Pay Off Loan Early

One financial question many people face during their lifetime is "Should I pay off my loan early?" There are several non-mathematical reasons a person might want to pay off a loan before it is due, such as the psychological satisfaction of being debt-free. Considering such personal preferences, the decision of an early payoff can be quite subjective. But if we limit our focus to only the mathematical part of the question, we can calculate an objective answer.

Determining whether to pay off a loan early involves a simple comparison. We compare the interest paid on the loan versus the interest earned on savings. The first step is to calculate the total interest that would be paid on the loan if it is paid out as scheduled, meaning not early. Multiply the periodic payment amount by the number of payment periods remaining, and then subtract the current principal balance. The result is the amount of interest to be paid.

The second step is to calculate the total interest that could be earned on a savings amount equal to the current principal balance of the loan for a number of periods equal to the number of payment periods remaining on the loan. Multiply the current principal balance of the loan by one plus the interest rate earned on savings raised to the power of the number of payment periods remaining on the loan. The result is the amount of interest that could be earned.

The two results are then compared. If the interest to be paid on the loan is greater than the interest earned on savings, then an early loan payoff may be advantageous. There are some other important considerations regarding this comparison that I will discuss later, but first, I want to present an example evaluation. Confusion can arise when trying to explain these calculations using only words, so I think using some numbers will help illustrate.

Let's say I have a loan with a current principal balance of $2,280, which is the amount I would have to pay the lender if I wanted to pay off the loan today. My scheduled monthly payment is $100, and I have 24 months remaining on the loan. If I paid out the loan as scheduled, I would make 24 payments of $100 for a total of $2,400. The difference between $2,400 and the current principal balance of $2,280 is the amount of interest I would pay if I pay out the loan as scheduled, which would be $120.

Let's also say I have a savings account with a current balance of $2,280, which is the same amount as my loan principal balance. I earn an annual interest rate of 2% on the savings account. If I earn monthly interest on the savings account for 24 months, the same number of periods as remaining on my loan, my savings balance of $2,280 would grow to $2,373, calculated with a time-value-of-money formula: 2280*((1+(0.02/12))^24)=2373. The difference, which is the interest earned, would be $93.

Now I have my two numbers for comparison. The $120 of interest cost I would incur on a $2,280 loan balance is greater than the $93 of interest I could earn on $2,280 of savings. Therefore, I choose to use the $2,280 to pay off the loan early. I forgo the $93 of interest I could earn on that amount, but I save $120 in interest costs I would have paid on the loan.

The important considerations I referred to earlier are in regards to taxes. Interest income earned may be subject to income taxes, which would reduce the realized interest. Let's say I pay income taxes at 25%. As in the example above, the $93 of interest I could earn on my savings account would be reduced by 25%, resulting in only $70 of earnings after taxes. If the potential interest earned is only $70 after taxes, I am even more willing to forgo the savings account interest and instead chose to pay off the loan and save $120 in interest costs.

Another important consideration is the tax deductibility of interest costs. Businesses can deduct loan interest, and individuals can deduct mortgage loan interest. If paying loan interest provides a significant tax deduction, there may be less incentive to pay off the loan early. Let's say the loan in my example above is a mortgage, and I itemize my deductions on my income tax return. The $120 of interest I would pay on the mortgage would reduce my income taxes by $30, which is my tax rate of 25% multiplied by $120. My after-tax interest cost would only be $90.

As you can see, if we assume my savings interest earned is taxable and my loan interest paid is deductible, I have two new numbers to compare. Since the $70 of after-tax interest potentially earned is less than the $90 of after-tax loan interest to be paid, I still chose to forgo the $70 of savings account interest and pay off the loan early to avoid the $90 of interest cost.

Personal preferences can make an early loan payoff a subjective decision, but when evaluating the decision from a mathematical perspective, we can calculate the better alternative. Several factors may influence the result, so give the evaluation adequate attention before making a final decision. If the "Should I pay off my loan early?" question has not been presented to you before now, chances are that you will face the issue sometime in your life. With an understanding of the mathematical evaluation and a feel for your personal preferences, you will be prepared to answer that question.

Compound Interest

Time is the greatest advantage young adults have in saving for retirement. Individuals who start saving at an early age can save fewer dollars, save fewer years, earn less return, and still retire with more money than individuals who delay saving until an older age. This phenomenon is known as the power of compound interest. Compound interest occurs when earned interest is added to the principal investment, and future interest is earned on both the principal investment and interest previously earned. I have generated a few calculations to demonstrate the power of compound interest. I believe the results clearly show that when saving for retirement, starting earlier is better.

Example One:

Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.

