Tips From Donna ( January 2016 Wesban Monthly)
by Donna Gordon on February 1st, 2016

Question: The amount we've saved in our child's 529 account will likely not cover the full cost of college. What are our options? Is there an order in which to tap other assets that makes the most sense?
Answer: There are many considerations, and the best strategy will, of course, depend on your individual situation. In addition to taking stock of the assets your family already has available to pay the bill in various college-savings accounts (529s, Coverdells, UGMA/UTMA accounts, and so on), you'll also want to assess whether your child might qualify for scholarships, grants, and credits.
Definitely do not skip the step of filling out and submitting a Free Application for Federal Student Aid, or FAFSA; schools use the information reported on the FAFSA to determine how much aid you qualify for. Also, remember to fill it out every year you plan to attend college. Bear in mind that colleges define 'aid' more broadly than you or I might. Some of this aid will need to be paid back (such as loans), and some of it will not (such as grants and scholarships).
The amount of financial aid you are eligible to receive is based on your 'financial need,' which is the difference between the cost of attendance (determined by each school) and the expected family contribution (a measure of the family's financial strength, calculated according to a formula established by law). So, the lower your expected family contribution and/or the higher the cost of attendance at the school, the greater your financial need.
1) Grants and Scholarships
Grants and scholarships are among the most desirable forms of financial aid and should be considered first. Grants and scholarships, also sometimes referred to as 'gift aid,' are essentially free money--they are financial aid that doesn't have to be repaid. Grants are often need-based, while scholarships are usually merit-based. Do your research to find out which grants or scholarships you might be eligible for and what their application deadlines are. (One caveat, however: Per the Department of Education's website, you might have to pay back part or all of a grant in the event you withdraw from school before finishing an enrollment period such as a semester.)
2) The AOTC
If you are eligible for the American Opportunity Tax Credit, carve out $4,000 in college expenses to be paid with cash or loans ahead of all other sources of money. You can then use the AOTC to offset those expenses. The AOTC isn't available to everyone: Qualified taxpayers with modified adjusted gross incomes of $80,000 or less (or $160,000 or less for joint filers) qualify for the full credit. Taxpayers earning more than this may qualify for a partial credit, but a taxpayer whose MAGI is greater than $90,000 ($180,000 for joint filers) cannot claim the credit.
The reason that AOTC-eligible families should carve out $4,000 of tuition and textbook expenses each year that will be paid for with cash or loans is because the AOTC is worth more than the tax-free 529-plan distribution. The AOTC yields a dollar-for-dollar tax credit based on the first $2,000 of tuition and textbook expenses, then $0.25 on the dollar for the next $2,000. It's also important to remember that you can't use the same qualified higher-education expenses to justify two education tax benefits. For example, you can't use a tax-free distribution from a 529 plan to pay for tuition and textbook expenses that you also want to use to justify the AOTC.
3) Federal Student Loans
As a next step, you should figure out how much of a gap you'll have beyond need-based aid and the 529- plan money and whether some of it can be covered with Direct Subsidized Loans or Direct Unsubsidized Loans, which have low fixed interest rates and do not require a credit check.
One of the benefits of subsidized loans is that the U.S. Department of Education pays the interest for you if you're in school at least half-time and for a limited grace period after you leave school. This makes subsidized loans a better deal for the borrower than other types of loans, where interest begins to accrue immediately. In addition, subsidized loans have low fixed interest rates.
Another option is unsubsidized Stafford loans, which are available to all students regardless of financial need. The unsubsidized federal Stafford loan has a fixed interest rate that is among the lowest available interest rates for unsecured debt that is not based on the borrower's credit. Although the limits are higher than with subsidized Stafford loans, there are also limits to how much you can borrow with unsubsidized Stafford loans.
4) Spend Down Certain Types of Student-Owned Assets Before 529 Assets
In terms of drawing down different types of college-savings accounts, some important considerations have to do with how different assets are 'counted' when calculating the expected family contribution. If possible, you should first spend down any assets that have a bigger impact on reducing the aid a student is eligible to receive.
