Protecting Your Assets

You may be at risk of making a catastrophic investing mistake: not protecting
your assets properly due to a lack of various insurance coverages. Manny,
a successful entrepreneur, made this exact error. Starting from scratch, he
built up a successful million-dollar business. He invested a lot of his own personal money and sweat into building the business over 15 years.
One day, catastrophe struck: An explosion ripped through his building, and
the ensuing fire destroyed virtually all the firm’s equipment and inventory,
none of which was insured. The explosion also seriously injured several
workers, including Manny, who didn’t carry disability insurance. Ultimately,
Manny had to file for bankruptcy.
Decisions regarding what amount of insurance you need to carry are, to some
extent, a matter of your desire and ability to accept financial risk. But some
risks aren’t worth taking. Don’t overestimate your ability to predict what accidents and other bad luck may befall you.
Here’s what you need to protect yourself and your assets:
✓ Major medical health insurance: I’m not talking about one of those policies that pays $100 a day if you need to go into the hospital, or cancer
insurance, or that $5,000 medical expense rider on your auto insurance
policy. I know it’s unpleasant to consider, but you need a policy that
pays for all types of major illnesses and major medical expenditures.
Consider taking a health plan with a high deductible, which can minimize your premiums. Also consider channeling extra money into a
Health Savings Account (HSA), which provides tremendous tax breaks.
As with a retirement account, contributions provide an upfront tax
break, and money can grow over the years in an HSA without taxation.
You can also tap HSA funds without penalty or taxation for a wide range
of current health expenses.
✓ Adequate liability insurance on your home and car to guard your
assets against lawsuits: You should have at least enough liability insurance to protect your net worth (assets minus your liabilities/debts) or,
ideally, twice your net worth. If you run your own business, get insurance for your business assets if they’re substantial, such as in Manny’s
case. Also consider professional liability insurance to protect against
a lawsuit. You may also want to consider incorporating your business.
✓ Long-term disability insurance: What would you (and your family) do
to replace your income if a major disability prevents you from working?
Even if you don’t have dependents, odds are that you are dependent on
you. Most larger employers offer group plans that have good benefits
and are much less expensive than coverage you’d buy on your own.
Also, check with your professional association for a competitive
group plan.
✓ Life insurance, if others are dependent on your income: If you’re single
or your loved ones can live without your income, skip life insurance. If
you need coverage, buy term insurance that, like your auto and home
insurance, is pure insurance protection. The amount of term insurance
you need to buy largely depends on how much of your income you want
to replace.
✓ Estate planning: At a minimum, most people need a simple will to delineate to whom they would like to leave all their worldly possessions. If
you hold significant assets outside retirement accounts, you may also
benefit from establishing a living trust, which keeps your money from
filtering through the hands of probate lawyers. Living wills and medical powers of attorney are useful to have in case you’re ever in a medically incapacitated situation. If you have substantial assets, doing more
involved estate planning is wise to minimize estate taxes and ensure the
orderly passing of your assets to your heirs.
In my experience as a financial counselor, I’ve seen that although many
people lack particular types of insurance, others possess unnecessary policies. Many people also keep very low deductibles. Remember to insure
against potential losses that would be financially catastrophic for you —
don’t waste your money to protect against smaller losses. (See the latest
edition of my book Personal Finance For Dummies, published by John Wiley
& Sons, Inc., to discover the right and wrong ways to buy insurance, what to
look for in policies, and where to get good policies.)

Allocating college investments

If you keep up to 80 percent of your investment money in stocks (diversified
worldwide) with the remainder in bonds when your child is young, you can
maximize the money’s growth potential without taking extraordinary risk. As
your child makes his way through the later years of elementary school, you
need to begin to make the mix more conservative — scale back the stock percentage to 50 or 60 percent. Finally, in the years just before entering college,
whittle the stock portion down to no more than 20 percent or so.

