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Archive for November, 2007

Don’t Confuse Stocks with Bonds

November 28th, 2007 at 05:10 pm

In the November 28th Wall Street Journal, Jonathan Clements seems to suggest that investors increase their yield on the fixed asset (bond and bond funds) portion of their portfolio by buying stocks (especially banking stocks) with a high dividend yield.

What his column seems to ignore is that a significant reason to buy fixed assets is to provide diversification and protection for when the stock market tanks. High yield stocks have a high yield because the company can find nothing better to do with their income than to redistribute it to their shareholders. Stock holdings in these companies can often be a high risk investment.

Often, high yields occur when a stock price falls precipitously. Consider Washington Mutual (WM) which currently yields around 13%. This stock has fallen approximately 60% since June, when it’s 5% yield was considered high. In WaMu’s present financial condition, the odds are very high that the dividend will receive a substantial cut in the near future.

The reason to diversify into fixed assets is not for your fixed income investment to outperform the equity market. You diversify to lower your overall investment risk. Short term bonds, CDs and money market funds will hold most, if not all of their value when the stock market sinks. High yielding stocks will fall with a falling market, often at an even faster rate than the overall market.

If you choose to chase high yields, be sure that you do not confuse stocks with bonds. Keep your high yielding stocks on the stock side of your portfolio. They are NOT fixed assets that will hold their value when the market declines.

Coverdell Education Savings Account

November 26th, 2007 at 02:29 pm

A Coverdell Education Savings Account (ESA) is an ideal way for young families to save for their children’s educational expenses. With a Coverdell ESA, you are able to save $2,000 annually, for each of your children, from the time they are born until they reach age 18. The Coverdell ESA deposits may be made by anyone, providing a great way for grandparents to help in fund their grandchild’s education.

You may set up a Coverdell ESA account at any institution that offers IRA accounts. A Coverdell ESA has tax advantages that are similar to a Roth IRA.

While the initial contribution to the account is not deductible, all growth and income from the account escapes taxation, as long as the withdrawn funds are used for education related expenses. These expenses can include tutoring, computer equipment, room and board and even school uniforms.

Funds from a Coverdell ESA may be used to pay for educational expenses from kindergarten through graduate school. The longer that the funds are allowed to grow, the greater will be your financial benefit.

Your may fund both a Coverdell ESA and a Section 529 College Savings Plan in the same year. A Coverdell ESA has Adjusted Gross Income limits for the contributor of $190,000 for couples or $95,000 for individuals.

If your income exceeds that limit, perhaps your parents or even your child’s godparents might be willing to make the contribution. Remember, you can always gift up to $12,000 to anyone, without any gift tax consequences.

If the funds in a Coverdell ESA are not consumed before the beneficiary reaches age 30, the beneficiary receives the remaining funds and must pay both income taxes and a 10% penalty on the remaining funds.

To avoid this problem, you may rollover the remaining Coverdell ESA assets to a sibling, a niece, a nephew or even the beneficiary’s child.

Start a Coverdell ESA as early as possible in your child’s life to help fund their education. As Robert and Cindy find in Financial Abundance Guide, the $2,000 per year that they invest for each of their children grows to $54,300 by the time the child is 15, with an 8% annual return on the invested funds.

Tax free income makes the Coverdell ESA an excellent vehicle for educational savings.

Save Taxes With a Roth Conversion

November 23rd, 2007 at 11:12 am

As 2007 comes to a close, now is the time to decide on strategies that can save on taxes, either now or in the future.

If 2007 has been a year in which your income is lower than your normal income and if you will have significant “Schedule A” income tax deductions, you may want to consider converting some of your traditional IRA funds to a Roth IRA .

Using your 2006 tax return as a guide, determine your approximate 2007 income. Reduce your income by contributions made to your Health Savings Account, IRA contributions, self employed health insurance and 1/2 of any self employment taxes paid. The remainder will be your approximate Adjusted Gross Income (AGI) for 2007.

If your AGI is over $100,000, you are not eligible to make a Roth conversion in 2007.

If your AGI is under $100,000, determine what your approximate “Schedule A” itemized tax deductions will be in 2007. Schedule A includes home mortgage payments, medical expenses, charitable gifts and state and local taxes plus any property taxes.

