I always check my taxes for next year at around end of September every year. That gives me 3 months to withhold any additional taxes for next year to avoid any under-payment penalty. I also check my accumulated capital gain/loss to plan for certain tax loss sales if any.

By paying taxes from withholding your paycheck, they get treated as if they are paid evenly throughout the year. You won’t get hit by any quarterly assessment of tax penalties, just because you pay them closer to the end of year. If you run a business, this option is not available to you, and Uncle Sam wants you to pay up every quarter.

This year due to extra stock option sale earlier in the year (before stock markets crashed), I need to withhold all of my income for the next three months. It certainly doesn’t feel good to “work for free” especially after I have already paid so much in taxes. My combined state & federal marginal bracket is at about 50%. It is amazing how much government can take, and still manage to run a deficit year after year.

Oh, well. Certainly, paying taxes is far better than taking unemployment benefit checks. My best wishes to anybody who has been left behind by the rolling recessions in the economy.

The earthquake disaster in Japan has been terrible. My prayers go to all the suffering victims. I have been trying to find a good charity for the earthquake in New Zealand, and unfortunately there comes another one, and bigger.

On Yahoo’s news, it listed 8 charities for donation. American Red Cross is one of them. However, after some research digging at CharityNavigator.org and google, I won’t be giving my money to American Red Cross.

Most of the American charities could be as corrupted as other big institutions. Majority of all big charities have a CEO that gets paid for $300K to $600K annually. If you find a charity CEO that is only paid at about $200K, it’s pretty good already. American Red Cross pays its CEO $446,867, with the highest salaried at $566,629. What bothers me the most is that the past poor handling of American Red Cross in Katrina and Haiti. In fact, there seems to be a consistent record of such at Red Cross.

While I don’t want to put any final words or judgment on American Red Cross, I plan to give my money to Americares or Convoy of Hope. All of the amount of my donated money is hard-earned, and I want to share it with the poor victims, not the highly salaried CEOs.

One day when I can retire from my day job, I hope to start a charity. I would not take any payment from doing it because that was how naive I have always thought how any charities should have been run.

I used to donate blood before I have children. With small children in the family, my life is always extremely busy and circles around children. This year however I finally made a vow to donate blood as often as I can. What made me a little sad is that because of all the constraints & regulation, even if I donate at maximum possible frequency which is every 56 days, or about 6 times a year, there is only so much blood that I can give (1 pint per visit). Human lifetime is so limited, and we can only give so much. I was going to fill up my office wall with Red Cross stickers. I guess I won’t be able to do that.

Even though I’m often so busy that I don’t even have 1 hour to spare for blood donation, that one hour is probably the best relaxation time for me for months. I lie there, staring at the fluorescent lights, imagining how helpless the sick people must have been at the hospitals lying on the same beds. And I always make a prayer during the blood donation that whoever receives my blood can recover as soon as possible with God’s granted grace. Yeah, sometimes the donated blood won’t get used in the allowable time, but that is just part of the business.

To be able to donate blood, one obviously must be healthy. The last time I donated blood, Red Cross told me that if my diastolic blood pressure is more than 100, I won’t be able to continue to donate blood. I measured 100 exactly. She advised me to start taking my blood pressure medicine, and don’t delay anymore. When I came home, my 4 year old kept staring at the bandage around my elbow. Finally, his curiosity overcame him. He asked me what happened to me. I told him that I gave blood. And he couldn’t understand. Then I showed him a youtube on blood donation. He was a little scared, a little amazed, and somewhat confused. I hope one day when he grows up, he will understand and also donate blood for good.

I have always made it imperative to teach my children about charity. I want them to understand that how lucky they are to enjoy all the material things around them, and that if ever we own anything, it is given by God. We all come to this world with nothing, and we will leave this world with nothing. I am not sure if my kids will understand all of these one day, but I have great faith & hopes just by looking into their innocent eyes.

Economic stimulus is coming. And many retailers are looking for you to spend your check. In the recession, it’s a good time to spend money if you have it.

Of course, the amount of my rebate check is $0. I’m not getting any. But it’s not like I’m making a lot more. The tax rebate calculation and tax system was unfair to places with a very high living cost structure. Even though you are supposed to have a “high” income on a national basis, your high income simply doesn’t go far enough after all the needed expenses.

So what’s my advice on your rebate check? You guess it. You should SAVE it. The current economic slowdown is not going away yet. You will have plenty of chances to spend it on good purposes later.

But if you have to spend, make sure you spend it wisely. Find good deals. Pay down your credit card debts. Pay down your college loans. Build your emergency savings. These are just basics. I hate to repeat what Suze Orman would say, because what she says is obviously boring. But the truth is often boring, and not pleasing to your ears or heart. There is never a get-rich-quick scheme (or if there is, it won’t last very long at all). To accumulate more net worth, you simply have to save/earn more and spend less. I know every reader here would like to earn more instead of to save more. But saving more is actually a whole lot easier than earning more.

Anyway, if you still don’t know how much you may be getting, here is a calculator from IRS for you to figure it out. Hopefully, it’s something non-zero for you.

