I just read a good article at ‘Seeking Alpha’ on the dangers of leveraged mutual funds and ETFs (Exchange-Traded Funds.)  A leveraged fund is one that uses fancy sercurities like derivatives and options to double or triple the daily returns of an index (like the S&P500, for example.)  However, this does NOT actually double (or triple) the total return for several reasons.

1) Constant rebalancing: Leveraged funds must buy more stocks when markets go up in order to maintain a certain ratio of leverage to investment (1:1 for a ‘double’ fund.)  Similarly, in down markets these funds must sell off their investments.

This creates a large amount of trading (read: transaction fees) and short-term capital gains (read: taxes.)  If you don’t know already, rapid active trading is a dumb investment strategy because the fees and taxes eat away your potential gains.  (You’re better off buying and holding broad, low-fee index funds, or an ETF of that index fund.)

2) Interest payments: All that debt that leverage funds use doesn’t come free.  These funds pay interest and fees to use fancy securities, which comes straight out of your pocket.  As you can see in the article I mentioned above, this results in woeful underperformance in bear markets (= market going down), with only slight overperformance (of the underlying index) in bull markets (= market going up.)

I would bet that over the long-term, these funds & ETFs will underperform the market, or at least not come close to making up for their huge risks and volatility with increased return.  Instead of looking for a get-rich-quick scheme by leveraging to the hilt, look at much better places to put your money.

Bottom Line: Stay away from leveraged mutuals funds and ETFs, they could be hazordous to your wealth!

(As an aside, I should note that the idea of leveraging (slightly) an index for the long term is not altogether a bad thing, and may be helpful if done in the right way.  However, the current set of leveraged ETFs and mutual funds that take on monster leverage and result in high fees and constant trading are BAD.  That’s not to say that an individual investor couldn’t use index funds in a margin account or other options (that the Seeking Alpha author suggests) to use leverage intelligently.  However, that’s a topic for another day, and one that I really don’t think anyone reading this needs to be worried about.  As of today, I use NO leverage in any of my financial securities (= stocks & bonds) investments.)

I quick note to prospective college students and their parents:

I was asked about a myth regarding students qualifying for in-state tuition rates when they go to school out of state. The MYTH is that if a student goes to an out-of-state school for 1-2 years (the typical school residency period), they become a resident for the purposes of receiving in-state tuition at public universities.  This appears to be FALSE!

It is true that there is usually a 1-2 year consecutive period that a person must live in a particular state in order to become a resident for the purposes of in-state tuition.  HOWEVER, the general rule is that IF the person attends school full-time during any quarter or semester in the 1-2 year period, they are a NON-resident and do NOT qualify for in-state tuition.

If you’re thinking about having the student live with Grandma in the state of University X for a year to qualify, think again.  I’ve also read rules that stipulate that prospective students who are dependents (which most kids are) of non-residents (like their parents living in another state) are also NON-residents, regardless of their stay in the new state.

It appears that loopholes are hard to come by for in-state tuition to those who are not residents of a state for any other purpose besides school.  Given that college tuition is expensive (but worth it), you’d better start saving today.

Where should you put your money?  There are a ton choices including credit card debt, retirement accounts, mortgage payments, that new Le Creuset stockpot that you’ve always wanted, a trip to Tahiti, etc.  Below is a list of where I think most people should put their money in order of priority.  That means that I recommend maxing out the first item on the list before going down to the others.

This list assumes a couple of things:

1) You have some cash to put towards these things.  If you don’t, you need to read Rule #1 of personal finance, cut costs where you can, optimize your spending, and automate your savings.

2) You are not endangering your health, have proper levels of insurance, and aren’t making yourself miserable by living like a total pauper because you’re following my savings suggestions to the extreme.

3) You’ll tailor this order to your own personal situation.  (But even so, I strongly recommend following items 1 & 2 in that exact order.)

Okay, ready?  Numero Uno for where your money should go is….

