Chapter 12

Setting Up Personal Investment Accounts for Yourself and Your Kids

In This Chapter

Saving for educational expenses in traditional investment accounts

Deciding how to register your account

Taking care of the account

Section 529 plans, Coverdell Education Savings Accounts, and even good old U.S. Savings Bonds are wonderful ways to save money for those (hopefully) inevitable college expenses looming on your horizon. They all, to some extent, allow you to put away money for later use, deferring, and even exempting, income you earn on that money from the income tax monster. And, given that everyone can invest in at least one of these savings plans and reap the tax benefits, why would you even consider putting money into more traditional investment accounts for yourself, your spouse, or your children and/or grandchildren with an eye toward using the cash for college expenses?

The answer is simple: Funds from tax-advantaged college savings accounts may only be used to pay certain qualified educational expenses. All other college expenses, such as health insurance, transportation costs, and excess living expenses, don’t fall into this category, and you may be looking at income tax and a penalty if you use funds from your Section 529 plan or Coverdell account to pay for them.

In this chapter, you discover how to save enough to pay for those nonqualified (but necessary) expenses that the other plans just can’t cover. You find out how total flexibility and absolute control may sometimes be worth the price of admission (the loss of income tax breaks). You explore the most advantageous ways to register for and invest in personal investment accounts in order to maximize their potential while minimizing your tax burden. You look at how new tax legislation may affect your investment choices. And finally, you see the pitfalls to avoid at all costs.

Pondering Personal Investment Accounts

Basically, a personal investment account is any financial account, whether a savings account, a stock or bond account, or a mutual fund account, into which you deposit money and on which you should receive some sort of investment return — either interest, dividends, or capital gains. These accounts are all taxed currently (you pay the tax in the year in which you earn the income), and you have absolute freedom to add money, subtract money, or leave the whole thing alone.

Freedom is what a personal investment account is all about. Other than following the rules that apply to all people dealing with investments (for example, no insider trading is allowed), you have absolutely no limits on what you may, and may not, do with the money going into or out of these accounts.

That’s why personal investment accounts can be so valuable when you’re planning for a future event that may or may not happen. The flexibility of a personal investment account registered in your name, your spouse’s, or jointly, also allows you to concentrate on your investments rather than trying to allocate resources between your children before you determine their needs. If you think you’re saving for one child’s college education, that’s fine; if that child then has no need of the money, you’re free to use it to pay for another child’s expenses, for your retirement, or to buy a sailboat and sail around the world. You have no limits on what you may use the money in the account for.

By lumping the available funds for all your children’s excess needs in one place, you minimize fees, and can therefore maximize results. And, if it turns out that your children’s financial needs aren’t exactly equal (one child is happy at a community college; another heads off to a private college), you can allocate your resources as needed without having to deal with complicated roll-over rules, and without any fear of tax penalties.

In addition to flexibility, you maintain complete and total control over your money. When you take distributions from an account registered to you, the check is made payable to you, and you get to cash it. You may even register an account in the name of your minor child, which then becomes his when he reaches the age of majority (either 18 or 21, depending on what state you live in). You direct your investments, unless you hire someone like a broker or an investment advisor to give you advice (see the “Choosing to hire an advisor or go it alone” section later in the chapter). You may move from investment to investment, or between accounts, as often as you like and for any reason.

You get the benefits of flexibility and freedom for the low, low price of . . . paying taxes on any income earned. As your money grows, so does your annual tax bill. Because income taxes aren’t deferred in this type of account, the amount that you pay in income tax will probably increase each year (the larger the account becomes, the more income is earned on those investments).

Still, when invested appropriately, personal investment accounts can be a valuable addition to your overall college savings program, and it’s up to you to know how to make the best choices for your money.

Looking at Your Investment Options

No matter what you’re looking for, there’s a type of account that will fit you perfectly. You may choose to go the staid and sedate root, sticking with a savings account at your local bank or savings and loan. You could give a broker a call, and set up an appointment. You can go online and see what’s being offered there. Or you can walk into the local office of your friendly mutual fund company and check out its offerings.

Interest-bearing bank accounts — “Ol’ Faithful”

Bank accounts are the most common type of personal investment account, and they may not be something that you typically associate with the term investment. Still, interest-bearing bank accounts have been around for a long time, and they represent a very safe, not-too-exciting place to keep your money. Savings and loan companies, commercial banks, and credit unions (which aren’t strictly banks, but which operate so similarly to a savings and loan that the difference, for this discussion, is moot) offer these accounts.

