgage, a borrower needs to prove to the lender that they’re on solid financial footing and capable of meeting the terms of the loan. And the more solid that footing is, the more favorable their loan terms are likely to be. Thus the upfront effort you put into making yourself a more attractive borrower can save hundreds, even thousands of dollars, in costs. To strengthen your borrowing position:

  • Reduce the amount of debt you’re carrying. Most lenders take a hard look at a borrower’s debt-to-income ratio — how much debt a person or household carries in the form of loans, credit card balances, etc., compared to total household income. Most lenders look for a ratio that’s below 38%, and preferably in the 25-35% range. The lower a potential borrower’s ratio, the more favorably a lender tends to view them. That often translates into better loan terms, including a lower interest rate.
  • Increase your credit score. Lenders look closely at a person’s credit score when weighing whether to loan them money to purchase a home. Generally speaking, the higher the credit score, the more favorable the loan terms. A score of 750 or higher is “ideal” for potential borrowers, according to certified financial planner Leon C. LaBrecque, managing partner at LJPR, a wealth management firm in Troy, MI. One way to boost credit score is by lowering the ratio of debt-to-credit limit on credit cards, says LaBrecque. Essentially that entails paying down the balance on credit cards while at the same time preserving the credit limits on those cards. “Don’t close credit card accounts, because that can impact your credit score negatively,” he advises. “Instead keep the accounts open, just don’t use them as much.” He suggests targeting a debt-to-credit limit ratio of 10% or less.

To find the best mortgage deal:

  • As the old song goes, “You better shop around,” because subtle and seemingly insignificant differences in the fees and costs associated with a mortgage (from the actual interest rate to closing costs and other fees) can translate into hundreds and sometimes thousands of dollars in savings, at the time of purchase and over the life of the loan. “I suggest looking on the Internet first, then talking with at least two other lenders,” says LaBrecque. “Be sure to get the full [annual percentage rate] from them, so you’re comparing apples to apples.” The APR includes not just the interest rate but other costs and charges and fees, some of which may be negotiable. With prevailing mortgage rates from a wide range of lenders as well as loan calculators for side-by-side comparisons, www.bankrate.com makes a good starting point for your online research.

To give yourself an edge in landing the home of your dreams:

  • Consider getting pre-approved for a mortgage. In situations where multiple buyers may be vying for a property, those who are pre-approved by a lender for a mortgage of a specified amount often have an edge over buyers who are not pre-approved. Pre-approval means a lender has agreed to provide a buyer with a mortgage for up to a specific amount. A seller who knows you’re pre-approved may be more inclined to accept your offer.

To be a shrewd borrower

  • Find a way to dodge private mortgage insurance. Borrowers who are unable to come up with a certain amount for a downpayment — the threshold for most lenders is 20% of the home’s cost — usually are obligated to purchase private mortgage insurance, or PMI. PMI can be pricey, costing 0.5% to 1% of the loan amount each year, or up to $1,000 for every $100,000 borrowed. So “if you’re anywhere close” to being able to make a downpayment of at least 20%, LaBrecque suggests findings the means to do so, such as by borrowing money from a family member.
  • “Be careful of overspending on a home,” cautions Russ Weiss, a certified financial planner with the Marshall Financial Group in Doylestown, Pa. “I like to keep the mortgage/taxes/insurance at about 20-25% of gross monthly income. Mortgage brokers will allow you to borrow up to 45% of income, but that [amount of debt] can make someone house-poor.”
  • If flexibility is a priority, start with a 30-year mortgage. While the prospect of paying off a mortgage in 10 or 15 years can be attractive, a shorter mortgage term usually means significantly higher payments than those associated with a 30-year mortgage. Those higher payments can be difficult to make if circumstances change unexpectedly (such as with the loss of a job), says LaBrecque. In many cases, the preferred route for people who want to aggressively pay down a loan is to pay more than the required amount on a 30-year mortgage, because once committed to a 10- or 15-year mortgage, they can’t choose to convert that to a 30-year term.
  • If cost-efficiency is a priority, don’t foreclose on a shorter-term mortgage. A shorter, 15-year mortgage can have its merits. To determine if one can work for you, do an apples-to-apples comparison of costs, taking into account the larger mortgage interest deduction you’ll likely be able to claims with a 15-year mortgage (as compared to 30-year mortgage on the same amount borrowed). Determine what the net cost would be to you and then amortize it to see how much more per day you’d pay with each. For several dollars a day, it may make sense to take the shorter mortgage.
  • Favor a fixed-rate loan over a variable-rate loan in order to lock in a low interest rate. Many observers expect interest rates to increase in the not-too-distant future. If they do, people with variable-rate loans will be required to pay higher rates.

