Where do you recommend putting away kids savings? 529 college savings, cash savings, other? I need to set up some accounts for my kiddos. Thanks!
You're on the right track for your kids education. There are two main routes to go if you want some type of tax advantage. One is a 529 Plan, the other is a Coverdell, also called an Education Savings Account (ESA). They have a few differences, primarily that 529 plans are sponsored by each state and, as a result, have different options available by state. You don't have to reside in the state of the 529 plan you choose, so it requires a little more homework to know what you get with each 529 plan. Some of the top state 529 plans are listed in Clark Howard's 529 Guide
The Coverdell, or ESA, is an account type held at a brokerage, similar to an IRA. You have more flexibility with investment options, but contributions are limited to $2,000 per year per child. That money grows tax-free if used for qualified education expenses, meaning you don't get any deduction for contributions to the account, but when you take the money out, you'll pay no tax on your gains if you use the money for education. Amounts can also be used for qualified K-12 education expenses. Another point is that if the first child does not use the full amount in the ESA, it can be transferred tax-free down to another sibling. There is also no restriction on where you invest the money. It is much like setting up an IRA in the sense that you can set it up at almost any institution and invest in any fund, stock, or bond.
529 plans have the same federal tax benefit when used for education (no tax on gains when withdrawals are taken) and may also include a state tax benefit, depending on your state of residence. 529 plans typically allow you to contribute much more than an ESA and may have age restrictions, but those are different for each state's 529 plan. If you decide to go this route, just make sure you read the details of any restrictions, which may include which funds you can purchase. Fees are also a consideration as some 529 plans also have their own fees, which you won't find with an ESA.
With both of these, if the money is not used for education, you'll pay an extra 10% tax penalty, so you want to be sure that you will use the funds for education. Remember that retirement savings should always come before education since you can find other sources to fund education expenses, even including loans, but you can't get a loan for retirement. So make sure you are already maxing out all your retirement savings vehicles such as 401(k)s and IRAs first (preferably by contributing at least 15% of your gross income to retirement savings).
Here is another blog post I wrote with similar info: Why I Like Coverdell Education Savings Accounts
Bottom line: the decision may come down to how much you plan to, or can, invest for education since the ESA has the $2,000 limit, but the ESA also has the most flexibility and no additional fees. If you want to contribute more than that, a 529 plan is probably best, but you'll need to do a little research to find one with appealing investment options yet still keeps fees low.
The first key to understanding annuities and whether one fits your needs is to know what exactly they are. An annuity is essentially an insurance contract in which a person pays a lump sum upfront or contributes savings during a period of time in return for guaranteed periodic income over a certain period or until death. The income received may be fixed or variable depending on the type of annuity purchased. The three main types of annuities are fixed, indexed, and variable. Fixed Annuities
In a fixed annuity, the insurance company agrees to pay you no less than a specified rate of interest during the time that your account is growing. The insurance company also agrees that the periodic payments will be a specified dollar amount in your account. These periodic payments may last for a definite period, such as 20 years, or an indefinite period, such as your lifetime or the lifetime of you and your spouse.Indexed Annuities
In an indexed annuity, the insurance company credits you with a return that is based on changes in an index, such as the S&P 500 Composite Stock Price Index. Indexed annuity contracts also provide that the contract value will be no less than a specified minimum, regardless of index performance.Variable Annuities
In a variable annuity, you can choose to invest your purchase payments from among a range of different investment options, typically mutual funds. The rate of return on your purchase payments, and the amount of the periodic payments you eventually receive, will vary depending on the performance of the investment options you have selected. This sounds like simply investing in mutual funds themselves, but there are some key differences. First, the payments you receive will often be for the rest of your life or life of a spouse. Second, there is typically a death benefit of a minimum amount, usually equal to at least the principal you have paid. This means a minimum return at death if payments have not yet started no matter what the markets are doing. Third, they are tax-deferred resulting in tax only being paid on the payments you receive.
Due to the many varieties of annuity products, determining whether an annuity is the right choice for you largely depends on your personal circumstances and risk tolerance. For example, an income, or fixed, annuity can guarantee income for your remaining lifetime with a set interest rate for growth and fixed monthly distribution amounts. Someone in good health with a low risk tolerance may choose to purchase such an annuity if worried about outliving his or her retirement savings. This option also requires that the person have sufficient savings to purchase the annuity without needing access to that money for other unforeseen emergencies.
