Money Management Q&As

March 3, 2006

A less-taxing way to rebalance

Q. I initially divided the mutual fund portion of my taxable portfolio among three funds in roughly equal amounts, and I'd like to restore that original allocation. But one fund really mushroomed last year and now represents two-thirds of my portfolio. How can I minimize the capital gains tax I'll owe when I rebalance?

A. Don't sell any shares. Instead, invest additional money in the other two funds until they all contain the appropriate amounts of assets. If that's just not practical, compare the prices you paid for the shares you bought at various times. You can probably minimize your gain by telling the mutual fund company that you want to sell the highest-priced shares first. (Note that you can do this only if you haven't previously averaged your cost for all the shares to figure capital gains on past sales.) Make sure the fund sends you written confirmation of this election.

Why a Roth could cost you

Q. In 2003, I converted a traditional IRA at my bank to a Roth account. Now I want to withdraw some of the money, but a bank employee says I'll owe a penalty tax on it because I'm under 59½. Since I paid tax on the funds when I converted, how can the IRS hit me a second time?

A. To discourage taxpayers from using IRA funds for purposes other than retirement, the rules call for additional tax on converted amounts withdrawn from a Roth account under certain conditions.

Generally, a 10 percent penalty tax applies to any portion of the amounts that were taxable when you originally converted the traditional IRA to the Roth, if you withdraw them within five years of conversion-in your case, before Jan. 1, 2008. You may escape this tax if you're 59½ or older, disabled, or meet certain other exceptions when you make the withdrawal.

But under a second rule, if any of the funds you withdraw are counted as earnings growth, they'll be subject to income tax at your ordinary rate unless one of the exceptions applies. For a complete list of those and a worksheet that will help you figure out what portion of the distribution would be taxable, see IRS Publication 590, "Individual Retirement Arrangements (IRAs)," at http://www.irs.gov/pub/irs-pdf/p590.pdf.

Claiming exemption from withholding

Q. Last summer, my 16-year-old son earned $90 a week from a job. He had to file a tax return to get a refund, because his employer withheld part of his wages. If the boy works this summer, can he get an exemption from withholding so he won't have to file?

A. Yes, if he didn't owe any tax for 2005 and his total income in 2006 won't exceed $5,150, including no more than $300 from savings and investments. Your son should fill out a Form W-4, writing the word "exempt" on line 7, and give it to his employer.

What if your son's investment income tops $300? Then he can't claim a withholding exemption unless his total income from all sources will be $850 or less.