Person B saves $5,000 on her 25th through 64th birthdays (40 years) and earns 8% annually after taxes. On her 65th birthday, Person B will have an account balance of $1,398,905.

Person B's balance is $787,176 greater because she started saving ten years earlier than Person A.

Example Two:

Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.

Person B saves $3,000 on her 25th through 64th birthdays (40 years) and earns 8% annually after taxes. On her 65th birthday, Person B will have an account balance of $839,343.

Person B saved $2,000 less per year than Person A, but Person B's balance is still $227,614 greater because she started saving ten years earlier than Person A.

Example Three:

Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.

Person B saves $5,000 on her 25th through 64th birthdays (40 years) and earns 6% annually after taxes. On her 65th birthday, Person B will have an account balance of $820,238.

Person B earned 2% less return than Person A, but Person B's balance is still $208,509 greater because she started saving ten years earlier than Person A.

Example Four:

Person A saves $5,000 on his 35th through 64th birthdays (30 years) and earns 8% annually after taxes. On his 65th birthday, Person A will have an account balance of $611,729.

Person B saves $5,000 on her 25th through 34th birthdays (10 years) and earns 8% annually after taxes. On her 65th birthday, Person B will have an account balance of $787,176.

Person B saved twenty fewer years than Person A, but Person B's balance is still $175,447 greater because she started saving ten years earlier than Person A.

As these examples demonstrate, the compound interest generated by starting to save ten years earlier will produce a greater account balance at retirement. Starting to save ten years earlier can result in a greater account balance even if the individual saves fewer dollars, saves fewer years, or earns less return. Compound interest and time can help heal unfortunate investment experiences. Time is a friend to young people saving for retirement. Start saving early, and time will treat you well.

Roth IRA Conversion

Retirement savings held in a tax-deferred, traditional IRA may be converted to a tax-exempt, Roth IRA. IRS tax law determines eligibility for a conversion, but the more important question is whether a conversion provides sufficient financial benefit.

To be eligible to make a Roth IRA conversion, the taxpayer’s modified adjusted gross income (AGI) must be $100,000 or less, and the taxpayer cannot be married filing separately. Modified AGI does not include the amount being converted to a Roth IRA. An important exception to the AGI limit occurs in year 2010. During 2010, taxpayers with incomes above $100,000 are also eligible to make Roth IRA conversions.

A Roth IRA conversion is essentially a withdrawal from a Traditional IRA and a matching addition to a Roth IRA. When money is withdrawn from a Traditional IRA, ordinary income taxes must be paid on the amount withdrawn. Penalty taxes of 10% normally apply to Traditional IRA withdrawals if made before age 59½. The 10% penalty does not apply if the total withdrawal amount is rolled over to a Roth IRA within 60 days, known as a conversion contribution.

Ordinary income taxes will be due on the amount of the Roth IRA conversion. Taxes can be paid from money held within the IRA or money held outside of the IRA in a taxable account. If money is withdrawn from the IRA to pay taxes, that money will not be converted to the Roth IRA, and therefore, subject to a 10% penalty tax if the taxpayer is younger that age 59½. If a taxpayer under age 59½ must use money within an IRA to pay the income taxes on the conversion, the conversion should not be made.

When taxpayers make Roth IRA conversions, they are electing to pay income taxes now rather than later. The benefit of this decision differs on a case by case basis. The Roth IRA conversion may not be a good choice for taxpayers in a high marginal tax bracket who expect to be in a lower marginal tax bracket during retirement. Making a Roth IRA conversion while in a high tax bracket would cause them to pay more taxes now than they would otherwise pay by waiting until retirement when in a lower tax bracket.

Roth IRA conversions become more attractive for taxpayers who expect to be in a similar or higher marginal tax bracket during retirement. This may be based on an expectation of having more income in retirement or a prediction that income tax rates will be higher in the future than they are currently. If a taxpayer expects to be in a higher tax bracket in the future, making a Roth IRA conversion and paying lower taxes now is favorable compared to taking withdrawals in the future when tax rates are higher.

An evaluation of the Roth IRA conversion may require highly uncertain assumptions about future income tax rates. However, making those assumptions will allow for an estimation of the financial benefit of a Roth IRA conversion. Three income tax rates need to be assumed: the tax rate in the year of conversion, the tax rate during the years after conversion but before retirement, and the tax rate during the years after retirement.

The income tax rate in the year of the Roth IRA conversion can be affected by the amount of the conversion, as a large conversion amount may place the taxpayer into a higher marginal tax bracket. The tax rate in the year of conversion is very important in the evaluation because it affects the upfront tax cost of the Roth IRA conversion. For example, a taxpayer is normally in the 25% marginal tax bracket, but a conversion of $100,000 increases the taxable income and places the taxpayer in the 28% bracket. The cost of the conversion can be estimated as 28% of $100,000, which equals $28,000 of taxes due.

