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April 16, 2005

Time to Rebalance Your Portfolio

With an asset allocation strategy, you can’t just allocate assets in your portfolio once and then forget about your portfolio. Over time, your actual asset allocation will stray from your desired allocation because different investments in your portfolio will experience different rates of return. At least annually, review your portfolio to see if changes are needed to bring your allocation back in line. Some factors to consider include:

  • Reevaluate your desired asset allocation percentages, deciding whether they’re still appropriate for your situation. Over time, how much you want to allocate to different asset classes will probably change as your personal circumstances change. For instance, you may want a high percentage of your portfolio in stocks when you are younger, but may want to increase your fixed-income investments as you approach retirement age.

  • Decide how much variation you are willing to tolerate in your asset allocation. Varying market values and rates of return make it difficult to maintain precise asset allocation percentages. For example, you may start to monitor your portfolio more closely if an asset class varies by 5% of your desired allocation, and rebalance when it varies by 10%.

  • Consider the allocation of your total portfolio, including both tax-deferred and taxable portions. Where possible, rebalance your tax-deferred portfolio, since this typically does not generate a tax liability.

  • Review the tax ramifications before selling investments to rebalance your portfolio. Since selling assets from your taxable accounts can result in taxable transactions, look for other ways to rebalance. You can make new investments in assets that are underweighted in your portfolio. Periodic interest, dividends, or capital gains can be redirected to other asset classes rather than reinvested in the same asset. Consider making withdrawals from overweighted asset classes.

  • Monitor your level of diversification both within and among asset classes. Evaluate your allocation within asset classes to make sure one or two investments are not dominating that portion of your portfolio.

  • Realize it can be difficult psychologically to sell an investment that is performing well. However, you selected your desired asset allocation percentages to help reduce the risk in your portfolio. Your portfolio may become more risky if an asset class starts to dominate your portfolio.

Financial Steps for New Graduates

Graduating from college is often viewed as the start of your adult life. The financial decisions you make as you start this new stage of life can significantly impact your finances for your entire life. Habits formed early are often difficult to change. To make sure you develop good financial habits, consider these tips:

  • Take a look at where you stand financially. First, prepare a net worth statement to get a feel for your assets and liabilities. Then, prepare a budget based on your income and expected expenses. Find a way to save at least a little from every paycheck. If you really want to achieve your financial goals, one of the smartest strategies you can adopt is to live below your means so you can save consistently.

  • Get a money management system in place. That way, you'll be able to easily track your expenditures, so your spending won't get too far out of line. For a top-of-the-line listing of budgeting software, visit our Software Center. The system will also help you organize information about your assets and investments.

  • Use debt cautiously. Only use credit cards if you can pay the balance in full every month. If you have student loans or other debts, come up with a plan for paying them off as soon as possible. Consider getting a Student Loan Consolidation loan where you can bundle all of your student loans into a single loan with one lender and one repayment plan.

    Take on other debt, like car loans and mortgages, only after a careful analysis of whether you can afford the payments and whether the purchase really fits in with your financial goals.

  • Sign up for your 401(k) plan at work. Even though you just graduated and retirement is probably decades away, start contributing to your 401(k) plan as soon as you're eligible.

  • Obtain health insurance. Once you graduate, you typically aren't covered on your parents' health insurance policy. If you don't receive health insurance at work, look into obtaining it on your own. Visit our Insurance Center to receive a free quote from a large selection of health insurance plans. Here you can compare plans and benefits to find the best match for you.

  • Decide where you will live. One of your most significant expenses will probably be housing. Review your options carefully before deciding between renting and owning. Also, don't stretch to live in the most expensive home or apartment you can afford. It's typically better financially to live in less expensive housing so you have more money to devote to savings.

  • Set financial goals. After you get the basics in line, take time to consider your long-term financial goals. Your biggest advantage at this age is that you have time on your side. If you start saving now, even small sums can grow to significant amounts by the time you retire.

Coping With the Financial Aid Process

Almost $122 billion of financial aid was distributed during the 2003-04 school year, with an average award of $10,472 per full-time student. Of that total, approximately 56% was loans and 38% was grants (Source: Trends in Student Aid, 2004). With so much money at stake, you should understand the financial aid process.

