A 529 Primer: A Tax-Advantaged College Savings Option Just Got Better

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1 A 529 Primer: A Tax-Advantaged College Savings Option Just Got Better 529 college savings plans were a good idea from the start, but severely hobbled by a yearend 2010 expiration date for the tax-free withdrawals that made the plans so attractive. As part of sweeping pension reform signed into law by President Bush in August, withdrawals from 529 plans are now permanently tax-free. In some states, contributions may also be deductible on state tax returns. Nearly all states have 529 plans and roughly 30 states provide additional incentives, such as a state-tax deduction to in-state residents who invest in their respective plan. It s a good idea to have your financial adviser help you sort through the details of various state plans. There are as variety of services including Morningstar Inc. that now rank the offerings of each state s plan. SavingforCollege.com and finaid.org are leading sites to help educate you in how these plans work. The Administration s action couldn t have come a moment too soon. Investments were starting to wane in the plans over the past two years as parents and other family members began considering the expiration and started looking for other options to save college money for their children. How a 529 plan works: 529 college savings plans are named for their place in the federal tax code and come in two varieties 529 college savings plans and 529 prepaid tuition plans. Prepaid tuition plans are just that tax-deferred savings plans that guarantee your child s tuition will be paid based on today s cost. Also, it s important to note that prepaid tuition plans are not an automatic guarantee a student will get into that college. A 529 college savings plan allows college savings to grow tax-deferred and withdrawals are completely tax-free as long as the money is used to finance college expenses. Each plan has various investment choices that range from low- to higher-risk, and that s why it s critical to discuss any plan s offering with an expert first. Financial aid issues: Earlier this year, the Deficit Reduction Act of 2005 was enacted and gave some positive news on the financial aid front. This law prevents a 529 account from being treated as a student asset on a Free Application for Federal Student Aid (FAFSA), which could limit the student s chances for aid. Also, a tax-free distribution from a 529 plan to pay currentyear college expenses won t impact income levels that could reduce financial aid eligibility in the next school year. Gift and estate tax advantages: Federal tax law allows for a general accelerated gift option that allows individuals to average gifts over $12,000 per beneficiary ($24,000 for married couples based on 2006 levels) over a five-year period without incurring federal gift tax. So an individual can contribute up to $60,000 per beneficiary in one year and a married couple up to $120,000 per beneficiary without incurring gift tax. If you give the full amount, you will not be able to give any gifts to the same individual during the five-year period without incurring gift tax or using up a part of your lifetime exclusion. -more-

2 2-2-2 Possible benefits for other members of the family: If a beneficiary doesn t need the money for college, everyone up and down a beneficiary s so-called lineal family tree parents, aunts, uncles, brothers and sisters as well as kids may benefit from the tax breaks and educational rewards of these plans. And depending on state laws, relatives and friends may get a tax benefit for contributing funds to a particular beneficiary s plan. Control issues: This is one of the more attractive aspects of the 529 plan the person who opens the account retains control of the funds. That means that parents can keep control of this substantial asset until the funds are spent. The holder also has the power to transfer accounts or excess amounts to pay for higher education costs for other children or other lineal family members. Performance: This is the one area where the choice of a 529 isn t always a lock. There are definitely mutual funds and other investment choices that may possibly earn more for your future student and possibly outweigh any of the tax advantages you get with a 529 plan. This is why it s particularly important to work with a planner who knows your financial situation and goals before you invest October 2006 This column is produced by the Financial Planning Association (FPA ), the largest membership organization of financial planners. Please credit FPA if you use all or part of this column. To connect with a member of FPA for your story, call FPA s Public Relations Department at , ext The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.

3 Get Ready for 401(k) Retirement Advice at Work, But Be Prepared to Ask Questions For the last two decades, employees in self-directed retirement plans like 401(k)s have had to largely go it alone for advice on the investment choices offered within the company s plan. A new federal law indicates that s about to change, but there s plenty of controversy swirling around it. The August passage of the Pension Protection Act will allow qualified fiduciary advisers to deliver personally tailored investment advice in person, by phone or electronically for 401(k), IRAs, Archer medical savings accounts, health savings accounts and Coverdell education savings accounts. Essentially, the new law in its current form will allow big 401(k) providers like mutual funds, insurance companies and brokerages to supply direct advice to workers on the investments the firms themselves sponsor. To proponents, the new law will provide necessary guidance for workers who have picked their retirement options at random with dangerously lukewarm results. To opponents, the new law may provide considerable risk of conflict of interest at worst and plentiful yet inadequate advice at best. Many financial planners indicate they are gun-shy about jumping in. The Financial Planning Association (FPA) is particularly suspicious of the new law s permission of plan providers to provide direct advice to investors buying their products, which the organization believes may be distorted by a clearly recognized conflict of interest. The law had declared two restrictions intended to keep the advisers from going overboard in supporting their own products. First, their recommendations have to be based on an objective computer model and the advisers will get the same fee no matter what funds they pick. FPA would have preferred a requirement that advisers be truly independent of connection to the plan providers so investors could receive advice that is not intended to favor certain investment choices that may be of greater benefit to the sponsor s funds as opposed to other choices available in the plan. Final language and requirements on the advisory issue are currently being worked out by the Labor Department, but the Pension Act itself contains provisions that are actually much broader in scope and extend beyond pension issues. For instance, the act extends popular retirement savings rules that were due to expire in 2010, including the Roth IRA, catch-up contributions, 403(b) plans and 529 plan savings benefits. Another provision would encourage employers to implement automatic 401(k) enrollment a popular provision given recent public outcry over how badly Americans have planned for retirement. In addition, the tax-free treatment of qualified withdrawals from 529 plans was made permanent. -more-

