December 2014 Newsletter

Four Questions to Ask Before You Open Your Wallet

Even if you have the best of intentions, it’s easy to overspend. According to a Gallup poll conducted June 9-15, 2014,* 58% of people who had shopped during the previous four weeks said they spent more at the store than they originally intended to. Even if you’re generally comfortable with how much you spend, you may occasionally suffer from a case of buyer’s remorse or have trouble postponing a purchase in favor of saving for a short- or long-term goal. Here are a few key questions to consider that might help you fine-tune your spending.

How will spending money now affect me later?
When you’re deciding whether to buy something, you usually focus on the features and benefits of what you’re getting, but do you think about what you’re potentially forgoing? When you factor this into your decision, what you’re weighing is known as the opportunity cost. For example, let’s say you’re trying to decide whether to buy a new car. If you buy the car, will you have to give up this year’s family vacation to Disney World? Considering the opportunity cost may help you evaluate both the direct and indirect costs of a purchase. Some other questions to ask:
• How will you feel about your purchase later? Tomorrow? Next month? Next year?
• Will this purchase cause stress or strife at home? Couples often fight about money because they have conflicting money values. Will your spouse or partner object to your purchasing decision?
• Are you setting a good financial example? Children learn from what they observe. What messages are you sending through your spending habits?

Why do I want it?
Maybe you’ve worked hard and think you deserve to buy something you’ve always wanted. But are you certain that you’re not being unduly influenced by other factors such as stress or boredom? Take a moment to think about what’s important to you. Comfort? Security? Safety? Status? Quality? Thriftiness? Does your purchase align with your values, or are you unconsciously allowing other people (advertisers, friends, family, neighbors, for example) to influence your spending?

Do I really need it today?
Buying something can be instantly and tangibly gratifying. After all, which sounds more exciting: spending $1,500 on the ultra-light laptop you’ve had your eye on or putting that money into a retirement account? Consistently prioritizing an immediate reward over a longer-term goal is one of the biggest obstacles to saving and investing for the future. The smaller purchases you make today could be getting in the way of accumulating what you’ll need 10, 20, or 30 years down the road. Be especially wary if you’re buying something now because “it’s such a good deal.” Take time to find out whether that’s really true. Shop around to see that you’re getting the best price, and weigh alternatives–you may discover a lower-cost product that will meet your needs just as well. If you think before you spend money, you may be less likely to make impulse purchases, and more certain that you’re making appropriate financial choices.

Can I really afford it?
Whether you can afford something depends on both your income and your expenses. You should know how these two things measure up before making a purchase. Are you consistently charging purchases to your credit card and carrying that debt from month to month? If so, this may be a warning sign that you’re overspending. Reexamining your budget and financial priorities may help you get your spending back on track. *Source: American Consumers Careful With Spending in Summer 2014, www.gallup.com.

 

Saving for College: 529 Plans vs. Roth IRAs

529 plans are vehicles tailor-made for college savings. But some parents like the flexibility of using Roth IRAs. So how does a favorite of the college savings world stack up against a favorite of the retirement savings world when it comes to putting money aside for college?

Contributions
529 plans: People at all income levels can contribute to a 529 plan. Lifetime contribution limits are high, typically $300,000 and up. And if certain requirements are met, 529 plans let you gift large lump sums gift-tax free–up to five years worth of the $14,000 annual gift tax exclusion, which would be up to $70,000 for single filers and $140,000 for married joint filers (in 2014).

Roth IRAs: Not everyone is eligible to contribute to a Roth IRA. Income must be below $129,000 for single filers or $191,000 for joint filers (in 2014). In addition, Roth IRAs have annual contribution limits–$5,500 per year, or $6,500 if you’re age 50 or older (in 2014).  Bottom line: Only 529 plans offer unlimited eligibility and the ability to make large lump-sum gifts in a single year.

Federal tax benefits
529 plans: Earnings accumulate tax deferred and are tax free if account funds are used to pay the beneficiary’s qualified education expenses (a broad term that includes tuition, fees, room, board, and books). States generally follow this tax treatment, and some offer an additional tax benefit: a deduction for 529 plan contributions. But if 529 plan funds are used for any other purpose, the earnings portion of the withdrawal is subject to income tax and a 10% federal tax penalty. Essentially, Uncle Sam is telling you to use the money for college.

