Sunday, December 24, 2006

529 Plan

A 529 plan is a state-sponsor plan that are designed to encourage saving for future college cost. All 50 states have their own 529 Plan. There are two types of 529 Plans and each state either has one or both types. The first type is called prepaid tuition plan. A prepaid tuition plan allows college savers to purchase units or credits at participating colleges and universities for future tuition, and in some cases room and board. In other words, you can lock in today's college tuition rates and the plan will pay for future college tuition at participating colleges and universities. Most prepaid tuition plan has residency requirements, meaning you have to live in that state to get that plan. In prepaid tuition plan, you need to put in one lump sum investment or with monthly installments. Investments in prepaid tuition plan are usually guaranteed a rate of return by the state. If you decide not to put in one lump sum or pay monthly installments, the plan will invest in mutual funds, which are not guaranteed.

The second type of the 529 Plan is the College Savings Plan. This type of plan generally allows the college saver (the account holder) to establish an account for the student (the beneficiary) for the purpose of paying the beneficiary's eligible college expenses. There are several investment options to choose from. Investment options often include stock (or equity) mutual funds, bond funds, money market funds, and age-based portfolios that automatically shifts to more conservative investments as the beneficiary gets closer to college age (which is usually 18 years old). This plan can be used with any college or university. Remember, mutual funds are not guaranteed a rate of return and are not FDIC insured.

Let's take a look at the benefits of the 529 Plan
1) Tax benefit. Any qualified withdrawal from the plan are tax-free. Qualified withdrawals are withdrawals that are used to pay for college tuition, room and board, textbooks, mandatory fees, and maybe a computer (if it is required by the school that students need it). In most states, earnings are tax-deferred. In some states, you may be allowed to make tax-deductions.
2) You have complete control of the account's assets. Unlike other education plans such as Coverdell or custodial accounts where the child can use it at age 18 or 21, the beneficiary does not gain control of the account no matter what age he/she becomes.
3) There are no restrictions on who you can open the account for. It can be your child, a relative, a friend, the mail man, or even yourself.
4) Since there are no restrictions, anyone can contribute to the account
5) No income restriction. It doesn't matter how much money you make, you can contribute!
6) Gift-tax exclusion. You can contribute up to $11,000/year or $22,000/year if you are married. (*Please note that this amount may change. Check for other sources to how much you can contribute tax-free.)
7) In most states, there are no age limit or time limit on when the money has to be used. If the child does not want to go to college, you can roll it over to another child in the same family.
8) In 529 College Savings Plan, the child can use the money for any college or university and maybe some international schools.
9) If your child gets a scholarship, the remaining balance in the plan can be rollover into another sibling or relative or it can be cashed out and you will just pay income tax on it.
10) Various investment options. Many states work with well known investment companies. There are many investment options to choose, but once you choose an option, you can't change it. You can roll it over to another state's 529 plan without any penalties if you are not happy with your investment option. You can only do this once every 12 months. Many plans offer age-based investments. That means your investments are invested in aggressive growth funds in early years to moderately aggressive growth in pre-teen years and finally in conservative funds (such as bonds and money market) in teenager years.

Let's take a look at some of the drawbacks of the plan:
1) If your child has a 529 plan, this may impact his/her ability to get financial aid.
2) Money in 529 plan can't be used as a collateral for a loan.
3) Any non-qualifed withdrawals will result in income tax and a 10% penalty tax. If the child receives a scholarship, you can withdraw money up to the amount in the scholarship and only pay income tax on it.
4) You don't control the investments since they are professionally managed by a portfolio manager.
5) You can only make cash contributions (by check or money order or direct debit).
6) Only one 529 plan per child.

Now that we establish the benefits and the drawbacks, its all up to you on which 529 plan to choose. I'm going to list some hints here to help you out.
1) Look at your state's 529 plan.
2) Check the manager of the plan. Look at investment company record of success.
3) Look at the fees the plan charges and the expense ratio.
4) Look at the maximum and minimum contribution limit.
5) Check if the plan offers any other benefits such as disability, terminal illness, or death.
6) Most of your questions can be answered in the prospectus.

