4 Goals and Strategies Name your dream: Is it to retire early? Buy a home? Pay for college? Preserve your wealth? Here are the strategies to make it happen.
(MONEY Magazine) – Think about the difference between a valuable piece of financial advice and a valuable financial strategy. Advice takes you from A to B; it's what helps you reach a light in the near distance. Strategy, on the other hand, is what gets you through the long haul. It would be nice if a good tip could get you to your most challenging goal. In truth, though, you'll need something more.
The four articles that follow lay out clear, detailed plans to take you where you want to go. Whether your dream entails retiring early, buying a home, affording your child's college tuition or preserving your wealth for the next generation, we'll give you the tools to help make it happen. Be aware that there are often obstacles along the way. And realize that implementing a strategy takes time and effort. But you may find it's easier than you think. First pick the goal that's right for you, then see for yourself.
1 RETIRE EARLY How to figure out if retiring early is a real possibility
Workers of America, raise your coffee mugs in a toast to the one, the only, the seemingly indefatigable bull market. Mushrooming stock portfolios have afforded us all sorts of material goodies--cars, new homes, vacations, you name it. We are a nation awash in Palm Pilots and pashmina. But for many of us, the bull market is providing something far more precious: the luxury of deciding how long we want to work.
Baby boomers are indeed blessed. The first of the 76 million boomers will hit 55 in 2001, riding a stock market that has more than tripled over the past five years and put retirement portfolios well ahead of where they might have been. The average 401(k) balance grew 26% just from 1996 to 1998, according to the Employee Benefits Research Institute and the Investment Company Institute.
Still, most of us have no idea whether the bull market's magnifier effect really makes early retirement a possibility. Leaving the corporate fold before age 65 is an aggressive financial move, and the big gains of recent years shouldn't give us false confidence about future returns. So just how realistic is the idea of early retirement for you?
That's the issue that Susan and Fernando Morales of Santa Clara, Calif. are wrestling with. They know that retiring at 50 or 55 is far from a slam dunk. So they're putting what they can into their nest egg. Yet setting a dollar target is daunting. "We know what we spend today," explains Susan, who is pregnant with the couple's second child, "but we wonder when calculating for post-retirement income what things will cost, what to use as the inflation rate, what you need for health coverage, what the penalties are for drawing on 401(k) money early...."
To demystify questions like these, we've developed a straightforward approach. Start by doing the worksheet on page 80 to get a rough estimate of how big a nest egg you would need to retire early. While this figure will undoubtedly shift over time, as your aspirations change, it is the essential starting point for any meaningful early-retirement strategy. We also tell you how to determine if you're on track to reach your goal and provide some tips for improving your odds of success.
HOW MUCH WILL YOU NEED?
Expenses drop in retirement, right? Think about it: no commuting costs, no Social Security tax, maybe no mortgage. Then think again, because costs don't always drop as much as you'd expect, and may even rise. Our worksheet recommends that you plan on 100% of your pre-retirement income (less the amount you're putting away for retirement now). You may decide to get surgery on the knee that's always bothered you, to join a golf club, to travel extensively or visit your kids more often. Of course, your spending will not be constant. Early on, it may be high, but as you slow down, so should most expenses.
WHAT RETURNS SHOULD YOU EXPECT?
Despite the fact that stocks have historically provided a real, or inflation-adjusted, return of about 8%--more than double the 3% real return of bonds--few prudent portfolios will be 100% in stocks. So your overall return will likely fall somewhere between 3% and 8%. That's why our worksheet, on the advice of planner Harold Evensky of Coral Gables, Fla., uses a 5% real return.
One word of caution: Returns don't come in nice, even increments, but in unpredictable bunches. If you get lousy returns early in retirement, you may pull out more than your portfolio earns, shrinking your nest egg and severely handicapping your future. Mutual fund firm T. Rowe Price provides a sobering example. Take a $250,000 portfolio invested in 60% stocks, 30% bonds and 10% cash from 1968 to 1998. Assume you withdraw 8.5% of the assets every year. If the portfolio earns the actual 11.7% annualized return each year, the $250,000 lasts for 30 years. But what if you get the actual, uneven returns of that period? The pot runs out in 13 years.
GETTING FROM HERE TO THERE
Okay, you've done the worksheet. How can you tell if you're on track to amass that amount by the time you want to retire? For a very rough sense of how your stake will grow, you can do a crude calculation using the "rule of 72." To see how long it will take your money to double under different conditions, divide your expected annual rate of return into 72. So at 8%, for example, your stake will double every nine years. To get a far more precise handle on your chances of reaching your goal, head to the Net. Sophisticated computerized calculators on many websites can run through any number of scenarios--varying inflation rates, investment returns and asset allocations--to show how tweaking your portfolio or your level of saving raises or lowers the odds that you'll meet your goals. Our free website at www.money.com uses a version of software that Nobel-prizewinning finance professor William F. Sharpe developed for his Web-based offering, www.financialengines.com. Or for $75 a year, you can play with variables to your heart's content at www.directadvice.com and get specific investment advice.
BRIDGING THE GAP
If the number you've arrived at after using our worksheet still seems high, don't despair. We've purposely been conservative--for one thing, by excluding the impact of any potential post-retirement employment. Yet scores of boomers will launch active second careers: Nearly two-thirds (61%) plan to work at least 20 hours a week, according to a study by builder Del Webb Corp.
Aside from increasing your cash flow, a job could also defray significant medical insurance costs--early retirees may have a gap in coverage of as much as $900 a month per couple until Medicare kicks in at 62. Medical coverage "is the primary reason people give for why they work after retirement," says Richard Koski, national director of pre-retirement for Buck Consultants.
Our worksheet also doesn't include any potential windfalls, whether from stock options, inheritances or even real estate. Selling your family home and moving some place cheaper is a standard retirement planning tactic. Most people, of course, would rather not be forced to downsize. That said, it's an option that can significantly boost your investment pool.