For instance, if you have one, UGMA and UTMA accounts should be spent down before taking a qualified distribution from a 529 plan. The reason is that UGMA/UTMA assets are student-owned and reduce financial-aid eligibility by a harsher 20% of the asset value. Likewise, savings accounts, real estate, mutual funds, or stocks and bonds held in the student's name can also have a bigger impact in terms of reducing the aid a student is eligible to receive.
5) Spend 529-Plan Money to Fill In Any Remaining Gaps
Assets in a 529-plan account can also reduce aid eligibility, but not to the same extent that UGMA/UTMA and other types of student-owned assets can. If the 529-plan account is owned by a dependent student or the dependent student's custodial parent, it is reported as a parent asset on the FAFSA. In a worst-case scenario, this will reduce aid eligibility by up to 5.64% of the asset value.
6) Federal Parent PLUS Loan
Another option is to use a federal Parent PLUS loan to address any remaining gaps that can't be covered by grants and scholarships, student loans, and 529 assets. The PLUS loan has a fixed interest rate for the life of the loan, plus a loan fee.
Unlike with student loans, the Parent PLUS loan does depend on the borrower's credit history, but the credit check may not be as stringent as with some private loans. That said, borrowers with excellent credit may be able to qualify for a lower interest rate on a private loan than on the federal Parent PLUS loan. Just be aware that if you sign up for a variable-rate loan, rates really have nowhere to go but up from here.
Although taking on debt to finance college is unavoidable in many cases, there are some important considerations. In terms of students taking on debt, an oft-cited rule of thumb is that their total education debt should be less than their expected starting annual salary--otherwise, they will have trouble paying back that loan debt. Likewise, it's a good idea for parents to be conservative about how much debt they can comfortably take on, particularly as they near retirement and may have reduced incomes and fewer resources available to pay off the loans.
 
How Your Investment Income Is Taxed  

 While this is by no means an exhaustive list, it covers some of the main categories of income-producing investments and how the income they produce is generally treated by the IRS at tax time.
Please note, though, that because every investor's tax situation is unique, you should consult your accountant for verification of your tax status and tax treatment of any investment product mentioned below. Also, we won't go into capital gains taxes in this article because the tax treatment of them is largely the same regardless of asset class.
Stocks With Qualified Dividends
For most stocks that pay qualified dividends, the tax treatment is pretty straightforward: Investors would report the income on a 1099-DIV in the Qualified Dividends box. Investors in the 10% and 15% brackets will have a zero tax rate on dividends. For individuals in income tax brackets greater than 15% but less than 39.6%, qualified dividends are taxed at 15%. Individuals in the 39.6% tax bracket are subject to a 20% tax on dividends. Higher-income taxpayers are also subject to a 3.8% Medicare surtax on investment income.
In order to be a 'qualified dividend,' the dividend must be issued by a U.S. corporation or a foreign company that either trades on a U.S. exchange, such as an ADR, or is eligible for benefits under a U.S. tax treaty.
Note that in order for the dividend to be 'qualified,' you must have owned the investment for at least 60 days of the 121-day period that begins 60 days before the ex-dividend date, or the day the stock trades without the dividend priced in.
Foreign Stocks With Nonqualified Dividends
If you're considering a foreign stock for a taxable account, do your homework on whether the company's dividends are qualified. You can find out more about this by consulting IRS Publication 17.
Preferred Stock
In many (but not all) cases, preferred-stock dividends are treated as qualified dividend income for tax purposes, even though they have many bondlike characteristics, such as a stated par value and fixed coupon.
Some dividends paid by U.S. companies are not eligible for lower tax rates, however. Here are a few examples:
REITs
Real estate investment trusts do not pay income taxes at the corporate level, but they are required to pay annually at least 90% of their taxable income in the form of shareholder dividends, which is one reason they pay out such large dividends.
