Money Mommy

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

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Category: Family

On Penny Pinching & Delayed Gratification

We have lost the ability to be penny pinchers.

Afraid to be labeled a tight wad, a miser, or a scrooge, we spend our lives “keeping up with Joneses” and we sacrifice our own financial security to the allure of having it all, all the time.

You can not build financial security if you spend beyond your means.  As I have stated in an earlier blog, you must plan your budget to meet your obligations, including your savings.  If these are not being funded, you do not have money for the extra stuff. I know a couple who regularly invests in a Christmas Club Account.  Kudos to them for planning ahead.  Unfortunately, they are not meeting their current bills, and rarely can pay their credit cards in full each month.  At the holidays, they joyfully present friends and family with gifts that are beyond their means.  They believe that they have carefully budgeted, instead they have put themselves deeper in the hole by allowing their credit card debt to increase and paying more and more interest.

Our great grandparents knew how to pinch pennies. If they did not have the coin to pay for a treat, they did without. Today we have no such constraints.  With a swipe of the credit card, we can buy fancy coffees, doughnuts, the latest fad toys and gizmos, a trip to the movie complete with soda and candy, the newest app, fashion apparel, sporting jerseys, the list is endless. And none of these items are required for life.  Remember the basics we were taught in grammar school: the necessities of life are food, clothing and shelter. Be sure what you are buying is a necessity and not a “want” or a “keeping up appearances” item.

Another story for you: My 90-year old neighbor (who has since died) told me about the day her boyfriend came to her and told her he would not be able to see her anymore.  It was the height of the depression and he could no longer afford the gas to drive from his farm-hand job to her house for their weekly visits.  It would be over two years before he once again came to her door.  The economy had started to improve and he was finally able to afford the gas.  Their marriage would last over 50 years before he passed away. This story spoke to me on so many levels – commitment, sacrifice, frugality.  It is hard to imagine not seeing someone for so long.  We have so many readily available technologies to stay in touch.  But the basic premise is there.  Live within your means, deny yourself the little extra luxuries that are fleetingly important (2 years compared to half a century!) and look towards your future.

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!