Q&A: Deploying a windfall wisely

Dear Liz: I recently received a $38,000 windfall. I have a student loan balance of $37,000. I want to buy a home, but I can’t decide if I should have a large down payment and continue paying down student loans slowly, or make a balloon payment on my student loans and put down a smaller amount on the home. The mortgage rate would be around 4% while the student loans are at 6.55%. The price of homes in my area is at least $250,000 for a two-bedroom house (which my income supports). I want to make a smart decision.

Answer: At first glance, the answer may seem obvious: Pay down the higher-rate debt. But a deeper look reveals that the second option may be the better course.

Student loan interest is deductible, so your effective interest rate on those loans may be less than 5%. If they’re federal student loans, they have all kinds of consumer protections as well. If you lose your job, for example, you have access to deferral and forbearance as well as income-sensitive repayment plans. In most cases, you don’t need to be in a rush to pay off this tax-advantaged, relatively low-rate debt.

A home purchase may be more time sensitive. Interest rates are already up from their recent lows and may go higher. If you can afford to buy a home and plan to stay put for several years, then you probably shouldn’t delay.

A 10% down payment should be sufficient to get a good loan. You’ll have to pay private mortgage insurance, since you can’t put 20% down, but PMI typically drops off after you’ve built enough equity. You usually can request that PMI be dropped once you’ve paid the mortgage down to 80% of the home’s original value. At 78%, the lender may be required to remove PMI. (Note that these rules apply to conventional mortgages and don’t apply to the mortgage insurance that comes with FHA loans.)

You can use the remaining cash to pay down your student loans, but do so only if you already have a healthy emergency fund. It’s smart to set aside at least 1% of the value of your home each year to cover repairs and maintenance, plus you’ll want at least three months’ worth of mortgage payments in the bank. Even better would be enough cash to cover all your expenses for three months.

Q&A: Getting cash to pay medical bills

Dear Liz: I am 63 and retired from my full-time job last year since I have bad health. I work part time now and have tons of medical bills because of stage one cancer. I need additional cash. Is there some way I can get an advance using my pension check as collateral? In addition, is there any way to get an advance from those insurance people who pay people who may die in less than five years? I can’t say when I’m going to kick the bucket but any suggestions you may have that will allow me to get some immediate financial assistance will be greatly appreciated.

Answer: Let’s reinforce what you just said: You don’t know when you’re going to die. A stage one cancer diagnosis is far from an immediate death sentence. You could live for decades, so the mistakes you make now could haunt you for a long time.

Yes, there are some companies that will give you a lump sum in exchange for the next five to 10 years of your pension payments. You should avoid them like the plague. The effective interest rates they charge can be astronomical and you’ll probably be much worse off. If you’re having a hard time making ends meet now, losing a source of income won’t help.

Even if you were going to die soon, no one would hand you money just because of that fact. Those “insurance people” are actually investors who buy cash-value life insurance policies, often from the terminally ill. If you had such a policy, you might be able to sell it for an amount somewhere between the surrender value (what you’d get from the insurer by cashing it in now) and the face value (the dollar amount for which you’re insured). These transactions are called life insurance settlements. If you did have such a policy, though, you probably would be better off just borrowing the amount you need from its cash value.

Consider consulting an experienced bankruptcy attorney if you have more bills than you can pay. Medical bills, along with credit card balances and other consumer debt, can be erased in a Chapter 7 bankruptcy filing. Once the debt is gone, you can start rebuilding your finances for what may be a longer life than you expect.

Q&A: The give and take of federal gift tax rules

Dear Liz: We are planning to build an addition to our home so that my mom can move in with us and will take out a loan to pay for it. Let’s say that we put down $50,000 and take out a loan for the remaining cost of $150,000. After the addition is built, my mom will sell her house and with the proceeds she will give us $200,000 to pay for the cost of the addition. Is this considered a gift? Or is it considered payment for a place to live (i.e. she gets something in return), and therefore it is not a gift?

Answer: What do you want it to be?

If you want it to be a gift, then it certainly can be. If your mother wanted to give you the money all at once, she would need to file a gift tax return because the amount exceeds the $14,000 per recipient annual exclusion. But she wouldn’t need to pay gift tax until the amount she gives away in excess of the annual exclusion reaches a certain limit (which is $5.49 million in 2017).

Gifts in excess of the annual exclusion also affect how much of a wealthy person’s estate can pass tax-free to heirs. If your mother is worth more than about $5 million, she should consult an estate planning attorney before making any gifts.

