February 1, 1997
The Parent Finance Trap!By Sally Field, Mother Wired Staff Writer
STOCKTON - When it comes to money, many parents need a refresher class in family finance. These days, parents have to keep up on tax laws and be conversant with insurance practices. We even need to be aware of the changing rules for obtaining financial aide for college students. Here are some surprising pointers for parents that appeared in a Wall Street Journal special report in January:
- Parents Should Not Invest College Money Too Conservatively.
"That's the most common mistake that I see," says Kenneth Klegon, a financial planner in Lansing, Mich. "Parents think this is the college money, so they really should be conservative" and put the bulk of their money in bonds and money-market funds. "But if you've got enough time, that's the wrong thing to do," argues Mr. Klegon.
Historically, stocks have done better in the long run than bonds, so they should be your best bet for making college money grow. Suppose, for instance, you sock away $200 a month. If you plunk the money in bonds that earn 7% annually, you will have $81,598 after 18 years. But if you stash the money in stocks that gain 10% a year, you will end the period with $109,438, some 34% more.
- Buying Series EE Savings Bonds.
If you purchase EE savings bonds and use the proceeds to pay for college, the interest you receive when you redeem the bonds isn't taxable. But you get the full tax break only if in the year you redeem the bonds, your income is below certain thresholds. For instance, if you're married and filing jointly, your modified adjusted gross income must be $63,450 or less. Above this income level, the tax break gradually is phased out. The income threshold rises each year, along with inflation.
Overall, though, EE savings bonds aren't likely to match the returns you'll get from stocks or stock-mutual funds. And if you don't get the tax break, EE bonds are a particularly poor investment.
- Purchasing Cash-Value Life Insurance Won't Pay For College Education.
Term insurance pays a death benefit and nothing more, while cash-value policies combine a death benefit with an investment account. Many insurance agents advocate buying cash-value life insurance, and then tapping the cash buildup to pay for college.
A good strategy? Mr. Klegon has his doubts. "Are you buying life insurance because you need protection or because you think it's a good investment?" he asks. "If you don't need the protection, it's not a very efficient way to grow your money. And if you need insurance, pure term will probably be more cost-effective."
Peter Katt, a fee-only life-insurance adviser in Mattawan, Mich., agrees that it's difficult to justify buying cash-value life insurance simply to fund your child's college education. But he says that if you are buying a cash-value policy to protect your family in case of your death, the policy also can provide a good way to amass at least part of the money needed for college.
Mr. Katt says you should avoid traditional high-commission policies and instead buy low-load universal life insurance or low-load variable life insurance. He advises "superfunding" the policy -- paying more than is required to keep the policy in force -- with the aim of building up the cash value quickly.
Once your child reaches college age, Mr. Katt says, you can withdraw your accumulated premiums tax-free to help with tuition costs. You could also borrow against the policy, though Mr. Katt discourages clients from doing so, in part because of the interest costs involved.
- Buying life insurance On Your Child's Life.
Parents often buy life insurance in their children's names. Because the chance that a child will die is slim, premiums tend to be low. But experts note that life insurance generally should be bought only by people with financial dependents. Because children don't have any dependents, buying life insurance for them almost never makes sense, experts say.
- Saving Money In Your Child's Name When You Hope To Qualify For Financial Aid.
Sure, it's tempting to do, because you get a small tax break. If your child is under 14, the first $650 of investment earnings is tax-free and the next $650 is taxed at 15%. Above $1,300, gains are taxed at the parents' rate. Once your child turns 14, all investment earnings are taxed at the child's own rate, usually 15%.
But while most tax breaks are irresistible, this one could come back to haunt you. Under the federal financial-aid formula, kids are expected to put 35% of their savings toward college each year, which means money in their name counts heavily against them when applying for aid. Parents, meanwhile, are expected to pony up a maximum of only 5.65% of their assets.
- Placing Money In Your Child's Name If Ffinancial Aid Not Expected.
When you invest in your child's name, you usually open a custodial account under your state's Uniform Gifts to Minors Act or Uniform Transfers to Minors Act. With these accounts, children get control of the money when they reach the age of majority, usually 18 or 21, depending on your state. At that point, they are free to blow the money on anything their little hearts desire. A Harvard education may not make your child's shopping list.
