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December 29, 2006

Strategies to Help Business Owners Survive the Cost of College

Everyone who has children is aware of the high cost of college. Over the last few decades costs have risen substantially faster than inflation. In-state tuition and fees over four years at the University of Tennessee (Knoxville)runs $22,488; for Belmont University $73,680; and for Vanderbilt - $133,760. This doesn’t include room and board. Is it any wonder parents get a knot in their stomachs when they think of college?

There are two ways of paying for college: with your money or someone else’s money. The main source of ‘other people’s’ money is through financial aid. Financial aid falls into the categories of gift or self-help aid and is based on financial need or merit. Many people assume they can’t qualify for financial aid for college due to their income or net worth. This may not be the case. Sometimes strategies can be employed that even help families with six-figure incomes qualify for financial aid. This brings us to our first college admissions Rule #1: Never assume you can’t qualify for financial aid. Always submit a financial aid application (called a FAFSA) when your child applies for college admission. It’s a good idea to consult with a college planning professional a year or more before college about strategies to improve your financial aid chances. There are many strategies to reduce the cost of college. I’ll focus on one approach I call the “tax scholarship.”

One of the largest overlooked costs of college is income tax. We pay for college with after-tax dollars. If you’re in the 25% tax bracket you would have to earn $170,667 before tax to pay $128,000 of college expense. That’s an added cost of over $42,600! Reducing any part of that tax cost creates a “tax scholarship”. So how do you do it?
People with businesses, highly appreciated assets, or those who own rental property are the best candidates for this type of planning. For example, assume you pay your 16 year old child $5,000 to work in your business. In 2006 your child would have no tax on the first $5,150 of earned income. He or she could then contribute $4,000 to a Roth IRA since IRAs are not assessed for financial aid. Penalty-free withdrawals can be taken in college for qualified expenses. Assuming you are in the 25% bracket, your “tax scholarship”, including self-employment taxes saved, is $3,562. Also, since your child is not over 18 years of age there is no withholding required.
Your business could also employ your child and reimburse him through a little-known tax rule that allows a business to assist with college costs. In the right circumstances, a business owner could pay their child over $10,000 tax deductible to the business and tax-exempt to their child!

Other college planning techniques to reduce taxes might involve shifting appreciated assets to your child and letting them realize the capital gains at their lower capital gains rate. With the passage of TIPRA in Spring 2006 a child must be age eighteen or older to avoid taxation of passive income at their parent’s rate. Also with TIPRA the capital gains rate for the two lowest tax brackets will drop from 5% to 0% in 2008. Other tax reduction strategies might be consolidating non-deductible debt payments into a home equity loan or shifting assets for college into tax-deferred vehicles which are not assessed for financial aid. These and other strategies can potentially result in tens of thousands of dollars in ‘tax scholarships’.

Finally, let’s not overlook the Hope and Lifetime Learning tax credits which can offset up to $2,000 in taxes per year. These credits are available to tax payers with Adjusted Gross Incomes of less than $110,000. This brings me to college planning Rule #2: don’t assume you earn too much to get these college credits. With planning many families are able to utilize the credits even though family income is much higher than the income cap.
Beware! A thorough knowledge of both tax law and financial aid rules is recommended when utilizing these types of strategies. It is possible to lose more in potential financial aid than is gained in tax reduction or vice versa. Rule #3: always use the combined expertise of your accountant and a Certified College Planning Specialist to avoid costly mistakes.

Author: Bill Garrett, President of Garrett Financial, LLC , a Member of the Paladin Registry

December 27, 2006

Interpreting 529 Plan Expenses

529 plans have many benefits, ranging from the fact that the owner, not the beneficiary controls the assets to the fact that earnings grow tax free from federal taxes and withdrawals for qualified education expenses are free from federal taxes through 2010. However, one reason many investors have not more readily utilized 529 plans is due to the extreme difficulty in understanding, calculating and comparing total plan expenses. Many of these plans’ expenses and cost structures are not very transparent. Furthermore, for those plans whose expenses and total costs are not transparent, there is usually a reason! Although the various expenses involved in 529 plans can get confusing, we’ll attempt to lift the veil of secrecy. We will not, however, attempt to also analyze the potential tax benefits some states offer residents who invest in their own state’s plan (although this is not an issue in Texas due to the fact that we do not have a state income tax), as this is a further complicating issue.

