Investing, Life Events, Strategies to Save

Guide to Choosing the Right IRA: Traditional or Roth?

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The Roth IRA versus traditional IRA debate has raged on for years.

What many retirement savers may not know is that most of the debate about whether it’s better to contribute to a traditional IRA or a Roth IRA is flawed.

You’ve probably heard that young investors are better off contributing to a Roth IRA because they’ll likely be in a higher tax bracket when they’re older. You’ve probably also heard that if you’re in the same tax bracket now and in retirement, a traditional IRA and Roth IRA will produce the same result.

These arguments are part of the conventional wisdom upon which many people make their decisions, and yet each misses some important nuance and, in some cases, is downright incorrect.

The Biggest Difference Between Traditional and Roth IRAs

There are several differences between traditional and Roth IRAs, and we’ll get into many of them below.

The key difference is in the tax breaks they offer.

Contributions to a traditional IRA are not taxed up front. They are tax-deductible, meaning they decrease your taxable income for the year in which you make the contribution. The money grows tax-free inside the account. However, your withdrawals in retirement are treated as taxable income.

Contributions to a Roth IRA are taxed up front at your current income tax rate. The money grows tax-free while inside the account. And when you make withdrawals in retirement, those withdrawals are not taxed.

Whether it’s better to get the tax break when you make the contribution or when you withdraw it in retirement is the centerpiece of the traditional vs. Roth IRA debate, and it’s also where a lot of people use some faulty logic.

We’ll debunk the conventional wisdom in just a bit, but first we need to take a very quick detour to understand a couple of key tax concepts.

The Important Difference Between Marginal and Effective Tax Rates

Don’t worry. We’re not going too far into the tax weeds here. But there’s a key point that’s important to understand if you’re going to make a true comparison between traditional and Roth IRAs, and that’s the difference between your marginal tax rate and your effective tax rate.

When people talk about tax rates, they’re typically referring to your marginal tax rate. This is the tax rate you pay on your last dollar of income, and it’s the same as your current tax bracket. For example, if you’re in the 15% tax bracket, you have a 15% marginal tax rate, and you’ll owe 15 cents in taxes on the next dollar you earn.

Your effective tax rate, however, divides your total tax bill by your total income to calculate your average tax rate across every dollar you earned.

And these tax rates are different because of our progressive federal income tax, which taxes different dollars at different rates. For example, someone in the 15% tax bracket actually pays 0% on some of their income, 10% on some of their income, and 15% on the rest of their income. Which means that their total tax bill is actually less than 15% of their total income.

For a simple example, a 32-year-old couple making $65,000 per year with one child will likely fall in the 15% tax bracket. That’s their marginal tax rate.

But after factoring in our progressive tax code and various tax breaks like the standard deduction and personal exemptions, they will only actually pay a total of $4,114 in taxes, making their effective tax rate just 6.33% (calculated using TurboTax’s TaxCaster).

As you can see, the couple’s effective tax rate is much lower than their marginal tax rate. And that’s almost always the case, no matter what your situation.

Keep that in mind as we move forward.

Why the Conventional Traditional vs. Roth IRA Wisdom Is Wrong

Most of the discussion around traditional and Roth IRAs focuses on your marginal tax rate. The logic says that if your marginal tax rate is higher now than it will be in retirement, the traditional IRA is the way to go. If it will be higher in retirement, the Roth IRA is the way to go. If your marginal tax rate will be the same in retirement as it is now, you’ll get the same result whether you contribute to a traditional IRA or a Roth IRA.

By this conventional wisdom, the Roth IRA typically comes out ahead for younger investors who plan on increasing their income over time and therefore moving into a higher tax bracket or at least staying in the same tax bracket.

But that conventional wisdom is flawed.

When you’re torn between contributing to a traditional or Roth IRA, it’s almost always better to compare your marginal tax rate today to your effective rate in retirement, for two reasons:

  1. Your traditional IRA contributions will likely provide a tax break at or near your marginal tax rate. This is because federal tax brackets typically span tens of thousands of dollars, while your IRA contributions max out at $5,500 for an individual or $11,000 for a couple. So it’s unlikely that your traditional IRA contribution will move you into a lower tax bracket, and even if it does, it will likely be only a small part of your contribution.
  2. Your traditional IRA withdrawals, on the other hand, are very likely to span multiple tax brackets given that you will likely be withdrawing tens of thousands of dollars per year. Given that reality, your effective tax rate is a more accurate representation of the tax cost of those withdrawals in retirement.

And when you look at it this way, comparing your marginal tax rate today to your effective tax rate in the future, the traditional IRA starts to look a lot more attractive.

Let’s run the numbers with a case study.

A Case Study: Should Mark and Jane Contribute to a Traditional IRA or a Roth IRA?

Mark and Jane are 32, married, and have a 2-year-old child. They currently make $65,000 per year combined, putting them squarely in the 15% tax bracket.

They’re ready to save for retirement, and they’re trying to decide between a traditional IRA and a Roth IRA. They’ve figured out that they can afford to make either of the following annual contributions:

  • $11,000 to a traditional IRA, which is the annual maximum.
  • $9,350 to a Roth IRA, which is that same $11,000 contribution after the 15% tax cost is taken out. (Since Roth IRA contributions are nondeductible, factoring taxes into the contribution is the right way to properly compare equivalent after-tax contributions to each account.)

So the big question is this: Which account, the traditional IRA or Roth IRA, will give them more income in retirement?

Using conventional wisdom, they would probably contribute to the Roth IRA. After all, they’re young and in a relatively low tax bracket.

But Mark and Jane are curious people, so they decided to run the numbers themselves. Here are the assumptions they made in order to do that:

  • They will continue working until age 67 (full Social Security retirement age).
  • They will continue making $65,000 per year, adjusted for inflation.
  • They will receive $26,964 per year in Social Security income starting at age 67 (estimated here).
  • They will receive an inflation-adjusted investment return of 5% per year (7% return minus 2% inflation).
  • At retirement, they will withdraw 4% of their final IRA balance per year to supplement their Social Security income (based on the 4% safe withdrawal rate).
  • They will file taxes jointly every year, both now and in retirement.

You can see all the details laid out in a spreadsheet here, but here’s the bottom line:

  • The Roth IRA will provide Mark and Jane with $35,469 in annual tax-free income on top of their Social Security income.
  • The traditional IRA will provide $37,544 in annual after-tax income on top of their Social Security income. That’s after paying $4,184 in taxes on their $41,728 withdrawal, calculating using TurboTax’s TaxCaster.

In other words, the traditional IRA will provide an extra $2,075 in annual income for Mark and Jane in retirement.

That’s a nice vacation, a whole bunch of date nights, gifts for the grandkids, or simply extra money that might be needed to cover necessary expenses.

It’s worth noting that using the assumptions above, Mark and Jane are in the 15% tax bracket both now and in retirement. According to the conventional wisdom, a traditional IRA and Roth IRA should provide the same result.

But they don’t, and the reason has everything to do with the difference between marginal tax rates and effective tax rates.

Right now, their contributions to the traditional IRA get them a 15% tax break, meaning they can contribute 15% more to a traditional IRA than they can to a Roth IRA without affecting their budget in any way.

But in retirement, the effective tax rate on their traditional IRA withdrawals is only 10%. Due again to a combination of our progressive tax code and tax breaks like the standard deduction and personal exemptions, some of it isn’t taxed, some of it is taxed at 10%, and only a portion of it is taxed at 15%.

That 5% difference between now and later is why they end up with more money from a traditional IRA than a Roth IRA.

And it’s that same unconventional wisdom that can give you more retirement income as well if you plan smartly.

5 Good Reasons to Use a Roth IRA

The main takeaway from everything above is that the conventional traditional versus Roth IRA wisdom is wrong. Comparing marginal tax rates typically underestimates the value of a traditional IRA.

Of course, the Roth IRA is still a great account, and there are plenty of situations in which it makes sense to use it. I have a Roth IRA myself, and I’m very happy with it.

So here are five good reasons to use a Roth IRA.

1. You Might Contribute More to a Roth IRA

Our case study above assumes that you would make equivalent after-tax contributions to each account. That is, if you’re in the 15% tax bracket, you would contribute 15% less to a Roth IRA than to a traditional IRA because of the tax cost.

That’s technically the right way to make the comparison, but it’s not the way most people think.

There’s a good chance that you have a certain amount of money you want to contribute and that you would make that same contribution to either a traditional IRA or a Roth IRA. Maybe you want to max out your contribution and the only question is which account to use.

If that’s the case, a Roth IRA will come out ahead every time simply because that money will never be taxed again.

2. Backdoor Roth IRA

If you make too much to either contribute to a Roth IRA or deduct contributions to a traditional IRA, you still might be eligible to do what’s called a backdoor Roth IRA.

If so, it’s a great way to give yourself some extra tax-free income in retirement, and you can only do it with a Roth IRA.