Todayis “Super Tuesday”. Chances are that a clear Republican winner will emerge at the end of the day but the Democratic contest will still be too close to call. FWIW, my personal choice for the presidency would be Ron Paul (Yes, unlikely), McCain, then Obama, in that order. McCain is the only Republican that stands a chance in the general election according to polling results summarized at RealClearPolitics.

The DC Current column in this week’s Barron’s (subscription) featured an interview with Austan Goolsbee, Obama’s economic policy advisor, and we have a preview of tax policy under President Obama. Some highlights:

He would hike most rates on dividends and capital gains from their current top of 15% to between 24% and 25% in order to generate new revenue and pay for middle-class tax simplification… That’s less than the 28% rate under Ronald REagan, and nore than the 20% rate under Bill Clinton.

To insure against a negative impact on innovation and new business formation, Obama would have a zero rate on capital gains for entrepreneurs, venture capitalists and small-business owners forming new enterprises.

And for ordinary income, Obama would allow the top marginal rates to return to the Clinton era’s 39.6% versus 35% today. Obama would also eliminate all tax shelters and loopholes.

Fore moderate wage earners who take the standard deductions, tax filing would be simplified. The Internal Revenue Service would figure out their taxes for them and send them a one-page form to sign, reducing preparation costs.

Even with a Republican in the White House, it’s probable that the Bush tax cuts will not become permanent given the Democratic control of Congress. However, a further increase of the capital gains rate to 25% (from the Clinton era’s 20%) would have pretty dire consequences for the stock market.

Look for your tax rebate in the mail soon, if you didn’t earn too much last year.

The details of the tax rebate are not all out yet, but here is what I can collect:
1. The minimum earned wage needs to be $3000 for you to qualify for at least the $300 per person rebate, or $600 per couple, plus $300 per dependent child.

2. The maximum before phasing out is $75000 for individual, and $150K for couple. As far as I can tell, those numbers are AGI or adjusted gross income. Therefore, all itemized or standard deductions don’t help you in this case. The phase-out goes pretty quickly. Once you reach $187K for couple, you get zilch or nada. But if you have children, the phase-out limits are higher. But I can’t find that number from all the press releases.

3. There seems to be an exception to #1. If you’re a retiree, and only have investment income, it appears that if you have paid some taxes, you can still get the $300 to $600 tax rebate. There was one example from marketwatch.com, and that’s about all that I can find.

Obviously, not all tax rebates will be spent. But this is probably a more fair way of dropping helicopter money. And I must applaud the quick actions by President and the Congress. Anything that is too late will not be useful at all.

A more important thing for the financial markets is that the loan limit on Fanni Mae and Freddie Mac will be raised to $729,750 or 125% of the median house price in the area. That is a huge increase. So it will help the jumbo loan interest rates, if you qualify for the payment. I tried a loan amount of $600K, with $150K or 20% down. Using 30 years fixed at 5.5%, $15K property tax, $1000 home insurance, and $200 monthly HOA fee (about the ballpark for the single family prices in 2006), one must fork out $5000 per month for housing. Since one needs to pay some payroll tax, if not income tax, plus one needs to eat and drive, I assumed that the monthly pre-tax income probably needs to be $12K per month, or $144K annual salary.

Again, I truly wonder how people can afford those homes a few years back (if it wasn’t negative ARM).

I have been watching for the AMT bill for sometime. The AMT bill affects me personally since my family income is right at the window of a middle-upper class income for a Californian, not too high to be called rich, but high enough to pay A LOT of AMT taxes (about $5000).

$5000 tax bite would definitely make some difference to a paycheck to paycheck Californian, and I think that will worsen the falling California housing market. I’m sure no one has ever planned for such a tax hike of $2000 to $5000. Without the patch, the AMT exemption was going to fall from last year of $62550 to $45000. Insignificant change, but meaningful dollars. Now that it appears that the tax bill would be passing, the AMT exemption would increase to $66250 instead.

Because of realized capital gains this year, I’m earning ZERO income for my last 5 biweekly paychecks for the remaining year, so that I can pay extra federal and state taxes for the realized capital gains. If I need to pay AMT taxes, it would put my long term capital gain at about 20% federal bracket, instead of normal 15% for long term gain. Of course, the california tax of 9.3% is on top of everything. Effectively I must pay about 25% on my capital gain tax, even when I don’t need to pay AMT tax.

Anyway, tax & inflation. That’s the game that we have to play as defense versus government.

This year I still have about $2000 left for my charity giving budget. But I haven’t found a good charity to donate to. I only have about one month left to do it, because I will be traveling internationally to visit my parents at the end of the year.

The biggest problem that I have with charities is that their CEO is paid way too much. Many are paid north of $150K up to $200K. Some are even paid more than $300K to $500K. Charity Navigator did a study on 2007 CEO compensation study for charities. The average salary is $145,270. The charity may say whatever they want, but the fact is non-profit also means no-profit. A CEO (or superintendent for a school district) for non-profit organizations is after all very different from a for-profit organization. There is no gross margin or pricing issues for products. The only effect from a better paid CEO and/or less efficiently organization is that the target that they serve ends up with less money. Taking money out of what poor people would receive is much easier than taking money out from a competitive and capitalistic marketplace of products.

