The Motley Fool loves to hear from members, listeners, and readers, and theAnswersteam has dedicated this entire episode to answering questions from their fellow Fools. In the process, the team will talk about:
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- Investing versus debt reduction
- Resources for starting a small business
- Social Security
- Pension benefits
- Minimum funds for investing
And that is only the tip of the iceberg.
A full transcript follows the video.
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This podcast was recorded on Dec. 13, 2016.
Alison Southwick: This is Motley Fool Answers. I'm Alison Southwick and I'm joined by Robert Brokamp, personal finance expert here at The Motley Fool. He's also the advisor on Motley Fool's Rule Your Retirement newsletter.
Robert Brokamp: That is true. Hi, Alison.
Southwick: Hi! As promised, it's an all-Mailbag episode, so we're going to tackle your questions about paying off debt versus investing, sources for seed money, Social Security, all things 401(k), and whether you should invest in Star Wars (sort of). All that, and more, on this week's episode of Motley Fool Answers.
Southwick: Today we're going to get some help from Sean Gates. You may know him as a certified financial planner with Motley Fool Wealth Management -- [whispers] a sister company of The Motley Fool. I know him as Robert Brokamp's biggest competition in the race to the bottom, because you [00:00:46]...
Brokamp: In a good way!
Southwick: No. The listeners have no clue how much audio hits the cutting room floor when you two are in the studio together.
Sean Gates: That's about the only thing that hits the floor.
Brokamp: I should point out that Sean ...
Southwick: See, I don't even know what you mean by that, but I know it was inappropriate.
Brokamp: Sean is the first person I ever hired in my professional life, so that explains a lot.
Gates: But also the only, so that also explains quite a bit.
Brokamp: One of the few. Certainly one of the few.
Southwick: Yeah, and we're stuck with you now. All right. Well, let's just get into the questions, shall we?
Brokamp: Let's do that.
Southwick: The first one comes to us from John in Pennsylvania. "I recently received a lump sum of money and am wondering what the best thing to do with it would be." Aside from mailing it to us.
Brokamp: Of course.
Southwick: Motley Fool, 2000 Duke Street, 4th Floor, Alexandria, VA 22314. John writes: "My wife and I already have our emergency fund in place and are maxed out on our workplace retirement contributions and IRAs."
Southwick: "We also don't have any credit card debt."
Southwick: Gold star.
Southwick: "We are debating whether to pay down some of our debt or invest the money. Our current debts are a mortgage at 3.375% and two cars (one at 2.49% and one at 2.99%). I know that investing the money would give us the chance to earn a higher rate than our debts charge in interest, but I also like the idea of getting a guaranteed return by paying off some debt. Thanks so much, and I love the podcast." What should John do?
Brokamp: Well, the first thing to do is look at the interest rates on the debt. Given what he has said about his financial circumstances, I'm going to assume that he can deduct his mortgage interest, which then says that maybe there's some value to keeping that debt. The rates are very low, so you'd think long term you'd be able to invest that money and exceed the rates of that interest. That said, there is a psychological benefit to paying off debt.
I was in this same situation where we got some money and we decided to pay off a car loan. But then what we have decided to do is the money that was going each month to the car loan is now going to go to our kids' 529. So we paid off the debt, but then we're using that as a way to put some more money in savings, as well.
Gates: And I think it's a case-by-case basis. There's studies that show that if you have a cash cushion, you're happier, so maybe having that money set aside in a retirement account or in an investable account (just knowing it's there, rather than locked up in a mortgage or in a car payment) is helpful. So there's a lot of different ways to look at it, but I think investing it, especially if you're young, is a good way to go, but you're never offbeat if you pay down debt.
Southwick: Sorry. I'm having a hard time figuring out what your answer is. Some people like to go that way. Other people like to go that way.
Brokamp: If you were to base it just on long-term, historical numbers ...
Gates: Yes ...
Brokamp: ... you'd have a higher net worth by investing that money and keeping the debt. The debt is crazy low. I don't expect the stock market to return that mythic 10% annually a year over the long term, but you'd still probably have more money by investing it. That said, if you feel better by paying off the debt, that's not a bad idea.
