Suze Orman's Action Plan (23 page)
Read Suze Orman's Action Plan Online
Authors: Suze Orman
SITUATION:
Your child is set to go to college next year. You want to stop putting money in your 401(k) and use those funds to pay for your child’s education. Should you?
ACTION:
No, no, no. Your retirement account must come first.
There is nothing—and I mean nothing—that takes precedence over locking in short-term security (in the form of an eight-month emergency savings account) and providing for long-term security by continuing to invest for your retirement.
I am not insensitive to the importance you place on providing the opportunity for your children to achieve and realize their greatest potential in life. And I am aware that it is not an easy thing to do to ask that your children share the cost of college by
taking out student loans. But it is necessary. Please review “Action Plan: Retirement” for my advice on why it is never wise to stop or suspend saving for retirement, and why down markets can actually be a good thing if you are saving for a goal that is 10, 20, or 30 years away.
Most important to keep in mind is that you need your retirement money waiting for you in retirement. If it’s not there, you could end up being a financial burden for your kids. If you fail to save today, what will you have to live on in retirement? Now, don’t worry, I am not suggesting you leave your kids high and dry. As I explain in the following pages, both your child and you can take out federal loans to help pay for school.
SITUATION:
You want to borrow from your 401(k) to cover the college bills.
ACTION:
Don’t you dare. It is never smart to touch your retirement savings to pay for another expense. Even if you have every intention of paying back the loan, there’s simply no guaranee that you will be able to. And to repeat myself: What happens if you lose your job? You need to understand that any outstanding loan must be repaid within a few months or the loan is considered a withdrawal. That will trigger income tax on the entire amount you withdrew and typically a 10% early-withdrawal penalty if you are not 55 or older when
you are laid off. If you need to come up with money for college, federal loans are the best option.
SITUATION:
You want to use IRA savings to pay for your child’s college tuition.
ACTION:
As I said earlier, raiding your retirement funds to pay for college is not ideal. What will you live on in retirement? Another potential problem is that taking an early distribution from an IRA can affect your child’s financial aid eligibility; the withdrawal will be treated as parental income, and that is a major factor in determining aid. My advice: Don’t touch your IRA to pay for college.
For those of you who refuse to follow this advice, I do want to point out that if you withdraw money early from your IRA to pay for college costs you will not owe the 10% early-withdrawal penalty typically charged by the IRS on withdrawals made before age 59½. You may, however, owe income tax on the withdrawn money. Withdrawals of money you contributed to a Roth IRA will not be taxed, though earnings may be taxed. Money withdrawn from a traditional IRA may be subject to income tax.
SITUATION:
You have no credit card debt and your retirement savings is on track, so you want to start a college savings fund, but you are not sure about the best way to invest.
ACTION:
A 529 savings plan is one of the easiest and smartest ways to save for future college costs. Money you invest in a plan grows tax-deferred, and eventual withdrawals will be tax-free if they are used for “qualified” college costs. There is also no income-eligibility requirement; all families can set up a 529, and contributions can come from parents, grandparents, aunts, uncles, friends. In addition to 529 plans, there are indeed other savings options, such as Coverdell Educational Savings Accounts and U.S. savings bonds. I highly recommend you check out the website
www.savingforcollege.com
; it is hands-down the most informative site for parents who want to save for their kids’ future college costs.
SITUATION:
You have been putting money into a 529 plan every month since your little one was born. After living through the bear market that began in 2008, you’re thinking you should move your money out of your plan’s stock fund choice and into bonds or cash offered by the 529 plan. Good idea?
ACTION:
Nooo. If you have at least 10 years until you need your money, you have time on your side to ride out volatility in the stock market. You don’t want to stop investing in stocks, or pull out of stocks when you have time on your side; the smart move is to invest
more
in your 529 plan’s stock fund, not less!
SITUATION:
The bear market that began in 2008 spooked you, and now you want to quit the 529 and move all the money into a safe bank account.
ACTION:
Do not do this, because it can have significant tax consequences. Money you leave in a 529 that is eventually used to pay for college expenses is free of federal tax and state income tax too (except in Alabama, should you use a non-Alabama 529). But if you pull the money out, you can be hit with a 10% penalty tax on any earnings on that account. Below you will find my recommendations for the right mix of stocks and bonds in your 529, based on your child’s age. If you feel you simply can’t stand to remain invested in stocks, then shift the money into a stable-value account within the 529.
SITUATION:
Your child starts college in two years and your 529 is 100% in stocks.
ACTION:
This is too risky. When your child is within a year or two of freshman year, you no longer have time on your side. You are going to have to start using that money sooner rather than later, so you need to make sure your money is safe and sound in the 529 plan’s bond or money market fund. My recommendation is that you slowly shift money out of stocks and into bonds starting at age 14. You goal should be that you are completely out
of stocks by the time your child is five years from
senior year in college
—typically, that is age 17.
| Under age 14: | 100% stocks |
| Age 14: | 75% stocks |
| Age 15: | 50% stocks |
| Age 16: | 25% stocks |
| Age 17: | 0% stocks |
If your current allocation exceeds those targets, I recommend you rebalance your portfolio ASAP.
Those of you who have opted for a fund in your 529 plan that automatically changes its allocation as your child gets closer to college still need to pay attention and understand how much you will have invested in stocks when your child hits 14, 15, 16, 17, and 18. I have seen plans with up to 50% in stocks a year or two before the child will enter school. That’s unacceptable.
If you find your target fund overloads on stocks close to college, I recommend moving out of the target option, finding the best low-cost stock and bond fund options offered by the plan, and putting your money in both those funds according to the strategy above.
SITUATION:
You have time on your side, but after watching your child’s college fund plummet, you just can’t stomach keeping the entire portfolio invested in stocks.
