Qualified 529 Spending (2006-08-28)

Qualified 529 Spending

(2006-08-28) by David John Marotta

The University of Virginia is back in session and Charlottesville was crowded with students last week stocking up for college. Total cost for attendance this year at UVa is estimated at $17,764 for Virginians and $35,644 for non-residents. While most of the bills can be paid from a 529 college savings account, a couple thousand dollars in expenses will not qualify.

My son, our oldest child, is starting college this fall as a film major at the North Carolina School of the Arts. He has two 529 plans which will help cover the costs of becoming the next M. Night Shyamalan.

With careful planning and a 529 college savings plans, you can reduce the cost of college by taking advantage of the plan’s tax-free benefits. Understanding what qualifies for a tax free withdrawal is important in order to receive the maximum benefit from the plan.

All that stuff for the dorm room and even that new laptop computer may not qualify as higher education expenses, according to Uncle Sam. In fact, that pack of no. 2 pencils probably won’t make the cut. Understanding what qualifies and keeping careful records is important if the IRS questions your withdrawals.

Qualified tuition programs like 529 savings plans have incentivised saving for college much like the IRAs have done for retirement. The simple beauty of these tax-efficient plans allows investments to grow tax-free and permits tax-free withdrawals on qualified education expenses like tuition, fees, books, supplies and - in most cases - room and board.

The IRS defines a tax-free 529 distribution as a qualified higher education expense at an eligible educational institution. But to qualify for the tax-free benefits, your withdrawal will have to pass two important tests.

First, it must be incurred for the purpose of education at an eligible institution. Eligible institutions include most colleges and universities in America, specifically those qualified to participate in the Department of Education’s student aid program. Some post-secondary institutions outside the US also qualify. To check for the list of eligible institutions, visit http://www.fafsa.ed.gov/fotw0607/fslookup.htm.

Second, the withdrawal must be for tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. For degree seeking students attending at least half-time, reasonable room and board expenses are also considered a qualified expense.

At first glance, it would seem just about anything might pass this second requirement. So, why can’t you reimburse yourself for that pack of pencils? If you were reading carefully, you noticed the key to passing the second test rests in one little word: "required."

For example, buying a textbook required for class would be a qualified expense. But additional reference materials, such as a dictionary or thesaurus, may not be. And, those pencils you bought cannot be considered a qualified expense unless they are specifically required for attendance. So, forget about reimbursing yourself for all that cool stuff for the dorm room.

Regarding the laptop you purchased, keep your fingers crossed. If the computer is required for class or for attendance at the school, it can pass as a qualified withdrawal. But, as demonstrated in the tax court case of Gorski v. the Commissioner, buying a laptop to save your daughter from waiting in line at the computer lab will not pass muster. In our case we are fortunate since NCArts considers a computer loaded with film editing software a requirement for attendance.

There are still plenty of gray areas. But, thus far, the US tax courts have taken a narrow interpretation of the term "required." All non-qualified withdrawals are subject to a 10 percent penalty in addition to federal and state income taxes on earnings. And while this may mean you pay out of pocket for the new bedding, mini fridge, and the pack of no. 2 pencils, the tax savings offered for those qualified withdrawals should be worth your troubles.

So, how do you go about getting your money?

529 accounts do not issue debit cards or checks. And, although plans vary by state, making a withdrawal can be as easy as calling your investment advisor or the investment company directly. Funds are typically sent by check to the account owner, to the account beneficiary, or to the college or university. Withdrawals can be made at any time by the account owner. However, the owner is responsible for determining whether an expense is qualified or not and for maintaining documentation for all qualified withdrawals.

Distribution requests involving large sums or funds made out to a third party will likely require the account owner to complete a distribution form accompanied by his or her guaranteed signature. With CollegeAmerica’s 529 accounts, withdrawals cannot exceed $75,000 per year, and no more than $5,000 can be payable to the beneficiary.