Southwick: OK. The next question comes from Dan. Dan writes: "My wife and I are 36 and 37, and currently set aside money in both our Roth IRAs and 401(k)s. I'm interested in investing in a business idea with some friends (commercial real estate), but it is four to five years off. I'll need some seed money for the investment, but I don't want to miss out on socking away money in either my 401(k) or Roth. I know I can withdraw my Roth contribution (I meet the five-year rule) but would a self-directed IRA be a viable option? What do I need to know about a self-directed IRA and is there a reputable firm equivalent to Vanguard in that space?"
Brokamp: A couple of things about this. First of all, as he points out, the money you put into a Roth IRA you can actually take out tax-and-penalty free anytime, and for that you don't even have to worry about the so-called five-year rule for the Roth. So he can put that money in and take it out anytime he wants.
Now he has used a term called the "self-directed" IRA. A lot of people think if they have their own IRA and they're just picking their own stocks and bonds, or whatever, that's self-directed. In a sense, it is, but that's actually an actual term related to a special type of IRA that allows you to invest in other things like real estate. Some businesses. All kinds of crazy stuff.
And the average broker, like Vanguard, doesn't allow you to do it, so you have to go find a specific type of custodian that usually has higher expenses, and there are a lot of rules about it. Like you can't use this money to buy a vacation house that you eventually stay in. You have to invest in some sort of business that you don't have any personal use of. Now Sean, in your history of being a financial advisor, you actually have dealt with this.
Gates: Yes. I've run into this a couple of times, and it's usually people who come to a financial advisor and say, "Hey I got into this investment idea and now I don't know how to get out of it." They're stuck, because a self-directed IRA, like Bro said, limits you to only a few organizations. Equity Trust is one. I think that Millennium Trust is another. It's usually trust companies. They do the annual reporting for you, but that's about it. So there's a whole other stack of documents and compliance that you need to keep up on, and it's not always clear whether the trust company is doing that for you.
Southwick: It sounds messy.
Gates: It's pretty messy. And then, in this case, if you go into a limited liability corporation or I've seen equestrian (like people invest in horses for horse racing), you can pretty much do anything you want.
Brokamp: I've seen people buy interests in parking lot meters and things like that.
Gates: You can invest in all sorts of wonky things, and it's just when you then need to go utilize that money, it's very difficult to get it back out. You don't know when the term ends, or how you get back out of horses, or this business, if this doesn't succeed.
Southwick: Do you really have to sell the horse in addition to getting out of it?
Brokamp: Right. Piece by piece, sell the horse.
Gates: You just end up, for the rest of your days, riding the horse in horse races. It's crazy.
Brokamp: Actually, not really. You actually can't do that, because that's personal use, and if you use the thing you invested in, then it could be considered distribution and then you pay taxes and penalties. So there are lots of rules around it.
Philosophically, I think it's a great idea. Especially if you have, already, other big accounts that have stocks and bonds, this is a way to diversify your portfolio. You just have to be very careful about it, and generally these things are not very liquid.
Gates: Yup. And we don't want to make it sound like it's all bad because, as Bro said, the diversification element is great and you can find some pretty sweet deals that you can't otherwise get. The stock market might get you 7% to 8%. Some private deals could get you 20% to 25%. I'm not trying to say that all do, but if you marry up with the right partner, it could be a great investment.
Brokamp: So to answer Dan, I would say your best bet is actually to put the money in the Roth with the idea of taking out the contributions. That's probably going to be an easier thing to do, but definitely look into self-directed IRAs and it might be suitable for you.
Southwick: I just realized I am not diversified at all into racing ponies.
Brokamp: You've got a next episode.
Southwick: Well, here's a question that's in a similar vein. This question comes to us from Peter. Peter writes: "I'm a 24-year-old tech worker and my dream is to retire when I'm in my mid-40s and start an e-sports bar one day." He wants to know which option he should pursue. He's basically saying (I'm summarizing this a bit) that he contributes to his 401(k) up to the company match and he also maxes out his Roth IRA.
But what he's wondering is if he should put an extra $360,000 per year into non-retirement accounts or if he should put that money against his capital of a 4% mortgage. So he says: "What are the best options if I want to start a bar? Are there any accounts that you can pull money out tax-free if you start a small business?"
