Money for College - Dos and Don'ts (Morningstar)

Dos and Don'ts of College Savings

Knowing financial aid rules is key given the rising cost of higher education.

Morningstar, 04/27/2012


Investor Question: I'm worried about how we're ever going to afford college for our children. What can we do to increase their odds of getting financial aid in case we can't save enough?

Answer: For many families, the cost of college has become daunting. Tuition, fees, room, and board at a public four-year school currently run $17,131 per year on average (in-state), and $38,589 per year for a private four-year school, according to the College Board. During the past decade, in-state tuition and fees at public universities have increased on average 5.6 percentage points per year beyond the rate of inflation. No wonder, then, that many parents are losing sleep worrying about how they will be able to pay for their children's college education and how much help they can expect from financial aid.

But whether college is just around the corner or years down the road for the student, there are many steps parents can take to improve their odds of making it affordable, including qualifying for financial aid. Below are some ideas to help get them started. Keep in mind that some financial aid is need-based while some is not and that aid includes not just grants and scholarships, but also work-study programs and loans.

Do: Start Saving as Soon as Possible
Some parents worry that saving for college will negatively affect their student's chances for financial aid. But that's misguided, says college planning expert Mark Kantrowitz, publisher of FinAid, an online guide to college funding. "There's this perception that you'd be better off not saving anything," Kantrowitz says, "but the reality is most of the financial aid you're likely to get is going to be in the form of loans, which you're better off not having to pay."

Kantrowitz estimates that every dollar saved for college potentially reduces a student's borrowing costs by two. He suggests parents and students start saving for college as early as possible, noting that he started saving for his children to go to college before they were even born.

Kantrowitz likes 529 accounts as college-savings vehicles in part because of their tax deductibility (in some states), which he likens to "getting a discount on college costs." (You can visit Morningstar.com's 529 Plan Center here.)

Do: Apply for Any Scholarships for Which the Student Might Be Eligible

Applying for scholarships costs nothing but time, and the payoff could make a big difference in reducing out-of-pocket college costs. An obvious place for parents to start is by filling out the Free Application for Federal Student Aid, or FAFSA, the federal government's form for need-based grants, loans (both need-based and non-need-based), and work-study opportunities. Good online resources for scholarship searches include Fastweb and Scholarships.com. Kantrowitz says about one out of eight incoming freshmen at four-year colleges are on some kind of scholarship, with the average amount around $2,800 per student. "The students who win a lot of money are the ones who apply for every scholarship for which they are eligible," he says. One important tip when applying for scholarships: The more optional information provided, the better the odds of matching. For example, if a student or parent has had cancer, including that in the student's profile helps improve his or her chances of matching one of the many scholarships related to the disease.

Do: Have Kids Close Together in Age

Financial aid formulas are weighted heavily on parental income, and having multiple kids in college at the same time actually improves financial aid eligibility because it reduces the amount parents are expected to pay for each. This helps ease the burden on families having to pay two or more tuitions simultaneously. "Someone who has twins is going to get more aid than someone who has single children separated by four years," Kantrowitz says. Of course, it may be a little late to put this plan into action for most parents, but it also works if, say, a parent attends college at the same time as their child or children. Having an older child delay college to attend at the same time as a younger sibling also works.

Don't: Put Assets in the Student's Name

In financial aid calculations, assets belonging to parents have less of a negative impact than those belonging to students. So money in a 529 plan, which is considered the parents' property, counts less against financial aid than, say, money held in a custodial account such as a UGMA/UTMA, which is legally considered the student's property. One way around this problem is to spend down the student's assets before applying for aid. UGMA/UTMA funds can be used for a wide variety of qualifying expenses, so long as they are for the minor's benefit. Incidentally, money in a 529 opened by a grandparent on behalf of a student does not count against financial aid.

Don't: Count on the Student Getting a Full-Ride Scholarship

Expecting a child's academic or athletic brilliance to bail the parents out from having to pay for college? Think again. Fewer than 0.3% of students win full-ride scholarships or need-based full-ride grants, says Kantrowitz, whereas about two thirds of all undergraduates receive some kind of financial aid, including student loans.