You can also look for ways to build up assets. You could trim expenses--take a less costly vacation, say, or keep your car for another year before trading it in--and put aside the difference. You may want to increase automatic deductions you have set up, even by a modest amount, to ensure that you save more. You could also invest more aggressively, perhaps increasing your stock weighting. Over the long term, more risk generally means greater rewards--just be prepared to endure steeper drops along the way. You might also consider postponing your early retirement for a bit, since giving your portfolio even two more years to compound can make a big difference. For example, let's say you had a $500,000 nest egg earning 7% a year. If you began pulling out, say, $40,000 a year, your stake would shrink to $483,854 after two years. But if you left it alone for those two years, it would grow to $572,450--plus whatever you managed to add.
BRIDGING THE GAP, PART 2
Even if your portfolio is way ahead of schedule and you're poised to retire early, there's still a key complication. Where will your cash flow come from if you're younger than 59 1/2 and can't tap tax-deferred accounts without penalties? (See the box on this page for early-withdrawal rules.)
The answer, of course, is your nonretirement accounts--but they alone may not generate enough investment gains and income to maintain your lifestyle. Your only choice: to dip into principal. That may sound like a bad idea, especially as you first embark on a future where you will rely solely on your nest egg. But as long as the amount you take out is less than the investment growth that you earn in your tax-deferred accounts, you wont' be endangering your future.
One accompanying tactic: As you near early retirement, you may choose to cut back on 401(k) contributions (though not below the point where you max out on your company match) and redirect the money into a taxable account. That way you'll have it available during "the gap years."
Similarly, once you hit 62, you have a choice of getting Social Security benefits early, but at a reduced level--25% to 30% lower (that percentage is set to increase through 2022). We'd encourage you to hold out for the bigger payment, provided the amount of principal--and future growth--you sacrifice now is less than the additional benefit you'll get once you're fully vested.
Today, early retirement is more strategic advance than hasty retreat. Boomers may send dictionary makers scurrying to rework the meaning of "retired." The current American Heritage definition: 1. Withdrawn; secluded 2. Withdrawn from business or public life. Not likely.
Laying the groundwork that will support you for 30 or 40 years is no small feat. Who knows what those decades will bring? You might launch a website. You might move abroad. As long as you've planned well, the only limiting factor should be your imagination. --S.W.
The Basics of Retirement
1 Invest the maximum in available tax-deferred accounts--401(k), 403(b), 457, Keogh, IRA and so on.
2 Invest heavily in stocks or stock mutual funds to maximize potential growth and stay ahead of inflation.
3 Avoid funds with high annual expenses.
4 Consider variable annuities, but only low-cost ones and only if you'll hold them for at least 15 years. Variables generally shouldn't be in tax-deferred plans unless you're quickly converting or annuitizing part of, say, an IRA to get a lifetime income (see "One (Small) Cheer for Variable Annuities," January 2000).
5 If at all possible, hold off tapping tax-deferred accounts for loans or early withdrawals, both to maximize the power of compounding and to avoid costly penalties and taxes.
What's Your Number?
This worksheet will help you calculate the rough amount you need to retire comfortably before age 65 in two different scenarios. One assumes that you want to leave a pot of money for heirs; the other is the more achievable goal of amassing a pot of money that you will consume over the course of your retirement. To see how close you are to retiring early, add up all your retirement savings and the value of any lump-sum pension you may be eligible for and subtract it from lines 3 and 4. Our bare-bones calculations assume 3% inflation, an inflation-adjusted investment return of 5%, and a life expectancy of 90; they exclude Social Security benefits.
1. Enter your desired annual retirement income. (We recommend using 100% of pre-retirement income, less what you are setting aside for retirement savings.) $_____
2. Multiply line 1 by Factor A below, based on a target retirement date. This is your projected income need in the first year of retirement. $_____
3. Multiply line 2 by Factor B, based on your age at retirement. The result is the ideal retirement stake you would need: This lump sum should generate enough income to meet your needs without tapping your principal. $_____
4. Multiply line 2 by Factor C, based on your age at retirement. This is your minimum retirement stake: This lump sum should generate enough income only for the period you've designated. After that, your assets will be exhausted. $_____
Years until Inflation Retirement retirement Factor A age Factor B Factor C
0 1.00 50 21.0 18.1 1-5 1.09 55 19.8 16.6 6-10 1.27 60 18.2 14.7 11-15 1.47 62 17.7 14.0 16-20 1.70 21-25 1.97
Source: Tarbox Equity Inc.
RESOURCES SITES THAT CAN HELP YOU REFINE YOUR STRATEGY
www.americanexpress.com Go to "retirement and workplace services" and play with the cool inflation calculator.
www.fidelity.com Calculators and an asset allocation planner.
www.bygpub.com The "Understanding and Controlling Finances" area has in-depth articles and a 401(k) calculator.
www.schwab.com Tips for all stages of retirement and a Q&A with a retirement planner every Wednesday.
www.quicken.com The retirement planner shows if you're on track to meet goals.
Watching your tax-deferred retirement savings compound over the years is a beautiful thing. But what if you need to tap those accounts before the legally sanctioned age of 59 1/2? It's possible--but the financial consequences can be painful. Here's how it works:
--401(k) plans. In general, if you pull money out before 59 1/2, you pay a 10% penalty and income taxes. (There's no penalty if you retire in or after the year you turn 55.) A calculator at www.quicken.com/retirement/401k lets you see the opportunity cost of early 401(k) withdrawals.
--IRAs. The only way you can take money out early without penalty is to make fixed withdrawals based on your life expectancy (or yours and your beneficiary's). Otherwise, you'll pay taxes and a 10% penalty--and you must keep making withdrawals for five years or until age 59 1/2, whichever is later.