Brokamp: This is an interesting question. The one thing I would say [is] when you are starting a business, when you pay off your loan, you lose a certain amount of liquidity. You've taken all this money that you had in a brokerage account, you paid off your loan, but now you don't have that money.
If you're going to be starting a business, it would seem to me like having that liquidity is pretty important. He's young. He's thinking long term in terms of when he's actually going to need that money, so you'd think over the long term he could earn a return that's higher than his current mortgage. So I would lean toward keeping the mortgage and then investing the money. What do you think, Sean?
Gates: Yes, and you're a brother of a different mother, I think, because I have similar goals. I don't have the e-sports thing down, but...
Southwick: Ooh! What do you want to open up?
Gates: Well, I just want to be a bum and travel the world.
Southwick: Just do nothing?
Gates: But, yeah, Bro's point is spot-on in terms of loss of liquidity. I would say it's very clear that in this case you would want to save that money in a taxable brokerage account on the side, and invest that money for this future goal. If you pay down your mortgage, that's locked up. Who's to say that another financial crisis happens and the value of your home goes down and then you're upside down. Actually, I guess he wouldn't be upside down at that point, because he'd be paid off. But the loss of the value of your house. Anyway, I think in this case save the money. Don't pay off the mortgage.
Brokamp: And this is a case that I think he could not use a self-directed IRA. Like you couldn't use it to buy your own bar that you are then working in, or could you?
Gates: I think in this case you can...
Brokamp: You can...
Gates: ... because it's an enterprise, and you could set it up like a limited liability corporation, or something, where he got shares in the bar ...
Brokamp: Got it. And one of the things that he's clearly worried about is if you take the money out of your retirement accounts before you're age 59 1/2, you could pay taxes and a 10% penalty. But there are, actually, many ways to get around that. It can be for a qualified first-time home purchase. It could be for qualified higher education expenses. These are different, by the way, if it's a 401(k) or an IRA, so you've got to know the rules.
But there's also something called "substantially equal periodic payments," which is very complicated. Look into it, though. It is a way for people who are younger than 59 1/2 to get money out of their retirement accounts and not pay that penalty.
Gates: And I think a lot of people get trapped in trying to figure out what type of account to save in. A 529 is for education. A 401(k) you max out for the match, and that's for retirement. Is there a business account?
When there is just a brokerage account which is a catchall, and it's available at any time, it's a great resource to go to if you have extra money saved there. Because, as you said, it's liquid and there are no penalties associated with it when trying to get it out for the goal that you haven't associated with it. If it's for education, you have to pull it out for education. This account can be for anything.
Brokamp: You just want to watch the tax consequences of what you invest in. Maybe favor stocks that don't pay dividends over the stocks that do. Don't do a lot of day trading or short-term trading. Buy a good solid company that doesn't pay a dividend you can hold onto for many years, and you basically don't pay any taxes until you sell.
Southwick: All right, next question. It comes from [Cheryl]. "I started collecting Social Security retirement benefits early because I needed the money. My pay just wasn't enough. When I turn 65 this year, does my Social Security benefit automatically go up because I'm full age?"
Brokamp: She's talking about what is known as the "full retirement age." It used to be 65. It then was moved up to age 66 for anyone born between 1943 and 1954, and then for other folks, it gradually moves up to 67 for anyone born in 1960 or later. So she's actually not reaching full retirement age. She might be confusing it with Medicare. Medicare is available to anyone who's 65, regardless of when you were born.
But the answer to her question is no, because when you take Social Security early, you basically have locked in a lower benefit, so it's not going to go up. It might go up if she's earning enough money to have the benefit adjusted, and what I mean by that is your Social Security benefit is based on [the] 35 years in which you earn the most money. If she's still working now and her last year's income was among those highest 35 years, it can adjust her benefit upward in the following year, but that's the only way that will be adjusted.
Gates: The only other thing is you can really put your money on the COLA, or the cost of living adjustment. That has been virtually zero in the last couple of years. If it makes you feel any better, I probably won't be able to claim Social Security until I'm 75, so I can commiserate.