There are a couple of main expenses to be aware of before purchasing an annuity. Fees
Annuities have a reputation of carrying higher fees than a typical investment. This is partially to compensate for some of the guarantees that may be included as part of the annuity. A variable annuity may have more features, often resulting in slightly higher fees than a fixed annuity. For example, the underlying mutual fund in which the funds are invested may carry a management fee typical for any managed mutual fund.
Additional fees often include a mortality and expense charge. This fee pays for the insurance guarantee, commissions, selling, and administrative expenses of the annuity contract. The mortality and expense charge in a variable annuity is charged as a percentage of the average value of the investment.
Another applicable fee is the surrender charge. This is to keep you from withdrawing the funds too early. This fee typically decreases as time goes by and even may reach zero once the investment has been there long enough. This fee supports the idea that annuities should typically be purchased as a long-term investment.
The last fee worth mentioning is the sales commission that typically goes to the advisor or sales person for selling the annuity to the client. These are often part of the price of the annuity but obviously are used for compensation purposes. There are some no-load annuities that are sold directly to the client from the insurance company for which there is no commission and possibly no surrender charge.Taxes
If an annuity is used in a qualified pension plan or an IRA, then all of the annuity payment is taxable as current income upon distribution (because the taxpayer has no tax basis in any of the money in the annuity). If the annuity contract is purchased with after-tax dollars, then the contract holder upon annuitization recovers his basis pro-rata in the ratio of basis divided by the expected value, according to the tax regulation Section 1.72-5. (This is commonly referred to as the exclusion ratio.) After the taxpayer has recovered all of his basis, then all of the payments thereafter are subject to ordinary income tax. In other words, the after-tax principal invested is not taxed while any income distributed above the principal amount is taxed as ordinary income. The exclusion ratio determines how much of each payment is considered principal being returned and how much is considered income. Once the principal has all been distributed then all of the subsequent payments are fully taxable. This is something to remember as the tax owed will increase with time and when the principal is all returned.Other Resources
One site that has a lot of resources regarding annuities is AllThingsAnnuities.com
. (This is not an endorsement of this website.)Vanguard
, a leader in low-cost investment options, also has information about annuities.Definitions provided by the Securities and Exchange Commission:
The fiscal cliff bill signed shortly after New Year's provided a permanent extension of the portability of the unused portion of a spouse’s lifetime gift and estate exclusion amount ($5.12 million in 2012 and indexed for inflation thereafter). This provision gives couples an additional way to preserve both spouses’ full exclusions without the need for traditional credit shelter and bypass trusts. In other words, a couple can combine their $5 million (indexed) exclusion when elected after the first spouse's death. This was already the case for 2011 and 2012 but was extended on a permanent basis.
The title may be a misnomer depending on which tax you are talking about and how large your income is. The bill signed by President Obama is fairly comprehensive in nature affecting income taxes, estate and gift taxes, and payroll taxes. You may have already seen the increase in the Social Security taxes on your paycheck, increasing from 4.2% to 6.2%. The payroll tax holiday is over with an obvious increase to taxes for the middle class as this tax is only on income up to $113,700.
What about income tax rates? The highest tax bracket moves from 35% to 39.6% and the capital gains rates increases from 15% to 20%, both for income over $400,000 ($450,000 joint filers).
Income tax credits: The child tax credit, child and dependent care credit, and the earned income tax credit are all extended.
Estate and gift taxes: The estate tax rate increases from 35% to 40% with the first $5 million still exempt per individual. The $5 million is indexed for inflation with the actual amount slightly larger. The gift tax annual exclusion has also increased to $14,000 per individual per year.
There are plenty of other provisions in the 153-page bill. Full legislation found here: American Taxpayer Relief Act of 2012
When considering this question I have typically recommended a decision based on two main factors: the length of time you expect to live in the same house and the amount of money you have to put toward a down payment on the house. I usually favor buying over renting due to the equity buildup over time, which results in a much better return on your investment than paying rent every month with no return. With that said, you first need some money to put down on the house to keep your monthly mortgage payment reasonable and you probably should expect to be in the house for at least three years. I'm sure you can find many other rules of thumb that others follow, but the fact is there are many other financial factors when considering a home purchase. In addition to the length of time you expect to live in the home and the amount of money you have for a down payment, you should consider the monthly rent amount you would otherwise be paying, the total purchase price of the home (especially compared to the amount you have for the down payment), the interest rate you will be able to receive based on your credit score, property tax payments, homeowner's insurance vs. renter's insurance, the expected appreciation in the home's value, and tax savings from mortgage interest payments.