Roth IRAs: Earnings in a Roth IRA also accumulate tax deferred and are tax free if a distribution is qualified. A distribution is qualified if a five-year holding period is met and the distribution is made: (1) after age 59½, (2) due to a qualifying disability, (3) to pay certain first-time home-buyer expenses, or (4) by your beneficiary after your death. If your distribution is not qualified, the earnings portion is subject to income tax and, if you’re younger than 59½, a 10% early-withdrawal penalty (unless an exception to the penalty applies). Again, Uncle Sam is encouraging you to wait and use the money for retirement. One
exception to the early-withdrawal penalty is when a withdrawal is used to pay college expenses. So it comes down to your age. Once you’ve met both the age 59½ and five-year holding requirements, money you withdraw from your Roth IRA to pay your child’s college expenses is tax free. But if you withdraw funds before age 59½ to pay college expenses–the likely scenario for most parents–you might owe  income tax on the earnings but not an early-withdrawal penalty. (Nonqualified distributions draw out contributions first and earnings last, so you could withdraw up to the amount of your contributions and not owe income tax.) Bottom line: 529 plans offer more potential tax benefits if the funds are used for college. But Roth IRAs offer greater flexibility for parents over age 59½ who are paying college bills.

Investment choices 
529 plans: With a 529 plan, you’re limited to the investment options offered by the plan. Most plans offer a range of static and age-based portfolios (where the underlying investments automatically become more conservative as the beneficiary gets closer to college) with different levels of risk, fees, and management goals. If you’re unhappy with the market performance of the option(s) you’ve chosen, you can generally change the investment options for your future contributions at any time. But you can change the options for your existing contributions only once per year (per federal law).

Roth IRAs: With a Roth IRA, you can generally choose from a wide range of investments, and you can typically buy and sell investments whenever you like. Bottom line: The 529 plan rule of “one
investment change per year” on existing contributions may restrict your ability to respond to changing market conditions.

Financial aid
529 plans: Under federal aid rules, 529 accounts are counted as parental assets (assuming the parent is the account owner), and 5.6% of parental assets are deemed available for college expenses each year.
Colleges also consider the value of 529 plans when distributing their own institutional aid. Roth IRAs: Under federal aid rules, retirement assets are not counted at all, so Roth IRAs don’t impact federal aid in any way. However, colleges may consider retirement plan balances when distributing their own aid. Bottom line: Only 529 plans count in both federal and college financial aid calculations.

 

Investor, Know Thyself: How Your Biases Can Affect Investment Decisions

Traditional economic models are based on a simple premise: people make rational financial decisions that are designed to maximize their economic benefits. In reality, however, most humans don’t make decisions based on a sterile analysis of the pros and cons. While most of us do think carefully about financial decisions, it is nearly impossible to completely disconnect from our “gut feelings,” that nagging intuition that seems to have been deeply implanted in the recesses of our brain. Over the past few decades, another school of thought has emerged that examines how human psychological factors influence economic and financial decisions. This field–known as behavioral economics, or in the investing arena, behavioral finance–has identified several biases that can unnerve even the most stoic investor. Understanding these biases may help you avoid questionable calls in the heat of the financial moment.

Sound familiar?
Following is a brief summary of some common biases influencing even the most experienced investors. Can you relate to any of these?
1. Anchoring refers to the tendency to become attached to something, even when it may not make sense. Examples include a piece of furniture that has outlived its usefulness, a home or car that one can no longer afford, or a piece of information that is believed to be true, but is in fact, false. In investing, it can refer to the tendency to either hold an investment too long or place too much reliance on a certain piece of data or information.

2. Loss-aversion bias is the term used to describe the tendency to fear losses more than celebrate equivalent gains. For example, you may experience joy at the thought of finding yourself $5,000 richer, but the thought of losing $5,000 might provoke a far greater fear. Similar to anchoring, loss aversion could cause you to hold onto a losing investment too long, with the fear of turning a paper loss into a real loss.

3. Endowment bias is also similar to loss-aversion bias and anchoring in that it encourages investors to “endow” a greater value in what they currently own over other possibilities. You may presume the investments in your portfolio are of higher quality than other available alternatives, simply because you own them.

4. Overconfidence is simply having so much confidence in your own ability to select investments for your portfolio that you might ignore warning signals.

5. Confirmation bias is the tendency to latch onto, and assign more authority to, opinions that agree with your own. For example, you might give more credence to an analyst report that favors a stock you recently purchased, in spite of several other reports indicating a neutral or negative outlook.

6. The bandwagon effect, also known as herd behavior, happens when decisions are made simply because “everyone else is doing it.” For an example of this, one might look no further than a fairly recent and much-hyped social media company’s initial public offering (IPO). Many a discouraged investor jumped at that IPO only to sell at a significant loss a few months later. (Some of these investors may have also suffered from overconfidence bias.)

