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[Financial Friday] What do I need to know about submitting the FAFSA?

The FAFSA, which stands for Free Application for Federal Student Aid, is the federal government’s financial aid application. Though the thought of completing it may inspire a collective groan from parents each year, this form is the prerequisite for many different types of federal and college financial aid, including loans, grants, scholarships, and work-study. So filling it out should be one of the first things on your list if your son or daughter will need some type of financial aid to attend college.

What do I need to know about submitting the FAFSA?

Even if you don’t think your child will qualify for aid, you should still consider submitting the FAFSA in two instances. The first is when you want your child to have some “skin in the game” by taking on a small loan. In this case, filing the FAFSA will make your child eligible for an unsubsidized Stafford Loan each year–up to $5,500 for freshmen, $6,500 for sophomores, and $7,500 for juniors and seniors. Unsubsidized Stafford Loans aren’t based on financial need and are available to any student attending college at least half-time.

The second situation for which you might file the FAFSA is when you want your child to be considered for college financial aid. Colleges generally require the FAFSA, along with the CSS Profile form, before they’ll determine whether your child is eligible for any college need-based grants and scholarships.

The FAFSA is available online at fafsa.ed.gov. A new sign-in method (as of May 2015) requires creating an FSA ID, which consists of a username and password. The FSA ID replaces the prior PIN sign-in method and is meant to be more secure.

The FAFSA should be filed as soon as possible after January 1 for both new and returning students because some aid programs operate on a first-come, first-served basis. Practically speaking, many families wait to submit the FAFSA until after they have completed their tax returns, but you don’t have to wait. The FAFSA can be submitted with estimated tax numbers and then updated later with final tax numbers by simply adding the final numbers manually or using the government’s online IRS Retrieval Tool. Regarding the filing timeline, look for a change on the horizon. Starting with the 2017/2018 school year, families will be able to file the FAFSA as early as October 2016 using their 2015 tax information.

What happens after I file the FAFSA?

After you submit the federal government’s FAFSA (Free Application for Federal Student Aid), you will receive a Student Aid Report (either electronically or by mail, depending on how you filed the FAFSA). This report summarizes key data from your FAFSA and provides you with the holy grail of numbers–your expected family contribution, or EFC, which is the amount of money the government expects your family to contribute toward college for the current year before being eligible for federal aid.

For example, EFC27000 means that your expected family contribution is $27,000. Keep in mind that this figure is what the government says you can afford to pay, not what you say you can afford. In fact, many families may find it difficult to pay their EFC, let alone any potential remaining costs.

Review your report carefully to make sure it contains your correct income and asset information. Any corrections should be made immediately and sent back for reprocessing. If you have questions, you can contact the Federal Student Aid Information Center at 1-800-433-3243. An asterisk (*) next to your EFC means that your application has been selected for verification, which means you’ll need to provide additional documentation as specified.

Your Student Aid Report is also sent to each college that your child listed on the FAFSA. The financial aid administrator at each school that has accepted your child will then use the report (along with the CSS Profile form, if applicable) to craft an aid package that attempts to meet your child’s financial need. Aid packages typically include various combinations of federal loans, grants, and work-study jobs along with college grants and scholarships. Colleges are not obligated to meet all of your family’s financial need. If they don’t, it’s called getting “gapped.” In this case, you’re on the hook for your EFC plus any gap.

Both new and returning students will be notified of a college’s aid package in the spring. Some colleges may send a letter, some may post the information on a password-protected online site, and some may do both. Make sure to look over the award carefully. If you have questions or your financial circumstances have changed since you filed the FAFSA, contact the college’s financial aid office.

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[Financial Friday] Investor, Know Thyself: How Your Biases Can Affect Investment Decisions

Over the past few decades, a field has emerged that examines how human psychological factors influence economic and financial decisions. Understanding these biases may help you avoid questionable calls in the heat of the financial moment.

Investor, Know Thyself: How Your Biases Can Affect Investment Decisions

Traditional economic models are based on a simple premise: people make rational financial decisions that are designed to maximize their economic benefits. In reality, however, most humans don’t make decisions based on a sterile analysis of the pros and cons. While most of us do think carefully about financial decisions, it is nearly impossible to completely disconnect from our “gut feelings,” that nagging intuition that seems to have been deeply implanted in the recesses of our brain.