1) Employer 401k matching

If you’ve read my articles on retirement, you’ve heard me say this before: don’t leave free money on the table!  What type of return do you  historically get from a risk-free investment?  Treasury bonds have returned about 4-5% annually.  What is your employer match return?  If you get matching of 50 cents on the dollar up to 6% of your salary, your return on that first 6% saved is an instantaneous, huge, risk-free 50%!!! There’s no better investment in the world that I’m aware of.  Max this out no matter what!

2) High-interest debt, like a credit card

- Some readers might quibble with this as #2, I can hear them now: “What!? Paying off your credit card balance is always the first thing you should do!”  There may be emotional benefits to making this #1 that you should consider, but  if your employer matching is 50% instantly, and your credit card rate is 25% annually, you’ll do way better to first max out your 401k matching.  After that, put the rest of your cash towards that VISA balance.

(Of course, if you have a rate as outrageous as this one, you may want to switch to paying this off first…)

3) Emergency fund (3 – 6 months worth of living expenses)

You need to have some money socked away for unforeseen expenses or losses of income.  While you should at least have long-term disability insurance to protect yourself against injury, you also need a shorter-term stash of cash to tide you over if you lose a job, get sick, or have to replace something valuable, like a car.  The general rule for insurance is to insure things which you wouldn’t be able to replace relatively quickly and that would cause you hardship if you had to go without them.  This includes your home, life, health, and possibly your car or jewelry, depending on the retail value of these items and your personal savings.  (Make sure to avoid useless insurance.)

Expenses you can afford should be ’self-insured’ by your emergency fund or other savings.  Raising insurance deductibles and banking (NOT spending) the difference in premiums is a good way to self-insure against small losses ranging from a few hundred to a few thousand dollars.  Store emergency money for unexpected car repairs, insurance deductibles (which can be large if you have catastrophic health insurance like I do), or high vet bills for your disgustingly-cute Cavalier King Charles spaniel.

Whether you need more or less living expenses saved depends on how steady your income is & how many liquid assets you already have (like non-retirement stocks that you could tap.)  The more financially secure you already are, the less of an emergency fund you need: a self-employed person with few liquid assets needs more emergency funds than a union schoolteacher with 20 years seniority and a sizable investment account.

Like all short-term (less than 3-5 year) savings, your emergency fund should be investing in something that is not only stable and liquid (easily accessible), but that will also give you a decent return on your investment.  High-interest savings accounts like the kind from INGDirect* fit the bill for very short-term savings since the principal is guaranteed by the FDIC.  Bond funds, which may vary slightly in principle but generally yield a higher return than savings accounts or CDs, work better for money that might sit there awhile.  I use a low-fee, highly-diversified bond index fund for my emergency fund due to the higher returns compared to high-interest savings accounts.

(Read this for an advanced way to juice your emergency fund interest rate while keeping your principal safe & accessible.)

4) Tax-advantaged retirement accounts (401ks, Roth or Traditional IRAs)

After you’ve maxed out your employer retirement matching, paid off your debts (except perhaps your lower-interest mortgage or student loan), and stored money for emergencies, it’s time to go back to saving for your retirement.  Read up on the Roth IRA, and then read this to see if it would be better for you to put your retirement savings in a pre-tax account like a 401k or an after-tax account like a Roth IRA or Roth 401k.  For people in high-ish tax brackets (25% and above as a rule of thumb) and who don’t already have a large pre-tax dollar nest egg saved up, I recommend putting the bulk of your retirement savings into a 401k plan (or a Traditional IRA if your employer doesn’t offer a 401k.)

If retirement is still 5-10+ years off, invest in broad, low-fee stock-market index funds like those that track the S&P 500 or the total stock market.  Index funds outperform mutual funds about 70-80% of the time and require no maintenance on your part since they passively track the entire market for you!  Any good 401k plan should offer at least one of these indexes.  If you’re investing in a Roth or Traditional IRA, select a mutual fund company that offers a good selection of  low-fee index funds like Vanguard or Fidelity.

Putting money into a tax-free retirement vehicle is critical to building up a nest egg for the future.  Assuming you’re in the 25% tax bracket (and some other things**), an investment in a tax-advantaged retirement account made when you’re 25 will be worth about 55% MORE in real dollars when you’re 65 than would an equivalent investment in a taxable account.  (Obviously, if your tax bracket is higher, it’s even more advantageous to avoid taxes.)

