• FIVE THINGS TO KNOW ABOUT GETTING AUDITED – 41
  BREAKING DOWN THE ROTH IRA HYPE – 43
  SECOND ACT: HOW I BECAME A PROFESSOR – 44

Credit or Debit? How to Decide

Surprise: Your bank card isn’t always the better option.

THE NEXT TIME you reach for your wallet at the grocery store or the mall, chances are you’ll whip out a debit card rather than a credit card. Since 2000, the number of debit payments has more than doubled, while the number of credit transactions has fallen by nearly half, according to bank card advisory firm R.K. Hammer.

Paying with cash — which, after all, is what debit is a stand-in for — may seem like the smarter move. But it isn’t necessarily. There are a few situations in which credit serves you better. As long as you routinely pay off the balance, choose credit if…

YOU’RE PLANNING TO MAKE A MAJOR PURCHASE

“Credit cards offer the strongest protections on purchase disputes,” says Gerri Detweiler of Credit.com. If goods or services aren’t delivered as stated, the issuer will battle with the merchant on your behalf. Until the problem is resolved, the charge is suspended, and no interest accrues. With a debit card, however, the money is gone from your account and you have to wrestle the merchant to get your cash back. Your bank may help, but there’s no guarantee.

Thus, it’s worth using credit if you’re about to spend a hefty sum on something — be it a TV or a home repair — and especially if you’re making the purchase online, where what you see is not always what you get.

Other reasons to use credit for big buys: You may get increased warranty protection and insurance against theft of the item. Use a Visa credit card, for example, and the manufacturer’s warranty may be extended up to a year. Check your card agreement to see what your card offers.

YOU’RE BUYING GAS, CHECKING IN AT A HOTEL, OR RENTING A CAR

When you use debit for those transactions, the merchant — to avoid being caught short — figures out the maximum you could spend, then puts a hold on your bank account for that amount.

For example, when buying gas, you prepay your purchase. And since the gas station doesn’t know how many gallons you’ll use, it picks a big number. “They’ll block $75 whether you’re filling up a moped or an SUV,” says Greg McBride of Bankrate.com. You can’t access the excess that’s frozen until the transaction is finalized, which can take up to 48 hours.

The stakes are higher when checking in at hotels and car-rental counters, which give themselves leeway for incidentals and damage. You could have hundreds or thousands frozen for days, which could trigger overdrafts or bounces on other payments. So secure a hotel or car with a credit card. (Bonus: Some cards also offer decent secondary auto insurance.) You can always make the final payment with debit.

YOU WANT BIG REWARDS

“Debit rewards have gotten better over the years,” says Curtis Arnold of CardRatings.com, “but still I’ve never seen a program that comes close to the best-of-breed credit card programs.” (See page 94 for a list of them.) Citibank’s debit cards, for example, offer one point for every $2 spent, and you need 8,000 points to get $50, so you’re earning a mere 0.31% on every dollar. In comparison, many credit cards offer at least 1% cash back.

Bear in mind, too, that many debit cards offer their top benefits only when you sign for purchases rather than use your PIN, as banks get more money from retailers on signature transactions. (The Citi card gives one point for every $3 on PIN purchases.) And some merchants — Wal-Mart, for example — steer you toward the PIN option.

YOU DON’T VIGILANTLY MONITOR YOUR ACCOUNT

Legally, if your credit card or its number is stolen, your liability is minimal — $50 max. With debit, the law can leave you on the hook for considerably more. Visa and MasterCard, however, extend the better protection to signature-based transactions on debit cards displaying their logos. So it’s pretty much a wash on liability.

That said, credit still has a major advantage: If your debit card or its number is used, the money is gone, and you’ll have to jump through a few hoops to get it back. In the meantime you could bounce checks or miss bill payments. The more times you use your debit card, the more you’re potentially exposing its number to scammers. So if you don’t have the time or energy to review bank transactions a few times a month, use a credit card instead. That way, it’s the bank’s money that’s on the line, not yours. ■

—ISMAT SARAH MANGLA

THINGS YOU NEED TO KNOW ABOUT… Getting Audited

1. AUDITS ARE ON THE RISE

Now that your 1040 is out the door, you may be second-guessing yourself: Will the IRS come a-calling?

Well, the number of audits has risen every year over the past 10. And experts expect that trend to continue, what with the ballooning federal deficit and the additional $400 million earmarked for tax enforcement in 2010.

Even so, your audit risk in any one year is slim — about 1% if your income is under $200,000,2% from there to $1 million, and 6% for the fiber-rich, based on 2009 data. Those selected tend to be self-employed or have unusually large write-offs, says Trudy Moore, an enrolled agent in Stevensville, Mont. If you do get hit this year, it’s likely to be for 2008 taxes: Audit letters typically go out 18 months after the filing date.

2. DELAYING CAN COST YOUTHE RIGHT TO FIGHT

If you are one of the unlucky few to get the dreaded letter from the IRS, be sure to take the action required within the time frame allotted, usually 30 days. Otherwise the dispute becomes a final assessment and moves on to the collections department, with no grace period.

Can’t get your act together in 30 days? You have the right to ask for a postponement, and the IRS should grant such a request if you say you need the time to track down records.

3. IT CAN HELP TO HAVE A PRO ON YOUR SIDE

Three-quarters of audits are conducted by mail, with the IRS simply requesting documentation (like receipts) on a specific part of the return. You can handle this type of audit on your own. But if someone else prepared your taxes, get him to weigh in. The fee you paid may cover such help, and the agreement you have may put the person on the hook for mistakes.

