Money Mommy

Stuff your mom should have taught you, but didn't…

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Year: 2016

Winning the Lottery!

Win the lottery! Win a new life! The allure of gaining a new life by simply plunking a dollar on the table is mind boggling.  Just one dollar for a lottery ticket. Anyone can afford that. Why wouldn’t you?

I met Benny 3 years ago.  He was one of the lucky ones. Benny won a million dollars from his state lottery when he was 35.  For the next twenty years, he would receive a check for $40,000, with the extra $10,000 going for taxes. For Benny, with a high school education and a warehouse job, this was a fortune. Set for life, he decided to quit his dead end job and live on his winnings. The years went quickly.  Benny soon discovered that $50,000 was actually a modest amount – especially since he had to pay his own medical insurance.  His lottery check remained stagnant at $50,000 each year even though inflation was slowly eroding its purchasing power. Every April, he looked forward to receiving a $4,000 tax refund from the $10,000 he had had withheld.

I met Benny 3 years before his lottery money ran out.  At 52 years old with no education and no experience, he was now struggling to find a job.  While many people his age were starting to think about retiring and social security, Benny had realized that he had not been contributing to social security and was consequently not eligible to collect. He planned to sell his modest trailer home and hope his extended family would allow him to move in.

I saw Benny again last year. He had not received a lottery check the previous year. The twenty years had already passed. There would be no tax refund that year. He came in anyway, hoping for a miracle. He had not found a job and was getting his place ready to sell. He brought in a sack of losing lottery tickets. He pushed it across my desk saying that’s all he had to report this year. And I had to tell him there could be no refund because nothing had been withheld. He went away sad and discouraged.

I hope you never win the lottery. But if you do, never quit your day job.

Smart Phones and FSA Plans

Medical Flexible Spending Accounts (FSA’s) are a great way to save money on your out of pocket medical expenses. By budgeting your expected expenses for the coming year and using your employer sponsored FSA plan, you can literally save hundreds of dollars in taxes.

It is important to remember that medical expenses must be within the FSA plan year. This means that you can only use qualified expenses occurring in the same year as the FSA.  If the plan year runs from Jan 1, 2016 through December 31, 2016, then the medical expense must occur during January 1, 2016 through December 31, 2016. If you see a dentist on December 29, 2015 you can not use 2016 FSA money to pay that bill, even if you pay it in January 2016. To use their Flexible Spending Accounts most advantageously, people often make medical appointments or purchase medical supplies and contact lenses etc in late autumn to use any money remaining in their FSA accounts.  Conversely, others choose to wait until January when the new plan year starts if they have no funds left in their Flexible Spending Account.

IRS regulations may allow employers to permit an additional 2 1/2 month grace period or allow employees to carry $500 into the next plan year. Check with your employer to see if their plan has one of these options.

Remember: although Flexible Spending Accounts are excellent tools for your financial health, they should not dictate your medical health.  Follow the directives of your health care providers for necessary appointments, prescriptions, tests etc  -Money Mommy

Depending on your FSA plan, you may need to submit your medical bills to the FSA provider for reimbursement. Or you may receive a prepaid credit card for your qualified medical expenses. Or you may put an app on your phone to request reimbursement for qualifying expenses. I have had experience with all three methods.

Medical bills can be submitted by mail, fax or email. Simply fill out the necessary form provided by your employer, gather the bills – copying or scanning as necessary –  and send them off.  Don’t forget to request payment for medical mileage. Payment will be received in a few weeks.

Using a prepaid credit card is the epitome of ease at the doctor’s office or pharmacy.  With a simple swipe of the card, medical bills are paid directly to the health care providers from your FSA account. Be aware that FSA providers often require a copy of the bill to substantiate medical expenses. If the required bills are not submitted in a timely manner, your FSA card may be  suspended until such proof is received.

Putting an app on your phone is a third option.  Many FSA providers have apps that allow you to submit medical bills by taking pictures of them.  Within a few days, your reimbursement for your qualified out-of-pocket expenditures and medical mileage will be deposited directly into your back account. Unlike the prepaid credit card, you will not need to substantiate medical expenses at a later date since you have already submitted a picture of your medical receipts with your request.

Whatever method you choose for reimbursement, don’t put off starting your own Flexible Spending Account.  You can literally save hundreds of dollars in taxes.