ACTION:
It’s fine to move up to 20% into bonds. A small amount of bonds will reduce your portfolio’s overall loss in a bear market, and if that helps you stay committed to investing and helps you sleep better, then it is the right move for you.
SITUATION:
You tried to move money out of your 529 plan’s stock fund and into the bond fund option, but you were told you had to wait until next year.
ACTION:
Understand that an IRS rule requires 529 plans to limit participants to rebalancing their portfolio just once a year. The reasoning is that you can’t be trusted to be a patient long-term investor, so this rule was meant to keep you from day-trading your kid’s college fund. As if. A special regulation in effect in 2009 allowed two rebalancing moves during the year. Please check my website for an update on whether this rule was extended past 2009.
SITUATION:
Your family doesn’t qualify for financial aid (or the aid package isn’t as much as you expected), but you don’t have money to pay the college bills this year.
ACTION:
First, you need to take a deep breath. I know it is stressful. I know it is upsetting. But you do have options. One of the great misconceptions is that federal loans are only for students and families
that meet certain income-eligibility rules. That is absolutely incorrect. In addition to the many forms of aid and loans that are income-based, there are also affordable loans available for students and parents regardless of family wealth or income. If you find that your school’s financial aid package is not enough to cover all your costs, you can supplement that aid with non-income-based loans.
The first step is for your child, the student, to apply for both subsidized and unsubsidized Stafford loans. Yes, your child borrows first, not you. Staffords are the cheapest loan options. If you want to make a side agreement with your child that you will help with the repayment of the Staffords, that’s fine. But please get over any concern or guilt about having your child borrow first.
If you meet income-eligibility rules, your child may qualify for a subsidized Stafford loan. (It is typically part of a financial aid package you receive from the school.) Subsidized means the federal government pays the interest on the loan while your kid is in school. The interest rate for a subsidized loan is 5.6% for the 2009–2010 school year. Subsidized Staffords issued in the 2010–2011 school year will have a 4.5% interest rate. Loans issued for the 2011–2012 school year will carry a rock-bottom 3.4% interest rate. That’s a fraction of what you can end up paying for a private student loan. But here’s what so many people fail to understand:
Anyone, regardless of income, can apply for an unsubsidized Stafford
. The interest rate is fixed at 6.8% and interest payments are the responsibility of the student. (The rate on unsubsidized Staffords will not change for the 2010–2011 and 2011–2012 academic years.) The student can opt to not pay interest while in school and have it added to the loan balance. Here’s a suggestion: If Grandma and Grandpa want to know how they can help with school, ask them to cover the unsubsidized Stafford interest payments so their grandchild can graduate with a lower loan balance. If that’s not an option, your child can work during school and make the interest payments him-or herself.
SITUATION:
How much can you borrow on a Stafford loan in 2009?
ACTION:
For the 2009–2010 academic year, freshmen can now borrow $5,500; sophomores $6,500; and juniors and seniors $7,500. Children who are not claimed as dependents by their parents are eligible for higher amounts. For subsequent years you can check the
finaid.org
website.
SITUATION:
Your child qualifies for a subsidized loan, but you need more money.
ACTION:
Make sure your child applies for an unsubsidized Stafford too. After maxing out on the
subsidized loan, your child is eligible for up to another $2,000 a year in an unsubsidized Stafford. Your school’s financial aid office should automatically alert you to this, but the sad fact is that many families leave Stafford money on the table every year because they don’t understand the rules about unsubsidized loans.
SITUATION:
What do you have to do to apply for Stafford loans?
ACTION:
There is one big requirement for Stafford loans (and school financial aid): You must complete the Free Application for Federal Student Aid (FAFSA). No FAFSA, no Staffords. It is not a fun form to fill out, but spending a few hours wading through all the financial disclosure is worth it, trust me. Check with the school’s financial aid office; they are set up to help you navigate this process.
SITUATION:
You have applied for subsidized and unsubsidized Stafford loans, but you need even more money.
ACTION:
Apply for a Parental PLUS loan, another federal loan program. The parent, not the student, is the borrower. There is no income limit, and you can borrow up to the full amount of college costs minus any aid and other loans. The interest rate is
a fixed 8.5% for most borrowers. (It is 7.9% if the school is part of a program that has you borrow directly from the federal government, rather than using a third-party lender. Only 20% or so of schools are currently part of the Federal Direct Loan program. But as I write this, the Obama administration has proposed that all federal loans be administered directly. The financial aid office at your child’s school will advise you on how to apply for a PLUS.) But I want to be clear: You apply for a PLUS only after your child has maxed out on the Staffords. A PLUS is a very good deal, but Staffords are even better given their lower interest rates. Staffords first. PLUS second.
SITUATION:
You looked into a PLUS loan when your older child went to college a few years ago, but the repayment rules were too tough, so you’re thinking it won’t be an option for your younger children.
ACTION:
Give the program a fresh look. In 2008 big changes were made to the PLUS program that make this a more viable and affordable option.
The big change is that you no longer must repay the loan while your child is in school; you can wait until your child finishes school. As I explain below this can be a huge help.
You will also find the qualifying rules for a PLUS to be less stringent than other types of loans. There is no FICO credit check per se to obtain a PLUS
loan, but your credit history is reviewed to check for any “adverse” actions on your credit profile. Families that have declared bankruptcy in the past five years are not eligible for a PLUS loan. (If you are turned down for a PLUS loan, your child can qualify for larger Stafford loans.) PLUS loans are also a little bit forgiving of small cash-flow problems. The standard regulation is that you can qualify for a PLUS as long as you are no more than 90 days behind on mortgage or medical payments. For 2009 this rule was extended to 180 days. Please check my website for an update on the rules past 2009.