Q&A: Investing vs Saving for college tuition

Dear Liz: We recently inherited some money. We’ve never had much. We want to invest our inheritance for our kids’ college education.

We asked around to find investment firms that people have had a good experience with. But how do we know they are honest and make sound investment decisions? How do we know if the rates they are charging are fair and reasonable? (For example, one charges a percentage of the value of the account. How do I know if their rate is a fair amount?)

Answer: If you want to invest the money for college education, you don’t need to consult an advisor at all. You simply can use a 529 college savings plan. These plans allow you to invest money that grows tax-deferred and can be used tax free for qualified college expenses nationwide.

These plans are sponsored by the states and run by investment firms. You might want to stick with your own state’s plan if you get a tax break for doing so (check http://www.savingforcollege.com for the details of each plan).

If not, consider choosing one of the plans singled out by research firm Morningstar as the best in 2014: the Maryland College Investment Plan, Alaska’s T. Rowe Price College Savings Plan, the Vanguard 529 College Savings Plan in Nevada and the Utah Educational Savings Plan.

College savings plans typically offer several investment choices, but you can make it easy by choosing the “age weighted” option, which invests your contributions according to your child’s age, getting more conservative as college draws nearer.

If you still want to talk to an advisor — which isn’t a bad idea when dealing with a windfall — you’ll want to choose carefully.

Relying on friends and family isn’t necessarily the best approach. Many of the people who invested with Bernie Madoff were introduced to him by people they knew.

Most advisors aren’t crooks, but they also don’t have to put your interests ahead of their own. That means they can steer you into expensive investment products that pay them larger commissions.

If you want an advisor who puts you first, you’ll want to find one who agrees to be a fiduciary for you, and who is willing to put that in writing.

Here are three sources for fiduciary advice:

•The Financial Planning Assn. at http://www.plannersearch.org

•The Garrett Planning Network at http://www.garrettplanningnetwork.com

•The National Assn. of Personal Financial Advisors at http://www.napfa.org.

Garrett planners charge by the hour with no minimums. Expect to pay around $150 an hour.

NAPFA planners often charge a percentage of assets — typically about 1%.

FPA members charge for advice in a variety of ways, including fees, commissions and a combination of the two.

Any planner should provide you with clear information about how he or she gets paid.

You’ll want to check the advisor’s credentials as well. The gold standard for financial planners is the CFP, which stands for Certified Financial Planner.

An equivalent designation for CPAs is the PFS, which stands for Personal Financial Specialist. People with these designations have received a broad education in comprehensive financial planning, have met minimum experience requirements and agree to uphold certain ethical standards.

Each of the organizations listed above has more tips for choosing a plan on its website.

Q&A: 401(k) employer limits

Dear Liz: My company doesn’t allow us to contribute more than 50% of our paycheck to our 401(k). This limits my contribution to far less than the IRS’ $18,000 annual limit because I’m low paid.

How can I tackle this situation, as I would want to contribute more but am being constrained by the 50% contribution cap?

Answer: Your zeal to save for retirement is admirable. Your company may not have anticipated that anyone in your situation would be able to save so much, so consider simply asking if the limit can be raised.

You can explore other avenues as well, such as contributing to an IRA or a Roth IRA. Many people incorrectly believe they can’t contribute to these individual retirement accounts if they have a workplace plan, but that’s not true.

You can contribute up to $5,500 to a Roth (plus a $1,000 catch-up contribution if you’re 50 or older) if your income is below certain limits. The ability to contribute is reduced between modified adjusted gross incomes of $116,000 and $131,000 for single filers and $183,000 and $193,000 for marrieds filing jointly. Alternatively, you can contribute $5,500 (plus the $1,000 catch-up contribution) to an IRA regardless of your income, although your ability to deduct your contribution if you have a workplace plan is phased out for incomes between $61,000 and $71,000 if single and $98,000 to $118,000 for marrieds.

Q&A: Max contributions to 401(k)s

Dear Liz: I understand that anybody with a 401(k) can contribute up to $18,000. Does the amount you can contribute depend on your salary? Say you make $45,000. Therefore I would assume you could put in the full $18,000, or 40% of your salary. Am I wrong?

