Surviving an Audit

Question of the week:I just received a letter from the IRS telling me that my tax return is going to be audited. I was completely honest on my return, but I'm still really nervous. What should I do to make everything turn out right? --Nik B. Dear Nik, I'm afraid you're one of the unlucky few. According to the IRS, only 0.57 percent of income tax returns were audited in 2001 (the most recent year for which stats are available). However, you should look on the upside: Not all audits turn out badly, as evidenced by these stories from members of the Armchair Millionaire community: Smooth sailing. "We've been audited, but no problems. We keep good records (receipts, etc) and had no problem supporting amounts and calculations." --Alan and Kay Coming out ahead. "I was audited a few years ago. All went well for me, but not so the government. I was looking at a $2,782 liability, but when the audit was over the IRS owed me $763." --Ted B. The reason the IRS conducts an audit is to figure out if you accurately reported your income, deductions and/or tax credits. This means that the best defense is to file your return correctly in the first place. And if you're in a group that the IRS just loves to audit--self-employed people are a prime example--keep meticulous records of all of your income and expenses. Even armed with an accurate return and complete records, you'll still need to be ready to face that audit. My guide provides the essentials on minimizing the pain. The Armchair Millionaire Guide to Surviving an Audit Prepare. Re-visit the return in question so that you're completely familiar with it. If any supporting evidence is missing, dig it up. If you can't find it, consult with a tax professional about reconstructing it. Provide complete information, but don't go overboard. Give exactly the information requested, and stop there. Your audit notice will tell you the issue that is in question. Bring only the documentation related specifically to that issue. When you're asked questions, be as brief as possible--especially when you're nervous, it's easy to talk too much and give away unasked for information. Don't be intimidated. The IRS must follow a clearly established set of rules when it conducts an audit. According to the Taxpayer bill of rights, you have the right to record the audit, to have it conducted at a time and place that is convenient to you, to limit its scope to the issues that are directly related to the items in question, and to appeal the findings if you disagree with them. For full details, get IRS publication 1, Your Rights as a Taxpayer, from the IRS Web site at www.irs.gov. Call in a professional. Especially if the issues are complicated, seriously consider hiring a pro to represent you. When possible, use the person who prepared your return. In many cases, your representative will really make it easy on you by requesting that you not even attend the audit. Never, ever: Leave your only copy of documentation with the IRS. Give the IRS your records to sift through. Sign anything you don't understand. THE BOTTOM LINE: You can and will survive an audit. But knowing what to expect, being fully prepared and having a pro by your side will all help make the experience less stressful.

Debt: How Much Is Too Much?

Question of the week:We're considering remodeling part of our house, but it will mean taking on a sizable home equity loan, which we're not entirely comfortable with. Is there a good way to know when you're taking on too much debt? --L.K., Chicago Dear L.K., You're wise to be wary of taking on new debt. Too often I see people simply borrow as much as lenders will possibly let them without ever stopping to consider if that amount of debt is actually right for them. Your question has many sides to it, and there's no single right answer for everyone. For some perspective, we recently asked members of the Armchair Millionaire community about how much debt they're willing to take on. This comment from Mattchiavo shows how he comes up with his own answers: Balance is everything. "I think one needs a balance. Most people will not be able to buy a home without borrowing, so you should borrow but stay at a reasonable level. Personally I like to keep my mortgage payments between 10 and 12 percent of my gross monthly pay. Do I have the biggest and nicest house? Nope, but I have a comfortable house with a comfortable mortgage. I also like to keep my car payments to 3 to 5 percent of my gross pay. Do I have the biggest and nicest car? Nope, but I have a comfortable car with comfortable payments." Mattchiavo is on the right track. I generally recommend that people try to spend a maximum of 20 percent of their gross pay on large-scale debts related to their home in order to remain well within a common sense financial plan. However, you still need to consider the whole picture because the kinds of expenses each of us has varies so much from person to person. When considering taking on substantial new debt, there are a few different figures that you should review to see if your personal financial profile still falls within your personal comfort zone. These are the same figures that lenders (banks, credit cards, etc.) will consider when they make a lending decision. The Armchair Millionaire Guide to Creating Your Debt-Worthiness Profile Ability to repay. Do you earn enough to make the payments? Do you have so much other debt that it would affect your ability to repay the new debt? Lenders often calculate your debt-to-income ratio to guide them here. This is the total amount of your monthly debt payments, including the new expected debt payment, divided by your gross monthly income. Collateral. Is the value of your collateral (usually a home or car) enough to ensure that the lender will recoup its losses, should you fail to pay? To help them here, lenders will often use the loan-to-value ratio--the amount borrowed divided by the value of the collateral. Credit history. When preparing to take on new debt, you should also review your credit history with the three large credit reporting agencies (TransUnion, Equifax and Experian) and close any old accounts or correct mistakes. If you've had any bankruptcies or foreclosures, this will be a significant strike against you. Cash on hand. How much cash will you have left over after any down payment and/or loan closing costs? Do you have just enough? Or more than enough? Purpose. Lenders also look at how you'll use the money. They might consider a loan to buy an apartment building (where you will depend on rents from tenants to be able to make your payments) riskier than a home mortgage loan, for example. THE BOTTOM LINE: Lenders follow basic rules of thumb. You should have your own rules of thumb that balance your financial profile with your personal level of comfort. Strike a good balance between the two and you'll generally choose the smartest path.