5) ‘Regular’ taxable investment accounts & short-term savings for big purchases

After you’ve either maxed out your retirement options (you’re a beast!) or decided you’re contributing enough to retire how you want to at a given age, it’s time to look at plain ol’ taxable investment accounts for long-term savings.  (Index fund recommendations still apply.)  I like to think of these as early retirement accounts; the more you sock away now, the quicker you can exit the rat race (or do something for lower pay that you like more.)

Also, you should be saving regularly for big purchases like a house, wedding, vacation or new car.  For these short-term items, I use the high-interest savings sub-account technique that I learned from Ramit Sethi (you could also use the Roth IRA ‘hack’ I mentioned in priority 3 above.)

Simply open an ING high-interest savings account*, then create multiple savings accounts, labeled according to each item you’re saving for (‘Wedding’, ‘San Francisco trip’, etc.)  Then, set up an automatic monthly contribution to each account based on the amount of time you have to save and the amount of money you’ll need.  For example, if you need $30,000 to put down on a house in 2 years, that’s $1250 per month that you need to be saving ($30,000/24 months = $1250 per month.)

Note that you might sometimes rank some short-term savings goals as higher priority than maxing out your retirement accounts (#4.)  That’s fine, but do NOT neglect your retirement.  Investing early, even with just a little bit of money, is the most important factor to building wealth.  Saving for retirement will be way easier if you start today with whatever you can.

Conclusion

So there you have it, the rank-ordered top 5 places to put your money: 1) Max out employer matching contributions before anything else, 2) pay off high-interest debt like credit cards, 3) create an emergency fund of 3-6 months worth of expenses, 4) put as much as you can into tax-advantaged retirement accounts, and 5) bankroll anything left into short- & long-term (taxable) savings/investment accounts.

Take each step one at a time until you’ve successfully mastered it, then move on to the next one (don’t try to do it all at once!)  Once you’re eventually able to do all of these things, consider yourself pwning your money!

* If you want to set up an ING Direct high-interest savings account, the first 24 people that email me can get a referral link that will get them a $25 bonus if they deposit at least $250 when setting up the account (I’ll get a $10. referral bonus.)

** This assumes dividends & capital gains remain at the historically low rate of 15% for those in the 25% and up brackets.  It also assumes an effective tax rate at retirement of 16%, which corresponds to an income in today’s dollars of about $90K for a married couple.  If dividend or capital gains rates go up, tax-advantaged accounts perform even better against taxable accounts.  On the other hand, if your tax rate goes up relative to the capital gains rate after you’ve retired, tax-advantaged accounts lose some of their edge (but they’re always better.)

You may remember my admonitions that ‘retirement savings are for retirement!’, but today I’m going to show you how to use your Roth as a sort of savings ‘hybrid’: you can use the Roth as short-term savings vehicle AND get the benefits of tax-free interest for retirement.  Before we get any further into this, make sure you understand how the Roth IRA works.

You may have decided that investing in a Roth IRA isn’t the best move for your retirement (opting instead for a 401k perhaps.)  Contributing to a Roth may still be a smart move, even if you want to use the money sooner rather than at retirement.  (Anyone with earned income whose modified adjusted gross income is less than $105,000 can contribute to a Roth IRA, regardless of age or participation in other retirement plans, like a 401k.)  Before we delve into the details, I want to let you know that this is an ADVANCED (though not hard) technique.   Make sure you understand all the details before deciding to use it.  (Post a comment with any questions you have.)

Recall that a Roth IRA lets you contribute after-tax dollars to a variety of investments including index funds, individual stocks and bonds.  The benefit over a ‘normal’ taxable account is that the money then grows tax-deferred, meaning you don’t pay interest on reinvested dividends or interest.  Plus, if you take out the gains AFTER age 59 1/2, you don’t pay any taxes on those either!  The catch is that if you DO take out any gains before turning 59 1/2, you generally must pay a 10% penalty on top of regular income taxes.  BUT, because you’re contributing after-tax money already, you can pull out amounts up to the value of your contributions with NO penalties/taxes at any time you want!

