Archives for March 12, 2020

Many Americans aren’t prepared as they should be when it comes to saving for college.

Working women are no exception. In a recent CNBC/SurveyMonkey Women at Work Survey, 7% of working women with children under 18 said they have at least $5,000 in a 529 College Savings Plan.

Of those who make $100,000 or more a year, 12% had at least $5,000 saved in a 529 plan. The poll surveyed 1,068 working women in the U.S. from Feb. 10 to 14.

A 529 plan allows people to save for education expenses using after-tax dollars. The money grows tax-free and can be used to pay for qualified education expenses, such as tuition, fees and books.

The lack of 529 savings may stem from a number of issues, such as misconceptions about the plans or the feeling that the anticipated expenses they address are far off in the future, said Shannon Vasconcelos, a college coach for Bright Horizons and former assistant director of financial aid at Tufts University.

“It’s easy to put off until tomorrow, especially when you are in the throes of young parenthood and overwhelmed and so busy,” she said.

Concerns about market volatility, as evidenced in the last two weeks, may also keep people on the sidelines. Wednesday,  stocks plunged, putting the Dow Jones Industrial Average, S&P 500 and Nasdaq Composite closer to entering bear-market territory.

Yet saving for college is vital, in light of soaring higher education costs. These days, the average tuition increase is 3% a year.

“You need to get your money in an account that is growing for you to keep pace with tuition inflation,” said Vasconcelos.

Here’s what you need to know about 529 plans and how to choose one that works for you.

529 plan vs. traditional investments

The biggest advantage to a 529 plan is the tax implications. When you take out the money for qualified expenses, you aren’t taxed. If you take money out of traditional investments, you’ll be taxed on any money you earned.

If your child decides not to go to college and doesn’t use 529 funds towards other qualified educational expenses, such as high school tuition, others in your family can. However,  if you take the money out for anything other than those qualified expenses you’ll be subject to a 10% penalty and income tax on the earnings.

One way people work around the restrictions of a 529 plan is by saving in a Roth IRA.

“The Roth IRA tax break is really identical to the 529 in that you get the earnings of the account tax-free,” Vasconcelos explained.

For older parents, this is a “win-win” since they can start taking money out of their Roth IRA when they are 59½, she said.

Those under 59½ can take out their principal balance, not earnings, without a tax or penalty.

How much you should save

If you think about saving for the entire four years of tuition, you may become too paralyzed to act.

In reality, your goal should be to save for about a third of future college costs, said Mark Kantrowitz, publisher of SavingForCollege.com. Another third would come from future college loans and a third would come from income, student financial aid and grants.

Based on that one-third rule and the cost of college today, you should be saving $250 a month for an in-state public college, $450 a month for an out-of-state public college and $550 a month for a private nonprofit college, he said.

Of course, by the time your child heads off to college, costs will be higher. You can use an online college cost calculator, like the one on SavingForCollege.com,  to get an estimate of tuition.

‘Time is your biggest asset’

The sooner you start saving, the sooner you will earn interest — and then interest in your interest, known as compound interest.

“Your greatest asset is time,” Kantrowitz said.

If you start saving at your child’s birth, by the time he or she goes to college, about a third of your college’s goal will come from earnings on your investment, he explained. If you wait until high school, it will be less than 10%.

“If you start saving in high school, you would have to save six times as much per month to reach the same college savings goal as compared to starting when your child is a newborn.”

How to choose a plan

You can get a plan through a financial advisor, which may work if you need “a lot of hand-holding” or already have a relationship with an advisor, said Kantrowitz.

However, it will cost you less if you do it yourself.

Each state offers a plan, but you don’t have to choose the one offered by the state you live in or the one in which your child will attend school.

What you should do is first check to see if you get a state tax break by contributing to your own state’s plan.

Also look at the fees that are charged, which will reduce your returns. You want to get the lowest fees possible.

Several plan managers “have been competing with each other to see who can charge the lowest fees,” Kantrowitz said.

