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Thursday, March 31, 2011

Family Man Mission

I often recommend, as I have in past blogs, that people open Individual Retirement Accounts (IRA) or 529 accounts (college savings plan). Both of these accounts allow you to participate in the Stock Market. I understand the fear and suspicion people feel towards the Stock Market. It is understandable really. When you don’t understand the rules or why things are happening it can be confusing and scary. I feel the same way about Cricket. I am sure it is a really great sport but for the life of me I just can’t figure it out.

I hope over the course of the next few weeks, months, maybe years to help you figure out the Stock Market (in return, if anyone knows how Cricket works, I am listening). If you’re interested in learning how the Stock Market works and maybe even how to manage your own brokerage account then subscribe to my blog or visit me periodically. If you have questions, please ask them and if I don’t have the answers I will do the research to find them. This is a passion of mine. I enjoy Finance and enjoy helping people out. That’s what this is all about.

I want to show you that the Stock Market isn’t gambling or throwing money away. It isn’t magic. You can make sense of it, you just need a guide.

The Stock Market is a tool that can help send your children to college. It can allow you to retire with dignity. It can help you buy your first house or get out of debt. I am not interested in making rich people get richer. I will not promote get rich quick schemes or promise guaranteed returns if you just donate x amount of dollars. This information is meant for anyone that is struggling to keep their head above the water or just wants to improve the quality of life for thier family.

From one Family Man to another (or to a Family Woman), I just want to share what I have learned through my experience and my studies.

Monday, March 14, 2011

College Savings Plan (529 Account)

Over the past 30 years it has become increasingly evident that getting a college education improves everyone’s chance to be financially comfortable or even wealthy. We all want our children to have a better life than we have had. While college is not a ticket to easy street it gives our children a fighting chance in the real world. Unfortunately college tuitions are going up fast and average household income rate cannot keep pace.
In a previous blog I mentioned college savings plans and specifically referred to a 529 account. This article will focus on what a 529 account is and how it can help pay for your children’s college expenses.

What is a 529 plan?
A 529 Plan is a tax-advantaged education savings plan that is run by a state that is designed to help pay for tuition and other college expenses. Every state has at least one 529 account and many have 3 or more. Think of the 529 account as a 401k or IRA but instead of saving for retirement you’re socking away cash (and hopefully getting a good return) to pay for college. A 529 account and an IRA share many of the same benefits but they are not identical and they differ from plan to plan. Here are answers to frequently asked questions regarding the 529 account:

What are the Federal Tax benefits?
In this respect a 529 acts like a ROTH IRA. The contributions to the account are not tax deductible but if the money is pulled out to pay for college expenses the contributions and any gains will not be taxed.

What are the State Tax benefits?
Some, not all, 529 accounts will allow you to deduct your contributions for your state taxes. Of course, this benefit doesn’t mean much for those that live in states like Florida or Texas which don’t have state taxes.

Who is in control of the money?
The owner of the account retains all rights to the account. This means that even if you appoint a beneficiary (a requirement for most 529 accounts) you still dole out the money as you see fit. If your beneficiary decides not to go to college, gets a full ride scholarship, joins the military or if you decide that they just don’t deserve it, you maintain all rights to that money. Furthermore, you can pull all of your contributions out of the account at any time without penalty (unless you touch the gains).

Who can contribute to the 529 account?
Anyone. Most 529 account websites will provide a link that you can email to your friends and family that will allow them to directly deposit money into the account. Contributions to a 529 account make great gifts for babies and toddlers especially since they would rather play with a cardboard box or wrapping paper than the expensive new toy you got them.

How much maintenance is this going to take?
Generally, when you open a 529 account you are given a number of investment options. The one I recommend is the aggressive time based option. It may be called something different depending on the account. This is a management technique that takes into account the beneficiary’s age. The portfolio will be a mix of bonds, stocks, mutual funds and cash. When the beneficiary is very young it will be mostly stocks and mutual funds and little bonds and cash which is considered riskier but should provide for higher gains. As the beneficiary approaches 18 years of age the investment mix will progressively become more conservative. The manager will cycle the investments out of stocks and mutual funds and into bonds and cash to protect it from potential economic threats.

