3 Steps to Figure Out How Much Mortgage You Can Afford

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Generally, the amount a lender will allow you to borrow for a mortgage is the amount at which the monthly loan payments (including principal, interest, property taxes, and homeowners insurance) equal no more than 28% of your gross monthly income. If you have excellent credit, some lenders may allow room for leniency. Additionally, your total debt payments (including the mortgage payment and all other debt) typically cannot exceed 36% of your monthly income.

While many borrowers use this as a guideline for the mortgage they can afford, it is really meant to be a lending guideline for how much you can borrow. However, the amount you should borrow is not necessarily the same as the amount you can borrow.

Follow this three-step process to help you determine how much you should spend on a home.

1. Prepare a Budget

In order to determine the mortgage payment you can afford, you need to first prepare a budget. It is critical to include the proper short-term savings and long-term investing in your budget before you establish the amount to allocate toward a mortgage payment. While owning a home can help build your net worth, it is an extremely illiquid asset that is not easily converted to cash. You should make certain that you have enough in short-term savings to pay your mortgage for at least six months in the event of an unforeseen financial setback. Also, make certain not to reduce your long-term savings goals for things such as retirement or your children’s future college education expenses.

2. Account for Increased Expenses

The good news is many of your budgeted items will not change with the purchase of a new home. For example, dining, food, clothing, and travel expenses will likely remain as they were before the move. However, some items like homeowners insurance, lawn care, pool maintenance, HOA dues, and utilities may increase when you purchase a residence. Property taxes will also likely increase, so just plugging in the amount the current owner pays may result in errors. If your purchase price is higher than the value listed on the tax rolls (as is commonly the case), you should recalculate the property tax based on the purchase price you will pay. It may take up to a year for the taxing authority to update the tax rolls, but eventually the purchase price will be used to determine your property tax due.

3. Determine Your Optimal Mortgage Payment

Once you have prepared a new budget, it will become apparent how much of a mortgage payment you can afford. If the amount you can afford is less than the amount you want to borrow, it may be necessary to adjust other budget items. Focus on reducing discretionary (non-essential) expenses. For example, you might consider reducing the amount you spend on vacations, entertainment, dining out, hobbies, and even your monthly television subscription so you can allocate more toward your new home. It is also a good idea to shop around for your auto insurance policy at the same time you are getting new homeowner insurance. Bundling these two policies with the same insurance company can often reduce your monthly premium by as much as 20%. All of these little changes to your budget can add up to a tidy sum that can help you purchase the home of your dreams.

Buying a home is no small feat, and there are many financial ins and outs to navigate as you prepare for this step in your life. As parting tips, don’t forget that you’ll need cash for your down payment (which will also influence the amount of your loan), and it’s helpful for you to check your credit report before speaking to a lender so you understand whether your lender will view you as a high-risk or low-risk borrower. Planning is key, and the more thought and energy you put into the process ahead of time, the more smoothly the home-buying process will go.

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8 Ways to Avoid Early IRA Withdrawal Penalties

An early distribution penalty isn't always inevitable. These exceptions might just apply to you.

Qualified retirement plans are designed to be used solely for retirement income. Taxable withdrawals from these plans before age 59.5 are generally assessed an additional 10% “early distribution tax” by the IRS. (The additional tax for SIMPLE IRA plans is 25% in the first two years of participation, and 10% thereafter). However, there are exceptions to this tax. Most of the exceptions apply to both individual retirement accounts and employer sponsored qualified plans, while a few only apply to IRAs. It may be possible, however, to roll a portion of your company’s retirement plan to an IRA in order to take advantage of those exceptions that only apply to IRA plans.

1. Disability

If you become disabled you can access your retirement funds without penalty, but there’s a catch. To claim the exemption, the IRS requires a “total and permanent” disability. You are only considered disabled if “you cannot engage in any substantial gainful activity because of your physical or mental condition. Additionally, “a physician must certify that the condition has lasted or can be expected to last continuously for 12 months or more, or that the condition can be expected to result in death.”

2. Education (IRAs only)

Distributions to pay qualified expenses for higher education qualify for the exemption if the student is enrolled in at least half of a full-time academic work load at an eligible academic institution. Qualified expenses include tuition, fees, books, supplies and equipment required for the education. These expenses can be for you, your spouse, you or your spouse’s child or grandchild. It is important to note that any expenses paid for with other government program funds or tax benefits are generally not eligible for this exemption. To qualify, the education expenses must be paid in the same year as the withdrawal.