When you put your money in a savings account (including passbook, regular savings, bank money market, or even certificates of deposit), you give your money to the bank, which in turn lends it to someone else. That person pays interest to the bank on the money he borrows, and the bank pays you interest (lower than the amount it charges the borrower) on your deposit. For handling this transaction, the bank keeps the difference between the amount it charges the borrower and the amount you receive. Everyone’s happy; at least while bank interest rates offer a reasonable return on your investment.

If you like the idea (and the perceived safety) of a bank account, shop around for the one with the highest interest rate and lowest fees. And, if your high rates vanish overnight (which often happens when certificates of deposit come due), don’t be afraid to go shopping again.

Interest-bearing savings accounts at commercial banks and savings and loan companies are insured by the Federal Deposit Insurance Corporation (FDIC) up to $100,000 for your total deposits inside one particular institution. Credit union accounts are usually federally insured by the National Credit Union Administration for the same amount, but check with your credit union.

The $100,000 maximum insured amount isn’t per account; it’s per depositor per institution. If you have several accounts at one bank all registered the same way (John Jones, for example), be certain that your combined balance doesn’t exceed that figure. If it does and the bank goes bust, you can recover only the $100,000. You lose the rest. If you have multiple accounts at the same bank, but they are registered differently (one is John Jones, for example, and the second is to John Jones and Mary Jones, jointly), each account is insured for the maximum $100,000 in case the bank fails.

Brokerage accounts

The days are long gone when only the rich had stockbrokers and brokerage accounts. In these times of easy access to stocks via discount and Internet brokers, anyone with a minimal amount to stake can play the stock market. And, because you need to have a brokerage account to buy or sell any stocks, bonds, or other type of marketable security, many people find themselves with one or more accounts in their names.

A brokerage account is one of the most flexible investment vehicles: You may buy, sell, and hold stocks and bonds, mutual funds, and any other sort of investment, including cash. If the brokerage lets you, you may borrow against the value of your stocks inside the account (a so-called margin account ). You can place shares of stocks that you already own into this account. In fact, there’s not much that you can’t invest in a brokerage account.

When you do this, the brokerage transfers the registration (how the company that issues the security records the name of the owner) of any stocks, bonds, or mutual funds of the account to its name, as nominee for you. At this point, the physical stock certificates you’re familiar with disappear, and are now accounted for electronically. Regardless of whether you have physical certificates with your name typed on the front, or your shares are registered in the brokerage’s nominee name, you remain the owner of the shares.

These accounts are widely available from the following sources:

Full-service brokers: They may charge you a fee to manage your account (but not always).

Discount brokers: They offer you no advice but provide you with statements showing transactions for the period covered, lists of your securities at the end of the month, and the beginning and ending values in your account.

Internet brokers: They operate almost entirely online. Discount brokers charge you a fee only when you actually buy or sell anything in the account; an Internet broker may also hit you with a monthly fee, or a statement fee, if you don’t keep a certain value in the account or if you don’t place any trades, and they’ll charge you a higher fee if you call them to buy or sell rather than placing that trade over the Internet.

Commercial banks: Many of them now own subsidiary brokerages.

Although brokerages do have insurance on the securities they hold, that’s insurance in case someone in their operation decides to walk off with the contents of the company vault. You’re not insured if the investments in your account do poorly or completely lose their value.

For more details on investing, check out Investing For Dummies, by Eric Tyson, and Stock Investing For Dummies, by Paul Mladjenovic (both published by Wiley).

Mutual fund accounts

Last, but not least, are mutual fund accounts, which you open any time you purchase a mutual fund directly from a mutual fund company. These accounts often function more like a bank account than a brokerage account (many accounts offer check-writing privileges and give you deposit tickets to add new money to an existing account), yet the investments inside the account more closely resemble those in the brokerage account.

Mutual fund accounts offer you the ability to hold one or more of a fund company’s funds inside the same account. After you purchase a fund, you can redeem it for cash at a later date or transfer it to any of the company’s other funds if you decide to change your investment strategy.

Unlike a brokerage account, a mutual fund account permits you to invest in the funds of only one particular mutual fund company, and that is its biggest limitation. If you want to change to another company’s funds, you have to open an account with that company or purchase that fund through your brokerage account (if that is allowed by the fund company — many only sell their products themselves and don’t allow brokers to become involved).

Mutual fund accounts, like brokerage accounts, aren’t insured against market downturns and loss in value. Invest carefully — there are no safety nets.

Registering Your Account

Whether you open a bank account, a brokerage account, or a mutual fund account, you have to provide the financial institution with some bare-bones information about yourself, namely your name, your address, and your Social Security number. You may also have to provide employment information and your date of birth. With this information, the institution can report your annual taxable earnings to you and the government for income tax purposes.