How flexible is a 529 account? What if I change my mind?
You can change the beneficiary or your investment option once a year or name multiple beneficiaries if you would like. You don't even have to wait to have children before you open a 529 account. You can open the account and name yourself as the beneficiary or your spouse, cousin, mother or father. If your child happens to get a full ride due to some academic or athletic achievement you can wait until your future grandkids are heading of to college. As long as the money goes towards college expenses there will be no penalty. If you do decide to use the money for something other than college expenses there is a penalty. That is discussed a bit more below.

Will this complicate my taxes?
Since the money you contribute is already taxed there are zero tax implications until you start distributing the money. Even when you do start taking or doling out distributions as long as they fall within the rules for a qualified college expense you will not be penalized. You also won’t receive a 1099 form to report taxable or nontaxable earnings until then.

What qualifies as a college expense?
Surprisingly, a lot qualifies as a college expense. College tuition is a no brainer but books, room, board, school supplies (paper, pens, scan-tron sheets etc). Even a laptop computer can fall into the category of qualified college expense as long as its primary purpose is school. Let’s get back to room and board for a second. This is not just a dorm room and a college cafeteria card. This can go towards an apartment or a mortgage (though not as a down payment). Groceries and dining out also count (but I wouldn’t push it by running up a large bar tab). 

What’s the limit on contributions?
Unlike a ROTH IRA, no one is excluded from using a 529 account regardless of income. Also, the contribution limit varies from state to state but it is typically a total of $300,000 per beneficiary. This means that you can contribute as much as you want annually but be careful, if you contribute too much ($13,000) you may have to pay the federal gift tax (but that is another blog entirely).

Will this impact my child’s financial aid application?
Parental assets are assessed at a maximum 5.64% when determining whether a student is eligible for financial aid. So the impact should be very small.

What if I decide not to use the 529 account for college expenses?
If the account distributions do not go to qualified college expenses than a penalty of 10% will be assessed. On top of that, if the gains on the account (anything over the total amount contributed) are used in an unqualified way taxes will also be assessed.

How do I set up a 529 account?
I suggest that you visit your bank and discuss it with someone from the investment group there. They will likely have a few to choose from that they recommend.

This was just an introduction to the 529 account. In a later blog I will dissect the 529 account, typical cost and the best benefits.

Remember, saving for your children to go to college is a high priority but you need to ensure that your retirement plan is in full swing first. The last thing your child will need when they are 30 years old and have a family of their own to take care of is the additional financial burden of supporting you through retirement. 

Tuesday, March 1, 2011

Why a ROTH IRA?

In a previous blog I recommended starting a ROTH IRA as a suitable retirement savings option but didn’t I didn’t tell you what a ROTH IRA is and what it can do for you. I intend to correct that omission now.  This Blog will discuss what a ROTH IRA is and why I recommend it over a Traditional IRA 9 times out of 10.

What is an IRA?

IRA is an acronym for Individual Retirement Account. This is an account with specialized rules, regulations and benefits designed to make it easier for folks to prepare themselves for retirement. This blog will focus on the ROTH IRA which has a few very important differences from the normal or Traditional IRA. It is these differences that prompt such a strong recommendation from me towards the ROTH IRA over the Traditional for anyone in the middle class or below. This will be discussed in further detail a little bit later.  

Here is a list of what the Traditional and ROTH IRA have in common;
·         Contribution limits: Both IRAs allow a person to contribute up to $5,000 annually for anyone under the age of 50. Anyone over 50 can contribute an additional $1,000.
·         An individual can contribute to both a ROTH and a Traditional IRA if they would like but the total of those contributions cannot exceed the annual contribution limit ($5,000).
·         Penalty free distributions after the age of 59 ½. “Distributions” is just a fancy way of saying withdrawal.
·         A person must have real income in the form of wages, tips, salaries, bonuses or fees to contribute. Stay at home spouses may contribute if taxes are filed jointly.
·         There is some form a tax benefit for each IRA.

Why a ROTH?