Brokamp: Is that your projection for where the age will be by the time you get there?
Gates: Yeah, that's correct.
Brokamp: I would definitely say that certainly younger folks in your 30s...
Brokamp: ... should probably expect the retirement age to go up by the time they get there.
Southwick: Another Social Security question, this time from Stan. "My ex-wife is drawing Social Security benefits at the age of 60. Am I eligible to draw a spousal benefit off of her earnings and continue to let my Social Security build? We were married 27 years. Been divorced 10 years. Have not remarried."
Brokamp: So here the requirement is to get Social Security based on the record of an ex-spouse. First of all, you have to be unmarried. You can't have been remarried.
Brokamp: You are age 62 or older. You're ex-spouse is entitled to Social Security retirement based on either retirement or disability and the benefit you are entitled to -- and this is the tricky part -- from the ex-spouse would be higher than what you'd get on your own. But that actually depends on your age.
So what he's talking about is something that changed very recently, so that not everyone can take advantage of it. If our fine fellow, here, was born before January 2, 1954, he can do that. He can, at his full retirement age, claim the benefit as a divorced spouse [and] let his benefit grow to age 70. If he was born after January 2, 1954, that no longer applies. You can no longer do that if you are not old enough.
Gates: What Bro talked about was called "file and suspend," where you file, suspend your own benefit, and then claim your spousal benefit ... and that allows your individual benefit to continue to grow ... and then you can swap back to your own benefit.
Gates: But that got phased out recently, and that's the age ban that Bro was referring to. And then there is a restricted application where you don't do the file and suspend game. You just file for the spousal benefit, only, with no anticipation of ever going back to your own benefit. You just claim the 50% of your spouse's benefit as a divorcee, and in this case, you can still do that but the wife would have to be 62 or older.
Southwick: Oh! Blah!
Brokamp: One of the interesting things about this question -- yes, it's very complicated -- is that he said his wife is 60, so she must be getting disability benefits because she's not old enough to get widow's benefits...
Gates: Widow benefits if she's married multiple times.
Brokamp: One thing this demonstrates is how complicated all this is, so what I almost always recommend that people do is find a good online tool that will take your information and give you a good answer based on your own numbers. First of all, the Social Security Administration website has tools like that. There's also something called SS Analyzer from Bedrock Capital. AARP has a Social Security calculator and Financial Engines also has one. Those are all free. There are other ones that are also very good that you can pay like fifty dollars for and it's probably worth the money. They can crunch all of these rules together and give you some solid advice.
Southwick: The next question comes to us from Warren in Alexandria. Hey, just down the road somewhere. "My former employer has temporarily offered me the opportunity to receive a $43,000 lump-sum payoff now instead of a pension that is projected to pay me about $550 per month starting in September of 2029. I do enjoy managing my family's accounts, but recall you saying on the podcast that the retirees with the most guaranteed incomes are the happiest. I am wondering about why I got this offer in the first place. Is the pension fund shaky? Am I better off simply keeping the pension, which is a single life annuity or taking the lump sum?"
Brokamp: Well, first of all, anyone who's going to get this sort of classic defined benefit pension should stay on top of their plan. Every plan has an annual report and it will give the funding status. So he can look into that and get an idea of whether this is happening because the plan is underfunded. There's also something called the Pension Benefit Guaranty Corporation (PBGC) that also has some of that information.
To really do the analysis for his question, if I were him I would run some numbers, and I will give you an example, here, and he would run various scenarios. Let's say if he earned 5% a year, his $43,000 or so could grow to about $82,000 in 2029. If he had that amount of money now and bought an immediate annuity, it would pay him about $450 a month. And I found that from ImmediateInnuities.com. You can get a quote. So just looking at those numbers, it looks like actually keeping his pension would result in a bigger payout as long as the pension is safe and it's going to be there in the future.
That said, if he gets this money now, he does have freedom with it. He can use it now if he wants to. It will be transferred from the pension into an IRA, so there will be some rules about how he can access it. And if he earns higher than 5%, it actually might end up benefiting him more by delaying it.