If you have an idea of what the amounts are for each of these considerations, you can get a good sense of whether renting or buying is better for you financially by using one of many online calculators. Ginnie Mae has a calculator here
in which you can play with the numbers to get a sense of which one saves you more money. Let's run through a quick example. Living in the San Francisco Bay Area, this example might seem outrageous for others across the country, but this is a reality here for a three-bedroom house.
Current rent: $2,000
Purchase Price of Home: $500,000
Down Payment %: 20% (20% will avoid having to pay a monthly fee for private mortgage insurance)
Length of loan in years: 30
Interest Rate: 4% (this is mostly dependent on your credit history and credit score)
Years you plan to stay in the home: 10
Property tax rate: 1%
Yearly home value appreciation rate: 1% (we'll keep this conservative with today's housing market)
These facts suggest a savings of $120,360 if you buy the home over renting. This assumes being in the home for more than three years and having 20% ($100,000 in this case) to put down. But who has $100,000 to put down on a house? Ok, good point. Let's look again with 0% down. We still get a savings of $89,801 if you buy the home. Well, what if your credit isn't very good? Let's change the interest rate to 6%. We still have a savings of $19,981 if you buy the home. If we go back to our original assumptions with 20% down and 4% interest rate, you find a breakeven point with the length of time at just less than three years.
Other assumptions are included in this specific calculator such as private mortgage insurance, homeowner's insurance, and other closing costs of obtaining the loan that Ginnie Mae has included but for which they have not disclosed any details. Needless to say, this calculation should not solely be relied on in making a rent vs. buy decision, but it can be helpful when running numbers to get some ballpark figures.
I still tend to find more financial benefits from buying a home over renting since you will have an asset when it is all paid off, while renting leaves you with nothing. Even if you never sell your house and are not able to take advantage of the cash from that asset, it will be an asset that can be passed down to heir of your estate.
Of course, all of this only addresses the financial side of buying a home and does not consider the emotional considerations of renting vs. buying. Those factors can often be just as important in the decision process. Let me know what you think about what other factors should be considered when making this decision as you may come up with other justifications to rent rather than buy.
Why choose a Roth IRA over a traditional IRA or a Roth 401(k) over a traditional 401(k)? Tax-free growth. There are two things that are inevitable in life: death and taxes. You may not be able to cheat death and choose the timing of it, but you can choose when to pay some of your taxes, now or later. By choosing a Roth account you are choosing to pay the tax now (by not being able to deduct contributions) and not later when you receive the distributions.
Some argue that you do not know whether your taxes will be higher or lower in retirement. In order to best prepare for this, tax diversification is advocated by keeping a portion of your retirement in tax-free accounts and a portion in tax-deferred accounts. This is not bad advice, but one thing to remember is that traditional IRA and all 401(k) accounts have required minimum distributions (RMD) starting in the year you reach age 70 1/2. Depending on the amount of your RMD, it might push you into the next tax bracket. Having more of your retirement in a Roth IRA can help avoid this scenario. You can also consider rolling over a Roth 401(k) to a Roth IRA to avoid additional RMD amounts.
If your employer does not offer a Roth 401(k), request that they add the option. Roth accounts are a great example of delayed gratification as you are giving up a little cash now for the peace of mind of not having to worry about whether your taxes will be higher in retirement. If you can afford to give up the cash now, you probably are not going to regret it when you reach retirement and pay no taxes on your Roth distributions.
Additional reading: The Retirement Savings Move Tax Pros Love
from the Bloomberg Personal Finance section.
Most parents worry about setting aside money for their children's education. Many even worry about it more than they worry about saving for their own retirement. This is unfortunate since you can always borrow money as a last resort for education after applying for other types of financial aid, but you cannot borrow money for retirement.
The Coverdell Education Savings Account, or ESA, makes for a nice investment vehicle that helps limit the amount you contribute so that you can continue to contribute a sufficient amount to your retirement accounts. An ESA limits contributions to $2,000 per year per child. They can be set up with any investment brokerage and there is no limit on what funds can be chosen for the investment. There is no tax deduction for contributions, but all earnings in the ESA grow tax-free as long as they are used for qualified education expenses. It is similar to a Roth IRA in the sense that you invest after-tax money that grows tax-free. Additionally, if you happen to not use it all on the first child's education, the balance can be rolled over to the next child's ESA account.
