Tax Tip: Choosing the Right College Savings Plan

529This time of year, everyone is looking to find ways to avoid large tax burdens. Contributions to your child or grandchild for college savings may be a great way to plan for the future and get some tax relief right away. As a college savings tool, 529 plans are the most popular choice to maximize tax-free growth of your investment, as long as it is used entirely for qualified secondary educational expenses. An individual can contribute up to $70,000 and a couple up to $140,000 to one beneficiary in a single year, as long as they count it towards their annual gift tax exclusion over a five year period. Many of the 529 plans allow for maximum account values of over $300,000. The 529 contributions are considered an asset of the custodian, allowing for flexible financial aid qualification for the student and transfers of the funds between accounts for other beneficiaries. Each state has its own plan and investment module and many offer tax benefits for contributions by residents. If your state does not offer tax incentives, then you are free to invest in any of the top-performing 529’s in other states, as most plans do not have residency requirements to participate. DWM can help find the best direct-sold plans with low operating expenses and good allocation menus. South Carolina’s direct sold plan ranks in the top 10 and Illinois in the top 15 for the last 5 years and both offer tax incentives for residents.

Before the 529’s were created, the investment choice for many was the Uniform Gift to Minor Acts (UGMA) or Uniform Transfer to Minors Act (UTMA) custodial accounts. These plans offer the advantage of allowing for non-qualified educational expenses without penalty. For example, if you want to use the funds to buy a car for your teenager. The UGMA/UTMA accounts also offer a full range of investment options with the ability to choose allocations and make changes as you would with any other investment account. There is also no limit on the maximum contribution amount. UGMA/UTMA accounts are taxed on their growth and mandated by the rules of the “kiddie tax”. This tax provision allows for the first $1,000 of unearned income of the minor to be tax-exempt and then the second $1,000 is taxed at the young account holder’s lower tax rate. Any gains from investment growth, dividends or interest above that $2,000 unearned income limit will be taxed at their parent’s higher tax rate. This tax provision affects all account holders under 19 or dependent full-time students between ages 19-23.

So what happens if you are the custodian for a UGMA/UTMA for a minor child or grandchild and you want to move it to a 529? 529’s can only accept cash deposits so the account will have to be liquidated and the custodianship terminated. The irrevocable provisions of the beneficiary arrangement in Uniform Minor acounts, however, must still be maintained, even in the 529. The 529 will ask for the source of the funds, and, if coming from a UGMA/UTMA, some 529 plans will register it as a Custodian 529. This simply means that the beneficiary rules designate the account holder be given control of the asset at age 18. The same Uniform Minor laws apply regardless of what kind of account these funds transfer to because the original asset was in an irrevocable account. Funds cannot be transferred or used by siblings or other family members without a penalty.

Is it prudent to move the funds into a tax-exempt 529? The biggest consideration are the taxes created by the liquidation of the UGMA/UTMA account and/or the annual taxes owed by the minor during its operation. After evaluating the potential gains to be made during the life of the account, you must consider what the tax on those gains will be. You can choose to liquidate the account in pieces over time or all at once, depending on the tax burden created. The tax must be paid at some point, so perhaps sooner rather than later will prevent it from increasing. Another choice is to leave the assets where they are and put any additional contributions in a new 529 for the beneficiary. This will avoid causing a taxable event while creating a beneficial 529 account. There may be a tax benefit to transferring the funds into a state-sponsored 529 plan because of tax breaks offered by some states, like South Carolina and Illinois. The tax owed on the gains may be offset by the tax incentives offered. You will have to weigh the implications of the long-term tax-saving benefit of transferring into a 529 against the tax burden created by liquidating the account.

While it’s true that the 529 is an excellent college-saving tool, there can be advantages to using the Uniform Minor accounts as well. And a conversion of a UGMA/UTMA account to a 529 can be a complex decision. At Detterbeck Wealth Management, we can help you evaluate your situation to determine the best option.

