The clock continues to tick towards the August 2, 2011 deadline when the United States debt ceiling limit will be reached. This limit is a key element of U.S. Government financial management. The U.S. Government is expected to receive about $175 billion in tax revenues for the month of August, but has $310 billion in monthly obligations that it needs to meet. As a result, the $135 billion in monthly shortfall is usually borrowed via the issuance of U.S. Treasury bonds. However, once the debt ceiling is met, the U.S. Government will not be able to issue new debt and will therefore, have to make significant decisions as it relates to what $135 billion or 44% of its “bills” it will delay payment on. That is, of course, if the debt ceiling limit is not raised by Congress and signed into law by the President.
While the rhetoric coming out of Washington has certainly transitioned from compromise to contention, it should not be overlooked that the divided parties are aligned on a few very important criteria that should bring a resolution closer to happening—namely that spending cuts should be enacted and that a more responsible government spending policy should be put in place to get a handle on the nation’s soaring national debt. In addition, both sides seem to now understand that the polarizing political view of revenue increases (the Democrats’ wish) and significant entitlement reform (the Republicans’ wish) are too significant a gap to overcome over the short term and are now virtually off the table.
Now, the only (and it is a big “only”) things that the two sides have to work out are: where the cuts in spending should come from, how long they will take to implement, and how much money they will save. The reality is that the two divided sides are not as far apart on the terms of a deal as they are from an ideological and political posturing perspective. Said another way: the two sides sound and act a lot further apart than their competing plans actually are.
We expect that the debate in Washington will continue over the next few days as the game of political ideological “chicken” plays out. However, our base case is that a compromise will be forged over the coming days and will result in either a short-term extension of the debt limit or, more likely, an agreement to raise the borrowing capacity of the United States Government until well into next year.
More importantly, even if a bill is not agreed upon and signed into law to raise the debt ceiling by August 2, we do not foresee the United States Government defaulting on its obligations. A default will occur if the government failed to pay the interest due on its debt. For the month of August, the interest due on Treasury bonds accounts for only $29 billion, which is easily met by the $175 billion in tax revenues that are expected. However, while a default would be avoided, the significant impact of dialing back $135 billion that could not be borrowed for other Federal services and obligations would have serious economic impacts.
While the debt ceiling debate has grabbed the headlines and is currently the most significant risk to the market, the underlying strength of the global economy remains solid. Moreover, several of the open-ended issues that have lingered for months are finally getting substantively addressed, including a plan for a second bailout of Greece, a stabilizing European debt crisis, and the re-emergence of Japan’s economic infrastructure from its terrible natural disaster in early spring. In addition, company earnings continue to be very strong as corporate America continues to benefit from a resurgent business reinvestment climate and a resilient consumer.
In the meantime, the current conditions support a cautious stance as the market is singularly focused on Washington. We expect that a resolution on extending the debt ceiling will ultimately be agreed upon, but not until the deeply divided government drags the nation and the market even further through the mud. But, on the other end of this self-imposed crisis stands an economic climate where businesses are earning near record profits, employment is improving, housing has stabilized, and consumers are once again revisiting the malls to spend. While the turmoil in Washington will invariably offer up several more nervous days as the debate lingers on, we believe that a relief rally for the market is around the corner once compromise replaces contention and unity trumps division.
As always, if you have questions, I encourage you to contact me.
__________________________________________________________
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An array of topics that can affect the growth and sustainability of your current and future assets.
Thursday, July 28, 2011
Friday, July 22, 2011
Coverdell, Custodial or 529? How to Choose
First the grim news: The cost of a college education has continued to increase at rates well above the general inflation rate in recent years. Now the good news: Your options for setting aside college money in tax-efficient investment accounts have increased as well. We’ll examine three of the most popular: 529 plans, custodial accounts and Coverdell accounts.
The Lowdown on 529 Plans
Created in 1996 and named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states, but in some cases may also be sponsored by qualified educational institutions.
College savings plans—a type of 529 plan. Many of these plans are national plans: no matter which state or school sponsors them, residents of any state can participate.
The potential advantages of 529 plans include:
UGMA/UTMA Accounts: Awarding Custody
Of course, not all college savings strategies require the involvement of a college or a state government. For example, by following the guidelines established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA)—each state uses one or the other—adults such as parents and grandparents can establish and contribute to a custodial account in a minor's name without having to establish a trust or name a legal guardian.
Contributing to an UGMA/UTMA account can accomplish two goals simultaneously: helping a future student prepare for college costs and reducing the value of a contributor's taxable estate. UGMA/UTMA accounts also offer favorable tax treatment of investment earnings. For example, the first $950 of earnings is tax free each year. If the minor is under 19, earnings in excess of $950 but not above $1,900 are taxed at the child's rate. If earnings exceed $1,900 for children under 19, the income is taxed at either the parents' rate or the child's rate, whichever is higher. If the child is older than 19, all income is taxed at his or her rate. Note that the age limit increases to 24 for a full-time student if the child doesn't have earned income in excess of half of his or her annual support.
Despite the obvious appeal of UGMA/UTMA accounts, it's worth noting that the assets in the account belong to the child, not to the contributor. When the child reaches legal adulthood at age 18 or 21, depending on the state, he or she is free to spend the money with no restrictions. In other words, contributors cannot force that individual to use the money for college costs.