Different types of REIT payments are taxed at different rates. In the majority of cases, REIT dividends are considered nonqualified and taxed at ordinary income rates; therefore, they are probably best held in a tax-advantaged account. But there are other types of income payments, such as those distributed from taxable REIT subsidiaries or out of long-term capital gains, which could be subject to lower tax rates; investors should consult with their tax advisors in these cases.
MLPs
Master limited partnerships are partnerships that trade on a public exchange. They may offer certain tax benefits but also some tax complexity. Unlike with REITs, however, it is best to hold MLPs in a taxable account, because owning them in a tax-deferred account can result in something called unrelated business taxable income, which then requires the account to pay taxes.
MLPs pass through their taxable income to unitholders, who then pay taxes on that income at their own marginal tax rates, often only when the units are sold. These can be a little complicated at tax time, owing to the fact that you don't use a 1099 form to report the distributions but instead have to use a K-1.
Another interesting feature of MLPs is that cash distributions are not directly taxable: The IRS looks at them as returns of capital, so it reduces the investor's cost basis in the MLP. In practical terms, that means that the investor will have to pay taxes on the spread between a lower cost basis and the MLP's price at the time of the sale, but most of the income the MLP distributes from year to year is effectively tax-deferred.
Exchange-traded products can sometimes sidestep tax-reporting complexities but oftentimes at the expense of the tax benefits one would get if the MLPs were held directly.
Taxable Bonds
Bond income is generally taxed at investors' ordinary income tax rates in the year it was received. The income is taxable at the federal level in all cases, but Treasury bonds are not subject to state and local income taxes.
TIPS Bonds
As with Treasury bonds, interest payments from Treasury Inflation-Protected Securities, and increases in the principal of TIPS, are subject to federal tax but exempt from state and local income taxes. One additional thing to remember about TIPS, however, is that the amount by which the principal of your TIPS increased because of inflation is taxable for the year in which it occurs, even if your TIPS hasn't matured (in other words, before you would receive an actual payment of principal).
Municipal Bonds
Muni bonds are issued by state and local governments to finance public projects. In the vast majority of cases, the income paid out by these bonds is not taxed at the federal level. In some instances (particularly if the bond is issued by a state or municipality in which you reside), munis' income is not taxed at the state or local level, either. It is also worth noting that income from private-active munis is subject to the Alternative Minimum Tax.
Commodities
There are typically no dividend or interest payments paid to investors who get exposure to commodities through exchange-traded-note (which are unsecured debt obligation) or grantor trust (which often hold physical commodities) structures. However, if you bought a commodity-futures-based ETN, you might have to report income using a Schedule K-1.
 
How RMDs Can Upgrade Your Portfolio   

Affluent investors love to hate their RMDs--the required minimum distributions they must take from their Traditional IRA and 401(k)s by the end of each year after they turn age 70 1/2.
They complain that their RMDs push them into a higher tax bracket and muck with their planned withdrawal rates. They wonder about how to reinvest their unwanted, unneeded distributions, as well as how to avoid RMDs in the first place.
The fact is, the best way to avoid RMDs is before they start--or ideally, before you retire. By investing in multiple silos--Roth and taxable, in addition to the RMD-subject Traditional IRAs and 401(k)s--in the years leading up to retirement, you avoid coming into retirement with all of your assets subject to ordinary income taxes and RMDs.
By the time you hit the age for RMDs--which must commence by April 1 of the year following the year in which you turn 70 1/2--dodging those distributions carries tax consequences of its own. True, it can make sense for some RMD-subject investors to consider converting those Traditional IRAs to Roth accounts, which offer tax-free distributions and aren’t subject to RMDs. But the conversions also have the potential to jack up taxes in the year in which they're executed, so the long-term benefits must be weighed against the short-term costs. And for older adults converting Traditional IRA assets to Roth so that their children or grandchildren will be able to take tax-free distributions (a common motivator), it is worth remembering that their own current tax rates--which will be levied upon the amount converted--may well be higher than the taxes their heirs would pay if they inherited those Traditional IRA assets. If the goal is to minimize the taxes levied on that IRA kitty, a conversion won't always achieve it.
