MONEY Financial Planning

The One Time Raiding Your Kid’s College Savings Makes Sense

Broken money jar
Normally, breaking into your college savings accounts is a no-no. Jeffrey Coolidge—Getty Images

It's never a great idea, but in an emergency tapping funds earmarked for education beats sabotaging your retirement plans.

Lauren Greutman felt sick.

She and her husband Mark were about $40,000 in debt, and were having trouble paying their monthly bills. As recent homebuyers, the Syracuse, N.Y. couple were already underwater on their mortgage and getting by on one income as Lauren focused on being a stay-at-home mom.

“We were in a really bad financial position, and just didn’t have the money to make ends meet,” remembers Greutman, now 33 and a mom of four.

There was one pot of money just sitting there: their son’s college savings, about $6,500 at the time. That is when they had to make a tough decision.

“We had to pull money out of the account,” she says. “We thought long and hard about it and felt almost dishonest. But it was either leave it in there, or pay the mortgage and be able to eat.”

It is a quandary faced by parents in dire financial straits: Should you treat your kids’ college savings—often housed in so-called 529 plans—as a sacred lockbox, or as a ready source of funds that may be tapped when necessary.

Precise figures are not available, since those making 529-plan withdrawals do not have to tell administrators whether or not the funds are being used for qualified higher education expenses, according to the College Savings Plans Network. That is a matter between the account owner and the Internal Revenue Service.

TIAA-CREF, which administrates many 529 plans for states, estimates that between 10% to 20% of plan withdrawals are non-qualified and not being used for their intended purpose of covering educational expenses.

It is never a first option to draw college money down early, of course. Private four-year colleges cost an average of $30,094 in tuition and fees for 2013/14, according to the College Board. Since that number will presumably rise much more by the time your toddler graduates from high school, parents need to be stocking those financial cupboards rather than emptying them out.

Joe Hurley, founder of Savingforcollege.com, has a message for stressed-out parents: Don’t beat yourselves up about it.

“The plans were designed to give account owners flexible access to their funds,” Hurley says. “I imagine parents would feel some guilt. But I don’t think they should. After all, it is their money.”

Why the Alternative Might Be Worse

Keep in mind that there are often significant financial penalties involved. With non-qualified distributions from a 529 plan, in most cases you are looking at a 10% penalty on the earnings. Withdrawn earnings will also be treated as income on your tax return, and if you took a state tax deduction on the original investment, withdrawn contributions often count as income as well.

Not ideal, of course. But if your other option for emergency funds is to raid your own retirement accounts, tapping college savings is a last-ditch avenue to consider. That’s not only because you do not want to blow up your own nest egg, but because it could make relative sense tax-wise. And as the saying goes, you can borrow money for college, but not for retirement.

“If you think about it, a parent who has a choice between tapping the 529 and tapping a retirement account might be better off tapping the 529,” says James Kinney, a planner with Financial Pathway Advisors in Bridgewater, N.J.

If the account is comprised of 30% earnings, then only 30% would be subject to tax and penalty, Kinney explains. And that compares favorably to a premature distribution from a 401(k) or IRA, where 100% of the distribution will be subject to taxes plus a penalty.

Lauren Greutman’s story has a happy ending. She and her husband made a pledge to restock their son’s college savings as soon as they were financially able. It is a pledge they kept: Now eight-years-old, their son has a healthy $12,000 growing in his account.

She even runs a site about budgeting and frugal living at iamthatlady.com. Still, the wrenching decision to tap college savings certainly was not easy—especially since other family members had contributed to that account.

“We tried to take emotion out of it, even though we felt so bad,” Greutman says. “Since we didn’t have money for groceries at that point, we knew our family would understand.”

Related: 4 Reasons You Shouldn’t Be Saving for College Just Yet

MONEY Ask the Expert

Help, My Spouse Is Afraid of Stocks. What Should I Do?

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Robert A. Di Ieso, Jr.

Q: I just got married, and my husband and I are both contributing to 401(k)s. But he is very conservative with his investments and keeps very little in stocks. We have more than three decades till retirement. How can we align our 401(k)s so we both feel comfortable?

