Understanding Financial Terms


Education IRA

Thank the Investor Relief Act of 1997 for this handy dandy little device and the tax cut of 2001 for improving it. An Education IRA is a special investment retirement account that, starting in 2002, let’s you invest up to $2,000 a year for each child under 18 for their education-related expenses. Why is this nice? The money grows tax-deferred and can be withdrawn tax-free. That means: no taxes. Nada.

Not impressed? If you open up an Education IRA for your newborn and deposit just $500 a year at 10%, in 18 years you’ll have accumulated $18,300, give or take. If you had to pay taxes on it (at the 28% bracket) then you’d only have $15,100. That’s a nice little tax benefit, and it was all rather painlessly accumulated. If you deposit the maximum of $2,000, you’d have $73,213 tax free. ($60,433 if you had to pay taxes.) Nice.

Until 2001, any individual can contribute up to $500 to a child’s Education IRA if the individual’s modified adjusted gross income for the taxable year is no more than $95,000 or $150,000 for married taxpayers filing jointly. Now, thanks to the tax cut of 2001, you’ll be able to quadruple your annual contribution per child. Nice. Further, you’ll now be able to put the money toward the cost of kindergarten through high school, not just the cost of higher education. And, the AGI levels have increased slightly, so check with your bank or brokerage to see if you qualify. 

Here’s another change – until this year, you were not allowed to contribute to both an Education IRA and a 529 state-sponsored savings plan in the same year. Now, you can. If you are looking to pay for elementary and secondary school expenses, then the Education IRA is tough to beat. (If your child uses the money for anything other than education expenses, expect a tax bill and a 10% penalty.) 

Contributions to an Education IRA are not tax-deductible. One great thing, however, the IRA can be rolled over to another family member who is a student. So, let’s say that 17 year old Jane has earned a serious scholarship and won’t need her $12,000 Education IRA money. She can transfer that account to her beloved eight-year old brother, who now has a great jump-start on his college savings plan. 

Here’s a tip – get a grandparent to open an Education IRA for your child. Grandparents often have lower incomes and tax brackets, and usually do not exceed the AGI ceilings. Just remember, $2,000 is the maximum that can be contributed during a calendar year.

529 College Savings Plan

Named after the tax code that created them, 529 College Savings Plans provide an interesting way to save for higher education expenses. The plans are state-sponsored, so the rules and opportunities vary depending upon the state in which you live. Because they offer investments that are managed by a professional financial services firm, must choose your plan as carefully as if you were selecting a mutual fund. (In many ways you are.) Read the rules, restrictions and investment objectives carefully. 529 plans share these basic characteristics

  • The account grows tax-deferred. Earnings on qualified withdrawals are taxed at the beneficiary’s (child’s) rate.
  • Each state gives you a choice of pre-established investment portfolios that were created for that plan. Some have fixed allocations, others let you change asset allocations based on the beneficiary’s age or years before college.
  • Contributions can be as low as $25 or as high as $150,000. Anyone can contribute to a 529 plan; there are no income restrictions.
  • The account owner is the only person who can authorize a distribution from the account – so you know your savings will go toward education expenses.
  • You can change the beneficiary if your child decides not to go to college, or won’t need all the money. There are no taxes or penalties for changing the beneficiary as long as the new beneficiary is a member of your family.
  • A relative can contribute up to $50,000 to the account free from federal gift taxes. (You can stretch the gift over a five year period.) Contributions also lower the giver’s estate for tax considerations.
  • 529 accounts do not affect eligibility for a Hope Scholarship or Lifetime Learning Credit.
  • The account is considered to be an asset of the owner, not the beneficiary, so that it won’t be evaluated as an asset of the child for financial aid purposes. (35% of a child’s assets must be considered by colleges, versus 5% of the parent’s assets.)


A UGMA, (which stands for Universal Gift to Minor Account) is a custodial investment account that an adult can open for the benefit of any child. (Remember, for legal purposes, a child is defined as any person under the age of 18, not just someone who behaves that way.) A UGMA can be opened at any brokerage firm and most mutual fund families, and behaves just like a regular investment account with the following exceptions. First, only adults may make gifts of cash or securities, and only the custodian may place trades. (The kids themselves cannot place trades, though they certainly can participate in the decision-making process at home.) Also, all gifts made to the accounts are irrevocable, which is synonymous with “You ain’t getting it back.” This is not the place to speculate on penny stocks or day-trade either, you are prohibited from pursuing unduly risky strategies in an UGMA. Further, the kids are under no obligation to use the money for education or any other agreed-upon purpose when they get their 18-year-old hands on it. In fact, your very last responsibility as custodian is to re-register the account in their names when they turn 18. Once it becomes their money they can do what they like with it.