How to pay for college

If you keep stashing away money in retirement
accounts, it’s reasonable for you to wonder
how you’ll actually pay for education expenses
when the momentous occasion arises. Even
if you have some liquid assets that can be
directed to your child’s college bill, you will, in
all likelihood, need to borrow some money. Only
the affluent can truly afford to pay for college
with cash.
One good source of money is your home’s
equity. You can borrow against your home at
a relatively low interest rate, and the interest is
generally tax-deductible. Some company retirement plans — 401(k)s, for example — allow
borrowing as well.
A plethora of financial aid programs allow
you to borrow at reasonable interest rates.
The Unsubsidized Stafford Loans and Parent
Loans for Undergraduate Students (PLUS), for
example, are available, even when your family
isn’t deemed financially needy. In addition to
loans, a number of grant programs are available
through schools and the government as well as
through independent sources.
Complete the Free Application for Federal
Student Aid (FAFSA) to apply for the federal
government programs. Grants available through

state government programs may require a separate application. Specific colleges and other
private organizations, including employers,
banks, credit unions, and community groups,
also offer grants and scholarships.
Many scholarships and grants don’t require
any work on your part — simply apply for such
financial aid through your college. However,
you may need to seek out other programs as
well — check directories and databases at
your local library, your kid’s school counseling
department, and college financial aid offices.
Also try local organizations, churches, employers, and so on, because you have a better
chance of getting scholarship money through
these avenues than through countrywide scholarship and grant databases.
Your child also can work and save money
during high school and college for school. In
fact, if your child qualifies for financial aid,
she’s generally expected to contribute a certain amount to education costs from employment (both during the school year and summer
breaks) and from savings. Besides giving your
gangly teen a stake in her own future, this training encourages sound personal financial management down the road.

Section 529 plans

Also known as qualified state tuition plans, Section 529 plans offer a taxadvantaged way to save and invest more than $100,000 per child toward
college costs (some states allow upward of $300,000 per student). After you
contribute to one of these state-based accounts, the invested funds grow
without taxation. Withdrawals are also tax free so long as the funds are used
to pay for qualifying higher educational costs (which include college, graduate school, and certain additional expenses of special-needs students). The
schools need not be in the same state as the state administering the Section
529 plan.
As I discuss in the previous section dealing with Education Savings Accounts,
Section 529 plan balances can harm your child’s financial aid chances. Thus,
such accounts make the most sense for affluent families who are sure that
they won’t qualify for any type of financial aid. If you do opt for an ESA and
intend to apply for financial aid, you should be the owner of the accounts (not
your child) to maximize qualifying for financial aid.

Education Savings Accounts

Be careful about funding an Education Savings Account (ESA), a relatively new
savings vehicle. In theory, an ESA sounds like a great place to park some college savings. You can make nondeductible contributions of up to $2,000 per
child per year, and investment earnings and account withdrawals are free of
tax as long as you use the funds to pay for elementary and secondary school
or college costs. However, funding an ESA can undermine your child’s ability
to qualify for financial aid. It’s best to keep the parents as the owners of such
an account for financial aid purposes, but be forewarned that some schools
may treat money in an ESA as a student’s asset.

Treading Carefully When Investing for College

Many well-intentioned parents want to save for their children’s future educational expenses. The mistake they often make, however, is putting money in
accounts in their child’s name (in so-called custodial accounts) or saving outside of retirement accounts in general.
The more money you accumulate outside tax-sheltered retirement accounts,
the less assistance you’re likely to qualify for from federal and state financial
aid sources. Don’t make the additional error of assuming that financial aid
is only for the poor. Many middle-income and even some modestly affluent
families qualify for some aid, which can include grants and loans available,
even if you’re not deemed financially needy.
Under the current financial needs analysis that most colleges use in awarding financial aid, the value of your retirement plan is not considered an asset.
Money that you save outside of retirement accounts, including money in the
child’s name, is counted as an asset and reduces eligibility for financial aid.
Also, be aware that your family’s assets, for purposes of financial aid determination, also generally include equity in real estate and businesses that you
own. Although the federal financial aid analysis no longer counts equity in
your primary residence as an asset, many private (independent) schools continue to ask parents for this information when they make their own financial
aid determinations. Thus, paying down your home mortgage more quickly
instead of funding retirement accounts can harm you financially. You may
end up with less financial aid and pay more in taxes.
Don’t forgo contributing to your own retirement savings plan(s) in order to
save money in a non-retirement account for your children’s college expenses.
When you do, you pay higher taxes both on your current income and on the
interest and growth of this money. In addition to paying higher taxes, you’re
expected to contribute more to your child’s educational expenses (because
you’ll receive less financial aid).
If you plan to apply for financial aid, it’s a good idea to save non-retirement
account money in your name rather than in your child’s name (as a custodial
account). Colleges expect a greater percentage of money in your child’s name
(35 percent) to be used for college costs than money in your name (6 percent). Remember, though, that from the standpoint of getting financial aid,
you’re better off saving inside retirement accounts.
However, if you’re affluent enough that you expect to pay for your cherub’s
full educational costs without applying for financial aid, you can save a bit
on taxes if you invest through custodial accounts. Prior to your child reaching age 19, the first $1,900 of interest and dividend income is taxed at your
child’s income tax rate rather than yours. After age 19 (for full-time students,
it’s those under the age of 24), all income that the investments in your child’s
name generate is taxed at your child’s rate.

