Personal Business: Strategies for Saving
HOW TO NURTURE THREE NEST EGGS AT ONCE
If you're in your early 40s, have a couple of small children, and don't stand to inherit a fortune, you're in for a crunch. In 10 to 15 short years, you'll be getting annual college tuition bills upward of $20,000--four years' worth for each kid. Then, if you are among the 60% of baby boomers who hope to retire by age 65 and live well, you'll need enough money to match 70% of your final salary for at least another 10 years. How will you raise the cash?
Financial planners are unanimous in their advice: Save early and often. Which vehicles you choose depends on your time horizon. Low interest rates have made it tougher to build a nest egg with the safest investments, such as Treasury securities or bank CDs. But the more time you have, the more aggressive you can afford to be.
BEST BET. First, estimate as accurately as possible how much you'll need and when. For college money, your best bet is to work from current costs, figuring on increases of around 6% a year at private institutions and 9% at public ones. At that rate, four years at a state school could run $80,000 by 2009, when today's newborns turn 18, and a Harvard sheepskin $200,000.
The College Board, a nonprofit national academic association, tracks price trends at public, private, and Ivy League schools. Its College Cost Explorer software program ($125) includes information on tuition, living expenses, financial-aid availability, application requirements, and deadline dates for all accredited two- and four-year U.S. colleges (call 800 323-7155 to order).
How you invest college savings depends on how much risk you can absorb. A growth or stock-index mutual fund is a good starting point when your children are young. By making regular contributions, you'll be dollar-cost averaging, which means that over time, you hedge temporary market dips. Long term, stocks still outperform every other investment, historically yielding around 10%.
If you don't want to pay someone else to manage your money, you might instead build a stock portfolio for your kids. Since children younger than 14 pay taxes in their parents' bracket, buying individual stocks can save you money over mutual-fund shares: You pay capital gains taxes only when you sell, not every time you realize a gain. Make sure the portfolio is diversified, and pick stocks you'll feel comfortable holding long term.
ZERO SUMS. When kids are older, and you don't want to entrust college funds to a fluctuating stock market, zero-coupon Treasury bonds can offer a sense of security. You buy them at a deep discount and redeem them at face value when they mature. You could pay $739 for a four-year zero that will be worth $1,000 in 1996--an annual yield of 6.37%.
The drawback is that you pay taxes on the bonds' imputed interest even though you don't collect it until maturity. And children younger than 14 pay taxes on any unearned income over $1,100 at their parents' rate. One way to get around this is to shop for municipal zeros, sometimes called baccalaureate bonds. These are exempt from federal taxes and, for state residents, from state and local taxes as well. Plus, some states offer bondholders a small cash bonus if their child attends a state school.
After the kid turns 14, buy zeros in your child's name. Children over that age pay taxes in their own, lower bracket.
Series EE savings bonds, secured by the government, may be one of the safest places to park college cash. But their returns aren't very sexy, generally around 6% now. Series EE bonds can be redeemed tax-free at maturity, provided the money goes toward college tuition and your adjusted gross income falls within certain limits. Families earning up to $60,000 get a full tax exemption for EE bonds bought after Dec. 31, 1989, and the exemption phases out gradually as adjusted gross income approaches $94,000. The ceilings are adjusted for inflation each year.
AGE ADVANTAGE. If you know you'll be at least 59 1/2 when your firstborn becomes a freshman, consider a variable annuity, so-called because earnings accrue at a variable rate each year. These allow you to shift funds between equities and other instruments, gradually decreasing risk as college approaches, and earnings grow tax-deferred. When the time comes to cash in, you won't pay the heavy penalty and surrender charges that a younger parent would owe.
How much to save each month? Many financial advisers are marketing "college planners." First, they create a formula based on estimated school costs, the number of years until matriculation, your savings to date, and a guess at your return on investment. Then, they sell you the investment. But instead of paying fees and commissions, you might just use common sense: Save as much as you can, regularly. The adviser's recommendation might be way beyond your means anyway. If you insist on precise calculations, buy Jane Bryant Quinn's Making the Most of Your Money (Simon & Schuster, $27.50), which has a chapter on college financing. The formula is in there.
As with college financing, saving for retirement should be done by working backward from your goal. Planners estimate that annual retirement expenses will run to about 70% of your final year's salary. It could take more if you travel a lot, buy a boat, or are hit with hefty medical bills.
Don't count too heavily on Social Security. Even if you've paid the maximum FICA tax, you now stand to collect a little less than $15,000 a year in benefits (plus half as much for a nonworking spouse).
Together, Social Security and a company pension may provide barely half of what you'll need to enjoy an approximation of your usual lifestyle after retiring at 65. To cover the rest of your expenditures, you'll need a pool of investments large enough to draw upon for at least 15 years. Baby boomers who start saving now can benefit from that 20- to 30-year stretch before they get a gold watch. It lets you choose vehicles, such as growth stocks, that promise the highest returns over the long term. The long time frame also lets you take full advantage of the compound-interest factor. The sooner you start to invest, the less you need to save each year (table).
Start a retirement plan with an estimate of how much you'll need each year, based on your present income and lifestyle. By calling 800 772-1213, you can order a form to see what Social Security may provide.