If she doesn’t want to bother with a gift tax return, she could give you and your spouse $14,000 each, or $28,000, per year until she’s given the $200,000.

If you or your mother prefer to make payments over time and treat the money as rent, you would need to declare the income. You could write off certain rent-related expenses, such as a portion of insurance premiums and repairs, that wouldn’t be deductible otherwise, plus you’d get another tax break from depreciating the portion of the property that’s considered a rental.

But that could trigger a big tax bill when you sell the home, so make sure you run this plan past a tax pro who can help you weigh the costs and benefits.

Q&A: Frequent flier cards

Dear Liz: I have an airline credit card but I find it really hard to use the frequent flier miles I get. The “free” flights have gotten more expensive (they take more miles) and harder to find. I’m getting sick of paying an annual fee for nothing. Would I be better off with a cash-back card?

Answer: Good cash-back rewards cards typically offer rebates of 1% to 2% on most purchases, and some have rotating categories that offer rebates of 5% to 6%. If you’re not an elite frequent flier or trying to amass miles for a special trip, then putting most of your spending on a cash-back card can make sense.

Think twice about closing that airline card, though. It likely offers some perks worth keeping, such as free checked bags and priority boarding. If you take one or two flights a year, the card may pay for itself.

Q&A: Investing during retirement

Dear Liz: I’ll be retiring shortly. After 30 years of public service, I’m fortunate to have a generous pension. I’ll be paying off all my debts upon retirement, including my mortgage. I have a deferred compensation account that I will leave untouched until I’m required to take disbursements at 70 1/2 (15 years from now). Until then I will have disposable income but no significant tax deductions. Short of investing on my own in a brokerage account (and perhaps incurring capital gains taxes), are there any other investment vehicles that perhaps would be tax friendlier?

Answer: A variable annuity could provide tax deferral, but any gains you take out would be subject to income tax rates, which are typically higher than capital gains rates. (Annuities held within IRAs are subject to required minimum distributions starting after age 70 1/2. Those held outside of retirement funds will be annuitized, or paid out, starting at the date specified in the annuity contract.) Also, annuities often have high fees, so you’d need to shop carefully and understand how the surrender charges work.

Many advisors would recommend investing on your own instead and holding those investments at least a year to qualify for lower capital gains rates. This approach is particularly good for any funds you may want to leave your heirs, since assets in a brokerage account would get a “step up” in tax basis that could eliminate capital gains taxes for those heirs. Annuities don’t receive that step-up in basis.

You also shouldn’t assume that waiting to take required minimum distributions is the most tax-effective strategy. The typical advice is to put off tapping retirement funds as long as possible, but some retirees find their required minimum distributions push them into higher tax brackets. You may be better off taking distributions earlier — just enough to “fill out” your current tax bracket, rather than pushing you into a higher one.

Q&A: The new reverse mortgage is safer but still expensive

Dear Liz: If you have never written about the new reverse mortgages, please consider it. I’m nearly 90 and this Home Equity Conversion Mortgage sounds too good to be true. Is it? I’ve talked to a broker and a direct lender and attended a two-hour seminar on the subject.

Answer: Reverse mortgages once deserved their bad reputation, but changes to the Federal Housing Administration’s HECM program in recent years have made them safer and less expensive. They’re still not a cheap way to borrow, though, because of significant upfront costs. Using a home equity loan or line of credit is often a better option if you can make the payments.

A reverse mortgage may be an option if you can’t make payments. These loans allow you to tap the equity in your home if you’re 62 or older. The amount you borrow plus interest compounds over time and is paid off when you die, sell or permanently move out. You can get the money as a lump sum, in a series of monthly checks or as a line of credit you can tap.

The older you get, the more you can receive from your home — but you can’t get the money all at once, as you could in the past. If you choose the lump sum option, you can only access 60% of your loan amount the first year. This restriction was put in place to keep you from blowing through your equity too fast.

While reverse mortgages have improved, some of the people touting them have not. Investment salespeople and scam artists sometimes try to push older people into reverse mortgages as a way to come up with cash to invest in their schemes.

You’re required to get counseling from someone approved by the U.S. Department of Housing and Urban Development to discuss how reverse mortgages work and how much one may cost you. In addition, consider hiring a fee-only financial planner to give you advice.

Q&A: More solutions for avoiding probate

Dear Liz: I’m wondering why, in your answer about whether to use a will or a living trust, you didn’t mention that probate can be avoided by using beneficiaries for assets such as mutual funds and brokerage accounts and now, in many states, homes. This seems quite relevant to the question and the gist of your answer.