So Many Numbers: Which Ones Are Important?

stock-photo-old-typeset-166120136Our world is full of numbers. They’re everywhere. Our calendars just moved from 2014 to 2015. We get bombarded continually with numbers representing time, temperature, and, yes, stock market reports. NPR’s Eric Westervelt last week called numbers “the scaffolding that our economy, our technology and huge parts of our life are built on.”

For this blog, I thought it would be interesting to look at the origin of our numbers and then highlight five key numbers that are of real importance to your financial future.

Mr. Westervelt was interviewing Amir Aczel who has written a new book “Finding Zero: A Mathematician’s Odyssey to Uncover the Origins of Numbers.” Mr. Aczel believes the invention or discovery of numbers “is the greatest intellectual invention of the human mind.” We use Hindu-Arabic numerals. Before that, there were many other systems including the Mayans, the Babylonians, and, yes, the Romans. The big problem with the Roman number system is that it had no zero. The numbers didn’t cycle and hence multiplication or division was almost impossible. Five (V) times ten (X) is 50 or L in the Roman system. Each value was unique in the Roman system whereas in our system, numbers can cycle. Two with a zero after it is 20. And, zero is very important. Without it, numbers couldn’t cycle. It’s the reason that 9 numbers plus a zero allow us to write any number we want. Pretty amazing.

stock-photo-old-typeset-166120136Our world is full of numbers. They’re everywhere. Our calendars just moved from 2014 to 2015. We get bombarded continually with numbers representing time, temperature, and, yes, stock market reports. NPR’s Eric Westervelt last week called numbers “the scaffolding that our economy, our technology and huge parts of our life are built on.”

For this blog, I thought it would be interesting to look at the origin of our numbers and then highlight five key numbers that are of real importance to your financial future.

Mr. Westervelt was interviewing Amir Aczel who has written a new book “Finding Zero: A Mathematician’s Odyssey to Uncover the Origins of Numbers.” Mr. Aczel believes the invention or discovery of numbers “is the greatest intellectual invention of the human mind.” We use Hindu-Arabic numerals. Before that, there were many other systems including the Mayans, the Babylonians, and, yes, the Romans. The big problem with the Roman number system is that it had no zero. The numbers didn’t cycle and hence multiplication or division was almost impossible. Five (V) times ten (X) is 50 or L in the Roman system. Each value was unique in the Roman system whereas in our system, numbers can cycle. Two with a zero after it is 20. And, zero is very important. Without it, numbers couldn’t cycle. It’s the reason that 9 numbers plus a zero allow us to write any number we want. Pretty amazing.

Now, knowing a little more about our number system and with numbers seemingly everywhere, where do we focus our attention? Here are five key numbers that have a big impact on your ability to meet your financial goals:

Percentage of your paycheck that goes to savings/investments. This may be the most important decision in your life. By saving early, you can have a portion of earnings grow in a compound fashion for decades. Furthermore, by “paying yourself” off the top, you limit the amount available for everyday living expenses during your working years. This discipline helps you in two major ways to obtaining early financial independence- first, by creating the fund for “retirement” and second, by reducing the expenses you will likely have during “retirement.” BTW- there is no magic percentage. Everyone’s circumstances are different. Consider an amount of 10-20% of your gross pay.

Your Annual Living Expenses. Monitor your expenses for last year and group them in three categories- needs, wants and wishes. Review the data from a long-term perspective. Spending a considerable amount now on wants and wishes will obviously reduce the amount available in future years. It’s all about choices and accountability. For the most part, you alone can determine and control your level of expenses.

The Asset Allocation of Your Portfolio. This is one of your most important investment decisions. Based upon your risk profile you need to determine how best to split up your investment funds between stocks, bonds and alternatives (which can include real estate). Studies show that 90% of your investment returns are the result of your asset allocation.