Gates: And I think the only perspective I would add, here, is that the only modifier to the calculations that Bro did, that you want to consider, is what does that $500 and change monthly benefit do to your income tax bracket, because a lot of the times you don't necessarily account for how an increased retirement income might affect your retirement tax bracket. Whereas if you take the lump sum and invest it, you could potentially stretch that out further. So there's another layer on taxes that you could look at.
There's actually a great study that came out where they showed that the typical person who has the option to take a lump sum would require almost a 9% rate of return annualized to achieve the same benefit that they would get on a monthly basis from the pension corporation. I don't want that to be a stat that people use to not take a lump sum, because sometimes that makes sense, but it's difficult to recreate that pension. And you're taking the risk on yourself, whereas if you leave the pension and just take the income, that risk of investing it to provide that benefit is on the company. You don't have to take on that risk.
Southwick: Talk a little bit more about pensions, though. When he talks about whether the pension fund is shaky, is that a serious concern? Do pension funds go belly up all the time and then people who are counting on them just get nothing in retirement?
Brokamp: That's what the PBGC does. It is an insurance, basically. It's sort of like the FDIC for pensions and it will pay that. The problem is there's a limit on how much you'll get, although based on the amount he's giving here, he's below that limit. But also, the PBGC is severely underfunded, so that's going to be another problem coming down the road [with] pensions, because a lot really are severely underfunded. That's a real question about what will happen in the future.
My answer for him is if he's a solid investor and he appreciates having more control over the money, go ahead and take the lump sum. If not, and the pension is on solid ground, it might be better to leave it.
Gates: We do this sort of analysis for clients all the time, and it is surprising how many pensions are underfunded. The stat that the PBGC, itself, is underfunded goes to speak to how often these companies are going ...
Because the PBGC is actually funded by, more or less, premiums that the pension companies pay to backstop that fund. It's not a federal organization funded by federal dollars. It's run by the federal government, but it's funded by premiums, mostly, from the pension companies themselves. And so normally they're like 80% funded, at best, so it just gives you a sense of how severely underfunded some of these can be. The state of Illinois, I think, is at like 65% funded.
Brokamp: It's really one of those things that doesn't get talked about a lot, but it can be a huge issue down the road. Illinois is an example we've heard about. Detroit and other places, too, with severely underfunded pensions. What's going to happen? Either those folks are not going to have the money they were counting on, or taxes have to [be raised] significantly and a lot of people are going to be like, "You're raising my taxes to pay for these people who are retired?" It's going to be very interesting.
Southwick: You look like the world's most sophisticated lumberjack, today. Did you know that? You're holding this wine glass of water, you've got some stubble, and you're wearing a very plaid, flannel shirt. Like the way you're comporting yourself, right now, is just pretty remarkable.
Brokamp: I go for remarkable, really, in all that I do.
Southwick: Yes, OK. The next question comes from -- they're just going by the name Jester. I don't know how I feel about reading this word for word.
Brokamp: It's the way our audience feels about you.
Southwick: OK, here we go. "Oh, great goddess Alison and fellow Alison-worshipper Bro."
Brokamp: Well, let's not go too far, here.
Southwick: "I beseech thee for thy wisdom. I am but a poor, humble dollar-cost averaging investor. I know that if I'm not beating the market, then I'm better off just buying an index fund, but I'm not sure how to calculate my returns. If I invest $1,000 and I make 10%, then I have $1,100. Yeah." By the way, that's his yeah, not my yeah. I know I'm prone to saying yeah, and things, while I'm reading these letters.
Gates: An important distinction.
Southwick: "All is well until next month when I deposit $900. Now my account is worth $2,000, only $100 of which is profit, so my return drops to 5%. Noo!"
Brokamp: He wrote that, too!
Southwick: "I know the market hasn't passed me by when all I did was deposit more money, right? How do I calculate my actual return on investment when I'm beefing up my account at regular intervals and amounts? Thanks and stay Foolish."
Brokamp: This is actually a pretty complicated question, and it's a very good question, because you want to know your actual returns and not just based on the money put in. A different problem was made very popular by the Beardstown Ladies.
Southwick: I was going to say. Are you going to talk about the Beardstown Ladies?
Brokamp: Do you remember the Beardstown Ladies?