--Roth IRA. You can withdraw new contributions anytime. The snag comes if you pull out earnings before age 59 1/2. With a few exceptions (disability, large medical or higher education costs, a first-home purchase) you will pay a 10% penalty--plus income tax on the earnings unless you've held your Roth for five years. --S.W.
2 BUY A HOME Can you afford to buy a new home? These strategies can make it possible.
As mortgage interest rates blow past 8% and sellers' markets persist, what's a would-be home buyer to do? Rent? Rant? Sign up for a storage unit to house out-of-season clothes?
There are no one-size-fits-all strategies for home buying--there are too many variables, from how much cash you have available to how long you plan to stay put. But if you ask yourself the right questions, you can put together a strategy that suits your particular situation. Today lenders are luring customers with an ever more inventive menu of hybrid mortgages and zero down payments. You can even use your investment portfolio as collateral. Choose wisely from these options and you may be sending off those change-of-address cards sooner than you think.
But we're getting ahead of ourselves. Before you get to dissecting financing options, you need to develop a plan. Here's how to begin.
LOOK INTO THE FUTURE
It turns out people move on average every seven years. Where will you be in seven years? Answering that question will help you determine what kind of home to buy and how to pay for it.
Say you expect to move again in a short period of time--perhaps you anticipate a job transfer--you'll want to look for low closing costs and a short-term mortgage that allows you to build up equity quickly. (Or perhaps you should rent, but that's a different story.) If one kid is on the way and the other is about to graduate from day care, you may want to strain your budget now for a larger house in a good school district. On the other hand, if your heart's desire is to settle into an older house and renovate it to your taste, you'd do well to think about a 20- or 30-year fixed mortgage with lower monthly payments. Whatever your plans, it's important that you have some time frame in mind.
SEE HOW YOU LOOK TO A LENDER'S EYES
The next step requires a little financial introspection. Chances are, the type of home you purchase depends on the loan you can get. So it's essential to know in advance how you look to lenders; you may be able to make some adjustments before knocking on their doors.
Your income and your level of debt will determine how much you will be able to borrow. (If you're buying a home with someone else, his or her income and debt count too, since both names go down on the loan agreement.) To determine how much money they are willing to shell out, lenders use two guidelines known as qualifying ratios.
The first one says that a household should spend no more than 28% of its gross income on housing costs. These include mortgage payments, property taxes and homeowners insurance. Tally your monthly income by adding gross wages, overtime, interest and dividends, alimony and any other money that's come in regularly for the last year or two. Multiply the total by 0.28. This is what a lender considers your allowable monthly housing expense.
Now for a reality check. Go to the worksheet on page 84 that helps you calculate the yearly costs of owning the house of your dreams. Divide your annual expenses number on line 4 by 12. If that figure is significantly more than 28% of your gross income, you'll probably have to settle for a smaller mortgage than you might like.
The second guideline concerns debt. Lenders look for your housing expenses plus long-term debt (which you have carried for 10 months or more) to total no more than 36% of your total income. The lower your debt-to-income ratio, the better your chances of getting a good rate. Add up revolving credit-card debt, student and car loans, current mortgage (if you won't be selling), insurance payments and alimony. Recurring expenses like rent or utility bills are not considered debt and should not be included. For help with the math, try an online calculator such as the ones at our own website (www.money.com) and on the sites in Resources, at right.
Another reality check: For every $50 or so of monthly debt above 36%, the amount that lenders are willing to lend you will go down by $6,000.
COUNT YOUR CASH
One of the first questions real estate brokers ask these days is how much money you can pony up for a down payment, which typically runs from 5% to 20% of the purchase price. To answer that question, you'll have to examine your whole financial picture. You don't want to be house-poor, so strapped for cash that you have to cut back on your 401(k) contributions or tap your emergency fund (which should equal three to six months' living expenses).
Your time frame is critical. If you plan to keep your new home for a long time, you'll want to put down as much as possible. Consider two scenarios, each with a 30-year mortgage of 8.47% on a $100,000 home. Put down 10% and you'll pay $690.10 a month in interest and principal; in 30 years you'll have shelled out $158,489 in interest payments. Plunk 20% down and you'll pay $613.43 a month--and in the end you'll have paid $140,835 in interest. So putting down $10,000 more today saves you almost $18,000 over the course of the loan. Plus, if you put down 20% or more, you won't have to pay private mortgage insurance, or PMI, which typically runs 0.25% to 1.25% of the total amount; the closer to 20% you come, the lower the charge.
If, on the other hand, you expect to move on in a few years, a smaller down payment may make sense, since you won't garner the long-term savings and may well earn more investing your money in stocks than you'll pay in effective interest and PMI. One danger of a small down payment: If the real estate market softens and you have to sell the house after only a couple of years, the price you get may not be enough to pay off the mortgage.
If you need to come up with more cash for the down payment that suits your needs, you can, of course, sell stocks or bonds--though that will trigger capital-gains taxes (and, again, may mean sacrificing future earnings). Or you may be tempted to borrow from your retirement accounts--something most financial planners will tell you never, ever to do, since you forgo the compounding interest. (For one exception, see "For First-Timers Only" on page 88.) Here are several smarter strategies for raising cash.
Gifts from friends or family. That's what allowed Deborah Schwartz, who appears on our cover, to buy her first home in Altadena, Calif. She wanted to put down 20% on a $197,000 property, but she was $11,000 short. So she borrowed the cash from her parents and paid them back over the following year. She and her parents were informal about the deal--there was no loan agreement drawn up. It turns out Schwartz's deal qualifies as a gift. Anyone may give up to $10,000 to any individual tax-free. If you're lucky enough to have indulgent parents or friends, you must present proof to the lender that the sum is a gift--and if you're putting down less than 20%, you must pay at least 5% of your down payment out of your own pocket.
Low-down-payment mortgages. Both fixed and adjustable-rate mortgages with down payments of 3% and 5% are available through traditional lenders. Countrywide (800-556-9568) even offers a 0% down mortgage. The rates are the same whether you put down 5% or 20%, but borrowers who come up short will have the added cost of PMI.
