Ask Linda: What should I do with this unexpected bonus?

Dear Linda,I will be receiving an unexpected bonus shortly. I want to make sure I am smart with the money and have a plan in place for what I am going to do with it. Any ideas?

Sincerely, Lucky Lady

Dear Lucky Lady,

Your question is a common one we receive around this time of year as companies complete their prior-year reporting and issue bonuses. You are wise to create a strategy before spending the bonus. Without knowing the details of your situation, here are some general thoughts to help you get started.

1) Obtain a detailed tax projection from your tax preparer so you know how much of the bonus will be yours to keep after taxes. If your employer withholds less taxes than projected, reserve the balance so you have it available when it is due at tax time. You can also increase your W-4 withholding for the rest of the year. Withhold at least enough to avoid the underpayment tax penalty.

2) Pay off high-interest rate debt including credit cards, personal loans, or student loans. For example, some student loans charge close to a 7% interest rate. If you pay that loan off, it is as if you earned a risk-free rate of return of 7% on the money. However, if you plan to qualify for a student loan forgiveness program, you may not want to rush and pay it off. It will depend on your situation.

3) Build a cash emergency reserve. If you don't have this in place, reserve at least three months' worth of expenses in a high-interest rate savings account. You can reserve a larger amount if you are worried about losing your job, are expecting to move soon, or simply feel more comfortable holding a larger amount of cash. Realize that the interest rate on a savings account will not keep up with inflation over the long-term, so keep this account at the minimum balance required for your personal situation.

4) Increase your retirement savings at work. If your employer offers a retirement plan, you can save up to the IRS limit for 2018. For example, if you have a 401k or TSP, the limit is $18,500 if you are under 50 years old and $24,500 if you are over 50 years old.

Increase savings elsewhere. After you have implemented the first four suggestions, you may consider one or more of the following options:

- Save to a Roth IRA or Traditional IRA, if you qualify.

- Maximize your Health Savings Account (HSA), if you qualify.

- Consider after-tax 401k contributions, if available. After-tax 401k contributions are different than Roth contributions. There is no tax deduction on the savings, but the money will grow tax-deferred and can be rolled into a Roth IRA (without limitation) after you leave the company. Not every company offers this option.

- Save to a Brokerage account. There is no tax deduction on contributions to a brokerage account, but it is still a good option. Qualified retirement accounts (such as a 401k or TSP) are taxed differently than a brokerage account. When you have a mix of account types, you have more flexibility to utilize asset location strategies and manage your tax bill in retirement.

- Save to a donor-advised fund (DAF). A DAF is an investment account for charitable purposes. You invest as you would with any investment account and when you are ready to donate to a qualified charity, use the money from the DAF. Assuming you are eligible for charitable deductions, you will receive the deduction when you place money into the DAF, not when money is withdrawn. If you are charitably inclined and expect to be in a higher tax bracket now than in the future, take advantage of the tax deduction now while it provides a greater benefit to you.

- Save $10K to an I-Bond. I-Bonds are government bonds adjusted for inflation. You are allowed to buy $10K each calendar year per person.

- Fund other goals you may have. Confirm you have enough life and disability insurance, and if not, use the bonus to become adequately insured. If you are saving for a house, earmark some of the bonus for the down payment. If you are saving for a child's college education, consider a 529 plan.

Work with a fee-only, fiduciary advisor and tax preparer if you want a customized strategy that prioritizes your available options in detail.

529 Plan Rules Have Changed

They are still the best tool in your toolbox for college planning, but there have been some changes. Here is a quick re-cap. What are 529 plans?

They are investment vehicles that are named after the Internal Revenue Code that created them. They have helped many of our clients pay for college for their children as they offer tax advantages when used for qualified education expenses at eligible educational institutions.

What tax advantages do they offer?

When used appropriately, the money placed in the 529 account is allowed to grow and be distributed tax-free. Additionally, many states are now offering a state tax deduction for contributions into the account. Here is the most recent list. It is subject to change, so continue to check back annually for the most up to date information. You are not obligated to use your state's 529 plan. A common scenario is that your state does not offer a state tax deduction (or you don't pay state taxes at all), therefore you can open a 529 plan in any state of your choosing, as long as the plan doesn't have residency requirements. What is an "eligible educational institution"?

Any college, university, vocational school, or other post-secondary educational institution eligible to participate in a student aid program run by the U.S. Department of Education (1).

New to the tax law passed in 2017, up to $10,000 in 529 withdrawals are allowed (once per year) to pay for K-12 tuition. Qualifying schools include public, private, and religious schools. That being said, you should check with your 529 plan to make sure they are conforming to the new federal law.

What are the qualified education expenses that the money can be used for?

Tuition, mandatory fees, room and board (limited to the cost of school housing), books, computers and related computer equipment. What about financial aid?

Having a 529 plan will affect your child's financial aid package, but very minimally, and not enough to dissuade you from using a 529 plan altogether. Assets owned by the parents, such as a 529 plan, will reduce a student's aid package by 5.64%. So if the 529 account is $50,000, the financial aid reward will be reduced by $2,820. The tax benefits and earnings on the 529 account are likely going to outweigh that $2,820. This also assumes you are eligible for any aid at all, which many children are not. Compare this to a UTMA account (another vehicle used for college savings) which would reduce the aid package by 20% ($10,000) since it is an asset owned by the child. Grandparent-owned assets are not included at all in the financial aid calculation, but they do affect the FASFA form in the year following the distribution as we noted in one of our previous blog posts.

Who can save to them?

Anyone. You can open as many 529 plans as you want and name anyone as a beneficiary. The most common scenario we see is that the account owner is the parent and the beneficiary is the child.