For example, say you contributed $2,000 to a Roth IRA in 2007, then another $4,000 in 2008.  You can take out up to $6,000 with no penalties/taxes.  IF however, your account increased to $7000 in value due to appreciation, you can still only take out up to the $6,000.  The extra $1000 gain must remain in the account until you’re 59 1/2 to avoid penalties (with a few exceptions detailed here.)

Since your money accumulates tax-free, you earn a higher after-tax rate of return in a Roth than in a taxable account.  If you’re earning say, 6% interest on $5000 and you’re in the 25% tax bracket, your after-tax return is only 4.5%  ($225 per year) in a taxable account.  If you had that money in a Roth IRA instead, you’d earn the full 6% ($300), which equals 33% more money per year.  Over time, small differences in interest rates make a huge impact on your wealth due compounding interest as shown by the below graph.*

After 5 years, your Roth IRA will have $400 (7.5%) more in it, in 10 years, about $900 (15%) more.  When we combine the two facts above, being able to take out contributions at any time plus tax-free growth, we get a great way to use the Roth IRA as BOTH a short-term savings vehicle AND a way to earn higher returns on that money.

First, open a Roth IRA account that is completely SEPARATE from any Roth IRA account you might have designated for retirement.  This is because you do NOT want you to think of any Roth money you set aside for short-term savings as retirement money.  This makes it easier to keep track of your contributions that you plan to take out.  I have two Roth IRA accounts at Vanguard, one for retirement (invested 100% in stock index funds) and one for short-term savings, like emergencies, invested 100% in a diversified bond index fund.  Here’s how it looks:

Next, use an Excel spreadsheet, like the one I developed here, to track your Roth IRA contributions.  Your spreadsheet should have at least two columns: one that shows the amount of money you either contributed or took out of ANY of your Roth IRA accounts and one that shows the date of the transaction.  To find past contributions, the financial institution where you have your Roth IRA should keep records of these transactions for a few years (or check all Form 5498’s that you might have received from your financial institution(s) over the years.)  Make sure you never take out more than you’ve contributed, or you’ll likely face taxes or penalties.

Next, fund your separate, non-retirement Roth IRA with money that you need in the short (or long) term.  If you’re saving for the short-term, like an emergency fund, choose a relatively safe investment like a bond or money market fund.  The beauty of using a Roth for an emergency fund is that you get the benefits of easily-accessible principle (your contributions) with the added bonus of tax-free growth that can be used for retirement.**

This is great because your emergency funds might be invested for a really long time, if you’re lucky enough to avoid costly emergencies.  In light of this, you’d like to maximize your gains by avoiding taxes while the money sits there.  You can use a similar strategy when saving for a down payment on your first home.  If (and ONLY if) you’ve had a Roth account open for at least 5 years, you can use up to $10,000 of Roth IRA gains towards a first-time home purchase tax- and penalty-free.  So in this special case, you can even use the earnings (plus all the contributions) from your Roth IRA.

(Remember, you must have opened a Roth IRA account and deposited money into it at least 5 years ago to use this exception.  There is a similar exception for qualified education expenses, except the earnings withdrawals are NOT tax-free, only 10% penalty-free.  However, there are better ways to save for education.)

As a final note, remember that the IRS doesn’t care which IRA accounts you deposit to or take money out of, all that matters is your total contributions & distributions from all your Roth IRA accounts combined.  (Even so, I strongly recommend keeping Roth accounts you intend to use for short-term events separate from retirement-designated Roths.)

Start using this strategy today by opening a Roth IRA online at a reputable mutual fund house like Vanguard, Fidelity or T. Rowe Price.  With minimum initial deposits as low as $50 for T. Rowe Price, there’s no excuse for not starting a Roth.

* The graph is inflation-adjusted because we always want to talk about ‘real dollars’, aka purchasing power.  Another way of saying this is that we don’t really care about how many dollars we have, but how much stuff we can buy with them.  If we didn’t factor in inflation, we would actually understate how valuable the tax-savings from a Roth are.