Taxes, as usual, can be a bit complicated. For the year 2001, the first $750 of any income in the account (dividend, interest or capital gains) is tax free. The second $750 is taxed at the child’s tax rate, which is usually 15%. If the child is under 14 years old, then any income over $1500 is taxed at the parents’ marginal tax rate. If the child is 14 or older, all income over $750 is taxed at the child’s tax rate. Phew. Consult your broker for the specifics as it relates to your situation, as the tax picture may change going forward.

A final thing to consider – if you think you’ll need financial aid for college, UGMAs can lead to smaller aid packages. The amount of money held in an UGMA is considered part of a student’s assets. Typically, financial-aid administrators deem 35% of a student’s assets available for college tuition, compared with only 5% of assets held by parents. So, if financial aid planning is on your radar screen, you may want to start socking away assets in your name instead.

Asset Allocation

In spite of the market’s ups and downs, the basics of smart investing haven’t changed much over time. Asset allocation, also known as diversification, is the investing opposite of “putting all your eggs in one basket.” In general, there are three types of assets:

  1. stocks
  2. bonds
  3. cash equivalents.

Each will behave differently in certain market conditions: some will grow, others will shrink. The goal? Select the best mix of assets for your personal needs and goals, and that will have the greatest likelihood of growing over time. Consider asset allocation, then, a financial stew that best meets your personal taste. Each of the asset classes has risk associated with it, and managing this risk is the key to successful investing – with success being measured as both a good return and a good night’s sleep. Building a portfolio simply means investing the right amount of money in the right types of investments to meet your goals and personality.

For new parents, asset allocation takes on a whole new meaning. Now, you’ve got specific financial needs that are directly related to your new bundle of joy such as, short term cash needs, medium term goals like camp and private school (What? I have to worry about camp or school for my infant already? Yes indeedy.) Of course there are also long term goals like college. You’ll now need to consider investment strategies appropriate to each. Selecting investment assets that meet your time and risk requirements are an essential part of a solid plan.

All experts recommend maintaining a liquid nest egg of cash for emergencies. Three to six months living expenses should be minimum, but with a new child, consider slowly adding to your stash of cash until you’ve accumulated at least six to twelve months, if you can. For this account, a money market or interest bearing checking account is best. As a general rule, any goal that is less than five years away is considered relatively short term. If you are saving for a short term goal, like an addition on your house, down payment for a car, or new baby gear, then consider primarily safer investments, like treasury securities or a conservatively managed mutual fund. Stocks, unless they are carefully selected, may or may not be your best choice. But, for long term goals, especially anything over 10 years, stocks are the way to go. Remember, the stock market has returned an average of between 10-11% since it was born, so stocks remain the wealth creation vehicle of choice for those with a significant time horizon.

Mutual Fund

These days, most people have mutual funds in their investment accounts. A mutual fund is a pool of many securities, which is run by a professional money-management firm. The fund manager buys and sells large amounts of securities, either, stocks, bonds or some combination, depending on the mission of the fund. When you purchase a mutual fund, you purchase a share of the company, not the individual stocks. Theoretically then, you are buying into a portfolio that is managed by someone who is supposed to be much smarter than you. (Sometimes yes, sometimes no. That’s why you have to shop carefully.) Mutual funds are popular for four primary reasons:

  • Diversification: Funds allow you to leverage a small amount of money into a larger number of investments than you would ordinarily be able to afford. This can dilute the risk of investing through diversification, an important strategy for success.
  • Expertise: Funds allow you to reap the benefits of someone else’s investment ability, namely the fund manager, and forego picking individual stocks themselves.
  • Pay Yourself First: Ah, the cardinal rule of investing. With mutual funds, you can easily make regular monthly purchases of the fund, by arranging to have the money automatically transferred from your checking or savings account.
  • Liquidity. Mutual funds are liquid investments. This means that you can redeem your shares in the market easily, if you find you need to raise cash for any reason.
  • Choosing a Fund that is Right for You. There are more than 10,000 mutual funds, with billions of consumer dollars under management. Yet, despite the compelling advertising they’re not all going to be right for you. Are you saving for a medium term goal like a new car or addition for your house? In this instance, you’ll want a more conservative fund that will grow your investment and minimize market risk. Are you saving for a faraway goal, like a child’s education? Then you may want to choose a more aggressive fund, to take advantage of the market’s ability to handle long-term ups and downs.

Your first step to purchasing a fund usually involves a call to the fund or brokerage firm. This is when you ask questions, request information about their funds, a prospectus of the fund you are interested in and an account application. Doing some initial research online is helpful as it gives you some idea as to what questions you’d like to ask. First of all, be sure you have their sales fees, or “loads” as they are known, quite clearly spelled out before you invest a penny. Have them walk through the fees associated with your initial investment, and any other annual fees that you should expect.

Check out Andrew Tobias’ great site Personal Fund for a helpful tool to help you evaluate the true costs of your mutual fund investments.


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