Ask Liz Weston

 

Dear Liz: My teenage daughter has a modest amount in a Roth IRA that has only a very small gain. I am thinking about using the principal on her private high school tuition so that the account is not considered when she applies for college tuition aid. Is this shortsighted?

Another factor is that I have inherited part of the estate of a relative. Although the transfer isn’t finalized, I probably will get the money during the same year that will be used to determine the financial aid for her first year in college.

Would she be better off if I left the Roth alone and used the inheritance? Or should I reduce the funds in her account?

Answer: Leave that Roth alone!

Retirement funds aren’t included in federal financial aid calculations. And it’s an awful idea to use retirement funds for educational expenses in any case.

Left alone, even a modest sum in a Roth can grow substantially, particularly because it will be 50 years or so before she reaches retirement. In that time, a $5,000 balance could grow to nearly $235,000, assuming she averages 8% annual returns.

Your inheritance will affect your daughter’s financial aid package, but perhaps not by as much as you think. The federal aid formula generally requires you to contribute less than 6% of your “discretionary” assets toward your children’s education.

Dear Liz: I’m interested in opening a Roth IRA for retirement purposes. My tax preparer tells me because I have an employer-sponsored retirement plan I can’t open a Roth IRA. Is that true? If I can contribute to a Roth, should I do so or pay down debt first?

Answer: You either misunderstood your tax preparer, or you need to find a new one.

Anyone who has earned income and whose adjusted gross income is below certain limits ($110,000 for singles, $160,000 for couples) may contribute to a Roth. The fact that you’re also covered by a plan at work is irrelevant.

You don’t need to pay down all your debt before you contribute to a Roth, and in fact you should be wary about passing up the chance to fund this terrific tax shelter. Withdrawals from Roths are tax free in retirement, and you’re not required to take out the money if you don’t need it, which means you can pass the account (and its tax advantages) on to your heirs.

You especially don’t want to forgo the opportunity to fund a Roth if the debt in question carries low rates, like most mortgages, auto loans and student loans. You’re likely to earn higher returns with a diversified portfolio of investments in a Roth than you’d save paying off relatively cheap debt.

Dear Liz: After years of enjoying good pay and bonuses, I have seen my income sharply reduced as my business unit suffers through some very hard times. I am the sole breadwinner and do not feel my spouse is ready to reenter the workforce. We are trying to cut expenses where we can, but I still do not feel it is enough.

We are in our early 40s and have accumulated about $250,000 in my 401(k). Our primary home has about 10 years left on a 15-year mortgage, so that will be with us for a while yet. Can you offer some advice?

Answer: Typically, the worse thing you can do with a 401(k) is to fail to contribute to it. The second worst thing is to prematurely withdraw the money you’ve accumulated.

Let’s review. Your $15,000 withdrawal is subject to regular income taxes plus federal and state penalties that could easily consume $5,000 to $7,000 of your withdrawal. What’s worse, though, is that the money you withdraw won’t continue to grow tax deferred. In 25 years, that $15,000 could easily grow to $100,000, assuming an 8% average annual return (which is a reasonable long-term assumption for a balanced portfolio of stocks and bonds).

A loan from your 401(k) isn’t necessarily a better option. If you lose your job — and the troubles at your company make that a possibility — you may have trouble paying the loan back quickly, which typically you must do to avoid having it treated as a withdrawal.

Besides, credit card debt is short-term debt that should be repaid with current income whenever possible. Turning it into a longer-term debt doesn’t solve your spending problem and could end up costing you more interest.

You’re grasping for a quick fix to an entrenched problem. What you really need to do is get realistic about your situation. Stop using the credit cards as a stopgap. Start making the more painful cuts in your budget to get your spending in line with your current income and debt repayment needs. You can find suggestions for trimming expenses on websites such as Dollar Stretcher (www.stretcher.com) or in books such as Amy Dacyczyn’s “Tightwad Gazette.”

A second income could help enormously here. So could selling possessions you no longer need at a yard sale, a consignment shop or an online outlet such as EBay.

Also, you might consider refinancing that 15-year mortgage to a longer-term loan. A 30-year mortgage in today’s low-interest-rate environment would significantly reduce your monthly expenses, and you could always accelerate your payments should your income increase.

Raiding a retirement account should be an absolute last resort, and you’re a long, long way from having run out of other options.

Dear Liz: I have been steadily investing in stock mutual funds since my early 20s. I have been following the buy-and-hold strategy, and unfortunately I have not been rebalancing my portfolio. Consequently, the vast majority of my portfolio is invested in growth mutual funds that have appreciated in value over the years.