 

 

On Flexible Spending – Medical Expenses

The concept of Flexible Spending Accounts (FSA’s) is so simple that people think there must be a catch.  There really isn’t. You budget what your expected annual out-of-pocket medical expenses will be.  Then, you request that amount of money be allocated to your FSA account.  Your salary will be reduced by that amount, so no income taxes will be due on that money.  Although your employer is deducting that amount over the full year, the entire amount will be available to you on January 1 (if that is the start of your plan year.) It is true that you will forfeit whatever you don’t spend, but this is not as much money as you might think.  Let’s examine these points more closer.

(In 2016, the most you can contribute to an FSA is $2,550.00 or approximately $49 per week.  For my examples, I will budget $520 towards medical expenses or $10 per week.)

Budgeting for medical expenses. Let’s assume you visit the dentist twice a year for cleanings ($200), are anticipating four “well baby” visits ($140), and plan on buying new glasses ($180).  Opening a medical FSA for $520 will give you immediate access to those funds on January 1, even though you have budgeted $10.00 per week. You could choose to purchase your new glasses immediately or wait. This will give you some additional flexibility. Because, even though you have regular cleanings, you might also have an expensive cavity. In that case you could choose to put off buying glasses until next year and use the funds available in your FSA account for the unexpected dental bill. Glasses could still be purchased towards the end of the year if funds remain in your FSA account; or they could be put off another year.  You are in control.

Immediate access to budgeted funds.  If you anticipate a major medical expense, FSA accounts will allow you to accumulate the necessary funds immediately and painlessly.  A good friend informed me she needed new dentures.  She anticipated that she would need to wait six months before she saved the $520 needed for a down payment. Luckily her employer  offered FSA plans, and they were still in the open enrollment period. My friend immediately signed up for the FSA plan.  The full amount was made available to her on January 1, and she was able to schedule a dentist appointment for January 10. Her employer reduced her wages by only $10 per week.

Deducting medical expenses from your taxes. Yes, medical expenses are deductible on Schedule A of your tax form.  But for most individuals, these deductions will not affect your taxes.  You can read why on my new blog.  So, the only way to get a federal tax break for most individuals is by using Pretax Dollars from an FSA or HSA account. (But we are focusing on FSA accounts in this blog.)

Tax Savings! I just mentioned saving on your federal taxes. Most Americans are in the 10% or 15% tax bracket. This means of the $520 that we placed in our FSA example, most Americans would save $52 or $78.  Not bad.  But there are more tax savings.  Since the $520 was not included in their wages, there will not be any social security or medicare taxes; additional tax savings of $39. Nor will there be any state or local tax owed on the $520. State tax brackets range from 3% to 13%, so let’s use the middle,  8%, for illustration purposes.  In this case the state tax saved would be $41.  So, we have $520 available in our FSA.  However, we have reduced our overall taxes by at least $132.

Use It or Lose It.  This is true.  If you don’t use the full $520 during the plan year, you will lose the remaining dollars in your account.  I have had people who were wary of opening an FSA because they didn’t want to lose any of their money.  If they choose not to use the $520, they will pay the taxes of $132. This means that only a portion of that $520 actually ends up in their pocket.  In fact, in order to break even in their FSA account they would only need to spend the difference of $388 ($520 – $132.)  The rest would have gone to pay taxes. But since the entire amount was placed in the FSA account, they actually have a free bonus of $132 to use.  Remember, FSA accounts can be used for  dental work, glasses,  diabetes testing supplies, hearing aids and batteries, contact lenses and a myriad of other items as well as medical copays and prescription drugs. So if you find yourself with additional funds at the end of the year, consider purchasing some of these items.

But I’m Healthy and Have Great Insurance.  I have met a few people who are indeed blessed with great health and have equally great insurance with little to no copays, and therefor no medical expenses.  If you are in that enviable position, an FSA might not be for you.  Just know that it is there should the need every arise.  Meanwhile I’m putting in my $520 and saving at least 25% in taxes.

Thoughts on Debt and Credit

Debt. Definitely a four-letter word.  And one to be avoided at all costs.  But no, not really.  Debt is simply another tool in your financial tool box.

When you go into debt, you have borrowed money with the intention of paying it back.  (Otherwise, it is simply stealing.)  Credit is a form of debt where you get the benefit of something now, and promise to pay for it in the future.    Credit includes mortgages, car loans, education loans, business loans and certainly credit cards.