To prepare for life as a homeowner:

  • Start setting aside money on a monthly basis for home-related expenses, including property taxes, insurance (homeowners, wind, flood, hazard, etc.), maintenance and unforeseen developments such as repairing or replacing a broken appliance, etc. Keep those savings easily accessible, such as in a savings or money market account.

Once you’ve purchased a home:

  • Take advantage of tax breaks. Talk to an accountant or financial professional about tax benefits such as the tax deductibility of mortgage interest (for homeowners who itemize deductions on their tax returns) and tax credits for purchases of energy-efficient appliances and the like.

May 2015 — This column is provided by the Financial Planning Association® (FPA®) of NENY, the principle professional organization for Certified Financial PlannerTM (CFP®) professionals. FPA is the community that fosters the value of financial planning and advances the financial planning profession and its members demonstrate and support a professional commitment to education and a client-centered financial planning process. Please credit FPA of NENY if you use this column in whole or in part.

The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.

RMD Time: A Guide to Handling Retirement Account Distributions

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Anyone who owns a tax-advantaged retirement account such as a 401(k) or individual retirement account (IRA) — that’s 63% of (or 77.5 million) American households as of 2014, according to the Investment Company Institute — would be well-served to familiarize themselves with required minimum distributions, or RMDs, and the sometimes complex rules that govern them.

“RMDs aren’t that tricky,” says certified financial planner Andrew Weckbach, founder of Scaling Independence in St. Louis, MO., “but there are wrinkles you need to be aware of.”

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An RMD is the minimum amount the owner of an IRA or retirement plan must withdraw from their account each year once they reach age 70½, as specified by the Internal Revenue Service. RMDs apply to people who own traditional IRAs, SEP IRAs, SIMPLE IRAs, 401(k) plans 403(b) plans, 457(b) plans, profit sharing plans, and other defined contribution plans.

RMDs from an IRA must be taken by April 1 of the year following the calendar year in which the account owner reaches age 70½. RMDs from 401(k), profit-sharing, 403(b) and other defined contribution plans generally must be taken by April 1 following the LATER OF the calendar year in which the account owner reaches age 70½ OR retires. RMDs then must be made by December 31 of each subsequent year. Withdrawals typically are considered taxable income except for any part that was taxed before (the basis). Delaying the first distribution into the second year doubles up the required distribution for that year and increases taxes for that year, which may not be a desirable result.

People who own multiple IRAs may choose to take their RMD for a given year from only one account, or they may take distributions from multiple accounts to meet the requirement. The former can make sense, Weckbach notes, when one of their multiple accounts includes an illiquid investment (such as a stock position in a small company) that’s not easily sold in order to raise funds for an RMD.

The RMD amount is calculated by dividing the amount in the account as of the end of the immediately preceding calendar year by a life-expectancy-based distribution period specified in the IRS’s “Uniform Lifetime Table.”

The IRS offers an overview of RMD rules on its website at www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-Required-Minimum-Distributions.

Failing to follow those rules can be costly. Account owners who do not take any required distributions, or take distributions below the required amount, may have to pay a 50% excise tax on the amount not distributed as required. On the other hand, account holders may withdraw more than the RMD amount without penalty.