Brokamp: So they were an investing club ...
Southwick: Right around when The Motley Fool was becoming a thing, too.
Brokamp: Yes. They were founded in 1983, and from 1983 to 1994 they had returns of 23.4%.
Southwick: And these are like ladies.
Brokamp: Yes. It's Beardstown, Illinois. So they wrote a book. It became a best-seller and became very famous until a couple of journalists figured out that actually what they were doing is they were counting the money they put into the account every month as returns. And then once the returns were audited, it turns out that they actually earned just 9.1% a year, considerably less than the 14.9% on the S&P 500.
Southwick: Still not bad, but ...
Brokamp: Yes ...
Southwick: ... not that great.
Gates: Not that great.
Brokamp: Not that great. So you don't want to do that. You don't want to count the money you put in or, if you're retired, the money you're taking out as part of your returns. The magic word you need to Google is "time-weighted returns." That's what you are looking for, and I can give you a couple of Fool articles to look for. One is "Computing Your Investment Returns, Redux" and "Keep Track of Your Returns." Both of those are by Matt Richards. They're actually over a decade old, but they do a great job of explaining how to do this.
In those articles, he mentions a spreadsheet that's no longer available, but one of our current analysts, Jim Mueller, actually created a spreadsheet on Dropbox and maybe we could tweet that out.
Southwick: Oh, yeah!
Brokamp: So you can get the spreadsheet and put your numbers in -- when you put your money in and when you take money out -- and it will calculate the time-weighted returns for you.
Southwick: Oh, nice. So the easy answer is we'll get it to you.
Brokamp: We'll get it to you. And also, ideally, your brokerage account is doing that for you, as well, but they don't always do that so you just have to keep an eye on it.
Gates: And I think the key distinction, there, is that most brokerage firms allow you to run multiple variants of your performance. There's the regular rate of return or the time period return, and then there's the time-weighted return. You can usually run a report where you run the time-weighted return of your account, so you can just easily see it from within your own account.
And it's funny that you mentioned that story, because a lot of the times when I was back in the business, people would come to me comparing their 401(k) returns to the returns they were getting in our investment portfolio, and the 401(k) always looked phenomenal, but it was because most 401(k)s report it including contributions ...
Gates: ... so everyone always assumes their 401(k) is doing gangbusters when it often is being reported as including the contributions that you make as part of its total return.
Brokamp: Look! It's up $25,000. Of course, I put in $18,000, but hey! That's really the secret to investment success. Just keep putting money in your account.
Gates: [crosstalk 00:26:12]
Southwick: The next question comes to us from Lindsey in Arlington, Virginia. Someone else just down the road. "Thanks for all the personal finance advice via your podcast. I just had a baby, so of course I'm already thinking about saving for college. However, I'm still confused about the benefits of a 529 plan. My husband and I have approximately $200,000 in non-retirement investments as we started following The Motley Fool when we were in our early 20s." Oh! "We're in our mid-30s now. Should we start a 529 plan, or just keep investing and pull his future college fund out of our investments? We are well on track with our retirement savings and have a ten-month cash emergency fund."
Brokamp: Very impressive.
Southwick: We are most impressed!
Brokamp: We are most impressed!
Gates: I don't even have a 10-month cash reserve.
Brokamp: So 529 plans are so named after its section in the IRS tax code, 529. They're sponsored by states. Often operated by financial services companies. And the benefit is that you put the money in and it grows tax-free as long as the money is eventually used for qualified higher education expenses like tuition, room and board, and a few other expenses that you can use. It has to be a qualified university. It can't be -- I don't know -- some crazy place in the Bahamas. Something like that.
And one of the other benefits is, since you live in Virginia and I participate in Virginia's 529 plan as well, is the money that you put in can be deducted from the state income tax return as long as you participate in Virginia's plan. But you don't have to participate in your own state's plan. You can look for a better plan if your state's plan isn't very good. The best source of information about that is Savingforcollege.com. It rates all the plans so you can see whether your state offers a break and whether it's worth staying in your state.
So I would say 529s are a good idea. I have it for my kids, but they're not the only things out there. What's your take on 529s?