3. You Might Have Other Income

Social Security income was already factored into the example above. But any additional income, such as pension income, would increase the cost of those traditional IRA withdrawals in retirement by increasing both the marginal and effective tax rate.

Depending on your other income sources, the tax-free nature of a Roth IRA may be helpful.

4. Tax Diversification

You can make the most reasonable assumptions in the world, but the reality is that there’s no way to know what your situation will look like 30-plus years down the road.

We encourage people to diversify their investments because it reduces the risk that any one bad company could bring down your entire portfolio. Similarly, diversifying your retirement accounts can reduce the risk that a change in circumstances would result in you drastically overpaying in taxes.

Having some money in a Roth IRA and some money in a traditional IRA or 401(k) could give you room to adapt to changing tax circumstances in retirement by giving you some taxable money and some tax-free money.

5. Financial Flexibility

Roth IRAs are extremely flexible accounts that can be used for a variety of financial goals throughout your lifetime.

One reason for this is that your contributions are available at any time and for any reason, without tax or penalty. Ideally you would be able to keep the money in your account to grow for retirement, but it could be used to buy a house, start a business, or simply in case of emergency.

Roth IRAs also have some special characteristics that can make them effective college savings accounts, and as of now Roth IRAs are not subject to required minimum distributions in retirement, though that could certainly change.

All in all, Roth IRAs are more flexible than traditional IRAs in terms of using the money for nonretirement purposes.

3 Good Reasons to Use a Traditional IRA

People love the Roth IRA because it gives you tax-free money in retirement, but, as we saw in the case study above, that doesn’t always result in more retirement income. Even factoring in taxes, and even in situations where you might not expect it, the traditional IRA often comes out ahead.

And the truth is that there are even MORE tax advantages to the traditional IRA than what we discussed earlier. Here are three of the biggest.

1. You Can Convert to a Roth IRA at Any Time

One of the downsides of contributing to a Roth IRA is that you lock in the tax cost at the point of contribution. There’s no getting that money back.

On the other hand, contributing to a traditional IRA gives you the tax break now while also preserving your ability to convert some or all of that money to a Roth IRA at your convenience, giving you more control over when and how you take the tax hit.

For example, let’s say that you contribute to a traditional IRA this year, and then a few years down the line either you or your spouse decides to stay home with the kids, or start a business, or change careers. Any of those decisions could lead to a significant reduction in income, which might be a perfect opportunity to convert some or all of your traditional IRA money to a Roth IRA.

The amount you convert will count as taxable income, but because you’re temporarily in a lower tax bracket you’ll receive a smaller tax bill.

You can get pretty fancy with this if you want. Brandon from the Mad Fientist, has explained how to build a Roth IRA Conversion Ladder to fund early retirement. Financial planner Michael Kitces has demonstrated how to use partial conversions and recharacterizations to optimize your tax cost.

Of course, there are downsides to this strategy as well. Primarily there’s the fact that taxes are complicated, and you could unknowingly cost yourself a lot of money if you’re not careful. And unlike direct contributions to a Roth IRA, you have to wait five years before you’re able to withdraw the money you’ve converted without penalty. It’s typically best to speak to a tax professional or financial planner before converting to a Roth IRA.

But the overall point is that contributing to a traditional IRA now gives you greater ability to control your tax spending both now and in the future. You may be able to save yourself a lot of money by converting to a Roth IRA sometime in the future rather than contributing to it directly today.

2. You Could Avoid or Reduce State Income Tax

Traditional IRA contributions are deductible for state income tax purposes as well as federal income tax purposes. That wasn’t factored into the case study above, but there are situations in which this can significantly increase the benefit of a traditional IRA.

First, if you live in a state with a progressive income tax code, you may get a boost from the difference in marginal and effective tax rates just like with federal income taxes. While your contributions today may be deductible at the margin, your future withdrawals may at least partially be taxed at lower rates.

Second, it’s possible that you could eventually move to a state with either lower state income tax rates or no income tax at all. If so, you could save money on the difference between your current and future tax rates, and possibly avoid state income taxes altogether. Of course, if you move to a state with higher income taxes, you may end up losing money on the difference.

3. It Helps You Gain Eligibility for Tax Breaks

Contributing to a traditional IRA lowers what’s called your adjusted gross income (AGI), which is why you end up paying less income tax.

But there are a number of other tax breaks that rely on your AGI to determine eligibility, and by contributing to a traditional IRA you lower your AGI you make it more likely to qualify for those tax breaks.

Here’s a sample of common tax breaks that rely on AGI:

  • Saver’s credit – Provides a tax credit for people who make contributions to a qualified retirement plan and make under a certain level of AGI. For 2017, the maximum credit is $2,000 for individuals and $4,000 for couples.
  • Child and dependent care credit – Provides a credit of up to $2,100 for expenses related to the care of children and other dependents, though the amount decreases as your AGI increases. Parents with young children in child care are the most common recipients of this credit.
  • Medical expense deduction – Medical expenses that exceed 10% of your AGI are deductible. The lower your AGI, the more likely you are to qualify for this deduction.
  • 0% dividend and capital gains tax rate – If you’re in the 15% income tax bracket or below, any dividends and long-term capital gains you earn during the year are not taxed. Lowering your AGI could move you into this lower tax bracket.

Making a Smarter Decision

There’s a lot more to the traditional vs. Roth IRA debate than the conventional wisdom would have you believe. And the truth is that the more you dive in, the more you realize just how powerful the traditional IRA is.

That’s not to say that you should never use a Roth IRA. It’s a fantastic account, and it certainly has its place. It’s just that the tax breaks a traditional IRA offers are often understated.

It’s also important to recognize that every situation is different and that it’s impossible to know ahead of time which account will come out ahead. There are too many variables and too many unknowns to say for sure.

But with the information above, you should be able to make a smarter choice that makes it a little bit easier to reach retirement sooner and with more money.

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Life Events

Term vs Whole Life Insurance

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The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Term vs Whole Life Insurance

If you’re shopping for life insurance, there are two main types you’ll likely encounter: term life insurance and whole life insurance.

Depending on who you talk to, you’ll hear different arguments for and against both types, which can make it difficult to figure out which type of life insurance will provide the right protection for you and your family.

This guide breaks it all down so that you can make the best decision for your specific situation.

What Is the Purpose of Life Insurance?

Before getting into the debate over term versus whole life insurance, let’s take a step back and remind ourselves why life insurance is important to begin with.

While there are some rare exceptions, life insurance primarily serves one main purpose: to provide financial protection to people who are financially dependent upon you.

In other words, life insurance makes sure that there will always be money available for the people who depend on you financially, even if you’re no longer there to provide for them.

A good example of this is a couple with young children. A toddler obviously cannot support herself financially, and life insurance makes sure that there would be financial resources to care for her no matter what happens to the parents.

Other examples of financial dependents might include a spouse who would struggle to handle all the bills on his or her own, or parents who have co-signed for your student loans.

So before you start thinking about which type of life insurance you need, ask yourself the following two questions to better understand why you’re getting life insurance at all:

  1. Is there anyone who would struggle financially without your support? If not, you probably don’t need life insurance.
  2. If so, for how long will they be dependent upon you? Is it a fixed time period or is it relatively permanent?

Your answers to those questions will help you sort through the term versus whole life insurance debate with a clearer, more personal viewpoint.

The Basics of Term Life Insurance

Term life insurance is coverage that lasts for a set amount of time, typically 5-30 years. Once that period is up, the policy expires and your coverage ends.

That expiration may sound like a problem, but it’s actually similar to most other types of insurance. Things like auto insurance and homeowners insurance are typically annual policies that have to be renewed each year, and you would cancel your coverage if you no longer had a need. Similarly, term life insurance is meant to provide coverage only for as long as you actually need it.

Let’s look at the pros and cons.

The Benefits of Term Life Insurance

It’s Inexpensive

Term life insurance is typically the most cost-effective way to get the protection you need. In fact, it’s often 10 times less expensive than whole life insurance for the same amount of coverage, especially if you’re relatively young and healthy.

The main reason for the price difference is that term life insurance eventually expires, meaning it has a smaller chance of paying out. And again, that may look like a downside, but…

The Coverage Period Lines Up with Your Need

Most people only have a temporary need for life insurance. Your kids will eventually grow up and be self-sufficient. Your spouse can eventually rely on retirement savings and Social Security income. Your joint debt will eventually be paid off.

Term life insurance provides financial protection for the amount of time that you need it and no more. You should hope it doesn’t pay out, because that just means that you didn’t die early. Like your car insurance, it’s good to have in case of an emergency, but the best case scenario is never having to file a claim.

In addition, if for some reason your situation changes and you no longer need life insurance, you can simply cancel your term life insurance policy and be done with it. Again, it’s coverage for as long as you need it and no more.

It’s Easy to Shop Around

Term life insurance policies are fairly simple and therefore pretty generic. As long as you’re looking at insurance companies with a strong financial rating, you can largely shop on price alone.