Continuing the example, an evaluation of the Roth IRA conversion would compare the financial benefit of $100,000 in a Roth IRA versus $100,000 in a Traditional IRA plus $28,000 in a taxable account. The taxable account holding represents the amount of taxes saved by not making a conversion. All three amounts are assumed to grow until retirement, with the Roth IRA and Traditional IRA growing at a before-tax rate and the taxable account growing at an after-tax rate.

Once retirement is reached, the evaluation compares the available withdrawal from the Roth IRA versus the available withdrawals from the Traditional IRA and taxable account. The withdrawal from the Traditional IRA is reduced by the amount of ordinary income taxes due. For example, if the IRA withdrawal is $30,000 and the taxpayer is in the 25% tax bracket, the withdrawal is reduced by $7,500, which nets to $22,500. After each year of withdrawals, the remaining balances continue growing, with the taxable account at an after-tax rate, until the accounts are fully depleted.

In comparing the results, the Roth IRA conversion proves to be beneficial if the available withdrawal from the Roth IRA is greater than the after-tax withdrawal from the Traditional IRA plus the withdrawal from the taxable account. If the after-tax withdrawals from the Traditional IRA and taxable account are greater than the available Roth IRA withdrawal, the conversion would not be beneficial. Remember this evaluation is largely dependent on uncertain tax rates, so the results should not be interpreted as definite, especially if the margin of benefit is small.

This example evaluation of a Roth IRA conversion ignores any outside factors assumed in an individual’s overall financial plan. Advisement from a financial professional is highly recommended before attempting a Roth IRA conversion. The circumstances of each person’s financial situation will determine if a Roth IRA conversion provides financial benefit or financial detriment to his or her specific financial plan.

How To Open An IRA

You want to open an Individual Retirement Account (IRA). You have stashed away an adequate emergency fund. You have paid off your high interest credit card debt. You have read about Traditional IRAs versus Roth IRAs, and you know which type best suits your needs. The next step is to open your IRA and start saving for retirement. This does not have to be a do-it-yourself assignment. Thousands of financial professionals are available to help you get started saving for retirement, but these services come at a cost. If you want to minimize the cost of saving and investing, I suggest you spend some time to get educated and do it yourself. I am going to share with you my evaluations and thoughts about opening an IRA and what I believe to be the best process. Hopefully, this discussion will help you feel better prepared to start saving for the important goal of retirement.

The initial step is to decide where to open your IRA. The major options are banking institutions, brokerage firms, and mutual fund companies. I believe mutual funds are the best option for investors just starting to save; bank instruments are too conservative, and individual stocks require too much research. Mutual funds can be bought through a brokerage firm, but the cheapest place to buy a mutual fund is directly from a mutual fund company. I would consider one of the three largest no-load mutual fund companies: Vanguard, Fidelity, or T. Rowe Price. Those companies offer a variety of mutual funds, so you can easily design an adequate investment allocation with all their available fund choices. Choosing among those three mutual fund companies requires an evaluation of their minimums and expenses.

The mutual fund companies have opening minimums and contribution minimums, so how much you can save may limit where you can save. The standard opening minimums for IRAs are $3,000 at Vanguard, $2,500 at Fidelity, and $1,000 at T. Rowe Price. That means you would need to save up the opening minimum amount first in your checking or savings account, and then you would invest the minimum balance all at once into the selected mutual fund. If you do not want to wait to accumulate the standard minimum, Fidelity and T. Rowe Price offer alternatives. You can start with as little as $200 per month at Fidelity or $50 per month at T. Rowe Price if you commit to contributing that amount every month to your IRA. If you forgo these options and contribute the standard initial minimum, the minimums for additional investments to the IRA will be $100 at Vanguard, $1,000 at Fidelity, and $1,000 at T. Rowe Price.

If the initial and additional investment minimum requirements have not narrowed your list of prospective mutual fund companies, a comparison of costs may be useful in your evaluation. Mutual fund companies sometimes charge fees to maintain your IRA, but these fees can be waived if your balance exceeds a certain amount. Fidelity does not charge a maintenance fee on IRA accounts. Vanguard does not charge a fee if you sign up for electronic delivery of statements; otherwise, Vanguard charges $20 per year unless your mutual fund balance is above $10,000. T. Rowe Price charges $10 per year unless your mutual fund balance is above $5,000. These maintenance fees are different than low-balance fees. The companies may charge low-balance fees if your mutual fund balance falls below the initial investment minimum. These fees are also different than sales load charges, which are not an issue if you are buying mutual funds directly from the company.

