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‘Wealth effect’ could fool you into bankrupcy

Updated: May 3, 2013 12:14PM

Originally published: August 7, 2001

The economic news gets better and better - low unemployment, strong growth, no inflation - and the stock market continues to push against its all-time highs. Then why did a record 1.44 million Americans file for bankruptcy last year?

In Chicago, bankruptcy filings climbed to 1,455 last year, a 5.8 percent increase in the figures for 1998 over 1997. That’s twice the national bankruptcy rate of increase, which was 2.7 percent.

Behind those statistics are individuals and families for whom bankruptcy will have a long-lasting impact.

Bankruptcy will stay on their credit reports for 10 years, and will affect all future applications for loans or mortgages. And there are hidden impacts; after a bankruptcy you’ll no longer qualify for the lowest rates on life or car insurance. Employers who pull a credit report to assess your character may decide not to give you a job or promotion when they see the bankruptcy filing.

Are more Americans headed toward bankruptcy, in spite of all the good economic news? The latest figures show that more Americans are over their heads in debt - and the savings rate is at an all-time low. In fact, the savings rate actually turned negative for two months, as people spent more than they earned - and charged the difference! The result is that Americans now have billions of dollars outstanding on their credit cards, according to CardWeb, which tracks consumer debt.

Now even the Internal Revenue Service is getting in on the act.

This filing season is the first in which consumers have the choice of telling the IRS to ``charge it.’’ Taxpayers can put the amount they owe in taxes on their MasterCard, Discover Card or American Express card. But this is not an easy way out of the IRS’ clutches. There’s a federal law that specifically says taxes charged on a credit card are not dischargeable in bankruptcy.

And that’s not the only problem with charging your taxes to your credit card. When you charge merchandise on your credit card, the merchant absorbs a processing fee which is paid to the bank that clears the transaction. Because the IRS is prohibited from paying fees to card issuers, consumers will have to pay that fee - about 2 percent to 3 percent of the amount they charge - on top of the amount owed to the IRS.

Consumer advocate Gerri Detweiler of Debt Counselors of America points out that even if you’re thinking of charging your taxes to pick up airline miles or reward points, this isn’t likely to be a good deal.

``Generally, the fee for using the credit card will be close to the value of the miles,’’ she said. A frequent flier mile is worth about 2 cents, and most programs offer 1 mile for each dollar charged. So, using Detweiler’s example, if you charge $2,290 of taxes on your card, you’d pay a processing fee of $49. But the airline miles would be worth only $45.80.

Some consumers might think of charging their taxes so they can stretch out payments. But the IRS will work out a repayment plan at a charge of 7 percent, plus a penalty of 6 percent a year.

Unless you have a very low-rate credit card, there isn’t much advantage to charging your taxes and delaying repayments. On the other hand, the IRS has a reputation of being much tougher when it comes after delinquents than the credit card lenders do.

The concept of stretching out payments and lowering the amount of monthly bills has attracted more and more consumers to consolidate their credit card bills by taking out a second mortgage or home equity line of credit. While credit card solicitations have been cut back as big lenders consolidate their portfolios, many people receive even more solicitations for debt consolidation based on the equity in their homes.

Undeniably this is an attractive proposition because of the way home equity loan repayments are computed. The result is a lower monthly payment and a deduction for all or part of the interest paid.

(In the case of loans made for 125 percent of the value of the home, the interest paid on the portion over the home’s value is not deductible.) With mortgage interest rates at historic lows, the difference in monthly payments can be a real incentive to pay off the credit cards with money taken out of your home.

Credit cards are tempting

The only problem is that you still have those now-empty credit cards, which may present a great temptation to charge them to the limit once again. Kate Williams, president of the Greater Chicago Area Consumer Credit Counseling Services (312-849-2227), points out, ``You still need to live on a budget and keep your spending in check, and you need to realize that you’ve just shifted the debt - you haven’t paid it down.’’

Williams says her agency is seeing more and more two-income couples, who are contributing money to their company retirement accounts but still find themselves overburdened by consumer debt.

This intuitive sense of wealth being built up in 40l(k) retirement accounts may be one reason the national savings rate turned negative this year. Economists call it the ``wealth effect’’ - and it affects decisions about spending and saving, even though those investment accounts are earmarked for retirement.

The wealth effect spreads even to individuals who have no stock market investments; they just feel more willing to spend because of the general positive news about the economy and the stock market.

Jim Bianco of Bianco Research estimates that the rising stock market has created nearly $5 trillion of wealth in the last two years alone!

But just because you’re ``feeling’’ wealthy doesn’t make you impervious to the need to pay your bills every month. What happens if the economy slows down, and one of the breadwinners in that two-income family loses his or her job? If you get in credit card trouble again, you’ve placed the family home in jeopardy. In fact, lenders are willing to make those huge home equity loans because they sense that consumers will be more anxious to make the required payments if they know their home is at stake.

Consumers who are overloaded with debt may ultimately have no choice but to tap their retirement accounts, and pay the taxes and penalties - a costly alternative.

Penalty takes toll

As a rough rule, you’ll only get to keep half of the money you withdraw; the rest will go for federal and state taxes, plus the 10 percent penalty for early withdrawal. And, of course, you’ll lose all the future tax-deferred growth in your retirement account.

Even worse, if you lose your job and turn to your retirement plan for cash it’s likely to be at a time when the general economy is entering a slowdown. That could coincide with a decline in the stock market - just the worst time to liquidate your account.

There’s simply no substitute for having a sound financial plan, and a ``safety cushion’’ of some savings outside your retirement plan to carry you through unexpected hard times.

Terry Savage is a registered investment adviser for stocks and commodities and is on the board of directors of McDonald’s Corp. and Pennzoil Co. You can send her questions via e-mail at savage@suntimes .com. Her second book, published by HarperCollins, is Terry Savage’s New Money Strategies for the ‘90s. Copyright Terry Savage Productions.

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