Pledged-asset mortgages. Borrowers who want to continue taking advantage of a high rate of return on their investments--or to avoid the capital-gains tax they'd incur by selling--might consider a pledged-asset mortgage. Both Merrill Lynch (www.ml.com; 800-854-7154) and Fidelity (www.fidelity.com; 800-544-6600) offer such plans. Here's how they work: Using your nonretirement accounts as collateral, the firm lends you up to an average of 39% (at Merrill) or 50% (at Fidelity) of the value of your accounts. In return, you must get your mortgage through a company selected by the brokerage--GMAC Mortgage at Fidelity and a subsidiary at Merrill. The advantage: You don't have to come up with any cash for your down payment. The drawbacks: You may not get the best rate on your mortgage. And if the assets fall below a number fixed by the lender, you get the equivalent of a margin call: Come up with cash or sell securities.
Help with closing costs. Closing costs and fees can add as much as 5% to 7% of the purchase price. If liquidity is a problem, fold some of these costs into your mortgage.
GET THE RIGHT RATE
The two big issues are how long you think you will stay in your new home and how big a monthly mortgage payment you can handle.
If your time horizon is short. If you think you'll remain under one roof 10 years or less, consider a hybrid adjustable-rate mortgage. ARMs are fixed for the first three to 10 years, then adjust every year after that. Recently, a seven-year hybrid ARM was 7.67%, almost half a point lower than the 30-year fixed. That's pretty appealing. Last year, Dino and Michelle Aloisio were buying a home in Pasadena. Since they expected to live there for less than seven years, the couple decided to take out an ARM for five years at a rate of 6.1%. With 30-year fixed rates then hovering around 7.25% and a mortgage of $456,000, that came to a savings of almost $350 a month for the Aloisios.
If you plan to stay put. Don't go for an ARM if you think you won't move for 15 or 20 years; once the adjustable portion kicks in, your rates could climb sharply, wiping out any earlier savings. Comparison shop for a 20- or 30-year mortgage with the lowest possible rate. You may also want to consider paying points. Each point--1% of the principal--typically trims your interest rate by .25%. And points are tax deductible.
If you're buying a new home before you've sold your old one. Ask the seller to finance the mortgage. You give the seller 5% to 10% as a down payment, then pay monthly at an agreed-upon interest rate. You save on points and closing costs, and the seller gets an income stream. The trick in this hot market is finding an owner willing to make this deal.
New twists. To get the best rate, look for a locked-in rate when you get pre-approved, sometimes available for no extra charge, or a float-down option, for a $250 fee, which lets you take advantage of a lower rate should one materialize before you close. --J.C. and N.P.
What Will It Cost?
Once you have a particular home--or one of a particular size in a particular community--in mind, fill out this worksheet to get a rough idea of the annual out-of-pocket costs of owning that home vs. your present home. To estimate mortgage payments and tax-deductible interest, consult your lender or use an online calculator. (See Resources on page 86.) For taxes and approximate homeowner's insurance costs, consult your real estate agent. Renters: Enter annual rent on line 1 of the left-hand column, and any relevant upkeep expenses on line 3.
CURRENT HOME NEW HOME 1. Annual mortgage payments 1. 2. Annual real estate taxes 2. 3. Annual upkeep (cleaning, association fees, 3. insurance, landscaping, repairs, utilities, etc.) 4. Total annual expenses (add lines 1, 2 and 3) 4. 5. Amount of mortgage payments that is interest 5. 6. Total tax-deductible expenses 6. (add lines 2 and 5) 7. Tax savings (multiply line 6 by your 7. top federal income tax rate) 8. Annual after-tax outlay 8. (subtract line 7 from line 4)
Note: If your state allows a tax break for real estate taxes or mortgage interest, your overall tax savings will be somewhat higher. Source: PricewaterhouseCoopers.
RESOURCES CHECK OUT THESE SITES FOR MORTGAGE CALCULATORS.
www.mortgage.com Factors in interest-rate changes and presents the information in a graph or table. Easy to navigate.
www.hsh.com Details monthly balances for the term of a 30-year mortgage.
www.homepath.com Fannie Mae's consumer site. Easy for beginners to use.
Where to Put Your Down Payment
Wondering where to put the money you're saving for your down payment? Your goals: a high return and the security that the money will be there when you need it. Here are the best options.
--If you plan to use the money in a year or two. A CD is safe, especially for three to six months; for this month's best rates, see By the Numbers on page 194. But in today's rising-interest-rate environment, financial planner Harold Evensky advises that you "find a money-market fund from a strong fund family that pays the highest rates." One good choice right now: Strong Investors Money Fund (800-368-3863), which boasts a seven-day yield of 6.04% with a minimum investment of $1,000 and a maximum of $50,000. If you're starting small, TIAA-CREF Money Market Fund (800-223-1200), with a $250 minimum, has a seven-day yield of 5.81%. Caveat: Money-market fund yields can change rapidly.
--If you plan to use the money in two to five years. Look for a short-term bond fund with a good long-term rate and low expenses. Check out Vanguard Short-Term Corporate bond fund, with a three-year average annual return of 5.47% (800-851-4999) or, if you're in a top tax bracket, Vanguard Short-Term Tax-Exempt; its current 4.06% yield is the equivalent of a 6.24% taxable yield for a taxpayer in the 35% bracket. "The maturities in short-term bond funds are longer than a year," says Evensky, "so if you need to withdraw the money within a few months, you could lose principal." (Rates as of Feb. 8, except Vanguard Short-Term Corporate, Jan. 31.) --JUDY FELDMAN
For First-Timers Only
If you've never bought a home before, you should look into several funding options designed for first-timers. Among them:
--Roth IRA. This isn't a tactic we encourage, because consistent retirement saving is so important for your future. But you can always withdraw your own contributions to a Roth, since they've already been taxed--and once your account is five years old, you can withdraw up to $10,000 of earnings tax- and penalty-free to buy a home, as long as you haven't owned one in the preceding two years.