The biggest difference between the ROTH IRA and the Traditional IRA is the tax benefit. The Traditional IRA allows you to defer taxes on up to 100% of your annual contribution depending on your income level. Instead of paying taxes on the money now you pay for it in when you take withdrawals. At first glance that seems like an amazing benefit and it is under some circumstances but I see two concerning issues with tax deferment in most cases;

1.       Not only will your contributions be taxed when you start to take distributions but any gains you made over the life of your account will as well. That means that the government defers taxes on a small amount now only to reap the rewards of your investments over the course of 30+ years.
2.       Currently we know how much we are taxed. Whether you like that number or not, it is a known quantity. The same cannot be said for the tax rates 20, 30 or 40 years from now. The money you withdraw in the future will be taxed at that future rate, whatever it is,  not the current known rate. I don’t know for sure whether taxes will go up or down over the next 30 years but I prefer not to chance it either way. (NOTE: I have a different opinion on this regarding 401ks, I will explain that in a separate blog)

Why is the ROTH better? Contributions to a ROTH are not tax deferred at all. So what’s the benefit?

By forgoing the instant gratification of a small tax deferment now, all future withdrawals are TAX FREE. This means that when you pull money out after the age of 59 ½ both the money you contributed and any additional money that you have earned throughout the life of the account is completely, 100% TAX FREE. In almost every scenario I can image tax free beats tax deferred hands down. The chart below is an illustration of the difference in the amount of taxes paid between the two. 



There are too many variables for this chart to be really accurate but if all things remain equal including tax bracket (28%) this is what the difference might be.

A ROTH IRA can double as an emergency savings account.

Yes, you read that right. All the money you contribute to a ROTH IRA can be withdrawn without penalty (or tax) at any time for any reason. It is very important to recognize the “all the money you contribute…” part of that sentence. You cannot pull out more than you have put in or you will be penalized 10% (still not taxed).

This isn’t so for the Traditional IRA. Not only will you be taxed for an early withdrawal but you will be penalized an additional 10% as well. This could mean giving as much as 40% of your hard earned retirement distribution to Uncle Sam.

Also important to note is It is not as “liquid” (meaning quickly converted to cash) as a typical savings account. Since the IRA is likely made up of mutual funds, stocks and bonds it may take one to three days for the money to be on hand.

And for the record, when I say “emergency savings” I don’t mean buying an “emergency” Lexus or taking an “emergency” Caribbean cruise. When you’re considering pulling money out think about this example;

Say you want to pull out $10,000 for a down payment on a house and you have 30 years until you retire. That $10,000 would have conservatively turned into just over $100,000 by the time you retire. You may be saving yourself 5% interest over the course of the 30 year mortgage but you are losing out on 8-10% return you would have received annually over that same time.   

You can contribute as long as you want.

Should you find yourself in the unbearable predicament of having extra disposable income well into your 60s, 70s or even into your 100s, you can still contribute to your ROTH IRA. That is not so for a Traditional IRA. In fact, a Traditional IRA requires distributions to start at the age of 70 ½ whether you need the money or not.

The ROTH IRA does not have mandatory distributions.

If you don’t need the money, you don’t have to take distributions, not ever. Why wouldn’t you take the money? Perhaps you happen to have a spouse without retirement benefits of their own or perhaps you just want to leave a sizeable inheritance to a favored grandchild.

The ROTH can be passed on to an heir without penalty. The spouse is the beneficiary if the account owner dies. If the spouse already has a ROTH of his/her own then these two accounts will be rolled together. If the spouse has also passed on then the account can be willed to another penalty free (estate tax does apply but is reduced because taxes have already been paid for all of the contributions) and but now there are rules regarding mandatory distribution.      

Restrictions

The ROTH IRA is a powerful tool for retirement savings and as such it has restrictions. A person has to earn under a certain amount each year to be eligible to contribute to a ROTH IRA. The numbers change periodically to keep up with the cost of living. Right now a couple that is married filing jointly must have an annual income of less than $177,000 for instance.  

Wrap up - So in a nutshell that it why I recommend the ROTH IRA 9 times out of 10. There are other options and in some cases better options depending on your individual circumstance. I will discuss 401K plans and an overall retirement philosophy here in the near future. Stay tuned and feel free to post questions and I will do my best to answer them.