Don't: Sell Assets the Year Before Applying for Aid

A common mistake parents make, Kantrowitz says, is to sell a large chunk of taxable investments to help pay for college the year before applying for aid. This might trigger capital gains that add to parental income and thus reduce financial aid eligibility. (Converting traditional IRA assets to a Roth can also add to taxable income, thereby hurting financial aid eligibility.) Keep in mind that students usually must reapply for financial aid each year, so holding off and waiting a year to sell might not help. It's best to plan ahead if possible by putting funds for college in a 529, where their impact on financial aid is reduced.


Other Financing Methods, With Caveats

Some parents opt to use their retirement accounts to help fund college costs. This has its advantages and disadvantages. The biggest advantage to this approach is that the 10% penalty for early withdrawals is waived if the money is used for qualified college expenses. Also, Roth IRA contributions might be withdrawn tax-free, though any earnings on those contributions are subject to regular income tax rates. All withdrawals from traditional IRAs are subject to regular income tax rates. The problem with this approach is that all IRA withdrawals, whether taxed or not, count as total parental income in financial aid calculations. So even though parents might save on taxes or penalties by doing this, they might also make it more difficult for the student to obtain need-based financial aid.

Borrowing from work-based retirement accounts, such as a 401(k) or 403(b) plan, is another option and does not affect need-based financial aid. However, the loan must be repaid within five years, and possibly immediately in the case of job loss. Parents might be eligible for hardship withdrawals, but those are subject to income taxes and penalties.

Learn from Mitt Romney's Tax Return (WSJ)

WEEKEND INVESTOR
JANUARY 28, 2012.

What You Can Learn From Mitt's Tax Return

By LAURA SAUNDERS
There are some very clear lessons for taxpayers that can be gleaned from Mitt Romney's most recent tax returns that the candidate released recently. WSJ's Laura Saunders spells out the details on Mean Street. How did they do it?

That is the question many Americans are asking of Mitt and Ann Romney's 2010 tax bill, disclosed on Monday evening. While the couple paid almost $3 million in taxes, that amounted to less than 14% of their $21.6 million income.

The Romneys' rate was far lower than the average of 24% paid by the top 1% of U.S. earners, according to the nonpartisan Tax Policy Center.

The couple's 2010 filing presents a rare glimpse into how the ultrawealthy can use the tax code to their benefit, and offers important lessons for others.

The biggest: the powerful tax benefits of capital gains, which are taxed at a top rate of just 15% if the underlying investment is held for more than a year.


GOP presidential candidate Mitt Romney paid a 14% effective income tax rate in 2010 after making $3 million in tax-deductible charitable donations and drawing most of his income from investments. Mitt Romney is working hard to make voters dislike Newt Gingrich and President Obama. But Mr. Romney has yet to crack a tougher nut: persuading voters to like him. Neil King has details on Lunch Break.
."There's a saying in Texas: If you don't have an oil well, get one," says Janet Hagy , a certified public accountant practicing in Austin, Texas. "I tell my clients, 'If you don't have capital gains, get some.'"

Another lesson: Get good tax help. The Romneys' 1040 return is 203 pages long, with different "schedules" and 20 different forms attached, some of them multiple times—not the sort of work typically done by a neighborhood Joe.

Says David Kautter of the Kogod Tax Center at American University in Washington: "The only schedules missing [from the Romneys' return] are the ones for fishermen, farmers and the elderly. Maybe Mitt should get some cows so he can have a 'full house' of schedules."

Some have suggested that, despite their low tax rate, the Romneys might have paid a few thousand extra dollars in tax. Among other things, they take no mortgage-interest deduction—a write-off claimed by 80% of taxpayers who itemize—or deductions for a home office, a car or travel expenses.

But given the complexity of their filings and the public scrutiny they were sure to endure, overpayments were far preferable to underpayments, experts say. The Romneys must file several separate returns for the "blind" trusts the couple set up to manage their investments, any of which could present snags. (The wealthy often do this when they are running for office, in order to avoid the appearance of conflicts of interest.)