Based on an evaluation of the mutual fund companies, I have a preferred choice: Vanguard. The only problem I have with Vanguard is their initial investment minimum of $3,000. Accumulating that amount first in a bank account before moving it to Vanguard is not a problem, but I do not like the idea of a beginner investor buying $3,000 into the market in one day. I would prefer if the investor could average into the market over time, as with the special programs at Fidelity and T. Rowe Price. However, once you get started with Vanguard, additional contributions are very flexible. You are not committed to investing a certain amount every month. You can invest $100 or any amount above as often as you want until you reach the annual limit, or you can never add money again, assuming you maintain the minimum balance requirement. And if you do not mind getting your statements on the internet rather than by mail, you cannot get cheaper than Vanguard on fees.

The next step is to choose a mutual fund to buy within your IRA. Sometimes people get this confused, so I will explain. A mutual fund is a type of investment. An IRA is a type of account. To invest in a mutual fund, you can buy either through a taxable account or a tax-advantaged account. A taxable account is just a regular investment account with no tax advantages and no specified purpose. An IRA is a tax-advantaged account opened for the purpose of saving for retirement. Within an IRA, you can purchase several types of investments, including stocks, bonds, and mutual funds. If selecting Vanguard as the company with whom to open your IRA, Vanguard will be the custodian of your IRA, and Vanguard's mutual funds will be the investment within your IRA.

Vanguard offers about 100 mutual fund choices, so you might be wondering which mutual fund to choose. Selecting mutual funds for your IRA depends on your time horizon, your risk tolerance, and how much money you have. The mutual fund allocations will probably look different for an aggressive, young person with many years until retirement compared to a wealthy, conservative, older person near retirement. Asset allocations can differ as much as people do, so I cannot suggest one catch-all mutual fund allocation that is appropriate for everyone. However, since choosing a mutual fund is a critical step when opening an IRA, I will attempt to provide some guidelines. My comments will assume the investor has limited funds, a long time horizon, and a high risk tolerance.

If you are opening an IRA for the first time, you will probably just choose one mutual fund to start with. The IRA contribution limit is $5,000 per year for individuals under age 50. And since the initial opening minimum is $3,000 at Vanguard, that means you can only open one mutual fund during a year. Opening two mutual funds at $3,000 each would put you over the $5,000 annual limit. In such case, you might want to look at Target Date Retirement Funds. For these, you choose the mutual fund that most closely matches your expected year of retirement. Target Date Retirement Funds are usually a fund comprised of other mutual funds. The mutual fund company will change out the funds within the Target Date Fund to make it more conservative as you approach retirement. These funds offer an easy way to set-it-and-forget-it for those investors who do not want to monitor their asset allocation.

Another option is to select a mutual fund that is widely diversified, such as the Total Stock Market Index Fund or Total World Stock Index Fund. These funds invest in thousands of stocks, attempting to track the overall performance of the stock market. If you are using only one mutual fund, make sure the fund includes a significant portion of large cap domestic stocks. Do not use a mutual fund that invests just internationally, or just in small companies, or just in limited sectors because those funds are too risky to own as your only investment. A similar rule would apply to bond mutual funds. If using only one bond fund, make sure it has a high average credit quality and a range of maturity terms. When choosing one mutual fund, the key is to make sure it is diversified.

My comments have covered the high level concept of opening an IRA. I would give more details on the step by step procedure of setting up an IRA, but the mutual fund websites are pretty self-explanatory. Just go to the mutual fund company's main website and find a link that says something like "open an account." You will need to provide all of your personal information, including name, birthday, social security number, and contact information. You will need to supply information about your funding source, such as your bank's name, routing number, and your account number. You will have to indicate that you are saving for retirement and choose which type of IRA you want. And of course, you will have to select which mutual fund you want to purchase for your IRA.

There you have it, my summary of how to open an IRA. I may have made the process seem simple, but that is good. I hope you feel confident enough to attempt opening your own IRA. Do not feel discouraged if the process still seems complex. I have done a lot of reading and studying about the IRA over the years to become comfortable with this topic. You can find plenty of additional information on the internet about the IRA if you want to learn more before investing. Please do not avoid saving and investing because you think it is too complicated. If you feel like the process is too difficult to accomplish on your own, contact a financial professional who can help. At the least, I hope you get motivated to start saving for retirement. When you do, consider using an IRA.

Credit Card Selection Process

Most American households use the popular purchasing tool known as credit cards. Hundreds of millions of credit cards are in circulation in the United States. Americans use their credit cards for more than one trillion dollars of transactions annually. Due to such popularity, credit card availability is abundant, and the industry is competitive. However, selecting the perfect credit card can be a daunting task. Credit cards have several different features to evaluate. Credit cards usually focus on making at least one feature really good so they can attract consumers who value that feature most. For example, one card may offer a low interest rate, whereas another card may offer travel rewards. The different types of benefits target different types of consumers. As a result, no one credit card is the best for everyone. In this article, I will review some relevant facts about the credit card industry and outline my recommended process for choosing a credit card.

