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September 12, 2005

Budgeting and Your College Student

Many students will first handle money without parental supervision during college. To help keep costs down and avoid conflicts, you may want to develop a budget to guide your child’s spending. As you go through the process, consider the following:

  • First, consider all potential expenses such as: travel, entertainment, food, clothing, phone calls, periodicals, computer expenses, medical and dental expenses, and insurance.

  • Develop a preliminary budget for the first couple of months of college. You may find that you forgot or didn’t think about certain items. After your child has lived on his/her own for a couple of months, you can develop a more realistic budget.

  • If your child has trouble staying within the budget or can’t account for large sums, have him/her keep a journal for a couple of weeks that details all expenditures. Go over the journal together to determine how expenses can be reduced.

  • Explain the basics of credit cards. Make sure your child doesn’t use a credit card as a means to overspend. Go over which types of items your child can use the credit card for and which items should not be charged. Make sure your child understands that if the balance isn’t paid in full each month, a significant amount of interest will be paid on the outstanding balance. If you teach your child nothing else, try to instill the concept of paying credit card balances in full every month. For a working knowledge of the different types of credit cards available, go to How to Select a Credit Card.

  • Consider providing your child with a debit card or Pre-Paid credit card instead of a regular or charge credit card. Since your child’s spending will be limited to the amount on deposit, it is harder to overspend. Or consider a Student Credit Card which is designed for students in college and are great for those who are just starting to build credit. Go to ManagingMoney.com – Credit Card Center to search for a credit card appropriate for your child’s needs.

  • Have your child provide you with a written monthly comparison of his/her actual expenses to budgeted amounts. Or you may want to consider an Online Budgeting System where you both can have online 24/7 access.

Investing in Foreign Stocks at Home

Looking for a way to invest in specific foreign companies without learning all the intricacies of other countries’ stock markets? You may want to consider American Depositary Receipts (ADRs).

ADRs are the form in which foreign stocks trade on U.S. stock exchanges. An ADR is a negotiable certificate issued by a U.S. bank (the depositary), representing shares of a foreign stock. The original foreign stock certificates are owned by the bank and held in the issuer’s country. Each ADR can represent a multiple or fraction of the original foreign stock, which is a ratio set by the depositary so the ADR’s price falls within a range considered typical for U.S. stocks.

For an investor, ADRs can offer advantages over purchasing individual stocks on foreign stock exchanges. Some of the advantages are:

  • ADRs are traded on U.S. stock exchanges. Thus, you don’t need to become familiar with foreign stock markets or deal with the delays that can occur in foreign markets.

  • All stock transactions are executed in U.S. dollars, including purchases, sales, and dividend receipts. Prices are quoted in U.S. dollars and include both changes in the local stock price and currency fluctuations.

  • Financial reporting tends to be more complete. If the ADR is sponsored, reports will be prepared in English. However, the financial reports are prepared using the accounting rules in effect in the company’s home country, which can differ substantially from U.S. accounting principles.

Keep in mind, that you are still investing in a foreign equity. In addition to the risks associated with domestic investing, international investing has unique risks such as: currency fluctuations, political and social changes, and greater share price volatility.

Before investing in ADRs, consider the following:

  • Research the ADR carefully before investing. You are investing in a company in a foreign country, so you should become familiar with the economics of that country.

  • Only consider ADRs if you are investing for the long term. If you are trying to take advantage of short-term exchange rate movements, there are other investment vehicles more suited for that purpose.

Selling Your Home

When selling your principal residence, the basic tax rule is that you can exclude gains of up to $250,000 if you are a single taxpayer and $500,000 if you are a married taxpayer filing jointly, provided the home was your primary residence in at least two of the preceding five years. This exclusion can be used once every two years. While this rule seems fairly straightforward, there are a number of special situations to keep in mind:

  • Your gain also includes deferred gains from the sale of previous homes. Under previous tax law, you could sell your home and defer any gains by purchasing a home of equal or higher value within a certain time period. Gains could continue to be deferred as you bought and sold homes. Under current tax law, when you sell your current home, you must recognize those deferred gains as well as the gain on your current home. If your total gain exceeds $500,000 for joint filers or $250,000 for single filers, you would owe capital gains tax on the excess.