Many 529 plans structure their investment options as fund of funds. In reality this means what it says. A fund of funds is simply a grouping of mutual funds into a single mutual fund. An example of a fund of funds is an age-based allocation fund. These fund of funds often build in various administrative expenses as well as underlying fund expenses. In contrast, plans that offer single-fund investment options may offer a unique 529 plan share class, with the administrative fees included in fund operating expenses. Further complicating the analysis is the fact that various plans may use different names for the fees and expenses!

Fund Operating Expenses
Fund operating expenses are those expenses that many of investors are already familiar with. These are asset-based operating expenses of the plan’s investment options. In a fund of funds, the total operating expenses would be a weighted average total of each individual fund’s operating expenses plus any additional fund of funds overlay expenses. Overlay expenses would be the extra level of expenses tacked on to compensate the 529 plan for assembling and maintaining the fund of funds.

Administrative Program Fees
Those plans that do not offer a unique 529 plan share class typically do not include administrative expenses in fund operating expenses, instead breaking them out as various flat fees for various transactions, a general asset-based fee, or utilizing both methods. Administrative fees compensate the 529 plan program manager and state sponsor for administration and oversight of the plan. Administrative fees may include (although names may differ from plan to plan): (1) account setup or enrollment (most are under $50 with the highest current fee being $90); (2) annual maintenance (which usually range from $10 to $50 per year); (3) state sponsor; (4) beneficiary change; (5) transfer; (6) termination; and (7) rollover.

Sales Charge
529 Plans purchased through a broker or financial advisor, depending on the share class, typically charge an upfront or contingent deferred sales charge. Purchasing a plan directly from the state that sponsors the plan or from the plan’s program manager generally costs less than purchasing a plan through a financial advisor. The plans are typically sold in A, B and C share classes. A shares typically carry an upfront commission charge of anywhere from 3% to 5.5%. Class A shares may also impose an asset-based sales charge but it is generally lower than the asset-based sales charge imposed by the other classes. A shares may also offer you discounts, called breakpoints, which may reduce the sales charge. B shares typically pay the financial advisor around 5% upfront, but instead of charging the investor immediately for the commission they might carry an ongoing sales charge of 1.00% for 5 or 6 years at which time the charge may fall back to approximately 0.25%. If the investor exits the plan before the reduction in the ongoing sales charge they may be charged a contingent deferred sales
charge that may fall from 5% to 0% over time. Finally, C shares typically charge an ongoing sales charge of approximately 1.00% starting in year one. This charge is never reduced, and, if the plan is exited in the first year to year and one half, the investor may be charged a contingent deferred sales charge of 1.00%.

However, some plans do not have sales loads and may only be purchased directly from the state or through a Registered Investment Advisor. These plans utilize no load mutual funds (i.e. Vanguard, T. Rowe Price, etc.) or typical load funds without the load (i.e. American Funds F shares, PIMCO Funds D shares, etc.). Remember, not all plans have sales loads and you can determine a plan’s sales charge by reviewing the fees and charges section of the offering document or prospectus.

We hope you now have a better understanding of 529 plan expenses and their originations.

Author: Paul Palmer, Managing Partner of Cypress Advisory Services, Ltd, LLP, a Member of the Paladin Registry

December 13, 2006

What Are American Depository Receipts

American Depository Receipts (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. This ratio is set by the depositary so the ADR’s price falls within a range considered typical for U.S. stocks. ADR's offer several benefits for individuals wanting to purchase stocks on foreign stock exchanges.