Your next step is calculate exemptions by multiplying your total number of claimed dependents (including yourself) by $3,400.

Subtract both your approximate Schedule A deductions (or the Standard Deduction, if that is greater) and your exemptions from your estimated 2007 AGI. The remainder is your approximate 2007 taxable income.

As a single filer, subtract your taxable income from $31,850. The remainder is the approximate amount of your IRA holding that you can convert to a Roth IRA at a 15% tax rate.

As a joint tax filer, subtract your taxable income from $63,700. This is the approximate amount that you can convert to a Roth IRA at a 15% tax rate.

Once you have converted IRA funds, they will grow tax free until they are withdrawn. When they are withdrawn, the withdrawals will also be totally tax free. The small amount of taxes that you pay now will keep you from paying significantly more in taxes when you retire.

There is one caveat. This approach should only be used if you have adequate non-IRA savings to pay for the increased taxable amount. However, if you are able to pay the increased taxes, your long term tax savings can be significant.

2007 Roth IRA conversions must occur before December 31, 2007. If this approach may be appropriate for you, do your homework now, so the conversion can be completed before the end of the year.

The Risks of Joint Tenancy

November 20th, 2007 at 11:48 am

Joint Tenancy with Rights of Survivorship, commonly call JTROS, is considered a “will substitute.” When you own property in JTROS, you own an undivided equal interest in the property with the other joint tenant(s). If an owner dies, the property passes to the surviving owner(s), without going through the deceased’s probate estate.

Many people use JTROS ownership to keep property out of the slow and often costly probate process. When a JTROS property owner dies, the remaining owner(s) has immediate access to the property and can use it or sell it at his/her discretion. The ability to avoid probate and to provide your surviving spouse with immediate access to the JTROS property makes this a very popular form of ownership between spouses.

Some of the risks associated with JTROS ownership are estate planning risks. Since the JTROS property passes outside of the deceased’s estate, it cannot be used to fund a “Bypass Trust” or any other type of estate planning device. If the JTROS property is owned by a married couple, ½ of the value of the property is included in the deceased spouse’s estate. If the other owner is not a spouse, the full value of the property is included in the deceased’s estate, unless the other owner(s) can prove that they contributed to the purchase of the property.

Other risks, associated with JTROS property, come from the fact that the owners have an “undivided equal interest” in the property. As described in detail in Financial Abundance Guide, this type of ownership can lead to unintended consequences. A lien can be placed on the property by one of the owners, without your knowledge. The property can also be sold and all of the funds taken by one of the JTROS owners, even your spouse. Finally, since JTROS property passes outside of probate, any disposition of the JTROS property that is included in your will is ignored.

Own property with your spouse in “tenancy by the entirety” instead of JTROS, If your state provides for this type of ownership. With “tenancy by the entirety,” you and your spouse must jointly consent before the property can be sold or gifted.

There are many situations where joint tenancy with rights of survivorship may be the best form of property ownership. However, it is important to understand the risks associated with using JTROS property ownership as a “cure all” for estate planning.

Financial Advisors: Which Type is Best for You

November 17th, 2007 at 12:39 pm

You recognize that you need help with financial planning and advice on the investments required to meet your financial goals. How do you find an advisor that is right for you?

The way an advisor is compensated can influence the advice that they provide. Let’s look at compensation methods for financial advisors.

Commissioned based advisors – These advisors typically sell both insurance based financial products and load mutual funds. They will often state that their financial planning services are “free” and that you will pay no commissions, as long as you hold the product for a period of five years or more. Always ask the advisor what they will receive in commissions for each product you are offered. Once you know what their commissions are, you know how much you are really paying for their advice.

Fee based brokerage advisors – To join the popular trend of charging fees instead of commissions, brokerage firms are offering “fee based” accounts. You pay an annual fee, based on a percentage of the assets in the account. For this fee, you may make unlimited trades without paying any brokerage commissions. Commissions on mutual funds (such as the 12-b1 annual load) and certain proprietary products may also compensate the broker.

Fee only assets based advisors – These advisors provided professional asset management and financial advice and typically offer products that pay no commissions. Their compensation is based on an annual percentage of the assets that you place with them to manage.

