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Custom TDFs: A Fast-Growing Investment Segment

According to Morningstar, target-date funds (TDFs) attracted nearly $70 billion in 2015. Another research firm, Cerulli Associates, has predicted that 88% of new 401(k) contributions will go into TDFs by the end of 2019. As this market expands, new versions are appearing: the “custom” TDF has been labeled the fastest growing segment.

The rise of custom TDFs is somewhat ironic, as these funds are meant to be one-size-fits-all for investors. TDFs are on the short list of qualified default investment alternatives (QDIAs). Department of Labor (DOL) regulations allow retirement plan sponsors to put contributions by plan participants who do not specify investment choices into a QDIA without being responsible for investment losses. That’s a prime reason for the growth of TDFs.

Now that custom TDFs are emerging, they help to point out that “regular” TDFs have cons as well as pros. If you invest in a TDF or if you’re considering one, you should know what’s inside the package, so you can decide on an appropriate strategy, going forward.

Down shifting

As the name suggests, each TDF has a target date: 2030, 2035, 2040, etc. These dates are meant to indicate the year closest to a participant’s anticipated retirement date.

Example: Lynn Martin, age 40, begins a new job at a company with a 401(k) plan that includes a TDF series. She plans to retire at 65, so she chooses the TDF dated 2040, when Lynn will be 64.

A TDF typically will be a fund of funds. Thus, Lynn’s chosen TDF includes a variety of stock funds and bond funds, currently allocated in a manner that the fund company believes is suitable for someone 24 years from retirement.

In this hypothetical example, Lynn’s TDF now has 60% invested in equity funds and 40% in fixed-income funds. TDF funds have a “glide path,” decreasing the exposure to stocks as the target date nears. Lynn’s TDF might have 40% in equities and 60% in fixed income by 2040, providing less market volatility and more income for shareholders who are in or near retirement.

TDFs don’t cease to exist at the target date. Instead, they continue on, providing shareholders with the option of cashing in for retirement expenses or staying invested, just as would be the case with any mutual fund. Some TDFs reach their most conservative asset allocation at the target date and remain there in future years. Many other TDFs, though, continue on their glide paths by reducing equity exposure for another 5, 10, 15 years and sometimes even longer.

Different strokes

Just as not all TDFs are alike, the same is true for participating employee groups. “Vocation and location” can make a difference, Morningstar has asserted, when designing custom TDFs. A relatively young group of technology employees in Silicon Valley, for example, may well have a different approach to retirement planning than workers at an industrial plant in the Midwest. A company in the oil industry might better serve plan participants with a series of TDFs with less exposure to investments correlated with oil prices and energy stocks because employee job security in that industry is highly vulnerable to those trends.

TDFs can be customized in many ways, from tailoring the glide path to cherry picking underlying funds to including asset classes not found in standard TDFs. The constant, at least so far, is the expense involved in creating and administering custom TDFs. For now, custom TDFs are usually offered by companies with retirement plans holding at least $100 million of assets. As the concept evolves, custom TDFs may become available to smaller companies or even to specific employee groups within large firms.

No matter what type of TDF you might consider, look closely to see just how your money will be invested. Moreover, you should keep in mind that you can put together your own custom target date portfolio if you’re willing to devote the time and effort to researching your own investments. Alternatively, you can seek a financial adviser with a proven record of developing individualized asset allocation strategies for clients as they head towards and through retirement.

Veering from the pat

  • If you are considering a target-date fund (TDF) for professionally managed asset allocation, look at the current glide path. Are you comfortable with this mix of funds and the plans for the future?
  • Keep in mind that a TDF can change its glide path. These funds generally lost heavily in 2008, when the financial crisis occurred, so many TDFs decreased their equity exposure.
  • The TDFs that changed glide paths in 2008 may have missed some of the subsequent stock market rebound, before moving money back into equity funds.

HLB International Appoints New Members in China and Malta

HLB International, one of the leading global accountancy networks with presence in 130 countries, continues its growth with the recent signing of new members in China and Malta.

China

GP CPAs LLP joins the network in Guangzhou, the capital and largest city of Guangdong Province in South China. Established in 1981, the firm is not only the eldest accounting firm in Guangdong, but also the top ranking indigenous firm in South China, with more than 800 staff including 29 partners, 250 CPAs and 100 CTAs. The firm also ranks in the top 10 in capital markets services in China.

