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April 1, 2003

Updating Your Important Documents

Whether or not this is your first marriage, you'll want to review major documents to see if changes are needed. Even if you've been married for some time, it's not a bad idea to take a look at these documents:
  • Estate planning documents -- If this is your first marriage, you may not even have estate planning documents. In that case, at least get a simple will and durable power of attorney. For those entering a subsequent marriage or with children, thoroughly review your estate planning documents. You may need to make changes to provide for your spouse while also protecting your children. Due to changes enacted by the 2001 Tax Act providing for the gradual elimination and then reinstatement of the estate tax, you should review your estate planning documents every couple of years.

  • Asset ownership -- Review how assets are titled to ensure they are consistent with your estate planning goals. If assets are owned jointly with rights of survivorship, that will take precedence over any provisions in your estate planning documents.

  • Assets with beneficiaries -- This would include life insurance policies, retirement plans, and Individual Retirement Accounts (IRAs). For assets with named beneficiaries, those designations will take precedence over your estate planning documents. For retirement plans and IRAs, new regulations issued by the Internal Revenue Service in April 2002 significantly changed how beneficiaries must take distributions from inherited plans.

  • Business arrangements -- If you are a partial owner of a business, review any agreements dealing with what happens to the business if you die or want to sell your interest. The agreement may need to be changed to make provisions for your spouse.

The Pros and Cons of Prepaying Your Mortgage

When you use funds to prepay your mortgage, you are basically investing at your mortgage interest rate. The question is whether it is a better financial decision to pay off your mortgage or to invest in other alternatives. Consider these factors before deciding:
  • Liquidity. By prepaying a mortgage, you are moving funds from a more liquid to a less liquid asset. The only way to access money paid on a mortgage is to sell your home or obtain a home-equity loan, usually at rates higher than the original mortgage. Thus, only use funds to prepay your mortgage that you aren't likely to need in the future.

  • Risk vs. return. Before prepaying your mortgage, you should consider whether other investment alternatives have higher potential returns. But in this volatile market, that can be a tough assessment. Your mortgage prepayments are effectively earning a return equal to your mortgage rate and that rate is guaranteed with no risk.

  • Other debts. You should typically pay off all your consumer debts before prepaying your mortgage. Consumer debt carries higher interest rates than mortgage debt and the interest is generally not tax deductible (unless it is a home-equity loan).

  • Financial considerations. The basic components of your financial plan should be in place before using funds for mortgage prepayments. For instance, you should have an emergency reserve fund and adequate disability income and life insurance before prepaying your mortgage. You may also want to contribute the maximum to your 401(k) plan, especially if your employer matches funds.

  • Emotional factors. As you approach retirement age, the idea of entering retirement debt free may make prepaying your mortgage a more attractive alternative. Or in this volatile market environment, you may like the certainty of positive returns from prepaying your mortgage.

If you want to prepay your mortgage, decide how you want to do so. Most mortgages allow you to add as little or as much as you like to your regular payment, making it an easy way to use excess funds. (Check with your specific lender to determine if prepayment penalties apply.)

The Increasing Importance of Merit Financial Aid

The basic premise of financial aid is that it is need based. Families fill out the government's aid form, the Free Application for Federal Student Aid, so mathematical formulas can determine a family's eligibility for federal financial aid. Colleges can use a different, though similar, methodology to make financial aid awards.

However, the same student can obtain very different financial aid packages from colleges with similar costs. If the financial aid process is truly need based, how could that happen? Part of it results from how individual colleges define your assets for financial aid purposes. For instance, some include home equity, while others do not. Another part of the difference results from colleges competing to attract top students. High-caliber students increase the college's prestige, making it a more attractive alternative to subsequent years' students. To encourage these students to attend their college, merit scholarships are often given or the mix of traditional need-based financial aid is altered. Financial aid consists of grants (which do not have to be repaid), loans, or work-study programs. Two financial aid packages may have the same dollar value, but the one with a higher percentage of grants will be more valuable to the student.

As evidence that colleges favor better students, one recent study looked at students' SAT scores and grant awards. Among low-income students who attended public colleges, those with high SAT scores received an average of $1,255 in grants compared to $904 for those with middle SAT scores and $565 for those with low SAT scores. At private colleges, students with high SAT scores received an average of twice as much grant money as students with low SAT scores. Those results only reflect need-based aid, not any merit financial aid that might have been awarded to those students (Source: Change, March 2002).

What implications does this have for a child approaching college? Consider these points:

  • Encourage your child to do well on college entrance exams. Not only will this make him/her eligible for acceptance at a broader range of colleges, it may increase your financial aid package.

  • Don't approach the process determined to enter one particular college. Start with a few colleges that would be acceptable alternatives and apply for financial aid at all of them. You may be surprised at how different the financial aid awards are, especially if your child is a strong student.

  • What should you do if your child has his/her heart set on going to one college, but you receive a better financial aid package from another college? Talk to the financial aid officer. While some colleges are receptive to matching other colleges' offers, others are not. In those cases, your best strategy is to review the financial aid calculations with the officer, looking for ways to increase the award. Many subjective factors go into calculating financial aid awards and you may be able to convince the officer to change some of those so the total award is increased. Perhaps just changing the composition of the award so more is given in grants will help.

Get To Know Section 529 College Savings Plans

Section 529 Savings plans include both prepaid tuition programs and college savings plans. While prepaid tuition programs have been around longer, it is the college savings plan that is garnering most of the attention these days. Recent changes to college savings plans enacted by the Economic Growth and Tax Relief Reconciliation Act of 2001 (Tax Act) made these plans more attractive from a tax-planning standpoint.