To see the 529 Plan in your state, go here:

Common questions and answers:
Q1) What if my child doesn't want to go to college?
A1) You can let the account grow tax-deffered until he/she changes her mind. You can change the beneficiary to another child. You can withdraw the money, but you will pay income tax and a 10% penalty. People who usually don't go to college usually can't afford it. But I find out that most people who didn't go to college really wanted to go. Some people start college later in life. Even older people in their retirement has went to college. If money wasn't the issue, more people will be attending college.

Q2) There are so many 529 plans. Which one should I pick?
A2) Look at your state's 529 plan. Though, I personally like Colorado's Scholar Choice 529 Plan. Learn more about it here: Which one is best? Compare it with your state's 529 plan with the one I recommend.

Q3) Are contributions tax-deductible?
A3) Only some 529 plans allowed that and others say you have to live in that state in order to make tax deductions. So the answer is "only some of them."

To see other questions and answers, go to the Securities and Exchange commission website:

Education Plans

So, you have a child under 18 years old and you wish to setup a savings account where your child can later use for college. There are various ways you can approach that, from opening a savings or CD account at the bank to investing in mutual funds. I believe the best way to accumulate money for the long term is investing in mutual funds. If you take at the rate of return on them in the past 10 years, they have average out anywhere between 5 to 14% (this including the effects of September 11). How much will public college cost in 10 to 15 years? To be conservative, lets say its $100,000. That may seem a very large number in today's numbers because an average cost of tuition is around $12,500 for 4 year public universities (nationwide). But if tuition keeps rising every year, its very possible that a 4 year college will cost $100,000 in 10 to 15 years.

Before we talk about education plans, you need to take a look at your retirement plan. Are you accumulating enough wealth to live on when you retire? If not, then setting up an education plan may not be the right move for you. However, its up to you on what you want to do with your money.

There are two types of plans that are designed specifically for higher education and offer tax benefits as well. They are 529 Plans and Coverdell Education Savings Accounts (formerly known as Education IRA), which will explained in the next couple of blogs.

Thursday, December 21, 2006

The other IRAs

Now that I covered what is a Traditional IRA and a Roth IRA are, lets talk about the other types of IRAs. Remember, all investments grow tax-deferred in all IRAs and the age 59 1/2 rule applies.

1) Single Employee Pension IRA (SEP IRA)
This is a Traditional IRA setup by an employer for a firm of employees. Self-employed individuals, partnerships, and sole proprietorships may setup one as well. Employers are allowed to make tax-deductible contributions to each of their employees. Employees do not pay taxes on these contributions, but will pay taxes when they withdraw money from it. Since SEP IRAs are Traditional IRAs, rules for Traditional IRAs are the same as SEP IRAs.

Employees cannot setup a SEP IRA. Instead, they must setup their own Traditional IRA in order to participate in the SEP IRA. When the employee setup a Traditional IRA, the employer will make contributions to employee's Traditional IRA. This is the definition of a SEP IRA. However, it is the employer's own discretion to contribute. So, don't expect the employer to contribute to your Traditional IRA every year. In order for the employee to participate in the plan, he/she must meet these eligibility requirements:

  • Must be at least 21 years old
  • Must earn at least $450/year
  • Has worked with the employer 3 out of 5 previous years prior to the year which contributions are being made. That means, you must worked full-time for three of the 5 previous years.

There is a limit on how much an employer can contribute to the employees. An employer can contribute up to 25% of the eligible employee's compensation, providing the contribution does not exceed $45,000 (for 2007). If the employee is at least 50 years old, he/she can receive an additional $5000. Of course, this is all up to the employer on whether to contribute or not.

2) Savings Incentive Match Plan for Employees IRA (SIMPLE IRA)
In this IRA, employers can make contribution to their employee's retirement plan and their own retirement plan. In SIMPLE IRAs, employees may choose to make a salary reduction contribution and the employer makes matching or nonelective contributions. Since contributions by employees are not taxed, any withdrawals they make will be taxed. Employers may make tax-deductions when they contribute to the plan.