3. First-Time Homebuyers (IRAs only)

Qualified first-time homebuyers can exclude up to $10,000 of penalty-free distributions from the early withdrawal tax if the proceeds are used to buy or build a primary residence within 120 days. The home can be for you, your spouse or either of your descendants. The term “first-time homebuyer” is a little misleading. According to the IRS, you are a first-time home buyer if you or your spouse did not have any ownership in a primary residence during the previous two years. So even if you have owned a home in the past, you can be considered a “first-time” homebuyer if it has been at least two years since you sold it. While this exemption can only be used once in a lifetime, both you and your spouse could each withdraw $10,000 and apply it to the same residence.

4. Unreimbursed Medical Expenses

Any unreimbursed medical expenses that exceed 10% of your adjusted gross income (Line 37 of the Form 1040) can be paid with funds from your IRA or company retirement plan without incurring the early distribution tax. The medical expenses must be paid in the same calendar year as the withdrawal to qualify.

5. Medical Insurance During Unemployment (IRAs Only)

If you lose your job and receive unemployment compensation for at least 12 consecutive weeks you may qualify to pay your medical insurance premiums with amounts withdrawn from your IRA without the early distribution tax. IRA withdrawals can be used to pay medical insurance premiums for yourself, your spouse, or your dependents without the 10% penalty. The distributions must be received in either the year you received unemployment compensation or the next year and must be withdrawn no later than 60 days after you start a new job.

6. Active Duty Military Reservist

If you are a member of the military reserves and are called to active duty for at least 180 days (or for an indefinite period) you will not have to pay the excess tax on any withdrawals made during your period of active duty.

7. IRS Levy

If the IRS places a levy on your retirement plan and you withdraw funds to satisfy the levy, you will not be charged the excess tax. If, however, you withdraw funds to pay taxes owed in anticipation of a levy, the exemption does not apply.

8. Substantially Equal Periodic Payments

If you do not meet any of the aforementioned exceptions, but still want to access your retirement plan without penalty, you can take “Substantially Equal Periodic Payments” over a period that is the longer of five years or until you reach age 59.5. The “Substantially Equal Periodic Payment” must be calculated according to complicated IRS actuarial rules. (You should consult a certified public accountant to perform the calculations.) These payments cannot be stopped or changed once they start or the 10% early distribution tax will be applied retroactively applied and you will also be charged interest.

It is important to weigh the consequences of taking distributions from plans designed to provide retirement income for non-retirement expenses. You should try to find another means to pay these pre-retirement expenses when possible. (If you plan to take out a loan, a good credit score will lead to a better rate. See where you stand before applying. You can check two credit scores for free at Credit.com.) Otherwise, make certain that you seek the advice of a competent tax adviser before making this critical decision. Mistakes can be costly.

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What Should I Do With My Retirement Plan When I Change Jobs?

When you terminate employment, you need to make some critically important decisions regarding your retirement plan.

When you terminate employment, you need to make important decisions regarding your retirement plan. Generally, you have three choices that allow you to continue to defer income taxation: leave the investments with your current employer, move them to your new employer or transfer them to an Individual Retirement Account (IRA). Of course if you are permanently retiring, the new employer plan is not an option.

Another choice is to cash out your account and pay income taxes on the withdrawal. This is usually not a good alternative since taxes will reduce the amount available for retirement and withdrawals prior to age 59 ½ will generally incur an additional 10% penalty.

There are several factors to consider when making this important decision, including investment options, investment costs, simplicity and the ability to borrow from the plan. Here are four things to keep in mind.

1. Investment Options

Most employer retirement plans have a limited number of investment choices. This can be good and bad. Plans with an abundance of choices can overwhelm the participant with difficult decisions. However, too few choices can limit the participant’s ability to properly diversify assets or select options that reflect their goals and objectives.

It is important to evaluate the options available in the previous plan as well as the new plan. Moving the assets to an IRA allows the participant to invest in a nearly unlimited number of options.

2. Investment Costs

One of the advantages of large employer plans is that investment costs may be lower than those charged in a smaller IRA account. Large employers have more leverage to offer investment classes with lower management fees than an individual can access. However, some larger plans may actually have higher fees than those charged in IRA accounts due to plan administrative expenses.

One way to evaluate the investment costs is to visit the Financial Industry Regulatory Authority Fund Analyzer. This free tool can illustrate the total fees paid over several years and can be accessed online.

3. Simplicity

If you are like most Americans, you will probably change jobs several times over your lifetime. (Here’s what to leave off your resume when that happens.) Each new employment stop creates a new plan to monitor after you move on. Companies merge, change investment options and change plan administrators.