Experts who have parsed the returns say the Romneys' advisers have been tax-smart without crossing legal lines. "The trustee has clearly gotten good advice and managed to reduce the Romneys' taxes in many perfectly legal ways," says Tom Ochsenschlager, a former official at the American Institute of CPAs who now teaches at American University.

Former IRS Commissioner Fred T. Goldberg, who examined the filings for the Romney campaign, characterized them differently: "This return reflects a trustee who spent a lot of care and time finding investment opportunities with the potential for substantial appreciation. By their very nature, these investments generate capital gains."

The returns don't disclose everything about the Romneys' finances. The couple isn't required to report their underlying wealth, investment returns or fees as a percentage of invested assets, for example.

But the filings do lift the veil on how the wealthy can use the tax code to their advantage. Here are some lessons the experts have gleaned.

A. Avoid salary, wages and tips to the extent possible. The Romneys reported no such compensation, which is taxable at rates up to 35%. In addition, these types of pay are subject to payroll taxes: a 6.2% Social Security tax (lowered to 4.2% in 2011) and 1.45% in Medicare tax, both of which the employer matches. While the Social Security tax is capped each year at a certain income level ($110,100 for 2012), the Medicare tax isn't.

Some experts believe "carried interest," or profits such as those from investments that Mr. Romney received as a partner at Bain Capital, should be taxed as compensation at rates up to 35%. Currently, those profits usually count as capital gains and are taxed at a top rate of 15%.

B. Muni-bond interest isn't the be-all and end-all. Many wealthy people turn to municipal bonds for tax-free income, but the Romneys reported only $557 of tax-free interest in 2010—and $3.3 million of taxable interest.

Kenneth Brier, an attorney at Brier & Geurden in Needham, Mass., notes that Massachusetts has a flat tax of 5.3%, making munis less attractive there than in high-tax states with graduated rates such as New York or California. And because the Romneys' overall tax rate is so low, the after-tax difference between munis and taxable bonds might not be large enough to justify investing in munis, Mr. Ochsenschlager says.

Some of the taxable interest on the Romney's 2010 return came from U.S. Treasurys; such interest isn't subject to state taxes.

C.Strive for "qualified" dividends. The Romneys' 2010 return reports $3.3 million of qualified dividends, which are taxed at a top rate of 15%. (There is another $1.6 million of nonqualified dividends, taxed like interest income.)

What makes a dividend "qualified"? In general, the dividend must be from a stock held at least two months and paid by any domestic corporation or most foreign corporations. The dividend can't come from a stock that a brokerage firm has lent as part of a short sale, says Robert Willens, an independent tax expert in New York.

D. If you have a "Schedule C" business, think twice before claiming a home-office deduction.The Romneys didn't take one on either of two Schedule C forms, which are for business results reported on personal returns. The Romneys used their Schedule C forms for director's fees and speaking fees.

Not only do home-office deductions raise red flags at the IRS, but they can come back to haunt taxpayers when the home is sold: Part of the gain on the home's sale may not be eligible for the $250,000 or $500,000 tax exclusion because taxpayers who took depreciation deductions in prior years have to reduce the exclusion by that amount.

In addition to raising taxes in many cases, this poses a record-keeping problem, Mr. Ochsenschlager says.

E. Generate income from long-term capital gains. The biggest factor in the Romneys' super-low tax rate is their outsize income from capital gains: $12.6 million in 2010. Most of that consisted of long-term gains, which, like qualified dividends, are taxed at a top rate of 15%.

The benefits don't end there. While the tax code gives wage earners almost no flexibility as to timing, the capital-gains rules offer unparalleled flexibility. Investors can often time when they take a gain or loss, and losses may be used to offset gains so that no tax is due. There are few restrictions: For example, a loss on land held as an investment can offset the gain from a stock.

Net capital losses can shelter up to $3,000 a year of ordinary income from tax, and losses can be carried forward indefinitely to shelter future gains. Canny investors or their advisers often "harvest" losses during market downturns, reacquire the investment after 30 days and use those losses to offset future gains, Mr. Willens says.