My two favorite sites for comparison shopping for term life insurance policies are PolicyGenius and Term4Sale, both of which only list policies from reputable companies.

For example, using the Term4Sale quote engine, a 34-year-old nonsmoking male in New York City with “Preferred” health status could get a $1 million 30-year term life insurance policy for as little as $939.98 per year or as much as $1,255.30 per year. And again, because term life insurance is fairly generic, you can compare those premiums with the confidence that your policy would be just as good either way.

You Can Typically Convert to Whole Life

What happens if you end up needing life insurance coverage longer than you originally thought? Since term life insurance eventually runs out, wouldn’t that be a problem?

It is a risk, but most term life insurance policies allow you to convert your policy to whole life insurance without medical underwriting as long as you do it before the policy expires. Your premium would increase significantly upon such a conversion, reflecting the increased liability the insurance company is taking on by providing permanent coverage. And if for some reason your policy did require medical underwriting at the time of conversion, there would be the risk of an even bigger premium increase if your health has declined since you originally got the policy.

Not all policies have this conversion feature, but those that do remove the risk that you wouldn’t be able to get permanent coverage later on if you need it.

The Downsides of Term Life Insurance

It’s More Expensive as You Get Older

Term life insurance is typically inexpensive if you’re relatively young, but it gets more expensive as you get older, especially if you’re looking at policies with longer terms. And the reason is simply that your odds of dying increase as you age, which means the insurance company faces a bigger risk.

For example, a 54-year-old male looking for the same $1 million, 30-year term life insurance policy we mentioned above is looking at an annual premium of $5,894 to $6,780 per year.

If you’re in your 50s or above and looking for life insurance, a term policy may or may not end up being a cost-effective way to get it.

It May Not Last as Long as You Need

Life is hard to predict, and it’s certainly possible that you end up needing life insurance for longer than you originally expected. If that happens, your term life insurance policy likely won’t have a lot of flexibility that allows you to extend it, beyond converting it to whole life.

There are also some insurance needs for which permanent protection is simply better. Those are rare, but we’ll talk about them below.

The Basics of Whole Life Insurance

Whole life insurance has two primary features:

  1. It provides permanent coverage, meaning that it will never expire as long as you continue to pay the premiums.
  2. It includes a savings component that builds up over time and can eventually be used for a variety of purposes.

There are several types of whole life insurance that have slightly different features and serve different purposes, like universal life insurance, variable life insurance, and equity-indexed life insurance. For the purposes of this article we’ll focus on the basic whole life insurance that most people will come across, and for the most part, all of the following pros and cons would apply no matter which type you’re talking about.

The Benefits of Whole Life Insurance

It Can Handle a Permanent Need

If you have a permanent or indefinite need for life insurance, whole life insurance is the way to get it.

For example, if you have a child with special needs who will likely be dependent upon others for his or her entire life, whole life insurance may make sense. Or if you will have multiple millions of dollars to pass on to your heirs, whole life insurance can help with estate taxes and preserve your family’s wealth.

Most people don’t have these kinds of permanent needs, but if you do, then whole life insurance can be valuable.

It Can Be a Form of Forced Savings

For people who struggle to consistently save money, whole life insurance can be a way to force yourself to build long-term savings while also providing financial protection.

It may not be the most efficient savings account, as we’ll talk about below, but having some savings is better than having none, and the savings you do accumulate can be withdrawn for any reason. Taxes are also deferred while the money is inside the account, which can be a benefit for high-income earners who have already maxed out their other tax-advantaged savings accounts.

It’s Can Be Structured to Meet Your Goals

If you work with a life insurance professional who really knows what they’re doing, you can specially structure a whole life insurance policy to serve specific purposes.

For example, if your main goal is permanent life insurance protection, you can structure it to minimize the savings component and make that protection as cheap as possible. If your main goal is to build savings, you can structure it to minimize other costs and front-load your contributions to grow your savings as quickly as possible.

If you can find a life insurance agent who’s willing to work with you in a fiduciary capacity, meaning they put your interests ahead of their own, you can get fairly creative and structure your whole life insurance policy to meet your specific needs.

The Downsides of Whole Life Insurance

It’s Expensive

Whole life insurance is an expensive way to get the financial protection you need. For example, remember the 34-year-old male who would pay $939.98 per year for a $1 million 30-year term life insurance policy? According to LLIS, a team of independent insurance advisers, a $1 million whole life insurance policy for the same individual would be $11,240 per year. That’s 12 times more expensive for the same amount of coverage. (Though, to be fair, for a longer coverage period.)

There are also a lot of hidden fees that add to the cost, from the sizable commission paid to the agent who sells you the policy to the management fees associated with the policy’s savings account.

Unless you truly have a permanent need for coverage, whole life insurance is probably not the most cost-effective way to get it.

Most People Don’t Have a Permanent Need

The simple fact is that most people don’t have a need for permanent life insurance coverage. As your children age and your savings grow, the financial impact of your death decreases until there’s little to no risk.

It might be nice to know that whole life insurance will eventually pay out, but is that something you need? And if not, is it worth paying those big premiums over all those years instead of putting that money elsewhere?

Don’t be fooled into thinking that your insurance has to pay out for it to be valuable. If you don’t have the need for permanent coverage, you shouldn’t pay for it.

It’s Not an Efficient Savings Vehicle

The savings component of whole life insurance might sound attractive, but the truth is that it’s not an especially efficient way to save money.

It takes a long time for the cash value to build up. It’s often 7-10 years just to break even, and even over long periods of time in the best of circumstances the return is likely to be low.

Not only that, but withdrawals from your account are actually loans, meaning you’re typically charged interest for the right to use your own money. Can you imagine if your savings account at the bank charged you interest each time you took money out?

Finally, unlike other savings accounts where you can simply decide to pause or decrease your contributions for a while if you hit a rough patch, your whole life insurance premiums are due like clockwork no matter what. Your policy can lapse if you fail to pay your premiums, losing you both the protection you need and the savings you’ve built up.

The truth is that unless you’ve already maxed out all your other tax-advantaged savings accounts — like your 401(k), IRAs, health savings accounts, and 529 accounts — the tax benefits of saving within a life insurance policy likely aren’t worth it. And even then you may be better off using a taxable brokerage account, depending on your specific goals and circumstances.

Which Type of Life Insurance Is Right for You?

If you’re purely looking for the financial protection that life insurance provides, and if your need is temporary, then term life insurance is likely the best option for you. It’s the cheapest way to get the protection you need, leaving more room in your budget for your other goals and obligations.

And for most people, quite honestly, that’s the end of the discussion. Most people don’t have a need for permanent coverage and will be better off putting their savings elsewhere, like regular savings accounts for short-term needs and dedicated retirement accounts for long-term investments.

But there are a few situations in which some kind of whole life insurance can make sense.

If you have a truly permanent need for life insurance, such as a child with long-term special needs, then a whole life insurance policy specially designed to provide the protection you need at the lowest cost possible may be well worth it.

And if your income is very high and you’re already maxing out all other tax-advantaged investment accounts, a whole life insurance policy can be a way to get some additional tax-deferred savings. Again, you’d ideally want it to be specially designed to minimize fees and maximize the amount that goes toward savings.

In any case, remember to focus on the reason why you’re getting life insurance in the first place and to make decisions around that need. The right type of life insurance will likely be pretty clear as long as you keep your personal goals at the forefront.

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Student Loan ReFi

Student Loan Consolidation vs. Student Loan Refinancing

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The editorial content on this page is not provided by any financial institution and has not been reviewed, approved or otherwise endorsed by any of these entities.

Student Loan Consolidation vs. Student Loan Refinancing

I haven’t met a single person with student loans who doesn’t want them gone as soon as possible. It’s hard enough to start a career or raise a family, and when a large chunk of your income is going toward student loans every month, it can feel downright impossible.

To help ease the burden of student loan payments, many borrowers opt to consolidate or refinance their student loans. Both options have the potential to help you pay your student loans off quicker and pay less interest along the way, but there’s a lot of confusion around how they work, how they differ, and whether they’re right for you.

By the end of this post you will understand both options and have a good idea whether one, or both, are right for you.

The terms student loan consolidation and student loan refinancing are often used interchangeably, but they actually mean two very different things, and they have very different sets of pros and cons. Lenders often add to the confusion by using the term consolidation when they’re actually talking about refinancing.

So before we dive into the specifics of each option, let’s first clear up what they are.

Student Loan Consolidation: The Basics

Student loan consolidation refers specifically to the federal student loan consolidation program, a process through which you can combine one or more federal student loans into a single Direct Consolidation Loan. You cannot use this program with private student loans. Refinancing, on the other hand, is done by private lenders. Unless you’re dealing directly with the U.S. Department of Education, you’re talking about refinancing, not consolidation.