7. Recency bias refers to the fact that recent events can have a stronger influence on your decisions than other, more distant events. For example, if you were severely burned by the market downturn in 2008, you may have been hesitant about continuing or increasing your investments once the markets settled down. Conversely, if you were encouraged by the stock market’s subsequent bull run, you may have increased the money you put into equities, hoping to take advantage of any further gains. Consider that neither of these perspectives may be entirely rational given that investment decisions should be based on your individual goals, time horizon, and risk tolerance.

8. A negativity bias indicates the tendency to give more importance to negative news than positive news, which can cause you to be more risk-averse than appropriate for your situation.

An objective view can help
The human brain has evolved over millennia into a complex decision-making tool, allowing us to retrieve past experiences and process information so quickly that we can respond almost instantaneously to perceived threats and opportunities. However, when it comes to your finances, these gut feelings may not be your strongest ally, and in fact may work against you. Before jumping to any conclusions about your finances, consider what biases may be at work beneath your conscious radar. It might also help to consider the opinions of an objective third party, such as a qualified financial professional, who could help identify any biases that may be clouding your judgment.

 

Do I have to pay an additional tax on investment income?

You might, depending on a few important factors. A 3.8% net investment income tax is imposed on the unearned income of high-income individuals. The tax is applied to an amount equal to the lesser of:
• Your net investment income
• The amount of your modified adjusted gross income (basically, your adjusted gross income increased by an amount associated with any foreign earned income exclusion) that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, and $125,000 if married filing a separate return).

So if you’re single and have a MAGI of $250,000, consisting of $150,000 in earned income and $100,000 in net investment income, the 3.8% tax will only apply to $50,000 of your investment income. The 3.8% tax also applies to estates and trusts. The tax is imposed on the lesser of undistributed net investment income or the excess of MAGI that exceeds the top income tax bracket threshold for estates and trusts ($12,150 in 2014). This relatively low tax threshold potentially could affect estates and trusts with undistributed income. Consult a tax professional.

What is net investment income?
Net investment income generally includes all net income (income less any allowable associated deductions) from interest, dividends, capital gains, annuities, royalties, and rents. It also includes income from any business that’s considered a passive activity, or any business that trades financial instruments or commodities. Net investment income does not include interest on tax-exempt bonds, or any gain from the sale of a principal residence that is excluded from income. Distributions you take from a qualified retirement plan, IRA, 457(b) deferred compensation plan, or 403(b) retirement plan are also not included in the definition of net investment income.

 

How can college students save and spend money wisely?

College is a pivotal time in a young adult’s life. Students gain a sense of independence that is accompanied by responsibility–especially when it comes to finances. If you’re a new college student, it can be overwhelming to figure out how to save and spend money wisely. However, if you take time to plan, you won’t have to worry about spending money carelessly. And your parents will be glad to avoid desperate pleas for cash over the phone.

It may be helpful to review campus resources ahead of time so you can eliminate items that you don’t necessarily need to bring with you to school. Why bring your car and pay for an expensive parking pass if you can use free public transportation? Similarly, it might make more sense to borrow textbooks from your university’s library or rent them rather than fork over the dough to buy pricey books you’ll use for a single semester.

Next, establish a monthly budget. Track your expenses for a month to determine where most of your money is going, then look for the areas where you need to reevaluate your spending. For example, you may be spending too much on take-out when you already have a prepaid meal plan at your school. Take advantage of your plan and put that money toward something else in your budget like clothing or
entertainment.

What if you have excess cash? Set aside a few dollars each week to create an emergency fund. Over time, that money could accumulate, and you never know when it might come in handy. But if you still find yourself strapped for cash, most college campuses offer a variety of part-time jobs that are designed to fit into a student’s busy schedule. Ask about a job the next time you go to the gym for a workout or the
dining hall for a meal. Or you can use your school’s career service website to browse work-study options available on campus. As long as you’re aware of what’s available to you, you’ll be better informed to make wise money decisions, which enables you to focus on making the most of this chapter in your academic career.

 

DISCLAIMER: This newsletter is for informational purposes only and does not constitute a complete description of our investment advisory services or performance. This newsletter is neither a solicitation nor an offer to sell securities or investment advisory services except, where applicable, in states where we are registered or where an exemption or exclusion from such registration exists. Any information contained in this newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding market or other financial information, is obtained from sources which we and our suppliers believe to be reliable. However, we do not warrant or guarantee the timeliness or accuracy of this information. Nothing in this newsletter should be interpreted to state or imply that past results are any indication of future performance. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION WRITTEN IN THIS OR ANY ‘LINKED’ ARTICLE.