Don’t Let Taxes Dictate Your Investing
Question: We have a 6-year-old grandson and are setting aside money for him under his Social Security number. After reading your article about the kiddie tax, I have the following questions:
If we invest in tax-free bonds, is the interest earned not taxable, regardless of the amount? Do we need to keep his taxable interest and income under $1,700? If we follow these steps, his mother (our daughter) will not have to report the interest or income on her tax form, right?
Answer: If your intention is to help your grandson finance school, you would probably be smarter to invest the money in a 529 state-sponsored education savings plan.
These accounts work much like a Roth IRA for college money. They shelter the investment returns from tax while the money is building. If the money is eventually used for college, the returns will never be subject to tax. You can put vast amounts of money in these accounts.
Every state sponsors a 529 plan and several states sponsor more than one. The investment options run the gamut, including age-based portfolios that get more conservative as the child gets closer to college age and funds that invest in all stocks or all fixed-income securities. Some states even provide tax deductions for money that is contributed to the accounts.
The best thing to do is check with your state to see whether it offers a 529 option and whether it provides tax deductions for your contributions. If it doesn’t offer tax deductions, or if you’re not wild about the investment options in your state’s plan, you can search for a better 529 plan at www.savingforcollege.com.
As for tax-free bonds: They’re tax-free, but you get a lower rate of interest on them to account for that. If you’re not avoiding tax at the highest rate, that’s not a good deal.
If you are saving for some purpose other than college, I’d suggest that you talk to both your daughter and a financial advisor. Then make the choice that makes the most personal sense, rather than what makes the most tax sense. The tax rules are moderately nuts. Don’t let them alter personal financial goals.
Forced 401(k) Payouts May Be an Opportunity
Q: I recently received information about the impending minimum distribution from my retirement plan. It gives details on how much money I will receive and what my options are. But I’m not being told why I have to take the funds at all.
I’m a widower who doesn’t need the money to live on. Why am I being legally forced to increase my income? Who did this to me and for what purpose?
A: The government requires minimum distributions after the age of 70 1/2 on tax-deductible retirement savings accounts, such as 401(k)s and traditional individual retirement accounts. That’s because Congress set up these accounts to provide a tax break to encourage you to save. They were never intended to be a tax-free legacy.
As a result, minimum distribution rules set up a formula by which you systematically drain the account over your expected life span. If you name a beneficiary, you can drain the account over your combined lives, and that can allow you to pull the money out more slowly.
But before you do that, here’s a thought: Because you don’t need this money, why don’t you give it away to your children or charity, or take your family or friends on vacation?
You don’t like the idea of having to pay taxes on money you don’t need. And I understand that. But what a shame it would be to die with a vast fortune when you could have enjoyed it more while you were alive.
Value of Starting Early to Save for Retirement
Q: I have two employees who recently graduated from college. I remember hearing long ago that if individuals begin contributing to a retirement account in their early 20s, they could contribute for just 10 years and accumulate the same retirement nest egg as those who start saving in their early 30s and contribute for their entire career.
I understand that there are other factors, but I want to impress upon these individuals the importance of starting their retirement savings early. If there’s an online resource that illustrates the above point, I would appreciate it.
A: I’m not sure whether the illustration you want is on the Web. However, your facts are right -- although somewhat understated, assuming historical average stock market returns of about 10%.
A hypothetical example can show how it works: Jane Jones starts contributing $10,000 a year -- $833 a month -- at age 25 and earns an average of 10% a year. At age 35 she’s got a tidy $170,704.
But then she decides to quit work for a few years to raise her young family. She stops contributing to the 401(k) but leaves the money alone to compound. For whatever reason, she never manages to save more. Is she lost at retirement? Hardly. She’ll have $3.4 million when she turns 65.
Now, consider John Smith, who starts saving at age 35. By age 45, he has the same $170,704. But, he continues contributing $833 a month for the rest of his career. What does he have at 65? About $1.88 million.
He’ll have to contribute significantly more or retire later to keep up with Jones, simply because she let her money compound for a decade longer.
It’s worth mentioning that this whole savings thing is not about being rich. It’s about being free.
The earlier you start saving, the more options you have.
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Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com.
