Which way to borrow on home equity? Some swans can turn into ugly ducklings; Using IRA funds for high school expenses; Payments to your ex aren't always alimony; Skimpy home insurance may trap you; Retracing your steps after a Roth conversion; Is it a repair or an improvement? If a pension plan starts in midyear
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Q: I need to raise some cash and wonder whether to open a home equity line of credit or take out a second mortgage. What should I consider in comparing the two?
A: When looking at annual percentage rates, keep in mind that the APR for a traditional second mortgage loanwhich a banker may refer to as a "closed end" loantakes into account the interest rate plus points and other finance charges. The APR for an equity credit line, an "open end" loan, is based on the periodic interest rate alone, so it doesn't reflect up-front costs (which typically run about the same amount for both loan types).
Also consider the difference in flexibility. With a closed-end loan, you borrow a fixed amount and generally make equal periodic payments of principal and interest over a set term. An open-end equity line lets you borrow as needed (up to a predetermined limit) at a rate based on a fluctuating index plus an add-on percentage ("margin"). The lender may let you delay repaying principal until a specified date, at which time you'll have to come up with the balance due or refinance the debt at the going rate. It may also charge you an annual fee for renewing the credit line.
Other things being equal, lean toward a credit line if your future financial requirements are uncertain, but favor a fixed mortgage if you have a particular purpose in view.
Q: My search for stocks that pay high dividends has uncovered several natural resources issues with exceptionally handsome yields. Is there something unusual about natural resources stocks?
A: If you're referring to stocks like BP Prudhoe Bay Royalty Trust or San Juan Basin Royalty Trust, Yes. Royalty trusts provide capital to companies owning natural resources. In return, the trusts get a percentage of the companies' operating income and pass almost all of these royalties on as dividends to investors. In the short run, yields rise or fall as commodity market prices vary. Over the longer term, resource depletion inevitably causes royalties and dividends to decline, shrinking the value of the trust shares. On the positive side, the dividends may qualify for favorable tax treatment.
Don't be dazzled by outsize current yields. Look for a trust with a stable dividend history and royalties based on resource assets with a long life expectancy.
Q: Our son, a high school student, is the beneficiary of an education IRA. Can he take tax-free withdrawals from the fund to cover his school expenses?
A: Yes, provided the money from the IRA (officially called a Coverdell Education Savings Account) goes for tuition, books, supplies, and computer equipment, Internet access, and software intended mainly for educational rather than recreational purposes. Also included are outlays for room and board, uniforms, and transportation, if the school furnishes or requires them.
Q: My wife and I are divorcing and we've agreed that I'll pay her alimony of $30,000 annually for 15 years, which totals $450,000. If she dies before the end of the period, she wants the unpaid balancethat is, $450,000 minus the total she received while she livedto go to her estate. Will I be able to claim an alimony tax deduction for the entire $450,000?
A: No. In fact, none of it will be deductible. Payments aren't considered alimony if they must continue after your wife's death. That restriction applies not only to the lump sum her estate would get, but also to the series of payments made before her death. Under the arrangement you describe, your wife wouldn't be taxed on the payments during her lifetime and you couldn't write them off.
Q: A mortgage broker says I can save money on home insurance by limiting the coverage to the amount of the loan. Should I take his advice?
A: Not without checking your homeowners policy. Many policies include a "coinsurance" provision that could reduce compensation for a partial loss when you insure your property for less than 80 percent of replacement value. Suppose you base your coverage on a loan amount that equals only 60 percent of the house's full value. If a fire caused damage costing $40,000 to repair, say, the insurer might pay you only three-fourths (60/80) of that, which is $30,000. Better talk with your insurance agent or consultant before you decide on the policy figure.
Q: The roof of a rental unit I own has sprung several leaks. I called in a roofer to repair them, but he recommended putting a new coating over the entire roof to prevent future leaks. Can I deduct the full $10,000 cost for 2004, or must I depreciate it annually as an improvement?
A: You have a good argument for writing off the cost as a one-time repair rather than a capital improvement. IRS Publication 946 states that "if a repair or replacement increases the value of your property, makes it more useful, or lengthens its life, you must treat it as an improvement," and it mentions a new roof as an example. However, in a case similar to yours, the Tax Court allowed a deduction as a current expense, because "the only purpose in having the work done to the roof was to prevent the leakage and keep [the] property in operating condition, not to prolong the life of the property, increase its value, or make it adaptable to another use."
Q: My traditional IRA consists of stocks with high growth potential, and I can convert it to a Roth account this year if, as I expect, my adjusted gross income doesn't top $100,000. Since I'll owe tax on the distribution when I do that, I'd like to make the move before the portfolio's value goes up further. But will I be penalized if it later turns out that my 2004 AGI is above the limit?
A: Not if you reverse the conversion by making a trustee-to-trustee transfer from the Roth account to a non-Roth IRA by the due date of your 2004 tax return, including extensions. No tax will be due on the previously converted amount or any earnings accrued on it while in the Roth account.
Q: My corporation adopted a profit-sharing plan on July 1 of this year. My annual salary for 2004 is $240,000. What's the most the corporation can contribute for me?
A: $25,625. The maximum an employer can contribute for any participant in a profit-sharing or other "defined contribution" plan is 25 percent of compensation, but the amount of earnings that can be taken into account for this purpose is capped. The 2004 limit is $205,000, but it's reduced to half in your case, because the plan wasn't in existence the first six months. Since 25 percent of $102,500 is $25,625, that's the maximum possible contribution for you this year. The annual limit is indexed for inflation, so it may be higher than $205,000 for next year.
Do you have a money management question that may be stumping other doctors, too? Write: MMQA Editor, Medical Economics, 5 Paragon Drive, Montvale, NJ 07645-1742, or send an e-mail to firstname.lastname@example.org (please include your regular postal address). Sorry, but we're not able to answer readers individually.
Lawrence Farber. Money Management Q&As.
Aug. 20, 2004;81:65.