Over the past few decades, another school of thought has emerged that examines how human psychological factors influence economic and financial decisions. This field–known as behavioral economics, or in the investing arena, behavioral finance–has identified several biases that can unnerve even the most stoic investor. Understanding these biases may help you avoid questionable calls in the heat of the financial moment.

Sound familiar?

Following is a brief summary of some common biases influencing even the most experienced investors. Can you relate to any of these?

  1. Anchoring refers to the tendency to become attached to something, even when it may not make sense. Examples include a piece of furniture that has outlived its usefulness, a home or car that one can no longer afford, or a piece of information that is believed to be true, but is in fact, false. In investing, it can refer to the tendency to either hold an investment too long or place too much reliance on a certain piece of data or information.
  2. Loss-aversion bias is the term used to describe the tendency to fear losses more than celebrate equivalent gains. For example, you may experience joy at the thought of finding yourself $5,000 richer, but the thought of losing $5,000 might provoke a far greater fear. Similar to anchoring, loss aversion could cause you to hold onto a losing investment too long, with the fear of turning a paper loss into a real loss.
  3. Endowment bias is also similar to loss-aversion bias and anchoring in that it encourages investors to “endow” a greater value in what they currently own over other possibilities. You may presume the investments in your portfolio are of higher quality than other available alternatives, simply because you own them.
  4. Overconfidence is simply having so much confidence in your own ability to select investments for your portfolio that you might ignore warning signals.
  5. Confirmation bias is the tendency to latch onto, and assign more authority to, opinions that agree with your own. For example, you might give more credence to an analyst report that favors a stock you recently purchased, in spite of several other reports indicating a neutral or negative outlook.
  6. The bandwagon effect, also known as herd behavior, happens when decisions are made simply because “everyone else is doing it.” For an example of this, one might look no further than a fairly recent and much-hyped social media company’s initial public offering (IPO). Many a discouraged investor jumped at that IPO only to sell at a significant loss a few months later. (Some of these investors may have also suffered from overconfidence bias.)
  7. Recency bias refers to the fact that recent events can have a stronger influence on your decisions than other, more distant events. For example, if you were severely burned by the market downturn in 2008, you may have been hesitant about continuing or increasing your investments once the markets settled down. Conversely, if you were encouraged by the stock market’s subsequent bull run, you may have increased the money you put into equities, hoping to take advantage of any further gains. Consider that neither of these perspectives may be entirely rational given that investment decisions should be based on your individual goals, time horizon, and risk tolerance.

A negativity bias indicates the tendency to give more importance to negative news than positive news, which can cause you to be more risk-averse than appropriate for your situation.

An objective view can help

The human brain has evolved over millennia into a complex decision-making tool, allowing us to retrieve past experiences and process information so quickly that we can respond almost instantaneously to perceived threats and opportunities. However, when it comes to your finances, these gut feelings may not be your strongest ally, and in fact may work against you. Before jumping to any conclusions about your finances, consider what biases may be at work beneath your conscious radar. It might also help to consider the opinions of an objective third party who could help identify any biases that may be clouding your judgment.

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[Financial Friday] When 401(k) Plans Go Bad–Avoiding Disqualification

As a small-business owner, you probably either have, or have considered adopting, a 401(k) plan. 401(k) plans have assumed their starry status in the retirement universe because of the favorable tax benefits they provide to both employers and employees.

when-401k-plans-go-bad-avoiding-disqualification

Most importantly, employers get an immediate tax deduction for contributions they make to their plans, and employees benefit from pre-tax contributions and tax-deferred, or in some cases tax-free, accumulation of investment earnings. But these tax benefits come at a cost. Employers must follow strict and often complicated laws in the Internal Revenue Code, and regulations promulgated by the government agencies charged with interpreting those laws–primarily the Internal Revenue Service and the Department of Labor.

Tax effects of plan disqualification

Plans that comply with the tax rules are said to be “qualified” and therefore entitled to their favorable tax status. But plans that run afoul of the rules (for example, by improperly excluding participants, missing contributions, or failing discrimination tests) can become “disqualified.” The potential consequences of disqualification are severe:

  • Employees are taxed on their pretax contributions in the year those contributions are made to the plan, rather than the year the contributions are paid from the plan.
  • In general, employees are taxed on employer contributions, and plan investment earnings, in the year they vest, rather than the year benefits are paid; in certain cases, highly paid employees are taxed on the entire value of their accounts (to the extent not already taxed).
  • Employers take deductions for plan contributions in the year their employees vest in that contribution, rather than the year the employer made the contributions to the plan.
    The plan trust must pay taxes on its earnings.
  • Distributions from the plan are ineligible for special tax treatment and cannot be rolled over tax free to IRAs or other qualified employer plans.