For an investor, ADRs can offer advantages over purchasing individual stocks on foreign stock exchanges:

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

All stock transactions are executed in U.S. dollars. These transactions include all purchases including sales, and dividends. Prices are quoted in U.S. dollars and include both changes in the stock price and currency fluctuations.

Financial reporting tends to be more complete. If the ADR is sponsored, reports will be prepared in English. However, financial reports are based on 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 stocks, international stocks have 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.

December 11, 2006

An Annual 401(k) Plan Review

At least annually, you should thoroughly review your 401(k) plan. Some of the items you need to review are your goals and objectives, contributions, allocation strategy, and more.

Have your goals or objectives changed? Most people use their 401(k) plan to fund retirement, although it can also be used for other things. Take time to reassess your goals and objectives, which can impact how much you contribute and how you invest those contributions. Calculate how much you will need at retirement as well as how much you should save annually to meet that goal.

Are you contributing as much as you can to the plan? Look for ways to increase your contribution rate. One strategy is to allocate any salary increases to your 401(k) plan immediately, before you get used to the money and find ways to spend it. At a minimum, make sure you are contributing enough to take full advantage of any matching contributions made by your employer. In 2006, the maximum contribution to a 401(k) plan is $15,000 plus an additional $5,000 catch-up contribution, if permitted by the plan, for individuals age 50 and older.

Are the assets in your 401(k) plan properly allocated? Some of the more common mistakes made when investing 401(k) assets include allocating too much to conservative investments, not diversifying among several investment vehicles, and investing too much in an employer’s stock. Saving for retirement typically encompasses a long time frame, so make investment choices that reflect that time period. For many, that means that a significant portion of their assets should be invested in growth vehicles.

Do your investments need to be rebalanced? Use this review to ensure your allocation still makes sense. Also review the performance of individual investments, comparing the performance to appropriate benchmarks. You shouldn’t select your investments once and then just ignore the plan. Review your allocation annually to make sure it is close to your desired allocation. If not, adjust your holdings to get your allocation back in line. Selling investments within your 401(k) plan does not generate tax liabilities, so you can make these changes without any tax ramifications.

Are you satisfied with the features of your 401(k) plan? If there are aspects of your plan you’re not happy with, such as too few investment choices or no employer matching, take this opportunity to let your employer know.

Managed properly, your 401(k) plan can play a significant role in helping to fund your retirement.

December 9, 2006

Determining When to Sell a Stock

It’s always difficult to determine the proper time to sell a stock. What if you sell and the stock price increases dramatically? Or what if you hold onto the stock and its price declines? To help you decide when to sell, consider these signals:

The price of a stock with a large loss isn’t moving. Investors hate selling a stock with a loss, often wanting to hold on until they at least break even. However, just because the stock’s price was much higher in the past does not mean it will hit that price anytime soon. You may want to sell and reinvest the money in another stock with better prospects. To help make that decision, forget what you paid for the stock. Instead, analyze it at its current price, deciding whether you would purchase it now at that price.

The stock has hit your target sell price. When you purchase a stock, set both high and low target sales prices. While you do not have to sell when the stock hits those prices, you should at least review it at that time. You might want to set rigid rules for selling a stock when it declines by a certain percentage of your purchase price, to ensure you do not incur substantial losses. Many investors find it emotionally difficult to sell a stock at a loss, so this rule takes the emotion out of that decision. Keep in mind that capital losses can be offset against capital gains, and an excess of $3,000 can be deducted against ordinary income. Any remaining capital losses can be carried forward indefinitely.

Your stock’s performance is lagging the market or its industry. Compare your stock’s performance to that of other stocks in the same industry and to the overall market. Keep in mind that your stock’s performance will vary over time, depending on the stage of the market cycle and how your stock’s industry is performing in that cycle. Consider selling a stock that has lagged in performance for an extended period.

The stock’s fundamentals have changed. The world is constantly changing and the market leaders of today may not be the market leaders of tomorrow. Thus, watch your stocks so you can spot when fundamentals may be shifting.