When you open that account, though, you’ll have a variety of options as to how you want that account owned, or registered. The two most popular choices are individual ownership and joint tenants with the right of survivorship. You may also choose to register an account in the name of your minor child, either as a custodial account (which may accept only cash), or as an account opened under the Uniform Gift (or Transfer) to Minors Act, discussed below. What you choose may have a staggering difference in what happens to that account down the road.

Owning the account all by yourself

When you open an individual account (and you must be at least 18 years old to do so), only your name will appear on the account registration. You are the sole owner, and you’re responsible for paying income tax on all the taxable earnings from the account.

Whenever you take money out of the account, you don’t become subject to income tax on that withdrawal; however, should you take the money and give it to someone else, you may have to deal with Gift Tax and/or Generation-Skipping Transfer Tax issues, depending on the amount of the gift. Check out Chapter 3 for the Gift and Generation-Skipping Transfer Tax rules.

Be prepared with a plan in case you die. With an individual account, if you die without a valid last will and testament, the value in the account is divided according to the laws in your state. If you assume that the money will automatically go entirely to your spouse or kids, think again. Living parents or siblings may also get a cut. If you don’t have a last will when you die, you may be able to avoid this scenario by setting up a so-called living trust or grantor trust and registering the account in the name of the trust.

Sharing ownership

Joint tenants with right of survivorship (JTWRS) is typically what people think of when they refer to joint ownership, and for most people who use it, it works well. Joint tenants with right of survivorship means that two owners are listed on a particular account; in the event of the death of one of the owners, the other becomes the owner of all of the property inside the account.

When you open a JTWRS account, both account holders must supply all the required information. At tax reporting time, you are each responsible for half of the total tax due. If you hold the account jointly with your spouse and you file a joint income tax return, there’s no problem. You report the full amount of your taxable income on the return. If, however, you hold the account jointly and you each file your own income tax returns, you need to split the income between the two of you so that you each pay tax on your half.

If you make a gift using funds from the account, there is no income tax consequence to you; however, the IRS considers that half of the gift comes from you, and the other half from your joint tenant, and you may both be required to file a Form 709, U.S. Gift (and Generation-Skipping Transfer) Tax return, depending on the size of the gift (see Chapter 3).

Finally, if you die, it doesn’t matter at all what your last will says — the joint owner inherits your share of the account.

Gifting your money to a minor

If ever there was a place where good tax planning ran completely counter to parental common-sense, gifting money or securities to your minor children qualifies. When you deposit cash into a custodial bank account (which may only accept cash), you transfer those funds into your child’s name and Social Security number. The taxes earned on income generated by that cash is now your child’s responsibility, and when your child turns 18, you no longer even have the nominal control over that account that you had as a parent.

If you want to make a gift of something other than cash, you may opt, instead, to fund an account for your child that is regulated by the Uniform Gifts to Minors Act (UGMA), also sometimes called the Uniform Transfers to Minors Act (UTMA) in some states. Under this provision, you can open an investment account for a minor child (even if it’s not your own child), gift it with money or securities, and operate it for the benefit of that child until the kid reaches either 18 or 21, depending on what state you live in and the age of majority. At that point, the account (which has always belonged to the minor child anyway) ceases to be your responsibility, and whatever is in it on that date reverts to the tender mercies of your formerly minor person.

Tax avoidance

What a great idea! When Congress first came up with the UGMA/UTMA marvel, it was touted as a great tax-planning device. Subsequent legislation has closed up most of this particular loophole, and whatever income tax benefit you (and your child) may still have will largely be eaten up trying to figure out how to calculate your child’s income tax. What’s more, the recent Jobs and Growth Tax Relief Reconciliation Act of 2003 has lowered income tax rates for long-term capital gains and dividends for everyone (see the section “Talking taxes” towards the end of this chapter).

When your child reaches majority

If UGMA/UTMA and custodial accounts no longer pack much punch as an income tax avoidance scheme, these fare even worse when you think about some of the real-life consequences of gifting large amounts of cash and securities to a child with no real-world experience. When your minor child is no longer a minor, she succeeds to the property, to save or spend as she will. If she opts to trek the Amazon instead of paying tuition, well, she can, and you have no recourse. The same holds true if she becomes the target of some unscrupulous scum, who sees a chicken ripe for the plucking.

Financial aid impact

And then there’s the financial aid angle. Actually, with an UGMA or UTMA account in your child’s life, or with a large custodial account, there is not much of a financial aid angle, if any; if you can’t find all the money to pay your child’s full expenses, you’ll probably end up taking unsubsidized Stafford Loans and/or PLUS Loans to pay the balance (see Chapter 17 for more info on Stafford loans and other forms of financial aid).

