Monthly Archives: October 2011

What’s an ESA, Coverdell Education IRA, and 529?

Following Dave Ramsey’s “From Fruition to Tuition” class, people often ask me about the education savings accounts and 529 plans.  It seems there is a little confusion.  Briefly…

The Education Savings Account (ESA) and the Coverdell Education IRA are one and the same. They are accounts that are set up specifically to fund college education. They are not tax-deductible for Federal income tax purposes, but they grow tax deferred, meaning that if they are used for college education, then the growth is not taxed when used for that purpose. A few states allow the tax deduction from state income  taxes. The contribution limit is $2,000 per year per beneficiary, but  it depends on the Adjusted Gross Income. The money can be invested in a wide range of investment accounts. This is the main reason Dave Ramsey recommends them over 529 plans.

The 529 plans are similar in many ways to the ESA. The biggest exception is much higher contribution limits. This is a little too complex to explain here, but per the IRS.gov website: “Contributions can not exceed the amount necessary to provide for the qualified education expenses of the beneficiary.” The 529 plans available vary by state. In Ohio, where I live, the investment choices are limited to five investment or bank firms. Individuals may purchase a plan offered in another state, if they prefer; however, some states offer advantages to purchase in your home state. There is a second type of 529 plan: purchasing pre-paid tuition credit. Your investment return is essentially tied to the rate of increase of qualifying school’s tuition and room and board. One investment professional I spoke to recently told me that since people can contribute more money to 529 plans versus ESAs, states are expanding their investment choices or are buying one out-of-state 529, and 529 plans are more flexible long-term (if the original student doesn’t use the funds) that fewer people are using ESAs today.

Investors should discuss the options with their tax advisors, investment professionals/financial planners, and they should spend a lot of time reading all of the information on their state’s 529 website before making a decision. You will want to know how these accounts affect qualifying for financial aid, fees, and limitations.

Financial Observations in Moby Dick, circa 1851

Herman Melville is an amazing author. His knowledge of the Bible and just about every other topic is astounding, and I am enjoying reading his book.

Ishmael – “Again, I always go to sea as a sailor, because they make a point of paying me for my trouble, whereas they never pay passengers a single penny that I ever heard of. On the contrary, passengers themselves must pay. And there is all the difference in the world between paying and being paid. The act of paying is perhaps the most uncomfortable infliction that the two orchard thieves entailed upon us. But being paid,- -what will compare with it? The urbane activity with which a man receives money is really marvellous, considering that we so earnestly believe money to be the root of all earthly ills, and that on no account can a monied man enter heaven. Ah! how cheerfully we consign ourselves to perdition!”

Interestingly, Melville knits scripture into commentary about earning money: orchard thieves being Adam and Eve, perdition an old-fashioned name for hell. He is indeed right; working and being paid is a really good thing. Sometimes it is something we don’t appreciate as much as we should. A large part of financial planning is managing the gift of careers. What we do with earnings can be a source of good things and ills. Thank you, Herman!

Retirement: Times are a changing?

Have we entered an era where we question if the concept of conventional retirement is a myth? To be fair to history, retirement is a marketing idea created by Arizona retirement communities and picked up as the main marketing focus for investment firms.  Working until around age 60, then being on permanent vacation wasn’t even possible until the last century when life expectancies increased from the late 50’s to the 60’s and 70’s.

Who is going to be able to retire these days? Anyone that has an old-fashioned pension plan, known in the industry as a defined benefit plan. Who has these today?  Most large corporations have either eliminated them or cut them back substantially, but you have to work there a long time for them to provide much income. So with massive layoffs over the last decade, fewer and fewer ‘private’ sector employees have them. Employees of state and federal governments still have them, so teachers, firefighters, politicians and the military are set as long as our financial system remains strong.  Unions still have them; they are safe too, as long as they are managed well. What about everyone else that works in private industry?  They must save enough to supplement their Social Security. However a large percentage of individuals over 50 have less than $50,000 in their 401(k). Some people have not been good money managers, while many have just faced unfortunate circumstances, such as extended job loss, career setbacks, health care crises, declining stock market values, and real estate debacles, to name a few.

21st century retirement is going to see many people working longer, because they just won’t have enough money to survive until their 80’s and 90’s, just on savings and investments alone, if they stop working in their 50’s and early 60’s.

How Does Obama’s College Loan Program Work?