A: It’s certainly not unusual for a couple to have different attitudes about how to manage their money. Spouses often aren’t on the same page when it comes to personal finances. But when you are investing for retirement, being too conservative can make it harder to reach your long-term goals.

“You need some of the risk that comes with investing in stocks, or you won’t have enough growth to fuel your portfolio for the long run,” says San Diego financial planner Marc Roland. And the younger you are, the more risk you can afford to take with your retirement money.

That’s because you have more time to ride out the anxiety-inducing downturns in the markets. Financial planners recommend using your age and subtracting it from 110 to get the percentage of your portfolio that you should keep in stocks. A 30-year-old, for example, should have roughly 80% of their holdings in equities.

So how do you mesh that guideline with an asset allocation that doesn’t panic your husband when the market drops?

First, understand that asset allocation isn’t the only important factor you should consider. How much you put away has more impact on your retirement savings success than how you invest your money. When you’re decades from retirement, it’s hard to know exactly how much you’ll need for a comfortable lifestyle at 65. But one rule of thumb is that you’ll need 70% of your pre-retirement salary to live comfortably. You can get a good ball park estimate with a calculator like this one from T. Rowe Price.

The more you are contributing to your 401(k)s, the less risk you have to take on, says Roland. If you’re both saving at least 10% of your income, and you boost that rate to 15% or more as you get older and earn more, a balanced portfolio of about 60% in stocks with the rest in bonds would work, says Roland. (That ratio of stocks to bonds is a bit conservative for investors in their 20s, who could reasonably stash as much as 80% in equities.)

To achieve that overall mix, the more aggressive spouse can invest 80% in stocks, while the risk-averse spouse can hold the line at 40%, assuming you are contributing similar amounts to your plans. “That blend will give them an appropriate asset allocation but each portfolio is tailored to each person’s risk tolerance,” says Roland.

Related links:

MONEY 401(k)s

Stock Gains (and Saving) Push 401(k)s to Record Highs

Staying the course has rarely paid off so well as average retirement account balances soar.

The financial crisis is so yesterday. Retirement savings accounts have never been plumper, according to a new survey of 401(k) plans and IRAs at Fidelity Investments.

At mid-year, the average 401(k) balance stood at a record $91,000, up nearly 13% from a year ago. The average IRA balance stood at $92,600, also a record, and up nearly 15% from the previous year.

These figures include all employees in a plan, even those in their first year of saving. Looking just at long-time savers the picture brightens further. Workers who had been active in a workplace retirement plan for at least 10 years had a record average balance of $246,200—a figure that has grown at an average annual rate of 15% for a decade.

Over the past year, the resurgent stock market accounted for 77% of the higher average balance in 401(k) plans, Fidelity said. Ongoing employer and employee contributions accounted for 23% of the gain. The typical worker socks away $9,590 a year—$6,050 from her own contributions and $3,540 from an employer match.

Of course, the financial crisis still weighs on many Americans. Employment has been an ongoing weak spot and wage growth has been all but non-existent. Meanwhile, those in or nearing retirement may have fallen short of their goals after losing a decade of market growth at just the wrong point in their savings cycle. Many had to sell while prices were down.

But the Fidelity data reinforces the value of steady savings over a long period. By contributing through thick and thin, savers were able to offset much of the portfolio damage from the crisis. They not only held firm and enjoyed the market’s robust recovery but also were buying shares when prices were low. They earned a spectacular return on new money put into stocks the last five years. In calendar year 2013 alone, the S&P 500 plus dividends rose 32%.

Despite continuing contributions, savings balances did not rise as fast as the S&P 500 due to plan fees, cash-outs and broad plan exposure to lower-return investments like bonds and cash. Roughly a third of job switchers do not roll over their plan savings; they take the money, often incurring taxes and penalties. The average 401(k) investor has 33% in fixed-income securities.

Related:

 

MONEY Kids and Money

The Surprising Place Your Kid Should Save His Summer Earnings

Pitcher of lemonade and a money jar
Your teen's summer earnings may not seem like much now, but they can serve as a cornerstone for his retirement 50-odd years in the future. Somos/Veer—Getty Images

Get your teen started off now in a Roth IRA for a big payoff down the road, says financial planner Kevin McKinley.

A few weeks ago, I wrote about how to figure out how much money you need to become financially independent, and how the process could help you teach your kids to reach the same goal.