When your child files his FAFSA (Free Application for Federal Student Aid), the full value of any account held in your child’s name, even if you are still listed as the custodian or trustee, is counted as an asset of the child, and 35 percent of the value of that account (plus any other assets your child has) will be counted as available to pay college costs for the next year. Your child may have other ideas, though, and between the time you fill out the form in the spring and he attends in the fall, he may spend all that money on a car.

Registering and administering an UGMA/UTMA account

Still, if you’re absolutely bound and determined to set up one of these accounts for your child, you need to provide the financial institution where you set up the account with your kid’s name, address, date of birth, and Social Security number. The registration on the account will actually show your name as custodian for your child under the Uniform Gifts (or Transfers) to Minors Act. Generally speaking, to make sure that you’re giving up all right, title, and interest in the property you’re gifting, it usually makes sense for one parent (or grandparent) to make the gift, while the other parent acts as the account custodian.

Each state has specific rules under which the account may operate. Regardless of where you live, you’re acting only as a fiduciary (a person responsible for someone else’s assets), so you must act prudently and make every effort to maintain the value of the account. Here’s what you can do with the account:

Buy and sell securities inside the account

Transfer the account from one financial institution to another

Make any other reasonable financial decision concerning account assets

Managing Your Personal Investment Account

After you open a personal investment account, you need to figure out what to do with it. Obviously, you’ll have to decide for what purpose you’re saving and how much you want to save on a regular basis. And then you need to follow through, making sure that money is deposited in the amounts and with the frequency you’ve determined.

You clearly have other matters to consider here. You must decide what types of investments you’re comfortable with and understand how those investments will help you achieve your goals. (Chapter 9 explains many terms you’ll run across as you begin your life as an investor, and many of the different sorts of investments available to you.)

Your personal investment accounts and your tax-deferred or tax-exempt accounts differ in two important ways: the level of control you have over your assets and how (and when) the income you earn on your investments is taxed.

Choosing to hire an advisor or go it alone

When you place money into a personal investment account, whether it’s a savings account, a mutual fund account, or a brokerage account, you retain absolute control over the money and over your investments. You may add or subtract money at any time in the account, and you may completely change investment strategies whenever and wherever you want. You may choose to wing it and invest solely on the basis of your own research, or you can hire someone to do it for you. Literally, all options are open to you.

Because you have almost no limitations, creating an investment strategy, as outlined in Chapter 10, is an important step. An investor who flails about and never clearly identifies any sort of direction is a gambler who almost always loses money.

Do-it-yourself research

When I was growing up, my father checked his stocks every morning in the newspaper, crowing when they inched up and turning stony-faced when they lost money. Now, of course, you can go through that exercise as many times in the day as you want, thanks to the Internet. Stock and bond quotes are available, at no cost, on a variety of search engines and Web sites. If you already have an Internet brokerage account, you can research an offering and buy some shares on the spot, all in the matter of a few seconds. Snagging a few shares of some hot stock can be incredibly gratifying, especially if you never have to pick up a phone or talk to another breathing body.

The ease with which you can trade in the stock and bond markets doesn’t mean that making money in these markets is easy. Take advantage of all the literature available on the Internet, through libraries, and in newspapers; find out how to read the detailed quote pages for various types of investments. Before you ever click on the “buy” icon, check out the earnings reports that are available and make sure that you’ll still want to own a piece of this company tomorrow. When you buy on a whim, you generally live to regret it. Do your research first!

Hiring (and firing) an investment advisor

Should you feel uncomfortable investing in anything more exciting than a bank certificate of deposit without first checking with someone else, you may be a prime candidate for the services of a professional investment advisor. An investment advisor can be anyone — your accountant, your lawyer, an insurance agent, a financial planner, or any other person who claims to know how to make money in investments. Remember, however, that because there is no such thing as Investment Advisor School, and because advisors don’t need any specific credentials, finding someone to work with can be tricky.

Still, it is possible to find a person who can help you choose and manage your investments. Here’s how to shop for an advisor:

Check credentials. Not everyone in the investment world has the same credentials, but find out whether the person has some professional standing, financially speaking. If the advisor is an accountant, tax professional, attorney, Certified Financial Advisor, Certified Financial Planner, or something along those lines, take some comfort in knowing that the person actually has some knowledge of what he’s doing.

Check references. Anyone who wants your business should be willing to provide you with some references, both business and personal. You want to trust not only your advisor’s business acumen but also his personal integrity. You’re considering handing control of your money over to a relative stranger; make sure that you trust him.