Obama mentioned that as of January 2012, student loan re-payments will be limited to 10% of income, and any left over balance after 20 years, would be forgiven. Sounds good, similar to the current plan that already exists for some loans and some non-profit employment situations after 10 years. So the new plan seems to expand this to more people, but probably only some federal loans. More details are forthcoming, but how would the math work out? The answer is hard to tell, no one knows how much money they are going to make for the next 20 years. But for the fun of it, let’s assume a modest starting income of $25,000 (about $12 per hour), and increased 3% per year for 20 years: income increased to $43,838. Total payment if limited to 10% of income would total to $67,175.  The next part of the calculation I am not totally sure of: how is the loan calculated? Is unearned interest capitalized back into the loan? What will the interest rates be over the next 2o years?  To keep it simple, (but taking some chance of mathematical error), let’s assume a low 3% interest rate, loan calculated annually (not monthly payments), and a $50,000 loan. I calculate that the amount of loan left after 20 years is approximately $2,600. Not a big forgiveness – no big deal. Sounds better from the podium than in actuality. But wait… this has me thinking, what would stop me from borrowing a lot more, and take it easy my college years, not working to minimize loans- heck I will be limited to pay back only $$67k, party hardy!?  I’m sure there are more details to work out in the days and months to come. Stay posted. I think politicians of both parties need to take more math courses before being elected to office!

Is Dave Ramsey’s 12% Inv. ROR Realistic?

Recently a small group leader of a Dave Ramsey Financial Peace University Class asked me: “I have been getting some questions in my group and I have been wondering myself, Dave is a big supporter of mutual funds for savings and I agree I have some myself; however, with interest rates being what they are, is Dave’s advice still relevant?  (People’s accounts are not going to grow at the rate he states, and in fact, as you know, we are losing money.  I don’t have as much as I had probably 10 years ago or it hasn’t grown much.) I have told my group that you have to look at the history of the fund and hang in there for the market to come back, but it is discouraging.  Do you have any other advice I could give to them?”

This is a tough question to answer, and I get this question more than any other. Dave contends that if people just do some basic funds analysis using Morningstar mutual fund analytical software, then they can easily find large, mid, small cap and international stock funds that consistently earn 12% rate of return (ROR) over time. The tricky part is to find the right funds that have great track records, low fees, good managers (maybe the old team with the good returns is gone), right risk level, minimal turnover and other factors, and to manage them over time, so that you don’t get in and out of them at the wrong time.

Dave gets this question frequently too, however if you read Dave’s response to this question, he is basically saying he doesn’t care which number people use for their rate of return assumption, he just wants to get the conversation started. He wants people to think like investors, who are taking part in the investment process; becoming engaged and informed responsible people.

To keep things fairly simple Dave recommends people to allocate their investments 25% each into small cap, mid cap, large cap and international funds- that is probably a good starting place for most people. Some professional investment advisers you talk to might recommend a different mix, perhaps an allocation customized more to the individual’s risk profile and age, including bond funds as well. Having been in the financial world for nearly 30 years, with experience in investments, mutual fund software, and asset allocation, it is my opinion that one’s investment expectation should match more closely their risk profile and asset allocation. Then consider what that allocation might do over time. I blog about this from time to time, and publish investment results, NOT net of expenses and taxes. For a sample of asset allocation and their historical investment returns click those links.

The last 10 years have been brutal in the stock market; it is very discouraging. This makes a lot of people question Dave’s advice and the advice given by professional investment advisers. Most experts tell people to just hang in there, keep the same asset allocation and don’t try to time the market, because over time (last 100) years stocks average about 11.5%, but given the difficult world financial market, it makes it difficult for people to hang in there, and be confident that those averages will work out for them in the long run. I recommend that people review all the investments they own, obtain Morningstar reports for all the funds they own, and talk to their investment professionals if they have a lot of confidence in them. I’ve also heard a lot of positive things about www.soundmindinvesting.com. Checking out their performance and reading their newsletters might be helpful too. Also, for a very bearish (negative) commentary about stock investing, read this article at The Atlantic.

As I said before, this is a tough issue given these economic times, made all the more difficult by conflicting opinions. My recommendation is to make informed decisions, not emotional ones. Do research and talk to wise seasoned investment experts while lowering expectations and managing daily personal finances wisely. Investments can be disconcerting, but ultimately our peace and hope isn’t in money, it is in Him. This isn’t a cop-out but an admonishment to help us keep our focus and our emotions in check.