We’ll get into the details below, but the primary reason to consolidate your federal student loans is to qualify for beneficial income-driven repayment plans you wouldn’t otherwise be eligible for. And the major downside is simply that consolidating won’t get you a lower interest rate, which is often a big point of confusion.

The Benefits of Student Loan Consolidation

Given that consolidation won’t improve your interest rate, why should you consider consolidating your federal student loans? How can it benefit you?

Here are three of the biggest reasons to consider consolidating your federal student loans.

1. You can qualify for better income-driven repayment plans

The government offers a number of income-driven repayment plans for federal student loans, and these plans are a real bargain for three main reasons:

  1. Your monthly payment is determined by your income, which means it will decrease during periods where your income is low.
  2. They all offer some kind of forgiveness as long as you make the required payments for a certain number of years.
  3. If you work for a qualifying nonprofit or government organization, these repayment plans qualify you for Public Service Loan Forgiveness, which takes even less time and offers more forgiveness.

The catch is that only Direct federal student loans are eligible for some of these repayment plans. Federal Family Education Loans (FFEL), which were all given out prior to 2010, are only eligible for income-based repayment (IBR), which is certainly good but often not as beneficial as Pay As You Earn (PAYE) or Revised Pay As You Earn (REPAYE).

So, if you would otherwise be eligible for those better repayment plans, you can consolidate your FFEL loans and turn them into Direct Loans, thereby opening up your eligibility. And keep in mind that you can consolidate a single loan all on its own, so you don’t need multiple FFEL loans to take advantage of this.

If you wouldn’t otherwise be eligible for those repayment plans, or if you already only have Direct Loans, then consolidation won’t help you here.

2. You can lock in low, fixed interest rates

Prior to July 1, 2006, most federal student loans were issued with variable interest rates that reset each year. Since then, all federal student loans have been issued with fixed interest rates.

If you have older loans with variable rates, consolidating them now can lock in a relatively low, fixed interest rate.

For example, according to Nelnet, variable rate federal student loans currently have interest rates ranging from 2.05% to 3.80%, depending on the type of loan and year of disbursement. By consolidating and locking in those low rates, you can ensure that your loans won’t get more expensive over time if interest rates rise.

3. You can get your loans out of default

If your federal student loans are in default, which typically means that you have missed payments for 270 days, you can consolidate your loans to get out. This can be an incredibly effective way to avoid the negative consequences of default, such as your loan immediately being due in full, taxes and wages potentially be garnished, and a big hit to your credit report, among others.

The catch is you can typically only use it once in your lifetime. So you should be confident that you won’t default again in the near future before proceeding. Otherwise, you may want to consider alternative ways to get out of default, such as rehabilitation.

The Downsides of Student Loan Consolidation

While all of the above are good reasons to consider consolidating your federal student loans, here are four things to watch out for.

1. You Won’t Get a Better Interest Rate

Consolidating your federal student loans won’t improve your interest rate. In fact, it’s likely that your interest rate will increase by just a tiny bit.

When you consolidate, the interest rate of your new loan is the weighted average of all of the loans included in the consolidation, rounded up to the nearest ? percent. What that means is that at best you’ll end up with the same combined interest rate that you had before, and at worst your interest rate will increase by about 0.125%.

You can use the following calculator to see what your interest rate would be after consolidation: FinAid Loan Consolidation Calculator

FinAid Loan Consolidation Calculator

The bottom line, though, is that student loan consolidation is NOT a route to a better interest rate. You need to refinance if that’s what you’re after, and we’ll talk more about that below.

2. You won’t be able to target your highest interest loans first

If you have two federal student loans with very different interest rates, you can pay them off faster and save yourself money by putting extra payments toward the loan with the higher interest rate first. But if you consolidate those two loans together, you end up with a blended interest rate and lose the ability to pay off the higher-interest loan quicker.

In this type of situation, it can make a lot of sense to consolidate those loans separately. Doing so would preserve the condition of having one high-interest rate loan and one low-interest rate loan, and would therefore allow you to keep prioritizing the high-interest rate loan.

3. You’ll lose any progress you’ve made toward qualifying for loan forgiveness

One of the benefits of enrolling in an income-driven repayment plan is the opportunity to have some of your student loan balance forgiven. Basically, with each plan you have to both be enrolled in the plan and make your minimum payment for a certain number of years. If you still have a balance at that point, it will be forgiven.

Here’s a quick overview of how long it takes to earn forgiveness with each repayment plan:

  • Income-Based Repayment = 20-25 years
  • Pay As You Earn = 20 years
  • Revised Pay As You Earn = 20-25 years
  • Public Service Loan Forgiveness = 10 years

Keep in mind that Public Service Loan Forgiveness is the only program that offers tax-free forgiveness. In all other cases, the amount of money forgiven would be considered taxable income.

If you’re already enrolled in an income-driven repayment plan and have made progress toward forgiveness, consolidating your loan means you’re likely starting over from scratch.

Depending on how much progress you’ve already made, and whether you could qualify for quicker forgiveness after consolidating, this might be a reason to avoid it.

4. Watch out for Parent PLUS loans!

Parent PLUS loans are federal student loans taken out by parents, and they are not eligible for the most generous income-driven repayment plans, even after consolidation.

What that means is that you need to be very careful NOT to mix Parent PLUS loans with other loans when consolidating. You should always consolidate them separately, if at all, to make sure that your other federal student loans remain eligible for the best income-driven repayment plans.

When Student Loan Consolidation Makes Sense

In general, federal student loan consolidation can make a lot of sense when you have one or more FFEL loans and your debt-to-income ratio is high, meaning you stand to significantly benefit from one of the more generous income-driven repayment plans.

It may also make sense if you have older, high-interest, variable rate loans and want to lock in a low, fixed interest rate.

Just be careful not to mix high-interest loans with low-interest loans, and not to consolidate Parent PLUS loans with other student loans. And make sure you’re not giving up on significant progress you’ve already made toward forgiveness on your current loans.

How to Consolidate Your Student Loans

If you’d like to consolidate your federal student loans, you can start the process here: Direct Consolidation Loan Application.

Student Loan Refinancing: The Basics

Student loan refinancing refers to the process of taking out a new private student loan to replace one or more existing student loans. You can refinance both federal student loans and private student loans, and there are specific pros and cons to each that we’ll talk about below.

The Benefits of Student Loan Refinancing

1. You can get a lower interest rate

The main reason to consider refinancing your student loans is the opportunity to lower your interest rate. A lower interest rate likely means lower monthly payments, a lower lifetime cost, and a quicker path to being debt-free.

Of course, refinancing doesn’t guarantee a lower interest rate. You still have to go through an approval process, during which the lender will evaluate your financial situation and offer you a loan, or not, based on the information they find. Some people go through this process only to get an offer that’s worse, or at least not much better, than the loans they already have.

The people who are most likely to get a better interest rate than what they have now are people who:

  1. Have high-interest rate student loans, and
  2. Have a credit score that’s significantly higher than when they took out their current loans.

If that’s the situation you’re in, you may benefit significantly from refinancing.

2. You may find a new private loan with better protections than your old private loans

For many years, most private student lenders offered very few protections to their borrowers. For the most part you had to make every payment on time and in full or you were in real trouble.

But that’s started to change. Newer lenders like SoFi and CommonBond have started offering greater protections, such as unemployment protection where your payments are forgiven during periods of unemployment, and disability protection where payments are forgiven during disability.

If you have older private student loans, refinancing may offer greater security. Every lender is different though, so you should carefully read the terms and conditions and compare each offer to see what kinds of protections are available to you.

The Downsides of Student Loan Refinancing

As tempting as it is to grab that lower interest rate, there are some big potential downsides to refinancing your student loans that need to be considered.

Here are four of the biggest.

1. You may lose federal student borrower protections

Refinancing your federal student loans is a big decision that needs to be made very carefully. You’re giving up a lot in the refinancing process, and in some cases you’re better off with the protections offered by federal student loans than you are with a lower interest rate.

Despite some improvements to borrower protections, private student loans still offer significantly fewer protections than federal student loans. Specifically:

  • They are not eligible for income-driven repayment plans
  • They do not offer the opportunity for forgiveness
  • They do not offer deferment
  • Many still do not offer things like unemployment or disability protection

2. Variable rates can be a tease

Some lenders will offer an incredibly low interest rate to entice you to refinance without emphasizing that the rate is variable and that it can change in the future.

If you have the money to pay your loans off quickly, taking advantage of a teaser rate like this can be a good idea. But if it will be a while before your loans are paid off, you should be careful about signing up for a variable interest rate loan that you may not be able to afford several years down the line.

3. Fees could eat away at your potential savings

Some lenders will charge application fees, origination fees, prepayment fees, and all kinds of other fees that can really add to the cost of the loan.

Just keep an eye out for fees when reviewing your refinance options. The more you have to pay, the less attractive that lower interest rate will be.

4. It could take you longer to pay off your loan

In some cases, refinancing will extend your loan repayment period. This may feel like a win given that it lowers your monthly payment, but it can end up costing you more over the long term, even with a lower interest rate.