But talking the talk only goes so far. You can walk the walk by helping them start saving for retirement in…drumroll, please…a Roth IRA.

Why a Roth IRA?

For most younger workers, the Roth IRA is preferable to a traditional IRA for two reasons.

The first is that contributions to a Roth IRA can be withdrawn at any time for any reason with no taxes or penalties whatsoever. Therefore, that portion of the account can be taken out for other expenses, such as college or a down payment on a house, without a severe cost.

The second reason the Roth IRA rules is that younger workers typically are in a low tax bracket, and therefore don’t need the deduction that a traditional IRA provides. But once they get to retirement, all the money in the Roth can generally be withdrawn with no taxes at all.

How much your kid can save

Children of any age can open a Roth IRA account—as long as they have legitimate earned income. Flipping burgers and bagging groceries certainly counts, but so does self-employment like babysitting and yard work, especially if it’s done for someone other than you.

Just make sure to keep track of what your kid makes so you know how much can be deposited in to the Roth IRA. For 2014 the contributions to a Roth IRA are limited to the lesser of the kid’s earnings, or $5,500.

Technically, for the 2104 tax year, the money doesn’t have to be deposited until April 15, 2015, the usual deadline for the federal income tax filing.

What you can do to encourage him

Congratulations to you—and your child—if you can convince her straightaway to put her hard-earned paychecks into an account that isn’t meant to be tapped for another 50 years.

But even if you can’t immediately get your teen into the savings habit, you may be able to motivate her by using some of your own money. The money for the Roth IRA doesn’t necessarily have to come from her. She can spend her earnings, and you can deposit into the Roth on her behalf.(Just remember that your deposits then become her money, and she’s free to do with it as she pleases once she reaches adulthood.)

Also, keep in mind that the source of the deposit to your child’s Roth IRA doesn’t have to be an all-or-nothing proposition. You may want to tell your kid that you will match every dollar she contributes with one of your own.

For further motivation, try showing your child how time can turn a relatively-small amount of money into a small (or large) fortune.

For instance, let’s say you and your child deposits $5,000 into a Roth IRA when he’s 15 years old, and it grows at a hypothetical annual rate of 6% per year.

By the time he’s 65 (and it will happen sooner than he thinks), the account would be worth over $92,000.

But if he has the earnings and discipline required to set aside $5,000 in to the same account every year until he turns 65, the Roth IRA will provide him with a tax-free total of $1.6 million.

And if that doesn’t get his attention, no amount of walking and talking will.

__________

Kevin McKinley is a financial planner and owner of McKinley Money LLC, a registered investment advisor in Eau Claire, Wisconsin. He’s also the author of Make Your Kid a Millionaire. His column appears weekly.

Read more from Kevin McKinley

Four Reasons You Shouldn’t Be Saving for College Just Yet

Yes, You Can Skip a Faraway Wedding

The Simple Formula That Can Help You Achieve Financial Independence

MONEY

5 Secrets to Saving for the Future While Enjoying Life Now

Piggy bank enjoying life in a field
iStock

A financial planner explains how to prepare for retirement while living the good life now.

Save? Spend? Or both?

In my work with younger clients, that’s one of the main conflicts I see: The desire to prepare for the future and save versus the impulse to live for the present and enjoy earnings now. People know that nobody is promised tomorrow, but they also don’t want to live out their retirement years with limited choices, or none at all.

So how can people strike a successful balance between these seemingly competing desires? Based on my work with financial planning clients, here’s my five-step plan:

  1. Understand your cash flow. I’m going to make a bold statement here: Nothing will affect your financial future more than your ability to understand your household cash flow. If you want more money to save for the future or to spend now, you have to understand your current spending patterns and habits to get there. Check in on your spending weekly; that takes far less time than a monthly review, and it’s easier to catch places you may have spent more than you planned. It’s easy to live lean for a week if you’ve overspent in a previous week. It’s a lot harder to catch up if you’ve been overspending for a month.
  2. Learn to say “no” by deciding on your “yes.” The clearer you are about what you want to do in the short and long term, the easier it is to make spending choices that you’ll be happy with when you look back at them. Before I married the woman who became my wife, I used to feel deprived if we weren’t going out to eat often. On our honeymoon, I discovered that what I really wanted to do was to travel the world with her. Once that became the big yes, I wasn’t depriving myself if I didn’t go out to eat. If I did go out to eat, I was depriving myself of what I really wanted, which was to travel more. That single idea helped me change my habits entirely and build up the money we needed to take a big trip every year.
  3. Limit your monthly bills. Eric Kies talks about Money Past, Money Present, and Money Future in his First Step Cash Management system. Money Past is all of the money you’ve agreed to spend at the beginning of the month — things like rent, utilities, and student loan payments. While buying a new car may not seem like a big deal if you think you can afford it, adding on a car loan to your Money Past comes with a major tradeoff: It limits your day-to-day spending (Money Present), and it cuts into your ability to save for the future as well (your Money Future). Be careful; I regularly see young couples adding to their Money Past bucket, limiting their present and future spending choices.
  4. Automate your savings for present and future goals. Chances are you get paid by direct deposit, and it’s easy to direct funds into multiple accounts. Beyond your basic emergency fund, I’ve seen clients have a lot of success in setting up multiple savings accounts to have balances grow for specific goals (a trip to Europe, for example, or a new car). This allows you to see the specific progress you’re making. The same concept applies for retirement plans at work. If you can save that money automatically before it reaches your bank account, you’re far more likely to continue saving those funds in the future and even to increase your contributions over time.
  5. Plan for spontaneity. This may sound contradictory, but I think it’s essential. Many people I’ve spoken to resist tracking their spending because it feels constraining. A good solution to this is to build in money that is purely for spontaneous spending. If you know there’s money in your budget that is there for the sole purpose of spending it, it protects the money that you’re saving into other accounts by providing an outlet for a spur-of-the-moment decision.

Follow these suggestions and you’ll soon find you have money for both your current needs and your long-term goals.

—————————————-

H. Jude Boudreaux, CFP, is the founder of Upperline Financial Planning, a fee-only financial planning firm based in New Orleans. He is an adjunct professor at Loyola University New Orleans, a past president of the Financial Planning Association‘s NexGen community, and an advocate for new and alternative business models for the financial planning industry.

 

MONEY Careers

What You Can Learn From Derek Jeter’s Perfect Exit

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ZUMA Press—Alamy

Whether you’re the Yankees' all-time leader in hits, games played, and stolen bases, or just a regular employee, leaving a long-term employer on the best terms can pay off handsomely. 

Updated on Sept. 25, 2014

When shortstop Derek Jeter plays his final home game at Yankee stadium tonight (weather permitting), you can bet the crowds will roar and the 20-year Yankee veteran will modestly acknowledge the fans, take his stance in the batter’s box, and get on with the job at hand. You can also bet that Jeter, who announced his retirement from active play at the start of the season, can parlay that adulation into a very lucrative post-baseball second act.

That’s what a job well done and a well-honed exit strategy from a long-term position can do for you too.

Whether you’re on the verge of retirement or are simply leaving a company you’ve been with for a while to take a new position, here are three lessons from the future Hall-of-Famer’s actions in his final season that you can take to the bank.

Get early buy-in from management. Jeter gave Yankee manager Joe Girardi, general manager Brian Cashman, and owners Hal and Hank Steinbrenner more than six months’ notice about his plan to end his playing career at the close of the current season. That’s allowed them plenty of time to plan for his replacement at shortstop.

Show your bosses the same courtesy. Notify your manager a good three to six months in advance if you’re retiring and a month to six weeks ahead of time vs. the standard two weeks if you’re leaving for a new job so they have enough lead time to fill your position. That’s especially important if you’re in a critical, revenue-generating role or are a highly skilled employee who may be difficult to replace. Help identify other staffers or professionals outside the company who might be good candidates, and offer to train them before you go, or at least to write a detailed memo that will help the person fill your shoes.

Your reward: If you’re retiring, you never know when you might want to earn a little extra cash by doing some consulting work or might want or need to return to part-time work. Your behavior helps ensure your former employer will want you back in some capacity. And if you’re simply moving on, you can count on a glowing reference if and when you need one in the future.

