Insurance You Don't Need
There are better ways to save for retirement and start a college fund than a variable life-insurance policy.
A couple of years ago, my wife and I were looking for a good way to add to our main retirement savings, start a college fund and get life insurance. We were steered in the direction of variablelife-insurance policies. We are 27 and 28 years old, healthy and childless, so far. We aren't maxing out our 401(k)s or Roth IRAs. We pay $1,860 per year for my $300,000 policy and $960 per year for my wife's $200,000 policy, which we bought last year. Are we paying too much? Is there a better way to accomplish our goals? -- Mike Jones, Rochester, N.Y.
Yes, you're paying way too much for those policies, and yes again, there are far better ways to reach your goals. You could buy term insurance with no rate increase for 20 years and the same $300,000 death benefit for as little as $173 per year. You're paying more than ten times that every year for exactly the same amount of insurance.
A variable life-insurance policy provides an investment account as well as life insurance, but you pay a slew of extra fees before any money is invested. "The cost of insurance within the policy is sometimes double or triple what term insurance costs, and front-end sales fees can typically be 5% of each premium," says James Hunt, a life-insurance actuary with the Consumer Federation of America who analyzes cash-value policies at www.evaluatelifeinsurance.org. "Plus, you sometimes pay as much as $10 per month just in administrative charges," Hunt says.
What to do with the money you'll save? Sock away as much as you can in your 401(k) accounts, which lower your taxable income, grow tax-deferred and may earn you free money from an employer match. Each of you can also contribute up to $4,000 per year to a Roth IRA, which allows tax-free withdrawals in retirement. And Roth IRAs let you withdraw contributions without a penalty at any time. For tax-free college savings, invest in a state-sponsored 529 plan. You could even open up a 529 in your own name now, then make your kids the beneficiaries after they're born. Invest additional savings in taxable mutual funds.
Cash-value life insurance can make sense if you need coverage for more than 30 years -- if you're worried about a big estate-tax bill, own a business or have special-needs children, for example. But it's not the best choice for young couples who have many less-expensive options and may not need life insurance yet.
If I start a freelance writing business, can I take advantage of common business write-offs even if I keep my current full-time job with a corporation? -- David Monroe, Atlanta
You bet. In fact, you can deduct more than you earn in self-employment income for the year, as long as you are running a legitimate business.
As a freelance writer, you can deduct all sorts of business expenses on Schedule C -- including the equipment you use primarily for freelance work, such as a new computer, fax machine, printer, separate phone line for business calls and office furniture. You can also write off business-related travel, advertising and printing costs. You can deduct a portion of your mortgage interest or rent, as well as utility bills, if a space in your home is used exclusively for your freelance job.
If business expenses exceed business income, subtract the extra costs from your other income. Taking a loss, however, might raise a red flag for the IRS. So be sure to document your expenses carefully, to prove that your business is legitimate, says Paul Gada, a senior tax analyst with the CCH Business Owner's Toolkit. If you lose money in three years out of five, the IRS generally considers your pursuit a hobby rather than a business, which makes it much more difficult for you to deduct expenses.
Use your profits to make tax-deductible contributions to a small-business retirement plan -- for instance, an individual 401(k), which gives you the highest contribution limits even if you've already maxed out your 401(k) in your primary job.
Bye-Bye, flex plan
What happens to the $1,000 I already put in my flexible-spending account for this year? I got laid off with one day's notice and had no medical bills for which to be reimbursed. Does my company have the right to keep the flex-plan money, or will I get it back? -- H.K., White Plains, N.Y.
Normally you lose any flex-plan money you haven't used when you leave your job. But you can buy extra time, if you know how to ask for it.
First, find out whether your employer will give you until the end of the month to use the money. That's an option under some employer plans, says Sharon Cohen, group and health-care benefits counsel for Watson Wyatt.
Or gain more time by signing up for benefits under COBRA -- the same federal law that lets employees keep group health insurance for up to 18 months after they leave their jobs. Most companies with 20 or more employees are required to offer COBRA coverage, which also applies to money in flexible-spending accounts. You don't have to use COBRA for health insurance to have a COBRA flex plan.
To keep your FSA open, you would continue making the same monthly contribution plus a 2% charge -- so if you signed up to have $100 per month deducted from your paycheck, you'd pay $102 per month and still have access to your FSA, says Brandon Wood, director of health-care product management for WageWorks, which administers employer health plans.
Then you can pay for COBRA for just a month or two while you get back your money. You'll be able to use $100 of the monthly COBRA charges, as well as the $1,000 you already contributed, for medical expenses.
You can use FSA money for eyeglasses, prescription and many nonprescription medications, dental care and a lot of other medical expenses that aren't covered by insurance.
What is the highest-yielding tax-free investment I could get into for less than five years? -- G.B., via e-mail
The safe answer is to buy an AA- or AAA-rated muni bond. Because you're not diversifying when you buy a single bond, lower-rated issues can take you on a ride that's exhilarating -- or nauseating. A North Carolina Eastern Municipal Power Agency Power System bond, maturing in January 2011, recently yielded 5.1%. If you're in the 28% tax bracket, that's equivalent to a 7.1% taxable yield. But the bond is rated BBB (or one step above junk). A Davie, Fla., General Obligation bond maturing in August 2011, rated AAA and insured, recently yielded 4.0% (equivalent to a 5.6% taxable yield).
For a little less excitement and a little more diversification, try a high-yield tax-free bond fund. Over the past year to August 1, T. Rowe Price Tax-Free High Yield (symbol PRFHX) returned 5%. Its 30-day yield was 4.9%, which is equivalent to a taxable 6.8%. Closed-end bond funds are good, too, but carry a bit more risk (see Squeezing Out More Income). Nuveen Municipal Value (NUV) recently traded at a 5% discount to its net asset value and yielded 4.8%.
Free ride at Penn
I read that the University of Pennsylvania now offers free tuition, room and board for low-income families. Do any other colleges have similar programs? How do they determine your income? Do they also look at your net worth? -- Kent Veron, Gonzales, La.
The University of Pennsylvania joins a handful of big-name public and private colleges that offer special deals for families whose income falls below a certain level. At Penn, the limit is much higher than you might expect; the program is available to families with an annual income of $50,000 or less.
Financial aid has always been available to low-income families. But Penn's new program promises to meet a family's entire need with no loans. For the 2006#208;07 academic year, a student with the greatest need will receive grant aid of more than $45,000.
Stanford offers a similar program for students whose families earn less than $45,000. Harvard, which started a program in 2004, recently raised its income limit from $40,000 to $60,000. It also reduced the amount that families earning up to $80,000 must contribute to their child's education.
Each school sets its own income standards, primarily to ensure that wealthy individuals who don't have regular jobs can't game the system. Harvard, for example, counts both taxable and nontaxable income, then considers assets -- including home equity and retirement savings -- on a case-by-case basis.Submit the standard aid forms, and you may qualify for assistance even if you don't get a full ride. At Harvard, about 1,000 families earning $100,000 or more receive need-based grants.
My thanks to Christine Varner for her help this month.