Not all employers can qualify for a SIMPLE IRA. Here are the eligibilty requirements for the plan:

  • The employer employed 100 or fewer employees. All employees employed during at any time during the calendar year are counted for, regardless of whether they qualify to participate in the plan or not.
  • Participating employees must earn at least $5000 in compensation during the preceding year.
  • The employer maintains no other plans, including collective bargaining agreements (Union plans)

If the employer employs more than 100 employees in any calendar year, the employer has two years to fix the problem or they will no longer be eligible to maintain the plan.

There are two ways that an employer can contribute. One way is matching the employee's contribution dollar for dollar up to 3% of the employee's compensation. The employer must give 3% in 2 of the 5 years when the plan is maintained. That means, the employer can't be cheap and only give 1% every year. An employer can't give any matching contribution below 1%.

Here are some examples to explain that last paragraph. Cindy, Joe, and Mary worked for company XYZ in 2006. XYZ decides to take the matching contribution of 3% for that year.
Cindy earns $10,000 and puts away $2000 into the plan. XYZ matches the contribution, but can only contribute $300 (10,000 x 3%).
Joe earns $200,000 and puts away $8000 into the plan. XYZ can only contribute $6000.
Mary earns $20,000 and puts away nothing into the plan. XYZ can only contribute $0.

Second way is a 2% non-elective contribution to all eligible employees, whether or not the employees make contribution. If the employer chooses the 2% non-elective contribution, they can only do so up to a salary cap limit of $225,000 (for year 2007. This amount will be adjusted every year by the US government). This salary cap limit does not apply to matching contribution.

Either way, the employer is required to make contribution for each year the SIMPLE IRA is maintained.

For employees, their contribution limit is $10,000 for 2006, $10,500 in 2007, $11,000 in 2008. If you are age 50 and above, you can contribute an addition $2500.

3) Spouse IRA
Simply put, if you have a spouse that makes little or no money, you can setup a Traditional or a Roth IRA for him or her. If you recall the contribution limit on Traditional and Roth IRAs, you can now double that figure. For example, the contribution limit for any individual who has a Traditional or Roth IRA in 2007 is $4000. Since you have a spouse, you can contribute up to $8000. However, you can only contribute $4000 for yourself and $4000 for your spouse. You cannot put $8000 into your own IRA. If you or your spouse are over age of 50, you can contribute an additional $1000 to yourself and another $1000 to your spouse. Remember income limit applies for Roth IRA, which is currently $160,000 for married couples.

4) Rollover IRA or IRA rollover
This means you can move a qualified plan such as a 401(k) into an IRA without any penalties and taxes. It also means you can move assets from one IRA into another IRA. Currently you can only move your employer's qualified retirement plan into a Traditional IRA and rules for Traditional IRA applies. Here are the different ways to do a rollover:
1. You can move your 401(k) into a Rollover IRA and later move it into another employer's 401(k), 403(b), or 457 plans. That is, the new company you work for allows it. If you make contribution into the Rollover IRA, you cannot move it into another employer retirement plan.
2. You can move your employer's qualified retirement plan (401k, 403b, or 457) into your own IRA. There are two ways to do a rollover. One is called the "indirect rollover." This is where the company will hold 20% of your assets and give you only 80% for taxation purposes. You must make up the 20% balance or you will pay a penalty on the entire rollover. You will have 60 days to move the entire balance of your 401(k) into your IRA. When you do your taxes, you will get the 20% balance back. The other rollover is called a "direct rollover." This is where your entire 401(k) funds are transfered into your IRA.
3. You can withdraw money from your current IRA and move it into another IRA, as long as you deposit this money in the new IRA or the current IRA within 60 days. During the 60 day period, you can use the money for whatever purpose. Failure to meet the 60 day requirement will result in a 10% penalty and the entire proceed is fully taxable.

It is important to know that you can only do a rollover once every 12 months. If you do it more than once every 12 months, your entire IRA account is fully taxable and there will be a 10% penalty as well.

If you want to keep your IRA, but want to change companies, you can do that as many times as you want. This is called an IRA transfer.