Even worse, a plan may be disqualified retroactively if the plan defect occurred in a prior year. This means that employers and employees would likely need to file amended returns to reflect the tax effects of disqualification for those prior years. Penalties for underreporting income in those prior years could also be imposed. And while the IRS generally can’t go back more than three years (six years if there was a substantial underreporting of income) to collect taxes for any earlier year, the IRS might require correction of those closed years if an employer seeks to requalify its plan.

IRS to the rescue

Luckily, the IRS has adopted several programs that may help you avoid the potentially disastrous consequences of disqualification.

The Self-Correction Program, or SCP, is generally the program of choice if you’re eligible. This program allows you to self-correct many plan errors–and preserve the tax-favored status of your plan–without contacting the IRS or paying a fee, and there are no application or reporting requirements. “Correction” generally means that the plan and participants must be placed in the same position they would have been if the failure had not occurred. The program is available for any errors that occur when you don’t follow the written terms of your plan. You can correct insignificant errors at any time. And you can even self-correct significant operational errors if you act promptly. (“Egregious” errors can’t be corrected using SCP.)

If you’re not eligible for SCP (or if you’d like the comfort of IRS approval of your corrections), the next step is the Voluntary Correction Program (VCP). This program is available only if your plan is not being audited. You must submit an application to the IRS describing the plan failure(s), describe how you intend to correct those failures, and detail the administrative changes you intend to adopt to avoid those failures occurring in the future. You must also pay a compliance fee, ranging from a few hundred dollars to $25,000, depending on the nature of the failure and the number of plan participants. If your application is approved, the IRS will generally agree not to disqualify your plan because of the disclosed failures if you complete the approved corrections within 150 days.

If you don’t use SCP or VCP to voluntarily correct plan errors, and the IRS discovers the failures itself (for example, during a plan audit), you may still be able to preserve your plan’s tax benefits by using the Audit Closing Agreement Program (Audit CAP). Under this program, you must correct the plan failures, enter into a “Closing Agreement” with the IRS, and pay a penalty equal to a negotiated percentage of the additional taxes that would have been payable had the plan been disqualified.

The qualified plan rules are complicated. Working with a retirement plan professional can help you avoid mistakes that could lead to the ultimate penalty of disqualification.

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[Financial Friday] Cost of Living: Where You Live Can Affect How Rich You Feel

Do you find yourself treading water financially even with a relatively healthy household income? Even with your new higher-paying job and your spouse’s promotion, do you still find it difficult to get ahead, despite carefully counting your pennies? Does your friend or relative halfway across the country have a better quality of life on less income? If so, the cost of living might be to blame.

Cost of living

The cost of living refers to the cost of various items necessary in everyday life. It includes things like housing, transportation, food, utilities, healthcare, and taxes.

Single or family of six?

Singles, couples, and families typically have many of the same expenses–for example, everyone needs shelter, food, and clothing–but families with children typically pay more in each category and have the added expenses of child care and college. The Economic Policy Institute (epi.org) has a family budget calculator that lets you enter your household size (up to two adults and four children) along with your Zip code to see how much you would need to earn to have an “adequate but modest” standard of living in that geographic area.

What areas have the highest cost of living? It’s no secret that the East and West Coasts have some of the highest costs. According to the Council for Community and Economic Research, the 10 most expensive U.S. urban areas to live in Q3 2015 were:

Rank Location
1 New York, New York
2 Honolulu, Hawaii
3 San Francisco, California
4 Brooklyn, New York
5 Orange County, California
6 Oakland, California
7 Metro Washington D.C./Virginia
8 San Diego, California
9 Hilo, Hawaii
10 Stamford, Connecticut

Factors that influence the cost of living

Let’s look in more detail at some of the common factors that make up the cost of living.

Housing. When an area is described as having “a high cost of living,” it usually means housing costs. Looking to relocate to Silicon Valley from the Midwest? You better hope for a big raise; the mortgage you’re paying now on your modest three-bedroom home might get you a walk-in closet in this technology hub, where prices last spring climbed to a record-high $905,000 in Santa Clara County, $1,194,500 in San Mateo County, and $690,000 in Alameda County. (Source: San Jose Mercury News, Silicon Valley Home Prices Hit Record Highs, Again, May 21, 2015)

Related to housing affordability is student loan debt. Student debt–both for young adults and those in their 30s, 40s, and 50s who either took out their own loans, or co-signed or borrowed on behalf of their children–is increasingly affecting housing choices and living situations. For some borrowers, monthly student loan payments can approximate a second mortgage.