I’m sure the salary is justified for some of the CEO, but I don’t have time to sift through all the details. Furthermore, when I need to justify for why I’m not spending my $2000 on my wife for jewelries or on my kids for more fancy toys, I must really spend my charity money for a VERY GOOD purpose. Every year, I easily donate more cash to charity than my total spending on jewelries for my wife and toys for my kids. But my wife understands that charity donation is spent for good purposes. Departing from your own cash is difficult certainly, but it is just part of the process needed to learn the truth about how every human being is part of the God’s family.

If you can know a charity that is involved with children and/or hunger (the causes that my wife and I are most interested in), and that 95% of the money goes to non-admin and non-advertisement activities, and the CEO’s salary is about $100K or less, please let me know. I would really appreciate it. Many thanks.

Any good ideas on how to collect an uncollectable personal debt?

I loaned $5000 to my friend back in 2001. It was meant to get him temporarily thru a job loss. So I never asked for any interest on my loan. Maybe he had a series of bad luck, or something. He found another job, and then got laid off again. It was during those high-tech recession. Later he managed to pay me back $500, which obviously wouldn’t cover any interest money that I would have lost. In any case, I counted it towards the principal.

As months and then years gone by, he is still unable to pay me back, and ran up his credit card debts. In fact, his credit scores were so poor that he couldn’t get any more credits nor even open a new bank account. Throughout these years, as a good friend to him, I have always being lenient to him by not giving him any pressure at all in repaying me. I only reminded him twice probably in 6 years that he should have a repayment plan. I also made it clear to him that requiring him to come up with a plan is really meant to get him in some financial order, rather than repaying me. Without a plan, an undisciplined person can’t go anywhere.

Then I sort of given up on him ever repaying me back. I simply asked him to help me document a personal loan loss with his social security number, plus signing/back-dating this loan document. This way I can properly deduct a long-term capital loss on my Schedule D, which would be allowed for this category, if such loan were not interest-free, and not meant to be a personal gift. I told him that he doesn’t need to pay me back, and that the worst consequence financially to him would be that he would have a personal and taxable gain of $4500, on which he most likely doesn’t need to pay any taxes (since it appeared that he didn’t have income that was taxable).

Throughout the entire process, I have never felt upset by him, but rather felt very sorry for him about his financial state. What was very unfortunate for him as a person was that he didn’t help me at all on documenting this. Rather, several months later, he simply disappeared. His phone number nor his address worked.

What a friend that I had! Despite this, I would still treat him as a friend if I see him again.

Of course, this unpaid loan hasn’t made my wife happy at all. Especially when my friend was buying the latest notebook computer, while I still had desktop, and that he has been using cell phones for years, when I had none. But given a choice of consuming my way to bankruptcy or saving my way to great wealth, I will always choose the latter option.

This is not another tax scam, but a tax law change. In 2008, if you qualify, you can pay 0% capital gain tax on your stock gain. But of course, this is not for everyone. If your marginal tax bracket is in 10% or 15%, you can pay 0% capital gain for any amount of stock gain before you exceed the 15% bracket. The maximum potential tax saving is about $3250 if you use $65000 for married filing joint, and all of the income comes from stock gain, which would be taxed at 5% in 2007, but will be taxed at 0% in 2008.

Although this doesn’t apply to me now, I was in 15% tax bracket only 7 to 8 years ago. I am sure that some of the younger readers here may take advantage of this, especially young couples. Even though you may not save much tax in total since you only pay 0% tax on the portion before your AGI (adjusted gross income) exceed the 15% bracket, it sure feels good. At the minimum, beating the inflation will be some 15% easier.

This tax saving however does not apply to kids under 19 or 24 if they are full-time students and dependent on their parents. But hey, who says that you must put your children as your dependents. You may save a lot more taxes if they (>19) simply file the returns on their own, paying a lot less capital gain, beating the kiddie tax at your own marginal bracket. Of course, this case is rare, but it would have applied to me, if not for the fact that my children are not more than 19.

Kiddie tax is a tax paying at the parental rate when the child’s income exceed $1700 (in 2007). For the first $1700, the tax that you would pay is 0% on the first $850 and 10% on the second $850, which amounts to $85. Assuming your marginal tax bracket is at 28%, that’s a tax saving of $391. But $1700 is not much at all after years of inflation. If you have a $34000 bank CD in your child’s name, you will have $1700 interest. And let’s say if your gift your appreciated stock to your child, which has returned you 25% total accumulated gain, you are due paying kiddie tax when this stock investment is valuing at $8500 (while your original cost was $6800, giving a 25% gain of $1700).

If you can afford to give away money to your child, I would guess that $8500 is not that much. It is almost guaranteed that you will be hit by the kiddie tax. The only way was to sell the stock with gain beyond the age of the kiddie tax, which was 14 and then changed to 18. But now it has been effectively changed to 24.

Here is from thestreet.com:

Last year, the age limit was raised, requiring children under age 18 to be taxed at the parents’ rate. Now, starting in tax year 2008, the age limit will apply to children under age 19 — or to “kiddies” who are full-time students under the age of 24.