If you are torn between a plan with a state tax break or one with a lower fee, Kantrowitz recommends focusing on the lower fees when your child is younger. The “inflection point” is around high school. Once they are that age, the tax breaks matter more.

Another thing to consider is an aged-based asset allocation fund offered by the plan. It will start out aggressive and automatically adjust the money so that the allocations are appropriately balanced. As the start of college draws near, the portfolio should be more conservative investments, like bonds.

Limited effect on financial aid

One thing Bright Horizons’ Vasconcelos often hears from parents is that if they save for college they won’t qualify for financial aid.

“Saving always helps more than it hurts,” she said. In fact, your aid is affected to a “very limited extent” by your 529 savings.

What usually puts parents out of range for financial aid is their income, not their savings.

While the financial aid formula is complicated, many families will be expected to contribute about 20% or 30% of their income to college each year, Vasconcelos explained.

Parents are only expected to contribute 6%, or less, of their parental savings, including 529 plans that list their child as a beneficiary.

For example, for every $10,000 you save, you’ll lose out on $600 of financial aid.

“That $10,000 you save helps you pay for college much more than the $600 loss of financial aid,” Vasconcelos said.

The actor Samuel L. Jackson didn’t get his big break in Hollywood until he was 43 years old. That’s an unconventional path for a movie star and a reminder that the road to success isn’t the same for everyone. Just as Jackson found his way to stardom, you can find your way to financial independence — with or without contributing to a 401(k).

The conventional retirement advice involves saving 15% of your income to your tax-advantaged 401(k), increasing those contributions every year, and investing for the long term in diversified mainstream investment funds. All of that is solid and appropriate advice for most working Americans. But as with anything, there are exceptions. Here are three situations when saving to your 401(k) may not be in your best financial interest.

1. There’s no employer match

401(k)s have their perks, including tax-free contributions and tax-deferred earnings. But the biggest perk is the employer-match contribution, which is an employer-funded deposit made to your retirement account. This is free money, and you qualify for it by making your own contributions. Typically, the employer matches your contribution up to a specified percentage of your salary. If your employer offers matching, you should contribute at least enough to maximize those free deposits.

A 401(k) without employer-match is definitely less interesting, but you shouldn’t write off your workplace plan for that reason alone. The question to ask at this point is: Do I have someplace better to put my money? Two possible answers might be a health savings account (HSA) or a Roth IRA.

Compared to a 401(k), the HSA has lower annual contribution limits, but better tax perks. In 2020, you can contribute up to $19,500 to a 401(k), but only $3,550 to an individual HSA or $7,100 to a family HSA. 401(k) contributions are pre-tax, but your retirement distributions after age 55 are taxed as income. HSA contributions are pre-tax and distributions for qualified medical expenses are always tax-free. You can take HSA distributions for nonmedical expenses after age 65, and these are taxed as income.

If you’re single and you make less than $124,000 annually, you can contribute up to $6,000 to a Roth IRA in 2020. The income cap for married filers is $196,000. You get no tax break for making these contributions, but you can take tax-free withdrawals after age 59 1/2. Roth IRAs have another perk, too. You can withdraw your contributions — but not the earnings — at any time without taxes or penalties.

2. The fees are too high

High fees are a deal-breaker for any 401(k) plan. Administration fees can be as high as 2% of your account balance annually. Plus, the funds you select as investments will also charge fees, and these can vary from less than 0.1% up to more than 1%. Together, your plan fees and fund fees dampen returns and limit your earnings growth.

If the only investment choices in your plan have expense ratios of 1% or more, consider investing your money elsewhere. You can easily open a Roth IRA, traditional IRA, or even a taxable brokerage account and invest in index funds that’ll deliver market-level performance with minimal fees.

3. You plan to retire before 55

401(k)s are structured to keep you from tapping your funds until you’ve left the workforce. That’s good and bad. It’s good to discourage savers from spending their nest eggs before retirement. But it’s also restrictive for those who want to retire early. Under the current rules, you can access your 401(k) savings without penalty as early as 55 if you are retired. But if you save enough to allow for an earlier retirement, you’ll pay a penalty to dig into those 401(k) funds.