Because there is no restriction on how long the money must be in the account before being withdrawn, Virginia residents can take a $2,000 state tax deduction each year by simply putting their money into a 529 account one day and withdrawing the same amount the next day. While they miss out on the years of tax-free compounding, they still benefit from the college funding deposit. If college expenses are more than $2,000 they can open multiple accounts and get a $2,000 state tax deduction on each account or roll their $2,000 deduction forward each year until it is used up.

The rules associated with college funding are not simple or rational, and you should consult a tax expert before taking any action. Coordinating tax-free 529 withdrawals with other tax benefits may be tricky. The bottom line is this: Uncle Sam prohibits double-dipping. You may take a qualified 529 withdrawal and a tuition deduction or education credit in the same year. However, the benefits cannot be taken for the same expenses. Tax-free distributions from a 529 account and a Coverdell Education Savings Accounts can be taken in the same year but, again, cannot be taken for the same higher education expenses.

To find a fee-only financial planner in your area who can assist with your college planning needs, visit www.napfa.org.

from http://www.emarotta.com/article.php?ID=193

Reverse Mortgages Are A Last Resort (2006-08-21)

Reverse Mortgages Are A Last Resort

(2006-08-21) by David John Marotta

Before reverse mortgages, pensioners wishing to tap into home equity were presented with two options: either sell the house or get a home equity loan. But since their humble beginnings in the late ‘80s, reverse mortgages provided seniors with an additional tool for accessing home equity. The going offer: get cash now, make no monthly payments, and keep your home sweet home. For retirees struggling to make ends meet, a reverse mortgage can provide a much-needed way forward.

A reverse mortgage should be considered only as a last resort. With early retirement planning, such 'last resort' options can be easily avoided. Still, reverse mortgages are a far cry from the blinking neon signs offering fast cash in exchange for a car title. At least with a reverse mortgage the borrower gets to keep the title and avoid the ugly monthly payments.

To understand the way a reverse mortgage works, let’s look at its opposite: the traditional home mortgage. Both are mortgages. But with a standard home loan—also known as a forward mortgage—over time the homeowner’s equity rises and the debt falls. A reverse mortgage does just the opposite. With a reverse mortgage, the debt rises and the homeowner’s equity falls.

Unlike a home equity loan or a home equity line of credit which immediately begin monthly collections on the loan, no payment is due on a reverse mortgage until the borrower sells or moves. Borrowers are given a guarantee of lifetime occupancy of the home. But, once the borrower no longer resides at home, the loan must be repaid. Typically, repayment is made from the proceeds from the sale of the home. The good news here is a reverse mortgage will not hold the borrower personally liable nor can they owe more than the market value of the home.

Minimum qualifications require borrowers to be age 62 or over and must either own their home free and clear or have little remaining debt against the house. But, meeting the initial requirements won’t mean the loan is a done deal. Borrowers should be prepared for an extensive interview and educational component before they can sign on the doted line.

Reverse mortgages are becoming ever more popular, in part, due to the customizable distribution options. Seniors may choose to receive one lump sum or monthly advances—either for a limited time or spread out over the course of their lifetime—for as long as they reside in the home. Others may choose to open a line of credit or pick a combination of payment options to suit their cash flow needs.

But, the convenience offered by a reverse mortgage comes with a price tag. Although loan fees can be financed as part of the loan, origination fees can easily cost borrowers in the neighborhood of $12,000- $18,000. Add to that the principal loan amount, interest, and maintenance fees, and the total cost will likely account for a sizeable portion of the home’s total value, if not all of it.

In addition to the costs of maintaining the home, borrowers are also expected to continue home owner’s insurance and property tax payment in addition to paying for routine maintenance on the home.

Currently, reverse mortgages come in three flavors: single-purpose, proprietary, and federally-insured loans. Single-purpose reverse mortgages are very low-cost. But, unlike the other two, they can only be used for one purpose, such as paying property taxes or making house repairs. Proprietary loans are offered through private banks. Although they are more expensive, they lend larger sums. Of the three loans types, the most common is the federally insured Home Equity Conversion Mortgage (HECM).