When Student Loan Refinancing Makes Sense

So, when should you refinance your student loans and when should you take a different route?

In most cases, the answer is pretty simple if you’re talking about refinancing your private student loans. If you can get a better interest rate by refinancing, it will usually make sense to do it. You should always compare all the details of the loans, including the protections they offer and other fees involved. But given that lenders have generally improved their standards over the past few years, it will usually make sense to refinance your private student loans to get a better interest rate.

It’s a lot more complicated if you’re considering refinancing your federal student loans. You shouldn’t give up those protections lightly, especially if your budget is tight and any change in your situation might make it difficult to afford your payments.

Generally, refinancing your federal student loans makes the most sense if you meet all of the following four conditions:

  1. You have high-interest federal student loans
  2. You have excellent credit that will qualify you for the best refinancing deals
  3. You have a high, stable income that makes it unlikely you’ll run into trouble paying off the loan
  4. You don’t qualify for Public Service Loan Forgiveness

If that’s you, then refinancing can be a great move. Qualifying for a lower interest rate could help you pay your loans off sooner, and you have little risk of running into financial trouble.

If that’s not you, you may be better off sticking with your federal student loans, even at a higher interest rate.

Where to Find the Best Student Loan Refinancing Deals

It always makes sense to shop around before making any decision to refinance, just to see what offers are available and how they compare. You can look at interest rates, borrower protections, application fees, and other requirements, and even get pre-approval from certain companies.

MagnifyMoney has a comprehensive page that makes it easy to compare many of the leading lenders and get a sense of what’s available to you.

Here are our top three picks. Each of these lenders has earned an A+ MagnifyMoney transparency score for excellent transparency and ease of use.

SoFi:

  • No origination fee or prepayment fee
  • Fixed interest rates range from 3.38% to 6.74%, and variable interest rates range from 2.35% to 6.27%
  • Flexible repayment terms
  • Strong borrower protections relative to other private lenders

Earnest:

  • No origination fee or prepayment fee
  • Fixed interest rates range from 3.43% to 6.74%, and variable interest rates range from 2.34% to 6.02%
  • Customizable loan terms where you choose the interest rate/length of loan combination
  • Unemployment protection

CommonBond:

  • No origination fee or prepayment fee
  • Fixed interest rates range from 3.37% to 7.74%, and variable interest rates range from 2.32% to 6.18%
  • No maximum loan amount and flexible loan terms

You can also check out your local credit unions, since they are member-owned and often offer loans with favorable terms and conditions.

Consolidation vs. Refinancing: Which One Is Right for You?

Student loan consolidation and student loan refinancing are very different processes with very different pros and cons. Each one can be the right choice, depending on your situation, and in some cases you may want to use both.

In the end, it’s all about your specific loans and the specific goals you’re trying to achieve. Use the information above to weigh pros and cons and make the right decision for yourself.

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Featured, Investing, News

The Basics of a Backdoor Roth IRA

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The Basics of a Backdoor Roth IRA

One of the nice things about making more money is that you have the opportunity to save more money.

But one of the downsides of making more money is that you eventually run into some restrictions on where you can save it.

Specifically, the IRS limits the amount you can contribute to a Roth IRA and the amount you can deduct for contributions to a Traditional IRA based on your income. Once your income reaches a certain point, those accounts are limited in their use.

However, there’s a loophole that can allow you to keep contributing to a Roth IRA no matter how much money you make.

It’s called the backdoor Roth IRA. Here’s how it works.

The Basics of a Backdoor Roth IRA

For 2017, Roth IRA contributions are not allowed once your modified adjusted gross income exceeds $196,000 for married couples, or $133,000 for single filers (source). And if you’re participating in an employer retirement plan like a 401(k), you would also be prohibited from deducting Traditional IRA contributions at that income level.

But there are two additional provisions that, when used together, can allow you to work around these limits:

  1. You’re allowed to make nondeductible contributions to an IRA no matter how much money you make.
  2. You’re allowed to convert money from a Traditional IRA to a Roth IRA no matter how much money you make.

So let’s say that between you and your spouse, you make more than the $196,000 limit for contributing to a Roth IRA. And let’s say that you also participate in a 401(k), meaning you can’t deduct Traditional IRA contributions.

Here are the workaround steps you could take to get money into a Roth IRA:

  1. Open a new Traditional IRA.
  2. Contribute to your new Traditional IRA. You won’t get a tax deduction for the contribution, but as you’ll soon see, that won’t matter.
  3. Wait until you receive your first statement from your new Traditional IRA, which should be in about one month. There is some disagreement around how long you should wait, but one month seems to be a fairly safe bet.
  4. Convert the money in your new Traditional IRA to a Roth IRA. Whichever company you have your IRA with can help you do this (it’s pretty straightforward).
  5. As part of the conversion you will be taxed on any growth that’s happened since contributing to the Traditional IRA, but since it’s only been a month or so, that should be minimal. You won’t be taxed on the amount you contributed, since that was already after-tax money.

And that’s how a backdoor Roth IRA works. And now that your money is inside a Roth IRA, you’ll eventually be able to withdraw it tax-free.

Of Course, There’s Always a Catch…

If you don’t have any existing Traditional IRAs, SEP IRAs, or SIMPLE IRAs, then it really is that simple. But if you do, there’s a big caveat you need to be aware of.

When you convert from a Traditional IRA to a Roth IRA, the IRS considers all of your IRAs to be part of one big pot, and it considers the money you convert to come proportionally from each part of that pot.

Here’s an example to show you what that means:

  • James has $20,000 in a Traditional IRA. All contributions to that IRA were deductible, so this money has never been taxed.
  • This year James makes too much to deduct contributions to a Traditional IRA, but he likes the idea of a backdoor Roth IRA. So he opens a new Traditional IRA, completely separate from his old one, and makes a $5,000 nondeductible contribution.
  • He converts the $5,000 in that new, nondeductible Traditional IRA to a Roth IRA.
  • From the perspective of the IRS, that $5,000 conversion was actually made from a single $25,000 IRA, even though James has two separate accounts.
  • Since 80% of James’ combined IRA money has never been taxed, 80% of his Roth IRA conversion will be taxed.
  • This means that $4,000 of James’ conversion will be taxed. Assuming James is in the 28% tax bracket, he will owe $1,120 on the conversion. And it may be more when you include state income taxes.

In other words, having an existing Traditional IRA that you’ve made deductible contributions to throws a big wrench in your plans to do the backdoor Roth IRA by subjecting a potentially significant portion of your conversion to taxes.

The Way Around the Catch

All hope is not lost. There’s a way to do the backdoor Roth IRA tax-free even if you have money in an existing Traditional IRA, SEP IRA, or SIMPLE IRA.

All you have to do is roll all of that existing IRA money into a 401(k) or other employer retirement plan BEFORE executing the backdoor Roth IRA. Then, when you convert your nondeductible contributions to a Roth IRA, there won’t be any other IRA money to look at and you’ll avoid the big tax hit.

Now, this may or may not be possible depending on your situation. First, you have to currently be participating in an employer retirement plan. And second, your plan has to accept rollovers from all of your existing IRAs, which they may or may not do. You can ask your employer for specific details.

It may also not be desirable for other reasons. Many 401(k)s are littered with high fees, and one of the advantages of having your money in an IRA is that you have much more control over both your investment options and how much you pay.

But if it’s allowed and if your 401(k) has reasonable investment options at a reasonable price, it can be a worthwhile move that frees you up to do the backdoor Roth IRA.

Tread Carefully

The backdoor Roth IRA is a legitimate tactic that’s used by a lot of people every single year.

But there are a number of moving parts and a number of potential hang-ups, so it makes sense to tread carefully and potentially even seek out the help of a professional before making any final moves. A financial planner could help you decide whether it’s the right move, and an accountant could help you navigate the tax issues.

Still, when it’s done right, a backdoor Roth IRA gives you access to a significant amount of tax-free money you wouldn’t have otherwise had.

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Featured, Investing

Hidden Fees That Could Ravage Your Investments

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Hidden Fees That Could Ravage Your Investments

Most of the time higher quality things cost more money. As the saying goes, “you get what you pay for.”

But the opposite is true when it comes to investing. Research has shown again and again that lower cost investments perform better. Quite simply, the less you pay, the more likely you are to get better returns.

And the great thing is that cost is one of the few investment variables you can really take charge of. You can’t control or predict how the markets will perform, but you can definitely control how much you pay to be in the market.

The bottom line is that finding lower cost investments is one of the easiest and most effective ways to increase your investment returns. Here’s how to do it.

Two Big Investment Costs to Watch Out For

For most people, the majority of their investment costs will come from the following two places. If you can minimize these two things, you’ll be in good shape.

1. Expense Ratio

Every mutual fund or exchange-traded fund (ETF) has something called an expense ratio, which is simply the annual cost of investing in the fund. That money is used to pay for the cost of managing and administrating the fund for you.

