Q: My daughters, who are 12 and 17, will receive a significant settlement when they turn 18. I'm concerned that they won't spend the money wisely. How can I best prepare them?
A: Your kids will learn from your example, so begin by showing them how to respect money: Pay your bills on time. Avoid credit card debt. Live within your needs but below your means.
I'd also encourage your daughters to divide their settlement money into specific buckets, the biggest of which should contain enough money to pay for college. A second bucket (labeled "when I'm at least 25") should hold funds that have been earmarked for later-life goals, such as a down payment on a home. That money could also be used to open a Roth IRA. A one-time $5,500 contribution that grows at an annualized 6 percent rate will be worth more than $75,000 by the time your children turn 70. (But remind them to make annual contributions to continue building their financial security.) Your daughters will also want to set aside some funds—no more than 5 percent—for today's desires. If they can spend even a small amount as they see fit, they'll be more likely to stick to their other financial goals. Finally, urge your children to create a bucket for charitable donations, so they can share some of their good fortune.
Q: What advantages do municipal bond funds offer, and is it a good idea to invest in them?
A: Municipal bonds, whose buyers lend money to state and local governments in exchange for interest payments, can be smart investments, depending on your tax bracket. The interest received from a muni is generally tax free, whereas other bond income isn't. True, a five-year municipal bond may yield only about 1.2 percent compared with 1.5 percent for a common investment like a taxable Treasury bill. However, for someone in the 33 percent tax bracket (individuals with at least $186,350 and married couples with at least $226,850 in taxable income), the 1.5 percent Treasury yield will become just 1 percent or so after taxes.
Stick with a diversified portfolio of high-quality bonds to minimize your risk. (Check the fund's website and look for the words high grade or investment grade in the description of the bond.) The overall default rate on muni bonds is less than 1 percent.
Q: I've been classified as a high-capacity earner at my job, and now I can't participate in our 401(k) plan this year. Since my taxable income will go up as a result, I'm afraid I'll face a huge tax bill. I already have both a Roth and a traditional IRA, so where should I direct the $600 per paycheck that I would have put in my retirement fund?
A: If more highly paid employees than lower-wage workers participate in a 401(k) plan, IRS rules can force a company to limit the contributions of staff who are better compensated. I suspect that's what happened to you. Talk to your employer about what policy changes can be made (such as a more generous company match) to attract folks at the lower end of the wage spectrum.
In the meantime, to compensate for your higher taxable income, increase the amount of money withheld from each paycheck. The IRS's free withholding calculator will help you figure out your withholding and minimize your tax bill.
Because you're already maxing out your IRA contributions, I also want you to open a taxable account at a discount brokerage that will allow you to expand your investing options. (Keep your original investments in your existing 401(k) and IRA accounts, since that money won't be taxed while it's growing.) Focus on exchange-traded funds or low-cost index mutual funds. Taxable distributions while you are invested will typically be low or nil. To minimize taxes on dividend income or bond interest, consider growth stock funds or muni bonds.