The credit industry is very active and certainly very lucrative.  Count how many credit card offers you receive in the mail; notice how often you are asked if you want a store credit card; listen to the television and radio commercials.  In exchange for paying later, you agree to pay interest every month.  The interest can easily be 18% to 30%, or as low as 0%.  Meanwhile, a whole industry has sprung up to convince you that creditors are evil and that you should not have to repay your loans.

Let me just say it: Ridiculous!  If you are old enough and mature enough to get credit; you should be mature enough to handle it.  I’ve got some suggestions for repaying your credit card debts here, but let’s take a look at some of the different types first.

If you are considering  going in to debt, FIRST consider how long you will benefit from your purchase.

Mortgages allow you to buy a house before you can save the money to buy one (or even build your own.)  Typically, mortgages last anywhere from ten to thirty years.   It seems reasonable to go into debt for a lifelong home.  Be sure to calculate the mortgage, utilities and taxes in your budget before you choose your home.  Failure to pay your mortgage would be very serious to your financial health.

Education loans are another common form of debt.  Here you are pledging future earnings for knowledge and training for a future career.  But, be very wary of taking on student debt.  You may be condemning yourself to a lifetime of debt.  I know a young couple who are starting their married life with education debt exceeding a third of a million dollars.  Ouch. Teaching is a very noble profession, but teachers are notoriously low paid.  Take the steps you can to minimize your student debt now – community college; instate and commuter schools; work study programs; apply for scholarships and grants.  Education is so important; choose carefully and wisely.

Car loans have some very low interest rates to entice a buyer.  In our car dependent society, most people see a car as a necessary luxury.  We need them to get to work, grocery shop, school, the list is endless. If you do decide to purchase a car, remember that you are in control.  You choose the make and the model, and ultimately the cost of your vehicle.  I know young people who bought a car so they could go to work.  Now they go to work to pay for their car.  It is an endless cycle.  Choose a vehicle that will fit in your budget, and aim to pay the car loan off within four years. Once you do pay off this loan, continue to place the same amount in a separate account each month.  This will provide you with funds to pay for necessary car repairs or purchase a replacement vehicle in the future.

I saved store and credit cards for last.  This form of debt creeps up very slowly and bites you before you see it coming.  Going through the drive-thru every day for breakfast or out for lunch may only cost you $10.00 a day, but at the end of the month you will have spent over $300 and have nothing to show for it.  Pay a minimal $25 (which the credit card company is quite happy with, since you now owe interest on the remaining $275), and continue the same pattern and you will owe nearly $600 on your credit card. By the fourth month your credit card bill is over $1,000 and you still have nothing to show for your debt.  Add in a few store credit cards for clothing and other “feel-good” purchases, and you are on your way to being seriously in debt.  Remember, you are in control!!  By using your credit card, you have agreed to pay your bill with interest.  The first month you can not pay off your credit card is when you stop using your credit card. If you are not still benefiting from your credit card purchases that you are still paying for months later, then you should not use the credit card to pay for them.  This is the time to use cash for your splurges.  If you don’t have enough cash – you don’t buy it.  Be in control of your own debt.

Like a chain saw, credit is an incredibly powerful too.  It must be handled carefully, or it could destroy your financial house.

 

 

The Roth IRA for College Savings

I’ve given a huge rant on why I don’t think you should use a 529 to save for college. I’ve laid out the scenario of when you still might choose to start a 529 savings account. Now you might be wondering what steps you should take to prepare for future college expenses.  The answer is quite simple: open a Roth IRA.

When you open a 529 account, you do not get any deduction on your federal taxes.  However, as the money grows, you never pay taxes on the growth – provided you use it to pay qualified education expenses.  The mere fact that the growth will not be taxed  is the only advantage that a 529 has.  The ROTH IRA has the exact same attribute, but without many of the restrictions that make the 529 so unappealing.

The IRA was conceived to be a retirement account: Individual Retirement Arrangement.  At age 59 1/2, you can take out funds completely tax and penalty free, as long as your IRA was started at least 5 years ago.  Taking it out early would incur some penalties, but there are notable exceptions. Among the exceptions is using your IRA to pay for college.  You can use your ROTH IRA to pay for college for yourself or your children with NO penalties or tax consequences.  Exactly the same way a 529 works.

