Do you want a tax refund?

The Myth of the Tax Refund

It’s that time of year again.  No not time for the ACC basketball tournament and March Madness, but that time of the year where everyone celebrates their tax refund.  It’s a time honored tradition where everyone is excited to get their money back from the Federal Government.  But should we celebrate it?  Let’s review the history of income tax withholdings first. 

History of Income Tax Withholdings

In 1943, Congress pushed through the Current Tax Payment Act which required taxpayers to stay current on their tax liability.  They accomplished this via a new withholding system applied to earned income (e.g., salary and wages). 

Prior to 1943, taxpayers didn’t have to pay throughout the year.  They simply had to pay “next year for taxes due this year.”  This made the US Treasury department a creditor to every single taxpayer in the country.  As the Federal government needed more revenue to fight World War II, it was necessary to expand the income tax base by taxing more citizens.  However, taxing more citizens meant that the quality of the debtors would decline unless a smoother way was made to collect taxes. 

It wasn’t just a deterioration of the income tax base that prompted Congress to pass the Current Tax Payment Act though.  The War was creating inflation.  And this meant that a dollar tomorrow was worth less to the Federal government than a dollar today.  It needed the revenue sooner and a withholding system was the perfect way to get it done.  Incidentally, it also made it easier for the Federal government to raise taxes in the future.  After all, a small increase in taxes owed every single pay period is not as tough to bear as a bigger check to cut at the end of the year. 

Congress had seen a successful withholding campaign implemented through the Bureau of Old-Age Benefits – which was one of three initial operating bureaus set up administer the Social Security Act.  So they passed a law that required citizens to pay income taxes on wages and salaries as the income is earned. 

Two Options with your withholdings

It is extremely unlikely that you will ever pay exactly what you owe in Federal income taxes - unless you owe nothing and you pay nothing.  Therefore, you really have two options: pay more than you owe throughout the year or pay less than you owe throughout the year.  If you pay more than you owe, then you get a refund at the end of the year.  If you pay less than you owe, then you write a check to cover the difference.  

So do you prefer to owe the government money or do you want to receive a refund?  

Lend Money to the Federal Government

Americans are known to spend.  It’s one thing that we do really well.  So the argument is that overpaying the Federal government is a method of creating savings.  The problem with this is that if Americans are truly spenders and not savers, most Americans will receive their tax refund and spend it.  So the question becomes do you prefer to spend your money now or in February, March or April when you receive your refund?  Or maybe more importantly, can you trick yourself into saving throughout the year.    

By overpaying income taxes, you need to realize that you are essentially giving the Federal government your money to spend as they will until you file your tax return.  At that time, they will send you back a check for what you owe – with no interest paid to you.  In essence, you have lent the government money through a no interest loan.  For all of those people complaining about not receiving interest on their checking account, beware as you are getting the same thing from the Federal government when you lend them money. 

Be Lent Money by the Federal Government

If you are a good saver then this is unquestionably the route for you.  If you can save money and be prepared to send a check to the Federal government in April then you have flipped the equation and received an interest free loan from the Federal government for the amount of taxes you owe them.  During times of higher interest rates, you could let that amount sit in a very safe checking account and earn you interest – with little to no risk.

You have to be careful though.  The Federal government (and state governments) recognizes that some individuals will try to minimize what they pay the government throughout the year so they require that you pay either 90% of current year taxes or 110% of your previous years tax liability.  If you don’t satisfy one of those two then you owe the Federal government an underpayment penalty. In other words, don’t stop paying them completely but do consider how

Conclusion

So it depends.  Are you a good saver?  If the answer is no, then you may want to change your habits and stop lending the Federal government money with no interest received.  If you are a good saver then stop lending money to the government and let it work for you.  Know your own limitations though.  Don't get caught thinking that you are a good saver when deep down you know that you aren't.  This could lead to further financial trouble, especially if you rely on a credit card to help you pay your tax bill come April. 

Is Tax-Free Always Better Than Tax-Deferred? 

There is an old saying that a bird in the hand is better than two in the bush.  I think about that when talking about Roth strategies because the old adage still applies, in many instances.  To put it in similar context, paying taxes today is better than paying taxes in the future – under the right circumstances.

The Roth account is a fairly new one - it was established by law on January 1, 1998 and remains a mystery to many people.  Nonetheless, the premise is quite simple.  You contribute money to the account and it grows tax-free until you take distributions. As long as you take distributions for a qualified reason - mainly retirement - you pay no income taxes upon distribution.  

Obviously that sounds too good to be true right.  In reality, tax-free growth is only good in certain circumstances.  Let's think about this a different way.  What would happen if I offered you $10,000 or $8,500 and that amount doubles in value at some point in the future - which one would you take?  In other words, the $10,000 now becomes $20,000 and the $8,500 now becomes $17,000.   You probably still want the $20,000 don't you?  

What if the $20,000 was in a 401(k) and your tax rate was 30% (meaning you get to keep 70% of the value after paying taxes)?  Now your $20,000 is only worth $14,000.  If the $17,000 is in a Roth account - meaning distributions are income tax free - then it is still worth $17,000 after taking the distribution.  In other words, in this instance taking $8,500 was better than taking $10,000 even after both doubled in value.  

Obviously, if your tax rate was only 10% then the $20,000 is still $18,000 after taxes (you get to keep 90%) and you would rather have $18,000 than $17,000, right?  If so, then taking the $10,000 was better than taking the $8,500 even after paying taxes in the future.

