Until about a decade ago, retirees desiring to convert equity in a home into cash could either sell the home or borrow against it. Now there’s a new financial technique. Reverse mortgages provide retirees with a third way of extracting money from a home—without having to move or make monthly loan payments.

TIP: Reverse mortgages generally make the most financial sense for retired homeowners who have high-value homes and who expect to outlive their life expectancies.

What Is A Reverse Mortgage?

A reverse mortgage is a loan against a residence that need not be repaid as long as the borrower lives in the residence. The proceeds of the loan can be paid to the borrower in a lump sum, in monthly or other periodic payments, or as a line of credit.

The loan proceeds must be repaid when the homeowner dies, sells the home, or moves.

Who Can Obtain A Reverse Mortgage?

Homeowners must be at least 62 years of age to be eligible for most reverse mortgages. To obtain a reverse mortgage, all owners of the home must undergo the application process and sign the note. The home must be the owners’ principal residence. Other than mobile homes and co-ops, most types of residences are eligible.

Reverse Mortgages Are Expensive

A major negative of reverse mortgages is that, because there are no monthly loan payments, the amount owed grows over time. Thus, the amount of equity that will remain after selling the home and paying off the loan diminishes over time. (However, the borrower cannot owe more than the home's value at the time of repayment.) Reverse mortgages are most costly in the early years of the loan and become less costly over time. The overall cost of borrowing can be very high in the short term, but less costly if the borrower lives beyond his life expectancy.

Who Offers Reverse Mortgages?

Reverse mortgages are offered by state and local governments or by banks, mortgage companies, and savings associations. Each type of program has various restrictions and limitations.

The amount of cash that home can generate under a reverse mortgage depends on your age, the home's value, the cost of the loan, and the loan program used.

TIP: Generally, the largest cash advances are obtained from the federally insured Home Equity Conversion Mortgage (HECM). This is usually the least costly of private sector reverse mortgage programs.

Conclusion

Because of the complex financial, estate planning, and income tax issues that can be involved in reverse mortgages, the advice of a professional is a must.

It’s a good idea to check with credit bureaus periodically to make sure their credit records on you are correct. To get a copy of your credit report from each of the three main credit bureaus, call, write, or visit their websites, and request a report. The report is free under certain circumstances.

• Equifax: Telephone 800-685-1111.
• Experian(previously TRW): Telephone 888-EXPERIAN (888-397-3742)
• Trans Union: Telephone 800-916-8800.

The best course of action is to request a report periodically from each of the three bureaus. Check the reports carefully. If you find an error, write to the bureau requesting a correction. If the bureau doesn’t agree to fix the mistake, you have the right under federal law to add a statement to the credit report, disputing the information. Or you can ask the creditor who reported the error to correct its report.

Insurance not only can provide protection in case of death but can also function as an investment. Although many insurance companies offer a wide range of policies, there are really only two basic types of coverage: (1) term insurance and (2) policies that generate cash values. The choice of insurance product depends, of course, on what you wish to accomplish.

(1) Term coverage: Term life insurance provides death protection for a specific time period. Premiums are based on the insured's age and may increase each year, but they are generally cheaper than other types of insurance such as whole life (discussed below). Some forms of term insurance include:

• Renewable insurance, which many be renewed at the end of the term without having to take a new medical exam. The renewal rate is usually higher than the original premium.
  
  
• Convertible insurance, which permits conversion into a cash-value policy without regard to changes in health.
  
  
• Decreasing term insurance, which is term insurance with a constant premium and a declining face value. Such policies are commonly used for paying off a mortgage.

(2) Cash-value insurance: Life insurance may be used to generate a forced savings or a rate of return as an investment.

• Whole life: One of the most popular forms of insurance is whole (or permanent) life insurance. It provides coverage for the insured's life as long as a constant premium is paid. The premium both pays for the insurance and builds up a cash value return. Usually the policyholder has the right to (1) borrow the cash value at good interest rates, or (2) terminate the policy and receive the cash value.
  
  
  TIP: The cash value's rate of return may be below what is available from other investments.
  
  
  
• Universal life: Universal life insurance combines a renewable term policy with a cash value feature. Many such policies guarantee a minimum interest rate of return. After you pay the first year's premium, the accumulated cash value can be used to pay the premium. You have the choice as to whether to make further payments (within certain limits). Also, many such policies allow you to select either a death benefit that is constant while the policy is in effect or one that increases according to changes in the policy's cash value.
  
  
• Variable life: This type of insurance provides a variety of investments for a fixed premium. The death benefit will reflect the investment's performance (i.e., the increase or decrease in cash value). These policies are securities that have prospectuses filed with the SEC.
  
  
• Universal-variable life: This combines the flexible premiums of universal life with the investment choices of variable life.
  