However, there are additional benefits to placing college savings in an IRA over the 529 account.

You will still be eligible to receive education credits such as the Lifetime Learning Credit or American Opportunity Credit if funds are taken from your IRA.  If you use funds from a 529 Account for education expenses, these same expenses will not be counted when you calculate the credit.  Remember, the American Opportunity Credit alone is worth $10,000 in tax savings.

By law, money saved in retirement accounts (such as the IRA or a 401K) are not included in the FAFSA calculations to determine federal student aid. On the other hand, money saved in a 529 account counts heavily against the student aid that will be made available.  FAFSA also examines your adjusted gross income, as shown on your 1040, to calculate student aid.  Money taken from a ROTH IRA for education benefits will not be taxed and will not be included in your adjusted gross income.

Because the government wants people to plan for their retirement, they first offered the Saver’s Credit in 2002 as an incentive to the populace to take an active role in their financial security.  Depending on your income, you could save up to $1,000 off your taxes for saving money in an IRA, a 401K or a 403B.  Once again,  the 529 is not eligible for this credit.

Finally, (and this is BIG) you are not limiting your scarce investment resources to pay for just one scenario.  If you do not need the money for college, the money you saved in the ROTH IRA is still available for your own personal retirement. It is your own account in your own name. There will be no penalty when you take it out for retirement.  There will be no taxes when you do take it at retirement.  However, that money had been available to be used exactly the same as if it were in a 529 account if you had needed it.

 

  • Your education tax credits are not limited because you used funds from a 529 account.
  • Your federal student grants and loans have not been decreased because you have funds in a 529 account.
  • You can use funds earmarked for education in your ROTH IRA to receive the Saver’s credit.
  • You can use the funds originally saved for education for anything you want if they were placed in a ROTH IRA (subject to age requirements).
  • You have not limited your options at all.

 

But you have saved.

 

 

 

 

 

Flow Chart for a 529

The 529 is a valid option for saving for college. You place money for future college expenses in a special account called a 529.

These accounts were named after Section 529 of the IRS code that originally created them back in 1996 in response to the need to save for ever rising college costs.  The concept is simple.  You set money aside in a special savings account administered by a state or educational institution.  There are no federal tax savings when money is first placed in the account, although many states will allow a deduction off the state income tax.  However, there will be no tax on any future capital gains, interest or dividends if funds are later withdrawn for qualified educational expenses.  Depending on your tax bracket, you could save a full one third of this future growth that would otherwise be forfeited to federal taxes.

Let me repeat, the 529 is a valid option for saving for college for some individuals.

Let’s do a simple flow chart and see if they are for you.

First, are you contributing enough to your 401K at a work to receive the maximum amount that your employer will match?  If your employer matches the first 5%, then you should have 5% allocated to your 401K.  If he matches the next 3% at only half as much, then you should still allocate an additional 3% for a  full 8% to your 401K.  You have just doubled the first 5% of your savings.  The next 3% received a fifty percent boost.  No other investment offers such immediate guaranteed returns.

If you are maximizing your 401K, read on.  If not, then the 529 is not for you.

Second, are you fully contributing to your IRA?  Currently (2016) you can contribute $5,500 to an IRA – either Traditional IRA, Roth IRA or a combination of both. (i.e., $3,000 to a Traditional IRA and $2,500 to a Roth IRA for a combined total of $5,500.)  Individuals over 50 can contribute an additional $1,000 as a catch-up contribution.  IRA’s can be funded for both the husband and wife provided at least one spouse has taxable earned income of at least the current year’s IRA contributions.  IRA’s can be opened at any bank or brokerage house.  You should check with your tax advisor before opening your IRA and then you should fund your IRA every year.

So, if both you and your spouse are fully funding your IRA, read on.  If not, then the 529 is not for you.

Do you expect to apply for and receive financial aid in the form of federal grants and loans?  When my husband and I filled out our first FAFSA form for our eldest son, we were amazed how much we were expected to contribute to his education. We were further dismayed to learn that the 529 we had diligently saved counted directly against us when it came to determining how much federal financial aid he would receive.

If you do not expect to receive any financial aid, the 529 my be for you.  If you expect/hope to receive federal aid, then the 529 is not for you.