The stock is subject to negative news stories. You should not sell a stock at the first sign of trouble, since it is not unusual for a stock to go through a difficult period. But if the news is continuing and involves significant events like management shakeups, major competitors stealing market share, unwelcome mergers and acquisitions, or top executives selling large blocks of stock, it’s time to reevaluate the stock.

The stock’s price has run up too much, too quickly. While this is a good thing, the price could have risen so significantly that you may not think it has the potential to increase much more in the future. At that point, you may want to sell and purchase another stock with better prospects.

If you have difficulty implementing your sell strategies, call for a second opinion. Often, discussing your thoughts with someone else causes you to consider other factors or helps ensure your reasons for selling are valid.

December 6, 2006

Costs of Long -Term Care

Life expectancies have increased significantly and are expected to continue to increase in the future. As people age, they are more likely to develop conditions that limit their ability to live independently. However, it is estimated that only 5% of people between the ages of 45 and 64 have purchased long-term-care insurance (Source: Employee Benefit News, January 1, 2006).

How likely is it that you will need long-term-care insurance? It is estimated that 69% of individuals age 65 and older will need some type of long-term care, with 37% entering a nursing home (Source: The Wall Street Journal, February 22, 2006). Those entering a nursing home face an average stay of 2 1/2 years, with an average annual cost of $74,000 (Source: Investment News, October 10, 2005).

Who needs long-term-care insurance? If your assets, not including your home, equal at least $2 million, you can probably fund long-term-care costs with those assets, although you may not want to deplete your assets for this care. Those with very few assets will probably be covered by Medicaid. It is the people between these two extremes who should consider long-term-care insurance. This coverage may be especially important for women, who tend to outlive their husbands.

If you are considering long-term-care insurance, review these points:

Purchase the insurance at a relatively young age. You should probably purchase the insurance by the time you are in your 50s or early 60s. After that, the premiums get much more expensive. Also, if you develop a serious health condition, you may not be able to purchase the insurance.

Check for inflation provisions. Since you may not receive benefits for many years and costs for long-term care have been increasing significantly in recent years, check inflation protection in your policy. Another option is to make sure your policy contains an annual renewal option, so you can buy additional coverage in the future.

Obtain insurance from a stable insurance company. You want to obtain insurance from a company that is sure to be around for the long term. For information on Insurance Company Safety Rankings go to the ManagingMoney.com Insurance Center. Here you will be able to purchase detailed research reports to assist you in making an informed decision.

Make sure the policy terms are reasonable. Many people choose a benefit period of three years to cover the average nursing home stay. However, due to the substantial costs associated with long-term care, you may want to select a longer period. Benefits should be paid in as many situations as possible, including skilled care, intermediate care, custodial care, home health care, and adult day care. Review the waiting period carefully to ensure a good balance between premium costs and out-of-pocket costs.

Review carefully the level of assistance needed to qualify for benefits. Typically, benefits are paid when you are unable to perform two of six activities of daily living, including bathing, eating, using the bathroom, moving back and forth from a chair to a bed, and remaining continent. Typically, benefits are also triggered when a cognitive impairment, such as Alzheimer’s disease, requires substantial supervision.

Determine how benefits are paid. Some policies pay a set daily amount, regardless of your actual costs. Other policies will only pay your actual out-of-pocket expenses up to a daily limit or reasonable and customary costs. Find out how you prove you are entitled to benefits. Some plans require an in-house doctor to review your health, while others allow your own doctor’s review.

Consider sharing a policy with your spouse. Some companies now offer policies that allow spouses to share the policy, with a variety of options available.

Check the policy’s tax status. A qualified policy allows you to deduct a certain percentage of the premium, depending on your age, as a medical expense on your tax return. Medical expenses are deductible to the extent they exceed 7.5% of your adjusted gross income. Also, payouts from qualified policies are received free from federal income taxes.

 

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