Reflecting on College Funding Paradigm

Last week we offered our first client workshop centered on college savings plans and understanding the financial aid application process.  We had a good turnout, and a big thank you for all who attended.
As the FAFSA (the required form to apply for federal financial aid) deadline approaches, I thought I would take a moment to review the aid programs that are available, as well as discuss a quick overview of the tax-advantaged savings methods.  I think it is important to realize that many of the aid programs are created for those who need it the most.  Middle class families are expected to be able to contribute a significant portion toward the cost of tuition when it comes to these programs.

Aid Programs

Pell Grant—the Pell Grant is entirely needs-based.  It is free money, meaning that it does not to be paid back in the form of a loan.  It is only available to undergraduates.

Stafford Loan—the Stafford comes in two varieties:  the Subsidized Stafford loan is entirely needs-based and the interest does not start accruing until schooling is complete.  With the Unsubsidized Stafford, loan interest begins accruing at grant.  It must be repaid in 10 years, and payment begins within 60 days of final disbursement.

PLUS Loan—the PLUS loan is a loan entirely dependent on the parent’s credit score.  These tend to be at higher interest rates.

Federal Supplemental Education Opportunity Grant—the FSEOG is only available to those families with a low expected family contribution.  It is only paid out if the funds are available (whereas the Pell is not limited in the funds that are paid out).

Work Study—work study provides on or off campus employment to pay for the cost of tuition.

Perkins Loan—Perkins loans are available to families with exceptionally low expected family contributions.  The school acts as the lender with very low interest rates.  These loans are awarded on a limited basis

Savings Programs

Prepaid Tuition—This program allows you to pay for college tuition at today’s cost.  The advantage is that you are able to lock in today’s cost of tuition for future attendance.  The disadvantages are that your return on investment is caps at the tuition inflation rate (which is not a bad return as compared to recent years); if the child receives a scholarship, then only your principal investment is re-paid; and the school or school system you pre-pay may not have a program that is strong that matches up to your child’s interest.

529 Plan—This account allows saving of after-tax assets in a tax-sheltered account.  Assets can be withdrawn tax-free if they are for qualified educational expenses.  The contributor retains control of the asset if the child decides not to go to college, and can re-assign the account to another beneficiary.

Coverdell Educational Savings Account—The tax benefits of the Coverdell ESA are similar to the 529 plan, however annual contribution totals for these accounts are much lower, and donors are phased out of contributing with modified AGI of $190k-$220k (MFJ) and $95k-$110k (other filing statuses).  Coverdell ESA funds can also be used for private elementary and secondary school.

Custodial Accounts—Funds that are established under the fiduciary control of an adult, but taxed at the rate of the child.  Unfortunately, these accounts are considered an asset of the child—a significant negative difference when applying for federal financial aid.  These accounts can sometimes be subject to “kiddie” tax—pulling them back into the parent’s taxable rate.  These funds become the full property of the child at the age of majority.

Planning for education funding is a very important goal-based part of being fiscally fit.  If you plan to help your child by contributing toward the cost of their education, but have not ear-marked funds to do so, this can have a severe affect on your other financial planning goals—specifically retirement savings.  A popular funding tool for college expenses has become the Roth IRA; because you can access these funds prior to 59 ½ if they are for qualified educational expenses.  The problem with doing this is that you are eating into funds that you may have previously designated as retirement assets.  Just as with other financial goals, the rules for college savings are start early and stay fit.

Debating the Tax Efficiency of Retirement Income Planning

The traditional retirement savings paradigm has been—Defer…defer…defer. The theory of saving for retirement on a pre-tax basis is rooted in the idea that you are socking money away in your “prime earning years” and thus avoiding taxation on that money at high income tax rates. This theory presupposes that you will be in a lower tax bracket when you start withdrawing the funds you have saved in your retirement accounts. But what if we are in a rising income tax environment? What if you have done such a great job of saving, that the government’s mandated amount that you must withdraw (which begins at age 70) pushes you into that same bracket you were in in your earning years?