Answer: Space limitations, and reader attention spans, prohibit exhaustive answers to many personal finance questions. Nowhere is that more true than in estate planning, which can get complicated quickly.

It’s hard to avoid probate entirely without a living trust. So-called transfer on death designations can indeed work for small estates, providing that the rest of the estate — the “tangible personal property” such as furniture and jewelry — is small enough to qualify for simplified probate proceedings. (In California, that limit is $150,000.)

Even with small estates, though, transfer on death designations aren’t necessarily the right solution for everyone. Beneficiary designations are easy to forget, for one thing, which can mean accounts going to the wrong people after life changes. In other words, your ex-wife or your mother may wind up with an account that should have gone to your spouse. People who choose to use transfer on death designations instead of a living trust need to remain vigilant about keeping those designations up to date.

They also need to explore other potential ramifications, especially if they’re taking a do-it-yourself approach. For example, if a beneficiary dies first, or simultaneously, the asset may wind up having to go through probate.

Also, as this column discussed a few months ago, real estate transfers in certain circumstances can cause the property to be reassessed, leading to much higher tax bills for heirs. That’s something an attorney would be able to explain to a client while preparing a will or living trust, but it’s something a DIYer might miss.

Q&A: When a living trust can save money

Dear Liz: Here’s another advantage to a living trust. If the person owns real estate in more than one jurisdiction and just uses a will, there will be a probate in the resident jurisdiction and ancillary probates the other location or locations, with the attendant time, costs and delays — all of which could be avoided with a living trust. All properties would have to be transferred into the trust, of course, and it’s always wise to have a pour-over will to make sure that anything inadvertently left out of the trust is included and protected from probate.

Answer: Good points. Living trusts are more expensive to set up than wills but can save money in the long run in such situations.

Q&A: How to make sure your financial planner is looking out for you

Dear Liz: As a recent retiree, I opened an IRA with a well-reputed, independent financial planner. I was assured of our fiduciary relationship and told “besides, it will soon be law” that advisors will have to put their clients’ interests first when offering advice about retirement funds.

I guess that whole “soon to be law” thing is out the window along with many other consumer protection regulations. My question is, should I ask my advisor to reaffirm our relationship formally and if so, is there a mechanism available to me to assure this relationship?

Answer: Technically, the U.S. Department of Labor fiduciary rule for advisors is still scheduled to begin taking effect in April, despite fierce opposition from the financial services industry. The Trump administration, however, has asked for a review to see if the rule should be modified or scrapped. That has been widely taken as a signal that the rule may never be enforced, even if it does go into effect.

So yes, retirement savers should continue to be skeptical. One way to make sure that your advisor is ready to put your interests first is to ask him or her to sign the fiduciary oath that you can find at www.thefiduciarystandard.org. The oath was created by a group of financial advisors who think that advice should always be in the clients’ best interests.

Q&A: Which is better: Will or living trust?

Dear Liz: I am 48 and my wife is 45. Should we set up a will or a living trust? Which is better?

Answer: One of the major differences between wills and living trusts is whether the estate has to go through probate, which is the court process that typically follows death. Living trusts avoid probate while wills do not.

Probate isn’t a big problem in many states, but in some — including California — it can be protracted, expensive and often worth avoiding. Another advantage of living trusts is privacy. While wills are entered into the public record, living trusts aren’t.

Living trusts can help you avoid another court-supervised process called conservancy. If you’re incapacitated, the person you’ve named as your “successor trustee” can take over management of your finances without going to court. To avoid the court process without a living trust, you’d need separate documents called powers of attorney. If you have minor children, your living trust trustee can manage their money for them. If you have a will, you would need to include language setting up a trust and naming a trustee.

One big disadvantage of living trusts is the cost. Although price tags vary, a lawyer typically charges a few hundred dollars for a will, while a living trust may cost a few thousand. Also, there’s some hassle involved, since property has to be transferred into the trust to avoid probate.

There are do-it-yourself options, including Nolo software and LegalZoom, that can save you money if your situation isn’t complicated and you’re willing to invest some time in learning about estate planning. If your situation is at all complicated, though — if you’re wealthy or have contentious relatives who are likely to challenge your documents — an experienced attorney’s help can be invaluable.

Whichever you decide, make sure that you have one or the other before too much longer. Otherwise, when you die, state law will determine who gets your stuff and who gets your kids.