Helping your children navigate the college selection process is probably one of the most important tasks you will do as a parent. Yet, like a lot of decisions in life, it is filled with emotion, frustration, a lack of full knowledge and ultimately parental ego. I have now been through it twice, with my now 24 year daughter and most recently my 18 year old son. And I am proud to admit, my daughter’s college counselor only had to call me twice to ask me to “relax” and to let me know she was on top of her college applications and essays. What I have learned, my thoughts, and my opinions follow. I hope they help you …
- The college decision is highly emotional and can be ego driven… as we all like to hear ‘’Oh that’s a great school” Yet, it is also an investment decision, an investment in human capital that should generate an attractive yield over the long term. One should weight carefully the cost of a particular school versus the potential earnings of the student’s chosen career. Does it make economic sense to pay or borrow up to $200k to prepare for a career that pays $18k per year? Perhaps, there is a more affordable school or a different career path. “Pursuing one’s dream” is an important goal which should be part of the decision process, but there are also economic realities that should be incorporated in the decision.
- Highly selective schools like Harvard, Yale and Northwestern are great goals to strive for, but by definition the vast majority of kids will not get into them. And while I would never discourage a student from striving to get into a selective school, I would recommend their focus should be on a wider range of potential schools based upon their career interests, economic resources and geographic region, with the ultimate goal of selecting a school in which they will thrive. Recent research discussed in the Wall Street Journal suggests that one’s major (especially if STEM related) can have a greater impact on long term financial success than the prestige of the school selected (WSJ: do-elite-colleges-lead-to-higher-salaries-only-for-some-professions). read more…
- The stock market historically creates wealth over the long term through reinvestment and compounding.
- Over the long term the return on equity investments exceeds inflation.
- In the short term the market is highly volatile, so it is only for long term investors.
- Risk takes a number of forms but is commonly measured through volatility (standard deviation).
- Asset allocation, the percentage of stocks versus bonds in your portfolio, is the primary method for managing portfolio risk.
- Sector allocation is a viable means to reduce risk through diversification (negative correlations) and facilitate yield through rebalancing.
- Index funds are low cost and tax efficient.
- Over the long term passive portfolios of index funds will beat active portfolios the vast majority of the time.
- It is almost impossible to pick winning active managers or stocks over the long term.
- Returns and valuations over time will revert to the mean.
- A diversified portfolio consisting of securities with negative correlations will maximize return and minimize risk over time.
- A diversified portfolio with low volatility will generate more cash return over time than a similar highly volatile portfolio with the save average return.
The Conclusion? Holding a diversified portfolio of low cost, tax efficient index funds over the long term will maximize your wealth. Beyond that, one should concentrate on what you can truly control your savings and spending.
Ok. So now you have extra cash or you have rearranged your priorities and you are ready to invest for retirement (a goal we all have in common). What next?
You want to set it aside and invest it. Invest it to maximize its long term investment growth and at the same time invest it in a way to minimize the tax bite. Here is the quick and dirty from a tax savings perspective:
If your employer offers a tax qualified plan, participate in the plan to the best of your ability and AT THE VERY LEAST enough to get the full employer match. The employer match is free money. Take it!
If your employer does not offer a plan or if you are self-employed and do not have a tax qualified plan, open a Traditional IRA account. Go to Vanguard.com and open it online. As long as you have earned income you can open an IRA. The IRA limit (that is the maximum tax deduction) for 2015 is $5,500 or $6,500 if you are over age 50. Your spouse may also be eligible to contribute to a spousal IRA. Unfortunately, if you earn too much or if either your or spouse participate in another employer sponsored plan, you may be limited in the tax deduction, but you can still invest.
If you are a small business (or S Corp) owner, you have other options.. You can still do an IRA, however, you may also consider a SEP-IRA, SIMPLE IRA or a Solo 401K all of which have their own pluses and minuses.
- SEP-IRA: Under a SEP plan, contributions are made by the business – not the individual – and it can contribute up 20% of its income for the sole proprietors/ partners and up to 25% of the employees (such as an S Corp) salary (up to a maximum $52k). SEPs are relatively inexpensive to set up, but all eligible employees need to receive the same percentage, which can be zero if cash flow is tight in some years. Contributions are also pre-FICA.
- SIMPLE IRA: With a Simple-IRA, each employee decides to make a pretax contribution up to $12,500 to an IRA from their wages,. The employer then matches up to 3% of the employee wages. Simples are relatively easy to establish and inexpensive both in terms of administrative costs and funding (employer only pays the 3% match). The employee contributions are subject to FICA, but the employer 3% is not.
- Solo 401K: A Solo-401k works well for a one-person or husband and wife S corp. The employee (or S Corp owner) can contribute up to $18k out of their wages. The corporation can then match some portion of that contribution or up to the lower of 25% of your salary or $52k. Employer contributions are discretionary so can be eliminate when cash flow is thin. The employee contribution is subject to FICA and the corporate match is not. Solo-401k’s are relatively easy to establish and have low administrative costs.
Alternatively, you may also consider a ROTH IRA, which is after tax. Or maximize your H.S.A. account – if you have one – since H.S.A. contributions are tax deductible, funds can be accumulated and it acts more like an IRA after you turn age 65.
In any event, get started. Save early, save often and do so in a way that minimize both taxes and expenses.
If you have any question, please feel free to contact us at…Keith@AskRFA.com