--Mortgage Revenue Bonds. If you earn below the median income for your area, you may be able to get help with your down payment and closing costs from your state or local government, which raises funds for this purpose by issuing MRBs. MRBs can also help qualified first-time buyers reduce monthly payments through low- interest-rate financing. Ask your local real estate agent about availability.
--Special products from Fannie Mae and Freddie Mac. If you earn no more than the median income in your area (or, in some high-cost localities, up to 170% of the median), ask lenders about products from Fannie Mae (800-732-6643) and Freddie Mac (800-373-3343) with relaxed credit and income guidelines. The maximum loan is $252,700. --J.C.
3 PAY FOR COLLEGE New state savings plans and a diversified portfolio can get you there.
For parents struggling to save for their children's college education, the recent news about tuition might seem like reason to cheer. In January, for instance, Williams College announced that it would freeze tuition costs for the 2000-01 academic year. Earlier, the College Board reported that after years of 7%-plus annual increases, college cost inflation was rising at a more modest 4% rate. And all the while, new 529 college savings plans that allow families to have tax-deferred savings for college have been cropping up around the country.
But don't get carried away. College costs are still outpacing the cost of living. Williams charges a steep $31,500 a year, including tuition, room and board. And as we'll see in a moment, 529 plans--named after a section in the tax code--aren't for everyone. Meanwhile, college expenses are still daunting: To put a newborn through four years of Ivy League schooling, you would, in theory, need to save thousands every year.
So here's some unconventional advice: Don't try to do it, especially if it would derail your retirement savings plans. After all, for many families there will be financial aid available for college, even if it comes in the form of loans--but no one is going to finance your retirement. That's why many financial advisers suggest you treat saving for college like saving for a down payment on a house. You can't expect to pay the whole bill up front, but anything you can put away now reduces the need to borrow later.
In this article we'll show you how to make the most of your college savings portfolio. To begin, we'll offer advice on the pros and cons of keeping money in your child's name; then we'll weigh the merits of 529 college savings plans against Education IRAs. Finally, we'll explain why any smart strategy should include a diversified portfolio of stocks or stock funds. And what if you're a late-starting saver? There's still hope. See "If You're Starting Late" on page 92 for last-minute tips.
But first, let's assume that you have some time to save. Ready? Here's your game plan.
TAKE A LOOK AT CUSTODIAL ACCOUNTS
You might think that putting money in an account in your child's name is a smart move. You'd be right--but only up to a certain point. Under the Gifts to Minors laws, you can pass along up to $10,000 a year to your child free of taxes (two parents can give $20,000). And that money can be invested in anything from bank accounts to stocks and bonds to mutual funds.
The good news: The first $700 a year that the account earns in investment income is tax-free, and the next $700 a year is taxed at the child's rate. But that's where the breaks peter out. Any amount above $1,400 a year is whacked at the parents' top rate, as high as 39.6%, until the child turns 14. At that point, the entire amount is taxed at the child's rate.
Moreover, putting money in a custodial account can cost more in aid (including loans) than you save on taxes. The formulas for determining aid require a child to contribute as much as 35% of his or her assets per year, while parents are expected to pay up to 5.6% of theirs. That means a sizable custodial account will limit the aid you receive much more than, say, a fund in your name. In addition, there's a risk that by putting the money in your child's name, you give up control. If you need to draw on those funds for some financial emergency, you won't be able to unless it's for your child's direct benefit. And once the child turns 18 (or 21 in some states), there's little to prevent him or her from using the dough to go to Belize instead of Brown.
So here's a reasonable compromise: Put a limited amount into a custodial account, just enough to qualify for the tax break. If you're certain you won't get aid (and you're confident that your child is college-bound), Kal Chany, author of Paying for College, suggests this: Invest in growth stocks, which appreciate in value but pay small dividends. When the student turns 14, sell the stock and take the capital gain, which is taxed at the child's rate. That's around the time you should start to shift to bonds anyway.
CONSIDER A 529 SAVINGS PLAN
A modest custodial account will get you only so far, of course. That's why other specialized plans should come into the picture. Although they're called retirement accounts, Education IRAs are really special educational savings accounts. You do not get a deduction for the money you put away but, just as with the Roth IRA, money saved in an Education IRA can be withdrawn tax-free, as long as it is used for higher education expenses (tuition, books, room, board and the like). Problem is, you can save only a paltry $500 a year per child--barely enough to make a dent in college costs. Another consideration: If you contribute to an Education IRA, you cannot put money in a 529 plan in that same year for the same beneficiary.
For those reasons, you should probably steer toward the latter. State-sponsored 529 college savings plans allow families to save tax deferred for college until the money is withdrawn, at which point it's taxed at the child's rate. So far, 23 states have launched some type of 529 savings plan, with nine more set to open new plans this year. Already 529s hold some $7.2 billion--up 40% since last June--which is spread among 1.2 million accounts.
First, some background. There are actually two varieties of 529 plans. The older version is the prepaid tuition plan, which allows you to lock in the future tuition of selected state colleges at today's rates. But with tuition inflation now averaging 4% (3% for public schools), that's a low rate of return. The newer variety of 529--the one you've been hearing most about and that we'll discuss here--is the college savings plan, which gives you more options.