The above rules generally do not apply to Roth IRAs. The amount you invest in a Roth IRA (the basis) can be withdrawn anytime penalty- and tax-free after five years, and there are no RMDs on Roth IRAs held by the original owner. For more about IRS rules for Roth IRAs, visit http://www.irs.gov/Retirement-Plans/Roth-IRAs.

Before RMD time rolls around, IRA owners can begin taking penalty-free withdrawals at age 59½. Taking those withdrawals makes sense in certain situations, such as when the goal is to minimize RMD amounts — and the associated income tax burden — when the account holder hits age 70½. The goal, says Weckbach, is to manage income and retirement account withdrawals in order to avoid income spikes (and thus, income tax spikes) that may result from a large RMD in a given tax year. Thus, starting withdrawals before age 70½ can be an effective way to reduce income tax exposure.

Distributions taken from traditional IRAs prior to age 59½ are subject to a 10% penalty and are taxed as ordinary income, with several notable exceptions. IRS rules allow penalty-free (though not income-tax-free) early withdrawals from an IRA before age 59½ to cover such things as higher education and medical expenses, a first-time home purchase and health insurance if you’re unemployed. Making early withdrawals for any reason “isn’t ideal,” says Weckbach, and should be viewed more as a last resort due to the damage they can inflict upon a retirement nest egg.

Some of the RMD wrinkles to which Weckbach refers pertain to inherited IRAs — retirement accounts that pass into the hands of a beneficiary following the death of the original account owner. Generally, a person who inherits an IRA from a person age 70½ or older who had been required to take RMDs must take the RMD the deceased account owner would have received. Then, in the year following the owner’s death, the RMD is calculated using the beneficiary’s age and life expectancy.

However, a person who inherits an IRA from a spouse (and is the sole beneficiary on the account) has several choices:

  • They can avoid the beneficiary RMD by electing to treat the IRA as their own;
  • They can base RMDs on their own current age;
  • They can base RMDs on the decedent’s age at death, reducing the distribution period by one each year; or
  • They can withdraw the entire account balance by the end of the fifth year following the account owner’s death, if the account owner died before the required beginning date.

If the account owner died before the required beginning date, the surviving spouse can wait until the owner would have turned 70½ to begin receiving RMDs.

Likewise, non-spouse individual beneficiaries can withdraw the entire account balance by the end of the fifth year following the account owner’s death, if the account owner died before the required beginning date, or calculate RMDs using the distribution period from the IRS’s Single Life Table.

Given the potential financial ramifications of these choices, it makes sense to consult a financial professional for advice and guidance on RMDs. Visit the Financial Planning Association’s national database at www.PlannerSearch.org to find a Certified Financial Planner™ (CFP®) professional in your area.

April 2015 — This column is provided by the Financial Planning Association® (FPA®) of NENY, the principle professional organization for Certified Financial PlannerTM (CFP®) professionals. FPA is the community that fosters the value of financial planning and advances the financial planning profession and its members demonstrate and support a professional commitment to education and a client-centered financial planning process. Please credit FPA of NENY if you use this column in whole or in part.

The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.

Traditional IRA or Roth IRA? Choosing the Right Retirement Savings Vehicle

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Recognizing that saving for retirement is a must for anyone who wants to control their own financial destiny and avoid running out of money later in life, Uncle Sam offers a variety of tax incentives to encourage people to set money aside in a range of investment vehicles, individual retirement accounts (IRAs) being among the most popular.

The challenge for investors is deciding to which type of IRA to contribute. Are they better off putting money in a traditional IRA, a Roth IRA, or both? The answer to that question is, “It depends.”