The expense ratio is charged as a percent of the money you have invested in the fund. So if a particular mutual fund has an expense ratio of 1%, that means that 1% of the money you have invested in that fund will be taken out as a fee each year.

And while 1% may not sound like much, it can add up to a huge difference over a long period of time. Assuming you contribute $5,500 per year and earn an 8% annual return, a 1% difference in fees will likely lead to more than a $100,000 difference in retirement savings over a 30-year period.

In other words, you’ll want to pay close attention to your expense ratios and minimize them as much as possible. Most good mutual funds these days have expense ratios of 0.2% or lower, though some specialized funds might go as high as 0.5%.

2. Sales Loads

Sales load is a fancy term for commission. It’s a percent of your investment that goes to the person who sold it to you.

For example, if you contribute $1,000 to a mutual fund that has a 5% sales load, only $950 will actually go into the fund. The other $50 will go to the person who sells you that mutual fund. And that will be true for every additional contribution you make to that fund in the future.

There are two big things to understand about sales loads:

  1. Not all mutual funds or ETFs have them. In fact, it’s pretty easy to avoid them.
  2. Research has shown that mutual funds with sales loads underperform those that don’t have them.

For those reasons, it will usually make sense to avoid mutual funds that have a sales load. There are simply better options out there.

Four Other Investment Costs to Watch Out For

While expense ratios and sales loads are the two biggest costs to watch out for, there are plenty more to keep an eye on. Here are four of the most common.

  1. Trading Fees

Depending on the company you use to do your investing, you may be charged a fee each time you buy or sell an investment. For example, E*TRADE currently charges $9.99 per ETF trade (with some exceptions) and between $0 and $19.99 for mutual fund trades.

And while that may not sound like much, it can add up pretty quickly. If you make monthly contributions to three ETFs, you’ll end up paying about $360 per year just for the privilege of contributing.

Of course, there are ways around this. For example, major investment companies like Vanguard, Schwab, and Fidelity allow you to trade their own funds for free. And many ETFs are commission-free on certain platforms. So there are plenty of ways to eliminate or at least minimize this cost.

  1. Taxes

If you’re investing in a retirement account like a 401(k) or IRA, you don’t need to worry about taxes until you start taking withdrawals.

But every trade within a taxable account is subject to potential taxes, and the more you trade, the more you may have to pay. And even if you never sell anything, the mutual funds you own will make trades, and those tax consequences will be passed on to you.

We all have to pay our fair share in taxes, but there’s no need to take on more than that. In general, the less often you trade, and the more tax-efficient your investments, the less you’ll have to pay in taxes.

  1. Management Fees

Whether you work with an investment adviser who manages your money for you or you invest through a company like Betterment, there’s a cost to having someone else in charge of your investments.

And while that cost can be worth it, make sure you know what you’re getting and that you’re not paying more than you should.

  1. Account Maintenance Fees

Some companies will charge you a monthly or annual fee simply for the service of providing you with an account.

These can often be avoided by meeting certain conditions. For example, Vanguard charges a $20 annual fee for IRAs, but it’s waived if you either sign up for e-delivery of statements or you have a certain total account balance with them.

In some cases, like with health savings accounts, a small maintenance fee might be unavoidable. But in most cases there’s no need to incur this kind of cost.

The Bottom Line: Lower Costs = Better Returns

Watching out for fees may sound kind of boring, but it’s one of the easiest and most effective ways to improve your investment returns.

Remember, not only does a smaller fee mean that more of your money is invested, but the research shows that lower cost investments actually perform better.

It’s a double win that you should definitely be taking advantage of.

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College Students and Recent Grads, Featured

The Pros and Cons of Subsidized Student Loans

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student loans college

After you fill out the Free Application for Federal Student Aid (FAFSA) and apply to colleges, you’ll start getting financial aid award letters from each school that explain the types of aid you’re eligible to receive.

One of the offers you may get is the opportunity to take out subsidized student loans. These loans can be incredibly helpful in the right circumstances, but before making any decision it’s important to understand what they are, how they work, and how they compare to your other options.

What Are Subsidized Student Loans?

Subsidized student loans are federal loans offered to undergraduate students who have demonstrated financial need, meaning that the cost of the school they are applying to exceeds their expected family contribution.

The big benefit of subsidized student loans is that the government pays the interest on the loan while you are in school, for the first six months after you graduate, and during any periods of deferment.

With other student loans, including unsubsidized federal student loans, the interest accumulates while you are in school (assuming you aren’t making payments), which increases the loan balance that you eventually have to pay back.

All of which simply means that subsidized student loans are less expensive and easier to pay back than most other types of student loans.

Who Is Eligible for Subsidized Student Loans?

One of the downsides of subsidized student loans is that not everyone will qualify for them. Generally, you have to meet the following criteria in order to be eligible:

  • You must be enrolled at least half-time in an undergraduate program participating in the Direct Loan Program that leads to a degree or certificate. Graduate students are not eligible for subsidized student loans.
  • You must demonstrate the need for financial help in paying for school. This is done by completing the FAFSA and comparing your expected family contribution to the cost of attending school. You might qualify for subsidized student loans at one school and not at another if the cost of attendance is different.

If you are eligible, the school will determine the amount that you qualify for and will let you know how much you’re eligible to borrow as part of your financial aid package.

The Benefits of Subsidized Student Loans

If you’re going to borrow money for school, it generally makes sense to take advantage of any subsidized student loans you’re offered before borrowing elsewhere.

The biggest reason is that you’ll save money by not having interest accrue while you’re in school and for the first six months after you graduate. Depending on interest rates and the amount you borrow, you could save anywhere from a few hundred to a couple of thousand dollars over other types of loans.

Subsidized student loans also offer protection in case you run into financial trouble. They are eligible for income-driven repayment plans where your monthly payment is limited based on your income, and you may even be eligible for forgiveness. Also, the interest is subsidized during periods of deferment, meaning that you won’t be penalized for periods of financial hardship.

Finally, interest rates on subsidized federal loans are currently low and are fixed for the life of the loan, making them a relatively cheap borrowing option.

The Drawbacks of Subsidized Student Loans

Of course, there’s no such thing as a free lunch, and subsidized student loans come with some drawbacks as well.

The biggest is simply that no matter how many attractive features they offer, you’re still taking on debt. And while it’s certainly possible that the benefits of the education you receive will outweigh the costs, taking on debt is always a decision that should be made carefully.

The second is that you’re limited in the amount that you can borrow. Currently, most students are limited to taking out $3,500 in subsidized student loans in their first year of school, $4,500 in their second year, and $5,500 in their third and fourth years. This isn’t a reason to avoid subsidized student loans, but it does limit their usefulness.

Finally, only students who demonstrate financial need will qualify for subsidized student loans. Depending on the results of your FAFSA and the cost of the school you’re applying to, you may not be eligible.

Should You Take Out Subsidized Student Loans?

The decision to take on debt is a big one, and there’s no one-size-fits-all answer. The right move for you will depend on the specifics of your situation, your goals, and the options available to you.

With that said, here’s how you should think about it:

  1. Do your best to pay for school without debt. This could mean a combination of using savings, paying from cash flow, taking advantage of scholarships and grants, and attending a lower-cost college.
  2. Before taking on any debt, evaluate what the potential benefits of going to a higher-cost school might be. Will it lead to a more enjoyable career? Will it lead to increased income? If so, how much more can you expect to earn? Try to imagine a best-case scenario, worst-case scenario, and middle-of-the-road scenario to get a sense of all possible outcomes.
  3. Compare those potential benefits to the cost of taking on debt. How likely is it that the benefits will outweigh the costs?
  4. If you decide that student loans are the right choice, subsidized student loans are a good option. The cost savings and protections against future financial hardship are hard to beat.

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Life Events, Mortgage

What Is Mortgage Amortization?

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What Is Mortgage Amortization?

Owning a home can feel good. But is it a good financial decision?

There’s a lot that goes into answering that question, and one of the biggest factors is something that sounds both incredibly boring and incredibly confusing: mortgage amortization.

It’s not the sexiest financial topic in the world, but it has a big impact on your personal finances. In this post we’ll break it down so that you understand what it is and how it should factor into your decision about whether to buy a house.

What Is Mortgage Amortization?

Each time you make your monthly mortgage payment, that payment is split between paying interest and paying down principal (reducing your loan balance). Amortization is simply the process by which that split is calculated.

See, your payment isn’t split the same way throughout the life of your mortgage. It’s actually different with each payment, with your earliest payments going primarily toward interest.

For example, let’s say you buy a $250,000 house, put 20% down, and take out a 30-year, $200,000 mortgage with a 4% interest rate. That means your monthly payment would be $955.