How do I know which is better?

With that bit of information, you can start to put together the picture of what makes a Roth account more successful than a traditional IRA or 401k.  Understanding your future tax rate can help you make an informed decision.  But that is only half of the picture because you need to know your current tax rate too.  

In essence, you are given $10,000 (though most of us earn it) every so often through work and you have decisions to make with that money. You can spend it (the popular American choice) or you can save it.  If you save it, the money can go into a savings account, a pre-tax account (IRA or 401k), or a Roth account.  There are valid reasons to save to a savings account but we are going to disregard that today and just focus on the decision to save it into a pre-tax account or a Roth account.  

If you choose to save $10,000 into a pre-tax 401k then the full $10,000 goes into the account – remember you pay taxes when it is distributed, not when it is contributed.  If you choose to save it into a Roth 401k then you have to pay taxes first – I know the persistent them of taxes is a real downer.  

If you are in the 15% tax bracket, then you can only contribute $8,500, not the full $10,000 (this is simplified for our discussion today).  The money grows over time and eventually you start taking distributions to support expenses in retirement.  The tax rate at which it goes into and comes out of the account determines the optimum way to save the money.  Ideally, you would contribute to a Roth account if your marginal tax rate is low today and expected to be high when taking distributions.  Alternatively, you would contribute to a traditional pre-tax account today if your marginal tax rate is high today and expected to be lower when you start taking distributions.  

Assume that you earn $10,000 and can contribute it to either a Roth account or a traditional account, your current tax rate is 25%, and you take a distribution when the account doubles in value.  This would mean that you can contribute $10,000 to a pre-tax account or $7,500 to a Roth account.  Which is better?

Future Tax Rate	15%	25%	39%
Roth Account Value	$15,000	$15,000	$15,000
Pre-Tax Account Value	$17,000	$15,000	$12,200

So the general principle is pay taxes when you know they are going to be the lowest. 

In other words, the bird in the hand is paying taxes today rather than in the future.  You know what you get today but the future is an unknown to all of us.  With that being said, Roth contributions still don’t make sense for everyone and should be used only in the right situations.  

What Happens to my Timeshare

What Happens to my Timeshare?

I had lunch the other day with a client – nice Italian meal – and we were talking about life so naturally vacations came up.  This client happens to own a timeshare in St. Thomas and was talking about taking a trip down there sometime soon.   As he was talking about it I realized that I had never thought about the estate planning issues around a timeshare.  In other words, what happens to a timeshare when you pass away? 

Joint ownership

The easy answer for most people that own a timeshare – couples – is that at the death of the first spouse it merely passes directly to the surviving spouse (who is typically the joint owner).  If the surviving spouse re-titles the house and splits the ownership with a child or sibling then the joint ownership nature remains and at the death of the first of the two the property passes to the second owner.  Repeat the process as long as the property is owned by two people (as long as it is not owned as Tenants in Common). 

Individually owned property

For individually owned property, it is not as simple.  Individually owned timeshares depend on what type of timeshare it is: deeded property or “right to use” property. 

      

      a.       Deeded property is the most common form of timeshare ownership in the US.  Having a deeded timeshare means that you have a deed that gives you full ownership rights to your parcel of the property.  This means that the clerk’s office in the county of the timeshare will have a record of your ownership. 

      

      b.      Right to Use property does not come with any ownership rights – meaning that you can’t pass it on to your heirs.  It typically expires after a certain number of years or with at your death. 

In other words, if you own a deeded property your heirs have to be concerned with the estate settlement of a timeshare but if you own a right to use timeshare then they don’t.  If you don’t know what type of timeshare you own, you should be able to determine it by looking at your contract.  If you can’t find your contract then you should be able to call the management company and ask. 

Deeded property

A deeded property is how we own our homes.  With a deeded property, you own physical property in the state, territory, or country where the timeshare is located. 

Therefore, when you die and there is no joint owner in the property it passes through probate according to the terms of your will.  Alternatively, if you have placed the property in your revocable living trust the property will avoid probate and pass according to the terms of your revocable living trust (if it is property in a foreign country or US territory you will have to check whether or not they recognize US trusts ). 

So the preferable method of timeshare ownership is clearly joint ownership or owning it through a revocable living trust.  Of the two, the revocable living trust is the preferred method because it is more permanent in nature. 

Problems

The challenge that I see is that passing a timeshare through probate can be an expensive process.  At a minimum you are likely talking about $1,000 to $1,500 in US.  However, if it is owned internationally you could be looking at a cost of as much as $3,000 to $5,000, potentially more.  Considering that the actual value of most time shares is less than $50,000 we are talking about a rather large cost to transfer ownership.

Conclusion

If you happen to own an international timeshare or one in a US territory, it becomes even more complicated because now your estate has to be settled in a foreign court.  I am not an attorney or an international law expert, but I do know that passing property through their courts system can be challenging and time consuming – both attributing to the higher estimated costs for timeshares owned internationally. 

What does this mean?  If you have a timeshare you need to figure out how it is owned (“right to use” or deeded property).  Once you know how it is owned you should talk with an estate attorney about the best way to structure your estate documents to pass the property at your death.   It may be that the cost of setting up a revocable living trust is similar to passing the property through probate at which you could determine that it is just as well to let you heirs deal with it.  Or you may realize that the headache and costs of the probate process isn’t necessary for your heirs so you take the steps on the front-end to reduce the costs and headache.  Either way, it is good to understand the costs and the options for making things pass as smoothly as possible.