The actual amount a homeowner can hope to borrow using a reverse mortgage will be significantly less than the market value of the home itself. Although a HECM offers lower interest rates than private lenders, borrowers are subject to regional 203b loan caps ranging from $200,160 to $362,790. Ultimately, the total loan amount will be determined by the value of the home or the regional loan cap (whichever is less), the borrower’s age and the going interest rate.

So how do you know if a reverse mortgage is right for you? AARP advises prospective borrowers to consider three questions: 'How much would I get?' 'How much would I pay?' and 'How much would be left at the end of the loan?'

Although the lender almost always wins, a reverse mortgage does offer a Band-Aid solution to pending cash flow problems. Some seniors take the loan to eliminate remaining forward mortgage payments still owed on their home. The majority, though, choose a reverse mortgage to pay medical bills. In either case, a reverse mortgage allows the homeowner to live at home while shoring up immediate, and even long-term, cash flow shortfalls.

There are some cases in which you should never take a reverse mortgage. Avoid a reverse mortgage if you are close to the minimum age requirement. Assuming a reverse mortgage early on will provide you little income and will ensure you will have no equity left in your home at the end of the road. If you currently have little equity in your home, a reverse mortgage is also not worth the cost of the loan origination fees. The fees alone will likely eat up what little equity you have. Finally, avoid a reverse mortgage if you expect to move in the near future. The hefty costs of getting the reverse loan will be wasted and the loan will come due as soon as you move out of the home.

Before going forward with your reverse mortgage, consider your options carefully. There are many creative ways of managing cash flow needs without taking a loan against the value of your home.

As always, begin by looking at your budget and cutting unnecessary expenses. Generating additional income may be as simple as renting out a portion of your home. Or, you may consider moving to an area with a lower cost of living. Sell high and buy low. Then, invest the profit from the sale of your home. By doing so, you may be able to create a permanent cash stream without taking on any debt at all!

Finally, investigate community assistance programs. You may find that you qualify for additional social security benefits or for property tax relief.

More information about reverse mortgages can be found by visiting the AARP website at www.aarp.org. Of course, the best way to avoid a reverse mortgage is by planning early for retirement. To find a fee-only financial planner in your area who will sit on your side of the table visit www.napfa.org.

from http://www.emarotta.com/article.php?ID=192

David John Marotta: What Is A Contrarian? (2006-08-14)

David John Marotta: What Is A Contrarian?

(2006-08-14) by David John Marotta

Much of my financial instincts were developed watching my parents manage money on a daily basis. Even now, one of the highest complements that I can be paid is for someone to say, "The apple didn’t fall far from the tree." Last week my father authored specific examples of contrarian investing. This week I’d like to show how contrarian investing is at work when you regularly rebalance your portfolio.

A contrarian is an investor who buys a category when most others are selling and sells when others are buying. A contrarian doesn’t chase what is hot, but is often buying a category that has recently underperformed.

Major news sources move markets just by the tone of optimism or pessimism they adopt. The financial news is often focused on daily price movements and like all sports trivia, it tends to emphasize winning or losing streaks.

Stock prices can move on very low volume if the volume is all in one direction. Even if the vast majority of those who hold stocks are continuing to hold them, if even a few investors are motivated to buy or sell the price moves significantly.

In the long term, the markets are brilliant at setting appropriate stock prices. In the short term, though, they have the IQ of a gnat. There is so much opportunity in the markets that even conservative investors get swayed by the siren songs of greed or fear. The strait between Sylla and Charybdis are a narrow path safely navigated only if you have a nymph like Thetis to guide you.

In the financial world your Thetis is a long term investment strategy and discipline that purposefully avoids moving in one direction. Not following the crowd is the definition of being a contrarian. And the cornerstone of being a contrarian is rebalancing your portfolio regularly.