Each of these changes requires you to set up new investment choices and website logins. Keeping up with all of these changes among several retirement plans can be burdensome. Transferring the assets to a new employer or to a single IRA account can simplify your life since your retirement investments will be situated in one central location.

4. Plan Loans

Employer retirement plans may offer the ability for the participants to borrow from their account (loans are legally available to most employer plans, but not all plan sponsors elect to offer them, and some plan types cannot offer them). Retirement plan loans are limited to less than 50% of the account value or $50,000. While there may be an administrative fee charged for the loan, the interest paid by the participant goes directly into the account, rather than to the plan.

Tax regulations do not allow loans from IRA accounts, so retirement plan loans can be a reason to move assets to your new employer. It is important to recognize that plan loans normally must be repaid upon separation from the employer. Any unpaid balance is considered a taxable distribution, subject to taxation and the early withdrawal penalties previously discussed.

Financial decisions vary for each individual and there is not a one-size-fits-all answer that is right for everybody. You should weigh each of the four aspects of this question to determine the best option for you. (Get a look at your financial health by checking your free credit report snapshot on Credit.com.) Retirement plans and taxation are complex, so we recommend seeking the advice of a certified financial planner and a certified public accountant before making your elections. (Disclosure: I am a financial planner.)

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Can I Still Contribute to an IRA & Get a Tax Break for 2016?

Can you contribute to your IRA and still get a tax break? Here's what you need to know.

Individual Retirement Accounts (IRAs) are an excellent means to save for retirement. You have until the tax-filing deadline (generally April 15) to make a contribution to your IRA for the previous tax year.

There are two types of IRAs: Traditional IRA and Roth IRA. The maximum contribution is the lesser of $5,500 ($6,500 for those aged 50 and over) or your earned income. This is a combined limit for all IRA contributions in a year (in either or both types). In order to contribute to a Traditional IRA, you must be under age 70½, but you can contribute to a Roth IRA at any age. You can learn more about IRAs here.

Whether you can contribute to an IRA and how much you can contribute depends primarily upon two factors: 1) your Modified Adjusted Gross Income and 2) whether you (or your spouse) participate in an employer-sponsored retirement plan.

Adjusted Gross Income (AGI) is the number listed on line 37 at the bottom of the first page of your Form 1040. In order to determine IRA contribution limits, AGI must be adjusted by adding back certain items that were deducted to arrive at AGI. Items added back to AGI include deductions taken for traditional IRA contributions, student loan interest, college tuition and fees, and some other less common items. The final result is Modified Adjusted Gross Income (MAGI).

Here’s how to know if you can deduct your IRA contributions this year.

Traditional IRA

While anyone under age 70½ with earned income can make non-deductible contributions to a Traditional IRA, deductible contributions are not as certain. If you are single and not covered by a plan at work or you are married and neither you (nor your spouse) have a plan at work, then your full contribution up to the annual limit is deductible.

However, if either you (or your spouse) participate in an employer retirement plan, your deductible IRA contributions may be limited or even completely eliminated. To determine if you are covered by work, you can look at your W-2. If there is a check next to “Retirement Plan” in Box 13, then you are covered. This chart on the IRS website illustrates deduction limits for both single and married taxpayers covered under an employer’s plan at work.

Roth IRA

While there are no age restrictions on who can contribute to a Roth IRA, there are income constraints that must be observed. Unlike Traditional IRA rules, Roth IRA regulations do not consider whether you have an employer plan. The only factor is your MAGI. Again, you can find the chart showing the income levels that affect Roth IRA contribution limits on the IRS’ website.

Kay Bailey Hutchison Spousal IRA

A Spousal IRA is not a third type of IRA but a provision for spouses without enough earned income to fully fund a Traditional or Roth IRA on their own. Named for the former United States Senator from Texas, the Kay Bailey Hutchison Spousal IRA allows a spouse with little or no earned income to have his or her own IRA account by qualifying with the working spouse’s income.

The Spousal IRA limits are the same as the Traditional and Roth limits ($5,500 or $6,500 if aged 50 or over). So the total combined contributions for both spouses are $11,000 or $13,000, if aged 50 or over. The working spouse must have earned enough money to fund both contributions.

Saving for retirement is more important than ever. (You can see if you have enough shored up here and keep tabs on your finances by viewing two of your credit scores, with updates every two weeks, on Credit.com.) If you don’t have a retirement plan, it’s never too late to start one. But knowing the rules is a critical step for a successful plan. Tax laws are complicated, and penalties for mistakes can be costly. Make sure you seek out the guidance of a tax professional before making important financial decisions.

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Financial Adviser or Financial Planner: What’s the Difference?