While the second question may be a good problem to have, “tax diversification” may be a good planning tool to make your retirement income plan more tax efficient. To achieve a tax-diverse savings, it can be a good idea to start an after-tax/taxable investment plan and/or look at starting or converting to a Roth IRA. It may also not be the best idea to wait on IRA withdrawals until age 70.

To achieve a “tax diversified” savings, annual evaluations should be made across all of your accounts taking under advisement the counsel of your tax advisor and your financial planner. These annual evaluations should begin in the years approaching your retirement, and continue through your first few years of retirement (when your taxes can vary widely). It is important to keep in mind that the taxation of your Social Security income is also highly dependent on your “other income.”

A Quick Breakdown on how the Various Types of Accounts fit into a Tax Diverse Plan:

Pre-Tax Plans (401k, IRA, 403b, etc.): These types of plans allow you to save on a pre-tax basis, meaning you lower your taxable income in your earning years. The assets grow tax-deferred, meaning you do not pay capital gains tax & ordinary income tax on the holdings as they grow. When you withdraw funds from these accounts, you are taxed as if you earned the income in that year; dollar for dollar. At age 70 ½ you the US Government requires that you begin withdrawing a determined amount from these types of accounts for the rest of your life.

After-Tax/Taxable Savings accounts: This is simply money set aside after you have paid income tax. Investments in these types of accounts are subject to capital gains tax & ordinary income tax as they accrue. It is for this reason that managing these accounts in a tax-sensitive way is important. Withdrawals from these types of accounts generally do not carry the same tax hit that pre-tax plans do because, generally speaking, you would be paying tax only on the growth of the asset, and typically at the capital gain rate.

Roth IRA: These types of accounts are funded with after tax dollars and growth accrues tax-deferred. Any withdrawals from these types of accounts are entirely income tax free.

It seems clear that have exposure across the different types of taxable accounts could potentially give your income plan the most flexibility.

2011 Winners & Losers

As a volatile financial year comes to a close, I thought it best to reflect on the large impacts to the financial landscape for 2011.  So I will give you my list of winners and losers for the year.  However, I want to take a different spin on this type of commentary by focusing on winners & losers within 4 major topics affecting the financial universe this year. 

News Networks – Those that read my blog, or work with me on their financial planning have more than likely heard me reference the “creation of crisis” that is created by the 24-hour news networks.  Well, 2011 provided no shortage of crisis.  Financial markets down one week had them proclaiming the return of financial armageddon (a la 2008); with a subsequent rebound rally 2 weeks later.  I often urge people to take headline news with a grain of salt when it comes to personal finance.  Financial reporters are unregulated financial pundits—meaning they can say whatever they want and they are not held to any standard.  This is not the case with those folks who hold any investment license, but reporters fall into an exempt category.  No wonder every week is a new crisis.  Compound that with every other commercial on these networks focused on selling gold to the viewer, and you have networks getting rich on selling fear.

Winners: Network Corporations   Losers: Nervous viewers cashing in their IRAs to buy gold 

Europe – When continental Europe entered into the single currency in 1999, it seemed like a fantastic idea. The prolonged issues in Europe over the last two years continue to revolve around no central decision making body to set fiscal policy for the Union, while the European Central Banks sets monetary policy. The debt crisis in Greece was like a virus that infected the world including Italy, Spain and France, scaring the global economy. On Dec. 5, French President Nicolas Sarkozy and German Chancellor Angela Merkel called for a new European Union treaty to help curb spending in an effort to end Europe's debt crisis and save the continent's euro currency.  As Europe turns (pretty much every week), US financial markets react with polarity.

Winners: Europe (if they can come up with a central policy/treaty)    Losers: US Banks 

Occupiers – Life isn’t fair…let’s put that out there straight away.  But when someone comes through a college graduation to spend the next few years of their life unemployed, it starts to take a toll.  Protracted unemployment has sapped the morale of the working American—and I believe that is what we are seeing in the Occupy protests.  Meanwhile corporate profits have continued to rise. One thing is for sure, companies will not invest in hiring until they have a clearer picture of their expenses to hire for the foreseeable future—and that remains difficult with health care legislation still in question and no long-term agenda for taxes. 