5) Inherited IRA
An inherited IRA is either a Traditional or Roth IRA that is given to a designated beneficiary who is not a spouse (such as a family member). So, if you received an IRA asset of the deceased owner and you are not married to that person, you cannot roll it over to another IRA or make tax deductions. There are limited choices on how you wish to receive the proceeds. Only the spouse has the choice of taking ownership of the IRA, cashing in the proceeds, or rolling it over to his/her own IRA.

Wednesday, December 20, 2006

Comparing Traditional IRA to Roth IRA

In my last blog, I talked about the difference between Traditional IRA and a Roth IRA. Let's compare them in numbers. This is a hypothetical illustration and actual results may vary.

Let's say you invested $6000/year for 30 years at a 10% rate of return. Your annual income tax is 27%.

If you invested this money through a Traditional IRA, in 30 years you will have $685,500.
If you invested this money through a Roth IRA, in 30 years you will have $1,192,500.
That's a difference of $507,000!!

Why? In Traditional IRAs, your withdrawals maybe fully or partially taxable, depending on whether you treated them as tax-deductible when you do your taxes. In Roth IRAs, any withdrawals you make after age 59 1/2 are tax-free because none of your contributions are tax-deductible.

Here are some more differences between Traditional IRA and Roth IRA.
1) There is maximum contribution limit you can make in any given year. If you are age 50 or above, you can contribute an additional $1000 to your IRA.
2) 10% penalty on any NON-QUALIFYING withdrawals before age 59 1/2.
3) Rule 70 1/2 only applies to Traditional IRAs.
4) Initial 5 year holding period only applies to your first Roth IRA and all conversions.
5) In Traditional IRAs, your contributions are tax-deductible up to a certain limit.
6) In Roth IRAs, your contributions are not tax-deductible.
7) In Traditional IRAs, your withdrawals maybe fully or partially taxable.
8) In Roth IRAs, your withdrawals may be tax free after age 59 1/2.
9) In all IRAs, your investments grow tax-deferred
10) Many, if not all, financial companies charge an annual custodial fee on the IRA account. In most cases, this fee will be automatically be deducted from the IRA, unless you choose to pay it by writing a check

Monday, December 18, 2006

The Individual Retirement Account.

What is an IRA? An Individual Retirement Account is a trust or a custodial account setup in the United States for the exclusive benefit of you or your beneficiaries. The trustee or custodian must be a bank, a federally insured union, a savings and loan association, or an entity approved by the IRS to act as a trustee or custodian.

All investments grow tax-deferred. That means any capital gains, dividends, or interests you receive in any given year, you do not pay taxes on them because they are automatically reinvested to purchase more shares of a fund. There are many types of IRAs, but the common ones you may of heard about are Traditional IRA and Roth IRA. IRAs are a great way to save for retirement because there are many investment choices you can pick to fund your IRA. The IRS website ( has in-depth definitions of the different types of IRAs.

Wednesday, December 06, 2006

About Mutual Funds

What is a mutual fund? It is an investment company that makes investments on behalf of individuals who share common financial goals. In simple terms, there are a pool of investors such as you and me who invest their money through a portfolio manager. This portfolio manager will use these investments to buy stocks of different companies to meet the fund's objective. There can be as little as 25 companies or over 100 different companies in a mutual fund. With so many companies or stocks in a mutual fund, a mutual fund is considered to be diversified. Diversification leads to lower risk because your investment is spread over several companies. The great thing about having a mutual fund is that you don't have to worry about which stocks you should buy and when to sell. The portfolio manager takes care of all that for you.

