“We want tax-efficient financial planning for our son’s college and retirement at age 55,” says José. “Also, should we convert our 401(k)s to Roth IRAs?”
The couple, whose names have been changed, have saved $256,115 in 401(k) plans, $10,000 in an IRA, $283,784 in mutual funds, 20,000 in a brokerage account, $53,700 in Certificates of Deposit, $38,950 in savings and 21,500 in checking.
The Star-Ledger tapped Doug Buchan, a certified financial planner with Tilson Financial Group in Watchung, to help the couple determine the best way to fund college and to prepare for retirement.
“When asked on a scale of one to 10 how important it is for them to be able to fully fund college, Jose said, ‘20!,’ ” says Buchan.
The couple say they don’t want to limit their child’s choice of college based on cost. With many private schools already north of $50,000 per year, getting some money to work in the right way is paramount, he said.
Buchan says aggressively funding a 529 plan is by far the best option. He calls it the “queen mother of all college savings strategies.”
Tax treatment on a 529 is very similar to the tax treatment of a Roth IRA. Like the Roth, Buchan says the couple would fund a 529 with after-tax dollars, then all earnings and income from the investments are tax-free as long as the money is used at an accredited college.
Additionally, they can gift their child’s 529 plan a significant amount of money in one shot without any gift tax implications.
“The current gift exclusion is $13,000, but 529 plans allow five-year acceleration, meaning the couple can gift $65,000 each, or $130,000 between the two of them, to their child in 2010 without any gift tax implications,” Buchan says.
And there’s more.
Making this gift takes the funds out of the couple’s estate, so in the event of an unexpected death, this could reduce estate taxes owed. Also, the couple could take the gift back if they ever needed to.
He recommends the couple fund a 529 plan with $50,000 in 2010, $50,000 in 2011 and $30,000 in 2012. They should then reassess the account in 2015 to determine if further funding is needed.
Which 529 plan to use? Buchan says some states offer tax benefits if residents use their “home state” plan, but New Jersey does not.
“There is no reason to use New Jersey’s plan if it’s not the best plan available, and in my opinion, it’s not even close,” he said.
They should consider a low-cost plan that offers a wide range of investment choices. He likes West Virginia’s plan, despite the high state management fee, or any of the states that offer mutual funds from Vanguard, Fidelity, TD Ameritrade and TIAA-CREF.
“The particular state doesn’t matter. It’s the funds and fund options that are important,” Buchan says.
He suggests they choose an age-based investment option and their risk tolerance.
“I am not a big fan of age-based plans or target date funds for retirement, but I believe they make a whole heck of a lot of sense for college planning,” he says, noting he likes Fidelity’s age-based plans the best because of its rebalancing methods and low cost.
Buchan says retirement at age 55 for José and Maria is attainable as long as they don’t stray off path. He says they’re maxing out their retirement plans and saving substantially outside of those plans.
“If they continue to save aggressively and continue to keep their investments allocated properly, they are on their way to achieving their retirement goal,” Buchan says.
On the option of a Roth IRA conversion, Buchan says the strategy has received significant press recently because the conversion is now allowed for high income earners and for some, he says converting is an absolute no-brainer.
For most though, including this couple, it’s not so easy.
“The short answer is it depends on multiple variables, some of which are not known,” Buchan says. “The long answer is to sit down with an adviser you trust to walk through the details of all the pros and cons of your particular situation.”
He says the couple won’t know what their taxable income will be or what marginal tax rates will be 20 years from now, so diversification — even with potential tax burdens — can be worth considering.
“Rolling over a portion of tax deferred assets (401ks/IRAs) to tax free-assets (Roth 401ks/Roth IRAs) is a prudent strategy to diversify your future tax burden,” he says.