Fee only financial planners – Fee only financial planners provide financial planning and investment advice for an hourly fee and/or retainer. They sell no products and receive no commissions. Since they are advising you on all of your financial resources, there is no incentive to have assets under management.

On the surface, advisors that sell commissioned-based products appear to charge less than fee only advisors. However, when you “look behind the curtain,” you will often find that the commissions paid are more than you would pay for fee only based advice.

To demonstrate this, ask a commissioned based financial advisor about variable annuities. Then compare their product with a similar product from Schwab, Fidelity or Vanguard (all non-commissioned brokers). You will always pay more for the variable annuity from a commissioned broker than you do from a non-commissioned brokerage firm.

Financial advisors are legally required to tell you how they are compensated. Always ask how they will be compensated for financial advice provided. Once you know how they are compensated, you can determine if any conflicts of interest might arise. With this knowledge, you can make an informed decision on the type of financial advisor that is best for you.

Section 529 Plans for Grandparents

November 15th, 2007 at 07:56 am

As you may already be aware, a Section 529 College Savings Plan is an excellent method of saving for a child’s college education.

The funds invested in a Section 529 College Savings Plan will grow on a tax-free basis and, when used for secondary educational expenses, can be withdrawn with no taxes ever paid. By never paying taxes on the plan's income, you are effectively buying educational services at a “discount”, equal to the combined federal and state taxes that you would have paid on the plan’s growth.

What you may not know are the benefits that Grandparents have when setting up a Section 529 Plan. The person that sets up the plan is the plan owner, with another person named as the plan beneficiary.

Setting up the plan is considered a completed gift to the beneficiary and is covered by the federal gift tax annual exclusion of $12,000. However, with a 529 Plan, you may elect to make a gift of up to 5 times the annual exclusion rate, allowing up to $60,000 to be given to each beneficiary or $120,000 if your spouse agrees to “gift splitting”.

If you or your parents or grandparents are concerned that their estate may someday be required to pay estate taxes, this is an excellent way of removing up to $120,000 for each grandchild from the estate, and avoid all gift and estate taxes.

The unique part of a 529 Plan for Grandparents is that, even though the funding is treated as a completed gift, the owner has virtually complete control over the 529 Plan funds. In the future, the owner can change the beneficiary to anyone in their direct family tree.

The owner can even ask for the money back, if their finances change. If the owner asks for the money back, they must pay ordinary income taxes plus a 10% penalty on the 529 Plan’s gains and income. However, all of the money in the plan will come back to the owner.

The Section 529 College Savings Plan is the only plan that I know of which allows giving money away as a completed gift and still maintaining virtually complete control over the funds. The owner can even choose the successor owner of the plan, if the owner dies.

For more information on the benefits of a Section 529 Plan and how to choose the best plan for your needs, go to www.savingforcollege.com.

Disability – An Abundance Risk

November 13th, 2007 at 03:22 pm

Disability is a risk that many people underestimate. While most people have life insurance, health insurance and property/casualty insurance, many people fail to carry adequate disability insurance. Some people believe that the risk of becoming disabled is so small that they can afford to ignore it. Others believe that they will get enough through Social Security, if they become disabled. If you believe either of these to be true, you might want to reconsider.

A U.S. worker, under the age of 65, has a considerably higher risk of being fully disabled for over six months than she does of dying. Why is it that many more workers have life insurance than have disability insurance? Can you financially afford the consequences if disability occurs?

Perhaps you are planning to rely on Social Security if you become disabled. The Social Security administration states that “you can receive disability benefits after six months if you have a physical or mental impairment that’s expected to prevent you from doing substantial work for a year or more or result in death.”

However, virtually no one begins collecting Social Security benefits before they have been disabled for at least one year. Combining the long “lead time” to begin collecting Social Security benefits, with the relatively low monthly payments is a recipe for financial disaster. Just as you are not planning on receiving 100% of your retirement benefits from Social Security, you should not depend on Social Security alone to take care of you if you become disabled.

If your employer does not provide you with long term disability coverage, you should seriously consider buying a personal disability policy. If you pay for the policy, the disability income will be tax free. Combining the tax free disability payments with Social Security payments will allow you to buy a policy that covers less than your current total income.