These savings plans can be a boon for investors in top tax brackets who have young children and do not expect to qualify for financial aid--they're the ones who can benefit most from the tax-deferred growth. The money can be used to pay the costs of any college, regardless of where you live or where your child wants to attend school. Unlike Education IRAs, there are no income limits for participation in 529 savings plans, and you can put away anything from $2,000 (Iowa) to $100,000 or more per child (New York and others), either in lump sums or through automatic deductions. (For the estate-tax implications, see "Preserve Wealth" on page 97.) Your money is placed in a mix of funds based on the age of your child--typically, the allocation is most aggressive for newborns and becomes more conservative as college draws closer. For all savers, the money will grow tax deferred until withdrawal, when it is taxed at the beneficiary's tax rate; for a child, that's usually 15%. (Many states also exempt the earnings on their own plans, and a few even allow a tax deduction on the money you invest if you do so in-state.) And unlike custodial accounts, 529 plans remain in the control of the parents.
If you don't like your in-state plan, some 17 savings plans are available to out-of-state residents, and many are run by well-known investment firms. Among the better performers: Maine (Merrill Lynch), Massachusetts and New Hampshire (both Fidelity). Of course, you'll need to weigh your choice against any potential state tax breaks that you may receive for staying in-state, as well as the plan's fees and withdrawal rules. (For links to these plans, log on to www.collegesavings.org.)
In the meantime, keep in mind that 529s have plenty of flaws. For starters, if you prefer to manage your own investments, you may find 529s too limited. You must submit to the asset allocation of the state--and that's often a conservative ratio of bonds and stocks. If you should become dissatisfied with the plan's performance or if you move to a different state, it can be tough, if not impossible, to shift money into another plan without paying taxes and penalties, notes C.P.A. Joseph Hurley, a 529 plan expert in Pittsford, N.Y. Another potential liability: 529 savings are currently treated as a parental asset, "but these plans are so new that financial aid directors don't know what to make of them," says Kal Chany. "As families start accumulating more money in them, aid directors will want a bigger piece."
One final consideration: When you withdraw the money from your 529 plan, be sure to have additional funds set aside. You can't use 529 assets to pay Uncle Sam without triggering taxes and penalties; that's because tax payments are not a qualified higher education expense. Bear in mind that you will also pay taxes--at your rate--if your child ends up not going to college.
HEDGE YOUR BETS WITH STOCKS AND FUNDS
If you choose a custodial account and a 529 plan, you can round out your strategy--and maximize your chances for high returns--by putting additional money in a well-diversified portfolio. And for active investors who want to remain in full control, setting up your own portfolio may be the sole (and preferred) plan of attack. In either instance, the best way to save is the automatic savings plan, which regularly funnels money from your bank account into the fund of your choice. If you're feeling squeezed, start out by saving a small amount--say, $100 a month. Then up the ante as your salary grows.
If your children are still young, at least 80% of your portfolio should be invested in stocks, which have the best shot at outpacing college costs. (For more details on asset allocation, see "Perfect Timing" at right.) You can minimize taxes by focusing on growth stocks that pay little or no dividends, or funds that own such stocks, notes Ray Loewe, president of College Money, a financial planning firm in Marlton, N.J. The truly tax-averse can focus on index funds, which by their nature register few taxable gains, or so-called tax-efficient funds that specifically seek to offset taxable gains with losses.
A stock investing strategy is working for P.J. and Jeff Broadfoot of Van Buren, Ark. The couple have about $130,000 in college funds set aside for their four children, ages 13, 11, 8 and 6. "We're investing mainly in growth stocks, such as Cisco, IBM and Wal-Mart, as well as funds like Janus," says Jeff, who works for the U.S. Department of Agriculture. But the couple are careful to keep saving in their own retirement plans as well. Says P.J., a veterinarian: "If they want to go somewhere besides a state school, they're going to [need to] win scholarships."
Then again, with the help of a good strategy--and just the right mix of stocks and funds--you never know. --P.W.
If You're Starting Late...
So your child is almost ready for college but your finances aren't? Don't panic--and don't raid your retirement accounts. Instead, consider other options. Perhaps your child can qualify for aid, or maybe there are generous grandparents in the picture. You also have plenty of loan choices. Here's how to make the most of your prospects.
--SIZE UP YOUR AID ELIGIBILITY Even if your child is still a freshman or sophomore in high school, you should get an early estimate of your financial aid eligibility; for Web-based calculators, see our list of Internet resources on page 94. One key point: The base income year (the one colleges use to make their financial aid decisions) is the tax year before college begins--that is, Jan. 1 of the child's junior year of high school to Dec. 31 of the student's senior year. So if you act fast, you may be able to qualify for more aid. Paying off consumer debt, for example, which is not considered in financial needs analysis, will reduce your assets and boost your aid prospects. Also consider such moves as accelerating bonuses or taking capital losses. For more tips, pick up a copy of Paying for College by Kal Chany.
--AIM FOR MERIT AID College financial aid packages are increasingly based on the student's merit, not parental income, and at many schools, even a B student can be highly sought after. That's why it's crucial to identify schools where your teen is likely to be in demand. Not only will that help maximize your chances of financial assistance, but you may be able to leverage competing offers. A good source on admissions strategies: Discounts and Deals at the Nation's 360 Best Colleges by Bruce Hammond. Or consider hiring an independent college adviser to guide you through the process. (For referrals, call 800-808-4322.)
--EXPLORE YOUR LOAN OPTIONS In the end, you can always borrow. One good deal may be tapping into your home equity. Interest on home-equity loans is generally tax deductible; rates recently averaged 9.12%. You can also turn to federal PLUS loans that let parents borrow up to the full cost of college (current rate: 7.72%). There are no income limits, but you must begin repaying PLUS loans 60 days after you receive the funds. One other option: education loans offered by private lenders, which allow parents to defer repayment until the student graduates. --P.W.
RESOURCES WHERE TO GO FOR UP-TO-DATE ONLINE INFORMATION
www.collegesavings.org The official 529 plan site, sponsored by the state treasurers' association, where you can find links to plans in your state
www.savingforcollege.com Run by 529 plan expert Joseph Hurley, this site provides regular updates on college savings plans. You can find details about each plan's strengths and weaknesses, as well as a lively message board.
www.finaid.org At this one-stop shop for college planning, you can find everything from aid-eligibility calculators to scholarship searches to detailed explanations of student loans.
www.collegeboard.org The purveyors of the dreaded SATs can help with the financial aid process. Their site offers calculators, scholarship searches and useful facts.
www.fastweb.com Best known for its searchable database of 400,000 scholarships, this site also provides general financial aid info--including calculators--as well as tips on admission.