What if my child doesn't go to college?

The money in the 529 plan has to be used as directed. If not, you will owe federal and state taxes on the earnings and an additional 10% penalty. You may also have to refund an amount to the state if you received a state tax deduction. There are a few ways to avoid this tax bill and headache:

- You can transfer the leftover funds to a qualified family member, such a sibling. You would simply change the beneficiary on the account.

- If your child receives a scholarship, you are allowed withdraw the amount of the scholarship without penalty (but you will still owe taxes on the earnings).

- If your child goes to a trade school or coding school, the school may still qualify! This is the list of the current institutions that are qualified and it includes some trade schools. If the school is not on the list, it is recommended you contact the school directly to confirm. As noted above, if they are eligible to participate in a student aid program run by the U.S. Department of Education, you can use your 529 money.

Contribution limits

Contributions to 529 plans are considered gifts. Therefore you can contribute up to the annual IRS gifting limits ($15,000 per person or $30,000 per married couple filing jointly for 2018). There is also an exception for 529 plans where you can contribute a lump sum of 5 years worth of gifting ($150,000 per married couple filing jointly) but you cannot make any additional contributions for the following 4 years for that beneficiary.

Get another perspective

Read the fine print for the specific plan you are interested in. Rules in the financial and tax world are always changing, so make sure you review your financial strategy annually to make sure you are within present guidelines and benefit as much as possible with what is available to you.


Are you eligible for the American Opportunity Tax Credit?

If you paid for higher education costs in 2013, be sure to speak with your tax preparer to see if you may benefit from this credit. What is it?

The American Opportunity Tax Credit (AOTC) modifies the Hope Tax Credit. It allows you to take a tax credit for qualified higher education costs including tuition, certain fees and course materials. See IRS Publication 970 for a complete list. It does not include room & board.

How much is it?

The credit amount is 100% on the first $2,000 of expenses and 25% of the next $2,000, so $2,500 max per year.

How long can I use it?

For four years! This is better than the Hope credit that could be used only for two years.

What exactly is a tax credit?

A tax credit reduces your tax liability dollar for dollar. It is preferable to a “deduction” which reduces your taxable income.

Can anyone claim it for higher education costs for themselves or a dependent?

If you are filing singly, your modified Adjusted Gross Income (AGI) has to be less than or equal to $80,000. For married folks filing jointly, the number is $160,000. After these income levels, the credit starts to phase out until it is no longer available.

How do I claim the credit?

Complete form 8863 and attach it to the 1040 when you file your tax return.

What if I only used 529 plan money for education expenses?

You can’t double dip. That is why I recommend that my clients use their own funds for the first $4K to make sure they can take advantage of the credit, then 529 funds after that.


Using a 529 Plan to Help a Grandchild Pay for College

When grandparents want to help pay for a grandchild’s education, they can choose a method that is just as beneficial to them as it is to their grandchild. With smart planning, grandparents can save taxes using a tax-preferred vehicle like a 529 plan. If they choose a 529 plan, it is important to understand the implications of having grandparents as owners instead of the child’s parents. Tax-deferred 529 plans have an account owner and a beneficiary. Typically, a parent is the account owner and a child is the beneficiary. This allows the parent to retain control over the account, preventing the child from making poor decisions with the money, like buying a new car. When determining financial aid eligibility, it is usually better for a parent to be the owner of the 529 account. While this calculation can get complicated, in general, parents are expected to contribute 5.64% of their eligible assets annually towards their child’s tuition. Retirement assets are not counted. The student is expected to contribute 20% of her assets. This is why it is typically recommended to spend down the child’s assets first, if they have any. Grandparents’ assets don’t count at all. So why would you not have the grandparent set up a 529?

The catch is this: If a distribution is taken from a grandparent owned 529, the distribution amount needs to be reported as income on the student’s financial aid form the following year. This can reduce the student’s financial aid amount by up to 50% of the distribution amount. So if $10K was distributed, the aid amount can be reduced by as much as $5K. If financial aid is not a possibility in your situation, this nuance doesn’t matter. If it is a possibility, hold off on taking distributions from a grandparent owned 529 until the last FASFA form is filed, typically the middle of the student’s junior year.

Another way for grandparents to contribute is to simply gift money (within gifting limits) to the parents to be used for college. It will affect the aid amount since it is the parent’s asset as discussed, but not by much. Here are some more pros and cons to having a grandparent owned 529. Be sure to consult with your financial and tax advisor to understand what is best for your specific situation.

The Dark Side of UTMA Accounts

With this next post, I wanted to share an issue I have seen a couple times within the last few months. Parents have called asking how to postpone their child from receiving a UTMA account at age 18. The answer is, you cannot postpone the inevitable. Minor children cannot legally hold mutual funds, stocks, bonds and life insurance policies. If parents want to transfer these to their children, they have the option to set up a UTMA (or UGMA) account for them. The issue is that this money needs to be handed over to the child at the age of majority (age 18 or 21 depending on the state).

This may seem in the distant future when you are holding a newborn in your arms, but the reality is that the age of majority, whether 18 or 21, is still incredibly young. Not surprisingly, there are some young adults that are just not ready or responsible enough to receive a lump sum.

UTMA funds are irrevocable gifts. The article below is a good overall summary of UTMA’s. It mentions that one option is to spend the money for the benefit of the child before the age of majority. You would need to use the money for items other than parental obligations and work with a qualified accountant.

An alternative vehicle for parents looking to gift assets to their children is a 529 account. It is often the one I recommend. While it also has its limitations, when presented with the pros and cons of each, parents often choose the 529.

I recommend meeting with a financial planner to review your specific situation and see which vehicle may be better for you.