On Schedule D of their 2010 return, the Romneys' original long-term capital gain of $16.8 million was reduced by $4.8 million of carried-over long-term capital losses.

F. Know the score on itemized deductions. One way the Romneys resemble many other taxpayers is that they didn't get a medical-expenses deduction. Only expenses above 7.5% of adjusted gross income are deductible; for the Romneys, that hurdle amounted to $1.6 million, while they reported medical expenses of just $14,176.

The Romneys did make tax-wise charitable contributions. They gave away nearly $3 million, almost 14% of their adjusted gross income, about half in cash and half in other forms.

All of their contributions were fully deductible, whereas the biggest givers are subject to limits. Billionaire Warren Buffett, for example, gives away such vast sums each year that much of it can't be deducted from his income tax (though the gifts will be out of his estate).

Making noncash gifts—such as appreciated stock or other assets—often is a smart move for people like the Romneys because they can skip paying capital-gains tax on any appreciation, while getting a full deduction.

For example, say a higher-bracket taxpayer has 100 shares of stock bought years ago for $30 a share that is worth $80 when he donates it. If he sold the stock, paid tax and gave the remaining cash to charity, it would receive $7,250 and he would have a deduction of the same amount. If he gives the stock directly to the charity, it would receive $8,000, and he could deduct the full $8,000. (Some restrictions apply.)

G. Capital gains and dividends can help trigger the AMT. Long-term capital gains and qualified dividends are taxed at 15% and aren't subject to the alternative minimum tax.

The AMT takes away the value of deductions, such as the one for state taxes, when taxpayers are deemed to have too many write-offs. But a large percentage of capital gains and dividends in a taxpayer's overall income mix can cause a taxpayer to owe AMT.

The reason: With capital gains and dividends off limits, deductions loom large relative to other income, and that triggers AMT. The Romneys paid $232,989 in AMT in 2010 and lost the value of their state tax and other deductions, according to Jay Starkman, a CPA in Atlanta. "Without that, their tax rate would have been even lower," he says.

H. Beware of small benefits requiring large tax-prep efforts. The oddest line on the Romneys' 2010 return is a tax credit for $1 of "General Business Credit." Don Williamson of American University's Kogod Tax Center says the credit could be for hiring a disadvantaged youth or qualified veteran and it flowed through from an investment partnership.

But likely it cost far more than $1 just to fill out the three-page Form 8300 for the return. Mr. Williamson says he sees this problem all the time. Often tax-prep fees are disproportionate to an investment's tax benefit or the income it produces, he says—especially with larger investment partnerships.

One other lesson: For the wealthy, offshore investments can save onshore taxes. Robert Gordon, head of Twenty-First Securities in New York, a firm specializing in tax strategies, points out that the Romneys' 2010 return has 17 different filings of IRS Form 8621. Each indicates an investment, perhaps a hedge or private-equity fund, held in an offshore corporation.

These are legal arrangements, Mr. Gordon stresses. They can have significant tax advantages for the wealthy who live in high-tax states—especially Massachusetts, because its flat tax allows no deductions.

Investments held offshore in what is known as a "blocker corporation" can allow U.S. taxpayers to pay less tax than if the same investment were made through an onshore entity, Mr. Gordon says.

He offers an example. Say a partnership based in the U.S. invests $100, $80 of which is borrowed. It earns $5 of profits and has $4 in interest expense, for $1 of net pretax profit. In Massachusetts there isn't an interest deduction, so the entire $5 would be taxable.

If the investment were held in a fund based in the Cayman Islands, however, only $1 would be taxable in Massachusetts. Federal deductions subject to limits would also be preserved, Mr. Gordon says.

Write to Laura Saunders at laura.saunders@wsj.com.

Corrections & Amplifications
Part of the gain on a home sale might not be eligible for an income-tax exclusion of $250,000 or $500,000 if the taxpayer with a Schedule C business has taken depreciation deductions for a home office. An earlier version of this article said the percentage of the sales price attributable to the home office wouldn't be eligible for the exclusion

Preferred Stock (Wall St Journal)

THE INTELLIGENT INVESTOR
FEBRUARY 5, 2011.
Preferred Stock: Are Those Juicy Yields Worth the Extra Risk?
By JASON ZWEIG..