Will you be eligible for education credits such as the American Opportunity Credit, Hope Credit or Lifetime Learning Credit? One of my favorite moments when completing taxes is asking parents for their students 1098T college tuition statements.  If their income is under $80,000 ($160,000 if filing joint), they are eligible for the American Opportunity Credit (AOC).  The AOC can reduce the tax bite by a full $2,500 for each of four years, a total savings of $10,000 over your child’s college career, based on qualifying education expenses of at least $4,000 each year. The Lifetime Learning Credit can reduce their taxes by a further $2,000 as long are attending school.   The government, however, does not allow double dipping.  If you pay college expenses with 529 accounts, you can not use those same college expenses to qualify for the AOC or other education tax credits.

If you will qualify for education credits based on your expected income, do not invest in a 529.  If you are lucky enough to be highly compensated and will thus not qualify, then read on.

Do you have superfluous funds that you are willing to allocate solely to education?  When you start a 529, that money is earmarked for education.  If you use it for anything else, you will pay penalties and taxes on the growth.  Of course, if your child does not attend college, you can share the 529 with another family member, or even use it yourself to further your own education.  I, for one, would prefer not to limit my investment dollars.

As I stated earlier, the 529 can be a fine way to save for college.  But without a crystal ball, I am reluctant to place limited resources in such a limiting account.  The ROTH IRA will overcome virtually all the concerns about saving for college, and will leave you maximum control over your investment dollars in the future.

 

 

 

 

529’s? Forget it!

I have to just come out and say it….Do Not Open a 529 college fund for your kid!

A quick “google” of 529’s will give you a plethora of sites singing the praises of the 529 college fund. The concept is really simple.  Start saving early.  Your money will grow tax free.  When you take it out to pay higher education expenses, none of the money will be taxed.  Your child will walk debt-free  across the stage at commencement.

Unfortunately, life is just not that simple. And unless you have a crystal ball, the 529 is not necessarily a good thing.

Suppose your child is incredibly talented and leaps right from high school to a music or acting career.  Or perhaps they are athletic and head right into the big league.  No college for them.  You cannot touch the money you had saved in a 529 without incurring penalties and taxes.   Imagine how disheartening it would be if your child decided to live in your basement and play video games.  You would be even more discouraged about that 529.

Our friend’s son went right from high school into the marines. They certainly were proud of him.  They had also dutifully saved for his college education in a 529 account.  They can’t touch that money without triggering penalties and taxes unless they use it for education.  Their only child is making a career of the military and does not expect to need it for his education.  The only option is to give the 529 money to a distant relative or bite the bullet and pay the taxes and penalty.  Neither choice is very appealing.

But suppose you have a student who is following the traditional path of high school to college to career.  Aren’t you glad you started that 529 for them now!  Not so fast. Nearly all students will fill out the Fafsa, and your child’s financial aid will be negatively impacted by your prudent college savings.

The Fafsa is the Free application for federal student aid form.  By submitting the Fafsa form you will be told your “expected family contribution” or EFC to pay for college.  This will determine the federal grants and loans that your student is eligible for.  The Fafsa form is incredibly detailed, requesting information from  the parents’ and the child’s tax forms, their savings, investments, wages, property, partnerships, 529 savings etc. Parents are currently expected to contribute 5.64% of their assets towards the EFC; students contribute 20%.  The bite is harder on earning; Fafsa uses 22 – 47% of the parents’ earnings and 50% of the student’s income to calculate the EFC. Put another way, nearly  everything you have saved and everything you earn can be used to reduce your student’s federal grants and loans.  (There are a few exceptions such as retirement accounts and the family home.  You’ll find out how to use these to your advantage in this blog entry. – MoneyMommy)

Okay, despite everything I said, you still want to save in a 529 account. You’ve heard this is the best option, and I haven’t managed to convince you otherwise. While I commend your due diligence, let’s see what happens to your taxes now that your child is in college.  There are awesome education credits that can reduce your taxes by $2,500 for up to four years. That is a savings of $10,000! After four years, the Lifetime Learning Credit can generated up to $2,000 more for continued higher education each year.  Wonderful!  Except for one small problem.  You used a 529 account to pay his college expenses.  The government does not allow double dipping when completing your taxes.  You will not receive these education credits for any expenses that were paid for with 529 funds.  Your diligence just cost you $10,000 in higher taxes.

So, unless you are quite well off and are maxing out all of your retirement accounts, have lots of spare change, don’t expect to receive any financial aid, and won’t qualify for any education credits, do not start a 529 account! 