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“There are some general rules of thumb to help guide you, but it really is a very situation-specific decision,” explains Scott Arnold, a certified financial planner with G&S Capital in Englewood, Colo. For that reason, he suggests potential IRA investors discuss their options with a financial professional before investing in an IRA. To find a Certified Financial Planner™ (CFP®) professional in your area, check out the Financial Planning Association’s national database at www.PlannerSearch.org. The following FAQ can help frame that discussion:

  1. What are some of the key distinctions and similarities between Roth and traditional IRAs?

Here are five to keep in mind:

  1. Traditional IRAs are tax-deferred vehicles, meaning distributions are taxed as earned income when they’re withdrawn. Roth IRAs work the opposite way: contributions are considered after-tax (that is, they are taxed on the front end as earned income, prior to landing in the account) and money comes out tax-free.
  2. Contributions to traditional IRAs may be tax-deductible. The amount of the deduction (full, partial or none) depends on whether the person (or their spouse) also has made contributions to a work-based retirement plan like a 401(k).
  3. In the case of Roth IRAs, contribution limits are lower for people whose income exceeds certain thresholds. No income restrictions apply to contributions to traditional IRAs. However, the tax deductibility of traditional IRA contributions may be limited for individuals (and couples) who also contribute to an employer plan.
  4. With a traditional IRA, withdrawals before age 59½ may be subject to a 10% early withdrawal penalty unless an exception applies, such as to cover the cost of college tuition. Those withdrawals also are taxable as ordinary income. With a Roth IRA, the amount invested (the basis) can be withdrawn anytime penalty- and tax-free.
  5. With traditional IRAs, the account owner must start taking required minimum distributions (RMDs) beginning at age 70.5 or face stiff penalties. No RMDs apply to a Roth IRA held by its original owner.
  1. How do current age and income factor into the decision?

The tax-deductibility of contributions to a traditional IRA means contributions lower a person’s taxable income, potentially putting them in a lower tax bracket, a key consideration come tax time.

Personal finance experts such as Arnold often steer younger clients toward Roth IRA contributions when their income (and thus their tax bracket as well) tends to be lower, so those contributions have longer to grow. Lower-income individuals and couples may also qualify for a retirement savings contributions tax credit for up to 50% of their contribution.

  1. How do a person’s current tax bracket and their expectations for future tax status figure into the decision?

Roth IRA contributions make sense for people who expect to pay taxes at a higher rate during the withdrawal stage (retirement) than they’re paying currently. Of course, this relies on a degree of speculation, as tax rules change frequently. On the other hand, if you think you will be in a lower tax bracket when you are ready to retire and take distributions, it may make sense to contribute to a traditional IRA.

When clients move from a low (15%) tax bracket to a higher (25% or more) tax bracket, it also can be wise to start contributions to a traditional IRA rather than a Roth to lower their taxable income and diversify the tax status of their retirement savings, explains Ben D. Gurwitz, a certified financial planner with Jim Oliver & Associates in San Antonio, Texas.

After age 59.5, it may also make sense for certain people to start taking penalty-free distributions from a traditional IRA in order to minimize RMD amounts — and associated income taxes — later, when they hit age 70.5. The goal is to manage retirement account withdrawals in order to avoid income spikes (and thus, income tax spikes), taking into account income from IRA RMDs and other sources like Social Security, pension, etc.

  1. Which type of IRA is best for people looking to pass wealth to beneficiaries?

For people to whom tax-efficient wealth transfer is a priority, a Roth IRA may be the best option, says Arnold, because a lack of RMDs allows the account holder to keep money inside the account so it has more time to grow before it transfers to beneficiaries.

  1. How important a consideration is tax diversification?

“It’s very important,” says Arnold, who recommends people maintain retirement assets in three categories: (1) tax-deferred accounts, such as a traditional IRA; (2) tax-free accounts, such as a Roth IRA); and (3) taxable accounts, such as brokerage accounts with stocks, bonds, etc.

Such an approach allows for maximum flexibility when it comes time to draw down from those accounts during retirement, says Andrew Weckbach, CFP, founder of Scaling Independence in St. Louis, MO.

  1. How much flexibility do you need with your IRA?

A Roth IRA account holder can withdraw account contributions (the basis amount) anytime, at any age, with no penalty, and can begin taking out earnings (above the basis) tax-free from a Roth after five years.

That’s one of the reasons Troy, Michigan-based certified financial planner Leon C. LaBrecque calls Roth IRAs “the Swiss Army knife of retirement tools.”