My own child paid more than one thousand dollar in kiddie tax last year from the stock gain. Tax sucks. There are just very little ways for savers to get ahead. Especially when the income tax rate is high like mine is at 40% marginal bracket, sometimes it is very hard to motivate myself earning more money. I only get 60 cents out of every $1 anyway. Even my long term stock capital gains/losses are marginally taxed at almost 30%. No wonder America likes to consume instead of working for the government 5 months (~40%) in a year every year. Maybe I really need to change my state of residence.

If your tax deduction is too much out of the range for your income, it may raise a red flag to IRS. Here is a link to the latest tax statistics excel spreadsheetdirectly from IRS. I modified the spreadsheet a bit so that it is showing the actual dollar amount PER filing, much easier to read. You can look at my spreadsheet here which contains the original IRS numbers (46 million returns in Fall 2006), and my modified sheet, converting “number of returns” to “percentage of returns”, and “(total) amount” to “dollar amount per tax filing”.

The most interesting column to me personally is the non-cash charity donation. It is amazing to me that these non-cash amounts are so large across all income range. For example, non-cash donation averages $1178 for 64.82% of the returns with AGI from $100K to $200K. I’m way under that amount. I really wonder how much “valuable junk” you can donate to charities. And even 23.45% of the filing with AGI less than $5000 can “think of” $562 non-cash donation. My cash donation to charity is right at the ball park of my income. I guess I’m not comparatively stringy nor generous among my peers.

If you are interested, you can also calculate out how many percentage of people who have adjusted gross income above $500K? I calculated at the bottom of column B. Just 1.33% of people who pulled in more than $500K. But there were 4.78% who earned $200K to $500K, and 18.94% who earned $100K to $200K. Note that these numbers are per Filing. So it can be incomes from two wage earners in married joint filing.

I am not at the top 6%, but I made it to the top 25%. Are you just starting or have made some progress on this income ladder already?

Posted by “Frugal” at My 1st Million At 33.com

It was no secret that I’ve got $11781.91 dividends for year 2005. For year 2006, my dividends are $11646.15, not counting $2200 in royalties, more than $500 dollar from MLP cash distribution, and also not counting about $860 dividends in my children’s custodial accounts. These amount look great on paper, but actually this year I got slaughtered in some of these dividend stocks, and incurred a net realized or unrealized capital losses of about $12000 in 2006 in these, which pretty much erased all the gains from dividends + royalties. I incurred this huge loss in my dividend portfolio because I didn’t stay diversified enough, and had sold out all of my MLP positions due to their lower yields. The ones that I sold last (MMP, EPD) have gone up by 20+% instead of falling 20+% for some Canadian royalties. I did trade MLPs for PM stocks at the lowest point which have gone up 32% so far.

There is nothing to brag about (especially this year due to the surprising Canadian tax law announcement), but I really just want to share with all of you some “potential” money making tips. Everytime a company management pays out some dividends, they have absolutely no intentions of bringing down the stocks by distributing cash out, but rather believing that such dividends are sustainable in the long term.

By the way, producing such dividend stream does not require investing millions of dollars especially if they are paying 10+%. Currently, I have less than 10% of my portfolio invested in such dividend stocks.

Check out some of the investing series on My 1st Million At 33.com if you have not done so. Just my “two-cents” investing tips.

A reader asks me about some tax advice to save on tax without setting up some complicate business structure. I wish I have more things to tell him and you. But the fact is that even if you have some rental business going on, your passive loss deduction is limited by the rental income, and even with active participation, the loss is limited to $25K, and will be phased out when your modified adjusted gross income reaches more than $150K. Now, $25K is a lot but not much in these days. A conforming loan of $417K at 6% mortgage interest rate will put you over $25K mortgage interest deduction.

My advice is to stuff some money into spousal IRA account, and then Roth IRA account, both of which you should probably do, AFTER you finish your taxes if your total income including all bank interest, capital gain, etc. is near $140K. The reason is that it is possible for you to hit the phase out limits around $150K. I hit that once, and I ended up filing form 8606 so that I can up the basis in my spousal IRA account. When I make a distribution 30 years down the road, I don’t need to claim those after-tax dollars that I put in as before-tax income.

There is really no “magic” way to avoid paying tax (unless you earn all of your income through having a business). Every year when I look at the amount of taxes that I’m paying, I feel a little down. But on the other hand, I actually feel that I am happy to contribute my part to the US treasury chest. Even though government is kind of wasteful, and they don’t spend every dollar according to your wish. But at least you know that some part of your tax money do go to the necessary social welfare programs that pay some elders’ bills and their medical bills. Furthermore, the total tax as a percentage of your total income is actually no where close to your marginal tax bracket. There were a couple of times that I hit a marginal tax bracket of 42% including state and payroll tax. That’s quite a lot, but hey, I was glad that I had those income to be taxed. In fact, I didn’t have any child credits, my exemption amounts are being phased out, and I got hit by alternative minimum tax.

The only tax that quite gets me is the tax on capital gain and dividends. Government inflates which causes everything to go up including your stocks, and you still need to pay tax on their sins. It’s really not that easy to achieve a positive return after-inflation and after-tax. There have been many discussions about tax reforms, and I fully agree that we should change to a consumption tax system. I am fully behind such system, even if the sales tax is more than 30%. Such system will level the playing field between business owners and salary earners.