The takeaway? If you plan to retire before age 55, the 401(k) isn’t the right answer. Open a taxable brokerage account and save your money there. You’ll miss out on tax perks, but you won’t be subject to withdrawal penalties. You can minimize your annual tax bill with long-term investing in a diversified portfolio of stocks and tax-efficient funds.

Putting away $500,000 for retirement seems like a lot, but it may not be enough to sustain you during your golden years.

That’s an eye-opener for sure, one that will become more common thanks to the Setting Every Community Up for Retirement Enhancement Act, otherwise known as the SECURE Act. Signed into law by President Donald Trump in late 2019, the act is designed to expand and preserve retirement savings. It makes it easier for small businesses to offer company-sponsored retirement plans, it increases the cap for automatic contributions to 15% from 10%, and it repeals the rule that prevents people from making contributions to a traditional IRA when they reach the age of 70 1/2.

It also beefs up the disclosures provided to retirement savers so they have a clearer picture of whether they are saving enough for retirement. It is that piece of legislation that may surprise many employees who think they are saving enough.

As of the beginning of 2020 when the SECURE Act went into effect, 401(k) plan administrators have a year before they have to provide employees with a lifetime income disclosure annually. These statements will show the amount of money you may receive each month based on the balance in your 401(k). The thinking is that if you have a better idea of how much your money will get you in retirement, you will be able to identify a shortfall at an earlier point.

According to Schwab Retirement Plan Services, participants believe they need $1.7 million on average to retire, yet many aren’t investing enough to reach that level.

Americans need a wakeup call 

401(k) plan statements that break out the monthly income from retirement may result in a necessary retirement savings wake-up call. According to a 2019 study by Northwestern Mutual, 22% of Americans have less than $5,000 saved for retirement.

Meanwhile, 15% have no savings for retirement at all. Among baby boomers, of whom 10,000 daily turn 65, 17% have less than $5,000 saved for retirement. Close to half of working adults don’t plan on retiring at age 65. And more than half of Americans don’t even know how much they will need to retire comfortably. 

Don’t become the next statistic 

Those are some scary statistics, but you don’t have to become one, nor do you have to wait for the SECURE Act disclosures to call your attention to a deficit. There are actions you can take and plans you can make for the future if you fear you’ll have a retirement savings shortfall. 

If you have a 401(k), the easiest and most effective action is to raise the percentage of your income that goes toward it (though always make sure you have an emergency fund in place before increasing any of your investments). As of the end of 2019, employees were able to contribute up to $19,000 to their 401(k) plan, yet only a small percentage do so. In a 2018 study, Vanguard found that only 13% of plan participants maxed out their 401(k) contributions. Raising your annual contribution rate will also increase your returns because of the benefit of compounding. 

If contributing the maximum isn’t feasible, make sure you are reaching the maximum savings level at which your employer matches your contributions. As of last year, the average matching contribution provided by companies was 4.7%. If you aren’t contributing the full percentage your company matches, you are leaving free money on the table.

For workers who don’t have access to a 401(k) but still want to save for retirement, there are individual retirement accounts, otherwise known as IRAs. An IRA is a tax-advantaged investment account that lets you contribute pre-tax dollars. Distributions, which can begin when you reach age 59 1/2, are taxed as ordinary income. Individuals can contribute as much as $6,000 a year. For those over the age of 50, the contribution level increases to $7,000. A Roth IRA is another option, in which you are taxed when you make the contributions but all withdrawals after the age of 59 1/2 are tax-free.

Of course, another option is to work longer than you had originally planned. The more years you’re earning income, the greater the sum you can save, whether it’s through a 401(k) or an IRA.

If your retirement shortfall is severe, it may require you to think differently about your retirement plans. Downsizing your living arrangements, choosing a cheaper place to retire to, or accepting that you may need a part-time job to supplement your income are all options.

While the SECURE Act may create a lot of sleepless nights in America, it could also prompt action. Sometimes it’s a dose of cold, hard reality that mobilizes us. If it’s to save more for retirement, then everyone wins.