The first step is filling out the appropriate forms so colleges can determine your financial need. After January 1 of the year your child enters college, you must complete the “Free Application for Federal Student Aid” form as well as any forms required by colleges your child applied to. These forms are used to determine your expected family contribution (EFC), which is the amount you’re expected to pay annually toward college costs. If college costs exceed your EFC, financial aid officers try to fund that difference, using grants, scholarships, work study programs, and student loans.

Be prepared! Most families are surprised by how much they’re expected to contribute toward college. The calculation is based on a formula, not your actual expenses. After some adjustments, your EFC equals 5.6% of your eligible assets and up to 47% of income plus 35% of your child’s assets and up to 50% of his/her income. Your EFC is the same no matter how many children are attending college, so you can expect more aid if you have more than one child in college.

Consider these tips to help maximize your financial aid award:

  • Understand how the financial aid system classifies income and assets. Your net worth, as defined by the financial aid system, includes bank accounts, stocks, bonds, and mutual funds, but not retirement funds, insurance, or annuities. However, individual colleges may have different criteria for certain assets. Loans against assets, such as mortgages, home-equity lines of credit, and margin loans, are deducted from your net worth, but consumer loans are not. Capital gains are included in income.

  • Consider using your child’s assets to pay school expenses before college. You might want to purchase a computer or car for commuting to college with your child’s money.

  • Apply to several colleges, evaluating each financial aid package. Your awards can vary significantly among colleges. Don’t just look at the total amount of the award — evaluate the composition of that aid. Grants, which are not repaid, are more desirable than loans. Even the types of loans offered can make a big difference.

  • Don’t automatically rule out more expensive colleges. Your EFC will remain the same, no matter where you child goes to college. Many private and Ivy League colleges have more merit aid and discretion when making offers.

  • Make sure to adhere to application deadlines. Typically, colleges first evaluate applications submitted on time. Anyone filing late is evaluated later, after a significant portion of aid has been awarded.

  • Talk to the financial aid officer if you aren’t satisfied with the financial aid package. Financial aid officers are often willing to reevaluate a financial aid package. If there have been significant changes in your financial situation since the forms were filled out, call and explain.

Withdrawing College Funds

Once your child starts college, you’ll want to use funds set aside for college to maximize tax advantages as well as your financial aid awards. Which investments should you withdraw first — money from personal savings, Section 529 plan assets, or funds from Coverdell education savings accounts (ESAs)? How will those withdrawals affect education deductions and credits for tax purposes? And then, what impact will all of this have on your financial aid award?

From a financial aid standpoint, you typically want to use your child’s assets first. In financial aid calculations, 35% of your child’s assets are expected to be used for college purposes, while only a maximum of 5.6% of your assets are considered. Thus, if your child has money set aside for college in a custodial or personal savings account, spend that money first, and possibly even before your child enters college. For instance, you could use those funds for a computer or a car.

ESA assets can be either your assets or your child’s assets, depending on how the account was set up. If they are your child’s assets, realize that they can be used to pay many education expenses while your child is in high school. You may even want to roll that child’s ESA over to a younger sibling, so the funds won’t be considered that child’s asset.

Payments for prepaid tuition plans reduce financial aid on a dollar-for-dollar basis. If permitted by the plan, you may want to transfer the funds to a Section 529 savings plan, since tax-free distributions are not considered at all in financial aid calculations.

You also need to consider the impact of withdrawals on tax deductions and credits. The deductions and credits available include:

  • In 2005, a maximum above-the-line deduction of $4,000 of qualified higher-education expenses is available for single taxpayers with adjusted gross income (AGI) not exceeding $65,000 and for married taxpayers filing jointly with AGI not exceeding $130,000. Single taxpayers with AGI between $65,000 and $80,000 and married taxpayers with AGI between $130,000 and $160,000 are entitled to a maximum deduction of $2,000.

  • The Hope scholarship credit is a nonrefundable tax credit equal to 100% of the first $1,000 of tuition and fees and 50% of the next $1,000 of tuition and fees (for a maximum credit of $1,500) paid for a taxpayer, spouse, or dependent for the first two years of post-secondary education. The credit can be claimed for more than one student in a given year. The credit is phased out for single taxpayers with modified AGI between $43,000 and $53,000 and for married taxpayers filing jointly with modified AGI between $87,000 and $107,000.

