EagleStone Tax & Wealth Newsletter – October 2015

Your 20s is a time for exploration and new experiences, but also a time of emerging personal financial responsibility. And though times are certainly different now for young adults compared to 10 or 20 years ago (for example, more college students graduate with significant student loans and many return home to live with their parents), some advice never goes out of style.

1. Live within your means

It may sound boring when the world is finally at your fingertips, but living within your means, even below your means, is one of the best things you can do to create a solid financial foundation. Your “means” is the income you have coming in. Living within your means involves not spending more than you have. This can be difficult for young adults when temptation often lurks around every corner–technology gadgets, gym memberships, free shipping and instant streaming services, daily coffee and smoothie runs, new clothes, outings with friends, traveling…you get the idea.

The key is to distinguish between your needs and wants. You need food, but you want to try that new restaurant downtown, and the other one across town, and the one that just opened right near your apartment. If your wants are leaving you broke, you need to curtail them.

Everyone’s income and expenses are different. At one end of the spectrum is someone living on her own paying 100% of rent and utilities, while at the other end is someone living at home with his parents and not paying any of those expenses. Analyze what you have coming in (income) each month and what you have going out (expenses), and keep track of where your money goes.

2. Save, save, save

Living within your means doesn’t entail breaking even each month. It means making room for savings, too. If you have a job, sign up for direct deposit so your paycheck will be automatically funneled into your checking account. Then re-route some of that money on payday to a linked savings account. You’ll start to build a savings fund, but you’ll still have access to the money if you need it. Any savings method you can put on autopilot is ideal because it’s one less thing you’ll need to remember to do and one less dollar you’ll miss or otherwise be tempted to spend.

Once you make it a habit to save regularly, you’ll want to think ahead. Sure, retirement is a long way off. But when you start saving at a young age, you can benefit tremendously from compounding, which is when your dollars earn returns that are then reinvested back into your account, potentially earning returns themselves. Over time, the process can snowball.

For example, a 22-year-old who saves $200 per month and earns a 4% annual return will have $274,115 at age 65. By comparison, a 32-year-old who saves and earns the same amount will have $164,113 at age 65, and a 42-year-old will have $90,327. (Note that this is a hypothetical example of mathematical compounding and does not represent the performance of any specific investment; all investing involves risk, including the possibility of loss.)

3. Borrow wisely

Looking to buy a car or a condo, or attend graduate school? These things typically involve debt, and debt is not your friend. Before you sign on the dotted line for a major purchase, ask yourself whether you’re overextending yourself, whether you’re getting the best possible deal, and whether borrowing is the only way to achieve your goals.

If you have student loans, make sure you’ve explored all your repayment options. Federal (but not private) student loans are eligible for the government’s Income-Based Repayment (IBR) plan, in which monthly payments are capped at 10% of your discretionary income (15% for loans made prior to July 1, 2014). If you don’t qualify for IBR, you might benefit from another income-sensitive repayment option or loan consolidation.

As the end of the 2015 tax year approaches, set aside some time to evaluate your situation and consider potential opportunities. Effective year-end planning depends on a good understanding of both your current circumstances and how those circumstances might change next year.

Basic strategies

Consider whether there’s an opportunity to defer income to 2016. For example, you might be able to defer a year-end bonus or delay the collection of business debts, rents, and payments for services. When you defer income to 2016, you postpone payment of the tax on that income. And if there’s a chance that you might be paying taxes at a lower rate next year (for example, if you know that you’ll have less taxable income next year), deferring income might mean paying less tax on the deferred income.

You should also look for potential ways to accelerate 2016 deductions into the 2015 tax year. If you typically itemize deductions on Schedule A of Form 1040, you might be able to accelerate some deductible expenses–such as medical expenses, qualifying interest, or state and local taxes–by making payments before the end of the current year, instead of paying them in early 2016. Or you might consider making next year’s charitable contribution this year instead. If you think you’ll be itemizing deductions in one year but claiming the standard deduction in the other, trying to defer (or accelerate) Schedule A deductions into the year for which you’ll be itemizing deductions might let you take advantage of deductions that would otherwise be lost.

Depending on your circumstances, you might also consider taking the opposite approach. For example, if you think that you’ll be paying taxes at a higher rate next year (maybe as the result of a recent compensation increase or the planned sale of assets), you might want to look for ways to accelerate income into 2015 and possibly defer deductions until 2016 (when they could potentially be more valuable).