  
• Single-premium life: This is paid for only once. Its cash value can be invested in a variety of ways, but the return may not be guaranteed. A holder of this type of insurance may also be able to borrow against the cash value at low (or no) interest rates after the first year.

We have only outlined general considerations in analyzing the amount of insurance that's right for you. You should seek the advice of a professional for your specific concerns. Further, it is vital that the estate planning implications of owning life insurance (not addressed here) be discussed with your tax advisor.

You can deduct for business transportation using your car, at a flat rate per mile. With gas prices currently below 2005 peaks, IRS has decreased the rate. The per-mile rate of 48½¢ for September 1 through December 31, 2005 is reduced to 44 ½¢ for 2006 business driving.

Employers who reimburse employee business driving expenses can use these rates. The employer can deduct reimbursement at these rates, and the employee pays no tax on the reimbursement, if the employee substantiates time, place, business purpose and mileage for each trip.

Note: The flat rate covers all expenses for maintenance, but you can deduct related tolls and parking fees in addition. Using the flat rate is optional. You can instead deduct specific expenses for gas, oil, insurance, upkeep, repairs, depreciation or lease payments, registration and other cost elements (including tolls and parking), to the extent allocable to business use.


TIP: Deducting specific expenses, though less convenient, could give a larger deduction—for example, where the vehicle is a gas guzzler.


The mileage rate for medical transportation (to and from doctors, etc.), which was 22¢ for September 1—December 31, 2005, is cut to 18¢ for driving in 2006. The rate for charity-related volunteer driving is fixed by statute at 14¢ a mile, but special, higher, rates are available for driving serving charities offering Hurricane Katrina-related relief. For these Katrina rates, click here.


Note: The rates for driving during January 1—August 31, 2005 were 40 ½¢ per mile for business driving, 15¢ per mile for medical and 14¢ per mile for charity.

IRA assets are subject to both income tax and estate tax. That is, the estate pays estate tax on the IRA’s fair market value and the IRA beneficiary owes income tax on IRA distributions as they are made. This “double tax” situation led an estate’s executor in a recent case to claim that the IRA’s value for estate tax purposes should be reduced to reflect the beneficiary’s future income tax liability.

An IRA owning securities, as almost all do, is valued at the fair market value of those securities. For publicly traded securities, this is their value on a stock or bond exchange. But, the executor argued, an informed buyer of securities would reduce his or her offer to reflect any income tax liability he or she would incur by the act of acquiring the securities. The IRA’s estate tax value should be reduced for the income tax liability the beneficiary incurs receiving the IRA distribution.

The court rejected the discount idea. There’s no point in trying to value the IRA separately from its underlying assets. An IRA can’t be sold. Only its underlying assets, here securities, can be sold. So the value of the IRA is the stock or bond exchange value of its securities. That’s the amount subject to estate tax.

The court gave another reason for rejecting a discount: The law already allows the IRA beneficiary an income tax deduction to somewhat compensate for the estate tax burden on the IRA. Thus, Congress has already provided the relief it thought necessary in this situation.

The remainder is domestic production income. Your domestic production deduction is 3% of that income, or 50% of your Form W-2 employee payroll if that’s less. (The 3% deduction for 2005-2006 is scheduled to rise to 6% for 2007-2009 and 9% thereafter.)

Note: The relief from Congress is for the beneficiary. The relief sought here was for the estate. IRA beneficiaries would often benefit from a reduction in estate tax, where such a tax applies (for persons dying in 2006, it applies where the taxable estate exceeds $2,000,000).

TIP: Estate tax is avoided for amounts passing to a surviving spouse or charity. Estate planners may suggest that IRA assets (and pension and profit-sharing assets) be left specifically to a spouse or charity. See what your estate planner thinks works best in your case.

Note: Estate tax values are sometimes reduced for costs of making estate assets marketable (environmental clean-up costs, for example). Closer to this case, the estate tax value of stock of a closely-held corporation can be reduced for an anticipated capital gains tax that would result on future liquidation of the corporation.

You may think that Americans don’t need yet another type of tax-favored retirement plan, but Congress knows better. Starting now—January 2006—Roth 401(k)s can be made available to employees and self-employed persons.

A Roth 401(k) must combine the key features of a Roth IRA and a 401(k), right? Yes, generally, but with modifications. Here’s what happens:

In a 401(k), the employer sets up a plan through which employees make pre-tax contributions (“elective deferrals”) from their pay. The amount contributed (up to a $15,000 ceiling in 2006) is not subject to current income tax—meaning that currently taxable pay is reduced by the amount contributed. Investment earnings on contributions grow tax-free until withdrawn. Withdrawal, in prescribed minimum annual amounts, is required, generally starting at age 70½. Withdrawals may be spread over the employee’s lifetime and, for balances at the employee’s death, over the lifetime of a beneficiary. Spreading withdrawals over as long a period as possible continues the tax shelter for contributions and earnings not yet withdrawn.