In any case, I’m sorry that I cannot be more helpful. I’ve heard people setting up business to channel their daily expenses. I would not advise that both on a legal and ethical basis. There are always some gray area for certain expenses, but to spend a majority of personal expenses as business expenses, hmm…. No further comments.

Before the end of year, I’m contemplating what stocks to sell for capital losses to offset my capital gain this year. Here are some of the evaluation & steps that I suggest to take:

1. The maximum loss that one can deduct per year is $3000 (married filing jointly) or $1500 (filing separately). By the way, The US government should really index this number by inflation. It has been this low for so many years.
2. You should try to sell the minimum number of positions, without impacting your overall investing portfolio/direction/philosophy.
3. Don’t fall into wash sale trap, selling the same stock, and buying back within a month.
4. In order to avoid wash sale trap, you can use this opportunity to swap with other technically stronger stocks in the similar sectors. Or you can use sector ETF instead of individual stocks.

Another tax tip that most people don’t pay attention to is the tax rate differences between long term/short term capital gain. Because long term capital gain is taxed at a lower rate, it also means that long term capital loss will offset less tax than short term capital loss (whenever you have some long term capital gain to be offset). Your long term capital loss will be equivalent to short term loss when you don’t have any long term gain, but only losses. In that case, all losses will be deducting against your highest tax bracket income.

Therefore, for tax purpose, you should try to take short term capital loss, while retaining long term capital gain. In principle, the two best scenarios for taxes are to show either a short and/or long term loss without any long term gain, or a long term gain (+ any short term gain but not loss). For example, if you have two stocks A & B. In stock A, you have made $3000, while in stock B, you have lost $3000. If you let them offset each other in the same year, you get $0. If you somehow make the gain to become a long term gain, and take the gain in a different tax year (1/1 and 12/31), you will actually gain some $300 from tax. How so? Take $3000 loss in one year, assuming that you don’t have any long term gain to be offset, then $3000 short or long term loss will be deducting against your highest tax bracket income. Then taking the $3000 long term gain in another year will be taxed at 20%. Assuming your tax bracket is at 28% to 33%, you can gain $240 to $390 in tax difference (after-tax money). A general tax strategy can be that you alternate between showing losses and long term (+short term) capital gain. But obviously, $3000 tax loss is too small of a room to play out such strategy for most people.

In summary, don’t “waste” your long term capital gain by shrinking it with losses. Move the losses to another year. The only exception to this is when you are hitting AMT or alternative minimum tax. But with Congress expanding the AMT deduction, most likely you won’t hit AMT unless your capital gain is above roughly $30000. In that case, you can use my tax calculator to exactly figure out whether you will hit AMT or not.

My biggest financial blunder is not using my parental gifts wisely. Most people don’t use their parental gifts wisely and spend through it. I’m at the opposite end of the spectrum. I didn’t use it wisely, because I did NOT use it.

If you have read the composition of my 1st million dollar, the money given by my parents was definitely not a small amount. But I did not considered it as mine for a long time. In fact, after my parents gave me the money, I simply left it under the control of my parents for probably 5 years before I had it transfered to under my control for the purpose of investing, but not spending. I have not spent a dime from that amount of money my parents have given me. I have always treasured the gift and vowed to pass it on to their grand children. I guess maybe the reason that my parents were willing to give me a significant sum of money to me is precisely because that they know me that I will NOT use the money on unworthy purposes.

But it did not occur to me much later that not using the money is NOT equal to using the money wisely. When I bought my current residence, I could have bought a bigger home, more commensurate to my networth. However, my consideration for home was more of an usage or spending, rather than an asset or as an investment. Because I treated buying a home more as a spending, I did not consider using the gift money from my parents at all. Certainly, with $90K less in my pocket, my choice for home was quite different than what it could have been, especially when my networth was much smaller at that time. With housing market gone up crazily, cash was certainly not a good investment. Eventually, I transferred those cash over for putting them into better investment. But I cannot go back to fix my financial blunder.

You may think that I may be the very few persons who don’t take the parental gifts into the pocket right away. Actually, I married another such person. My parents-in-law also gave my wife and I some $30K cash as a wedding gift (at the same time as the $90K from my parents for our wedding gift too). She never took it. She asked me whether I am okay with it, and I told her that I had no problem at all. My wife is very filial, and she thinks that her parents can use those money better than we do. In fact, I also told my wife that her parents can always count on my financial help anytime as long as they may need it and within what I can afford to help. Of course, my wife did not deny her parents’ gift, but rather left the money under her parents’ control. Till this day, I’ve never counted that $30K as part of my networth even though my parents-in-law still have it available for us.

The primary reason for putting money into 401K or traditional IRA account is for the current tax benefit.  However, if the current tax benefit is small, it may not make a lot of sense to stuff money into your IRA account.  Obviously, we don’t know what the future tax rates will be, but my best guess is that it will be higher, if not much higher than today’s tax rates & brackets.  The reason is that the coming dues of social security & medicare services will simply drain the tax revenue base, and will require raising tax (and lowering benefits and probably print more money) to cover any shortfalls.