There are four major credit card brands in the United States. In order of popularity, they are Visa, MasterCard, American Express, and Discover. Visa and MasterCard are used for about 80% of credit card transactions in the United States and are the most widely accepted cards around the world. Discover cards are rarely accepted outside the United States. If you are only going to have one credit card, I would suggest the Visa card since it is the most popular. For your second credit card, I would suggest getting a MasterCard so you have some variety. Once you have a Visa and a MasterCard, take your pick among the four brands for your third credit card. I do not see the need in having more than three or four credit cards, so do not overload just for variety's sake. You can probably work fine with just one credit card, but if you are also looking to maximize your credit score, two to four cards is the best mix.

After deciding on a credit card brand, you need to find a credit card issuer. Visa and MasterCard branded cards are issued by banking institutions. A few of the largest credit card issuers are Citibank, Chase Bank, and Bank of America. The design of the credit card will display the issuer's name in most cases. For the issuer, I suggest choosing a large bank with expansive geographic coverage, giving preference to banks where you already do business. Managing your credit card may be somewhat easier at a bank where you are already a customer. Also, a large bank may provide better account access, features, and security. In Texas, the largest national banks are Bank of America, Wells Fargo, and Chase, and they all offer credit cards. Some other issuer choices in the United States are Citi, Capitol One, HSBC, and U.S. Bank. American Express and Discover cards are usually self-issued by their respective brands, but I have seen some American Express cards offered through banking institutions.

To help narrow down which credit card issuer to select, you may want to compare the features of each credit card. There are low interest cards, balance transfer cards, poor credit history cards, travel rewards cards, cash back cards, and possibly other credit card features that target specific consumer groups. For example, I pay my credit card balance in full each month, so I do not care about a low interest rate. I value more the rewards options. Some credit cards will charge fees for certain features or benefits. I suggest avoiding credit cards that charge annual fees unless you actually do the math and know the feature is worth the fee. The credit card industry is competitive enough that you should not have to pay for features. The cash back feature is my favorite. The typical rate is 1% cash back, meaning I can receive $25 cash for every $2,500 I spend using my credit card. Most major credit card issuers offer a cash back option.

Based on my credit card selection process, I have found a few credit cards I favor: Chase Freedom Cash Back Visa, Bank of America Cash Rewards Platinum Plus MasterCard, Wells Fargo Cash Back Platinum Card Visa. I am not suggesting these credit cards are the best. The appropriateness of a credit card can vary depending on the needs of the individual. When using credit cards, remember that credit card purchases are short term loans that have to be repaid in full, possibly with interest. Accumulating credit card debt at an interest rate of 20% or 30% can cause a challenging financial burden. Failure to pay your credit card balances in agreement with the credit card company terms will damage your credit history. All of that said, credit cards can be financially helpful when used wisely. Credit cards provide a convenient way to make purchases, track expenses, and build credit history. Invest some time to evaluate and select the credit cards that best serve you and use those credit cards wisely to your advantage.

Sources: CreditCards.com, Wikipedia.org

529 Education Savings Plans

College education costs are increasing at about twice the rate of inflation. This presents a real challenge to families saving for higher education expenses. They may have trouble finding risk-appropriate investments that earn enough to keep pace with rising education costs. They certainly do not need taxes on investment growth slowing them down. Fortunately, there are tax-advantaged ways to save for higher education, such as 529 Plans. Created by Section 529 of the IRS code, the state-operated 529 Plans are now offered by every state in the country and are becoming a very popular option for college education savings.

Two types of 529 Plans exist: Prepaid Plans and Savings Plans. Prepaid Plans allow the purchase of contracts or prepaid credits for college tuition at today's prices. The tuition credits will be redemed by the beneficiary at the time of college attendance. 529 Prepaid Plans allow families to lock-in today's college costs at in-state public colleges. If the student decides to attend a private or out-of-state college, their Prepaid Plans may not pay the full costs. Higher education institutions are allowed to offer their own Prepaid 529 Plans that are not affiliated with the state sponsored plans. One such example is the Independent 529 Plan for private institutions.