** If you really want to optimize your investment performance, you could periodically (perhaps annually) move the gains on your non-retirement Roth into a Roth you’ve designated for retirement.  You would do this in order to move these gains (which shouldn’t be taken out until retirement) into a more volatile long-term investment, like a stock index fund, rather than having them sit in a stable, but lower expected return, short-term investment.

As some of you may know, I’m currently an MBA student at the University of Washington’s Foster school of business.  Here’s a video we watched in class on the history of currency.  It’s pretty interesting if you’re up for some high-falutin’ monetary policy learnin’:

Part I: http://www.youtube.com/watch?v=FcIszzV-WrY

Part II covers personal economics: http://www.youtube.com/watch?v=Vfr8gwL5UkM&NR=1

I’ve already railed against Forbes for insinuating that a college degree doesn’t help a person become a billionaire, but they’ve come out with another idiotic article claiming the same thing.   In my prior article, I showed that billionaires in the Forbes 400 list were actually 6 times more likely than the general US population to hold a bachelor’s degree.
Forbes has stated that two-thirds of these billionaires at least have bachelor’s degrees, compared to roughly 25% of the general population.  This new Forbes article goes on to state that “[o]f the 274 self-made tycoons on the Forbes 400, 14% either never started or never completed college.”  Really?  Hmmm, so that means that “self-made” billionaires, presumably those that didn’t start with ludicrous wealth, are even MORE likely (86% versus 66%) to hold college degrees than “regular” billionaires!

In fact, a self-made billionaire is 6.1 times more likely to have a college degree than not (=0.86/0.14.)  Also, it’s not too hard to show that a random person with a college degree is 18 times more likely to be a self-made Forbes 400 billionaire than a person without a college degree*!

If you’re not heir to a fortune already, finishing college (or even graduate school) might be the best wealth-building move you can make.  Investing in yourself often pays much bigger returns than anything you could get out of the stock market.  (Save and send your kids too, they’ll thank you later.)

* To prove this, let’s assume a population of 1000 people.  Let’s also assume, for round numbers, that 14 of these are self-made Forbes billionaires.  (It doesn’t matter how many billionaires you assume, the numbers still come out the same.)  We know that 12 of these billionaires have college degrees (86% of 14), and 2 don’t.  We also know that 25%, or 250, of the general population have college degrees.  Therefore, of the 750 people without college degrees, only 2 of them are Forbes self-made billionaires, which works out to 0.267% (=2/750.)  Of the 250 people WITH college degrees, 12 are self-made billionaires, or 4.8% (=12/250.)  Therefore, a randomly-selected person WITH a college degree is 18 (=4.8%/0.267%) times more likely to be a billionaire than a person without a degree! QED: GO TO SCHOOL IF YOU WANT TO BE RICH!

Disclaimer: I wrote this article solely to make bad puns off the Wu-Tang Clan’s debut album classic “‘Enter the Wu-Tang (36 chambers)“.

The same rapper that cautioned us to safeguard our neck has been neglecting his paycheck, or rather, the state income taxes that didn’t come out of it.  New York state has brought the muthaf’in ruckus as they prepare to “R.E.A.M.” Wu Tang Clan’s Method Man for dolla dolla bills y’all.

Before you start to chastise the hip hop star with cries of “shame on a nigga” for tryin’ to run game on NY state, note that poor Method Man defended himself on the grounds that “I’m a pothead…I go on the road and forget everything else.”

Don’t shed too many tearz for the man, though, he’s probably worth millions, especially considering the wealth management services he has access to as a Wu member.  Just remember, the tax man ain’t nuthing ta f’ wit!

The above is an interesting graph of car reliability.  It’s no surprise that Japanese automakers lead the way, but I was surprised that the American manufacturers aren’t too far behind (~25-30% more problems.)  Kia still seems to be WAY behind the curve… (apologies to my Korean in-laws.)

Does anyone know how Hyundai stacks up?  If so, please post a comment with some data.

It’s good to keep things like this in mind when buying anything you want to last or use a lot.  The general lesson is to consider total costs of ownership over the lifetime of your purchase (not just the original purchase price.)  This applies to thinking about future car repairs as well as dry cleaning costs & time for dry clean-only clothes.