Perfect Timing As your child gets older, your college savings portfolio will need to evolve--that means fewer stocks, more bonds and cash. Here are three asset-allocation models worth following:
AGES 0-14 Bonds 0% to 20% Stocks 80% to 100%
AGES 15-18 Cash 25% Bonds 25% Stocks 50%
AGES 19-22 Cash 75% Bonds 25%
Source: College Money, Marlton, N.J.
4 PRESERVE WEALTH How to shield your estate from taxes and make your money last
What are your hopes for the wealth you've amassed through a lifetime of hard work and smart investing? A financial safety net for your family? A college education for your grandchildren? For Mel and Ruth Kohl of St. Louis (right), their dreams include preserving a 24-year-old business where three generations of family members have worked. Whatever your goal, you may not reach it if you don't take steps to protect what you own. You can't shield your estate from every threat, but you can keep it from getting mauled by federal estate taxes, which, at 37% to 55%, may be the biggest menace of all. Here's how.
The good news is that you can leave more than ever to your heirs tax-free: $675,000 this year, $700,000 in 2002 and $1 million from 2006 on. (As always, you can leave an unlimited amount to your spouse, as long as he or she is a citizen.) But thanks to the recent gains on Wall Street and a booming economy, you can't assume that the estate-tax exemption is rising fast enough to protect your wealth. Indeed, the federal government expects the number of taxable estates to grow by roughly 5% a year through 2004, drop for two years as the $1 million exemption takes effect, but then pick up once again in 2006.
To determine whether your estate will outstrip the exemption, first tally up what you have now, including the value of your home, retirement funds, investments and life insurance death benefit. Of course, to get a snapshot of what will be left for your heirs, you'll have to estimate the future value of your assets--minus what you'll spend in retirement. Even if predicting your financial future seems as uncertain as reading tea leaves, the exercise is worthwhile. "Most people don't have a clue what they're worth, and they end up paying estate taxes because they didn't realize how much they have," warns New York City estate attorney Martin M. Shenkman. You can go online for help. The same calculators that let you see if your money will last through your retirement can also provide a best-guess estimate of what you'll have left. Try www.quicken.com/retirement or the American Savings Education Council site, www.asec.org.
Once you know whether your estate is likely to exceed the estate-tax exclusion, settle on your goals. If what you care about is making sure your kids can buy a home or put their children through school, consider making tax-free gifts now. By paring your estate, you may be able to reduce or eliminate estate taxes altogether. You can give an unlimited number of people up to $10,000 a year each without triggering federal gift tax; married couples can give up to $20,000 a year.
You can give even more tax-free by paying tuition or medical bills. If the payments go directly to a school, hospital or other institution, you won't trigger federal gift or estate taxes, no matter the amount. You can contribute up to $50,000 to some state college savings plans in one year (or $100,000 if you're married, filing jointly) without incurring a federal gift tax as long as you don't make additional contributions for the next four years. (For more on these plans, see "Pay for College" on page 90.)
If you have substantial assets, the best way to preserve your hard-earned estate for your heirs is to establish a trust. These vehicles can help you do more than reduce estate taxes, including avoiding costly probate or controlling how your heirs spend inheritances. No matter what trust you choose, you'll need to work with a financial planner as well as an estate attorney. The one-time costs of drafting the trust documents range from $1,000 to $10,000, depending on the size and complexity of your estate. You may also have to pay ongoing maintenance fees.
Here are five reasons you might want to set up a trust--and the vehicles that will best help you reach those goals.
DOUBLE WHAT YOU AND YOUR SPOUSE CAN LEAVE TAX-FREE
If your and your spouse's combined assets exceed the estate-tax exemption, there's a relatively simple way to double that tax break: Open credit-shelter trusts, also called bypass trusts, which let a husband and wife claim one exclusion apiece. Credit-shelter trusts are "easy to set up and easy to manage," says Dee Lee, a financial planner in Harvard, Mass. "They're not so fancy or complicated that you can't live with them."
Here's how they work: You and your spouse must divide your assets. (It's possible, but more difficult, to fund credit-shelter trusts with jointly held property.) Then you each bequeath property worth up to the estate-tax exemption to a credit-shelter trust. If you die first, your spouse can tap the trust until his or her death, at which time the remaining assets go to your heirs tax-free. Plus, the surviving spouse can leave his or her own estate to the kids tax-free as long as its value doesn't exceed the exemption.
SUPPORT CHILDREN FROM A FIRST MARRIAGE
Tax avoidance isn't the only reason to set up a trust. For instance, what happens if your surviving spouse remarries and her new husband spends the money you hoped would go to your kids? A credit-shelter or bypass trust helps to safeguard your assets for your heirs. But remember, you can't put in more than the estate-tax exclusion. If you have remaining property, add a Qualified Terminable Interest Property, or QTIP, trust. "Usually bypass trusts and QTIPs go hand-in-glove," says New York City C.P.A. and attorney Stuart Kessler. "In most second marriages, I'd advise it."
Under QTIP rules, your spouse must receive income from the trust for life--and can tap the principal if you wish. Upon his or her death, the QTIP will pass to your heirs as part of your spouse's estate (so it may be taxable).
SHELTER A LIFE INSURANCE POLICY
Your most valuable asset may be that rich life insurance policy you bought to protect your family. Well, you may have bought your loved ones a hefty estate-tax bill instead. Life insurance proceeds are taxable, even though many people think otherwise.