Ben He, International Contact Partner at GP CPAs LLP, said: “Joining HLB International is of great significance in the process of our firm’s development. As a new member of HLB International we look to promote the development of HLB in China, and hope to make a significant contribution on the network’s future growth.”

GP CPAs LLP appointment is strategically important for HLB’s regional development, and will bring positive changes in Greater China and positive influences in Asia Pacific.

www.gpcpa.cn

Malta

HLB CA Malta Ltd joins the network and will operate from its brand new offices situated in Lija, a strategic location in the center of Malta.

The firm provides Audit, Accounting and Tax Advisory services and, through related entities, also Company Setup and Company Administration Services including Fiduciary and Trust Services. The firm is a result of a merger between the business section of one of the former partners at HLB Falzon & Falzon and another firm in Malta, CA international, which from 2012 has developed a strong base of international business. The client base of the firm varies across all sectors of the Economy including Public Listed Companies on the Malta Stock exchange and Investment Funds.

Today HLB CA Malta Ltd places within the top Audit and Accounting firms of the island.

Already working in conjunction with HLB members in both Europe and the Caribbean, HLB CA Malta Ltd will be a great addition to the HLB network.

www.ca-int.com

Are You Giving Up Free Money?

Many companies offer 401(k) or similar retirement plans to their employees, and an employer match might be available. If that’s the case, you should contribute to the plan at least enough to get the full match.

Example 1: Melissa North earns $80,000 a year. Her company’s 401(k) plan offers a full match for up to 6% of salary. Therefore, Melissa should contribute at least $4,800 (6% of $80,000) to her 401(k) account this year, which will entitle her to a $4,800 company match.

Whether you’re offered a full or partial match, you should contribute at least enough to get all the dollars your company offers. Failing to get the maximum match means you’re giving up free money: relinquishing part of your compensation package.

Paying down debt

Getting your employer match is a no-risk way to earn a 100% return (or a lesser return, with a partial match) on your money. If that’s often someone’s best investment move, paying down debt may be next best. When you reduce a loan balance and thus reduce the interest you’re paying, you’re effectively earning the loan interest rate.

Example 2: Owen Palmer has a credit card that charges 12% on unpaid balances. When Owen prepays $1,000 of his balance, he saves $120 (12% of $1,000) in interest that year. That’s a 12% return on his outlay. What’s more, credit card interest typically is not tax deductible. Thus, Owen earns 12%, after tax, by prepaying his loan.

It is possible that Owen could receive a higher return by doing something else with his $1,000, but that probably would mean taking substantial risk. Prepaying debt, conversely, has no investment risk beyond forgoing the chance for a higher return. In today’s low-yield environment, prepaying debt can be appealing.

Evaluating education loans             

 Prepaying credit card debt may be attractive for many people, but prepaying student loans can be a tougher call. Interest rates may be lower than on credit card debt, so the benefit of prepaying is not as great. What’s more, up to $2,500 of interest on student loan debt is tax deductible each year. To get the maximum deduction, your modified adjusted gross income (MAGI) can be no more than $65,000, or $130,000 on a joint return. Partial deductions are allowed with MAGI up to $80,000 or $160,000.

If interest is tax deductible, the benefit of prepaying the loan is reduced.

Example 3: Rita Simmons has outstanding student loans with a 7% interest rate. This year, she expects to fall in the 25% federal tax bracket, so paying the interest actually saves her 1.75% (25% of 7%) in tax. Thus, Rita’s net interest rate cost for her student loans is 5.25%: the 7% she pays minus the 1.75% she saves in tax.

In her situation, Rita would earn 5.25%, after tax, by prepaying her student loans. That could be a good move, for an outlay without investment risk, but it’s also possible that Rita could earn more by investing elsewhere. Moreover, Rita would have to relinquish liquid assets by prepaying, and replacing those assets in case of an emergency might not be simple.

Money from home

Prepaying a home mortgage may be even less beneficial than prepaying student loans. Assuming a 4% interest rate and a 25% tax rate, the after tax benefit of prepaying would be only 3%. Although virtually all homeowners can deduct mortgage interest, the net payoff is even smaller for taxpayers with tax rates higher than 25%.

The bottom line is that prepaying a loan makes the most financial sense with high interest rates and low tax benefits. State income tax also should be considered. Our office can help you calculate the true return of debt prepayments, so you can make informed decisions.