Remember that a low up-front price doesn’t always mean less costly over the long term (that’s a lesson that a cheap bastard like me still has problems learning.)  Value is what really matters; a combination of the price you pay and the quality you get.  As I’ve gotten older, busier and more crotchety, saving time & headache has become more valuable to me.

In light of all this, I recommend buying quality, hassle-fee products & services, and keeping those quality items for as long as they’ll last.  It’s better to own fewer items that you’ll really love and use rather than a lot of cheap stuff that wears out or needs to be constantly replaced or maintained.  This rules goes for clothes, cookware, cars, etc.

A message from one loyal reader:

“I had a bizarre dream last night in which you opened an office called “village personal finance” and all the decor was sparkly pink hello kitty stuff right down to the mailbox outside…”

If you’re not dreaming about my blog yet, you definitely need to read it more, or at least insert it repeatedly into everyday conversation, just like I do.

… thanks to T. Rowe Price’s Total Equity Market Index fund (ticker: POMIX.)  Most funds require a few thousand dollars to open an account.  T. Rowe Price lets you open, say, a Roth IRA, with as little as $50 as long as you sign up for minimum automatic monthly contributions of $50 as well (taken right out of your checking account.)  With this particular fund, you get a low-fee, broadly diversified, US stock market index fund.  It’s the kind of thing you can invest in regularly and forget about until you’re within 10 years of retirement.

(If you invested the bare minimum of $50 per month for 30 years at 7% interest, you’d have over $58,000.   Plus, you would only have invested $18,000 of your own money [= $50 * 12 * 30]. That’s an extra 40 grand in your pocket just for 50 bucks a month!)

POMIX’s expense ratio is a low 0.40% (not quite as low as Vanguard’s 0.18%, or Fidelity’s approaching-absolute-zero Spartan fund ratio of 0.10%.  Unfortunately, they require $3000 and $10,000 to open an account, respectively.)

Bottom Line

If you’re not saving for your retirement (or for whatever long-term goal you have), and you don’t have a few thousand laying around to open an account, you can still start with $50 today!

Multi-billionaire investor Warren Buffett, CEO of Berkshire Hathaway, on the Charlie Rose Show in October 2008.  This is a facsinating look back through what was happening during the financial crisis, and Buffett’s insightful and easy-to-understand thoughts on it.

Buffett is a personal hero of mine, both in terms of investing and as a model of integrity & compassion in business and life.  I find he’s a great conversationalist, so I hope you enjoy this interview as much as I did.  Check it out on your lunch break!

Okay, so this is kind of a random post for a personal finance blog, but one way to save money is to cook for yourself. To do that, you need some good kitchen knives.  90% of those knife needs can be handled by 2 implements: A Chef’s knife and a paring knife.  I recently came across a good deal for 2 high-quality versions of each (both of which I’ve purchased; they work great!)

Make sure you get a sharpening steel as well, like this one from Chicago Cutlery or this one from OXO.  This is so you can sharpen the knives yourself when they inevitably lose some of their edge.

Here’s a useful site that discusses how to pick good kitchen knives.  He goes over the various types of steel, but I haven’t figured out how to know which knives contain which steel!

3.25” Paring knife:

8” Chef’s knife:

It’s a given that your kids should go to college.  How are you going to pay for your kid’s education?  (Or your own, if you’re planning on going back to school.)  College tuition has been rising at an obscene rate, much faster than inflation.  To meet your education savings goals, you need to invest, and you need to start right away to give your money a chance to grow.  How early you invest is the biggest factor in your future wealth. Read the below and start socking away money for education today.

Whether you want to send Junior to an Ivy League private institution or a public state school (where serious students are powerless against the drunken jock-ocracy), I can tell you where to put your college nest egg to get the most bang for your buck.

There are really only two worthwhile education savings vehicles to choose from:

1) A state 529 savings plan.  This can be any state’s plan, not just your own.

2) A Coverdell Education Savings Account (ESA.)

Both accounts allow the money you contribute for a designated beneficiary (like your child) to grow tax-deferred.  The distributions (money you later take out of the account) are tax-free as long as they are then spent on qualified education expenses (defined later.)  (Unlike, say, a 401k, there’s no option to deduct your contributions to these education plans from your taxable income.)