May 2015 — This column is provided by the Financial Planning Association® (FPA®) of Northeastern NY, the principle professional organization for CERTIFIED FINANCIAL PLANNERTM (CFP®) professionals. FPA is the community that fosters the value of financial planning and advances the financial planning profession and its members demonstrate and support a professional commitment to education and a client-centered financial planning process. Please credit FPA of Northeastern NY if you use this column in whole or in part.

The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.

Year-Round Tax Tips for Business Owners

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Business owners are constantly seeking ways to strengthen their financial bottom line, to gain that little extra competitive edge. The tax code is one place worth looking.

Here the Financial Planning Association (FPA), the nation’s largest group of personal finance professionals, combs through the tax code to provide business owners with tips to maximize the efficiency of their tax returns and bolster their bottom line in the process.

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TIP: Before executing any of the suggested maneuvers that follow, be sure to consult an attorney, accountant and/or financial advisor, suggests certified financial planner Kelly L. MacRae of Beacon Point Advisors in Newport Beach, CA. “It’s a good idea to have an expert help you flesh this tax stuff out, because it can get tricky sometimes.”

TIP: Consider (or reconsider) your company’s legal structure. How a business entity is structured can have major consequences not only on taxes, but also on the personal and financial liability of its owners. To protect owners from liability, says MacRae, consider converting a sole proprietorship to an LLC, LLP or corporation, for example. Also, since retirement plan contribution limits and business tax liabilities (such as FICA, Social Security, employer and employee taxes) often are determined by the legal structure of the business, talk with an attorney or accountant about the type of entity that might fit best with your situation.

TIP: Take advantage of the Section 179 tax deduction that allows businesses to deduct from gross income the entire purchase price of qualifying equipment (computers, copiers, office furniture, certain business-use vehicles, etc.) and other “tangible” business goods, including software, purchased or financed in the year they acquire it instead of depreciating the purchase price over a period of years. The equipment must have been financed/purchased and put into service by Dec. 31, 2014.

If possible, take advantage of this provision in the 2014 tax year, says MacRae, before the maximum deduction drops drastically, from $500,000 (the limit for the 2014 tax year) to the 2015 limit of $25,000. Check out this page of the IRS website for more info about Section 179 deductions: http://www.irs.gov/publications/p946/ch02.html.

TIP: Weigh which retirement plan is right for your business. From traditional 401(k)s and individual 401(k) plans to SEP IRAs and more, businesses can choose from a range of retirement plans, each of which comes with its own distinct features and tax ramifications. For business owners seeking to maximize tax-deferred retirement plan contributions for themselves and their employees, while maintaining year-to-year flexibility with those contributions, the combination of a 401(k) with profit-sharing often provides the most bang for the buck, according to MacRae. SEP IRAs also hold appeal for the flexibility they provide, as they allow contributions to be made up until the tax filing extension deadline of October 15 the following year.

TIP: Be diligent in tracking, documenting and claiming expenses. From meals and entertainment to automotive expenses and much more, a broad range of business expenses can be claimed to offset income and thus, to reduce tax liability. With automotive expenses, does it make more sense to use the standard mileage deduction or to deduct actual expenses and depreciation? An accountant or financial professional can help answer questions like these.

TIP: Take advantage of other available deductions and write-offs, for home office, charitable donations and more. One worth noting is a provision that allows a business owner to write off 100% of a charitable contribution as advertising if their company logo appears somewhere on the donation recipient’s collateral materials, such as the program for a charitable event held by that organization.

TIP: Track business income over the course of the year and adjust tax payments accordingly. This applies chiefly to business owners who pay quarterly state and federal taxes. Be sure those quarterly payments are in line with income, so you don’t over- or underpay.

April 2015 — This column is provided by the Financial Planning Association® (FPA®) of Northeastern NY, the principle professional organization for CERTIFIED FINANCIAL PLANNERTM (CFP®) professionals. FPA is the community that fosters the value of financial planning and advances the financial planning profession and its members demonstrate and support a professional commitment to education and a client-centered financial planning process. Please credit FPA of Northeastern NY if you use this column in whole or in part.

The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.