A financial planner explains what to look for when asking someone for help managing your money.

The financial world is full of confusing acronyms and titles, and it seems everyone touting financial advice has a myriad of bewildering designations after their name. One of the most widely used titles is financial adviser. This label is problematic because it is generic and entirely too broad.

Insurance agents, stock brokers, investment advisers, accountants, bankers, and even some attorneys often refer to themselves as financial advisers. The term is so expansive that it typically covers any area of financial assistance. Unfortunately, there is no regulatory guidance or rules for using such a title. So, when you hire a financial adviser, you should also ask about any areas of specialization. You might find that if you want to hire someone who charges a fee for financial advice, your insurance agent — who calls herself a financial adviser — will not be able to help you.

When people ask me what I do for a living, I say, “I am a financial planner.” They typically respond by saying something like, “Oh yes, my financial adviser is with XYZ Company.” This always makes me cringe a bit because I am not just a financial adviser, but I specialize in financial planning. While financial adviser is a broad category, a financial planner — specifically a Certified Financial Planner (CFP) — specializes in providing comprehensive financial planning services (Full disclosure: I am one). Granted, your financial planner may also offer financial products like insurance or investments, but the key difference is he prepares a comprehensive written financial plan.

There are primarily two reasons why hiring a financial planner is important.

1. It minimizes some conflicts of interest. 

Several years ago, a potential client told me I was the third financial adviser he had interviewed. He said the first two said they would provide retirement projections for him at little or no cost. He wondered why I charged a fee for the plan I provide. I asked him one simple question: “How do you think they will be compensated for their time and expertise?” The answer was clear. They had to sell him something in addition to the plan to make the engagement worth their while.

You expect to pay your physician for his advice, and would never go to one who only is compensated if you fill the prescription that he writes. When I deliver a custom financial plan and am paid for my time and expertise, the plan stands on its own. I do not need to sell additional products or services. If the client decides to implement the plan with me, I can certainly help. If, however, he goes elsewhere, it was a fair and profitable engagement for me; I have already been paid for my advice and the client has a working plan.

2. A comprehensive written financial plan can uncover often overlooked but critical financial issues.

Imagine going to your physician with a complaint of chest pain. After the obligatory blood pressure and pulse readings, he places his stethoscope on your chest, listens to your heart and states, “Let’s schedule you for open-heart surgery tomorrow morning.” What would you think? Obviously, you would want some additional testing before jumping to the conclusion that you need open-heart surgery. Just as recommending surgery without a comprehensive medical exam would not be wise, providing investment advice without a full fiscal exam is equally imprudent.

Tax laws are complex, the investment landscape is volatile, and changes in one part of your plan could wreak havoc on another part. You should have a plan that covers all areas of your financial life and clearly shows how each area is impacted by your decisions to implement one or more financial strategies. Just completing a two-page investment questionnaire from your financial adviser is not enough to ensure high-quality financial advice.

[Editor’s note: Knowing your credit score is a key part of understanding your financial health. You can see how you’re doing with our free credit report snapshot, which includes two free credit scores, updated every 14 days.]

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its partners.

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7 Documents You Need to Fill Out Before You Die

Here's a list of all the important estate planning documents you'll want to compile.

Estate planning is the process of establishing a framework to manage your assets upon death, disability or incapacity. It involves creating documents that outline your wishes. While estate planning is not a pleasant task, it is critical that you implement it before you need it.

Here are seven critical documents necessary to cover the aspects of a well-devised estate plan.

1. Last Will & Testament

The fundamental purpose of a will is to outline who will receive your assets upon your death. Another important purpose of a will is to specify guardianship for your minor children. A guardian is one who takes legal responsibility for the care of your minor or incapacitated children after you are gone. It is important to understand that a will does not become effective until the date of death. So it does not provide any benefits during your lifetime. A will can be changed at any time (assuming you are not mentally incapacitated). It can be amended by using a codicil or revoked by writing a new will. A will can also create a trust upon your death (more on this below). If your estate is large enough (over $5.49 million in 2017), you may also need to incorporate federal estate tax planning into your documents.

2. Trust

A trust is a legal instrument that provides ongoing management for your assets. It can be inter vivos (also known as a Living Trust, which exists during your lifetime) or Testamentary (one that is created by your will upon your death). It is a good idea to leave assets in trust if the beneficiaries are minors, incapacitated, or if they are simply not fiscally responsible. The trust document names a trustee who has the responsibility of managing the assets in the trust and determines when and how much of the trust assets to distribute (subject to the terms you have written in the trust). You may want to name a trustee while your child is under a certain age, say 25 or 30. Then, once your child reaches that specific age, they can either act as their own trustee, or the trust can terminate and distribute all of the assets to your child outright.

