Don't Be Spooked By the Market
By Kimberly Lankford, Contributing Editor
From Kiplinger's Personal Finance magazine, July 2008
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I am 52 years old. I have $22,000 in my 401(k) plus $10,000 in an IRA, and that's all of my retirement savings. My quarterly 401(k) statement showed a loss of $2,000. I can't afford to lose that much. My money is divided among UBS International and four T. Rowe Price funds: Balanced, Equity Income, New Horizons and Summit Cash. Should I do anything? I am terrified.
Robin Brown; Huntington Beach, Cal.
The first quarter was a rotten one for most markets, and because you effectively have 75% of your investments in stocks, your portfolio took a beating. Unfortunately, this kind of setback occurs frequently. Since 1926, the U.S. stock market has lost money in roughly one year out of every four, on average.
Consider short-term volatility the price you have to pay for the opportunity to earn superior long-term results. And over the long term, stocks have delivered superior results: an annualized return of more than 10% since 1926. That includes the catastrophic 90% loss that coincided with the Great Depression, plus bear-market declines of nearly 50% in 1973-74 and 2000-02.
Nevertheless, we agree with the conventional wisdom that you should base your investments on your time horizon and your personal tolerance for risk. The longer your horizon, the more you should have in stocks. If you're planning to retire at, say, age 66, you're 14 years from your goal. A portfolio that's 75% in stocks and 25% in bonds and cash seems reasonable, assuming you can withstand occasional downward spirals.
As for your fund holdings, you are well diversified, with funds that specialize in big-company stocks, small companies and foreign firms. Your overseas fund, UBS International Equity, is nothing to write home about, having lagged the returns of other funds in its category by a few percentage points per year over the past five years. But it's better to have this fund than to have no foreign stock fund at all.
Bottom line: We wouldn't change a thing. Stick to your plan and try to keep your cool when the stock market sneezes.
Paying the college bills.
My son starts college this fall. Which account should I tap first to help pay the bills -- a custodial account, his 529 college-savings plan or a taxable account?
Kannan Sreedhar, Richmond
It all depends on your tax situation. If you're eligible for the Hope credit, for instance, you won't want to pay the full tuition bill from the 529 plan because you can't double-dip on income-tax breaks.
You can take the Hope credit if your adjusted gross income in 2008 is less than $116,000 on a joint return (or $58,000 if you're single). In that case, you get a tax credit of up to $1,800 per child for the first two years of college, which lowers your tax bill dollar for dollar. In order to claim the credit, however, you have to pay at least $2,400 of your bill from an account other than a 529.
After your child's first two years of college, you may qualify for a lifetime-learning credit of up to $2,000 per tax return. You have to meet the same income requirements as for the Hope credit, plus you have to pay at least $10,000 in college bills from a source other than a 529 plan.
If your income is higher, you might qualify for a tax deduction for tuition and fees (a tax break that has expired but could be revived for 2008 returns). Once again, however, to be eligible you can't pay the entire college bill from a 529 savings account.
After you've maximized your tax breaks -- or if you don't qualify for any in the first place -- go ahead and tap your son's 529 plan. Money from that account can be used tax-free to pay for tuition and other qualified college expenses.
From a tax perspective, tapping your son's custodial account becomes a bit dicier. The first $900 of a child's unearned income is tax-free, and the next $900 is taxed at the child's rate -- which is 0% for long-term capital gains and qualified dividends in the bottom two tax brackets in 2008, 2009 and 2010.
But investment income above $1,800 is taxed at the parents' higher rate -- generally 15% for long-term capital gains. And this "kiddie tax" applies to dependents younger than 19 and full-time students younger than 24.
You can lower your tax bill by keeping your child's investment income (including dividends as well as capital gains on the sale of stock or mutual funds) below the $1,800 limit each year as long as your child is still in school. Your son could withdraw the rest of his money, and pay taxes at his own rate, after graduation or age 24, whichever comes first.
Note: Your child needs to be on board with this strategy because he gains control of the custodial account when he reaches the legal age. That's generally 18 or 21, depending on the state.
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