If you’re not paying much income tax, or your marginal tax bracket is not that high (below 20%), I would actually consider not saving in your pre-tax accounts, but instead saving those money in Roth IRA.  A Roth IRA is an IRA that you pay tax now, but don’t pay tax later on the earnings.  Comparing Roth IRA to individual IRA, it has a couple of benefits like no forced withdrawal, nor an age limit on the contribution.

While it may be extremely time-consuming to go over the 100+ pages of IRS Pub 590 document on traditional IRA & Roth IRA, you can use my tax calculator to figure out the contribution limit on your Roth IRA & traditional IRA accounts.  The calculator may not contain all the necessary inputs, but for the most part, it suffices.

The decision over whether Roth IRA vs 401k/IRA is actually pretty simple.  Excluding the factor of company match on 401k account, for investing in Roth IRA in respect to pre-tax dollars, you will be getting taxed now.  And for 401k/traditional IRA accounts, you will be getting taxed (much) later.  Assuming that the rate of return on investment is the same for both scenario, if the tax factors are exactly the same, then both decisions will come out equally.  If you think tax rate may go up, or your retirement income may be quite high due to all the accumulated assets, then it might be better to just take some tax bite now instead of 30 or 40 years down the road.

Some people don’t have the financial discipline to carry out a plan of under-withholding taxes. Some people don’t have the financial cushion to carry it out to make a difference. However, if you have both, you can use under-withholding to your advantage.

Is under-withholding illegal? No. Unlike estimated tax payments, which go towards a specific quarter and due on the 15 of April, July, October, and January for the following year, the tax withheld from your paycheck is calculated as if the entire withheld amount is contributed throughout the entire year. What does that mean exactly? It means that whether you pay your tax out of your paycheck in January or December, they’re treated exactly the same by IRS, as if every 1/12 of the amount was paid evenly every month throughout the entire year. Knowing this, why would you want to pay IRS in January when you can pay IRS in December? You can almost put the amount in a 11 month CD, and get some 4% to 5.x% interest out of it.

I personally have carried out this practice for several years now. I under-withhold my taxes throughout the entire year, and I start to check on the exact amount of taxes that I should be paying in around October. The bigger amount you under-withhold, the earlier before year end that you should check on your taxes. The reason is that if you don’t start planning early enough, you may not pay enough taxes for the whole year, even if you send your entire paycheck to IRS for the last month in December. Essentially, you want to pay just enough taxes in a year, as not to trigger a tax penalty, and you want to pay more of your taxes near the end of year, instead of the beginning of the year. Calculating how much taxes you should pay can be very complicated. It’s also different for people whose adjusted gross income in the last year exceeded $150K. But you can easily figure out the underpayment taxes using my 2006 tax calculator. The calculation of underpayment taxes have taken into accounts for all of the conditions listed by IRS. It is the amount of additional taxes that you need to pay in order to avoid any tax penalty assessment. You don’t need to work through any IRS rules. Just enter all the numbers, and it will tell you how much more in taxes you need to withhold or pay.

To under-withhold or pay additional amount of taxes from your paycheck, you can simply fill out a W-4 form and give it to your payroll department. Besides under-witholding your taxes, another trick that you can play is over-contributing to your 401K, so that you can put in most of the contribution dollars upto the maximum earlier in the year, instead of later. For more details, you can find them at my other post “How I earn extra 1.45% return without risk in my 401k account”.

To summarize and put your cash flow into timeline, here is the picture of “paying yourself first” if you have utilized both early 401k contribution and under-withholding taxes:

1. If you make early 401k contribution, the first 3 to 4 months are the months when you will be paying into your own 401k account. Your net cash from paycheck will be tiny. You will be paying mostly the payroll taxes (social security and medicare taxes), but not much income taxes.
2. Then from March/April to probably October, these are your golden months for cash flow. Since you’re done with your 401k contribution, plus that you are under-withholding income taxes, your net cash from paycheck will look really good. But obviously, it’s not the time for you to spend those cash. Rather, you should be saving or investing those cash and prepare for the upcoming November/December and also till next year of April if you’re doing early 401k contribution every year.
3. November and especially December will literally be the dry months. If you have executed your under-withholding plan perfectly, you should be paying your entire paycheck towards IRS at the end of year. That means that there is $0 or close to $0 cash flow from your paycheck. You will need to be surviving from cash accumulated in the previous boom months of either January through October, or March/April through October if you contribute early to 401k.

Too complicated for you? Hey, if you know any ways to save or earn more money without any work, please let me know. To get something in return, you always need to pay at least a little bit of effort, whether it’s planning your cash flow, reading books or articles, etc.

Here is an article “Get next year’s tax refund now” from MSN money that talks about under-withholding taxes. It should supplement and reinforce this “tax saving” tip.