3. Power of Attorney

A Power of Attorney allows you to empower someone else to act on your behalf for legal and financial decisions. It can be a Durable Power of Attorney, which becomes effective immediately, or a Springing Power of Attorney, which becomes effective upon a stipulated event, typically when you are disabled or mentally incompetent. It is critical that you completely trust the person to whom you provide this power, as he or she can legally act on your behalf.

4. Healthcare Power of Attorney

A Healthcare Power of Attorney (also known as a Medical Power of Attorney) gives a trusted individual the authority to make decisions about your medical treatment should you be unable to do so on your own. No financial authority is granted in this document, only medical power. So you could provide one person the Durable Power of Attorney and another person the Healthcare Power of Attorney if you desire.

5. Living Will

While the Healthcare Power of Attorney authorizes another to make medical decisions on your behalf, a Living Will (also known as a Directive to Physicians) sets out your predetermined wishes regarding end-of-life care should you become terminally ill or permanently unconscious. Essentially it takes the decision to withhold life out of the hands of your medical providers and the ones you love so that they are not burdened by it and so that you can be assured your wishes are respected.

6. HIPAA Release

One of the important provisions of the Health Insurance Portability and Accountability Act of 1996 (HIPAA) is the obligation that medical records be kept confidential. While this is definitely an important requirement, it can have severe unintended consequences. Without the legal authority to share medical records, your family may not be able to obtain important information regarding your medical condition and treatment if you were to become incapacitated. A HIPAA release allows your medical providers to share and discuss your medical situation with whomever you specify in the document.

7. Letter of Intent

A Letter of Intent is a simple, non-binding personal letter to the ones you love expressing your desires and special requests. It may include information regarding burial or cremation, or a specific bequest of collectibles or personal items. While it does not typically have legal authority, it can help to clear up confusion regarding your personal preferences.

Estate planning can be complex and the laws vary widely by state. This article is general in nature and is not meant to provide legal advice. I recommend that you engage the services of an estate planning attorney to discuss your wishes and prepare the appropriate documents.

[Editor’s Note: You can find more on estate planning here. There are also some tips to ensure your debt after death doesn’t harm your family here. Also, it’s a good idea to get your free annual credit reports every year so there are no surprise debts that need to be addressed. You can get a free credit report summary every 14 days on Credit.com.]

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How to Pick the Right Healthcare Plan for You

Choosing medical coverage can be daunting. Here's how to select a healthcare plan.

Selecting a health insurance plan that works for your family can be an overwhelming task. However, there are four critical steps you can take to make certain that the plan is right for you and your family.

1. Network

Ever since managed care took over the health insurance industry in the 90s, insurance plan networks have become a critical part of selecting the “right” plan for you and your family. All of the major insurance companies offer online directories for finding medical providers. Those directories, however, can be very confusing. While you may find your physicians are contracted through your insurance company, you might be terribly disappointed when you schedule an appointment only to find that they are not on the sub-network that your plan utilizes.

Insurance companies normally have several different networks and your doctors may not belong to all of them. I have found that the simplest way to find out if your providers are on the network is to call their offices directly and provide the name of the insurance company and the name of the network you will be using. The other piece of information you will be able to glean is if your doctors will be participating in that network in the upcoming year. This will not usually be indicated on the insurance company’s website. Contracts between insurance companies and medical providers change constantly, and a network that includes your physicians this year may not include them next year.

2. Benefits

Many benefits that used to be optional are required to be included by the Affordable Care Act (a.k.a. the ACA, or Obamacare). For example, mental health benefits, maternity coverage and guaranteed coverage without pre-existing condition limitations are currently all mandated by law. These standardized benefits may not last if the ACA is partially or fully repealed.

While many benefits are standardized, benefit levels are not. There are typically three types of policy benefits you will need to consider when selecting a plan. It is very important to read the Summary of Benefits and Coverage for your selected plan before you make this important decision.

