Tara Unverzagt February 21, 2016 No Comments

The Bond Case

I recently had a conversation about buying individual bonds versus a bond mutual fund. I’m always amazed that investment advisors believe that buying individual bonds is a bad idea. The most cited reason for not holding individual bonds is that you get a terrible price compared to the “Big Boys” at a mutual fund. But the difference in price is less than the 1% that the Big Boys are charging you annually to manage your bond fund (and some funds have much higher annual management fees).

Another argument is that the Big Boys get a much better price when selling. I argue that the Big Boys are probably selling far too often. I’m a big believer in buy and hold, especially with bonds. Get a bond ladder in place and hold the bonds until maturity. You don’t have a selling commission and you get full face value for the bond. Why sell and potentially lose money?

Some say that “you never know when you’re going to need the money NOW!” My first response to that is, “If you have a plan in place with a proper Emergency and Set Aside Fund, you won’t need to liquidate your bonds NOW.” And my second response is, “Does that mean you’re not going to invest in stocks? Because being forced to sell at a bad price is far more likely with equities than bonds.”

I’ve also heard it said that you can’t diversify and will have larger holdings in each bond. This argument implies that if a company defaults on a bond you own, you’ll be out a lot of money. I only recommend buying investment grade bonds which are highly unlikely to default. That’s not to say that investment grade bonds never default, investing your money always carries risk, but an investment grade bond defaulting is not as likely as stock prices falling.

Some will argue that your principal in the bond isn’t protected against inflation. Is any investment “protected” against inflation? Inflation exists and we are always trying to beat inflation. The cash you put in any investment is going to devalue at the same rate, you aim to have the return (growth and income) outpace that devaluation. Money used to buy bonds in a bond fund will be affected by inflation the same as money used to buy an individual bond.

Another concern with bond funds is that it’s not always obvious what you are buying. The Big Boys might appear to “beat the market”, but this is achieved by taking on increased risk with lower grade bonds (which have high yields due to high risk) or by using derivatives (futures and options) that can definitely raise yields in good times, but can also go very badly in bad times.

It seems to me that the Big Boys have done a wonderful job marketing and selling to the masses that you can only invest in bonds if you go through them. I argue, individuals can do just as well or better at a given risk level by investing in individual bonds.

All information provided is general in nature and not meant to be advice for you in particular. I can’t predict the future, the discussion above is my best guess given the current data that’s available to me. If you’d like to know more about how this topic relates to your situation or are looking for a financial planner, contact me.

Tara Unverzagt February 19, 2016 No Comments

What’s up with 529 plans?

Let’s explore college planning for your children or grandchildren. There are so many great questions about the “best way” to get ready financially for college, but the answers are very complicated. There’s no way to cover this vast topic in one shot, so let’s look at one college saving method: the 529 plan.

If you haven’t heard of 529 plans, they are college saving accounts that are run by states. You can invest in the state where you are a resident or most any other state’s plan. Most people only look at their state, but if you are considering a 529 plan, it’s a good idea to look at what plan fits your needs best. That may be your state’s plan or another state’s plan.

I’ll use Illinois and California as examples of the differences between states. California has one 529 plan which is a savings plan. Illinois has four different plans which include saving plans and pre-paid tuition plans. I’ll just be addressing the Illinois Bright Start program here which is a savings plan similar to the California 529 plan.

What are the advantages of saving for college in a 529 plan?

  • On the state level, there are often tax advantages on contributions.
  1. California does not have a tax advantage for California residents.
  2. Illinois has a deduction of up to $20,000 of Illinois income for a married couple. Illinois businesses can also get a tax break for matching contributions. And there’s a tax break for rolling over another state’s program into Illinois.
  • On the federal level, 529 accounts are somewhat like a Roth IRAs. Contributions are after-tax dollars while the account’s earnings and growth are tax free.
  • The accounts are professionally managed. If you don’t have an investment advisor or you aren’t comfortable managing your own investments, 529 plans can help you with investment decisions.

Are there disadvantages to investing in a 529 account verses other investment accounts?

  • At the state level, some of the advantages mentioned above can come back to haunt you.
  1.  If you rollover your Illinois account to another state, it will be included in your Illinois income.
  2. Since California doesn’t allow deduction on contributions, there is no recapture if you move the funds to another state.
  • Most 529 plans have low fees, but each plan is unique. Illinois has the same plan via advisors and direct with the state. The Advisor version can have almost 1% higher fees than the direct plan. If your account has $100,000, that’s almost $1,000 per year going to fees!
  • Most plans are with a particular investment company (for example, TIAA-CREF or Fidelity) and you will be limited to the investment options they allow. This doesn’t always represent the best choices for you.
  • On the federal and state level, if you don’t take the funds out to pay for qualified expenses, you may pay taxes on the earning and a penalty. I’ll discuss this further later.

What if my child doesn’t go to college or goes to a cheaper college than we expected?

  • Non-qualified distributions (distributions not used for tuition or fees) will be taxable and have a 10% penalty on the earnings if withdrawn.
  • You can use the funds if your child wants to go to graduate school or take vocational/advance skills classes.
  • You can change the beneficiary and use it for someone else’s educational expenses. Haven’t you always wanted to go to culinary school?
  • You can save it for the next generation’s education.
  • There are exceptions that can eliminate the penalty (but you will still pay taxes on the earnings), including: the beneficiary dies or becomes disabled, goes to a US Military Academy, or receives a scholarship.

How does a 529 account affect federal financial aid?

  • A 529 account is counted as an asset of the parent. Federal financial aid considers 5.64% of parents’ assets and 30% of their income “available” to pay for college and 20% of a student’s assets and all their income over $6,260.
  • A grandparent can also start their own 529 account for a grandchild. That account is not included in financial aid reporting.
  • The catch with a grandparent’s account is that the distribution is included in the child’s income the following year.
  • If a grandparent plans to have a 529 account with one year of tuition and fees, your grandchild could save it for their senior year. The funds would never be counted as assets or income for financial aid.

What are the advantages of using a retirement account to pay for college instead of a 529 account?

  • A Roth IRA or Roth 401(k) makes a good college saving tool. You don’t pay taxes or penalty on Roth distributions for principal that has been in the plan at least 5 years.
  • Retirement accounts aren’t counted toward assets for financial aid.
  • If you distributed the taxable earnings from a Roth IRA or Roth 401(k) or from a traditional IRA or 401(k), the funds distributed won’t be penalized (they will be taxed though)

What are the disadvantages of using a retirement account to pay for college instead of a 529 account?

  • The limit for a Roth IRA or Roth 401(k) contribution is $5,500 ($6,500 if you’re over 50) in 2016 and phased out for higher incomes.
  • Each 529 plan has its own limits, but many will let you contribute $300,000 or more at one time.
  • Grandparents should remember you will have to pay gift tax for contributions over $14,000 ($28,000 for married couples) to each beneficiary or up to $70,000 each using a special 5 year exemption, but requires a Form 709, Estate & Gift Tax form, to be filed for each grandparent.
  • Distributions will count as income towards financial aid the next year.

Whether you should use a 529, a Roth IRA/401(k) or other saving plan depends on your needs and expectations. You also need to think about everyone’s tax situation, likelihood of wanting financial aid or need based scholarships, and flexibility. There’s not one right answer for everyone.