When I started blogging, I talked to my accounting friend who is a CPA about taking home office tax deduction.  Besides the trouble of maintaining and documenting the exclusitivity of the business usage, and sending a warning flag for audits, he advised me not to take any such deductions for the following financial reasons:

1. If you own your home, the expense items that you can claim for such deductions are mostly mortgage interest, property taxes, insurance, and utilities.  The biggest items are usually mortgage interest, and then property taxes, both of which can already be fully deducted through itemized deduction on the schedule A for your personal tax.  Unless you rent, and have very big utilities bills, the total deductible amount that is otherwise not available in personal taxes, will not be very significant, especially after pro-rating of business usage area to the total.
2. Any amount of depreciation of the home office will need to be re-captured as business gain at the time of the sale of your home.  If no business conversion of the home is taken, your gain is tax-free if it’s $250K for singles, and $500K for couples.  Those business gain can be defered through more complicated loopholes of 1031 exchange.  But this 1031 exchange that involves both home & business will not be as straightforward as a regular 1031 exchange.
3. Home office deduction is limited to your net business positive earning.  You simply cannot use home office deduction and increase your business loss to offset against your other income like salary wages.  Although you can carry forward the deductions that you cannot take in the current year, it is of no use if your business cannot produce significant income to take advantage of those deduction.  You can check out form 8829 for home office deduction and Schedule C for business income.

Here are some other useful links for more information:

1. Directly from IRS: home office deduction.
2. From Quicken: Factors to Consider Before Taking Home Office Deduction.  This article is very informative.
3. A very good online calculator for home office deduction.

I updated my federal tax calculator for 2006, with the latest AMT exemption amount passed by Congress.  Without an increase in the AMT exemption in 2006, a lot of working family will need to pay about extra $2000 in federal taxes due to kick-in of AMT.  You can experiment yourself using my 2006 tax calculators, entering $45000 for married couple (now at $62550), and $35750 for singles (now at $42500):

1. Joint with 2 kids, $80,000 income with $5000 401k contribution will need to pay $830 AMT tax.
2. Joint with 2 kids, $100,000 income with $15000 401k contribution will need to pay $1910 AMT tax.
3. Joint with 2 kids, $140,000 income with $15000 401k contribution will need to pay $2310 AMT tax.

I am glad that this is passed.  In fact, millions of families in the higher income states would face with paying extra taxes.  While I am concerned about growing government deficit from this tax cut, I think less taxes and smaller governments should be better for the citizens.  According to Lao Tze in his Tao Te Ching, ”Governing a great state is like cooking small fish“.  When my teacher in religion asked for the meaning of Lao Tze’s writing, one of my classmates answered that politics is like a culinary art, requiring many delicate and complex handlings.  I was a little shocked by the westerners’ default perspective because I knew what the answer was from my Asian background.  The correct answer was that government should leave people (fish) alone, and the less handled, the more remained.

So back to my point.  I’m for less taxes and smaller government.  Hope you have enjoyed the little digression.

A reader John has asked me about how to get the withheld taxes out of the paid dividends back, in my post of “My Dividend Investing ($11775.91 for 2005)”.  He said that he has 28% withheld.  28% is a very weird withholding percentage.  For all of my stocks, I had 15% withheld for foreign paid dividends.  Because I am not sure about his US status (citizenship/green card or foreign).  I will explain both.

For all foreigners who have brokerage accounts in the US, I believe 28% or 30% withholding is assessed on all dividends.  If the account has an expired W-8 form, any stock sale proceeds in your brokerage account will also be withheld for tax at the same rate.  To get that tax back, non-US citizens or anyone who doesn’t have a tax ID in their account MUST register for a tax ID by going to social security agency, and use that tax ID to file tax using 1040NR and reclaim your tax withheld.  You also need to contact your brokerage house and make sure that they send you the documentations (1099 form) to prove that you had taxes withheld in your account.  Please do make sure that your W8 or W8-BEN form is updated or else you will get lots of money withheld even when you don’t have any gain.

If you are a US citizen or green card holder, but getting foreign taxes withheld by other countries, it is pretty simple to get them back at the tax time.  As long as your total withholding is below $300 for single, and below $600 for married joint status, you can put that number (sum of all the numbers in box 6 from your 1099-DIV and 1099-INT) into line#47 of form 1040 as the foreign tax credit, and get all of your money back at the time of filing tax.  If you exceed the limit, then you will need to file form 1116 which is quite complex.  There are certain types of dividends, for example oil trust, that you cannot get any foreign taxes back.  My current tax calculator does not provide calculations for foreign tax credit using form 1116, but it will be implemented soon.  You can still enter the number, and the taxes will be calculated correctly.

Let me know if anyone has more questions related to this.

If you have never paid AMT or Alternative Minimum Tax, you may not be familiar with the intricacy of the other tax system.  About 2 or 3 years ago, I knew that most likely I had to pay AMT that year.  So in order to reduce my federal income tax, I did what I normally do, over-paying or pre-paying my state and property tax so that I can have more itemized deduction, ihoping to reduce my federal tax and AMT.  Everything was well-planned and well-executed.  Until the next year when I tried to file my tax, I finally discovered the stupidity of my tax strategy.  On the AMT tax form 6251, line #3, you actually add back all the state and property tax when you calculate your AMT income.  So by over-paying my state tax, I actually got zero tax benefit for the current year, while at the same time, getting a bigger state tax refund to be taxed federally for next year.  By pre-paying my property tax, I got no benefit for federal tax, and slight benefit for my state tax.  My tax strategy totally back-fired.