Gates: I think 529s are a great option. One of the other things that people, I think, get stuck on is what happens if their kid is a bum and they don't go to school and they can't use that money. Well, one of the nice things about a 529 is you can continually roll it to additional family members. So if you have multiple kids, and the first one's a bum, [that's a] bummer...
Southwick: Many successful people didn't go to college.
Gates: That's true.
Brokamp: That's right, or a self-starter, or an entrepreneur.
Southwick: Or an entrepreneur.
Gates: And that's a very fair point.
Southwick: Doesn't even need the money.
Southwick: Mom, thanks for the 529, but I already bought my Tesla and my little start-up is doing fine, thank you.
Gates: The point of the story is most kids are bums.
Southwick: Oh, ho, ho.
Gates: So if the first kid is a tech genius and doesn't go to college, you can give it to the second child and they can use it. So eventually it's pretty easy to use it up if you have multiple kids. You can also transfer it from yourself, actually. I know a couple of folks who have started a 529 for themselves early, before they even ever had kids, and then transferred it to their child to get a jump-start on savings for college.
Gates: So there's a lot of flexibility in there.
Brokamp: One of the drawbacks for some people to a 529 is that you can only invest in mutual funds. And for people who really want to save for college and invest in individual stocks and are looking for a tax-advantaged account, there is the Coverdell Education Savings Account. It has a low contribution amount. You can only contribute $2,000 a year, but that's still nice.
There are income limits, so if you have an adjusted gross income of $110,000 if you're single and $220,000 if you're married, you're supposedly not allowed to contribute to it, but all you do, then, is just give the money to the kid and they contribute to the account themselves. And in that not only can you buy just about anything you can normally buy at a brokerage account, the money can also be used for qualified education expenses for a private elementary or secondary school. So it has a little bit more flexibility. It does have to be used up by the time the kid is 30, however.
Gates: And just a couple of additional gotchas. I think Bro's website is definitely one of the better resources to follow, but reciprocity is one thing that exists for a lot of these accounts, especially 529s, so if you're in Virginia, and you participate in the D.C. plan, you might still be able to claim that state tax deduction. So there's a couple of different areas where you don't have to use your state's 529 if you find a better alternative, as Bro mentioned.
And the final thing is you just want to make sure that how you classify your assets (parents versus grandparents versus the child's) is all sort of aligned when you go to file for FAFSA, so utilizing the various buckets that you have had saved makes a material impact on their ability to get education loans assuming that you haven't fully funded it via the 529.
Southwick: So you're looking way down the road.
Brokamp: Yeah. And FAFSA is the form you fill out to determine how much aid you're eligible for and definitely, the worst situation is for the kid to own the asset. And there are some great calculators out there called EFC calculators (basically expected family contributions) that will give you a rough estimate of how much aid you might be eligible for anyhow.
Southwick: And we have our final question.
Brokamp: Da da!
Southwick: We're finished. We're at the home stretch. This comes from Kurt. "I currently don't own any stocks directly -- only those in my 401(k), which is managed by the firm my company uses to administer our plan. One of your recent podcasts got me interested in buying some stock on my own, but I don't have a lot of spare money laying around to get started. However, I will be receiving $500 at the end of the year for participating in my company's wellness program."
Brokamp: Good for you!
Southwick: I know! "Originally I thought I would buy a new home theatre receiver, but decided maybe I would open a brokerage account and buy some stock, instead. So is $500 enough money to get started in buying stocks or should I just get the receiver and rock the house with Star Wars on the subwoofer? Any advice you can provide would be greatly appreciated." As you all know, I am a big Star Wars fan, so I am very torn by this.
Brokamp: Yes, as someone who named his firstborn Lucas, I am also torn about this when you threw the Star Wars part in there...
Southwick: Yeah. Uh!
Brokamp: But to answer your question, yes, $500 is enough. We talked on a previous episode about this old Fool rule of thumb that you have to keep transaction costs to 2% of your investment, and then when we looked into it, we couldn't really find where the heck we came up with that.
Southwick: We just pulled the number out of thin air.