Yet while there are few good ways to dodge RMDs and their related tax bills, there's one key silver lining. You can use these forced withdrawals to improve the risk/reward profile of your portfolio--especially its risk level--without triggering any additional tax costs. Whereas rebalancing is often psychologically difficult, RMD season leaves little room for excuses. You have to take those distributions or else face a 50% penalty on the amounts you should have taken but didn't, so you might as well take the ones that make the most sense from a portfolio standpoint.
Strategic RMDs in Action
To use a simplified example of how RMDs could help improve a portfolio's risk/reward profile, let's say a retiree allocated her $1 million IRA portfolio three years ago, at the beginning of 2012. She was targeting a 60% equity/40% bond portfolio, so she put $400,000 into a U.S. equity index fund, $200,000 into a foreign equity index fund, and $400,000 into a total bond market index fund.
Fast forward to today: Her portfolio has appreciated to $1,389,040 by mid-November 2015, and its contents have shifted around, too. Her U.S. equity fund now accounts for more than half of her balance, after starting as 40%. Meanwhile, her international equity and bond funds have shrunk below their original position sizes, to 18% and 31%, respectively. They've appreciated in dollar terms, but not nearly as much as the U.S. stock fund in her portfolio. Her bond fund has been the biggest (relative) loser.
She turned age 70 1/2 this year, so she will be required to take her first RMD by April 1, 2016. (Required minimum distributions are normally due by Dec. 31 of each year, but first-time RMDers can take advantage of a special three-month extension.) To calculate her RMD, she'd look back to her balance on Dec. 31, 2014--$1,387,680--and divide that by 27.4, the distribution period for a 70-year-old in the IRS' Uniform Lifetime Table. That calls for a distribution of $50,645 from her IRA.
Because she has multiple holdings with different performance patterns, she can be surgical about which holding she taps for distribution. Assuming she'd like to get her portfolio back in line with her original targets of 40% U.S. equity, 20% foreign equity, and 40% bond, the answer is easy: She should sell a chunk of the U.S. stock fund. Selling $50,645 of that holding is not enough to restore her portfolio to her original allocations, especially because she’s a young retiree and her RMD is a fairly small portion of her total kitty. It has also been a while since she made any portfolio alterations.
But that doesn’t have to be the end of her rebalancing activity. If she doesn't need the RMD for living expenses, she could plow the proceeds into a bond fund in a taxable account, boosting her bond allocation to 35% of her total portfolio, both taxable and IRA--closer to the 40% target. (If she's a higher-income investor, she'll want to consider municipal bonds for her bond holdings inside of a taxable account.)
Of course, she may still wish to take action to restore her balance further to her original allocations, and she can do that repositioning without incurring additional tax costs in her IRA. But the strategic RMD and rebalancing have gotten her at least part of the way there.
Implications for Holdings
As the strategies outlined above strongly suggest, having at least a few discrete holdings gives the retiree some latitude to be strategic when taking RMDs. By contrast, the retiree holding a single fund in an IRA--one that combines both stocks and bonds, for example--wouldn't have discretion over which investment type she sells for distributions. Selling the fund would mean that she's selling a chunk of both her stocks and her bonds.
Retirees interested in exerting even tighter control over their portfolios' allocations could consider subdividing their holdings even further than the three-holding IRA in my example above. For example, maintaining separate holdings for small-, medium-, and large-cap exposure; value and growth exposure; and developed- and developing-markets foreign exposure would likely afford even more rebalancing opportunities. But retirees should weigh the potential benefits of such a strategy against its complexity; when it comes to the number of holdings in retirement--especially in later retirement--less can be more.
 


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