Answer: The maximum the IRS allows someone under 50 to contribute to a 401(k), 403(b), most 457 plans and the federal government’s Thrift Savings Plan is $18,000 in 2015. The additional “catch up” contribution limit for people 50 and older is $6,000.

The plans themselves, though, may impose lower limits. Even if the plan doesn’t cap contributions, your contributions may be limited if you’re considered a “highly compensated employee.” Last year, highly compensated employees were those who earned more than $115,000 or owned more than 5% of the business. If lower-earning employees don’t contribute enough to the plan, higher earners may not be able to put in as much as they’d like.

Q&A: Shifting Roth IRA Broker Fees

Dear Liz: What can I do to stop my broker from deducting trading fees from my Roth IRA contributions, which I make monthly? Let’s say I invest $420 each month, but the broker takes $7, or $84 a year. Shouldn’t this be payable from a separate source so that I can invest the full contribution each year, thus reaping the eventual benefits of compounding the extra $84 sum over a long period of time?

Answer: As you understand, $7 per month isn’t such a small sum when you factor in how much more you’d get over time by investing that money instead of paying it to a broker. If that money remained in your account, you’d have roughly $8,500 more at the end of 30 years, assuming 7% average annual returns.

All investments have costs, of course, but minimizing those costs typically means you’ll create more wealth.

You can ask your broker if there is a way to pay the monthly fee from another account, but any commission you pay would be included in the annual amount you’re allowed to contribute. If your broker isn’t providing helpful investment advice to justify the commission, you can look into ways to invest for less, such as using a discount brokerage.

Q&A: Rolling traditional IRA to a 403(b)

Dear Liz: My husband and I both have employer-sponsored 403(b) retirement plans. We each also have a Roth IRA, and I have a traditional IRA that I started in the 1980s before I started work with my current employer. I do not actively contribute to this traditional IRA as I am contributing the maximum amount allowed into both my Roth IRA and my 403(b) plan. My husband is also maxing out on his Roth and 403(b). We are both in our 50s. Should I contribute anything into my traditional IRA? Should I see if I can roll it into my 403(b)? Or roll it into my Roth? Our adjusted gross income is high enough where I would not be able to take the deduction if I did start contributing. Your thoughts would be greatly appreciated.

Answer: If you can’t get a tax deduction for your contributions, then putting the money in a Roth IRA is usually the better option — assuming, of course, that your income is under the Roth limits (which it sounds like it is). Nondeductible contributions reduce the income taxes owed on any withdrawals from a traditional IRA, but withdrawals from a Roth can be entirely tax-free.

If you have a good, low-cost 403(b), rolling your traditional IRA into it could be a good choice. It would be one less account for you to have to monitor and coordinate with your other savings.

You won’t be able to roll your traditional IRA into a Roth without triggering a (possibly hefty) tax bill. The older you are, the harder it is to make a good argumen

Q&A: Balancing savings vehicles and tax benefits

Dear Liz: I’m 26 and make $45,000 per year. I currently have about $60,000 saved with no debt. Roughly half of my assets are in retirement accounts, and the other half are in non-retirement accounts. I strive to save 30% of my income (about 15% in pre-tax retirement accounts and 15% in taxable accounts). I hope that my savings habits will provide me the option to retire early. But I am concerned that I am locking up too much of my money in retirement accounts and that a couple decades down the road, I will not be able to access my money when I would like to. How should I balance various savings vehicles and tax benefits, so that I have most options down the road?

Answer: Your savings habits are admirable, but you shouldn’t worry too much about “locking up” your money. There are a number of ways to tap retirement funds if you really need the cash. Ideally, you’d leave the money alone to grow tax-deferred until you’re ready to retire, but you’re not required to do so.

One way to save for retirement with plenty of flexibility is to fund a Roth IRA each year. You don’t get a tax deduction upfront, but you can withdraw your contributions at any time without penalty. If you don’t tap the money until you’re 59 1/2 or older, your contributions and your earnings are tax free if you’ve had the account at least five years. Another advantage of a Roth is that you’re not required to start distributions after age 70 1/2, as you are with other retirement accounts.