Transportation. Do you have access to reliable public transportation or do you need a car? Younger adults often favor public transportation and supplement with ride-sharing services like Uber, Lyft, and Zipcar. But for others, a car (or two or three), along with the cost of gas and maintenance, is a necessity. How far is your work commute? Do you drive 100 miles round trip each day or do you telecommute? Having to buy a new (or used) car every few years can significantly impact your bottom line.

Utilities. The cost of utilities can vary by location, weather, usage, and infrastructure. For example, residents of colder climates might find it more expensive to heat their homes in the winter than residents of warmer climates do cooling their homes in the summer.

Taxes. Your tax bite will vary by state. Seven states have no income tax–Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. In addition, property taxes and sales taxes can vary significantly by state and even by county, and states have different rules for taxing Social Security and pension income.

Miscellaneous. If you have children, other things that can affect your bottom line are the costs of child care, extracurricular activities, and tuition at your flagship state university.

To move or not to move

Remember The Clash song “Should I Stay or Should I Go?” Well, there’s no question your money will go further in some places than in others. If you’re thinking of moving to a new location, cost-of-living information can make your decision more grounded in financial reality.

There are several online cost-of-living calculators that let you compare your current location to a new location. The U.S. State Department has compiled a list of resources on its website at state.gov.

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[Financial Friday] Important Changes to Social Security Claiming Strategies

The Bipartisan Budget Act of 2015 included a section titled “Closure of Unintended Loopholes” that ends two Social Security claiming strategies that have become increasingly popular over the last several years. These two strategies, known as “file and suspend” and “restricted application” for a spousal benefit, have often been used to optimize Social Security income for married couples.

Social Security check

If you have not yet filed for Social Security, it’s important to understand how these new rules could affect your retirement strategy. Depending on your age, you may still be able to take advantage of the expiring claiming options. The changes should not affect current Social Security beneficiaries and do not apply to survivor benefits.

File and suspend

Under the previous rules, an individual who had reached full retirement age could file for retired worker benefits–typically to enable a spouse to file for spousal benefits–and then suspend his or her benefit. By doing so, the individual would earn delayed retirement credits (up to 8% annually) and claim a higher worker benefit at a later date, up to age 70. Meanwhile, his or her spouse could be receiving spousal benefits. For some married couples, especially those with dual incomes, this strategy increased their total combined lifetime benefits.

Under the new rules, which are effective as of April 30, 2016, a worker who reaches full retirement age can still file and suspend, but no one can collect benefits on the worker’s earnings record during the suspension period. This strategy effectively ends the file-and-suspend strategy for couples and families.

The new rules also mean that a worker cannot later request a retroactive lump-sum payment for the entire period during which benefits were

suspended. (This previously available claiming option was helpful to someone who faced a change of circumstances, such as a serious illness.)

Tip: If you are age 66 or older before the new rules take effect, you may still be able to take advantage of the combined file-and-suspend and spousal/dependent filing strategy.

Restricted application

Under the previous rules, a married person who had reached full retirement age could file a “restricted application” for spousal benefits after the other spouse had filed for Social Security worker benefits. This allowed the individual to collect spousal benefits while earning delayed retirement credits on his or her own work record. In combination with the file-and-suspend option, this enabled both spouses to earn delayed retirement credits while one spouse received a spousal benefit, a type of “double dipping” that was not intended by the original legislation.

Under the new rules, an individual eligible for both a spousal benefit and a worker benefit will be “deemed” to be filing for whichever benefit is higher and will not be able to change from one to the other later.

Tip: If you reached age 62 before the end of December 2015, you are grandfathered under the old rules. If your spouse has filed for Social Security worker benefits, you can still file a restricted application for spouse-only benefits at full retirement age and claim your own worker benefit at a later date.

Basic Social Security claiming options remain unchanged. You can file for a permanently reduced benefit starting at age 62, receive your full benefit at full retirement age, or postpone filing for benefits and earn delayed retirement credits, up to age 70.

Although some claiming options are going away, plenty of planning opportunities remain, and you may benefit from taking the time to make an informed decision about when to file for Social Security.