If the audit requires an in-person meeting, it will probably get into greater depth on a certain issue. So you’ll want an advocate, ideally a CPA with audit experience. Expect to pay $500 to a few thousand bucks.

4. ANYTHING YOU SAY CAN BE USED AGAINST YOU

In any audit, avoid offering information beyond what’s asked for by the examiner, says Silicon Valley CPA Alan Olsen. You might unwittingly give evidence that could expand the scope of the investigation.

It’s especially wise to remain tightlipped at a face-to-face audit: Even by engaging in small talk you could incriminate yourself. That’s another good reason to hire representation— when you do, you don’t have to attend the meeting.

5. THE AUDITOR’S BOSS MAY BE ABLE TO NEGOTIATE

Unhappy with the auditor’s finding? Ask (nicely) to speak with a supervisor. “The manager has more latitude than the front-line employee,” says Charles Hayes,

a CPA in Coronado, Calif. This can be effective if the issue falls into a gray area.

Should the manager fail to see your side, file an appeal. IRS officers will consider the “hazards of litigation” — if there’s a shot the feds would lose in court, they’ll offer you a deal. Your final option is taking it to the legal system. But that may not be worth the cost unless there’s more than $10,000 at stake. ■

—BETH BRAVERMAN

Roth Conversions: Beware the Hype

Now anyone can convert a traditional IRA. That’s good news — but there are catches.

SINCE THE BAN on converting to a Roth IRA by folks making more than $100,000 was lifted this year, the buzz surrounding conversions has been deafening. Everywhere you turn, some adviser or investment firm is blaring the benefits of switching to a Roth: Tax-free withdrawals! Tax-free returns! A tax-free legacy for heirs! But before you hop on the bandwagon, keep the following in mind:

ROTHS ARE NO FREE LUNCH

A few months ago, I wrote that most people should at least consider converting a portion of their traditional IRAs. So I’m the last person to rain on the Roth’s parade. But I also emphasized that a Roth was no freebie.

To get a Roth’s tax-free benefits in the future, you’ll have to pay taxes today. That means a conversion makes the most sense if you think you’ll face a higher tax rate — or for that matter the same rate — when you pull money out at retirement. And as the box shows, a Roth makes more sense if you can pay the levy from funds outside your IRA.

True, a conversion can pay even if you drop into a lower bracket down the road. But as I noted in my prior column, time is a huge factor. Depending on what bracket you fall into, it could take years and possibly decades for the Roth’s tax-free compounding to make up for the taxes paid at conversion. So if you intend on cashing out as soon as you’re allowed—rather than, say, preserving your Roth for your heirs—a conversion may not make a lot of sense.

THE DOWNSIDE

When converting to a Roth, try not to use funds inside your IRA to pay the taxes.

$5,000

Is how much you would give up, over 20 years, if you converted $25,000 and paid the $7,000 tax bill with money in your IRA rather than outside funds

NOTES: Assumes 28% bracket before and after converting, no early-withdrawal penalty, and annual returns of 7%. Tax on gains in an outside account is 15% a year SOURCE: MONEY research 

CONVERSIONS CAN CAUSE UNEXPECTED TAX HITS

Unless your conversion includes after-tax dollars — say, from a nondeductible IRA — the entire amount you convert becomes taxable income. So the conversion itself can kick you into a higher tax bracket.

Also, income generated by the conversion can reduce your ability to deduct certain expenses. For instance, you can deduct only those medical costs that exceed 7.5% of adjusted gross income. But if the conversion boosts your AGI, you might lose some or all of those medical deductions. The added income can also trigger or raise taxes on Social Security benefits. In some cases, it could also subsequently boost your Medicare premium. There are ways around these drawbacks, such as converting small amounts over several years. But you have to know the ramifications.

BEWARE OF PITCHES

Insurance sales organizations are encouraging advisers to push annuities at conversion. That’s not to say an annuity can’t ever make sense in a Roth. But those with high fees can be inappropriate. Bottom line: Don’t convert unless you’ve studied the numbers. Online calculators may be able to help somewhat, but, frankly, if you’re thinking of converting a large amount, have a financial planner do a more thorough analysis. ■

—WALTER UPDEGRAVE

SECOND ACT

WHEN GARY Buslik graduated from college with a degree in English, his parents were concerned about how he’d earn a decent living. “It worried them to hear me quoting Shakespeare,” he jokes. Their fears were misplaced: Buslik went on to start an alarm company in Chicago that would eventually grow to $6 million in annual sales and earn him §500,000 a year. But he wasn’t happy. “My passion was literature, not alarm systems,” he says.

So when Buslik turned 50, in 1997, he sold his business (for several million bucks) in order to pursue that passion. With a recommendation from a pal who was an assistant dean, he got into the English Ph.D. program at the University of Illinois at Chicago. In return for his work as a TA, the school waived his tuition. Buslik graduated in 2007 and now teaches there part-time while writing books on the side. He makes just $13,500 a year, but “I’ve never regretted my decision,” he says. “I’m content to be sending Shakespeare lovers into the world.”

HOW HE DID IT

1. By taking the first good offer. In putting his company up for sale, he didn’t wait around for the best price. “I could’ve held out for more money,” Buslik says, “but I wanted to get on with my plans.”

2. By investing conservatively.

Expecting slim future wages, Buslik paid off his mortgage and put much of his savings in ultrasafe I bonds, which are indexed to inflation.

3. By drawing down cautiously. A divorce cut into his nest egg, but Buslik figures his savings will last him if he’s careful. “I’m not a flashy guy,” he says, noting that he still drives a 1986 Mercedes.

—JOSH HYATT