I am now approaching retirement and want to reduce my risk. Should I leave my portfolio as is and invest any new money into fixed-income securities, or should I sell some of my growth mutual funds, which will trigger a substantial capital gains tax?

Answer: It sounds as if you’ve done a good job investing for your future. Now, you need to call in some help.

An objective, experienced, fee-only financial planner could take a look at your total financial situation including your age, life expectancy, risk tolerance, expenses and other sources of income to construct a portfolio strategy that will guide you safely through your retirement years.

This really isn’t a do-it-yourself project. There are too many ways to mess up your retirement income stream and too few ways to fix any errors you make. Take too much risk or withdraw too much from your accounts, and you could run out of money. Take too little risk, and the same thing could happen.

You really want professional help. Two sources for referrals are the National Assn. of Personal Financial Advisors (www.napfa.org or by phone toll-free at [888] FEE-ONLY) and the Garrett Planning Network, http://www.garrettplanningnetwork.com ).

If your portfolio truly is overweighted with growth funds, the planner — perhaps in consultation with a tax pro — might have you gradually sell off some of those investments so you can diversify into bonds, cash, value funds and international investments.

The good news is that the top federal capital gains rate, 15%, is low, so you should still have plenty of money to reinvest.

Dear Liz: I’m interested in opening a Roth IRA for retirement purposes. My tax preparer tells me because I have an employer-sponsored retirement plan I can’t open a Roth IRA. Is that true? If I can contribute to a Roth, should I do so or pay down debt first?

Answer: You either misunderstood your tax preparer, or you need to find a new one.

Anyone who has earned income and whose adjusted gross income is below certain limits ($110,000 for singles, $160,000 for couples) may contribute to a Roth. The fact that you’re also covered by a plan at work is irrelevant.

You don’t need to pay down all your debt before you contribute to a Roth, and in fact you should be wary about passing up the chance to fund this terrific tax shelter. Withdrawals from Roths are tax free in retirement, and you’re not required to take out the money if you don’t need it, which means you can pass the account (and its tax advantages) on to your heirs.

You especially don’t want to forgo the opportunity to fund a Roth if the debt in question carries low rates, like most mortgages, auto loans and student loans. You’re likely to earn higher returns with a diversified portfolio of investments in a Roth than you’d save paying off relatively cheap debt.

Dear Liz: After years of enjoying good pay and bonuses, I have seen my income sharply reduced as my business unit suffers through some very hard times. I am the sole breadwinner and do not feel my spouse is ready to reenter the workforce. We are trying to cut expenses where we can, but I still do not feel it is enough.

What I am considering is withdrawing $15,000 from my 401(k) to clear out some of our accumulated debt. Specifically, I want to pay off several thousand dollars in credit card debt and retire one of our car loans to bring our expenses back in line with my monthly income. That would also free up more income for upcoming college expenses for our children.

We are in our early 40s and have accumulated about $250,000 in my 401(k). Our primary home has about 10 years left on a 15-year mortgage, so that will be with us for a while yet. Can you offer some advice?

Answer: Typically, the worse thing you can do with a 401(k) is to fail to contribute to it. The second worst thing is to prematurely withdraw the money you’ve accumulated.

Let’s review. Your $15,000 withdrawal is subject to regular income taxes plus federal and state penalties that could easily consume $5,000 to $7,000 of your withdrawal. What’s worse, though, is that the money you withdraw won’t continue to grow tax deferred. In 25 years, that $15,000 could easily grow to $100,000, assuming an 8% average annual return (which is a reasonable long-term assumption for a balanced portfolio of stocks and bonds).

A loan from your 401(k) isn’t necessarily a better option. If you lose your job — and the troubles at your company make that a possibility — you may have trouble paying the loan back quickly, which typically you must do to avoid having it treated as a withdrawal.

Besides, credit card debt is short-term debt that should be repaid with current income whenever possible. Turning it into a longer-term debt doesn’t solve your spending problem and could end up costing you more interest.

You’re grasping for a quick fix to an entrenched problem. What you really need to do is get realistic about your situation. Stop using the credit cards as a stopgap. Start making the more painful cuts in your budget to get your spending in line with your current income and debt repayment needs. You can find suggestions for trimming expenses on websites such as Dollar Stretcher (www.stretcher.com) or in books such as Amy Dacyczyn’s “Tightwad Gazette.”

A second income could help enormously here. So could selling possessions you no longer need at a yard sale, a consignment shop or an online outlet such as EBay.

Also, you might consider refinancing that 15-year mortgage to a longer-term loan. A 30-year mortgage in today’s low-interest-rate environment would significantly reduce your monthly expenses, and you could always accelerate your payments should your income increase.

Raiding a retirement account should be an absolute last resort, and you’re a long, long way from having run out of other options.