Let’s start with the Coverdell ESA

- Coverdell’s have contribution limits of $2,000 per year per beneficiary (= child.)  This means that you have to make sure that ALL the people (grandparents, parents) who contribute to a Coverdell for a child  don’t contribute more than $2,000 combined in a given year.  You must make these contributions by April 15th (tax day) of the following tax year (same rule as for IRAs.)  This means you can make a 2009 Coverdell contribution as late as April 15th 2010.

- Coverdell ESA’s, like Trix, are for kids.  You can only make contributions for any person who is under 18, unless that person is a special needs beneficiary.  Also, the beneficiary must use all of the money for qualified education expenses before age 30 in order to avoid taxes and penalties.  Alternately, you can transfer the account to another eligible beneficiary who is under 30.

Eligible beneficiaries include the beneficiary’s siblings, parent’s (presumably YOU), kid’s, spouse, in-laws, aunts/uncles, first cousins or any of the prior folks’ spouses.

- In order to contribute the $2,000 max to a Coverdell, your modified adjusted gross income (MAGI) must be less than $95,000, or $190,000 if you’re married filing jointly.

- You can contribute to Coverdell’s for as many separate beneficiaries as you like.  For example, if you have 5 kids, you can contribute up to $2,000 for each of them in separate Coverdells (Mormons take note.)

- If you’re thinking about private elementary or secondary schooling for your precocious youngster, the Coverdell is the way to go*.  Elementary and secondary school expenses count for tax-free distributions.  (The 529 plans only allow for postsecondary  expenses, like college or vocational school.)  For all levels of education, these qualified expenses include required tuition, fees, room and board, books, supplies and equipment.

For elementary or secondary education ONLY:

Add to the above academic tutoring and even computer equipment & internet service “if it is to be used by the beneficiary and the beneficiary’s family during any of the years the beneficiary is in elementary or secondary school.”

Also, add in the following if they are required or provided by the school:  transportation and “supplementary items and services (including extended day programs.)”

- You can invest in pretty much whatever you want: stocks, bonds, mutual funds, etc.  I recommend you invest regularly into a market-tracking stock index fund like Vanguard’s VTMSX, and then reallocate some of that money to a bond fund (like VBMFX) once the beneficiary gets within 3-5 years of starting college.  If you don’t want to worry about doing the reallocation yourself (or you’re afraid you’ll forget), use a 529 savings plan that offers target-date funds that automatically changes your investment from aggressive to conservative as the child gets closer to college.   (So far, I haven’t found a target date fund made for college that individuals can buy outside of a 529 plan, but if you see one, let me know!)

- You can rollover a Coverdell ESA to a 529 savings plan (but you CAN’T rollover a 529 to a Coverdell.)   So if you think there’s a good chance you’ll want education savings for private elementary or high school, invest that money in a Coverdell.  If your kid doesn’t use it for St. Mary’s Academy, roll it over to a 529 if you like (or just leave it in the Coverdell.)

- For federal financial aid planning, both Coverdells and 529 Savings plans count as parental assets.  This is good because parent’s are only expected to contribute ~6% of their non-retirement, non-home assets, while kid’s are expected to contribute 35% of theirs.  (Note that this exclusion of retirement assets in financial aid calculations is a good reason to have your kid start a Roth IRA once they have some high school job savings.  The IRA will exclude their assets from financial aid calculations, whereas a savings account or taxable stock account wouldn’t.)

[529 Pre-Paid Tuition plans (versus 529 Savings plans, which I discuss below) are counted as the student's assets, and thus diminish financial aid eligibility.  This is one reason I don't recommend them.  Another reason is that the plans guarantee to cover only in-state public school tuition amounts.  Also, many plans only cover tuition, which is often just a fraction (albeit a large one) of the total cost of attending college.]

529 Savings plans

- 529 savings plan distributions are only tax-fee for post-secondary expenses (like college.)