Because of this risk, you shouldn't put too much money in your child's name. And that's especially true if you're in the 15% tax bracket. After the first $650 of investment earnings, your child will be taxed at the same rate you are: 15%. You'd be better off putting the money in your account, where you'll retain control. So how much can you stash in your child's name before generating $650 in earnings? You could hit that target with $7,000 or $8,000 in savings, presuming the money generates an annual realized return of 8% to 9%.
What if you are in the 28% bracket or above? If your child is under 14, the first $1,300 of investment earnings will be taxed at a less punitive rate than if the money was in your name, so it makes sense to put some money in the child's account. You should start bumping up against this $1,300 earnings target once you have $14,000 to $16,000 invested in the child's name.
Still intrigued by the tax break, but unsure what to do? Consider the following strategy. When your child is a toddler, put enough money in his or her name to generate as much as $650 or $1,300 in annual investment earnings, depending on your tax bracket. Then hold off on further gifts until the child turns 14. If, at that point, you are in a 28% tax bracket or above, your child seems responsible and definitely won't be eligible for financial aid, you could give the child more money, so that the investment earnings then get taxed at the lower rate.
Indeed, a popular strategy is to give stocks with hefty unrealized capital gains as a gift, and then let your child sell the stocks and pay taxes at the lower tax rate. But if you do this, make sure the stocks really have appreciated, Mr. Klegon says. If the shares have lost value, you are better off selling them yourself and deducting the loss at your higher tax rate.
- Waiting Until Your Child Applies To College Before Planning Financial Aid.
Kalman A. Chany, president of Campus Consultants, a New York-based firm that counsels families on financial aid, says you should start thinking about aid eligibility when your child is in ninth or 10th grade. When doling out aid, some colleges now want two years of tax returns, which means they will be looking at your earnings going back to January of the year that your child was in 10th grade.
To have the best shot at getting a decent amount of financial aid, you need to minimize your income during these years, as well as the years that your child is in college. Mr. Chany says you should make a particular effort to keep down your income in the calendar year prior to the year your child enters college. Your child's first year of financial aid is based largely or entirely on this year, and this year then influences aid decisions in subsequent years.
Mr. Chany suggests that, in an effort to hold down your income, you should avoid retirement-account withdrawals, delay cashing in savings bonds and hold off selling stocks with large capital gains. He says large charitable contributions can also hurt your child's aid eligibility. How come? Charitable gifts, if deducted, lower your taxes, which makes it look like you have more income available to pay tuition.
- Letting Children Earn & Save When They Are On Financial Aid.
This is possibly the most perverse aspect of the financial-aid system. "After [college students] make about $2,000, every additional dollar they earn and save will cost them 85 cents in aid," Mr. Chany says.
How can that be? After roughly the first $2,000 in income, every additional dollar earned results in 50 cents in lost aid under the federal financial-aid formula. If these additional dollars are then saved in the child's name, they cause an additional 35 cents in aid to be lost under the formula.
- Pulling Money Out Of Retirement Accounts To Pay For Child's College Fees.
If you tap your retirement accounts to pay for college, you will get hit with a quadruple whammy. First, you will owe income taxes on the money withdrawn. Second, you will have to pay a 10% tax penalty on the money if you are under age 59 1/2. Third, the money withdrawn from your retirement account will boost your income, thus hurting your child's financial-aid eligibility. Finally -- and maybe most critically -- you could seriously dent your own ability to retire.
"When their kids are in college and they're on financial aid, parents often don't want to borrow any more money," Mr. Chany notes. "So they pull money out of retirement accounts, and they get hit with income taxes, penalties and lost aid." Mr. Chany figures that, if you're in the 28% bracket and you pull money out of a retirement account, you could lose close to 70 cents out of every dollar to lost aid, taxes and penalties.
So what should you do? Consider borrowing while your kids are in college and then paying back the money after they graduate. By then, you may even be able to tap your retirement accounts without incurring the 10% tax penalty.
Indeed, retirement accounts can be a useful college-savings vehicle for parents who don't have children until their late 30s. They can stash college savings in a retirement account, let the money grow tax-deferred until after their children graduate and then pull the money out to repay debt. At that point, the retirement-account withdrawals will incur income taxes, but they won't hurt aid eligibility or trigger the 10% tax penalty, presuming you are over 59 1/2.
- Not Being A Good Consumer.
Mr. Chany says many parents fork over money for summer courses, private tutors and high-priced colleges without thinking about whether the money is well spent. "Don't forget your consumerism," he counsels. "A lot of parents are vulnerable to the soft sell."
Parents also tend to acquiesce >