October issue
I believe Autumn has finally fell upon Central Illinois... this morning we have a light rain, with high temperatures only in the 60's. It was only a week ago when we were still having highs near the 90's - so it's been a late-starting Autumn for us. Hopefully it will stick around for a while before the cold blasts of Winter begin!
In mid-August, investors as a group took a look around at the credit crunch (associated with the sub-prime mortgage debacle unfolding) and very quickly hit the markets with a 10% correction. As anticipated, this was extremely short-lived, and September saw the markets return to their recent bullish trends. As your advisor, I take very seriously my job of helping you to interpret these situations, understand that we've developed portfolios that account for short-term anomalies, and maintain the course. I believe that the greatest value that I bring to our relationship is the discipline to view such events without emotion, and to help you weather these minor storms without losing our cool. I heard from a few of you during this event, and I think I did my job - and I hope you benefited from my advice.
In this month's newsletter, I thought we'd talk briefly about the pros and cons of using regular tax-efficient mutual funds for college savings instead of 529 plans. The second article is a brief overview of IRA Accounts and the Required Minimum Distribution (RMD) rules. I believe that just about anyone can get a benefit from an overview of these two topics.
Mutual Funds vs. 529 Plans
Saving for college is a tough job - on par with saving for retirement, and often in direct conflict with that goal as well. Adding to the difficulty of the task is the fact that there are so many different options out there (in terms of investment vehicles) that really muddy the waters for the individual college saver.
One question that comes up very often is whether it is just as effective to utilize tax-effficient mutual funds instead of 529 plans as we save for college. The idea is that the mutual fund can generate a higher overall return than the 529 plan due to the additional costs associated with the administration of the 529 plan.
It is a fact that most 529 plans charge management fees that have a direct impact on the overall return of the account, and it is also a fact that many tax-efficient mutual funds (such as index funds) can produce higher returns at a lower cost than most other investments. But here are a few reasons why a 529 plan is nearly always the superior choice when it comes to college savings activities:
A. Taxing Matters - with a 529 plan, you pay no tax at all (when the funds are used for Qualified Higher Education Expenses, QHEE), while with any other type of account, you'll pay some tax. In my book, no tax is always better than some tax, no matter how little.
In addition, while today's tax rates on capital gains (the tax you'd pay on an indexed mutual fund) are at the lowest they've historically ever been, at either 5% or 15%, depending upon your tax bracket - these rates are scheduled to sunset at the end of 2010, increasing the rates to 10% or 20%. So, the question becomes: will your student be finished with college before the rise in rates?
The third taxing matter has to do with the Kiddie Tax. Recently there have been some changes made to this portion of the tax code, with detrimental effects for parents who have counted on a strategy of repositioning funds to the child's name in order to benefit from a lower tax rate. Beginning next year, the child's investment income above a minimum of $1,700 can be taxed at the parent's highest rate all the way up to age 23!
B. Financial Aid Impact - any income that is reported on your form 1040 (which includes capital gains) is considered as a part of the calculation for financial aid for the following year. As you begin drawing monies from the mutual funds, it is possible that you will be increasing your income to the detriment of available need-based financial aid. If, on the other hand, these funds were in a 529 plan and withdrawn for use in paying QHEE, there will be no taxable income reported on your 1040, thereby having no impact on the financial aid calculation.
C. Inherent Costs - with the 529 plans, there are administrative and manager fees, but, as shown with the recent changes to the BrightStart plan in Illinois, these fees are beginning to come down. Plus, most 529 plans (BrightStart and Bright Directions included) have very low-cost investment options available, reducing the expense ratio of the funds themselves. Analysis of 529 plans versus mutual funds has consistently shown that, when considering the tax benefits and the costs of the two options, there are very few instances where a low-cost mutual fund performs better than a 529 plan, and then only when the 529 plan in question is one where the administrative expenses are relatively high and the taxpayer is in the lowest possible tax bracket.
In addition to the internal costs of the various options, mutual funds quite often make certain investment decisions that have tax consequences, such as distributing capital gains and dividends. 529 plans do not have to make this sort of decision, and therefore decisions can be based entirely on investment considerations.
All in all, while non-529 investments may provide additional investment options over those available in the 529 plans, unless for some reason you do not have the option of choosing a 529 plan for specific college savings, the 529 plan is the better choice across the board.
RMDs From IRAs
I've made the observation before - IRAs are like belly-buttons: just about everyone has one these days, and quite often they have more than one. Wait a second, maybe they're not quite like belly-buttons after all. Oh well, you get the point - just about everyone has at least one IRA in their various investment holdings, and these accounts will eventually be subjected to Required Minimum Distributions (RMD) when the owner of the account reaches age 70 1/2.
So what are RMDs, you might ask? When the IRA was developed, it was determined that there would be a requirement for the account owner to withdraw the funds that had been hidden from taxes over the lifetime of the account, in order for the IRS to begin benefitting from the taxes that would be levied against the account withdrawals. A schedule was prepared, which approximates the life span of the account owner, and prescribes a minimum withdrawal amount for each year that the account owner is alive, until the account is exhausted.
A participant in a traditional IRA (Roth IRAs are not subject to RMD rules) must begin receiving distributions from the IRA by April 1 of the year following the year that the participant turns age 70 1/2. In other words, assuming that the participant reaches age 70 during the months of January through June of 2007, means that the participant reaches age 70 1/2 during the 2007 calendar year, so RMDs must begin by April 1, 2008. An individual who reaches age 70 during the latter half (July through December) of 2007 does not reach age 70 1/2 until the 2008 calendar year, and as such, RMDs must begin by April 1, 2009.
After that first year's RMD is taken, the second year's must be taken by December 31 of the same year. In our examples above, the first participant must take an RMD by April 1 2008, and another by December 31, 2008. The second participant must take an RMD by April 1, 2009 and another by December 31, 2009. For all subsequent years, the RMD must simply be taken by December 31 in order to be credited for that year.
Calculation of the RMD is fairly straightforward, although there is some math involved. For the first year of RMD, the participant will be age 70, and according to the Uniform Lifetime Table (See IRS Publication 590 for more detail on other tables), the distribution period is 27.4 for 2007. So if an individual participant has IRAs worth $100,000 at the end of the previous year, dividing that balance of $100,000 by 27.4 produces the result of $3,649.64 - the RMD for that first year. Each subsequent year, you would take the balance of the accounts on December 31 of the previous year and divide them by the distibution period from the Uniform Lifetime Table, and make sure that you take a distribution of at least that amount during the calendar year.
Now, I made a point of indicating that you calculate your RMD based on the balance of all of your IRAs. This is because the IRS considers all of your traditional IRAs as one single account, and you are required to take RMD withdrawals based on the overall total of all accounts. This withdrawal can be from one account or evenly from all accounts, or in whatever combination you wish, as long as you meet the minimum.
Another point that is extremely important to note: taking these distributions is a requirement. Failing to take the appropriate amount of distribution will result in a penalty of 50% (yes, half!) of the RMD that was not taken. So, as you can see, it really pays to know how to take the proper RMD withdrawals - the IRS has very little sense of humor about it.
Understand that the examples I've given are for simple situations, involving the original owner of the account and no other complications. In the case of an inherited IRA or other complicating factors, or if the account is an employer's qualified plan rather than an IRA, many other factors come into play that will change the circumstances considerably. If you need help on one of these more complicated situations, let me know and I'll be happy to work with you on it.