The 529 Savings Plans differ by allowing contributions to an account with tax-free growth and tax-free withdrawals when used for qualified higher education expenses. Contributions are non-deductible for federal income taxes but may be deductible for some state's income taxes. Qualified expenses include tuition, fees, books, supplies, reasonable costs of room and board, and other items required by the institution for enrollment or attendence. The Pension Protection Act of 2006 made permanent the federal income tax exclusion for qualified withdrawals. The account owner has some flexibility in choosing the investment strategy for the 529 Savings Plan, but the investment strategy may only be changed once per calendar year.

The IRS states that the 529 contributions "cannot be more than the amount necessary to provide for the qualified education expenses of the beneficiary." Each state sets the contribution limit for their 529 Plans somewhere around $300,000 per beneficiary. If a family wanted to contribute more than the total limit, they could open 529 Plans in multiple states. High-income taxpayers do not encounter any phase-out restrictions for 529 contributions, probably because contributions do not directly benefit the donors. Contributions only benefit the donors if they would otherwise be paying the beneficiary's education costs with after-tax dollars, or if they would otherwise have a large taxable estate that could be reduced with gifts.

Contributions to 529 Plans are considered completed gifts under federal gift tax regulations. For 2009, contributions in excess of $13,000 per donor, per recipient, per year count against the $1,000,000 lifetime gift tax exemption. For example, two parents who have three children could give $26,000 (2 x $13,000) to each child for a total of $78,000 (3 x $26,000) per year while remaining below the gift tax exclusion amount. The donor may contribute more in one year by making a special five calendar-year election and filing IRS Form 709. For 2009, the special five calendar-year election allows a donor to give up to $65,000 (5 x $13,000) to a beneficiary in one year if they do not give that beneficiary any additional amounts within a five year period.

All 529 Plans must have a designated beneficiary, the student for which the plan is established. 529 plans are established on a per beneficiary basis. For example, a family wanting to save for three children would need to establish three 529 Plans. The family has the option to rollover assets from one 529 Plan to another or change the plan beneficiary to another family member without tax consequences. See the "Rollovers" section of IRS Publication 970 Chapter 8 for the list of qualified family members. If the new beneficiary is not an IRS-defined family member, the change is treated as a non-qualified distribution and all earnings in the 529 Plan become taxable to the account owner. The investment strategy for the 529 Plan may be changed whenever a new beneficiary is assigned.

For distributions from 529 Plans that are not used for qualified higher education expenses, the portion representing the amount contributed is non-taxable and the portion representing the amount of earnings is taxable. The taxable portion of a distribution is calculated on a pro rata basis. For example, a family contributed $16,000 to a 529 Plan, and the balance grew to $20,000 (80% contributions; 20% earnings). If $5,000 was withdrawn and not used for qualified higher expenses, $1,000 of the distribution (20% attributed to earnings) would be taxable. The taxable portion of distributions will generally incur a 10% penalty tax as well. An exception to the 10% penalty tax may be allowed if the beneficiary has died, become disabled, or received a scholarship or educational assistance that is not a gift or inheritance.

Funding college education is one of the biggest expenses many families will ever incur. Considering the rapid rate at which education costs are rising, those families should begin saving as early as possible. Tax-free 529 Plans can help families achieve this important goal. Our government has provided tax advantages to those saving and paying for higer education because it sees education advancement as a social benefit to society. Make use of these tax benefits. When saving for higher education, consider investing with 529 Plans to combat the challenge of increasing education costs by saving taxes and keeping more of those dollars earned.

Sources: IRS Publication 970, FinAid.org, SavingForCollege.com

Online Savings Accounts

An online savings account is an interest-paying bank account managed primarily through the internet. Customers open and fund their online savings accounts through a bank website rather than walking into a bank branch to conduct business in person. Online savings accounts may be offered by internet-only banks or by online divisions of traditional brick and mortar banks. These banks may also offer other accounts through the internet, such as checking accounts, but online savings accounts have an important competitive advantage: higher interest rates.

Online savings accounts, sometimes referred to as high-yield savings accounts, generally pay higher interest rates than traditional bank savings accounts. Online savings accounts can pay more interest because they have fewer overhead costs compared to traditional brick and mortar banks. When banks can service accounts without the expenses of maintaining physical locations to service those accounts, the banks can pass along the savings by paying their customers more interest. The higher interest does not translate as more risk. The major online banks are all FDIC insured, so online savings accounts are just as safe as traditional bank savings accounts.

The higher interest rates offered by online savings accounts are more attractive, but they do not attract all banking customers. When it comes to saving money, some people feel more comfortable using their local bank down the street. They like the idea of walking into a branch location and talking with a live person rather than clicking through the bank website and seeing confirmation messages. However, the later scenario is becoming more common as technology advances. With credit cards, debit cards, direct deposits, and online bill pay, money is becoming more electronic, and online banking is becoming more popular.