Find out how he makes his money. An advisor who makes his money selling a financial services product will generally steer you to the benefits of that product instead of looking at all available investments. You’re better off paying an hourly rate or a percentage of your asset base as your advisor’s fee — without the need to sell you a specific product, your advisor can then help you select what’s truly best for you.

Trust your personal instincts. If an advisor you’re thinking of hiring makes you in the least bit uncomfortable, walk away. He may be a terrific analyst, but if you can’t get past your feelings of unease about him personally, he’s not the person to handle your money.

After you choose an advisor, you’re not honor-bound to stick by him through thick and thin. If you give that person a reasonable amount of time to manage your account and he doesn’t do as well as you’d have liked, or you find someone you think you like better, you can move your account and change your advisor. Even if you sign an agreement with an advisor, it’s generally not set in stone, and an escape clause is usually built in. An ethical advisor never wants an unhappy client.

Talking taxes

When you invest in a personal investment account like those described in this chapter, you pay income tax each year on the income your account earns on your investments annually. This means that when you take money out to pay for education expenses, for example, you don’t pay any tax at the time you withdraw the money because you’ve been paying the tax on an as-you-go basis. And, because the tax is already paid, you don’t need to worry about whether your withdrawal is used to pay for qualified or nonqualified expenses.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 has made investing outside of tax-deferred and tax-exempt savings accounts more attractive. The reduction of income tax rates on corporate dividends (the slice of profits that a corporation may choose to pay its shareholders) and long-term capital gains (the profit you make when you sell a security that you’ve owned for longer than one year for more money than you purchased it for) means that, even without the tax deferrals, your money may grow faster, and cost you less in income tax, than it would within a tax-deferred account. All bets are off with a tax-exempt account, though, because paying no tax is always better than paying just a little tax.

The investment portions of this new bill, which covers only the years 2003 through 2008, include the following provisions:

A top income tax rate on corporate dividends of 15 percent: If you are a lower-bracket taxpayer, this new tax rate on dividends may be as low as 5 percent.

A top income tax rate on long-term capital gains of 15 percent: You must own an asset for over one year to qualify for this rate. Once again, lower-bracket taxpayers could pay as little as 5 percent if their income tax rate is only 10 or 15 percent.

An immediate reduction in overall income tax rates: In 2003, the income tax rates run from 10 percent for low income taxpayers to 35 percent for extremely high income taxpayers, lowered from a range of 15 to 38.6 percent prior to the 2003 act. (People who earn less money pay a smaller percentage in tax than people who earn more money — at least that’s how it’s supposed to work.)

To make the best use of these rate reductions, you may want to consider using your investment account to buy securities that pay corporate dividends or that have a real chance of appreciation, enabling you to realize a capital gain when you sell. Interest-bearing bonds that you own may be better placed in tax-deferred or tax-exempt accounts, such as Section 529 plans or Coverdell ESAs, as the interest earned on these securities is taxed at the ordinary income tax rates of between 10 percent and 35 percent.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 is set to expire on December 31, 2008, and all these provisions will disappear in a puff of smoke unless Congress makes them permanent. Don’t count on it happening; many of the provisions in the overall bill are viewed as regressive, and as national budget deficits continue to explode, the wisdom of these cuts may be questioned. Still, while they’re in effect, take advantage of this gift.

Investing in real life

Almost everything that is written about investing and investments is tackled from a purely theoretical standpoint — how to achieve the best result given a certain set of circumstances. In real life, your circumstances almost never absolutely conform to the model, so your proper choices may not be the same as those of the so-called experts.

No place is this truer than when looking at tax benefits and ways to avoid tax. Paying tax is, to some extent, inevitable and necessary. And while trying to minimize the amount that you pay is natural, using the tax card to trump every other consideration is short-sighted and foolish. You may actually save some tax by gifting securities to your child in an Uniform Gifts to Minors Act account; however, you may have also just given control over a substantial sum of money to someone who, at age 18 or 21, will probably not be equipped to handle it. The amount of money that you save in income tax during the time your child is a minor could be far exceeded by the amount that your minor could lose when he takes possession of the account.

When you invest, first identify your savings goal, whether it’s college expenses, retirement money, or just the security of knowing that you have a healthy nest egg stashed away. Then you should arrive at a plan for how you think you’ll get there — through careful saving and cautious investing, perhaps, or through a more aggressive investment approach, if you’re comfortable with that. Only after you’ve outlined your plan should you attempt to mold it more by using the various tax considerations.

Remember, an investment plan that makes perfect tax sense but that doesn’t serve your needs is a plan doomed to failure. Use your common sense.