Easing into risk: Dollar cost averaging

Dollar cost averaging (DCA) is the practice of investing a regular amount
of money at set time intervals, such as monthly or quarterly, into volatile
investments, such as stocks and stock mutual funds. If you’ve ever deducted
money from a paycheck and pumped it into a retirement savings plan investment account that holds stocks and bonds, you’ve done DCA.
Most people invest a portion of their employment compensation as they earn
it, but if you have extra cash sitting around, you can choose to invest that
money in one fell swoop or to invest it gradually via DCA. The biggest appeal
of gradually feeding money into the market via DCA is that you don’t dump all
your money into a potentially overheated investment just before a major drop.
Thus, DCA helps shy investors psychologically ease into riskier investments.
DCA is made to order for skittish investors with large lump sums of money sitting in safe investments like CDs or savings accounts. For example, using DCA,
an investor with $100,000 to invest in stock funds can feed her money into
investments gradually — say, at the rate of $12,500 or so quarterly over two
years — instead of investing her entire $100,000 in stocks at once and possibly
buying all of her shares at a market peak. Most large investment companies,
especially mutual funds, allow investors to establish automatic investment
plans so the DCA occurs without an investor’s ongoing involvement.
Of course, like any risk-reducing investment strategy, DCA has drawbacks.
If growth investments appreciate (as they’re supposed to), a DCA investor
misses out on earning higher returns on his money awaiting investment.
Finance professors Richard E. Williams and Peter W. Bacon found that
approximately two-thirds of the time, a lump-sum stock market investor
earned higher first-year returns than an investor who fed the money in
monthly over the first year. (They studied data from the U.S. market over the
past seven decades.)
However, knowing that you’ll probably be ahead most of the time if you
dump a lump sum into the stock market is little solace if you happen to invest
just before a major plunge in prices. In the fall of 1987, the U.S. stock market,
as measured by the Dow Jones Industrial Average, plummeted 36 percent,
and from late 2007 to early 2009, the market shed 55 percent of its value.
So investors who fear that stocks are due for such a major correction should
practice DCA, right? Well, not so fast. Apprehensive investors who shun
lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA
during a declining market.
So what’s an investor with a lump sum of money to do?
✓ First, weigh the significance of the lump sum to you. Although $100,000
is a big chunk of most people’s net worth, it’s only 10 percent if your
net worth is $1,000,000. It’s not worth a millionaire’s time to use DCA
for $100,000. If the cash that you have to invest is less than a quarter of
your net worth, you may not want to bother with DCA.
✓ Second, consider how aggressively you invest (or invested) your
money. For example, if you aggressively invested your money through
an employer’s retirement plan that you roll over, don’t waste your time
on DCA.
DCA makes sense for investors with a large chunk of their net worth in cash
who want to minimize the risk of transferring that cash to riskier investments, such as stocks. If you fancy yourself a market prognosticator, you can
also assess the current valuation of stocks. Thinking that stocks are pricey
(and thus riper for a fall) increases the appeal of DCA.
If you use DCA too quickly, you may not give the market sufficient time for a
correction to unfold, during and after which some of the DCA purchases may
take place. If you practice DCA over too long of a period of time, you may miss
a major upswing in stock prices. I suggest using DCA over one to two years to
strike a balance.
As for the times of the year that you should use DCA, mutual fund investors
should use DCA early in each calendar quarter because mutual funds that
make taxable distributions tend to do so late in the quarter.
Your money that awaits investment in DCA should have a suitable parking
place. Select a high-yielding money market fund that’s appropriate for your
tax situation.
One last critical point: When you use DCA, establish an automatic investment
plan so you’re less likely to chicken out. And for the more courageous, you may
want to try an alternative strategy to DCA — value averaging, which allows you
to invest more if prices are falling and invest less if prices are rising.
Suppose, for example, that you want to value average $500 per quarter into
an aggressive stock mutual fund. After your first quarterly $500 investment,
the fund drops 10 percent, reducing your account balance to $450. Value
averaging suggests that you invest $500 the next quarter plus another $50 to
make up the shortfall. (Conversely, if the fund value had increased to $550
after your first investment, you would invest only $450 in the second round.)
Increasing the amount that you invest requires confidence when prices fall,
but doing so magnifies your returns when prices ultimately turn around.