  • A deductible is the amount of money you must pay before any expenses will be covered by your insurance company. The deductible typically resets on January 1st of each year. So, if you have a $1,000 deductible, you will have to pay the first $1,000 of eligible expenses, and the insurance company will start paying a portion of the next expenses incurred in that calendar year (see co-insurance, below). Generally, the higher the deductible, the lower the premium. So if you want to save money on your monthly premiums, you can select a higher deductible. There may also be a separate per-stay deductible if you need hospitalization or go to the emergency room. Sometimes, the deductible will be waived and a smaller copay will be required upon each visit to the doctor. The amount of the co-pay will vary by plan. Typical co-pays range from $25 to $100 per visit.
  • Co-insurance is the split between what the insurance company pays and the expenses for which you are responsible after the deductible has been paid. You might select a plan that pays 80% of approved medical expenses after your deductible has been satisfied. You would then be responsible for the other 20% of expenses. A plan that only pays 50% of expenses (with you paying the other 50%) would generally cost less than the aforementioned 80%/20% plan. This sharing stops and the insurance company pays 100% of the remaining charges when you have reached the out-of-pocket maximum. This limit is expressed in a dollar amount and includes all of your deductible and co-insurance payments. A typical out-of-pocket maximum might be $4,000 per person, with an $8,000 family limit. So if you have a family of four and each had expenses of $2,000, the family limit would be reached even though no one person reached their individual limit.
  • The final benefit selection you will need to make is for prescription drug coverage. Some plans cover prescription drugs just like any other medical expense, subject to the deductible and co-insurance described above. Other plans might waive the deductible and co-insurance but require a separate co-pay each time you refill a prescription. Since name-brand drugs are more expensive, the co-pay is usually higher. Generic drugs, however, cost less so they enjoy a lower co-pay. Finally, there may be a separate prescription drug deductible, which must be satisfied before any co-pay applies.

3. Insurance Company

The strength of the insurance company backing the policy you choose is just as important as the network or benefits selected. There is a misconception that Obamacare is an insurance policy backed by the government. Each policy is still underwritten by an insurance company, not the federal government. Since claims are paid by the insurance companies, you should check out the financial strength of the company. Several rating agencies evaluate the financial strength of insurers, including Moody’s, A. M. Best and Fitch Ratings. Look for companies with an “A” or better rating from all three rating agencies. (You can check your own credit rating for free by viewing your free credit report snapshot, updated every 14 days, on Credit.com.)

4. Premiums

The premium is the monthly amount paid to the insurance company in return for the policy benefits purchased. All of the factors discussed above will work together to determine the premium required for your insurance coverage. And while your health, medical history or gender can’t affect your premium, a few other factors can. Premiums increase with age and as family members are added to the plan. Premiums can also vary widely based upon where you live in the country or even within your own state. Rates are determined, in part, by the medical expenses in your particular zip code. The insurance company can also charge more if you use tobacco.

While deciding on the correct medical insurance plan can be tedious, balancing these four critical details can help you make an informed and appropriate selection.

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What Your Family Needs to Know About Your IRA Distributions

ira-distribution-after-death

Things become complicated upon an IRA owner’s death. If the account holder dies before his required beginning date, or RBD, there is no required minimum due for that year. If, however, the participant dies after his RBD, the beneficiaries must take his final required minimum distribution (RMD) before December 31 of the year of death. If it is not taken, the 50% penalty applies.

After the year of death, the beneficiaries now are obligated to take their own RMDs annually. While the requirement for lifetime minimum distributions is commonly recognized, many people are unaware that RMDs continue after death. If the correct RMD is not taken, the same 50% penalty is assessed on the beneficiaries.

The rules for these required distributions are determined by two broad factors:

  1.  Whether the participant had reached his RBD before death
  2. The type of beneficiary: spouse, non-spouse, trust or estate

Roth IRAs do not require lifetime RMDs. However, upon the death of a Roth IRA owner, the beneficiaries are required to take RMDs or face the same stiff 50% penalty.

Death Before the Required Beginning Date

First, we will assume that RMDs have not yet started prior to the participant’s death (he died before reaching age 70½, leaving his wife as the beneficiary). In this scenario, the spouse would have three options:

  1. Treat the IRA as her own and follow the RMD rules for her own IRA
  2. Start distributions when the participant would have turned age 70½ using her current age each year to determine the correct life expectancy factor from Table I
  3. Take any amount each year, but take the entire balance December 31 of the fifth year following the spouse’s death (known as the five-year rule)

If the goal is to defer taxes as long as possible, the five-year rule is probably not ideal since the entire account will be liquidated and all taxes paid within five years, which may be significantly shorter than the life expectancy of the beneficiary. However, if no distributions are made in the year after death, this option becomes the default.

It is important to remember that RMDs are just that: required minimum distributions. Any of the affected parties can always take out more than the minimum required. So electing an option that provides for the lowest minimum distribution offers the best planning opportunities. It provides the absolute least that must be taken without penalty, without compromising the option to take more at any time.

A non-spouse has two options if RMDs have not yet started prior to the IRA owner’s death:

  1. Distribute the balance by using the Table I factor corresponding to the beneficiary’s age on December 31 in the year following the owner’s death. Each subsequent year, she would reduce the previous year’s factor by one (rather than using the factor for the new current age each year)
  2. Assets can be distributed using the five-year rule.