Mentor younger players. They don’t call Jeter the Captain for nothing. Since late Yankees owner George Steinbrenner appointed him team leader in 2003, Jeter has taken his job as a role model seriously, consistently mentoring younger players and youth off the field through his Turn 2 Foundation.

Share your knowledge as generously with younger colleagues at work, especially those who toil in a similar capacity albeit at a more junior level. Offer some inside tips that only someone who’s been around for a while would know, and make yourself available for questions and as a sounding board. Be especially generous in passing along your know-how to the person who’s taking your place. Those junior staffers will be the bosses one day, possibly sooner than you think. Good for them to remember you fondly if they’re in a position to hire you someday.

Show fans your appreciation. Jeter is notoriously not on board with hoopla over his career accomplishments, and his farewell tour has been subdued compared with that of fellow Yankee Core Four member Mariano Rivera last year. Yet Jeter has graciously accepted the gifts and gratitude shown him as he plays at various ballparks for the last time and tips his cap to the fans, just as they tip theirs to him.

Remember to show your gratitude to those who helped your career along as well. If you had a mentor at work, let him or her know how much you appreciated the help and mention a particular lesson or words of wisdom that were especially useful (the specificity makes your gratitude seem more genuine). Let colleagues who you particularly admire know and, again, try to identify a specific accomplishment or skill that you believe sets them apart. Bring in bagels or doughnuts for the staff one morning near the end of your run or buy a round of drinks. Think of it as a form of networking that may one day help you professionally.

This kind of classy behavior may not earn you a standing ovation on your way out the door, let alone an emotionally resonant and star-studded tribute videos sponsored by Nike and Gatorade. But it can’t hurt in the good karma department — and is very likely to pay off in hard currency after you hang up your spikes.

More in Careers:
These Two Key Moves Will Help You Land Your Dream Second Career
How to Find Happiness in Your Second Career—And Earn Money Too
Your Career Is Your Biggest Asset. Here Are Five Ways to Protect It

 

MONEY Investing

Are You On Your Way to $1 Million? Tell Us Your Story.

There are many ways to build lasting wealth. MONEY wants to hear how you're doing it.

The number of millionaires in America hit 9.6 million this year, a record high and yet another sign that the wealthy are recovering from the Great Recession, thanks in large part to stock market and real estate gains.

Are you on target to join their ranks? Are you taking steps—through your savings, your career decisions, your investments, or your rental properties—to make sure that by the time you retire your net worth will be in the seven figures? MONEY wants to hear your story.

Related: Where Are You On the Road to Wealth?

There are many paths to that kind of wealth, and they don’t necessarily involve a sudden windfall, a big head start, or a six-figure salary. You can build up a million or more in assets through steady saving, a sensible approach to investing, modest real estate holdings, or a winning small business idea. Are you finding ways to boost your savings at certain point of your life, like when the kids are out of school or the mortgage is paid up? Are you planning to take more or fewer risks with your investments as you near retirement? And if you invest in real estate, do you find that owning even one or two rental properties is enough to achieve prosperity?

Got a story like this to share? Use the confidential form below to tell us a bit about what you’re doing right, plus let us know where you’re from, what you do for a living, and how old you are. We won’t use your story unless we speak with you first.

MONEY Ask the Expert

How Do I Find the Best Place to Retire?

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Robert A. Di Ieso, Jr.

Q: I live in New Jersey. Which state would be financially better to retire to: Pennsylvania or North Carolina? – Kevin, Bridgewater, NJ

A: Your cost of living in retirement can make or break your quality of life, so it’s smart to take financial factors into account as you decide where to live. Moving from New Jersey where taxes are steep and home prices are high to a more affordable area will allow your savings to stretch further. Housing and property taxes are the biggest expenses for older Americans, according to the Employee Benefit Research Institute.

By those measures, North Carolina and Pennsylvania both stack up fairly well. Neither state taxes Social Security benefits or has an estate tax, though Pennsylvania has an inheritance tax and North Carolina will begin taxing pension income for the 2014 tax year. When it comes to cost of living, Pennsylvania has a slight edge. The median price of homes in Pennsylvania is $179,000 vs. $199,000 for North Carolina, according to Zillow. Income tax is a flat 3.07% in Pennsylvania while North Carolina has a 5.8% income tax rate. You can find more details on taxes in each state at the Tax Foundation and CCH. But both states have cities—Raleigh and Pittsburgh—that landed at the top of MONEY’s most recent Best Places to Retire list.