Winners: Are there any?                                  Losers: Everyone (Closing of West Coast ports as the ultimate example)

Polarized Washington – The failure of Congress to come to any swift conclusion on raising the debt ceiling resulted in S&P cutting the US credit rating from AAA.  But with the refusal of policy makers to address a number of issues, it was only a matter of time.  Entitlement reform, out of control deficits, tax reform—“compromise” is not in the vocabulary of any of these politicians.  The recent failure of the “Super-Committee” is just one more example of a year of political brinksmanship.  The leadership vacuum in Washington is quickly becoming a black hole.

Winners: Career politicians                            Losers: The next generation of Americans

It is difficult to isolate the “most important issues” of the year when you write one of these kinds of pieces, but I believe these will have the most lasting effects on us all.  The bright news for the start of 2012 is that the underpinnings of the US economy continue to foreshadow strength.  Cheers to a happy and healthy new year to all.

Asset Location is As Important as Asset Allocation

After a year in which the Euro vacillated between survival & collapse, democracy reached the shores of North Africa, and Wall Street got “occupied”, one thing remained sure & true: VOLATILITY.  As I meet with people every day, it is the ubiquitous item that is keeping people up at night as they prepare to transition to & through retirement.  

A 1991 study conducted by Brinson, Singer & Beebower showed that 91% of an investment portfolio's performance is determined by the allocation of its assets—meaning diversifying (& re-diversifying) your investments between different types of companies is the best way to assure long term performance gains & reduce risk.  More recently though, the increasing complexity of economic forces and the interdependence of global markets have contributed to significantly alter the investment landscape. The current market environment poses new hurdles: unprecedented volatility, economic forces putting pressure on equity markets, the prospect of a resurgence in inflation, & rising interest rates, all compounded by unfavorable demographic trends for most of the developed world. In short, to paraphrase an old saying, in today’s investment landscape, the only certainty is that nothing is certain.

Investors can no longer necessarily rely on traditional strategies to reach their financial goals. As a result, traditional diversification (or Asset Allocation, as it is called) may not be as effective as it once was in serving investors’ needs.  However, the concept of choosing investments based on how they correlate with one another—how their prices change in relation to each other—is still an integral part of investment planning. But asset class diversification alone may not get the job done.

What I call “Asset Location” has become just as (if not more) important as asset allocation.  Asset location is about diversifying across different investment vehicles to take advantage of possible tax advantages, income focus, or non-traditional investment classes.  While traditional asset allocation remains important for a significant portion of your portfolio, asset location can help you to build an infrastructure around your investment plan to help weather times of protracted volatility.

This is how financial planning benefits the investor—more specifically, it structures portfolios by combining different asset classes and investment vehicles in an attempt to provide more effective diversification in order to combat volatility, mitigate risk, overcome inflation and provide income in your retirement years.

Please remember that diversification, asset location and asset allocation do not guarantee profit nor protect against loss in a declining market.  They are methods used to help manage risk.

Super-Failure…

The result of the U.S. debt ceiling’s dysfunctional debate this summer was Congress’s passing of the Budget Control Act of 2011, which created the Joint Committee on Deficit Reduction, more commonly known as the Super Committee. The committee was made up of 12 members of Congress, evenly divided between the House and Senate and both political parties. Their objective by November 23 was to find ways to reduce the deficit by at least $1.2 trillion (to be spread out over 10 years). Unfortunately, they failed to do so.

Failure of the congressional joint committee on deficit reduction likely means little chance to make progress on comprehensive tax or entitlement reform before the November 2012 election.

Now that the economic anchor has dropped, Washington still has to make difficult choices that will likely be a drag on already slow – but recently improving – economic growth. However, given the resiliency in Washington and Congress’s constant focus on electability over sustainability, it would not be surprising if they found a way around the mandatory cuts. After all, the ratings agencies have said that a debt downgrade is not imminent, which could have the political effect of inspiring further inaction.