As mentioned before, online savings accounts may be offered by internet-only banks or by traditional brick and mortar banks; however, the operation of the two may be indistinguishable. The traditional banks usually establish separate divisions to service the accounts offered exclusively online. In most cases, the online accounts cannot be serviced from the bank's physical branch locations. In addition to the web interface, customers may be able to access their accounts through ATM machines or by calling bank representatives, but they will not conduct business face-to-face with the bank.

FDIC-insured online savings accounts are a great choice for short-term savings or emergency fund savings. At this time, online savings accounts are earning higher interest rates than many money market funds, which are not FDIC-insured. High-yield certificates of deposit may offer higher interest rates, but of course, they are not as liquid as savings accounts. If the individual wants to earn maximum interest on liquid savings with guaranteed principal, online savings accounts may be the best option.

Click here for a list of popular online savings accounts and their interest rates.

Health Savings Accounts

A Health Savings Account (HSA) is a tax-exempt trust or custodial account set up with a qualified HSA trustee to pay or reimburse certain medical expenses incurred by the covered individual or family. HSAs are available to everyone covered under a high deductible health insurance plan. The health insurance plan's annual deductible must be at least $1,150 for individual coverage or at least $2,300 for family coverage, as of 2009. Also, the maximum limit for the annual deductible plus other out-of-pocket expenses must equal no more than $5,800 for individual coverage or $11,600 for family coverage, as of 2009. Individuals who are covered under other health insurance or are enrolled in Medicare are not eligible for HSAs.

HSAs can be established by individuals or employers. HSA contributions by an employer are excluded from the individual’s taxable income and are not subject to FICA taxes. Contributions by an individual, a family member, or anyone other than an employer are tax-deductible to the individual even if he/she does not itemize his/her deductions. Contributions made each year are tax-deductible up to the amount of the health insurance policy’s annual deductible, subject to a maximum of $3,000 for individuals or $5,950 for families, as of 2009. Individuals age 55 or older can make additional contributions of up to $1,000 per year, as of 2009. For example, an individual who is age 60 and has self-only coverage could contribute up to $4,000 for 2009. Because the contribution limits apply to employers and employees on a joint basis, any employer contributions will reduce the employee's allowable contribution amount.

The interest and investment earnings generated by assets held within the HSA are not taxable while in the HSA. Amounts distributed from the HSA are not taxable as long as they are used to pay for qualified medical expenses. See IRS Publication 502 for a full description of qualified medical and dental expenses. Note that both prescription and over-the-counter drugs are qualified medical expenses for the HSA. Medical expenses can be paid by direct debit from the HSA or paid out-of-pocket by the individual who then requests reimbursment from the HSA. Amounts distributed from the HSA which are not used to pay for qualified medical expenses will be included in the individual's taxable income, plus an additional 10% penalty tax may apply. Distributions made after the individual is disabled, reaches age 65, or dies are not subject to the 10% penalty tax. Expenses paid from the HSA are not tax-deductible. All distributions, quallified or non-qualified, must be reported on the individual's income tax return in the applicable year.

HSAs are portable, so an individual is not dependent on a particular employer to enjoy the advantages of having an HSA. Like an individual retirement account (IRA), the HSA is owned by the individual, not the employer. If the individual changes jobs, the HSA goes with the individual. The HSA is not a “use-it-or-lose-it” account. All contributions to the HSA remain in the account from year to year until they are used by the individual. If the HSA owner selects his/her spouse as the beneficiary, the HSA will be treated as the spouse's after the owner dies. If the beneficiary is not the spouse, the fair market value of the HSA becomes taxable to the beneficiary at the owner's death.

All HSA limitation amounts presented here are current for 2009 but may be adjusted for inflation in future years. See IRS Publication 969 for additional details about Health Savings Accounts and IRS Publication 502 for Qualified Medical and Dental Expenses.

Real Return

On more than one occasion, I have heard a proposed scenario similar to the following: "I need $50,000 per year for my living expenses. If I had a $1,000,000 investment that would earn just 5% annually, I could live off the $50,000 earnings each year and never touch my $1,000,000 principal investment." The flaw with this proposal is that it does not consider the effects of inflation. Although an individual might might only need $50,000 for living expenses this year, inflation will likely cause that person's annual need to increase above $50,000 in future years.

Let's say the rate of inflation averages 3% per year. If you require $50,000 in year one, and the cost of living inflates by 3% the following year, then your cost of living will be $51,500 in year two. The $1,000,000 would produce $50,000 of earnings in year two that you would withdraw, but you would also need to withdraw $1,500 from the principal balance to cover the increased expenses in year two. In year three, your cost of living inflates by another 3% to make your expenses total $53,045. Also in year three, the principal balance has been depleted by $1,500 to a current balance of $998,500. Assuming the investment earned 5% again, you would have earnings of $49,925 in year three. You would withdraw the $49,925 earnings plus $3,120 from the principal to cover the increased cost of living. As you may start to detect, this process compounds every year, and you keep taking more and more from the $1,000,000 initial balance.