Of course, you need to look beyond taxes and home prices when choosing a place to live in retirement, says Miami financial planner Ellen Siegel. Does your dream locale have high quality, accessible healthcare or will you have to travel far to find good doctors? Will you be near a transportation hub or will you live in a rural area that’s expensive to fly out of when you want to visit family and friends?

There are lifestyle considerations, too. If you like to spend time outside, will the climate allow you enjoy those outdoor activities most of the year? If you favor rich cultural offerings and good restaurants nearby, what will you find? Small towns tend to be less expensive but may not offer a vibrant arts scene or many dining options.

To determine whether a place is really a good fit for your retirement, you need to spend more than a few vacation days there. So practice retirement by visiting at different times of the year for longer periods. Stay in a neighborhood area where you want to live and get to know area residents. “Having a strong social network is important as you get older and if you move to a new area, you want to make sure you can make meaningful connections and find fulfilling activities,” says Siegel. By test driving your retirement locations before you move, you”ll have a better shot at getting it right.

Have a question about your finances? Send it to asktheexpert@moneymail.com.

MONEY

The Simple Formula That Can Help You Achieve Financial Independence

Man writing formulas on a chalkboard
You don't need a Ph.D. in math—or even a chalkboard—to figure out if you're on the path to financial independence. Justin Lewis—Getty Images

Your ability to retire well depends not on how much you save but on how much you spend, says financial planner Kevin McKinley.

As you’re celebrating our nation’s independence this weekend, you might want to spend some time—between your first and second hot dogs, maybe?—contemplating how well you’re doing in achieving your own financial independence.

Your ability to reach a comfortable retirement has less correlation than you might expect with how much money you earn, how much money you already have, or how you invest that money.

Instead, it depends upon how much you spend—and how much you plan to spend in the future. The more money you spend now and going forward, the more you will need to accumulate to support your lifestyle.

A simple formula can tell you not only how much you will need, but also how close you are now to getting where you want to be.

What’s your destination?

Start by looking back on the last month to see how much you’ve spent. You can do this by reviewing your checking and credit card account statements, or you could use an expense-tracking program like You Need a Budget or Mint going forward a month.

Once you have a handle on a typical month’s spending, subtract any Social Security payments you and your spouse or partner expect to receive in retirement (find estimated amounts at the Social Security website). You can also subtract any pension payments you know will be coming your way.

Then multiply the remaining amount by 200. The result is what you will need to have in savings, investments, and retirement accounts before you can retire comfortably.

Or, in a formula:

(Monthly Spending – Expected Monthly S.S./Pension) x 200 = Target Retirement

So, if you’re spending $4,000 per month and can expect $1,500 per month in Social Security retirement benefits, your net required liquid assets are $2,500 x 200, or $500,000.

Are you on track?

You can use a similar variation of this formula to see how you’re doing toward your goal. Again, start with your typical monthly expense amount. Here’s where you should be…

In your 20s: Current Monthly Spending x 10

In your 30s: Current Monthly Spending x 25

In your 40s: Current Monthly Spending x 50

In your 50s: Current Monthly Spending x 100

(By the way, in case you plan on winning the lottery well before retirement age and want to be financially free forever, you’d better hope you hit the Mega Millions, since you’ll need about 300 times your monthly expenses.)

If your net worth isn’t where it should be, don’t panic. Instead, go back to your list of expenses to see what is less important to you than your long-term financial security, and try to reduce or eliminate it. A quick way to increase your net worth and reduce your spending is to bump up your deferral in to a pre-tax retirement plan, like an IRA, 401k, or 403b. The money is still yours, but since you’re taking home less, you’ll be forced to live on a little less (and you can always change it back).

Bonus: Saving more for retirement this way also means you’ll pay less in taxes each year.

Will your kids be on track?

Best of all, this process can help you provide a priceless lesson to your children.

Many of us want our children to have high-paying jobs in adulthood so that they can cover their own living expenses with as little parental assistance as possible.