Q&A: Tax credit for Roth IRA contributions

Dear Liz: You told a reader that “contributions to a Roth are never deductible.” This statement is a common misconception and is not correct. You can get a tax credit for Roth IRA contributions as long as you fall under the income limits and itemize on your taxes. The credit phases out at $30,000 for singles and $60,000 for married couples.

Answer: A credit is different from a deduction, but thank you for pointing out a tax benefit that many people don’t know exists.

This non-refundable credit, sometimes called a Saver’s Credit, can slice up to $1,000 per person off the tax bill of eligible taxpayers. The credit is available to people 18 and older who aren’t students or claimed as a dependent on someone else’s return. The lowest income taxpayers — those with adjusted gross incomes under $36,000 for marrieds filing jointly or $18,000 for singles in 2014 — can get a tax credit of 50% of up to $2,000 per person ($4,000 for married couples) contributed to retirement plans. Those plans can include traditional or Roth IRAs, 401(k)s or 403(b)s, 457(b)s and SIMPLE IRAs, among others. The credit drops to 20% and then 10% before phasing out. The average amount saved isn’t spectacular: The IRS said credits averaged $205 for joint filers in 2012 and $127 for single filers, but every bit helps.

One of the problems with this tax break, besides so few people knowing about it, is that many low-income people don’t owe income taxes, so they have nothing to offset with this credit. Another issue is that taxpayers need to file a 1040 or 1040A and use Form 8880 to claim it. Low-income taxpayers often use the 1040EZ form, which doesn’t allow them to claim the credit or alert them that it exists.

Q&A: IRA’s and 401(k)’s

Dear Liz: You answered a reader who asked whether to contribute to her IRA, her Roth IRA or her regular or Roth 401(k) account. I thought that if you have access to a 401(k) at work, you couldn’t make a contribution to an IRA or Roth IRA.

Answer: That’s a common misconception. You can contribute to an IRA even if you have a workplace plan. What you may not be able to do is deduct the contribution. The tax deduction depends on your modified adjusted gross income and phases out in 2015 between $61,000 and $71,000 for singles and $98,000 to $118,000 for married couples filing jointly.

You also may be able contribute to a Roth IRA if you have a workplace plan. Contributions to a Roth are never deductible, but your ability to contribute phases out between $116,000 to $131,000 for singles and $183,000 to $193,000 for married couples filing jointly.

Q&A: Maxing out retirement savings

Dear Liz: My husband and I are in our late 40s. We’re in a good financial position and trying to max out our retirement savings. We have small traditional IRAs and are now above the income limit to deduct contributions to it. We have Roth IRAs that we converted from traditional IRAs several years ago (our income is borderline for being able to contribute directly to a Roth). We also recently got a Health Savings Account that we are maxing out and saving for retirement. But the bulk of our retirement savings is in our 401(k)s, which we max out every year. I hear I should have a mix of pre-tax and after-tax sources of income in retirement. Can I wait until the first year we retire and roll some of my 401(k) into a traditional IRA and then convert it to a Roth, at presumably a lower tax rate due to lower income? Or would it be better to contribute now to a Roth 401(k) at work instead of a regular 401(k), even knowing that our tax rate will probably be lower in retirement?

Answer: You already have a mix of pre- and after-tax sources of income in retirement. Withdrawals from your Roth IRAs will be tax free in retirement, as will your HSA withdrawals if they’re used for medical expenses.

Roth conversions and contributions to Roth 401(k)s make the most sense when you expect to be in a higher tax bracket in retirement, rather than a lower one. Otherwise, you’re giving up a tax break now (your deductible contributions) for what’s likely to be a lesser tax benefit later. Conversions at retirement are particularly tricky, since you may not have decades of tax-free compounding ahead of you to make up for the fact that you accelerated the tax bill.

Talk to a tax pro, but it’s likely that maxing out your regular 401(k)s is the best move.

Q&A: Brokerage follow-up

Dear Liz: You recently explained the insurance limits for brokerage accounts covered by the Securities Investor Protection Corp. I recently retired from the brokerage industry and wanted to add that many firms have additional insurance coverage beyond the SIPC limits.

Answer: Good point. Brokerages often purchase additional coverage from private insurers on top of what’s provided by the SIPC. To find out how much coverage may be available, ask your brokerage or conduct a search with the brokerage name and “how are my accounts protected” as a search phrase.