There are many decisions to make with a disability policy such as a “noncancelable” policy in which payments never rise versus a “guaranteed renewable” policy where the insurer may increase premiums over time. Before buying any disability insurance policy, find a trustworthy insurance agent who will explain the costs and benefits of all of the policy options. Choose the policy with the coverage amount, benefit period and policy options that meets your current financial

Avoid Paying Double Taxes on Mutual Funds

November 11th, 2007 at 10:58 am

As the end of the year draws near, mutual fund companies are required to distribute all of their capital gains and dividend income accumulated over the past year. If you have mutual funds, you likely reinvest these distributions into more shares of the mutual fund.

If you plan on selling a mutual fund soon, you might want to sell the fund before the year end distribution, to avoid paying taxes on this year's distributions. If you are planning on buying a mutual fund, you may want to wait until after the yearly distribution is made, to avoid paying taxes on gains in which you did not participate.

A costly mistake, that many people make, is not keeping track of their yearly distributions from mutual funds. Each year, you will pay taxes on the capital gains and dividend distributions from a mutual fund. If you reinvest your capital gains and dividends, when you decide to sell the mutual fund, these distributions should be included in your cost (basis) of the fund. If you forget to do this, you will end up paying taxes twice on these distributions.

As an example, suppose that you bought a mutual fund five years ago for $10,000. Each year you reinvest your $1,000 capital gains and dividend distribution. At the end of five years, your mutual fund holdings are valued at $17,000. What is your capital gain if you sell?

If you forget that you have already paid taxes on $5,000 of capital gains and dividend distributions, you might report a capital gain of $7,000. However, since you have already paid taxes on $5,000 of capital gains and dividends, your cost/basis is $15,000 and your capital gain is only $2,000.

If you buy and hold mutual funds, be sure to keep track of the reinvested gains that you receive and pay taxes on each year. This will keep you from paying Uncle Sam more than you should when you sell the fund.

Choose the High Deductible Health Plan

November 8th, 2007 at 03:34 pm


Many companies are now offering the choice of a “traditional” health care plan or a high deductible health plan (HDHP). Often, the employees are only told that the HDHP costs less (usually by 20% - 30%) and has a higher deductible. The deductible for a family “traditional” plan is often at least $500 per individual and $1,000 for the family. For a HDHP the family deductible is often as much as $3,000.

If your traditional plan costs $200 per month and the HDHP costs $160 per month (20% less) you might be believe that the $40 per month ($480 per year) savings is not worth the risk of possibly paying $2,000 more in deductible expenses. This would be true, if you do not take advantage of the tax free Health Savings Account (HSA) that can be matched with the HDHP.

However, if you are in at least the 25% federal income tax bracket and deposit the family policy maximum of $5,650 into your HSA, the cost of an HDHP will always be less than a the cost of using a traditional plan.

If you are in the 25% federal tax bracket, the $5,650 HSA deposit will provide a federal income tax savings of ($5,650 *25%) = $1,412.50.

Next, using your HSA for medical expenses lets you pay for them with tax-free dollars. The $3,000 deductible can be paid with these tax-free funds. This reduces the $3,000 cost by your 25% tax bracket to a cost of $2,250 on an after tax basis.

Let’s add up the after tax costs of each plan. The traditional plan costs $480 more and saves you ($2,250 - $1,000) = $1,250 on after tax deductible costs, for a net “savings” of ($1,250 - $480) = $700

However, the HSA deposit of $5,650 has an income tax saving of $1,412.50. When the income tax savings is included, the HDHP plan costs ($1,412.50 - $770) = $642.50 less than the “traditional plan, even when your health care costs “max” out the $3,000 deductible.

If you only use $1,000 in medical expenses for the year, the savings with the HDHP is $2,142.50. This represents the sum of the insurance savings ($480), the HSA tax savings ($1412.50) and the savings from paying the deductible with funds that are never taxed ($250).

If you are in a higher tax bracket and/or if you pay state income taxes, your savings with an HDHP are even greater. Plus, the funds remaining in the HSA continue to grow tax free and can be used for future medical expenses tax free.

The bottom line is that, if you are in at least the 25% federal income tax bracket and your company offers an HDHP, you will come out ahead with the HDHP, as long as you contribute the maximum amount allowed to your HSA.