But simply by learning that it’s easier to spend less money than it is to make more, our children will be free to pick an occupation based on what they find most fulfilling, rather than the one that just fills up their bank accounts fastest. Minimizing their expenditures also gives them more flexibility to change careers, move to a more desirable location, go back to school, or stay home to care for a child (our grandchildren!).

Most importantly, spending less money allows them to save more of what they earn—so that they’ll be able to reach their own financial independence much more quickly.

__________

Kevin McKinley is a financial planner and owner of McKinley Money LLC, a registered investment advisor in Eau Claire, Wisconsin. He’s also the author of Make Your Kid a Millionaire. His column appears weekly.

Read more from Kevin McKinley:

Four Reasons You Shouldn’t Be Saving for College Just Yet

Yes, You Can Skip a Faraway Wedding

This is What Sting Should Have Done for His Kids

MONEY Taxes

The Moves to Make Now So You Can Cut Taxes Later

A financial adviser explains that to maximize income, you need the right kinds of investment accounts, not just the right investments.

In my work with financial planning clients, I can see that people understand the merits of having a diversified mix of securities in an investment portfolio. Investment advisers have done a good job of explaining how diversification can improve clients’ risk-adjusted returns.

What can be a little harder for advisers to explain and clients to understand, though, is the value of “tax diversification” — having investments in a mix of accounts with different tax treatments. By having some securities in taxable accounts, others in tax-deferred accounts, and still others in tax-free accounts, people can maintain the flexibility that makes it easier to minimize their taxes in retirement.

The benefits of traditional tax-deferred retirement accounts, such as IRAs and 401(k)s, are easy for participants to see. Contributions reduce people’s current tax bills. And the benefits continue to compound over the course of the investors’ careers, since none of the income is taxable until withdrawals are made.

Yet what clients don’t often grasp is the price they’ll wind up paying for this tax benefit later in life. Distributions from tax-deferred accounts are treated as ordinary income. It can be more expensive to spend money from a traditional IRA than from a taxable account, since dividends and long-term capital gains in taxable accounts are taxed at more favorable rates. And IRS-mandated required minimum distributions from traditional retirement accounts can force a retiree to generate taxable income at times when he or she wouldn’t want to.

So how do you get clients to understand that traditional IRAs and 401(k)s may cost them more than they think? Sometimes it’s a matter of being blunt — saying that the $1 million they see on their account statement isn’t worth $1 million; they may only have $700,000 or less to spend after paying taxes.

Once clients understand that, they also understand the appeal of Roth IRA and Roth 401(k) accounts, since current income and qualified distributions are never taxable. Another advantage: The IRS also does not require distributions from Roth IRAs the way it does for traditional retirement accounts. For many high income taxpayers, $700,000 in a Roth IRA is more valuable than $1 million in a traditional IRA.

But Roth IRAs and 401(k)s aren’t perfect and shouldn’t be a client’s only savings vehicle either. Participants don’t receive any upfront tax benefit. And it’s conceivable that future legislation may decrease or eliminate the benefits of Roth accounts. If the U.S. or certain states shift to a consumption-based tax system, for example, a Roth IRA will have been a poor choice compared to a traditional IRA.

And it’s useful to have money in taxable accounts, too. People need to have enough in these accounts to meet their pre-retirement spending needs. In addition, holding some stock investments in taxable accounts allows people to take advantage of a market downturn by realizing capital losses and securing a tax benefit. You can’t do this with a retirement account.

Given that each type of investment account has advantages and disadvantages, advisers should encourage all their clients to keep at least some assets in each retirement bucket. That way, retirees have the flexibility to choose the source of their spending based on the tax consequences in a particular year.

In a low-income year, retirees may want to pull some money from their traditional IRAs to benefit from that year’s low tax bracket. Depending on the retiree’s income level, some traditional IRA distributions could escape either federal or state income tax entirely. In a high-income year, when investments in a taxable account have a lot of appreciation, it may make sense for the retiree to spend from a Roth account instead.

Since we don’t know what a client’s tax situation will look like each year in the future, diversification of account types is just as prudent as investment diversification.

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Benjamin Sullivan is a manager at Palisades Hudson Financial Group, where he helps the firm’s high-net-worth clients with their personal financial planning, investment and tax planning needs. He is a certified financial planner certificant, an IRS enrolled agent, and a member of the New York chapter of the Financial Planning Association.

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