Kitchen Table Planning - How Much Will You Need

If you were planning a vacation you would start with a desired destination, select the dates you can go, determine your budget, and then tweak your plans to fit your budget. It is the same with financial planning. You have to determine where you want to go (how much income or how big a nest egg you need), set a target date for getting there, determine how much you need to save and invest, and then tweak your plan for the realities of your situation.

If you are planning for a down payment on a home you will have to amass a lump sum that you will be spending all at once. So calculating your need is pretty straight forward. If you want to buy a $300,000 house, you will need to save at least a 10% down payment, or $30,000.

If you are planning to send a child to college you can look up the cost of tuition, books, and living expenses at the schools web site. But unless your child is starting school this year you will have to estimate what future expenses might be, or you will surely come up short due to likely increases in costs between now and the time your student enrolls.

So how do you plan for such price increases? Well, if you do a little snooping around you will learn that college costs have been increasing at about twice the level of general inflation. Armed with that and the number of years until your student enters college, you can make an educated estimate of how much you will need in the future to pay for this expense, by using one of the 'secret' formulas of financial planning.

It is called the Future Value formula. It is, like the name implies, a formula to calculate the compound interest future value of something. Here's the 'secret' formula:

FV = PV * ( 1 + i )^N

PV = present value
FV = future value (maturity value)
i = interest rate in percent per period
N = number of periods

When estimating the future cost of something the i represents the rate you expect that something to go up in real terms. To learn about real rates of return see this previous post.

So lets work through an example. I have a daughter who will enter college in 12 years. The cost of attending a university in my state is currently about $17,000 per year, so in todays dollars I would need $68,000 to pay for her education.

PV = $68,000
FV = future value = ?
i = interest rate in percent per period = 6% (nominal college inflation)-3%(expected general inflation rate) =3%
N = number of periods = 12 years

FV = $68,000 * ( 1 + .03)¹²

If you are like me you don't have one of those fancy TI calculators you kids use, but that is okay. to solve the ( 1 + .03)¹² part you just add 1 and .03 then enter 1.03 times 1.03 into your basic calculator and hit the enter button twelve times. That gives you 1.4685. Now multiply $68,000 by the 1.4685, and presto, you find you will need about $99,860 (lets call it an even $100,000) in inflation adjusted dollars to send little Debbie off to college when the time comes.

Finally, when you are planning for retirement the 'how much will I need?' question is usually answered with a per year income figure. Here you have to estimate what you would need if you retired today. You don't need to adjust this amount for inflation because we will be adjusting investment returns for inflation as we go. So just figure what you would need today (you should make adjustments for children that are grown and gone, and any debts like your mortgage that you expect to be paid off.)

From this income need you should subtract any pension, social security, or annuity income you will receive during retirement. This leaves you with the annual income needs you will have to pay for yourself. For example; I need $50,000 in retirement income. I expect to receive $1,400 a month or $16,800 in social security benefits and a company pension of $12,000 per year. That leaves me with a shortfall of $21,200 per year that will have to come from my investments.

If you have read my post on safe withdrawal rates, you'll remember that the estimated real rate of return on your investments is your maximum withdrawal rate. Let's say my expected real rate of return is 5%. To estimate how much I would have to have in savings and investments to fund the $21,200 per year shortfall in retirement income I would simply divide $21,200 by .05. This tells me I need to have $424,000 in investments to fund the balance of my retirement income needs.

Coverdell Education Savings Accounts

I have written a couple of times about 529 college savings plans. Another alternative is the Coverdell Education Savings Account or ESA. While there are unique advantages to 529 saving plans the Coverdell ESA is a college savings vehicle you should know about.

Coverdell ESA's allow contributions of up to $2,000 per year that while not tax deductible, do grow tax free, and earnings remain tax free for qualified education expenses that include secondary schools (private, religious, etc.). The range of investments is generally larger than that offered by 529 plans which are run by mutual fund companies. Any IRA custodian can also offer Coverdell ESA's and companies like Shwab and Vanguard offer these accounts. With a self directed account you can choose from stocks and bonds in addition to mutual funds, so your portfolio can be managed with greater flexibility.

To make contributions a couple's adjusted gross income must not exceed $220,000, or $110,000 if you are single. To qualify for tax free withdrawals the money must be spent for qualified education expenses before the beneficiary turn 30 years old, however you can change the beneficiary to another family member once per year. The beneficiary must be under age 18 unless the beneficiary is a special needs child. Contributions from all donors cannot exceed the $2,000 per year cap.

With the rising cost of educating our children outstripping the general rate of inflation saving for college becomes more and more imperative. Coverdell ESA's are another account you should consider.

A 529 Plan For Your Retirement Years?

Here is a good story about a unique use of 529 college savings programs. Bottom line, if you are interested in studying at home or abroad when you graduate from your first career, you can use a 529 plan to pay for it!

• May be eligible for state tax deduction
• Investments grow without taxes and when spent for accredited higher education withdrawn without taxes also
• You can name a contingent beneficiary

Check it out here.
Courses here.

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The South Carolina 529 College Savings Plan

The state of South Carolina's 529 College Savings Plan- FutureScholar - is managed by Columbia Management a division of BankAmerica. For South Carolina residents it offers one very clear advantage to any other 529 plan a South Carolina Resident may be considering - a deduction from your South Carolina state income taxes. Note- Not a deduction on your federal return.

Contributions to the FutureScholar program work much like a traditional IRA deduction on your South Carolina income taxes, contributions reduce your taxable income. With the realatively flat income tax rates in South Carolina this means most residents will save 7% for any contribution made to their FutureScholar accounts. For example, if you are a South Carolina resident and contribut $10,000 to a FutureScholar account for your child or grand child you will recognize savings of $700 when you file your state income tax return (this will, unfortunately, also reduce your deduction for state income taxes paid on your federal return if you itemize deductions).

Like all 529 college savings accounts the investments in your account will grow tax deferred and currently can be withdrawn tax free to pay qualified education expenses. While there is a sunset provision for tax free withdrawals in 2010, 529 plans have become so popular that Congress may well extend this tax break, and even if they do not, the portion of the withdrawals representing investment gain would be taxed at the students income tax rate.

529 plans also have some features that make them useful in developing an estate plan. You and a spouse can both contribute, allowing contributions of up to $12,000 each without triggering a gift tax return and you can make up to a five year contribution in one year or up to $120,000 for a married couple if they make no other gifts to the student during that period of time, and if you die before the five year period has passed a prorated portion of the gift will be includable in your estate. Many worry about moving large sums of cash from their personnal assets, however the contributor retains control of the assets and can even reclaim (withdraw) the assets themselves subject to taxes and a 10% penalty on the earnings portion of the withdrawal.

South Carolina residents can also establish a 529 plan directly, without a financial intermediary, and invest in the mutual funds offered in the plan with no sales charge (commision). The forms needed are available on the website, FutureScholar.com.

With college costs rising at about twice the reported CPI, an early start is essential. If you are a South Carolina resident you should consider this college savings option. For more information visit FutureScholar.com.

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