Note: 401(k)s may be used in the same way by self-employed persons, who contribute a portion of business earnings rather than salary.


Roth IRAs are like other (traditional) IRAs in that investments grow tax-free while in the IRA. Major differences, from traditional IRAs and 401(k)s, are these:

Roth IRA contributions are always after-tax, never deductible. But Roth IRA withdrawals are tax free, if made after the Roth IRA has existed 5 years and after the owner has reached age 59½.

Roth IRA contributions are allowed up to $4,000 a year (2006 amount), where the owner’s modified adjusted gross income (MAGI) is less than $95,000 ($150,000 on a joint return). The $4,000 limit is reduced by the amount of traditional IRA contributions that year. Partial Roth contributions are allowed for MAGIs between $95,000--$110,000 ($150,000--$160,000 on a joint return), but none where MAGIs are higher.

There’s no requirement that the Roth IRA owner take withdrawals at age 70½ or any other age. Thus, the Roth IRA owner can pass a sizable tax-free investment to his or her heirs (beneficiaries). They must withdraw required minimum amounts annually over their lifetimes, but amounts withdrawn are free of income tax. As with traditional IRAs and 401(k)s, amounts not withdrawn continue to grow tax-free.


Note: A Roth IRA can be augmented by a rollover, in a taxable transaction, from a traditional IRA.


Creating a Roth 401(k)

Employers may choose to make a Roth 401(k) an option to their regular 401(k) plan. The employee participant may then decide to direct any or all of his or her elective deferral to the Roth 401(k) account up to a ceiling of $15,000 (2006 amount) minus any amount going into the regular 401(k). The amount going into the Roth 401(k) is not tax-deferred; it is included in currently taxable pay. The employer must keep regular and Roth 401(k) amounts separate.


Note: The $15,000 ceiling may be reduced where rank-and-file employee participation in the 401(k) (regular and Roth combined) is low.


Special Roth 401(k) Advantages

• Roth IRA funds tend to build slowly because of the relatively low ($4,000) contribution ceiling. Roth 401(k)s, with a much higher ceiling ($15,000), can grow much faster.
  
  
• With a Roth 401(k), there’s no income ceiling on the right to contribute (unlike the $110,000/$160,000 ceiling for Roth IRAs).

TIP: One can have both a Roth IRA and a Roth 401(k).



A Roth 401(k) Drawback

Unlike the case with Roth IRAs, a Roth 401(k) owner must take withdrawals from the 401(k) under the same rules that apply to regular 401(k)s and traditional IRAs—generally starting at age 70½. This would tend to mean smaller amounts passing tax-free to heirs.

TIP: As rules now stand, a Roth 401(k) owner can avoid the required minimum withdrawal rules for his or her lifetime by rolling Roth 401(k) amounts over to a Roth IRA—which imposes no minimum withdrawal on the original owner.


Over Age 50. Persons over age 50 are allowed to make additional “catch up” contributions on their own behalf. For regular and Roth 401(k)s, the 2006 catch-up amount is a total $5,000: pre-tax in regular 401(k)s and after-tax in Roths. An amount contributed to one type of 401(k) -- say, $3,500 into a regular 401(k) -- correspondingly reduces the ceiling for the other type (here, to $1,500 for the Roth).

For traditional and Roth IRAs, the 2006 catch up amount is total $1,000, with contribution to one account reducing dollar-for-dollar the allowable contribution to the other.

Employer Matches. Employers often match employee 401(k) contributions, to some degree, such as one dollar from the employer for every three from the employee. Employer matches of employee Roth 401(k) contributions are not currently taxed to the employee. They would go into the employee’s regular 401(k) and would be taxable when distributed.


Note: Roth 401(k)s, like regular 401(k)s, are fully available to self-employed persons, whether or not they have employees.


TIP: Congress thought it was doing prospective retirees a favor when it enacted the Roth 401(k). Despite the added complexities for employers, employees and self-employeds, it might be right for you. Consult your tax or financial adviser.

You’re wrong. It’s when you’re in your 20s, 30s, and 40s, that you most need to think about planning for survivors. A family with young children needs to plan financially--usually regarding the use of life insurance and guardianship of the children in case of the loss of both parents.

>> back to top

Start Saving Early for Your Child's Education

If you anticipate hefty college costs for your children, you should, if possible, start saving even before they are born. The sooner you begin, the less money you will have to put away each year. Another advantage of starting early is that you’ll have more flexibility when it comes to the type of investments you can use. You’ll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments in the long run.

>> back to top