The Net Returns on Your Portfolio. Research shows that fees really matter. A $1,000,000 portfolio that earns 5% net per year will grow to $4.3 million in 30 years. The same portfolio that earns 4% net per year will grow to $3.2MM. The difference is $1.1 million- a 26% reduction. Over long periods, loads, commissions, high operating expenses and management fees can be a significant drag on wealth creation. Low cost passive investments are best for stocks and bonds. Make sure you understand and monitor all fees charged to your portfolio. Make sure you are getting real value for all the fees. And certainly, know what your net returns have been, are expected to be and how they compare to the appropriate benchmarks.

Your Effective (average) and Marginal Tax Rate. Tax costs on earnings, investment returns and other income can be huge, particularly as a result of the increases caused by the Affordable Care Act. You and your advisors should know your tax rates and use them as a key factor in decision making and investment strategy. Furthermore, proactive planning designed to minimize taxes is a must for you and your advisors.

Over the last 45 years, I have worked with clients of all ages, income levels and circumstances. A common thread among those who have achieved or are achieving their financial goals is that they all knew of and monitored these five key numbers regularly, making adjustments as appropriate. And, of course, they use objective, proactive, value driven advisors like DWM to help them as well.

Why not make it a New Year’s Resolution to know and monitor these five key numbers for your financial future? It could change your life.

Turning Uncle Sam into Santa Claus

uncle sam santa clausWe hope everyone had a great Thanksgiving holiday. We certainly did. Now starts the final countdown for 2014. Only twenty-some days to Christmas, and less than 30 days left before 2015 arrives. Hard to believe. Certainly, most everyone’s calendar is packed full for the next four weeks. We just wanted to make sure that tax planning is on your list of “must do” items before year-end. Of course, tax planning doesn’t rank in the same category as giving my mother a Christmas kiss, being with my family or watching Dickens’ “A Christmas Carol” for the fiftieth time, but it is important.

Two good reasons: none of us likes surprises and most everyone wants to take advantage of every legal way to reduce taxes. By reviewing your taxes before year-end (hopefully with your CPA), you not only see roughly where you are for the year, but also learn what you might be able to do before year-end to reduce Uncle Sam’s share of your income.

Congress is making it tough on all of us this year. They have delayed action on more than 50 business and individual tax breaks that expired on December 31, 2013. These so-called “tax extenders” include provisions that allow businesses to write off the cost of substantial equipment at a faster rate, tax credits to weatherize homes and some higher education expenses to be deducted.

The tax extenders have commonly been renewed each year, often right after elections or even retroactively at the beginning of the next year. As we go to press, the jury is still out on renewal. Even so, there are some tax breaks you should consider for 2014:

  • Consider upping your charitable contributions. This could be writing a few more or larger checks and/or giving non-cash items, like clothing, furniture and even an old car.
  • Consider giving appreciated stock to charity this year. You get a deduction for the value of the stock given, not the cost. And, you don’t pay capital gain taxes on the money if you have held the security for 12 months. If you aren’t sure of the charity you want to give the funds, you can make the gift to a donor-advised fund, such as Schwab’s, which allows you to get a deduction this year and then advise on the recipient next year.
  • Consider gifts to your family. No, there is no tax deduction for gifts. But, you can give up to $14,000 ($28,000 if you are married) to as many individuals as you like before December 31 without anyone incurring any tax. And, if you would like to, you can do it all over again on January 1, 2015.
  • Consider harvesting tax losses within your portfolio. DWM clients know that we already did this for our clients last month. It was tough again this year, as most positions for our clients are showing unrealized gains. Furthermore, remember that you can’t sell a loss position and buy it back within 30 days. That’s a “wash sale” and the IRS bars you from claiming this loss.
  • Consider paying certain items before year-end. These could include items such as real estate taxes, state income taxes, college costs, and mortgage payments.
  • Consider funding your IRA or Roth early. Yes, you have until April 15th to make the contribution for 2014, but why not get it working for you as early as possible. And, consider making 2015 contributions in early 2015.
  • Consider a Roth conversion for part of your IRA funds. Pay the tax once and allow the funds to grow tax-free forever; for your lifetime and that of your descendants. Furthermore, there are no required minimum distributions from Roth accounts starting at age 70 ½. You and your tax adviser will need to look at current and expected future tax rates to determine if this makes sense for you.
  • Check your withholding. Compare your estimated taxes to how much you have withheld. If you are way under, consider taking extra withholding in your final paychecks. And, if you are way under or way over, consider revising your withholding allowances for 2015.

