There are four financial strategies that seem to make good financial sense, but have the potential for trouble. Here are the strategies and the dangers:
1. Purchase the largest home you can afford. Many individuals calculate the maximum amount they can borrow and then purchase a property based on that amount. After moving into the house, they find their budgets strained, with little money left over for other expenses. It’s a better strategy to review your expenses, deciding how much you’re comfortable devoting to a mortgage payment. You want to make sure you have money left over for other financial goals, and that unforeseen problems won’t prevent you from making your mortgage payment.
Homeowners may also overestimate the tax breaks they will receive from mortgage interest and property tax deductions. The reason: The tax advantages of home ownership are eroded for some taxpayers due to “phase-out” rules, which reduce the benefit of deductions for high-income filers. Also, taxpayers who are liable for the alternative minimum tax (AMT) cannot deduct property tax.
To make sure there are no tax surprises in your future, check out the consequences of home ownership based on your current income and projected future income.
2. Pay off your credit card debt with a home-equity loan. Credit card and other consumer debt typically carry high interest rates that are not tax deductible. Home-equity loans, on the other hand, typically have lower interest rates and the interest is tax deductible as long as the balance is less than $100,000.
Thus, by using a home-equity loan to pay off consumer debt, you replace higher interest, nondeductible debt with lower interest, tax-deductible debt. This is not necessarily a bad strategy, but the danger is you will run up credit card balances again. In that case, you reduced your home’s equity without improving your financial situation.
Also, the growing number of taxpayers who are hit with the AMT are not allowed to deduct interest on home equity loans unless they can prove that the loan proceeds were used for home improvements.
3. Get a loan from your 401(k) plan. Most 401(k) plans allow participants to borrow against their balances, believing that it will increase employee participation by allowing access to the funds before retirement age. The loan is not considered a distribution, so it is not subject to income taxes or the 10 percent early withdrawal penalty. Typically, interest rates on 401(k) loans are reasonable and the loans are fairly easy to obtain. Any interest paid on the loan goes back into your 401(k) plan.
Sounds like a good deal and it can be. But the danger is that many people will have trouble saving enough for retirement if they regularly dip into their 401(k) plans. Also, some of your investments may have to be sold to provide the loan proceeds. Even though your original contributions to the plan were made with pre-tax dollars,the money used to repay the loan is made with after-tax money. Another danger exists if you leave your job before the loan is paid off. In that case, you must repay the entire balance in a short time or the balance will be considered a taxable distribution, subject to income taxes and possibly the 10 percent federal income tax penalty if you are under age 59 1/2.
4. Start savings accounts for your children or grandchildren in their own names. Although shifting income to the kids can lower taxes, it could also hurt your student’s chances for getting financial aid later on.
That’s because of the way the financial aid system treats different assets. The college aid formula treats 20 percent of the assets in your child’s name as being used for college costs (decreasing from 35 percent on July 1, 2007). But the government-mandated formula only expects about 5.6 percent of the money in the parent’s name to be spent.
So you may be better off keeping accounts in your own name, especially during the last two years of high school, which is generally when you’ll be asked to start providing tax returns. Retirement plans and IRAs don’t count for college aid purposes. You’re not expected to break into these accounts to pay for tuition.
Don’t assume you’re not eligible for assistance. With the high cost of college today, many schools now have programs available to relatively well-off families if they meet certain qualifications. For example, your child might be able to get a “merit award” based on high standardized test scores and superior grades.
Good strategy: If you expect to apply for financial aid, don’t hold back placing money in your own retirement plan in order to put away savings in a college account in your child’s name. Contributions to retirement accounts are usually tax-deductible and the earnings are tax deferred until withdrawn. On top of these tax breaks, your family may also become eligible for more financial aid.
Remember that you can usually tap retirement accounts for college money. As described above, many 401(k) plans allow loans to be taken. And thanks to a tax law that went into effect in 1998, you can generally withdraw a limited amount from your IRAs penalty-free to pay higher education costs for yourself, your children and grandchildren.
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