Coverdell Benefits
Coverdells are qualified investment accounts that allow nondeductible contributions of up to $2,000 annually per beneficiary. Earnings in the account are not taxed, and as long as withdrawals are used for qualified education expenses, they are tax free as well. Assets in a Coverdell must be used before the beneficiary's 30th birthday. Keep in mind that the designated beneficiary of a Coverdell account is free to take withdrawals at any time, but any amount in excess of his or her qualified education expenses will be taxable as income. A 10% additional federal tax may also apply.
Coverdells also have a special feature unavailable with 529 plans: Qualified withdrawals may be used to pay for an elementary, secondary, or college education. Withdrawals from 529 plans can only be used for college expenses. Unlike 529 plans, Coverdells impose income eligibility limits on contributors. Single filers with modified adjusted gross incomes of more than $110,000 and joint filers with incomes of more than $220,000 cannot contribute.
The deadline to contribute to a Coverdell is generally April 15, the same deadline that applies to IRAs. Before making a decision about a Coverdell, evaluate the investment options, fees, and services offered by competing financial institutions that provide the accounts. Also, bear in mind that rules governing the Coverdell Education Savings Account will revert to 2001 rules in 2013 unless Congress reenacts them.
Finally, when choosing a college investment vehicle, remember that it may not be a “one or the other” decision. It may make sense for you to contribute to more than one type of account simultaneously. Speak with a financial and tax advisor about your particular needs.
The Lowdown on 529 Plans
Created in 1996 and named after the section of the federal tax code that governs them, 529 plans are generally sponsored by individual states, but in some cases may also be sponsored by qualified educational institutions.
College savings plans—a type of 529 plan. Many of these plans are national plans: no matter which state or school sponsors them, residents of any state can participate.
The potential advantages of 529 plans include:
- Tax-free earnings — Earnings in a 529 plan accumulate free from taxes, and qualified withdrawals are federally tax free. Withdrawals may be exempt from state taxes as well (tax rules vary from state to state). Nonqualified withdrawals from a 529 plan may be subject to income taxes and a 10% additional federal tax.
- Gift tax benefits for contributors — A contribution to a 529 plan is considered a gift for federal tax purposes. Tax rules currently let you give up to $13,000 in 2011 to as many individuals as you choose, free from federal gift taxes. Gifting schedules can also be accelerated through a lump-sum contribution of $65,000 to a 529 plan in the first year of a five-year period.
- Generous contribution rules — Lifetime contribution limits on 529 plans vary from state to state, but often exceed $200,000 per beneficiary, including earnings. In addition, there usually are no income restrictions on contributors to a 529 plan.
- Account control — The individual who creates a 529 plan account on behalf of a beneficiary generally maintains complete control over the account. This is not the case with Coverdell Education Savings Accounts or certain types of custodial accounts. Account owners may also change beneficiaries.
UGMA/UTMA Accounts: Awarding Custody
Of course, not all college savings strategies require the involvement of a college or a state government. For example, by following the guidelines established under the Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA)—each state uses one or the other—adults such as parents and grandparents can establish and contribute to a custodial account in a minor's name without having to establish a trust or name a legal guardian.
Contributing to an UGMA/UTMA account can accomplish two goals simultaneously: helping a future student prepare for college costs and reducing the value of a contributor's taxable estate. UGMA/UTMA accounts also offer favorable tax treatment of investment earnings. For example, the first $950 of earnings is tax free each year. If the minor is under 19, earnings in excess of $950 but not above $1,900 are taxed at the child's rate. If earnings exceed $1,900 for children under 19, the income is taxed at either the parents' rate or the child's rate, whichever is higher. If the child is older than 19, all income is taxed at his or her rate. Note that the age limit increases to 24 for a full-time student if the child doesn't have earned income in excess of half of his or her annual support.
Despite the obvious appeal of UGMA/UTMA accounts, it's worth noting that the assets in the account belong to the child, not to the contributor. When the child reaches legal adulthood at age 18 or 21, depending on the state, he or she is free to spend the money with no restrictions. In other words, contributors cannot force that individual to use the money for college costs.
Coverdell Benefits
Coverdells are qualified investment accounts that allow nondeductible contributions of up to $2,000 annually per beneficiary. Earnings in the account are not taxed, and as long as withdrawals are used for qualified education expenses, they are tax free as well. Assets in a Coverdell must be used before the beneficiary's 30th birthday. Keep in mind that the designated beneficiary of a Coverdell account is free to take withdrawals at any time, but any amount in excess of his or her qualified education expenses will be taxable as income. A 10% additional federal tax may also apply.
Coverdells also have a special feature unavailable with 529 plans: Qualified withdrawals may be used to pay for an elementary, secondary, or college education. Withdrawals from 529 plans can only be used for college expenses. Unlike 529 plans, Coverdells impose income eligibility limits on contributors. Single filers with modified adjusted gross incomes of more than $110,000 and joint filers with incomes of more than $220,000 cannot contribute.
The deadline to contribute to a Coverdell is generally April 15, the same deadline that applies to IRAs. Before making a decision about a Coverdell, evaluate the investment options, fees, and services offered by competing financial institutions that provide the accounts. Also, bear in mind that rules governing the Coverdell Education Savings Account will revert to 2001 rules in 2013 unless Congress reenacts them.
Finally, when choosing a college investment vehicle, remember that it may not be a “one or the other” decision. It may make sense for you to contribute to more than one type of account simultaneously. Speak with a financial and tax advisor about your particular needs.
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