If a person wants the "living off the earnings" proposal to work, an assumption needs to change. The proposal above uses a nominal rate of return of 5%. The proposal should use a real rate of return, also know as an inflation-adjusted rate of return. The real rate of return is NOT calculated by subtracting the inflation rate from the investment growth rate, such as 5% growth minus 3% inflation to equal 2% real return. I have seen some sources incorrectly calculate the real return that way. The real rate of return is CORRECTLY calculated as one plus the nominal rate divided by one plus the inflation rate, then subtracting one from that result. Here is how the real return would be calculated in the previous example:
{ [ (1+.05) / (1+.03) ] -1} = 1.94%

Let's now revisit the proposal considering inflation this time. If I had a $1,000,000 investment that would earn at least 5% annually, and inflation equals 3% annually, I could live off $19,400 of the earnings each year, adjusted for inflation, and never touch my $1,000,000 principal investment. The $19,400 is calculated by multiplying $1,000,000 by a 1.94% inflation-adjusted return. Alternatively, let's say I want to determine what principal balance amount I need to support $50,000 of annual living expenses without breaking into the principal balance. I calculate this number by dividing the $50,000 expenditure need by the 1.94% inflation-adjusted return. In this example, I would need a principal balance of $2,577,320 in order to support annual living expenses of $50,000, adjusted for inflation, without needing to withdraw anything from my principal balance.

To this point, I have only considered inflation in calculating the real rate of return. However, taxes should also be considered. Assuming the investment is taxable, the investment earnings will not be completely retained. When considering taxes, the more relevant performance measurement is the after-tax return. The after-tax return is a little more simple to calculate than the inflation-adjusted return. It is calculated by multiplying the investment growth rate by one minus the tax rate. For example, if my investment produced 5% earnings, and I paid 15% tax on those earnings, my after-tax return would equal 4.25%, calculated as follows:
[ .05 X (1-.15) ] = 4.25%

All investment performance evaluations should compare the real rates of return. A non-taxable investment may have a lower nominal return, but it might be the more favorable investment option for a person in a high tax bracket. Although the nominal return of a taxable investment may appear more attractive, we must consider taxes in the real world. Adjusting a nominal return for both inflation and taxes can result in a significantly reduced real return, but the real return should always be considered when we want to avoid falling short in our projections.

Mutual Fund Companies

The list below displays some of the largest no-load mutual fund companies in the United States. The companies shown in this list do not charge sales loads on at least 80% of their mutual funds. A sales load is the fee an investor pays when buying or selling mutual fund shares. Sales loads do nothing to improve investment performance. Sales loads are just a way for brokers to score commissions from selling loaded funds to uninformed investors who don't know better. These fees are completely unnecessary when plenty of good no-load fund choices exist. Therefore, I recommend investors give preference to no-load mutual funds whenever possible.

Many mutual fund companies allow investors to open and manage accounts online. I would suggest sticking with one of the larger fund families listed below. Personally, I like Vanguard for their numerous index fund options and ultra-low expense ratios. Almost all of Vanguard's mutual funds have $3,000 opening balance minimums and allow subsequent fund purchases of as little as $100. Also, their website is easy to navigate, which is a big plus for do-it-yourself investors. Click on the companies' names to visit their websites.

Largest No-Load Mutual Fund Families, Ranked by Total Assets
(measured in billions of U.S. dollars, rounded to nearest billion)
Vanguard: 1,154 (1 trillion, 154 billion dollars)
Fidelity: 622
T Rowe Price: 270
PIMCO: 212
Doge & Cox: 87
Janus: 63
American Century: 52
Schwab: 50
Russell: 38
Oakmark: 35
USAA: 32
Dreyfus: 31
Royce: 27
Neuberger Berman: 23
Northern: 21
Loomis Sayles: 20
TIAA-CREF: 20
Third Avenue: 18
William Blair: 15
Artisan: 14

For size comparison purposes, the United States equity market is about 10 trillion dollars in size, as represented by the Wilshire 5000 Index. That does not mean all investments within these mutual fund companies are part of the United States equity market. The investments within these mutual fund companies include significant holdings in markets such as fixed income and foreign securities.

The data presented here is current as of December 31, 2008. Morningstar was the source for determining the mutual fund families' total assets and percentage of no-load funds. The list above may not be fully representative of the largest no-load mutual fund families and should be regarded as a sampling rather than a comprehensive list.