Imagine you have a $100,000 portfolio consisting of two different categories called A and B. Your wise financial advisor suggests diversifying your portfolio by investing half in each category. At the end of the first year, Category A has earned 30 percent and Category B has just broken even. You now have $115,000: $65,000 in Category A and $50,000 in Category B.

You are happy with your investment in Category A, but you still aren’t sure about Category B. All the financial news is about Category A’s stellar returns, how the industry is booming, and how Category A’s products are essential to life on this planet. The news is also about the slump in Category B. No one is buying their products. They are laying off employees, firing CEOs, and facing a wall of pending indictments and lawsuits.

To make matters worse, your neighbor to the right works in Category A and his 30 percent investment returns is all he can talk about. Your brother-in-law is dumping all of his investments in Category B and adding to his investment in Category A. So, you call your financial advisor and ask if you should make some adjustments in your asset allocation as well.

"Yes," answers your financial advisor, "You should sell $7,500 of Category A and invest that in Category B." You are stunned. Your first thought is that your investment advisor is so stubbornly enamored by Category B that he won’t admit his mistake and insists on pouring more of your investment gains down the drain.

While you are not convinced by this ‘asset allocation’ strategy you decide to give it another try. So you sell some of Category A and buy more Category B. Now you have $57,500 invested in each.

Fortunes change. The layoffs and new leadership in Category B return profitability and the industry begins to recover. Stock prices, which were beaten down because of losses rebound from their lows, and Category B gains 30 percent the second year.

Meanwhile, Category A’s growth falters. Stock prices had been driven up from new investments and were now pricing the company for 30 percent annual growth. When the industry of Category A only experiences 15 percent growth, the stock prices falter and appreciation ceases. Despite 15 percent growth, current stock valuations are barely justified and drift sideways for a 0 percent gain for the year.

Your brother-in-law and your neighbor to the right are tight-lipped.

Your neighbor to the left, however, is ecstatic. He works for a company in category B. Not only is his company doing better, his investment made a 30 percent return this past year!

You are happy, but not ecstatic. You’ve never gotten a 30 percent return. You return to your investment advisor and ask him, "If you knew that Category B was going to do well, why didn’t we put all the money in that category?"

"I didn’t know Category B would do well," your advisor admits. "But when a good category falls out of favor with investors, rebalancing your portfolio is automatically a contrarian investment. Your portfolio returned 15 percent the first year and 15 percent the second year. Unlike your neighbors, the second year’s gains compounded with the first’s years gains to produce a total gain of 32.5 percent"

You are stunned. The simple contrarian act of pulling money out of the investment which was the darling of the industry and investing it in the dogs of the industry boosted your two-year returns by 2.5 percent. Not only did your investments do better than your neighbors’, but you avoided the feast or famine volatility inherent in their approach.

As a financial advisor I can often foresee which category will perform the best over the next year by which category new clients are the most reluctant to invest in. It is tough being a contrarian, but investing in beaten down categories is too important for your investment returns to let emotions get in the way.

from http://www.emarotta.com/article.php?ID=191

George Marotta: What Is A Contrarian? (2006-08-07)

George Marotta: What Is A Contrarian?

(2006-08-07) by George Marotta

A father and son’s thoughts on contrarian investing. Part one of two.

A contrarian is one who takes a side different from the masses. When everyone is going in one direction, a contrarian chooses to go in the other direction. I confess. I am a contrarian. In investment terms, it is difficult to be a contrarian. Here are some examples.

In the spring of 2000, most investors were buying the Standard and Poor’s 500 stock index fund. This index fund had been outperforming most mutual funds that were run by trained and highly-paid portfolio managers. The success of this fund kept attracting more and more money from investors during the five-year period running up to 2000. This fund was and still is a capitalization-weighted fund. In other words, the majority of dollars coming into this fund went into the biggest companies in the index such as Microsoft, Cisco, etc. And guess what? When the bubble finally burst in 2000, that fund and those stocks took the biggest dive. Since then, the small and mid-cap stocks (non-500 stocks) have been outperforming the big boys. In 2000, contrary to "the crowd," I was not investing in that index or in tech stocks.