To calculate how much of that first payment goes toward interest, you simply divide the interest rate by 12 to get a monthly interest rate and multiply that by your outstanding loan. Here’s how it looks in this example:

  • (4% / 12) * $200,000 = $667

That means $667 of your initial mortgage payment is used to pay off interest, while the remaining $288 reduces your mortgage balance to $199,712.

Next month the same calculation is run again, but this time with your slightly lower mortgage balance. That leads to a $666 interest payment and $289 going toward reducing your loan.

And that’s how it works. Your early payments are primarily used to pay interest, but over time it slowly shifts so that more and more of your monthly payment is used to reduce your mortgage balance.

You should receive an amortization schedule when you apply for a mortgage, and you can also run the numbers yourself here: Zillow Amortization Calculator. This will show you exactly how much of each payment goes toward interest, how much goes toward principal, and how much interest you’ll pay over the life of the loan.

What Does That Mean for You?

Okay, great, so you have the technical explanation for how mortgage amortization works. But how is that actually relevant to you? Why should you care?

There are two big implications to keep in mind as you consider whether or not to buy a house.

The first is this is one of the reasons it often requires you to stay in your house for several years before your home purchase pays off versus renting. People often talk about renting as if you’re “throwing money away,” but they forget that you’re doing something very similar in those early years of your mortgage as well.

Remember, those interest payments you’re making, which are the majority of your early mortgage payments, aren’t building equity in your home. That money is going straight to your lender and will never be yours again. It usually takes a while before your home equity really starts to grow.

The second is buying a house costs much more than most people realize. Take the example above. You might think of it as just a $250,000 purchase, but when you include all the interest you pay over the life of that 30-year mortgage, the total cost rises to $393,739.

And that doesn’t even include the cost of homeowners insurance, property taxes, repairs, upgrades, and everything else that comes with owning a home.

The bottom line is buying a house is expensive, and in many cases renting is actually a better financial move, especially if you aren’t committed to staying in the house for an extended period of time. You can run the numbers for yourself here: New York Times buy vs. rent calculator.

How to Combat Amortization

To be clear, mortgage amortization isn’t a bad thing. It’s just how mortgages work, and it’s important to understand so you can evaluate the true cost of buying a house.

But if you’d like more of your money to go toward principal sooner, and therefore decrease the amount of interest you pay, there are a few ways to do it.

The first is to put more money down when you buy the house. That down payment is immediate equity in your home that will not be charged interest.

The second is to make extra payments and make sure they go toward paying down principal. You will have to double-check your mortgage’s specific terms, though, to make sure there aren’t any prepayment penalties or other clauses that would make this a bad idea.

And the third is to take out a 15-year loan (or other shorter term). Using the same example above and changing only the length of the loan from 30 years to 15 years, the monthly payment increases to $1,479, but the total cost of the house over the life of the loan decreases to $316,287. That’s a savings of $77,452 and doesn’t factor in the likelihood of getting a better interest rate in return for the shorter loan period.

Keep in mind all of these strategies can be beneficial in some situations and not in others. In some cases it can make more sense to invest your money elsewhere, so you’ll have to run your own numbers and make the best decision based on your personal situation.

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Best of, Investing

8 Blogs to Help You Understand Investing

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8 Blogs to Help You Understand Investing

As a financial planner and an overall money nerd, I read a lot of investment material. Some of it is for fun. Some of it is for my general education. Some of it is done to answer specific client questions. And because my livelihood depends on it, it’s important for me to find information that’s useful, accurate, and easy to understand. To be completely honest, most investment sites just don’t cut it.

But there are some good ones out there, and below are eight of my favorites.

1. The Bogleheads Wiki

URL: https://www.bogleheads.org/wiki

Okay, so I’m cheating a little bit right at the start. This one isn’t technically a blog, but it is updated regularly, and it’s a goldmine of investment know-how, so here we are.

The Bogleheads named themselves after John Bogle, the founder of Vanguard, and their overall philosophy centers around using low-cost index funds to implement a simple, yet effective, investment plan.

You can think of this wiki as an encyclopedia of investment knowledge, with articles ranging from the basics of getting started to the intricate details of advanced strategies like asset location.

As a bonus, there’s also an active forum where people are constantly asking questions and talking about the best ways to put these investment practices into place.

If you’re looking for an answer to a specific question, this is a fantastic place to start.

2. The Oblivious Investor

URL: http://www.obliviousinvestor.com

Mike Piper is one of my favorite investment writers because he gets right to the point and explains everything with a simple clarity.

Though he clearly has a detailed understanding of the nuances of investing, he’s a fan of simplicity and backs it up with his own personal investment strategy. He makes things easy to understand so that you walk away knowing exactly how to apply his advice to your specific plan.

He’s also a CPA and shares a lot of advice about how you can maximize your investments from a tax perspective, which isn’t something you’ll find on a lot of other sites. 

3. Ms. Cheat Sheet

URL: https://mscheatsheet.com/blog/

Kathryn is not only smart, she’s hilarious (check out the video on her home page).

Kathryn combines her 10+ years of hedge fund experience with humor and common sense to make investing both interesting and easy to understand. And she strikes a great balance between timeless investment advice and commentary on current events, so no matter what you’re looking for you’re bound to find it.

4. The Mad Fientist

URL: http://www.madfientist.com

Brandon reached financial independence in his 30s, and he’d like to show you how to do the same.

What I love about this site is that it explores ideas and tactics you won’t find almost anywhere else. He shows you things like:

5. JL Collins

URL: http://jlcollinsnh.com

Many of the readers of my site have credited Jim for their investment success, so I’ve gotten to hear firsthand how much of an impact he’s made on others.

Jim is a regular guy who’s learned how to harness a set of powerful investment principles and use them to create a lifetime full of choices based on happiness instead of money. For example:

  • At the age of 21 he negotiated an extra six weeks of paid time off per year because the money he had saved and invested gave him the freedom to not need the job.
  • Later in life he chose to be unemployed for three years so he could spend that time with his young daughter.
  • These days he spends his time writing, reading, riding his motorcycle, and generally doing what he pleases as he lives off his investments.

I would suggest starting with Jim’s Stock Series, which is a fantastic overview of all the most important investment lessons he’s learned.

6. Betterment

URL: https://www.betterment.com/resources/tags/investing-101/

Betterment sells an automated investment platform, so you will see some sales pitches on their blog. But it’s also packed with good advice that’s worth using no matter where you invest your money.

Betterment explains the basics around concepts like diversification and rebalancing while also diving deep into more complicated topics like tax loss harvesting and asset location strategies. No matter where you’re starting from, there’s almost certainly something to learn.

7. Retire by 40

URL: http://retireby40.org/

Joe started Retire by 40 six years ago when he realized that his physical and mental health were suffering as a result of his job. He wanted out, and he started documenting his journey toward financial independence.

His blog is a fantastic and down-to-earth overview of what it’s really like to pursue financial independence and what it’s like when you get there. It’s a mix of life lessons and investment lessons from a regular guy trying to figure it all out, which makes it an enjoyable and educational read.

8. Nerd’s Eye View

URL: https://www.kitces.com

If you’re looking for technical detail, this is the place to find it.

Michael Kitces has made a name for himself in the financial planning community by being the guy who knows it all. The breadth and depth of his knowledge is second to none, and he shares all the intricate details on his blog.

He writes for financial professionals, so there’s a lot of industry-specific language, and he takes each topic into more depth than you’ll find in most other places. But if you nerd out on investing, and if you’d like to up your game, this is the place to do it.

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Life Events

The First 7 Financial Moves You Should Make When Changing Jobs

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The First 7 Financial Moves

Changing jobs can be exciting and overwhelming all at the same time.

There’s the thrill of beginning a new opportunity and advancing your career. But transitioning into a new role can also be a logistical nightmare, especially when it comes to your finances.

While we can’t help with everything, we can help you make the most of this transition from a financial perspective so that you avoid some common pitfalls and keep every last dollar you’re owed.

Here are the first 7 financial moves you should make when changing jobs.

1. Get the Skinny on Your New Paycheck

In addition to a change in your take-home pay, there may be a change the frequency and/or timing of your paycheck, either of which may require a change in habits.

As an example, maybe you’re currently paid twice per month on the 1st and 15th, but your new company will pay you every two weeks. That kind of change could mean a couple of things:

  1. Even if you are getting a raise, your paycheck may not be as big as you think, because your salary will now be spread over 26 paychecks per year instead of 24.
  2. You may need to adjust certain spending and savings habits to account for the fact that you’ll be getting paid on a different schedule. You should especially be careful about updating any auto-bill pay or auto-saving withdrawals through your bank account. If those were tied to your previous paycheck cycle, you could risk overdrafting your account.

Of course, you’ll also want to know how much you’ll actually be taking home with each paycheck after everything is taken out. Here are a few things to consider:

  • Your gross salary per paycheck. This is your annual salary divided by the number of paychecks you’ll receive over the year.
  • How much will be taken out for company benefits like health insurance and 401(k) contributions? More on this below.
  • How much will be taken out for taxes?