So, between all the holiday festivities in December, you’ve got some homework to do. Get with your CPA and review your 2014 taxes and see if you can lower them. Let’s try to make Uncle Sam start to look like Santa Claus. Cheers!

Thomas Piketty’s “Capital in the Twenty-First Century”

piketty-capital-21st-centuryI’d sum it up this way: Interesting data, controversial conclusions. Regardless, it’s not often that a 600+ page economics book tops the NYT Best Seller list. However, Thomas Piketty has the right subject at the right time-inequality. It’s a hot and controversial topic for politicians here and abroad. Subtopics are the excesses of Wall Street, minimum wage, and redistribution of wealth.

There does seem to be a consensus that Piketty’s book does a great job tracking the history and status of inequality. His projections for the future and his proposals to remedy inequality, on the other hand, have delighted the left and infuriated the right.

A French born professor at the Paris School of Economics, Mr. Piketty, along with a few colleagues, have done a remarkable job tracking the concentration of wealth deep into the past. In the U.S. and Britain, he goes back to the early twentieth century. And, all the way back to the eighteenth century for France. He also illustrates the wealth of the idle rich of past generations using characters from Jane Austen’s “Pride and Prejudice” and Honore de Balzac “Pere Goriot.” I thoroughly enjoyed how Professor Piketty was able to blend centuries of tax records and history to produce a comprehensive record of the periods of low and high inequality.

Europe’s Belle Epoque and America’s Gilded Age are examples of high inequality. Unequal ownership of assets, not unequal pay, was the prime driver of income disparities. At that time, 20% of the national income went to the top 1%, another 30% to the next 9% and only 20% to the bottom 50%. Contrast that with the low inequality period from the start of WW I to the end of WW II when 7% of the national income went to the top 1%, 18%, to the next 9%, and 30% to the bottom 50%. Since the 1970’s, both wealth and income gaps have been rising to turn of the century levels. As a result, the top 1% again receive 20% of the U.S. income.

Piketty’s contention is that inequality is here to stay and will continue to grow. For him, it’s all about the rate of growth of capital versus the rate of economic growth. He assumes that wealth (aka capital or net assets) will generally grow at a rate of 4-5% greater than inflation. Wages, he contends, can only grow at a rate equal to inflation plus economic growth. In fact, since 1970, wages for most US workers have barely kept pace with inflation, while top earners’ pay has grown at double-digit annual rates. With economic growth falling and returns on capital expanding, the gap will widen, according to Piketty.

Frankly, no one knows what the future might bring. Professor Piketty seems to be simply extrapolating the last 30 years into the future. There is no hard and fast rule of capitalism that this will occur. And, history shows us that, over time, what goes up, generally comes down.

Then, Mr. Piketty really gets everyone’s juices flowing. He suggests that traditional remedies, such as education spending, worker protections, more progressive taxation, etc. may be helpful at the margins, but that inequality will worsen “no matter what economic policies are.” Hence, he suggests that major changes are needed. He proposes a global wealth tax on capital starting at .1% and increasing to 2% annually. In addition, he suggests a progressive income tax up to 80% on incomes above $500,000. These proposals are likely politically unachievable and are considered confiscatory by many.

Certainly, we Americans support equal opportunity. Redistribution of wealth is another matter. If Mr. Piketty’s objective was to spark conversation on a very important topic, he certainly has accomplished that.