To make life insurance payouts estate-tax-free, move your policy into an irrevocable life insurance trust. The trade-off is that you must give up ownership of the policy, which means you can't borrow against it or change beneficiaries. Two more important caveats: You may owe gift taxes when you fund the trust and pay the premiums, depending on the policy's value and the number of beneficiaries. Second, if you die within three years of establishing the trust, the death benefit will be included in your estate.
PROVIDE FOR YOUR GRANDCHILDREN
If your children have already built up sizable assets, leaving them money may only shift estate taxes to the next generation. Fortunately, you have several ways to support your grandchildren, including direct gifts, custodial accounts and a generation-skipping trust, which will be part of your estate, not your children's, and therefore subject to estate taxes only once.
You can make a direct tax-free gift or fund a custodial account--best known by the acronyms UGMA and UTMA--if you don't want a young child to have the money right away. The child, however, does gain complete control of the money at age 18 or 21, depending on the state.
By contrast, if you set up a generation-skipping trust, you can control when a grandchild, or any other beneficiary at least two generations your junior, will receive the money and for what reasons. You can even let your kids collect income from the trust.
But tread lightly. If you put more than $1.06 million in the trust (or $2.06 million if you fund it jointly with your spouse), a 55% generation-skipping tax kicks in on top of the already hefty estate tax (unless the children's parents have died).
KEEP A FAMILY-OWNED BUSINESS INTACT
Protecting a family firm from crippling taxes is tough for two reasons: The small business estate-tax exemption is only $1.3 million and, to qualify for the break, you must meet a slew of specific requirements. If you run your own business, a family limited partnership can help keep taxes from wiping out your legacy. With this complicated tool, you essentially transfer ownership of your business to a partnership that you control. Over time, you give family members limited interests. Because they don't control the business, their shares can be valued at less than fair market value--which can reduce your estate-tax liability. You may even avoid estate taxes if the discounted value of the shares is less than the estate-tax exemption.
Once again, family limited partnerships must be handled gingerly so that the potential tax savings don't vanish. The IRS stays alert for excessively discounted shares, so hire an expert to appraise the business and calculate the discounts.
Ruth and Mel Kohl are considering a family limited partnership to pass their metal-compound manufacturing firm to their three children. "If the business continues to grow and the value of the stock rises, it's probably a good idea," says Ruth. "We're really proud of the success of the business, but the added dimension is having our children working here for their future and their children's future." --L.H.
RESOURCES WHAT TO READ TO LEARN MORE
Death & Taxes: The Complete Guide to Family Inheritance Planning by Randell C. Doane and Rebecca G. Doane. One of the most thorough and easy-to-understand estate-planning books around.
The Complete Book of Trusts, Second Edition by Martin M. Shenkman. Detailed discussions on the potential benefits and little-known pitfalls of 50 types of trusts. Also, check out Shenkman's site, www.laweasy.com, for sample forms and a glossary of terms.
9 Ways to Avoid Estate Taxes by Mary Randolph and Denis Clifford. Your best starting point; clear explanations of gifting, bypass trusts and charitable donations.
Beyond the Grave: The Right Way and the Wrong Way of Leaving Money to Your Children (and Others) by Gerald M. Condon and Jeffrey L. Condon. Arguing that family wars can be just as devastating to estates as taxes, the father-son lawyer team emphasizes the "human factor" in estate planning.
What to Do with an IRA
The stock market gains of the past decade may have given you an unexpected luxury: more money in your individual retirement account (IRA) than you'll ever need. If so, you face a dilemma: Should you drain your Roth or traditional IRA, put it in a trust or leave it intact for your heirs? Here are the best ways to preserve the income tax benefits for your heirs.
--The basics. Put off tapping an IRA as long as possible so that it can continue to grow tax-sheltered. If your spouse won't need the IRA, make your children the beneficiaries. Leave the account in your estate. Cashing in the IRA to put it in a trust will make the earnings taxable. If the IRA is sizable enough to trigger estate taxes, Ed Slott, a C.P.A. in Rockville Centre, N.Y. and editor of Ed Slott's IRA Advisor, suggests buying life insurance to cover the bill.
--Roth IRA. Bequeathing a Roth is relatively simple. You don't have to tap the account during your lifetime, so the entire IRA can flow to your beneficiary, who can choose to stretch the income-tax-free withdrawals over his or her lifetime.
--Traditional IRA. You must start tapping the IRA by April 1 of the year after you turn 70 1/2. To leave behind as much as possible, name a young beneficiary--your distributions can be based on your and your heir's joint life expectancy. (The IRS, however, considers a nonspouse beneficiary to be no more than a decade younger than you.) As for the distribution method, Lisa Osofsky, a partner at M.R. Weiser & Co. in New York City, suggests term certain, which results in a set number of payouts. That way your heirs won't have to cash out your IRA more quickly or even all at once when you die. --L.H.
Find the Right Pro
Okay, so you need to hire an accountant or financial planner to help you plan your estate and an attorney to draft a trust and will. But how do you know if the pros have the right expertise? We asked David S. Rhine, director of family wealth planning at the New York City accounting firm BDO Seidman, for advice:
What's the first thing to look for in a lawyer or planner?
Hire a pro who spends substantial time, roughly 40% to 60%, on estate-planning issues. You don't want a financial planner who devotes his practice to advising clients on investments or a lawyer who specializes in real estate.
What about referrals?
Make sure other clients have financial profiles similar to yours. If you're worried about estate taxes, you don't want a lawyer or planner who works with smaller, nontaxable estates.
Are special degrees and memberships important?
Membership in the American Bar Association's estate-planning arm or the National Association of Estate Planning Councils is a plus, but doesn't mean much unless someone's actively involved to keep abreast of estate-tax issues. They should be participating in lectures or other activities that are challenging.
Do I need to know about estate planning first?
Estate planning is not do-it-yourself. However, the more informed you are, the better you can interact with an expert. Educating yourself so you know the buzzwords will help you evaluate the estate-planning options that are available. --L.H.