Complicating factors

First, you need to factor in the alternative minimum tax (AMT). The AMT is essentially a separate, parallel federal income tax system with its own rates and rules. If you’re subject to the AMT, traditional year-end strategies may be ineffective or actually have negative consequences–that’s because the AMT effectively disallows a number of itemized deductions. So if you’re subject to the AMT in 2015, prepaying 2016 state and local taxes probably won’t help your 2015 tax situation, and, in fact, could hurt your 2016 bottom line.

It’s also important to recognize that personal and dependency exemptions may be phased out and itemized deductions may be limited once your adjusted gross income (AGI) reaches a certain level. This is especially important to factor in if your AGI is approaching the threshold limit and you’re evaluating whether to accelerate or defer income or itemized deductions. For 2015, the AGI threshold is $258,250 if you file as single, $309,900 if married filing jointly, $154,950 if married filing separately, and $284,050 if head of household.

IRA and retirement plan contributions

Deductible contributions to a traditional IRA and pretax contributions to an employer-sponsored retirement plan such as a 401(k) could reduce your 2015 taxable income. (Note: A number of factors determine whether you’re eligible to deduct contributions to a traditional IRA.) Contributions to a Roth IRA (assuming you meet the income requirements) or a Roth 401(k) plan are made with after-tax dollars–so there’s no immediate tax savings–but qualified distributions are completely free of federal income tax.

For 2015, you’re generally able to contribute up to $18,000 to a 401(k) plan ($24,000 if you’re age 50 or older) and up to $5,500 to a traditional or Roth IRA ($6,500 if you’re age 50 or older). The window to make 2015 contributions to an employer plan generally closes at the end of the year, while you typically have until the due date of your federal income tax return to make 2015 IRA contributions.

Important notes

The Supreme Court has legalized same-sex marriage nationwide, significantly simplifying the federal and state income tax filing requirements for same-sex married couples living in states that did not previously recognize their marriage.

A host of popular tax provisions (commonly referred to as “tax extenders”) expired at the end of 2014. Although it is possible that some or all of these provisions will be retroactively extended, currently they are not available for the 2015 tax year. Among the provisions: deducting state and local sales taxes in lieu of state and local income taxes; the above-the-line deduction for qualified higher-education expenses; qualified charitable distributions (QCDs) from IRAs; and increased business expense and “bonus” depreciation rules.

529 plans are savings vehicles tailor-made for college. Anyone can open an account, lifetime contribution limits are typically over $300,000, and 529 plans offer federal and sometimes state tax benefits if certain conditions are met. Here are some common questions on opening an account.

Can I open an account in any state’s 529 plan or am I limited to my own state’s plan?

Answer: It depends on the type of 529 plan. There are two types of 529 plans: college savings plans and prepaid tuition plans. With a college savings plan, you open an individual investment account and direct your contributions to one or more of the plan’s investment portfolios. With a prepaid tuition plan, you purchase education credits at today’s prices and redeem them in the future for college tuition. Forty-nine states (all but Wyoming) offer one or more college savings plans, but only a few states offer prepaid tuition plans.

529 college savings plans are typically available to residents of any state, and funds can be used at any accredited college in the United States or abroad. But 529 prepaid tuition plans are typically limited to state residents and apply to in-state public colleges.

Why might you decide to open an account in another state’s 529 college savings plan? The other plan might offer better investment options, lower management fees, a better investment track record, or better customer service. If you decide to go this route, keep in mind that some states may limit certain 529 plan tax benefits, such as a state income tax deduction for contributions, to residents who join the in-state plan.

Is there an age limit on who can be a beneficiary of a 529 account?

Answer: There is no beneficiary age limit specified in Section 529 of the Internal Revenue Code, but some states may impose one. You’ll need to check the rules of each plan you’re considering. Also, some states may require that the account be in place for a specified minimum length of time before funds can be withdrawn. This is important if you expect to make withdrawals quickly because the beneficiary is close to college age.

Can more than one 529 account be opened for the same child?

Answer: Yes. You (or anyone else) can open multiple 529 accounts for the same beneficiary, as long as you do so under different 529 plans (college savings plan or prepaid tuition plan). For example, you could open a college savings plan account with State A and State B for the same beneficiary, or you could open a college savings plan account and a prepaid tuition plan account with State A for the same beneficiary. But you can’t open two college savings plan accounts in State A for the same beneficiary.