The only option available to trust or estate beneficiaries when RMDs have not yet commenced is the five-year rule. The estate is automatically the presumed beneficiary if there is no beneficiary listed. So, it is critical that the participant names both a beneficiary and a contingent beneficiary in order to preserve the tax deferral available using the life expectancy option above.

Death After the Required Beginning Date

If, however, the participant had already started RMDs prior to death, a separate set of rules apply. Again, the spouse enjoys the most flexibility. Her options include:

  1. Treat the IRA as her own (like the previous scenario)
  2. Distribute the balance over her life using her current age each year to determine the factor used in Table I
  3. Distribute the account based on participant’s age as of his birthday in the year of death (if he died prior to his birthday, add one year to his age) using Table I. Then each subsequent year, reduce the previous life expectancy factor by one.

While a spouse has several options to continue pre-death RMDs, a non-spouse is left with only one option. They must use the younger of:

  1. Their age at year end following the year of the owner’s death or
  2. The owner’s age at birthday in year of death

To calculate the RMD, divide the account balance by the life expectancy factor that corresponds to that age in Table I. Each subsequent year, reduce the previous life expectancy factor by one (as opposed to looking up the new current age each year).

If multiple beneficiaries are named, it is best to establish separate accounts for each beneficiary at death so that each can utilize their own life expectancy factor. A single beneficiary account will force all of the beneficiaries to use the oldest beneficiary’s age to determine RMDs for all of them. This will force higher RMDs than necessary for the younger beneficiaries, which will accelerate taxation.

A trust or estate beneficiary has the same single option as a non-spouse, with one modification. Since a trust is not a natural person with a life expectancy, it cannot use the beneficiary’s age but is forced to use the participant’s age as of his birthday in the year of death to find the corresponding Table 1 life expectancy factor. Some Trusts can be drafted to include a “look-through provision” that names a qualified individual beneficiary or beneficiaries that qualify as individuals. However, if the estate is named, or no beneficiary is named at all, this rule applies.

In my many years as a Certified Financial Planner practitioner, I have come across situations where individuals were provided inaccurate advice from bankers, stockbrokers and even financial planners. IRA distribution planning is very complex. It requires a high level of expertise in order to make the best decisions that minimize taxes and penalties and provide the most flexibility for the individuals affected. Since the general information provided in this article is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice, I highly recommend that you consult with a Certified Public Accountant and a Certified Financial Planner professional before making any of these critical financial decisions.

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5 Things You Must Know About Lifetime IRA Distributions

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Individual Retirement Accounts, or IRAs, are wonderful retirement accumulation vehicles. Contributions are generally tax-deductible (with limitations), and the assets in the accounts grow without the burden of taxation until withdrawn. Distributions are generally taxed the same as earned income. Roth IRAs are similar to Traditional IRAs in that the account also grows free of income taxation. However, contributions are not tax-deductible and qualified distributions are generally income-tax free. For the purpose of this discussion, I will primarily focus on lifetime traditional IRA distributions.

1. There Is a 10% Penalty Tax

Since Congress designed IRAs for retirement needs, and not for pre-retirement vacations or mid-life crisis Porsches, there is a 10% penalty tax imposed on the taxable portion of withdrawals taken prior to age 59½ (with a few limited exceptions). While the pre-59½ rule limits early distributions, there is also a rule that forces distributions to be taken later in life. This rule prevents the accountholder from overusing the tax deferral provided by the plan. Generally, April 1st of the year after the accountholder turns age 70½ is the Required Beginning Date (RBD) for withdrawals. This is when the first Required Minimum Distribution (RMD) from the plan is due. An individual reaches age 70½ six months following their 70th birthday. If you turn age 70 between January 1 and June 30, you will turn 70½ during that calendar year. If your birthday is between July 1 and December 31, you will turn 70½ in the following calendar year.

2. The RMD Must Be Taken Annually

The RMD must be taken annually by December 31 each year thereafter using the year-end value of the IRA of the previous year. It is important to note that the first RMD can be taken in the actual year that the participant turns 70½. The following year’s April 1st deadline is actually sort of a first-year grace period. If the first RMD is delayed until April 1st (as opposed to taken by December 31 of the 70½ year), another RMD is due by December 31 of that same year. So it may actually make sense to take the first RMD by December 31 of the year in which the participant actually turns 70½ instead of waiting to avoid two withdrawals in the same calendar year and possibly increase taxation by potentially pushing the participant into a higher tax bracket.