If you were to start contributing the maximum $2,000 per year per child in the year the child is born, you will have almost $73,000 by the time the child is 18 years old and ready to head off to college (assuming a 7% annual return). Even with how high college expenses are and how fast they are rising, $73,000 will definitely help pay tuition and avoid some student debt.
I reiterate that education expenses should always be second behind retirement contributions. If you are not able to contribute 15% of your gross income to retirement accounts, then you should not worry about funding an education account.
Additional information can be found at the IRS website
How much money do you have set aside for emergencies? Will one emergency wipe it out, or is it sufficient to last through an extended crisis?
Whether it is large or small, whether you have started saving or not, it should be at the top of your financial priority list.
I found some great suggestions here
for how to get started or to replenish what you may have used up. Not all of the suggestions may work for you personally, but they should get you thinking. You can start by choosing one or two that fit your situation and make a goal to start this week. Also share any other ideas that have worked for you.
Some retirement accounts require minimum distributions once the retiree reaches a certain age. For example, a 401(k), a Roth 401(k), and a traditional IRA require minimum distributions starting with the year that the retiree reaches 70 ½ years of age. The government also takes a cut from the 401(k) and the traditional IRA distributions as they are tax-deferred accounts, meaning they are taxed as ordinary income. A Roth 401(k) and Roth IRA are not taxed when distributions are received, but the Roth 401(k) is subject to the minimum distribution requirement at age 70 ½ .
Due to the tax treatment of distributions, it would seem most logical to draw retirement money from regular taxable accounts first as well as use the required minimum distributions from accounts such as a 401(k), Roth 401(k), or traditional IRA. The last account to draw from would be a Roth IRA since it grows tax free, has no required minimum distribution, and is better for transferring assets to heirs.
This logic typically holds but it may be worth playing with the order in some cases. For example, if 401(k) withdrawals in excess of the required minimum distribution push you into a higher tax bracket, take out just enough to stay in a lower bracket and pull the rest from your Roth IRA because it is tax free. In other words, take you required minimum distributions, then take any additional amounts from taxable accounts and tax-deferred accounts but not allow these additional withdrawals push you into the next tax bracket. If you still find you are needing more retirement distributions, fall back on a Roth IRA. This will help keep your taxes down throughout retirement.
Many people have more than one account for investments, whether they are for everyday savings, retirement, education, or some other purpose. Retirement and education accounts have tax advantages, such as an IRA, Roth IRA, or 529 Plan. Other accounts may not have any tax advantages and may simply be an investment holdings in a brokerage account. The goal with these different investment accounts is to match your investments with the type of tax treatment of the account in order to minimize your taxes on your investment growth. For accounts with the greatest tax advantage such as a Roth IRA, where the earnings and dividends grow tax-free, place your money in your highest growth investments such as growth stocks or growth mutual funds. Stocks, mutual funds, or other equity securities will yield the greatest growth and return over time so you want to be holding them in an account where they will not be taxed. Money market funds or bonds will not yield that same return. Therefore, the lower risk and lower return investments should be in your taxable brokerage accounts.
As an example, I have a Roth IRA account, a 401(k) account with an employer, and a brokerage account. The Roth IRA, as I mentioned, gives me tax-free growth. I pay no taxes on earnings or dividends in that account when I take the money out during retirement. For this reason I would want to put this money into my highest-growth investments. The 401(k) account is a tax-deferred account. I get a tax deduction now on my contributions, but I will pay taxes on the distributions I receive during retirement. Since I will pay the taxes on the distributions, it makes little difference whether these investments have experienced large or little growth as far as my taxes are concerned; I pay the taxes on the distribution amount whether that money was principal contribution money or earnings from the investments. My brokerage account has no tax advantages. I pay taxes on its growth as it happens. Such taxable accounts should hold the portion of your investment portfolio that grows the least so that you pay as little tax as possible. This would most likely be a money market account that is low risk and serves as a nice place to hold a rainy day fund.
In the end the following account types are candidates for high income and growth securities due to their tax-free nature: Roth IRA, Roth 401(k), 529 Education Plans (when distributions are used for qualifying education expenses), and Coverdell Education Savings Accounts.