Basically, a 529 college savings plan allows you to place money in a state plan to be used for the beneficiary's higher-education expenses at any college or university, which include tuition, fees, books, supplies, and certain room and board costs. Your money is invested in stocks, bonds, or mutual fund options offered by the plan, with no guarantee as to how much will be available when the beneficiary enters college. Some of the more significant benefits of these plans include:

  • Distributions from state-sponsored plans to pay qualified higher-education expenses are excluded from income if made after 2001 and before 2011. Distributions from private college and university plans are excluded from income if made after 2003 and before 2011. (Based on sunset provisions of the Tax Act, prior tax law will become effective in 2011 unless there is further congressional action. That law required income on distributions to be taxed to the beneficiary, although earnings grew on a tax-deferred basis until withdrawn.)

  • While prepaid tuition programs require you to use funds to pay tuition at your state's public colleges, college savings plans allow you to use distributions at any college in the country for a broader range of expenses.

  • You are the account's owner and can change the beneficiary or even take the money back, if permitted by the plan. Thus, you can change the beneficiary if your original beneficiary decides not to go to college. If you take the money back, you owe ordinary income taxes on earnings and the 10% federal income tax penalty. The money can be withdrawn without penalty if the beneficiary dies or becomes disabled.

  • You can contribute up to $55,000 to a qualified plan ($110,000 if the gift is split with your spouse) in one year and count it as your annual $11,000 tax-free gift for five years. However, if you die within the five-year period, a pro-rata share of the $55,000 returns to your estate. Grandparents can set up accounts for grandchildren, transferring large sums from their estates while providing for their grandchildren's education.

  • There are no income limitations for contributions. Thus, these plans may be of particular interest to higher-income individuals who may not qualify for other college savings strategies.

  • The assets in the plan are considered the account owner's assets, not the beneficiary's assets. For financial aid purposes, 5.6% of the parents' assets and 35% of the child's assets are expected to be used for college costs. If the grandparents are the owners, the assets may not even be considered for financial aid purposes. Even though distributions are income tax free, their status for financial aid purposes is not clear. It may come down to a college-by-college decision whether the income will be considered the child's income.

  • You can now make tax-free transfers of funds from one plan to another or from one investment option to another for the same beneficiary once every 12 months. In the past, the beneficiary had to be changed to make a tax-free transfer.

Most states now offer college savings plans, with the plans administered by the state or financial institutions. Some state programs only accept residents, but most plans accept participants from any state. Before contributing to a plan, consider these tips:

  • Check out your own state's plan first. Many states offer state income tax benefits to residents who contribute to its plan.

  • Review investment options carefully. You can't actively control the investments in your account, so you'll have to select from the plan's options. Some plans offer a couple of options, while others offer a more diverse selection. Recently, several plans added a principal-protected or guaranteed-return option to counter concerns about stock market volatility.

  • Examine fees. The management fees charged by plans vary widely and can significantly impact your funds' performance. Some plans also charge an enrollment fee, an annual maintenance fee, and other annual expenses.

College savings plans offered by each state differ significantly in features and benefits. The optimal plan for each investor depends on his/her individual objectives and circumstances. In comparing plans, each investor should consider each plan's investment options, fees, and state tax implications.

Just How Expensive Is College?

For the 2002-03 school year, the average annual cost of a four-year public college is $12,841, while a four-year private college costs $27,677 (Source: Trends in College Pricing, 2002). Trying to fund four years of those types of costs can be an overwhelming prospect. If you have a young child, you probably don't even want to think about how high those costs could be when your child enters college. But before you decide you'll never be able to afford a college education for your child, take a closer look at these cost figures.

While college costs are definitely increasing by more than the inflation rate, they aren't increasing as much as they were 10 years ago. From 1982 to 1992, the median family income increased 16% after inflation, while tuition increased 62% at private four-year colleges and 58% at public four-year universities. From 1992 to 2002, median family income increased 8% after inflation, while tuition increased 37% at private four-year colleges and 38% at public four-year colleges (Source: Trends in College Pricing, 2002). However, tuition has increased at relatively high rates over the past two years. For instance, four-year public college tuition increased by 8.4% after inflation in 2002-03, which was attributed to lower state appropriations resulting from a slowing economy. Although no one knows how much college costs will increase in the future, it's probably a safe bet it will be by more than the inflation rate.

However, consider whether you even need to worry about the average cost of college. Approximately 38% of full-time college students attending four-year universities pay less than $4,000 annually in tuition and fees, while 70% pay less than $8,000. Only 7% of students attending four-year colleges pay over $24,000 per year in tuition (Source: Trends in College Pricing, 2002). If your child commutes from home, you can subtract anywhere from $5,327 to $6,779 in room and board charges from the average college costs.

These costs also don't consider any financial aid you may receive. While college costs increased 38% over the past 10 years, financial aid increased 117% after inflation. The average financial aid award per full-time equivalent student was $7,827 for the 2001-02 school year. However, only $3,085 was in outright grants that don't have to be repaid, while $4,200 was in loan aid, $437 in federal tax credits, and $105 in work aid (Source: Trends in Student Aid, 2002).

While those figures might make college seem more affordable, realize that much of financial aid is based on need. That need is determined by financial aid officers, using formulas that often result in much higher estimates of what you can afford than what you think you can afford.

What you should take away from all these figures is the realization that college costs are a significant expense that require planning and saving on your part. Even if your child is young, start thinking about college. Consider what colleges your child might attend and then find out what they currently cost and how much tuition has been increasing. Find out how financial aid is calculated and determine how much aid you can expect. Approximately 54% of financial aid is in the form of loans, so relying solely on financial aid may mean that either you or your child will incur a substantial amount of loans.

Armed with this information, you can then map out a plan to save for your child's education. There are now many tax-advantaged ways to save for college, including Section 529 plans (both prepaid tuition plans and college savings plans) and Coverdell education savings accounts.


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