Withdrawals from 529s can be tricky

Dear Liz: As a parent of a college freshman, I rushed out and closed out one of my son’s 529 college savings plans, thinking I would use the money to pay his expenses for the whole year. It turns out I will have pulled out $6,000 too much in 2010, because I was charged only for one term of room and board. Can I prepay the extra in 2010 for 2011 room and board and tuition as a valid college expense to avoid any 2010 taxes on the extra funds? If not, do you have any suggestions to avoid 2010 taxes?

Answer: Withdrawals from a 529 plan are trickier than many people think. They’re tax free only to the extent that you pay qualified higher education expenses in the same calendar year that you take the distribution — and that other tax breaks aren’t used.

Qualified expenses include tuition, fees, books, supplies, equipment and additional expenses for “special needs” beneficiaries. Qualified expenses do not include insurance, sports or other activity fees, transportation costs or the purchase of a computer, unless it’s required by the school.

If you pull out too much, you have to pay income tax and a 10% federal penalty on the earnings portion of the excess withdrawal. (For example, if your account totaled $10,000, and $6,000 was earnings while $4,000 represented your original contributions, you would pay the penalty on 60% of any excess withdrawals.)

There’s another way you might get hit. If you were planning to use an education tax credit, such as the Hope or Lifetime Learning credit, you would have to deduct from your qualified expenses the amount used to generate the credit. Let’s say you used $5,000 in tuition expenses to generate a $1,000 Lifetime Learning credit. That $5,000 would have to be deducted from your qualified expenses total, which would further reduce the amount of your 529 withdrawal that’s tax free. You wouldn’t have to pay the penalty on the excess withdrawal created by the tax credit adjustment, but you would have to pay income tax on any earnings.

Now the good news: You are allowed to prepay next year’s costs to help boost your qualified expenses total. If it’s been less than 60 days since the withdrawal, you also would be allowed to roll the excess distribution over into a new 529 account.

Fortunately, you discovered the problem before the end of the year. If you’d learned about the problem only when you started preparing your tax return next spring, as many people do, it would be too late and you would be stuck with the extra tax and penalty.

Retirement savings should take priority over paying down mortgage

Dear Liz: This is regarding the couple in good financial shape who asked if they should save more for retirement or focus on paying down their mortgage. I suggest you recommend that 60-year-olds pay off their mortgage under any circumstances. They can afford to miss out on investment income. They can’t afford to be stuck with a mortgage. I’ve read some sad testaments to this. To those telling you how many more years they plan to continue working, they should take into consideration that they may not be allowed to continue working.

Answer: It’s true that many people are forced to retire earlier than planned, but that in itself isn’t a reason to prioritize paying down a low-rate, potentially tax-deductible mortgage over saving more for retirement.

The two people in question were 50 and planning to retire in 10 years when they turned 60. They had no credit card debt or other loans except for a 15-year mortgage at 4.5%. If they’re in the 25% federal tax bracket and itemize their deductions, that would be an effective rate of just 3.4%. In any case, it’s a pretty cheap loan and one that would be paid off within a few years of their retirement. They almost certainly would be far better off taking advantage of opportunities to put more money into 401(k) accounts and Roth IRAs.

Focusing on paying down a mortgage may seem like the smart choice because it saves on interest, but it can leave people poorer in the long run if they’re ignoring opportunities to get retirement account matches, tax breaks and better returns on their money.

Since everyone’s situation is different, though, they’d be smart to find a fee-only financial planner to offer personalized advice.

How to prioritize your money goals

Dear Liz: We’re a newly married couple with an 11-year-old and hope to have another baby soon. We have $20,000 in emergency savings, $40,000 in investments, $480,000 in retirement funds, $20,000 in low-interest student loans and $43,000 in high-interest credit card debt. If we have another child, we’d like for my wife to be able to stay home. I am struggling with how to prioritize debt reduction, college savings, home improvements and building our emergency fund. I don’t want to tap our savings or investments, as there are often surprises in life and I do not want to be caught short. The problem is that aggressively paying down the debt hurts our cash flow for our other goals.

Answer: It’s understandable that you don’t want to tap your savings or investments, since it’s difficult to build up those funds. But it really makes no sense to carry high-interest debt when the returns you’re getting on these other accounts are probably much lower.

Talk to your tax pro about the implications of selling some or all of your non-retirement investments, though. If your investments have gained substantially in value, you’ll want to factor in the tax bill or consider selling some of your money-losers instead.

Once the credit cards are paid off, some money that used to go to those payments will be freed up for other goals.

Your priority needs to be saving for retirement. Once you’re on track there, you probably should focus on rebuilding your emergency fund to equal at least three and preferably six months’ worth of expenses. You may not be able to accomplish that before your second child arrives, though, so consider opening a home equity line of credit as a proxy for a larger emergency fund. Leave the line of credit open and unused, however, because racking up a balance would defeat the purpose.

Saving for college is a worthy goal, although it shouldn’t take priority over retirement, paying off toxic debt or having an emergency fund. You may not be able to save enough to pay the whole bill, but you can shoot for saving one-third or half the expected cost, and your child can use federal student loans for the rest. SavingForCollege.com has a calculator to help fine-tune your plan. Even if you can’t save as much as you’d like, you should save something. Even $25 a month over time will help reduce the amount your child needs to borrow.

Home improvements should be last on your list of priorities, and you should try to pay for those with cash. They are not an investment in your home — although they may improve the value somewhat, you’ll typically get back less than 70% of what you spend.

When to pay down your mortgage

ear Liz: Should you pay off your mortgage or keep a sudden financial windfall? I’m in that situation and was surprised to find that financial experts, including you, generally recommend investing the cash. I understand the attraction of the argument but am not sure the assumptions hold water.

The experts’ argument boils down to this: You can make more money by investing the proceeds than you’d save by paying off the mortgage. Keeping the mortgage — with an interest rate of, say, 5.8% — is fine because the returns on your investments, plus the tax deduction for the mortgage, will more than cover that cost. A mortgage is the cheapest money you can get and a hedge against inflation. This plan also gives you more liquidity.

I say: Unless I can guarantee that I can make 5.8%, I might lose money. And I’d basically be borrowing money just to invest it (and keep some liquidity). That seems risky! If certificates of deposit were earning 6% it would be a no-brainer, but they’re not. Also, it’s impossible to put a price on the sleep-well-at-night factor.

I’d like to read your thoughts.

Answer: You’re right that the investing argument requires a lot of assumptions that may not hold up in real life. But that’s not the reason most people should think twice about paying down a mortgage.

The reality is that most people have better things to do with their money than pay down a low-rate, deductible debt such as a mortgage. For one thing, they should be taking maximum advantage of their tax-deferred retirement options, especially if their company plan offers a match. They also need to pay off other, higher-rate debt before considering extra mortgage payments, and they should have a substantial emergency fund set aside as well. Then there’s insurance to consider: If you don’t have adequate life, health, disability and long-term care coverage, those policies should be purchased before considering mortgage repayment.

If you’ve got all your bases covered and still want to pay down or pay off your mortgage, then have at it. For many people, the security of a paid-off home is well worth forgoing some extra investment income.

A business loan can turn into an unintended gift

Dear Liz: My sister started a business two years ago. Needless to say, the economic conditions weren’t good, but at first she seemed to be doing okay. Lately business has dropped off dramatically and she’s asked us for a loan. We’re not sure if she was ever realistic or even truthful about her business’s prospects. What should we do? READ MORE