After that incident, I’ve made my own tax calculator to estimate my regular and AMT taxes, so that I don’t make the same stupid mistake again.  Going through Form 6251 once, I also learned other details, such as mortgage interests are deductible from AMT income, but not the interests from a refinancing loan.  And personal and child exemption amounts are all added back to the AMT income.  The most significant saving grace from paying AMT is the AMT exemption amount which is $58000 for year 2005.  However, in 2006, this exemption amount is dropping back to $45000, and is going to affect some 15 million people.  Congress has not been able to pass the AMT tax reforms, because they need to find additional tax dollars from elsewhere if they ever extend the 2005 exemption amount of $58000 for year 2006 and beyond.  You can write to your congressman here if you think this tax issue will affect you.  I think AMT should not be meant for a working family with 1 or 2 children, but rather for richer people.

The annual 401k contribution limit is $15K in 2006 now. Every year I always contribute to the max allowed by the law. My company allows the worker to contribute up to 60% of the salary. 60% of my salary at about $100K is $60K, far exceeding over the $15K annual limit. At the first thought, one would think that 60% is probably for the people whose salary is around $25K, but choose to crazily contribute 60% of the income into 401k account. Obviously, I don’t know of anyone who can live on a $25K – $15K = $10K pre-tax income. But after a little contemplation, I foud out this trick of earning extra 1.45% return without any risk in my 401k account.

Here is how I do it. I simply contribute at the maximum possible rate of 60% at the beginning of every year. My investment choice is usually cash/bond at Fidelity which is yielding about 3.8% APR. Now if you look at the following comparison table, using 26 bi-weekly contributions:

Do you see how I end up extra (15495.07 – 15277.45) / 15000 = 1.45% at the end of the year? After the year is over, all the money in both cases will be earning at the 3.8% APR. However, by simply paying myself first before IRS every year, I end up getting extra $217.62 or 1.45% yield every year. I have been doing this for several years now, and IRS has never complained (since my 401k account gets to the money first). Certainly this strategy is not for everyone. There are three problems with this:

1. You need to have a sufficient cash reserve in the beginning of the year to cushion the lack of after-tax money coming in.
2. Your contribution now is not at the even rate, and therefore, if you choose to contribute to other investment choices, you have extra risks of getting into market at the wrong time (or right time for that matter). Or you can phase in your contribution dollars evenly back into the market yourself.
3. If your company has 401k match, it is possible that you may lose some match dollars with this uneven contribution rate.

In any case, this shows clearly the advantage of paying yourself first over the tax man (especially if you are a business owner). You can also appy the same principle outside of the 401k account. On the W4-form, you can reduce the paycheck withholding amount in the beginning of the year, but then pay extra at the end of the year to avoid underpayment tax penalty. I use my tax calculator near the end of every year to underwithhold a little bit throughout the year, but catch up with extra tax payment at the end of year. But of course, in that case, your extra dollars may or may not go as far because although the total amount is not limited to $15K, whatever extra money that is earning returns needs to be taxed (at some 20 to 40% marginal tax bracket) unless you put the extra money into your Roth IRA or (spousal) IRA accounts. So don’t delay your contribution to Roth or regular IRA accounts until the April 15 of the next year. You pay yourself extra one-time return by contributing on Jan 1st of that tax year which is 1 year and 3.5 months earlier than contributing at the last minute. And if you do this every year, those extra one-time returns are not a one-time event, but a consistent annual extra return dollars that you pay yourself.

Your marginal tax bracket essentially defines how many cents after tax you get for every additional dollar that you earn.  A marginal tax rate of more than 50% will inevitably reduce economic activities.  If after all of your wits and labor and all the risk-taking, and you get less than the taxing by government, obviously anyone would be less incentivized to work.

Despite the progressive design of the US tax system, US tax is not really progressive (meaning that the more you earn, the higher marginal tax brakets that you are in).  When you consider the payroll taxes which include the social security and medicare taxes, the tax system is no longer progressive.  While the US federal government reports its deficit number under a unified budget (of which the actual deficit is the sum of the surplus/deficit of the ongoing budget deficit and the social security system surplus), payroll taxes are often looked at separately.  Obviously, the payroll taxes tax the poor and middle class people the heaviest, and raise the threshold for the decision of whether getting a job that pays close to minimum wage, or simply obtaining social welfare.

In a future post, I will make a plot of the marginal bracket versus wage income.  But here, I would like you to try out my tax calculator.  I tried to get this out before April 17, the tax deadline.  There are still a few things that are not perfect yet.  However, the tax calculation is accurate.  The thing that I like most of this calculator is that it’s a one and half page long instead of hundreds of tax instructions or tens of screens of turbo tax questionaires.  And experimenting the entries with different numbers will give you a very good idea about the effect of different types of income at the different levels.  The the most important thing is that it gives you the tax benefits of owning the home accurately by accounting for the standard deduction that you would have used.  Unless your income is quite high, the tax benefits reduction is often significantly less than your marginal tax bracket.