After the market peak in 2000, the NASDAQ Index declined more than any other stock index, falling from over 5,000 to below 1,700 in 2003. Tech stocks that had been stratospheric became very, very cheap. For example, during that correction period, I bought Yahoo for $4.50 a share (it had been as high as $120 and is now $25). I also bought Corning Glass Works for $2.50 (it had been $110 in 2000 and is now $19). And Williams Companies was almost bankrupt because it got caught up in the fiber-optic craze and overextended itself with capital spending. The stock had been $45 in 2000, and I bought it for $2.30 in 2002 (and it is now $22).

Let’s scroll ahead to today. What are the masses buying? Oil stocks, of course, because the price of oil has been going up steadily from $20 a barrel in 2002 to about $75 today. So everyone is thinking that investing in oil is a great buy– a sure winner. However, nothing goes in one direction forever.

So, how can one benefit if the price of oil goes down? The answer is: invest in things that use and depend on oil. I have been taking profits and trimming my positions in oil stocks and have started to invest in airlines and automobile companies. I know that I am sometimes early in my buys, but time will tell. These are speculative investments suitable only for a portion of someone’s portfolio if they have a high risk tolerance.

Investors always talk about their winners, as I have just done. After 9/11, I made a "contrary" purchase of stock in several cruise companies that looked very cheap. Two purchases turned out to be great bargains, but one—Classic American Voyages— promptly got a lot cheaper because the company went bankrupt a short time after my purchase.

Looking at foreign stocks, the markets that are doing the best today are the former communist countries. Communism made these countries so backward that a little entrepreneurial spirit is fueling extremely fast development. The end of communism is even benefiting some states that were socialistic, with a lot of central government control and high tariffs. Those countries are doing well as they reduce government control. I am investing heavily in "emerging-market" countries.

Just think, if you can look ahead to the next country that will shed communism for free markets, you could make a mint. Think in terms of Cuba and North Korea. As soon as Cuba abandons communism, rush in and buy real estate. That tropical paradise is going to bloom and boom when Castro’s dictatorship comes to an end.

If you look at the Korean peninsula at night from a satellite, you can clearly see where the 38th parallel (the division between North and South) is located. You can see light shining at night in the south while it is pitch black in the north. Someday, the north and the south will be one country again. How could one benefit from that? I say, invest in the Korean Electric Company located in South Korea. They know how to produce light and make a profit. And, they will sometime (soon, I hope) bring light to the north.

The iShares Morgan Stanley Capital International Emerging Markets Index (EEM) is a good way of investing in international markets. And the Korean Electric Power Corporation happens to be the eighth largest holding, accounting for nearly 2 percent of the market cap of the iShares MSCI Emerging Markets Index (EEM).

Let’s see... what else has been going up for a long time? Oh, yes, real estate! It looks like it is beginning to level off and decline a little. Let’s hope that the decline is gradual because it has been fueling the US economy for the past five years as the stock market has been correcting. Be a contrarian. If you are heavily invested in real estate, congratulations as you have made a bundle. But, if you are a real contrarian, you will begin to lock in those high prices. Remember this cliché, but truism, "Nothing goes in one direction forever."

It’s tough being a contrary investor. It means buying at a time of maximum pessimism and selling at a time of maximum optimism. It is a lonely position, but it is exciting….and sometimes profitable (more than not, I hope). A savvy Rothschild banker once gave this "contrary" advice: Buy when there is blood on the street and sell on the sound of the trumpet.

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George Marotta is a contrarian and founder, senior advisor and a portfolio manager with Marotta Asset Management, Inc. and a Research Fellow at the Hoover Institution, Stanford University in northern California.

from http://www.emarotta.com/article.php?ID=190