College Planning - SMR Strategic Investments

The Case for Individual Bonds

June 12, 2024 No Comments

Exchange Traded Funds (ETFs) are fantastic investment products that provide diversification at a relative low cost to investors. These funds can hold stocks, bonds, real estate, gold, or about any kind of investment you can think of. I use them for my clients and myself. However, when it comes to fixed income products there are some important reasons to consider using high grade individual bonds and CDs for your portfolio.

Predictability:

When you buy an individual bond, you know much you’re paying for it, how much it’s paying you, and how much you will receive when the bond is due. A steady stream of income can be created from several different individual bonds. This predictability can be particularly valuable for retirees relying on bond income to cover living expenses.

It is also helpful when you know a large expenditure is coming. Whether that is buying a house, paying for college, or any large ticket item, individual bonds can take the guess work out of returns. For example, you can buy a US Government Treasury or CD that comes due right before the date that you need the funds

Less Volatility:

Most bond funds have a target duration or time frame that they want to hold bonds. For example, the fund may target bonds that come due in about 10 years. To achieve is, they will usually own a collection of bonds that have 8 to 12 years until they are due. As time goes by and a bond has less than 8 years left, it will be sold and replaced by a bond that has 10-12 years left. They then go out and buy the best bonds for their fund. They are at the mercy of where current interest rates are at the time. This can lead to more inconsistent returns. Most bonds funds that aren’t very short-term funds don’t hold any bonds to maturity. This isn’t a criticism. It’s just how those funds work.

The strategy of using individual fixed income products works best using Certificates of Deposit or very high grade bonds, such as United States Government Treasuries and highly rated Municipal and Corporate Bonds. This greatly reduces risk of default. When it comes to lower grade and higher yield bonds, diversifying is very important. That’s why I do use ETFs for higher yield bonds. That’s when it’s better to pay them a small fee to own hundreds, or thousands, of different bonds from different issuers.

Avoiding Fund Fees and Expenses:

Bond funds typically charge management fees and expenses, which can erode investors’ returns over time. Most of the bond ETFs that I use charge very low fees, but they can add up over the long term, especially in periods of lower interest rates or market volatility. By investing in individual bonds, investors can bypass these fees and improve their overall returns.

Conclusion:

Building a fixed income portfolio is like putting together a puzzle. How much income is needed? How will this income be taxed? How much risk should I take? Diversification provided by ETFs is integral, but allocating at least some of your portfolio to individual bonds will take out some of the guesswork when you’re trying to solve your income needs.

Smart Money, Bright Futures: Your College Savings Playbook

November 2, 2023 No Comments

Saving for college can be intimidating. We know that we’re going to have a large expenditure coming up, but we don’t know how much. Where will they go to college? How much will it cost? College tuition inflation averaged 4.63% annually from 2010 to 2020. Since 2019, the price of tuition, fees, and room and board has been rather flat, and actually lower in some cases. I don’t think that we should plan for that to continue. I have included a list of a few college tuition rates at the end as a guide.

There are several different ways to save for college. I’m going to narrow this article down to 529s and Direct Payments. Under most circumstances, they will be the best options.

529 College Savings Plans

529 plans are fantastic tools that are designed specifically for college savings. Earnings grow tax-free and withdrawals for qualified education expenses are also tax-free. Qualified expenses are tuition, fees, books, supplies, and equipment. Room and board can also be included in many cases.

The owner of the 529 account is often a parent or family member of the beneficiary. The beneficiary of the account can also be changed, so if one child doesn’t go to college or doesn’t use all of the funds in the account, you can change the beneficiary of the account can be changed to a different child, as long as the new beneficiary is in the same generation as the original beneficiary. A student can also be a beneficiary of multiple 529 accounts.