  • The lifetime learning credit is a nonrefundable tax credit equal to 20% of up to $10,000 of tuition and fees (for a maximum credit of $2,000) for post-secondary education, including courses to acquire or improve job skills. The credit can be claimed for an unlimited number of years. The credit is phased out based on the same modified AGI limits as the Hope scholarship credit.

The deduction cannot be claimed in the same year for the same student as the Hope scholarship or lifetime learning credit. Also, these credits and deductions cannot be claimed for amounts paid with tax-free distributions from Section 529 plans and ESAs.

Tips for Your College Education Fund

No one disputes the fact that the cost of a college education is high. For the 2004-05 school year, the average annual cost of a four-year public university is $14,640 and for a four-year private university is $30,295 (Source: Trends in College Pricing, 2004). While those prices are sure to increase in the future, that doesn’t mean you should just give up and ignore the entire subject. There are a number of strategies to help you fund that college education:

  • Start investing as much as you can now. The sooner you start saving, the more time you’ll have to let those savings grow. Figure out how much you need to save annually to meet your goal. Don’t panic if you can’t afford to save the entire amount. There are other sources to help fund a college education, such as borrowing and financial aid. Your goal may be to save 30%, 50%, or some other percentage of the total cost.

  • Adjust your investment mix over time. For years college costs have been increasing by more than the overall inflation rate. Just for the 2004-05 school year, tuition at four-year public colleges increased by 10.5% compared to overall inflation of 2.2% (Source: Trends in College Pricing, 2004). Thus, you should select investments likely to stay ahead of increases in college costs. However, as your child nears college age, take steps to protect your principal by shifting to more conservative investments.

  • Become familiar with the financial aid system. If you think you’ll qualify for financial aid, learn about the system now, no matter what your child’s age. Calculate your expected family contribution to get an idea of how much aid you might receive and research what types of aid are available. Many families are surprised to find out a significant portion of most aid packages comes in the form of loans.

  • Decide whether to save in your name or your child’s name. If you expect to qualify for financial aid, you may want to save in your name, since only 5.6% of your assets are considered available for college costs, while 35% of your child’s assets are considered. If you don’t expect to qualify for aid, you can make annual gifts, up to $11,000 in 2005 ($22,000 if the gift is split with your spouse), to your child without paying federal gift taxes. Those assets are then removed from your taxable estate and any income becomes taxable to your child.

  • Look into section 529 plans, which include prepaid tuition programs and college savings plans. Prepaid tuition programs guarantee funds to cover tuition at your state’s public colleges and universities, although some private colleges also offer these plans. College savings plans invest your money in stocks, bonds, or mutual funds. You can use distributions to pay higher-education expenses at any college or university. Qualified distributions taken before 2011 are tax free.

  • Examine Coverdell education savings accounts (ESAs). You can make annual contributions of $2,000 per beneficiary under age 18. While contributions aren’t tax deductible, earnings grow tax free as long as proceeds are used for qualified education expenses. In addition to college expenses, proceeds can be used for elementary and secondary school tuition and expenses and computer technology and equipment. Eligibility to make contributions is phased out at adjusted gross income (AGI) levels of $95,000 to $110,000 for single taxpayers and $190,000 to $220,000 for married taxpayers filing jointly. If your income exceeds those limits, however, your child or other relatives can make the contribution.

  • Consider using a Roth Individual Retirement Account (IRA) to help fund college costs. However, only consider this strategy if you have other means to save for retirement. Your contributions to a Roth IRA can be withdrawn at any time without paying federal income taxes or the 10% early withdrawal penalty. If you’re under age 59 1/2 when distributions for qualified education expenses are taken, you’ll have to pay ordinary income taxes on earnings, but not the 10% federal income tax penalty. If you’re over age 59 1/2 and opened the Roth IRA at least five years before the distribution, you may not have to pay federal income taxes on the earnings.

  • Realize that education credits and deductions may reduce the cost of college.
  • Investigate borrowing options. Borrowing can put a significant strain on your finances, usually at a time when you should be concentrating on saving for retirement. However, if you need to borrow, there are a variety of loan options available, with the federal government offering several attractive alternatives to students and their parents.

  • Encourage your child to participate in the process. Maintaining good grades and participating in extracurricular activities may make your child a more desirable candidate for college. He/she may then be eligible for a wider range of grants and scholarships. You may also expect your child to work part time to fund part of his/her college education.

 

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