  • You did not live in the home for at least two of the preceding five years. If you are forced to move due to employment changes, health reasons, or unforeseen circumstances, you can prorate the exclusion amount. For example, if a married couple owns and uses their principal residence for one year and then sells it because of a job change, they can exclude $250,000 of gain (one-half of the exclusion amount of $500,000). To qualify for prorating the exclusion, the Internal Revenue Service has indicated that unforeseen circumstances can include divorce, death, multiple births from the same pregnancy, becoming eligible for unemployment compensation, a change in employment status making you unable to pay household costs, damage to your home from a natural or manmade disaster or from an act of war or terrorism, and the condemnation or seizure of the property. There is a safe harbor rule that assumes a change in employment is the primary reason for your move if your new job is more than 50 miles farther from the home you sold than your prior job. The change in employment can apply to anyone who lives in the household.

  • Your spouse dies and you sell the home after the year of his/her death. Starting the year after your spouse’s death, you must start filing as a single taxpayer. If you sell your home after that, you are limited to a $250,000 exclusion. However, if the home was jointly owned and you inherit your spouse’s share, the basis of your spouse’s share will be stepped up to market value at the date of his/her death.

  • You married recently. Even if you file a joint return, each party receives a $250,000 exclusion when both individuals own a home. If one spouse has a large gain on his/her house, however, the couple may want to live in the home for at least two years. Then, if the sale occurs more than two years after the sale of the first house, the couple will be eligible for the full $500,000 exclusion.

  • You divorce. If you sell your principal residence prior to becoming divorced, you will be eligible for the $500,000 exclusion. However, if only one spouse owns the home after the divorce, the exclusion will be reduced to a $250,000 limit. In the situation where both parties retain ownership but one party moves out, make the arrangement a condition of the divorce decree. Then, when the home is sold, the $500,000 exclusion will apply, even though one of the parties did not live in the home in two of the preceding five years.

  • Part of your home is used for business. You no longer have to allocate the gain between home and business use (including a home office or rental of a portion of your home) when selling your home, as long as the portion used for business is part of your main dwelling unit. Thus, all of your gain is eligible for exclusion. Previously, you had to allocate the gain between the home and business use portions, paying taxes on the gain attributable to the business use. If the business use portion is separate from your main dwelling unit, such as a converted detached garage, you must still allocate between business and home usage. In all cases, you still have to pay tax on the portion of the gain related to post-May 6, 1997 depreciation deductions. That gain is taxed as unrecaptured Section 1250 gain, subject to a maximum tax rate of 25%.

Estate Planning for Combined Families

The most common estate plan is to leave everything to your spouse, who then leaves everything to your children after his/her death. However, if this is other than a first marriage, you and your spouse may also have children from prior marriages. Then, you need to make fundamental decisions about how to treat assets each spouse brings to the marriage, how to distribute assets acquired after marriage, and how to provide for children from prior marriages. Some items to consider include:

  • Prepare formal estate planning documents to carry out your wishes. Without a will or other estate planning documents, the state will determine how your estate is distributed. That means your spouse will receive a statutory percentage of your assets. Even with a will, your spouse can typically override its terms and elect to receive the statutory percentage. To prevent this, you usually need a prenuptial or nuptial agreement, detailing how assets will be divided after death.

  • Consider a Qualified Terminable Interest Property (QTIP) trust to protect your children’s inheritance. When assets are left outright to your spouse, he/she controls their ultimate disposition. With a QTIP trust, your property is placed in a trust after your death to be used by your spouse during his/her lifetime, with the principal distributed after your spouse’s death to beneficiaries you designate. Since this qualifies for the unlimited marital deduction, no estate taxes will be paid when you die. This may not be a valid strategy if your spouse and children are approximately the same age, since your spouse could outlive your children.

  • Title property carefully. Property owned jointly will automatically pass to the survivor. You cannot change this distribution through estate planning documents.

  • Review beneficiary designations and life insurance amounts. It’s not unusual to forget to update beneficiary designations for retirement accounts, individual retirement accounts, and life insurance policies. These assets will be distributed to the named beneficiaries, regardless of the terms of your estate planning documents. Also review your life insurance amounts. You may find you need more to help ensure all heirs are treated equitably.