Gifting Ideas for 529s

Annual Limit Single	Annual Limit Couples	5 Year Front-Load Single	5 Year Front-Load Couple
$17,000	$34,000	$85,000	$170,000

A contributor can give up to the annual gift exclusion amount each year without incurring a gift tax. In 2023, that amount is $17,000 per person. That $17,000 limit is per person, so a married couple can give up to $34,000 per year without incurring any gift tax liability. Another unique feature of 529 contributions is that a contributor can give up to 5 years worth of the annual gift exclusion amount without incurring gift taxes. The IRS will treat each year as 1/5 of the contribution per year. So, a contributor in 2023 can give $85,000 ($17,000 x 5) to any 529 beneficiary that they wish. A married couple can double that number to $170,000. They would then not be able to give that beneficiary any gifts for the next four years without incurring a gift tax penalty. Any amount given over the annual gift exclusion ($17,000) can be applied to the contributor’s lifetime exclusion, currently $12.92 million per person.

Contributions to 529 plans are not federally tax deductible. They can be deductible at the state level in some cases, but that depends upon the state.

If funds are not used for qualified education purposes, any distributions will be treated as ordinary income, and possibly incur a 10% penalty as well. Beginning in 2024, up to $35,000 can be rolled over a lifetime from a 529 to a Roth IRA tax-free, but there are some restrictions. This does help a little for those that are concerned about overfunding a 529 and potentially having to pay taxes later.

Direct Payments

You can pay for anybody’s tuition or medical expenses directly without it counting toward your annual or lifetime gift exclusion. Yes, you read that correctly. As long as the payment is made directly to an accredited educational institution, that gift is never applied to any of your exclusions. This is the most tax efficient way of gifting for college and reducing the size of your estate. Do not write a check to the student or their parents. The payment HAS to be made directly to the institution.

Investment Allocations

Since we know when we’re going to start withdrawing money from the account, we can thoughtfully plan our investment allocations. When the child is a baby or toddler, we can be more aggressive. The reason being that the longer time frame, the longer we have to make up losses in the event of a market decline. Stocks have traditionally outperformed bonds over longer time horizons, but typically bring more risk. This is the standard allocation for the Schwab 529 Education Savings Plan. Portfolios are not one-size-fits-all, but this is good information to keep in mind.

Stock Allocation of Age-Based Tracks

Age of Student	Aggressive	Moderately Aggressive	Moderate	Moderately Conservative
4 and Younger	95%	80%	60%	40%
5-7	80%	70%	60%	40%
8-10	70%	60%	50%	40%
11-13	60%	50%	40%	30%
14-15	50%	40%	30%	20%
16-17	40%	30%	20%	10%
18-19	30%	20%	10%	0%
20+	20%	10%	0%	0%

As you can see, allocations to stocks should decline as you get closer to paying those tuition bills, regardless of how much risk you are willing to take. Remember that this is just a guide. Speak to your advisor about what kind of allocations are right for you.

FAFSA

The Free Application for Federal Student Aid (FAFSA) is used to determine a student’s eligibility for financial aid. It takes into account the assets and income of the child and their parents. Income is more important than assets in this calculation. The student’s assets and income have a higher weighting than their parents. This make 529s a better option than trusts, because 529s are typically owned by a parent or grandparent, while a trust is often owned by the student.

Visit this website to get an idea of how much aid a student may receive.

https://studentaid.gov/aid-estimator/

Tuition, Fees, and Room and Board

College	In-State	Out-of-State
University of Illinois	$40,000	$62,000
Indiana University	$29,000	$57,000
UCLA	$39,000	$71,000
Harvard	$57,000	$57,000
Vassar College	$85,000	$85,000
Northwestern University	$88,000	$88,000

These numbers all come from the websites of the prospective schools. Total expenses for a four-year school can cost well over $100,000. Saving $4,000 a year for 15 years at a 6% return would bring the account value to $93,000. With some planning and consistent additions to a 529 account, college savings can be more manageable. The sooner that you start saving, the less stress you’ll have when your child starts filling out college applications and touring schools.

If you have any questions, please email me at shawn@smrstrategic.com.