The website paycheckcity.com can help you estimate your new take home pay. Michael Solari, CFP®, the founder of Solari Financial Planning, recommends paying special attention to your withholdings on your W4, which may need to increase in order to avoid a large tax bill, or could decrease if you’re moving to a state without an income tax.

2. Split Your Raise 50/50

If your job change comes with a raise, congrats! Now it’s time to put that new money to work.

The key here is striking a balance between allowing yourself to live and being responsible. You don’t want to waste the money, but you don’t need to completely deprive yourself either.

Pam Capalad, CFP®, the founder of Brunch and Budget, advises her clients to put 50% of their raises towards spending and 50% towards savings and debt.

“If your net paycheck goes up by $400 each month, give yourself permission to spend $200 of that,” Capalad says. “Now you’ve given yourself some leeway to spend a little more each month, which is what would happen anyway, but you’re also committing a good chunk of your new earnings to savings.”

3. Prepare Ahead for Any Decrease in Income

New jobs don’t always mean higher pay. You may take a pay cut at a new job either out of necessity or in pursuit of a more enjoyable job.

Whatever the case, you should start preparing for the change as soon as possible, preferably before you actually change jobs.

  1. Estimate your new take-home pay and the expected difference in income.
  2. Start living on that decreased income ahead of time if possible.
  3. While earning your old income, put the difference into a savings account.

Following these steps allows you to adjust to the change ahead of time and build up some savings to help with any bumps in the road.

4. Know Your Health Insurance

Depending on the specifics of your coverage and your particular medical needs, your new health insurance plan could end up saving you money or forcing you to pay more out of pocket. Getting up to speed on how all of that works will help you prepare either way.

“Get familiar with the new deductibles,” says Capalad. “Make sure you know the new costs of any regular prescriptions you take, and talk to your doctor if you need to switch to brand name or generic, depending on what the new insurance will cover.”

If you are stuck with a high deductible plan, see if your employer offers access to a health savings account or flexible savings account, which allow you to cover medical expenses with pre-tax dollars. A health savings account can even be used as a retirement account. FSA accounts can also be used to help pay for childcare expenses.

5. Take Advantage of Employee Benefits

Companies offer all kinds of employee benefits, from life and disability insurance to free fitness equipment and child care reimbursement. These are valuable benefits that can save you money and add some security to your financial life.

Capalad recommends looking into worker benefits in your first week on the job, just to make sure you don’t forget and leave a valuable perk behind.

6. Rollover Old Retirement Accounts

Did you have a retirement account with your previous employer? If so, now is the time to decide whether to move the money.

Many 401(k)s are laden with high fees that eat away at your investment returns. But you don’t have to keep your money there once you leave. You can choose to roll it over to an IRA, or even into your new 401(k) if it’s a good one.

7. Make a Backup Plan

As hopeful and excited as you are about your new job, there’s the unfortunate possibility that it might not work out. You may not like it and want to leave, and you could also be laid off.

That’s why Eric Roberge, CFP®, the founder of Beyond Your Hammock, encourages people to have a backup plan.

“You really need to have a plan B,” he says. “You don’t want to get locked into a bad situation. You’ll end up resenting the move and your job performance will suffer.”

In addition to thinking about other potential opportunities, Roberge recommends building up a healthy emergency fund.

“That extra cushion will allow you to take a lower paying job that is more fulfilling, or cover you in case the unexpected happens and you lose the next job.”

Hopefully all that happens here is that you end up with a little extra money in savings, but no matter what you’ll be able to sleep better at night knowing you have cash on hand if you need it.

 

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College Students and Recent Grads, Life Events

10 Financial Moves to Make Before Your Child Goes to College

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Financial

Every parent I’ve ever talked to wants to be able to support their child’s college education. After all, you want to give your child all the opportunity in the world, and that’s exactly what college represents. But it’s a big expense and it’s growing. So how can you prepare to cover your child’s education while still paying your bills and saving for your own future?

Here are 10 financial moves to make before your child goes to college that will help your entire family build a better financial future.

1. Remember: Sometimes your needs come first

As much as you want to provide for your child, it’s important to take a step back and make sure you are on solid financial footing first.

The truth is that there are many routes to both obtaining and paying for a college education, from loans, to scholarships, to work-study, to less expensive schools.

But there is only one route to you having a secure financial future: your savings.

Putting yourself first not only ensures that you’ll be able to support yourself later on, but it ensures that your children won’t have to support you. So before you commit tens, or even hundreds, of thousands of dollars to your child’s college education, make sure your own financial needs are on the right track.

2. Get to the real goal

College is the default path, and for good reason. On average people with a college degree earn almost twice as much as those without one and are much less likely to be unemployed.

But before you assume that your child needs to go to the most prestigious (and expensive) college possible, take some time to think about what the real goal is here and if your child would flourish in the traditional four-year college setting. Perhaps a trade or technical school is the better fit.

Talk to your spouse or partner about the kinds of opportunities you’d like to provide. And talk to your child about the opportunities she wants for herself.

Figure out what you’re really working towards before making a huge financial commitment.

3. Evaluate your options

Once you know what you’re working towards, you can start to look at the options available to you.

When it comes to evaluating different colleges, you can look at cost. You can look at specialized programs. You can look at location, opportunity to travel, access to merit-based scholarships, and any other factors that are important to you.

You can also look at alternatives like taking a gap year, traveling, starting a small business, going to trade school, or self-directed or online education.

It’s important to be realistic about what many employers value, which is certainly a college education. But it’s also worth keeping an open mind about what truly matters for your child’s specific goals and evaluating all of your options.

4. Estimate your ‘Expected Family Contribution’

As you investigate the college route, you can start to get a sense of your expected family contribution.

This is the amount you will be expected to contribute to your child’s college education, with the cost above that amount presumably being covered by financial aid (which includes student loans).

You can estimate your expected family contribution here.

5. Decide how much you’re willing to contribute

Your expected family contribution is one thing. Deciding how much you can and are willing to fund is another. And there are a few factors that should go into that decision.

The first is what you can afford to pay. This involves the work you did in Step 1 to evaluate your progress towards other financial goals, as well as a look at your budget to see whether there’s any room to shift things around.

The second is being clear about the things you are willing to fund. In addition to tuition, there are books, room and board, food, fraternity/sorority dues, and other discretionary living expenses. Have a conversation that includes your child about how much those things cost and whose responsibility each expense will be.

The third factor is what you expect your child to contribute, which we’ll get into next.

The goal here is to be realistic about what you can afford and to be clear about what’s expected from all parties.

6. Make sure your kid has skin in the game

Given that you’re talking about your child’s future, it’s not unreasonable to expect your child to help pay for it. In fact, doing so may give him more ownership over the decisions being made, which could lead to better results.

There are many different ways for your child to help financially, from working in the years leading up to school, to working part-time during school, to applying for scholarships and grants. You don’t have to put it all on them, but involving them in the process can be beneficial for everyone.

7. Create and implement a savings plan

With your funding targets in mind, you’re ready to start saving.

The younger your child is, and the more likely it is that he or she will attend a traditional college, the more helpful a dedicated college savings account will be. That’s because the tax-deferral those accounts offer will have longer to work their magic. But if you live in a state that offers an income tax deduction for contributions, they can be helpful even in the years right before college.

Here’s a list of the top 529 plans in the country to help you decide: The 5 Best 529 Savings Plans Anyone Can Use.

And don’t forget that a regular investment account can offer a lot of flexibility. The money can be used for college if necessary, or you can hold onto it and use it for other goals.

8. Get up to speed on student loans

Student loans will almost certainly be an option, and there’s a good chance that they’ll end up as part of your strategy. That’s not necessarily a bad thing either. The value of a good education can be incredibly high, and taking on some debt in order to make it happen can be a smart move.

They key is to make sure it’s done purposefully and with a strong understanding of the consequences. Far too many students are graduating with far more student loan debt than they should have ever taken on, largely because of a lack of knowledge about what they were getting into.

So take some time to learn about the pros and cons of the options available to you, and make a decision based on what you can afford and what your child truly needs in order to get the education she wants. This article will give you a good start: How to Handle Student Loans in 4 Easy Steps.

9. Apply for scholarships and grants

It takes some work, but you may find that your child can qualify for a significant amount of money in scholarships and grants. This can not only reduce your financial burden, but it can also be a great way for your child to help financially without having to come up with a large amount of savings.

Students can start applying for college scholarships can be as early as middle school. At the latest, start preparing for applications in the first year of high school.

Here’s a guide to help you get started: 6 Ways to Find College Scholarships.

10. Plan ahead for your new budget

No matter how much you save, college years can be tough on your budget. That’s especially true if you’ll have two or more children in college at the same time.

If you can, make your best guess at what your budget will look like during those years and start living on it a year ahead of time. That will not only help you get used to the budget, but it will allow you to build some extra savings to help smooth out any bumps in the road.

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