Steps for New Parents

A new baby is a life changing event!  Have I stated the obvious? Your home will be one of upheaval when a new baby arrives.  Those idealic weeks of planning the nursery and imagining yourself holding a smiling baby will quickly give way to the reality of changing diapers, spitting up, sleepless nights, and a crying baby.  I’m here to tell you that it is all worth it!  I look back on those hectic early months and only remember snuggling my sweet babies in their little jammies and listening to their baby coos. It’s only when I actually skype with my sons and their new babies that I am reminded of the chaos that a baby can bring into a well ordered life.  My daughter-in-law put it very simply, “I knew it would be hard in the beginning, but no one told me how much I would really love having him.”

Along with setting up the nursery, daycare, feeding schedules, car seats, baby wardrobe etc comes some other very big responsibilities.  Don’t put these off.  In fact, you might just want to start them before baby even arrives.

First and foremost is your will.

Who will take care of your child/children should you pass away. Don’t be silly and put this off just because you can’t face the prospect of your own mortality.  Look at this as a gift to your child and the chosen guardian. I have been totally honored to be asked to step in as a guardian if the unthinkable happens for several different friends and family.  I am forever grateful that I never needed to fulfill this role.  But I did take special joy over the years watching these various children grow into adulthood.  Don’t be afraid to change the guardian in your wills as circumstances change: i.e., a move out of state, a change in child rearing philosophy, drifting apart from old friends.  I changed my will a few times as my children were growing up to ensure the best person for them at different stages of their lives.

When you choose your guardian, do not automatically list both halves of a couple.  If you want Aunt Jane, then just specify Aunt Jane.  Uncle Frank will be there too.  Given the crazy divorce rate, no one can guarantee that your sister or brother’s marriage will last forever.  You don’t want your child caught in the divorce settlement or being sent to live with an ex-partner that you haven’t seen in years.

Sometimes, the best guardian for your child’s physical and mental needs might not be the best one for their financial needs. You might consider a financial guardian, institution or a trust for this purpose.  At that point, you need to determine how much money will be made available for the ongoing care of your child and at what time all the funds would be made available to your child.  At 18? 21? All at once or slowly over time.  I recently did the taxes for a 65 year old woman.  She and her sister were each receiving $100 a month from her aunt’s estate for the past 40 years.  At one time, that was a lot of money.  Now it barely covered the groceries. Even after forty years have passed, they can’t change the trust.  So please, don’t try to control forever from the grave.

Now is a good time to review and update your beneficiaries.  Check your life insurance policies, your pensions, your 401 K’s, your IRA’s, your TOD accounts.  Make sure they go to the person you want.  The internet is full of stories of people who didn’t update their beneficiaries.  Upon their death these assets did not go to their family and loved ones.  Instead they went to an old grumpy uncle, a divorced spouse or a forgotten fling from thirty years ago.  It takes only a little time to protect your family by updating your beneficiaries.  Remember, whomever is listed as the beneficiary of these life insurances, pensions, IRA’s etc is the person who will actually get the money at the time of your death, regardless of what you might put in your will later.

This is also a good time to make sure you have ample life insurance to provide for your family.  Both parents should have adequate life insurance whether both work or not.  After all, the “bread earner” may bring home the bacon, but the stay-at-home parent provides the “daycare” and various other home duties that would otherwise have to be paid for.  Competent daycare can cost upwards of $1000 a month.  Consider term insurance which is substantially cheaper than whole life.  You will also want it for 20 – 30 years; longer if you plan on more than one child.  My own children are seven years apart.  When my eldest turned twenty, my youngest was still thirteen.  If my life insurance had ended after only 20 years, she would have had no financial net during all of her teen years.

You just had a baby.  Are you already thinking of saving for college?  Unless you have limitless funds, DO NOT INVEST in a 529!  I know, this is totally opposite of what most financial advisors tell you to do, but please listen to me.  Instead, you should contribute the maximum to your ROTH IRA.  As long as you are married and one of you has wages, both of you can have an IRA.  It is here that you will start saving for baby’s education.  This is such an important topic, that I have written a whole blog entry about it.  Meanwhile, trust me.  Start your IRA. Now.