  • Discuss your plans with your spouse and children. Openly discussing your plans before death may prevent disagreements among heirs after your death. This can be especially important in situations involving stepparents and stepchildren.

If you are interested in do-it-yourself legal solutions, you may want to visit ManagingMoney.com – Legal Center. Here you will find personal legal solutions such as Wills, Trusts, Divorce Forms, Powers of Attorney, Premarital Agreements, Name Change, and much more.

10 Tax Strategies to Consider

If you’re looking for ways to reduce your income tax bill, you may want to consider the following tax-saving strategies:

  • Contribute the maximum amount to your 401(k) plan. Your contributions, up to a maximum of $14,000 in 2005 (individuals over age 50 may also be able to make an additional $4,000 catch-up contribution), are deducted from your gross pay, so you won’t pay current income taxes on the contributions (although you still pay Social Security and Medicare taxes). In addition, earnings and capital gains on your investments grow tax deferred until withdrawn. When you make withdrawals, you’ll have to pay taxes on the contributions and earnings (and a 10% early withdrawal penalty if withdrawals are made before age 59 ½), but this tax-deferred growth typically means you’ll have a larger retirement fund than if you had been paying taxes currently during the years.

  • Decide which type of Individual Retirement Account (IRA) to contribute to. Find out whether you’re eligible to contribute to a traditional deductible or a Roth IRA and then decide which is the better alternative for you. Make your contribution early in the year to allow your funds to compound tax deferred or tax free for a longer time.
  • Consider investing in municipal bonds if bonds comprise a portion of your investment portfolio. Interest income from municipal bonds is generally exempt from federal, and sometimes state and local, income taxes. In general, the higher your marginal tax rate, the more advantageous you’ll find investing in municipal bonds. Before investing, compare the yield on the municipal bond to the after-tax yield of other types of bonds.

  • Investigate investments that generate capital gains, such as growth stocks. Capital gains on investments held over one year are subject to the 15% capital gains tax rate (5% if you are in the 10% or 15% tax bracket), compared to the highest ordinary income tax rate of 35%. Also, you do not pay any tax until the investment is sold, allowing you to decide when to recognize the gain. You may also want to consider stocks that generate dividend income, since that income is now subject to the capital gains tax rate.

  • Replace loans that generate personal interest with mortgage loans or home-equity loans. Personal interest cannot be deducted on your tax return, while mortgage and home-equity loan interest typically can, as long as your mortgage does not exceed $1,000,000 and the home-equity loan does not exceed $100,000.

  • Make annual gifts (up to $11,000 in 2005 or $22,000 if the gift is split with your spouse) to your children tax free. Doing so shifts the income from the assets to your children, who may be in a lower tax bracket. If your child is under age 14, be aware that the “kiddie tax” rules apply. In 2005, the first $800 of investment income is tax free, the second $800 is taxed at the child’s tax rate, and any remaining income is taxed at the parents’ marginal tax rate. Thus, you may want to utilize tax-free or tax-deferred investments for at least a portion of the child’s investments until he/she turns 14. All investment income of children age 14 or older is taxed at the child’s marginal tax rate.

  • Take advantage of education tax breaks. If eligible, make sure to document and claim the above-the-line deduction or Hope or Lifetime Learning credit. Be aware that you may be able to deduct a portion of the interest paid on student loans. Also, decide whether you want to save for college with a Coverdell education savings account or a Section 529 plan.

  • Obtain a receipt for any household goods donated to charity. You can deduct those contributions on your tax return. Also, keep track of any out-of-pocket expenses incurred while you are performing charitable activities; those can also be deducted.

  • Keep track of expenses incurred while searching for a new job. Items like resume preparation, mileage, airfare, and hotels can be deducted as miscellaneous itemized deductions. If you get a new job in the same field and relocate more than 50 miles from your current home, you can also deduct all unreimbursed moving expenses. You don’t even have to itemize to claim the expenses.

  • Review your tax situation now. This gives you time to consider various tax planning strategies and ensure you have adequate time to implement them before year-end.


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