Brokamp: It's this old Fool lore, but it's still a good guideline. I mean, the one thing about investing a smaller amount of money is you don't want to buy 25 stocks and then have the commissions eat up everything. So there are brokerages out there that will charge you seven bucks, or five bucks. Some are even free. That's the only concern I would have, otherwise go ahead and start investing.
Gates: This question warms my heart, because it touches on getting people started. So just for a reference, there are stocks that exist that are worth more than what you are trying to invest. Priceline, for example, is an over $1,000 stock, so with your $500, you could not buy one share of Priceline. But that doesn't mean that you should not invest that $500. You can buy an index fund, or you can buy any other company that's worth less than $500.
Southwick: What's Disney going for today?
Gates: It's like $90.
Brokamp: The Star Wars Enterprise, of course.
Gates: Yeah, it's like $92 or something like that. So you could buy multiple shares of Disney. Yes, I think you should invest that money and get started. One tip -- consider something like Robinhood, which is free trades ...
Southwick: Right ...
Gates: ... so that you don't get eaten up by transaction costs, as Bro said. And just get started. Invest in Disney. Like you were saying, they own Star Wars now, so go nuts.
Southwick: We own Disney. Should I disclaimer that? We own Disney.
Brokamp: Sure, go ahead.
Southwick: You guys don't own Disney?
Gates: I do. Yes, disclaimer, thank you. I do own Disney.
Brokamp: I don't.
Southwick: You don't?
Southwick: I guess you don't really love Star Wars as much as you were sounding like you did.
Brokamp: But you know, it's funny. In our last episode or two episodes ago, we talked about giving stocks for Christmas...
Gates: Love it...
Brokamp: ... and giving the stock and the product that it makes. I've been thinking -- and I'm going to propose this to my wife tonight, actually -- of doing it the opposite way. Looking at what we bought for the kids and then seeing which of those have stocks that we think are decent and then throw the shares on top of it.
Southwick: Aw! That's nice.
Brokamp: Yes. So given that I know that I'm getting Star Wars-relatedstuff for Christmas, maybe I'll get some Disney, too. Who knows?
Southwick: It always fits, man. It's always the right size. It looks good on you. All right, Sean, thank you for joining us, today.
Gates: It's always my pleasure.
Southwick: You guys managed to stay on the rails.
Brokamp: For the most part.
Gates: You can. It's all audio. There's no visual.
Brokamp: You don't know what's going on under the table.
Southwick: You two. All right, I also want to thank Heather and Anne for sitting in for Rick who is home sick today.
Brokamp: Hi, Rick.
Gates: Hi, Rick.
Southwick: Also, thanks to Vicki who sent a postcard of the Mona Lisa from Paris.
Southwick: I know. They're still coming in. Our email is Answers@Fool.com. Drop us a line. Ask us a question. We do read every single one and just like with the nine questions we answered today, we try to answer as many of them as we possibly can.
Gates: Fun fact for the audience. Rick is a fantastic Spikeball player.
Brokamp: Oh, that's right. You guys are part of the Spikeball club, aren't you?
Gates: I don't know about the audience. If you Google or YouTube Spikeball, just envision Rick, who provides this show to you being a standout player.
Southwick: With his long, flowing locks.
Gates: Oh, it's a beautiful thing to watch.
Southwick: Breaking into song, every now and then, and playing his guitar. I don't know.
Gates: He serves, and his whole body gets into it. He's got like a full tennis serve. You should come see it sometime.
Brokamp: I will.
Southwick: We'll bring popcorn. It sounds great. All right. So that's the show. Also, if don't have a question to send us, you can also send us what we requested last week, which was some of your favorite go-to places for holiday shopping and also some of your holiday traditions because Bro would like to steal some of your holiday traditions.
Brokamp: I just love hearing what people do. It just warms my chestnuts.
Southwick: See, you had to get that in, didn't you?
Brokamp: I don't know why that's funny. I don't!
Southwick: All right, so for Robert Brokamp and Sean Gates, I'm Alison Southwick. Stay Foolish, everybody.
Alison Southwick owns shares of Walt Disney. Robert Brokamp, CFP has no position in any stocks mentioned. Sean Gates owns shares of Walt Disney. The Motley Fool owns shares of and recommends Priceline Group and Walt Disney. The Motley Fool has a disclosure policy.