Campus Tax Credits Top Tax Deductions

Besides financial aid, specific tax benefits can reduce the net cost of sending a child to college. Among the three major tax breaks—American Opportunity Tax Credit, Lifetime Learning Credit, tuition and fees deduction—you can claim only one on your tax return.

American Opportunity Tax Credit (AOTC)

This credit, which recently was extended through 2017, typically will be the best choice for parents of collegians. The AOTC can produce the biggest tax saving: as much as $2,500 per student per year. In addition, the AOTC has the most generous income limits.

The maximum tax credit is available with modified adjusted gross income (MAGI) up to $80,000 for single filers, partial credits with MAGI up to $90,000. For married couples filing joint tax returns, the comparable income limits are $160,000 and $180,000. Typically, MAGI for this credit is the same as your AGI, reported on the bottom of page 1 of your return.

To get the full $2,500 in tax savings, your spending must be at least $4,000 of qualified expenses for each college student. Qualified expenses include tuition and required fees but not room and board, transportation, insurance, or medical expenses. Unlike other education tax breaks, the costs of course-related books, supplies, and equipment that are not necessarily paid to the school can be qualified expenses.

You can take the AOTC for each of the first four years of a student’s higher education but not for subsequent years. Each year that you claim the AOTC, you must claim the student as a dependent on your tax return. (You also can claim the AOTC for yourself and your spouse, if the other conditions are met.)

The AOTC is also refundable: If the AOTC reduces the tax you owe to zero before the full credit is used, 40% of the remaining credit amount (up to $1,000) can be paid to you in cash.

Lifetime Learning Credit

For the Lifetime Learning Credit, the income limits are lower than for the AOTC: for single filers, the MAGI phaseout range is $55,000-$65,000; for joint filers, the range is $110,000-$130,000 of MAGI. In addition, the tax savings can’t be more than $2,000 per return, not per student. The Lifetime Learning Credit is set at 20% of the first $10,000 you spend on higher education. Otherwise, the rules for the Lifetime Learning Credit are similar to those for the AOTC.

If the AOTC is far more appealing, why use the Lifetime Learning Credit? Because the Lifetime Learning Credit might work when the rules for the AOTC can’t be met. As mentioned, the AOTC only covers a student’s first four years of higher education. Students for whom the credit is claimed must be enrolled in college at least half-time for one academic period during the tax year. The Lifetime Learning Credit, on the other hand, is available for all years of higher education as well as for courses taken to acquire or improve job skills. You can claim the Lifetime Learning Credit for an unlimited number of years, so it can be useful once you’ve claimed the AOTC for four years.

Tuition and fees deduction

A tax credit is generally better than a tax deduction, so either the AOTC or the Lifetime Learning Credit usually will save more tax than the tuition and fees deduction. You can deduct up to $4,000 of tuition and required college costs with MAGI up to $65,000 (single) or $130,000 (joint). With larger MAGI, up to $80,000 or $160,000, you can deduct up to $2,000 of those expenses. With even greater MAGI, no deduction is allowed.

Taxpayers with qualifying MAGI usually will be in the 15% or 25% federal tax bracket, so the tax savings may be modest.

Example: Ken and Kathy Long are in the 25% tax bracket. Taking a $4,000 tuition and fees deduction reduces their tax bill by $1,000: 25% times $4,000. Thus, their tax saving is less than the $2,000 possible from the Lifetime Learning Credit or the $2,500 per student from the AOTC.

If that’s the case, why would anyone choose this deduction, instead of one of the tax credits? Note that the income limits for the Lifetime Learning Credit are lower than the limits for the deduction. Thus, if the Longs can’t qualify for the AOTC (say, they’ve already used it for their child for four years) or for the Lifetime Learning Credit (their income is just over the Lifetime Learning Credit threshold), they may be able to benefit from the tuition and fees deduction.

Also, this deduction is taken as an adjustment to income, reducing your AGI. (A tax credit reduces your tax obligation, not your AGI.) A lower AGI, in turn, may offer benefits throughout your tax return. HLB Gross Collins, P.C. can make sure you use the most effective education benefit on your tax return.

Make the Most of College Financial Aid

The net price of higher education will depend on the amount of financial aid that’s received. The greater the financial aid, the lower the net cost of college.

In order to obtain financial aid, a key step is filling out the Free Application for Federal Student Aid (FAFSA). This is a complex form with many questions; its aim is to get a picture of a student’s family income and assets. Some of the questions request tax return information. Our office can help if you have difficulty with any FAFSA tax questions.