As the Federal Reserve's low-interest-rate policy has turned the world of income investing into a howling wilderness, one oasis seems to remain: preferred stocks. With yields averaging nearly 7%, preferred shares seem to offer higher income at lower risk than either conventional stocks or the bonds that feel overpriced to many investors.

And the preferred oasis is one hot destination. The iShares S&P U.S. Preferred Stock Index Fund was the fourth-most-popular exchange-traded fund in 2010, returning 14% and doubling in size to more than $6 billion. Last month, it took in another $200 million. Fidelity Investments, Charles Schwab and TD Ameritrade all report rising interest in preferred stock among their brokerage clients.

It isn't hard to fathom why preferred shares might sound appealing. Ranking between common stock and bonds in a company's capital structure, preferred shares have the first claim on dividends. And those dividend yields may be "qualified," or taxable at lower rates than bond income.

But preferred stocks aren't low-risk. Unlike the interest on bonds, the dividends on preferred (as with common) stock can be shut off at will.

During the financial crisis, U.S. regulators suspended dividends on preferred shares issued by such giants as Fannie Mae and Freddie Mac. Many other banks stopped paying their preferred dividends. The Standard & Poor's U.S. preferred-stock index fell roughly 26% in September 2008, three times worse than "junk" bonds. Even in a bull market, preferred stocks are about 10% riskier than junk bonds, reckons economist Eddie O'Neal of Securities Litigation & Consulting Group in Fairfax, Va.

Preferred stock also can be "called away" if the issuer wants to retire it. That caught Stan Aten, a printing-company employee in Dallas, by surprise last year when some of his preferred shares of real-estate operator Public Storage, for which he had paid $25.74, were redeemed by the company at $24.50. Mr. Aten, who had bought a few months earlier, lost about $135. He still buys preferreds, but more carefully. "I should have read the prospectus and realized they had the right to do that," he says.

Also, "preferred stock" and "financial stock" are virtually synonymous. Fully 84% of the assets of the iShares preferred ETF are in financial firms, including Barclays, Bank of America and MetLife. Banks get special regulatory treatment on their preferred shares that other companies don't; outside of utilities, only 6% of nonfinancial firms have preferred stock, according to Standard & Poor's index analyst Howard Silverblatt.

"If you work in the financial sector you should definitely not buy a preferred fund," says Mariana Bush, a fund analyst at Wells Fargo Securities. With your career riding on the health of that financial industry, you shouldn't put even more money in the same place.

Finally, the income on preferred shares can be taxed either at the 15% rate that applies to dividends—or at your ordinary income rate, which can range up to 35%.

Generally, for the income to be taxable at the lower rate, a fund must own the preferred shares for at least 61 out of the 121 days on either side of the dividend date. That could get tricky for a fund whose asset base changes quickly, says independent tax expert Robert Willens. If a growing fund had to buy a lot of preferred shares quickly, or a shrinking fund had to sell them in haste, it wouldn't be able to keep them all for the minimum holding period. That, in turn, could subject investors to the higher tax rate on those dividends.

"Even if you are able to hold for the requisite period, you could be out of luck," Mr. Willens says. "That's because so much is dependent on the actions of other people over whom you have no control"—those who happen to be buying or selling the fund.

The iShares preferred fund has grown steadily and gradually over the past year, rather than in sudden bursts. Portfolio manager Greg Savage agrees that rapid inflows or outflows "can potentially affect the mix" of how the fund's income would be taxed. He adds that "flow impact has been negligible" so far. About 40% of the fund's dividend stream qualified for the lower tax rate in 2010, the same as the year before and the same as the underlying index.

These rules also apply to individuals buying preferred stock directly; sell too soon and you could double your tax rate on your latest dividends.

Preferred investors are pursuing long-term yield, says Rob Williams, director of income planning at the Schwab Center for Financial Research. "Unfortunately, a lot of investors also have short memories."

— twitter.com/jasonzweigwsj
Write to Jason Zweig at intelligentinvestor@wsj.com