- Unlike the Coverdell ESA, you can contribute for a beneficiary of any age.  If plans change, you can transfer the account to an eligible beneficiary.  These  include the beneficiary’s kids, grandkids, siblings, parents, neices/nephews, aunts/uncles, in-laws, first cousins, and all those folks’ spouses (including the beneficiary’s.)  (Step-family count too.)  This means you could start a 529 for yourself to go back to school, and if you don’t use all the money, give it to your spouse, kids or even grandkids.

- These plans are offered by states, and you can invest in ANY state’s particular plan (not just your home state.)  It pays to shop around, and you should always at least glance at your home state’s plan to see if there are any special benefits in it for residents (like state income tax breaks.)  I checked in my home state of Washington, and there’s no special benefits for residents.  So if you live in Washington state, see the Utah plan below.

In order to save you some virtual leg-work, I particularly recommend the Utah 529 plan.  It’s rock-bottom fees and excellent investment options (run by index fund giant Vanguard) just can’t be beat.  If you’re going to go with the Utah plan and you want to pick a low-hassle, target-fund approach, I recommend splitting your money 50-50 between Option 3 & Option 7.   That way, you don’t have to worry about rebalancing your portofolio from stocks to bonds as your child gets closer to needing the money.  (That being said, I recommend rolling the Option 7 money over to Option 5 when your kid starts college. That way you’re in a higher-return bond fund (Opt 5) instead of a crappy interest rate savings account (Opt 7.)  If you’re too lazy to do this last step, don’t worry about it; it’s not a huge deal.)

ALWAYS, check out the asset allocations of any investment choice you’re considering to make sure you’re comfortable with the amount of risk/volatility.  You should take a lot of risk (= all stocks; higher average return, but volatile) when the child is young, and less risk (= mostly bonds; lower average return, but stable) when the child is a few years from college.

- Morningstar also recommends a list of state 529 plan choices for 2009 in this article.

- There are no income limitations for contributors, so you can make millions and still contribute to a 529 plan.  Also, you can contribute as much as you like, but only up to the gift tax exclusion limit ($13,000 per person in 2009) to avoid paying a federal gift tax.

How do I choose the right option for me?

Review the info above, and see if that helps.  If you’re still not sure, take a look at these what-if scenarios:

- If you need money for pre-college education like private elementary or high school, a Coverdell ESA is the way to go.

- If you make a boatload of money and therefore can’t invest in a Coverdell for college, use a 529 plan instead.  Or, if you want to contribute above the $2000 Coverdell limit, you can put $2000 in the Coverdell and the remainder in a 529.

- If you have significant state tax benefits from your state’s 529 savings plans, you probably want to use that.

- If the savings are for you, use a 529 plan since it has no age limits for contributions or withdrawals.

Generally, I would recommend starting with the Coverdell ESA for its flexibility.  If you or other contributors want to contribute more than $2,000 in a year per child, put the excess in a 529 savings plan.

If you’re incapable of using any of the above to make your own decisions, here’s a link from Vanguard to help you choose.  It asks you a few questions and spits out an answer.

So do a little homework, and then start funding the plan you choose ASAP, even if you can only afford to put in a little bit each month.  We didn’t tackle how much to save in this article, so use this college savings calculator to get an idea.

Happy education savings!

Other resources:

Fool comparison of 529s and Coverdell Education Savings Account (ESA).

Motley Fool FAQ on 529 plans

* – “Unless Congress acts, certain ESA benefits expire after 2010. K -12 expenses will no longer qualify, the annual contribution limit will be reduced to $500, and withdrawals will not be tax-free in any year in which a Hope credit or Lifetime credit or Lifetime Learning credit is claimed for the beneficiary.” From: Savingforcollege.com

Hopefully Congress will renew these benefits.  I’ll update this post after a decision is made.  Don’t worry though, if the Coverdell benefits fall through after 2010, you can rollover your Coverdell into a 529 plan.

2006 stats from the U.S. Census Bureau:

• Average annual salary without a high-school degree: $19,915
• Average with a diploma: $29,448
• Average with a bachelor’s degree: $54,689
• Average with a master’s degree or higher: $79,946

Read this to find out how to pay for college.

(Source: The Motley Fool.)

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