Next, get a projection of your pension. The figures are easy to come by if the company has a defined-benefit plan that guarantees you a specific sum. Forecasting is tougher if your company has a defined-contribution plan, where it contributes a percentage of your salary to your account each year or partially matches what you put into a 401(k). So your pension will depend on how much goes in and how well the plan manager invests it. Or, if the company uses a profit-sharing arrangement, reduced contributions in bad years may trim your pension.
INFLATION HEDGE. The projected difference between what you'll get and what you'll need is your savings goal. To keep inflation from eroding buying power, your savings should target investments earning four to six points above current inflation rates, says Stanley Breitbard, financial-services director at Price Waterhouse. Earn less, and your nest egg may show cracks.
Because you can't predict the future, it helps to develop some "what if" scenarios. You can do it on paper with a free retirement-planning kit from T. Rowe Price (800 638-5660). Or you can use some simple computer software that lets you do the number-crunching on a home computer (BW--Feb. 24).
The starting place for savings is the 401(k) plan--or a Keogh if self-employed. Contributions to it reduce your gross income and trim your tax bill, so you have more dollars to invest. Standard advice says to fund it completely (up to 20% of your wages, or a maximum $8,728 this year). Depending on your age and salary, that may be enough to put you on the safe side.
Earnings also grow tax-deferred on insurance and annuities, and on mutual funds and other vehicles in an individual retirement account. Even if you can't claim a deduction for an IRA investment, its tax-deferred earnings often can build up faster than alternative tax-free bonds or bond funds.
Realistically, most people don't save money for college and retirement at the same time. You'll probably put most of your savings into retirement accounts until you have children, then stop funding those accounts and concentrate on college until the kids graduate.
But Steven Lee, a commercial airline pilot, and his wife, Karen Platt-Lee, are doing both. The San Diego couple is salting away college money for their three daughters, aged 6, 5, and 15 months. After projecting future college costs, Steve figured they needed to set aside at least $500 a month. They divide that among three growth-stock funds, one for each child.
THRIFTY FOLKS. Even though Steve should receive pensions from both his airline and the Navy, he's saving for retirement, too. He invests about $7,800 annually in his company's 401(k) plan. And he and Karen have individual retirement accounts totaling $31,000.
Steve, 39, and Karen, 42, are both fortunate in having living parents, too. The Platts, who live in a retirement community in nearby Mission Viejo, were thrifty themselves and urged the younger couple to start saving early. But Steve's parents are more vulnerable. He has asked them to consider buying long-term health insurance through Steve's employers. "I'm interested in protecting them in case of catastrophic illness, so they wouldn't have to go on medicaid," he says.
With many people living well into their 80s and 90s, baby boomers will get to spend more years with their parents than past generations have. But that blessing has its darker side: If parents become ill or don't have resources, their adult children may have to take care of them. If an infirm parent needs long-term care, the costs can wipe out assets in no time.
Right now, about 10% of workers have some responsibility for an aging parent. The New York-based Families & Work Institute, a nonprofit research institute, expects that proportion to swell to 40% in the next 10 to 15 years. That prospect is causing many boomers to turn to insurance companies, tax attorneys, and financial planners for help. A growing number of insurers now offer long-term-care policies. And "elderlaw" attorneys are talking about preserving assets through "medicaid estate planning," restructuring assets so that qualifying for medicaid doesn't wipe them out.
Fueling all this activity is the obvious fact that as parents live longer, their chances of needing expensive long-term care increase. With nursing-home costs ranging from $30,000 to $70,000 a year, it doesn't take long for assets to be depleted. If a parent is fairly healthy but could use some help, say, three days a week, home visits by a registered nurse can top $10,000 a year. For constant home care, the cost goes through the roof.
Medicare provides little or no relief for nursing-home or home-care costs. Medicaid does cover nursing-home costs, but only if the person going into the home has few or no liquid assets. For many people, qualifying for medicaid involves "spending down" or transferring assets until they are largely gone.
It's little wonder, then, that people are trying to manipulate the system. Many people have lawyers setting up irrevocable trusts, which put assets at arm's length and other such gambits. One way elderly parents attempt to qualify for medicaid and preserve assets is by giving children their assets. That may raise uncomfortable issues about who really controls the money. And some states investigate back a number of years to see if a transfer of assets to children has taken place, and if it has, may disallow state aid.
SHOP AROUND. Another way to plan for nursing-home costs is to buy long-term health care insurance. The policies can be costly, so make sure premiums don't rise as your parent gets older. "If you buy between age 55 and 60, the premiums are much less expensive than if you wait," says Victoria Ross, a planner with IDS Financial. Ross says a 60-year-old could buy a policy with a $40- to $60-a-day benefit to be paid indefinitely, for a yearly cost of about $400. At 67, the same policy would run $700 to $800 a year.
Checking out a long-term-care policy takes a good bit of work. First, note the financial strength of the insurer by looking at its rating in A. M. Best, Standard & Poor's, or Moody's. And make sure that the actual policy you're considering is guaranteed renewable and that it carries no prior-hospitalization requirement. Also, check that there is coverage for home care, a cost-of-living benefit that tracks inflation, and no exclusion for preexisting conditions, such as Alzheimer's.
Caring for your parents can involve a difficult role reversal. But helping them through their old age can help you prepare for the time when you may be in the same boat.Don Dunn, Joan Warner, and Suzanne Woolley, with bureau reports EDITED BY AMY DUNKIN