Get With The Plan: October 17, 2010

101710Will and Liz are saving, but they’re also paying out a hefty sum for college tuition. Their oldest child is a junior in college, and their youngest will start next year. Some of the college funding comes from savings but a lot is coming from current cash flow.

“I feel we are not making any headway, especially in light of heavy education expenses,” says Will, 53. “I am basing my planning on working at my current job another 13 years to reach full Social Security retirement age. If I don’t, the future savings will not be there as I do not think I can duplicate what I am earning at another job at my age.”

Will and Liz, 54, have set aside $580,514 in 401(k) plans, $87,381 in IRAs, $198,100 in a brokerage account, $130,597 in mutual funds, $96,972 in bonds, $242,749 in CDs, $277,588 in money markets, $86,381 in savings and $28,956 in checking. They also have $74,874 earmarked for college bills.

The couple also pays 10 percent of their income to charity.

The Star-Ledger asked Jerry Lynch, a certified financial planner with JFL Consulting in Fairfield, to help Will and Liz look at their overall financial position to see what they can do better.

Lynch says the couple is saving a good amount to Will’s 401(k): $22,000 in contributions plus a $9,600 company match. Before college bills, they saved about a third of their income.

“Any time someone saves that much, it means that they are living below their means and over time, that person will be very successful,” he says.

The couple needs to better diversify their investments, however. For example, Will’s substantial 401(k) plan is only split among four mutual funds. Plus, 85 percent is in stock investments.

What’s more, excluding liquid funds, 92 percent of all their invested holdings is in equities — extremely aggressive given that they consider themselves moderate in risk.

“They also own a good amount of individual stocks, but literally all these stocks are in the S&P 500,” Lynch says. “In addition, they own S&P 500 mutual funds so they are not getting more diversification by owning these stocks.”

Lynch prefers a more balanced approach.

Because Will earns a very good income, Lynch recommends he keep about 18 months of expenses in cash. Excluding charity, that would be about $100,000.

He suggests they set aside the additional college expenses and then dollar-cost-average into a diversified portfolio over the next 12 to 24 months.

Next, charity. They currently “tithe,” or give 10 percent of their total gross income, or about $30,000 a year, to charity.

Lynch says the problem is they are giving cash, which is one of the least effective ways to give money to charity.

“In order for them to give $30,000 to charity, they have to earn about $50,000, pay about $20,000 to the fed and state governments, and they get back about $9,000 after taxes,” Lynch says.

Instead, he says, if they donate appreciated securities, they’d avoid paying the capital gains on a state and federal level. This is especially important, Lynch says, as taxes are scheduled to increase in 2011.

New Jersey is a unique state from a tax perspective, Lynch says, as charitable contributions are not tax deductible. Plus, the state does not have a lower capital gains rate like the federal government does. That means if Will and Liz donate stock instead of cash, they wouldn’t have to pay capital gains in 2011, saving 20 percent in federal and 6.37 percent for New Jersey.

This change in gifting strategy could save $6,592 in taxes.

There are other tax considerations for the family. Lynch says their taxable interest last year was about $5,000. The couple should look at some tax-advantaged investments instead.

The couple also receives dividends from some of their stock holdings, and that could get expensive next year. Today, these dividends are taxed at a low 15 percent, but next year, those dividends will be taxed as ordinary income, which for this couple is a rate of 36 percent.

“This is a 140 percent increase that will result in them paying an additional $2,344 in taxes,” Lynch says. “Dividend-paying stocks need to be owned in a tax-deferred account like an IRA, not in a taxable account due to their tax rate and this change. This is huge.”

Lynch says the couple also has not been taking advantage of offsetting capital gains with losses. He says a portfolio almost always has a loss somewhere, so the couple should sell losers to offset gains. For example, Lynch said, in 2008, the couple could have saved $1,500 by offsetting gains.

“With some minor changes, we are looking at savings of about $12,000 annually,” Lynch says. “We all have to pay our fair share of taxes but we do not have to leave a $12,000 tip.”