Here are some benefits of owning a mutual fund:
1) They are professionally managed. That means there are one or two portfolio managers who has many years of investing experience.
2) They are diversified. This means that a mutual fund invests in many companies, some of which you already know or heard of such as Disney or Microsoft.
3) You may receive dividend payments, though this is not guaranteed.
4) Any dividends you do receive can be automatically reinvested.
5) Mutual funds are regulated by the United States Securities and Exchange Commission (SEC). All funds must provide a prospectus, which describes the fund in great detail, to every investor.
6) Mutual funds will send you an annual statement showing your income and capital gains, if any for tax reporting purposes.
7) Your money is always available. Should you decide to sell your shares, your mutual fund will buy your shares at the current net asset value. By law, mutual funds must send you a check within 7 calendar days. Be careful if your mutual funds are in a retirement account. You may pay a 10% penalty if it is in an IRA.
8) Tracking your investments is easy. Most major newspapers have a daily listing of the fund's performance. Plus you'll receive fund statement whenever you make a transaction, as well as semi-annual or annual statements on your progress.
9) There are a variety of objectives. Every mutual fund has a specific investment objective, from aggressive growth to conservative growth to everything in between.
10) There is a potential for growth. Historically, mutual funds have far outperformed more conservative investments. There is some risk, but the returns in mutual funds offer a far better potential for growth than investments that are completely risk free.

Things you should do when choosing a mutual fund:
1) Obtain a prospectus, which is a small booklet that contains lots of information about that particular mutual fund you are looking at.
2) Check if this fund's objective is meeting your investment objective.
3) Check the past performance of this fund. While past performance cannot guarantee future results, it gives a good indicator on how well the fund has been managed.
4) Check its sales charge. Studies has shown that Class A shares or Class B shares has no distinct advantage over the other. Whether you pick Class A or Class B, its totally up to you. Class A shares mean you pay an upfront sales charge. Class B shares mean you don't pay any sales charge when you invest, but if you redeem the shares in the first 5-8 years, you will pay a sales charge on the shares you are selling. This sales charge decreases by 1% every year until it hits zero. Class B shares become Class A shares after 8 years.
6) This is the most important factor when choosing a mutual fund. Check its expense ratio, which is usually shown in the tables near the end of the prospectus. You want to pick funds with a low expense ratio since this will effect the rate of return of your porftolio over the long run.
7) Check its turnover ratio. A fund with a high turnover ratio (anything above 50%) is never good. The turnover ratio means how often a fund sells and buys shares of a stock. If the fund is constantly trading, it incur costs each time it buy and sell shares of a stock. Usually aggressive growth funds or high growth funds has a low turnover ratio and conservative funds and bonds have a high turnover ratio.

Things you should do when investing in mutual funds:
1) Ignore all headlines and news media since they don't provide any details or information about the mutual fund.
2) Depending on your income level, you maybe able to put your funds in a tax-deferred account such as a Roth IRA. If you have kids and want to start a college fund, invest in 529 Plans. Tax-deferred accounts always have a higher capital gain advantage over taxable accounts.
3) You should setup a systematic investing plan with your mutual fund(s). This means, you invest your money each month. When you setup a systematic investing plan, you give your bank account number to the fund and the fund will automatically take money out of your bank account on the same day each month. With most funds, the minimum to invest systematically is $25/month. Why systematic invest? On some months, price of a share maybe high, so you buy fewer shares of that fund. On other months, price of a share maybe low, so you buy more shares of the fund. This is known as dollar cost averaging, which lowers the cost per share.
4) Never pull out when stock market crashes. This is only a temporary phase. Instead of pulling out, you should continue to invest. Since prices are so low, you can buy lots of shares. While they don't worth much at that moment in time, the stock market will always rebound.
5) Over time, your investment objective will change. So, you need to make some changes in your portfolio as well.
6) Stick within the same fund family. For example, if you invest in Legg Mason Partners Fund (formerly known as Smith Barney), then pick mutual funds from this family. Don't mix your portfolio with so many different families. Investing in two fund families is good enough such as Legg Mason and Van Kampen. Though, its up to you on whether you want to invest with other fund families. The reason why I don't mix my portfolio with so many different families is because of the sales discount. If the value of all my mutual funds (including your spouse and children under age 21) in the same fund family meets a certain limit, which is $25,000, I get a sales charge discount. The lower the sales charge, the more of my money is being invested.
7) The earlier you invest, the less you need to save toward retirement. So, stop procastinating, stop saying "I don't have any money" because you can invest as little as $25/month and start saving!

Disclaimer: I am not an investment advisor. The information in this blog are only my opinions and are base on the information I am aware of. I am not responsible on how your portfolio performs. It is totally up to you on how you want to invest.