Also keep in mind that if you do open multiple 529 accounts for the same beneficiary, each plan has its own lifetime contribution limit, and contributions can’t be made after the limit is reached. Some states consider the accounts in other states to determine whether the limit has been reached. For these states, the total balance of all plans (in all states) cannot exceed the maximum lifetime contribution limit.

Can I open a 529 account in anticipation of my future grandchild?

Answer: Technically, no, because the beneficiary must have a Social Security number. But you can do so in a roundabout way. First, you’ll need to open an account and name as the beneficiary a family member who will be related to your future grandchild. Then when your grandchild is born, you (the account owner) can change the beneficiary to your grandchild. Check the details carefully of any plan you’re considering because some plans may impose age restrictions on the beneficiary, such as being under age 21. This may pose a problem if you plan to name your adult son or daughter as the initial beneficiary.

What happens if I open a 529 plan in one state and then move to another state?

Answer: Essentially, nothing happens if you have a college savings plan. But most prepaid tuition plans require that either the account owner or the beneficiary be a resident of the state operating the plan. So if you move to another state, you may have to cash in the prepaid tuition plan.

If you have a college savings plan, you can simply leave the account open and keep contributing to it. Alternatively, you can switch 529 plans by rolling over the assets from that plan to a new 529 plan. You can keep the same beneficiary when you do the rollover (under IRS rules, you’re allowed one 529 plan same-beneficiary rollover once every 12 months), but check the details of each plan for any potential restrictions. If you decide to stay with your original 529 plan, just remember that your new state might limit any potential 529 plan tax benefits to residents who participate in the in-state plan.

Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may offer growth potential. Others may provide regular income or relative safety, or simply serve as a temporary place to park your money. And some investments may even serve to fill more than one role. Because you likely have multiple needs and objectives, you probably need some combination of investment types, or asset classes.

Balancing how much of each asset class should be included in your portfolio is a critical task. The balance between growth, income, and safety is determined by your asset allocation, and it can help you manage the level and types of risks you face.

The combination of investments you choose can be as important as your specific investments. Your mix of various asset classes such as stocks, bonds, and cash alternatives generally accounts for most of the ups and downs of your portfolio’s returns.

Ideally, your portfolio should have an overall combination of investments that minimizes the risk you take in trying to achieve a targeted rate of return. This often means balancing conservative investments against others that are designed to provide a higher potential return but also involve more risk. However, asset allocation doesn’t guarantee a profit or eliminate the possibility of investment loss.

Someone living on a fixed income, whose priority is having a regular stream of money coming in, will probably need a very different asset allocation than a young, well-to-do working professional whose priority is saving for a retirement that’s 30 years away. Even if two people are the same age and have similar incomes, they may have very different needs and goals, and their asset allocations should be tailored to their unique circumstances.

And remember, even if your asset allocation was appropriate for you when you chose it, it may not be appropriate for you now. It should change as your circumstances do and as new ways to invest are introduced. A piece of clothing you wore 10 years ago may not fit now; you just might need to update your asset allocation, too.

Your Social Security number is one of your most important personal identifiers. If identity thieves obtain your Social Security number, they can access your bank account, file false tax returns, and wreak havoc on your credit report. Here are some steps you can take to help safeguard your number.

Never carry your card with you. You should never carry your Social Security card with you unless it’s absolutely necessary. The same goes for other forms of identification that may display your Social Security number (e.g., Medicare card)

Do not give out your number over the phone or via email/Internet. Oftentimes, identity thieves will pose as legitimate government organizations or financial institutions and contact you to request personal information, including your Social Security number. Avoid giving out your Social Security number to anyone over the phone or via email/Internet unless you initiate the contact with an organization or institution that you trust.

Be careful about sharing your number. Just because someone asks for your Social Security number doesn’t mean you have to share it. Always ask why it is needed, how it will be used, and what the consequences will be if you refuse to provide it.

If you think someone has misused your Social Security number, contact the Social Security Administration (SSA) immediately to report the problem. The SSA can review your earnings record with you to make sure their records are correct. You can also visit the SSA website at www.ssa.gov to check your earnings record online.

Unfortunately, the SSA cannot directly resolve any identity theft problems created by the misuse of your Social Security number. If you discover that someone is illegally using your number, be sure to contact the appropriate law-enforcement authorities. In addition, consider filing a complaint with the Federal Trade Commission and submitting IRS Form 14039, Identity Theft Affidavit, with the Internal Revenue Service. Visitwww.ftc.gov and www.irs.gov for more information.