Buy Your First Home with a Roth IRA

November 7th, 2007 at 10:15 am

Thanks to the present financial crisis that began with the proliferation of “sub-prime” mortgages, housing prices are dropping and mortgages are getting harder to obtain, even for people with a good credit history. If you are wondering if you will ever be able to buy your first home, you may want to consider the benefits of saving for it by using a Roth IRA.

If you are single, with an Adjusted Gross Income (AGI) of under $99,000, or married (filing jointly) with an AGI of under $156,000, you may contribute up to $4,000 of your income to a Roth IRA. In 2008, the maximum Roth IRA contribution will be $5,000. While your contribution does not lower your immediate taxes owed, it can literally open the door to owning your first home.

Let’s assume that you would like to buy a house in the next 5 years. In 2007, you contribute $4,000 to a Roth IRA. In 2008 -2011, you contribute $5,000 each year. At the end of 5 years, assuming an 8% return on your Roth IRA investments, the $24,000 that you have invested will have grown to over $30,000.

With a Roth IRA that has been established for at least five years, you are allowed to withdraw up to $10,000, in income and growth, plus all of your contributions, when the proceeds are used to buy a first home. In the example above, all $30,000 can be withdrawn to purchase a first home, without any income tax or penalties.

This approach will allow you to make a 10% down payment on a $300,000 house. If the remaining $270,000 is financed with a 30 year mortgage with a 6% annual interest rate, your monthly payments would be approximately $1,620 (plus taxes and insurance). While this approach takes patience, it may allow you to become a home owner, building up equity in your future, while your friends are still renting.

IRAs: Roth or Traditional

November 1st, 2007 at 03:59 pm

I am often asked whether it is better to contribute to a traditional, deductible IRA or to a Roth IRA. As with most personal finance questions, my answer is typically “it depends.” In this entry, I will provide some guidelines to help you decide which is best for you.

When I use the term “IRA,” I am only addressing deductible IRAs. In a future entry I will discuss why I believe that it is seldom wise to fund a non-deductible IRA.

Let’s first look at the rules:

With a traditional IRA, you must be under 70½ years old plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you are covered by a retirement plan, you can only deduct the full amount contributed to your IRA if your Modified Adjusted Gross Income (MAGI) is no more than $52,000 as a single tax payer or $83,000 as a joint filer.

With a Roth IRA, your Adjusted Gross Income (AGI) must be less than $99,000 as a single filer or $156,000 as a joint tax filer plus you and/or your spouse must have earned income. In 2007, your maximum contribution is the lesser of $4,000 ($5,000 if you are over age 50) or the total amount that you and/or your spouse earned. If you make any deductible IRA contributions, the amount that you can contribute to a Roth IRA is further reduced by the amount that you contributed to the deductible IRA.

Based on these rules, the decision on which IRA to use is sometimes obvious:

1. If you are a single filer with an AGI over $99,000 or a joint filer with an AGI over $156,000 and you are not covered by a retirement plan, you can only fund an IRA.
2. If you are covered by a company retirement plan and your MAGI is over $83,000 but less than $156,000 as a joint filer or $56,000 but less than $99,000 as a single filer, you cannot receive full IRA deductibility, but you are able to fully fund your Roth IRA.
3. If you are over 70 ½ and have earned income, you can only fund a Roth IRA.
4. If you are saving to buy your first home, up to $10,000 of growth and income from a Roth IRA, plus all of the contributions may withdrawn, tax and penalty free.

Now let’s look at the more subtle differences between the IRA plans:

1. If you are under 40, the tax free growth combined with the tax free withdrawal of the funds (when you are over 59½) often make the Roth IRA a better, after-tax investment strategy.
2. If you may need some of the funds before you turn 59½, with a Roth IRA you can typically withdraw all of your contributions and pay no taxes or penalty on the withdrawal.
3. If you are over 40 and wish to pass some of your estate to your children, a Roth IRA is an excellent way to pass funds to younger generations.

When none of the above apply, the decision of funding a Roth IRA or a traditional, deductible IRA must be made by analyzing your current tax bracket, what you believe will be your future (retirement years) tax bracket and whether you expect to consume the retirement funds or pass them to future generations. This is never easy and often comes down to whether you want the tax reduction now or you can wait to get it later.