— Q U E S T I O N: My wife and I have no concept of money. I bring home just under $1,500 every two weeks, and we struggle to make ends meet. We have a child, and I'd like to ensure that he will have something for college. I am at a loss as to where to go or turn to improve our situation. We constantly have late bills and disconnection notices. My wife and I have been married for a year and a half and we never have extra spending money to do things that I would like us to do — like vacations. Please help.
A N S W E R:
You have to look at the glass as half full instead of half empty. With the $54,000 you make you should be able to develop a comfortable life. The challenge is to live within your means and not above your means. A budget is in order. What this will do is keep your worry level down and put your priorities in order.
Know what you earn. Know where you spend it. Separate essential from nonessential expenses. Identify the difference between what you earn and what you spend. Create a budget to get your spending in line with your earnings. Change your spending habits to reflect your goals.
You need an emergency fund. I recommend that you have six months of expenses set aside in case you are disabled or laid off. You don't need to create an emergency fund all at once or panic if you don't have one in place. But you should designate an account that will serve as an emergency fund and begin to put money in it. Even if you only budget $10 per month, it's a good way to start.
It appears that you have a priority of your child's education. That is good. The time to begin that effort is now while you are young. There are at least two excellent programs to assist you in your goal. Let me explain them to you.
Prepaid Tuition and College Savings Plans
These plans are generally offered by the states (although a consortium of colleges now also offers a prepaid plan). Named for the section of the Internal Revenue Code that governs them, 529 plans come in two varieties — prepaid qualified tuition plans and college savings plans. Both types of plans allow annual taxes on account earnings to be deferred. At least until 2010, earnings withdrawn from the account are also free of taxes if they're used to pay for qualified education expenses. (Congress will have to pass additional legislation for the tax-free benefits of 529 plans to extend beyond 2010.) The prepaid tuition plans offer protection against future tuition increases.
They let parents buy tuition credit at today's prices, and the credits can be used years down the road when your children are ready for college. (Not all states, however, guarantee their prepaid plans.) College savings plans don't offer any guarantees on investment returns but, like an IRA or 401(k), they allow the account owners to choose their investment strategy from among the options offered under the particular plan.
These plans offer parents the potential to earn returns above the yearly tuition inflation rate, which is the effective return a prepaid plan offers. (The savings plan accounts will not grow at all, however, if there are not earnings on the investments parents choose.)
Forty-nine states and the District of Columbia offer 529 college savings plans. Many plans are national and thereby available to residents of any state. About half of the states' plans offer in-state residents additional state income tax benefits. Still, even parents who live in states with tax benefits for residents may want to compare all of their options. A college saving plan from another state may offer advantages — such as better investment performance, plan features, or flexibility — that could outweigh the tax benefits of participating in the in-state plan.
Money in 529 plans is considered the account owner's asset. If a student is not the account owner, it could be expected that a 529 plan won't reduce financial aid as much as money in an Education Savings Account or a custodial account can. When putting money into 529 plans, however, parents need to be mindful of the fact that they may have an additional plan fee that other investments, such as custodial accounts, do not have. 529 plans also offer unique gifting and estate tax benefits.
When someone makes a contribution to a 529 account, they can use up to five years' worth of their annual gift tax exclusion, which currently is $11,000 per year. With a one-time gift, then, someone could put $55,000 into an account for a beneficiary and remove that money from his or her taxable estate. Because a husband and wife each qualify for his and her own annual gift tax exclusion, a couple can contribute up to $110,000 to an account with a one-time gift.
These are the old standbys for college savings. They are also known as UGMAs and UTMAs, which are the initials for the state laws that govern them — either a Uniform Gifts to Minors Act or Uniform Transfers to Minors Act. Custodial accounts don't offer the potential to defer and potentially escape taxes on investment earnings. But they do have significant tax benefits.
Any or all of the earnings in a custodial account is taxed at the child's generally lower income tax rate. The tax treatment of the earnings depends on the child's age and the amount of earnings realized each year. (If the child is age 14 or over, all of the earnings are taxed at his or her rate. If the child is under age 14, the earnings are taxed at the child's rate up to a certain limit, then the parent's income tax rate applies.) With custodial accounts the parent, as custodian, can select the account investments and exchange between various types of investments as they wish.
One potential disadvantage of custodial accounts is that they become the child's asset once he or she reaches the legal age of adulthood, which is either 18 or 21 depending on your state. If a child wishes to use the money for a purpose other than college, the parent has no legal right to stop him or her.
Because the money in the accounts is considered the child's, the accounts also can reduce financial aid more than money in a 529 would. One advantage of custodial accounts, however, is that they don't have the additional plan fee that many 529 plans do.
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Jesse B. Brown is president of Krystal Investment Management, a financial advisory firm in Chicago. For a free trial copy of his monthly electronic newsletter, e-mail email@example.com, or write to him at 3 First National Plaza, PMB Suite 14042, 70 West Madison, Chicago, IL 60602. He is the author of the books Investing in the Dream — Wealth Building Strategies of African-Americans Seeking Financial Freedom and Pay Yourself First: A Guide to Financial Success. His Web site is http://www.jessebrownonline.com.