3. There Is a 50% Penalty If the Accountholder Doesn’t Take the RMD

If the accountholder does not take the required minimum amount, a 50% penalty is imposed on the portion of the required amount that was not taken. That is not a typographical error. The penalty is really 50%. This penalty is in addition to the normal income tax payable on the distribution. The purpose of this Required Minimum Distribution, at least theoretically, is to liquidate the entire balance of the retirement account by the end of the participant’s lifetime. In order to do this, the IRS has developed three Life Expectancy Tables (see below). Table I applies to RMDs after the death of the participant, while Tables II and III applies to required distributions during the participant’s lifetime.

4. There’s a Specific Way to Determine the Lifetime RMD

The lifetime RMD is determined by dividing the account balance as of December 31 of the previous year by the factor on Table III of the IRS Publication 590 Life Expectancy Tables, corresponding to the age of the account owner. If, however, the sole beneficiary of the account for the entire year is a spouse who is more than 10 years younger than the participant, Table II must be used. For subsequent years, the new attained age for that year is used to determine a new RMD divisor in the same Table that was used in the first year. In other words, increase the age by one year and look up the corresponding new life expectancy factor each year.

5. Lifetime RMDs Do Not Apply to Roth IRAs

It is important to note that the lifetime RMDs generally apply to Traditional, SEP, and SIMPLE IRAs, but do not apply Roth IRAs. (The RMD rules vary somewhat for employer-sponsored retirement plans like 401Ks, 403Bs, pension plans, and government plans, which are not covered in this discussion.) If the participant owns multiple IRAs, the values must be combined to determine the correct RMD, but withdrawals can come from any or all of the accounts.

[Editor’s Note: Saving for retirement is an important part of any financial plan, and so is improving your credit. You can monitor your financial goals, like building a good credit score, each month on Credit.com.]

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Do You Need Disability Insurance?

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Imagine you had a machine that sat in the corner of your office and generated the equivalent to your entire annual salary. It dependably spits out money, month after month, year after year, without fail. Would you purchase a warranty on that machine? Would you call your insurance agent and buy an insurance policy to protect your money machine? Of course you would.

Well, that machine is you. A disability policy provides the assurance that your “machine” can continue to generate a consistent income each and every year, if you become sick or injured and unable to work. Most of us have purchased a life insurance policy or have one that is provided to us at work. However, many do not own any disability insurance, or are woefully underinsured. I believe that disability insurance is equally important, if not more vital than life insurance. Whether you are married, single, with or without children, owning a disability insurance policy is critical to your financial security if you rely on your earned income to pay your bills. Once you can afford to retire, you no longer have the need for coverage and can let it go. (Full Disclosure: As a Certified Financial Planner, I do sell disability insurance.) 

How Much Do I Need?

You should own enough disability insurance to pay your non-discretionary expenses. If disabled, you might not be able to afford vacations or entertainment, but you will still need to pay your mortgage or rent and utilities. [Editor’s note: Failing to pay loans and everyday bills can seriously damage your credit scores and subject you to debt-collection activity. To keep an eye on how your credit is faring, you can get two free credit scores with regular updates from Credit.com.]

In my experience reviewing my clients’ policies, most disability insurance companies limit the payout to 60% to 75% of your pre-tax income. The reason for this limitation is that they do not want to incentivize you to become disabled. Obviously, most of us do not want to be disabled, but fraudulent claims are always a possibility with unscrupulous people. If you pay the disability insurance premium with after-tax income, then a 60%-to-75% benefit could replace most, if not all, of your after-tax take home pay.

What If I Already Have Benefits at Work?

If your employer provides disability insurance for you, consider yourself one of the fortunate few. According to 2014 data from the Bureau of Labor Statistics, only a third of American workers (in the private sector) have long-term disability through their employer.

If your income includes a bonus, chances are that bonus is not covered. As I review my clients’ employee benefits, I have seen that most of the disability benefits only cover the base salary and do not include the bonus. So if your total compensation of $70,000 comprises $60,000 in base salary and a $10,000 bonus, your annual benefit would likely be between $36,000 and $45,000. If your employer pays all of the cost of this benefit, then the disability payments to you would be fully taxable. You could, however, purchase additional coverage on your own to cover the bonus. Typically you might qualify for at least an additional $7,000 to cover your bonus, bringing your total disability benefit up to $43,000 to $52,000 per year.

Disability insurance isn’t cheap: There are many factors, including age, gender and occupation, that can significantly affect the premium; you can easily pay 1% to 3% of your annual income for it, but not having it when you need it could be devastating to your finances.

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