While we’re on the subject of IRA’s and retirement income, make sure you are taking advantage of any employer sponsored 401K.  See my entry on starting 401K’s if you haven’t already begun one. Time goes fast when you have a little one.  Why it was just yesterday that you were carefree and attending high school or college, and now you have a whole new person depending on you.

Speaking of work related benefits, check out any maternity or paternity leave that might be offered by your employer. Be sure baby is added to your health insurance as soon as possible.  If you both are planning to return to work after baby and you need child care, consider signing up for your employer’s dependent care flexible spending plan.  You will not pay (and therefor will save!) taxes on money set aside and used for qualified daycare expenses. This works the same as flexible savings accounts for health care, another work related benefit you should consider using.

With all this financial talk, let’s not forget the baby! Ever! I’ve heard too many horror stories of children forgotten in a hot car.  Strap your purse, your briefcase, your lunchbox, whatever! in the back with your baby.  We might forget we were supposed to drop a sleeping baby off, but I don’t know too many who will forget their purse when they leave the car.  For the more technological, they even make gadgets that will beep if you get too far from a car seat.  Remember: Protect my grandbabies at all times!

 

401K “Let it be!”

Did you listen to me?

Did you start your 401K?

Excellent!

Now leave it alone!  No, I don’t mean the occasional rebalancing.  I mean the whole thing!  Leave it alone!

Nearly every year that I have prepared taxes, someone comes in with a decimated 401K. No, I’m not talking about a 401K that is riding the roller coaster of the market; I am talking about a 401K that has been purposely destroyed.  This is the account that was cashed out in one ill conceived moment.

Let’s review the attributes of the 401K.

It is first and foremost a retirement plan.  You are saving for your future self. With a little luck and a modest 6% return, it should double every twelve years.  That means that one thousand dollars (invested at 22) will turn into two thousand dollars by the time you turn 34; then four thousand dollars at age 46; eight thousand dollars at 58 and sixteen thousand dollars by the time you are 70 and ready to retire. Save two thousand dollars when you are 20, and you will have thirty-two thousand dollars at 70. Many companies will match whatever you are willing to invest in your own 401K.  So, if you save two thousand dollars in your 401K, your employer will place an additional two thousand dollars in your 401K.  Now you will have sixty-four thousand dollars at retirement, and all you had to do was save two thousand dollars in your 401K.

A 401K is designed to be used for retirement.  To encourage you to save, the federal government will NOT tax you on any money you put in your 401K.  This means that you will save $300 in taxes if you invest two thousand dollars in your 401K and you are in the 15% tax bracket.  Put another way, that sixty-four thousand dollar retirement only cost you one thousand seven hundred dollars.  If you are in the 25% tax bracket, you will have actually only spent one thousand five hundred dollars, since your taxes will be decreased by five hundred dollars. It is only when you retire and start using the 401K that you will pay taxes on this money. By then, your peak wage earning years will be over and you will probably be in a lower tax bracket. Until that future date you will not owe any tax money on your own contributions, your boss’s contributions, interest, dividends or any growth in your 401K.

So, we have a retirement plan with no tax liability until we take it out. Hopefully, we will be in a lower tax bracket when we take it out.  However, if we take it out BEFORE retirement age – usually 59 1/2 – there is a ten percent penalty on the money withdrawn early.  That doesn’t sound like much. IT IS!!!!

I have seen many naïve individuals in their peak earning years cash out their 401K’s early.  My last simpleton was 40 years old when he was laid off last year.  His severance package swelled his taxable income to nearly one hundred thousand dollars.  Then he decided to use his 401K to pay off his mortgage, so he cashed that out too.  With that decision, all of his 401K became taxable. Tacked onto his regular pay and severance package, the tax rate on his 401K  soared up to 28%.  An additional 10% was required to pay a penalty for early distribution.  With state taxes taking another bite, fully one third of his nest egg was used to pay taxes.

What should he have done?  Well, he used it to pay his mortgage off.  But, he could have tightened his belt and continued to make payments.  He could have taken the minimum necessary to survive from his 401K and allowed the balance to grow.  Assuming that he needed an additional one thousand dollars a month, he could have opted to only take twelve thousand dollars out last year.  The penalty would still be 10%, but the tax rate would have been lower, and he would have had time to find another job.  He could have opted to start taking annual payments from his 401K, generally known as a 72T to avoid any penalties.  (Google it if you are in these circumstances – Mommy)

My simpleton was 40. Last year, he had a 401K worth seventy-two thousand dollars.  By the age of sixty-six, assuming 6% growth, he would have had two hundred eighty-eight thousand dollars, over a quarter of a million dollars, to use during his retirement.  Instead he settled for just over fifty thousand dollars after taxes.