After filling out the FAFSA, your answers go through a formula that determines your expected family contribution (EFC). The lower your EFC, the greater the amount of financial aid a student might be awarded. This number may change every year, so if aid is requested each academic year, a FAFSA must be completed annually.

Potential financial aid awards are determined by comparing an applicant’s EFC with a given school’s listed cost.

Example 1: Carla Davis, a high school senior, fills out the FAFSA. Her EFC, based on family income and assets, is placed at $27,000 for the next academic year. Suppose Carla is accepted at a college where the published cost for the coming academic year is $44,000. Carla could be awarded as much as $17,000 in need-based aid: the $44,000 published cost minus her family’s EFC of $27,000.

Note that this process would not result in any need-based aid for Carla at a college where the published cost is $25,000. Carla and her parents would be expected to pay the full price.

New rules for the FAFSA

 Starting this October, new FAFSA rules go into effect. Under the current process, including the one for the 2016-2017 academic year, the FAFSA could be submitted no earlier than January 1 of the coming school year. Thus, Ed Franklin could submit his FAFSA no earlier than January 2016 for the 2016-17 academic year.

In October 2016, Ed will be able to submit a FAFSA for 2017-18. Because of this shift in submission timing, “prior-prior year” tax return information will be required, rather than prior year numbers.

Example 2: Assume Ed submitted his FAFSA in January 2016, as early as possible. Data show that early filers tend to get more aid than latecomers. However, in January 2016, Ed’s parents had not yet prepared their 2015 (“prior year”) tax return. Therefore, the FAFSA had to be submitted with estimated information, subject to subsequent verification once the Franklins’ 2015 tax return had been filed.

If Ed wants to get an early start again, he can file his FAFSA for the 2017-18 year in October 2016. Under the new rules, Ed will use the 2015 tax return (now the “prior-prior year”) information for the 2017-18 FAFSA. He won’t have to estimate income numbers, assuming his parents’ and his own 2015 tax returns already have been filed.

Going forward, the October submission date and the prior-prior year tax returns will be used on the FAFSA. A student applying for aid in the 2021-22 academic year, for example, will use the numbers from 2019 tax returns on an October 2020 filing of that FAFSA.

Planning pointers

As mentioned, reducing your child’s EFC may result in increased financial aid. In determining an EFC, income typically is the most important factor. (Assets count, too, but generally to a lesser extent.) Therefore, holding down income can be helpful. Under the new rules, timing strategies have been changed.

Example 3: Greg and Heidi Irwin have a daughter Jodi, age 15. The Irwins expect Jodi to go to college, starting with the 2019-2020 school year. They hope that Jodi will receive some need-based aid.

Even so, the Irwins believe they’ll have to dip into savings to pay college bills, and the money might come from selling stocks they feel have become overvalued. Selling those stocks at a gain in 2017 could increase the income they’ll report on the FAFSA, for 2019-2020, so the Irwins could decide to take gains this year. If those gains are realized in 2016, the income will never show up on the FAFSA.

On the flip side, suppose the last FAFSA filed for Jodi will cover the 2022-2023 school year. Then the last relevant tax return will be for 2020. If the Irwins plan a bump in income, perhaps from selling a vacation home at a profit or converting a traditional IRA to a Roth IRA, they might decide to wait until 2021 or later, when the income won’t affect Jodi’s financial aid.

Be aware that the new schedule poses a peril: income might decline in the interim. In example 3, Jodi Irwin files a FAFSA for the 2019-20 year, using tax return data from 2017. However, Jodi’s family might have much lower income in 2018 or 2019, perhaps because of a job loss, so the FAFSA understates her financial need. In this case, the Irwins can request a professional judgment review by a college’s admissions office, which could verify the increase in need.

Aid Without Need

 

  • Many colleges award what’s known as merit aid: grants or scholarships not based on financial need.
  • The “merit” might be academic success in high school. It also might result from accomplishments in sports, music, community service, and so on.
  • Colleges may restrict merit aid to students who fill out the FAFSA. Thus, youngsters from well-to-do families might gain by filling out the form, even if need-based aid isn’t expected.
  • Information sources can include the college guidance counselor at your child’s high school as well as online sites that list scholarships awarded by companies or other organizations.
  • Considering the rising cost of higher education, it can be well worthwhile to encourage youngsters to participate in pre-college activities and to actively seek merit-based money.
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