4 2-2-2 This discussion of investment advice comes as the government is hoping to light a fire under contributions. Indeed, the new pension law allows 401(k) savers to put more away. The current annual contribution limit on 401(k)s of $15,000 is set to increase every year for cost-of-living until 2011, at which point it is scheduled to fall back to approximately $13,000. The new legislation makes permanent the $15,000 level plus annual cost-of-living adjustments. In the meantime, it s time for individual investors to ask some important questions of their employers, tax and financial advisers: 1. When advisory services are offered at my company, who will be providing them? 2. What investment choices will be available, and what is the adviser s connection to those offerings? 3. What does the adviser get paid for making recommendations to individual employees? 4. Does the employer receive any incentives for picking certain plan providers over others? -30- October 2006 This column is produced by the Financial Planning Association (FPA ), the largest membership organization of financial planners. Please credit FPA if you use all or part of this column. To connect with a member of FPA for your story, call FPA s Public Relations Department at , ext The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.

5 Felt the Pinch From Your Adjustable Rate Mortgage Yet? Be Ready for the Moment You Will The Federal Reserve has taken what many believe is a temporary pause in the interest rate hikes it began back in But that won t be much comfort to mortgage holders who signed up for adjustable rate mortgages (ARMs) set to readjust this year, particularly those who signed on for interest-only mortgages. According to a 2005 study by Deutche Bank Global Markets Research, resettable debt was scheduled to approximately double in 2005, 2006 and Those are truly staggering figures a sign that a sudden slowdown in the economy could shatter the lives of tens of thousands of American families. Trouble seems to be accelerating. According to the Mortgage Bankers Association, the second quarter delinquency rate for ARMs, climbed 0.51 percentage points compared with the second quarter of 2005, to 2.7 percent an increase of 23 percent in the number of borrowers in this category who are falling behind in their payments. A January 2006 study by the Federal Reserve said that 35 percent of people with ARMs didn t know when their rates would reset or the potential maximum they might pay on those loans. For some people who last refinanced one, two or three years ago particularly those who went with interest-only loans - an increase based on current rates could raise the size of the payment as much as 60 percent. Don t want to get caught with a rate adjustment nightmare? It may happen, but at least you can prepare. Keep these questions in mind: Do you know whether you have an ARM? It may sound silly, but if you re not sure, check. Fixed-rate mortgages carry an interest rate that stays the same during the life of the loan. But with an ARM, the interest rate changes periodically based on your loan agreement, usually in relation to a particular financial index. Payments may go up or down depending on where that index is heading. When s my adjustment period? If you ve already signed on the dotted line, dig out those mortgage documents and look for the margin. "Margin" is the percentage amount the lender adds to the index rate to get the ARM's interest rate. With most ARMs, the interest rate and monthly payment change every year, every three years, every five years or possibly longer, depending on what you agreed to. The period between one rate change and the next is called the adjustment period. A loan with an adjustment period of one year is called a one-year ARM, and the interest rate can change once every year. You need to ask your lender how much warning you ll get about an approaching adjustment period and how your current payments may be affected. Did you get an introductory rate with your loan? During the height of the mortgage boom, lenders took a cue from credit card companies by offering customers a lower rate during the first year of the ARM. When that rate goes off, it s quite a shock. Realize that you ll have to adjust to the possibility of significantly higher payments later on, especially if interest rates keep heading up. Make sure you understand the relationship of any introductory rate to a permanent rate. -more-

6 2-2-2 What s the cap? On most conventional ARMs, the lender caps the percentage increase in the interest rate. It s very important to ask your lender or review your loan documents - about how your rate cap works on your particular loan. Interest caps come in two versions: Periodic caps, which limit the interest rate increase from one adjustment period to the next, and Overall caps, which limit the interest-rate increase over the life of the loan. Ask whether there are any other conditions under which your monthly payment might change. Are there restrictions on prepayment and conversion? For borrowers with lower credit scores or those who had to go to sub-prime lenders, there may be interesting language in your loan agreement restricting prepayment or converting your loan to a fixed rate whenever you want. Obviously, at some point you might need to create an escape plan, and if you got stuck with this language, figure out how much the divorce is going to cost October 2006 This column is produced by the Financial Planning Association (FPA ), the largest membership organization of financial planners. Please credit FPA if you use all or part of this column. To connect with a member of FPA for your story, call FPA s Public Relations Department at , ext The Financial Planning Association is the owner of trademark, service mark and collective membership mark rights in: FPA, FPA/Logo and FINANCIAL PLANNING ASSOCIATION. The marks may not be used without written permission from the Financial Planning Association.

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