Knowing Your Score

Question of the week:I've heard that it's important to check your credit score, but I've no idea of how to go about this, or if it's even worth it. What are your thoughts? --Marti O.

Dear Marti,

Ah, the elusive credit score. This seems to be one of the most mysterious--and misunderstood--issues in personal finance. But it's certainly an important part of your overall financial picture, and one that it really pays to understand.

When we asked members of the Armchair Millionaire community about whether they make it a habit to check their credit scores, we found that many do. Here are two of the comments we heard:

Prevent surprises. "I regularly (once per year) check my credit score, along with my credit report. I don't want any surprises when I need to get a loan." --Bryan J.

Make a resolution. "I check mine once a year when I check my credit reports for identity theft problems. I made it a New Year's resolution to improve my credit score last year, and it worked. I was able to raise it a bit." --Andy

In a nutshell, a credit score is simply a number that helps lenders know your credit risk. In other words, it tells them how likely you are to pay back your loan in time. While lenders may make their decisions to extend you credit based on many different factors and credit scoring models, the one credit score used by most lenders by far is the FICO score (so named because it is developed by Fair, Isaac and Company). This score is based on information on your credit report and is provided to lenders by the three big credit bureaus: TransUnion, Experian and Equifax.

While that's simple enough, it's made more confusing by the fact that you don't have a single credit score. Because each credit bureau may have slightly different information about you, and may treat that information slightly differently, your score will likely be a little different at each bureau. And because your financial situation changes all the time, so do your credit scores.

The Armchair Millionaire Guide to Credit Scoring

• Why they matter. The better your credit scores, the lower the interest rates you'll be offered. For example, according to FICO, a high credit score could mean that you're offered a 30-year mortgage at 6.3 percent. With a low score, you'd be offered a much higher rate--9.4 percent. On a $150,000 mortgage, this translates into big bucks. With the higher credit score, you would save more than $300 on your monthly payments.
• How they're formulated. FICO evaluates five primary issues in creating your credit score. Your payment history carries the most weight (35 percent), followed by the amount you owe (30 percent), the length of your credit history (15 percent) and the type of credit you're using and how much new credit you've opened recently (10 percent each).
• How to get them. Your credit scores are generally not given out as part of a regular credit report. However, you can obtain it from www.myfico.com along with your credit report, as well as online from each of the three credit bureaus. You may have to pay a few dollars extra to have your score included along with your credit report.
• How to improve them. The better you manage your debt, the better your credit score will be. Pay your bills on time, keep your credit card balances low and don't open unneeded credit accounts. If you've had problems in the past, it's especially important to get current and keep current with your loan payments.

THE BOTTOM LINE: While keeping tabs on your credit scores may seem an afterthought, remember that people with a better credit score are offered lower rates when borrowing. That could make a big difference in your monthly spending. When it comes to financial planning, little things can add up to a lot.

Sector Funds:Investing Deep and Narrow

Question of the week:I've noticed in the mutual fund rankings that some technology funds have done extremely well over the last three months--way better than the market overall. Why not just put all my money in them? If they go down, then I can just switch to whatever is doing best at that time. --Max L. Dear Max, Be careful here. What you're talking about is chasing performance, one of the classic traps that many mutual fund investors fall into. Sector funds--mutual funds that specialize in one industry, like the technology funds you mentioned--will always tend to lead the performance charts. This obviously makes them very tempting for many investors. The problem is that sector funds can also be found at the bottom of the performance rankings. By the time you buy into last quarter's hottest sector, the market could have a new favorite sector and you may find your own funds in the basement. So you really need to look at much more than just performance when deciding if a sector fund is right for you. When we asked Armchair Millionaire community members about how they choose their funds, we found that most people look at a broad range of factors. This comment from Jeremy is typical: A mutual fund laundry list. "I first look for funds from well-established mutual funds companies with long track records of success. Next I look at the expense ratio. Also, the turnover in a fund is very important to me. Finally, I want to own a fund with competent managers who have been with that fund company and particularly that fund for a substantial amount of time and who done well against their appropriate benchmark." As long as you evaluate them carefully on their merits--and that means much more than just recent performance--sector funds can have a place in a common sense portfolio. If you choose to dive into these specialty funds, my guide will get you started. The Armchair Millionaire Guide to Sector Funds How to use them. Sector funds are useful for increasing your position in a particular industry, especially if you don't want to buy individual stocks in that industry. As always, however, you don't want to go overboard and reduce the diversification of your overall portfolio. For this reason, I recommend that no more than 10 percent of your portfolio be in sector funds. What's available. Sector funds span the entire breadth of the economy. For example, there are funds in the financial services, health care, real estate, and consumer services industries, to name but a few. Some funds may specialize even more deeply. A technology fund, for instance, might invest only in wireless services and products. How to buy them. The volatility of sector funds means you should pay special attention to how you buy them. You can even out this volatility and avoid the temptation to time the sector by making your fund purchases with monthly dollar cost averaging. What to watch out for. Sector funds tend to have some of the highest expenses in the mutual fund industry. Since these expenses come directly out of your returns, it pays to shop around for funds with lower expenses. Check the prospectus of any fund you're considering to find out its expense ratio. THE BOTTOM LINE: The beauty of mutual funds is the broad diversification they deliver to your portfolio. Because sector funds go deep and narrow, the concentration they offer has to be taken into consideration along with the rest of your portfolio. So make sure to consider sector funds as a part of your overall strategy and not the whole strategy itself .