Failure of the committee may present some economic hurdles, as it reduces the chances of extending recent tax breaks like the payroll tax cuts that are set to expire at the end of this year. Further, we will see mandatory cuts in entitlements and defense to the tune of around $600 billion each. These enforcement mechanisms do not take effect for 14 months, and how those cuts will be enacted is currently a bit unclear. Some members of Congress are already talking about reconfiguring the cuts.  We should have more clarity on where the cuts come from as we move closer to the time they are enacted in 2013. These automatic cuts were supposed to be painful enough that they could force agreement in Washington, but it now appears that our representatives in Congress would prefer to throw out an anchor on economic growth rather than tackle spending. Failure to reach a deal has the potential to decrease GDP growth next year by nearly 1 percent, attributed primarily to the ending of some tax breaks and not extending unemployment benefits.  Failure also kindled fears about Washington’s willingness to overcome political gridlock and take the necessary steps to improve the nation’s fiscal health.

Despite the failure, Standard & Poor’s reaffirmed that it would keep the U.S. credit rating at AA+ after removing its top AAA grade on August 5. Moody’s Investors Service reaffirmed its AAA rating with a negative outlook. In a statement following the super committee’s announcement that it was unable to reach a compromise, Fitch Ratings noted that it said in August that a super committee failure would probably result in a “negative rating action,” (likely a revision of its outlook to negative), and that a review would be concluded by the end of this month. It is worth noting that bond investors have shrugged off the August downgrade, as yields on 10-year U.S. treasuries stood at 2.56 percent on August 5th, the time of the S&P downgrade of U.S. debt, and are now around 2 percent.

With an economy still trying to climb out of one of the worst financial crises in history, I believe more political leadership will be needed to right the economic ship.

How Should We Measure Inflation?

Those readers who have heard me speak at various engagements will note that I devote a significant amount of time focusing on inflation.  My argument is always in finding the correct measure.  While the Bureau of Labor Statistics publishes their monthly change to Consumer Price Index, it remains to be seen how much “trust” should be put into these numbers.

Earlier in the year, the Wall Street Journal Online published a great piece on why the “official” inflation numbers are probably skewed.  All of the adjustments to the calculation of CPI over the last 30 years have made CPI seem “more bearable”.

Two areas that I think are of major concern in the calculation are the principles of substitution and hedonics.  Substitution simply states that when the cost of fresh vegetables creeps to high, the government calculation assumes you buy canned veggies—and thus any additional inflation on vegetables is avoided.  Hedonics attempts to value a product based on the values of its underlying constituent parts—the best example is a piece of technology.  CPI takes into account that if the same technology is the same today as it was three years ago, that the product has experienced negative inflation (deflation) due to the fact that the parts used in today’s model are better or more efficient.  I will let you judge whether that argument has merit or not.

The bottom line is that the calculation of CPI is constantly changing, and at the suggestion of one “rogue” economist John Williams, if we still calculated inflation the way we did when Jimmy Carter was president, the official rate wouldn't be current CPI of 3.7%--it would be closer to 10%.  These factors tell you how central a concern that inflation should be in the financial planning discussion.

The Impact of the “Boomer-ang” Phenomenon

As I write about often in my posts, the Baby-boom Generation are right in the midst of making the transition toward retirement.  As they do so, they must come to grips with the unique risks associated with this transition.  But a recent phenomenon is adding a new complexity to the boomers ability to plan for the retirement financial goal.  One of the realities in the era Post-Great Recession is that more adult children are expecting financial help from their parents.—in the form of a down-payment for a home, tuition payments, or in many cases a roof over their head.

There were some interesting statistics in a recent Harper's magazine article.  85% of this year's college graduates were planning to head back to live with parents for at least some time. Columbia University conducted a study in 2010 that showed 52.8% of 18- to 24-year-olds were living at home, up from 47.3% in 1970.  That means that it is now more common for this age group to be living with their parents.  Some of this can be attributed to the protracted unemployment we are facing on a national level.  Others are trying to super-charge their savings to attempt to get ahead in saving for a home.  Still others help parents in meeting monthly expenses.

The challenge (and danger) to the Boomers, is in the cases where a child living with them (or using funds ) is a significant drain on funds that were earmarked for use in retirement.  While some folks may have a goal to leave a financial legacy, this is not to be focused on at the expense of running out of money in retirement.  This creates a difficult psychological position for parents and is another side-effect of stutter-step recovery to the global financial crisis of 2008.