 

 

Personal Budgets A Top Down Approach

We’ve all heard it.  You need a budget! What’s your budget? Did you budget for that?

Ugh.  How to get started.

Budgets are simply  a framework for  handling your money. They are as fluid, detailed and structured as you want them to be. At the very least, you should know whether you have enough money for your expenditures.

Your first budget is a first pass. Just a guess. Know that it will change over time and that’s OK! That really is what it is about.

Marie bought her first house on a whim.  Tired of renting, she went  house hunting, found a little place that the realtor said she could afford, and made an offer.  Imagine her delight when it was accepted!  She moved her studio apartment into a 3-bedroom bungalow and that’s when reality set in.  Mortgage, insurance, taxes, repairs, new fridge and stove, furniture, car loans.  She called me in a panic when she received her first property tax bill.  “Mom, they made a mistake!  I paid all the taxes when I bought the house!  They just sent me another bill!?”  Somehow, her dad and I neglected to tell her that property taxes come due every year.  We all got a chuckle out of her naivety. Luckily, she still had enough in her checking account, but it was clear she would need a budget to handle her funds.

Although I am a bookkeeper by trade, I do not want to track every penny.  Neither does my daughter.  And especially neither does my husband! We opted for a Top Down Approach for her budget.  We divided  her expenses into tiers: fixed, necessary, discretionary, savings and emergency.

In the fixed tier we placed her mortgage, car and property insurance and property taxes.  We totaled these expenses for the year, and then divided that number by 26  since she received a pay check every other week.  (If you receive a monthly pay check divide by 12; if you receive a weekly pay check divide by 52.) This amount was put in a separate checking account every pay period.  Every month, her mortgage was paid from this account.  And every year, when property taxes and insurance come due, there will be enough in this account to cover them also.  Marie also added her installment payments to this account – $40 for her fridge; $30 for her student loans – and increased her biweekly deposits to cover those expenses.  She then set up automatic payments, so she would never be late, and she was building excellent credit.

Next we turned our attention to the necessary expenses – utilities, food, gas, phone bill, etc.  A portion of her check was placed in a second account to cover these costs.  Since these payments would fluctuate, she would need to monitor this account a little more closely. She could control these costs to some extent and she could adjust the amount of her paycheck that was allocated to this second account.  There are oodles of sites for conserving electricity – another word for sayings – and making succulent cheap meals to save.

Finally we have the discretionary tier.  Anything you don’t need to live as a functioning adult, but would like to have. New clothes, morning coffee shop, movies, sports events, gifts, eating out, vacations, apps for your phone, the list is endless.  Once you have the fixed tier and the necessary tier properly funded, the remainder of your pay check can go here. This tier can be further sub-divided to fit your personality. Do you need/want a category for gift giving, charitable donations, the hair dresser etc.  You may decide that some of these items are not discretionary, but necessary. Allocate your paycheck accordingly.

Notice that I did not include a tier for savings and emergency funds.  That is because these are the over-arching tiers that you must have, and yet are the first things that are omitted to balance a budget. As we created her tiers, we allocated a healthy 15% to savings and apportioned funds to create a six month emergency fund,  Unfortunately, this meant there would not be enough to cover even the second tier of necessary expenses.  It became necessary to decrease the percentage of savings and slow down the accumulation of emergency funds.  These will be increased over time as pay raises happen and fixed debt (ie car loans) are paid off.

So there you have it.  A Top Down Approach.  Emergency funds and saving first.  Then determine what your fixed expenditures are and allocate appropriate funds there.  Next, place funds in a second account to pay all necessary living expenses.  A final account will hold your totally discretionary funds. Any of these accounts can be subdivided if you want to save for something specific. IF necessary, you can tinker with the Emergency and Savings tier to meet fixed and necessary  expenses.  But DO NOT give up your future security for current short term enjoyment. You can always move your discretionary funds into fixed or necessary accounts.  But NEVER pull money out of your fixed account to pay discretionary items.  This is a sure sign that you are living beyond your means.

Remember, you are in charge!