How can you get the best terms on a new loan?

Where can you get the best terms on a new loan? Often, it’s the family bank, meaning Mom and Dad, your successful big brother or your great aunt Doris. You can usually get away with a low interest rate, or perhaps no interest at all. Trouble is, loans among family members touch on two areas about which the IRS is especially sensitive: gifts and interest income. To avoid a tax nightmare later, be sure to follow these rules.

Document the Loan

The first step to avoiding trouble is to clearly document that the money is actually a loan, with or without interest. The documentation should also include payment terms and the collateral for the loan, if any. This will avoid conflict about what exactly you agreed to pay. And, if you don’t do this, your lender could find himself paying income taxes on interest he never received and gift taxes on money he never gave away. And, in the long term, the loan could cut into the lender’s gift and estate tax exemptions.

You don’t need a lawyer to draw up the documentation. In fact, you can easily satisfy the IRS with a do-it-yourself document. Try the document-creation software Quicken Family Lawyer, which sells for about $29. It’s simple and well worth the price, even if you use it only once.

Secure the Note

If you are borrowing money to buy a new home, you should take the extra step of legally securing the note with your residence. (This does require a lawyer.) That way you can take advantage of one of the most popular tax deductions: interest on a home mortgage. Anyone thinking of not reporting a family loan when applying for a mortgage should consider this point: You could face criminal charges if you falsify a mortgage application to hide the origin of your downpayment money.

Establish Solvency

In order to clarify that the loan is not a gift, the lender should write a memo establishing that you, the borrower, were solvent at the time of the loan. This proves the lender has a reasonable expectation of repayment and is not actually making a gift.

Set an Interest Rate

Interest-Free doesn’t mean hassle-free. Many loans among family members are interest-free. But be careful. If you don’t set an interest rate, the IRS, in its family-friendly way, will do it for you. And since that interest would be considered income for the lender, the IRS will happily tax the interest payments that were never paid. You have now entered the hideously complex world of “imputed interest.” Essentially, the IRS, eager to raise revenue, has decided that for a loan to be a loan, interest must be paid, and if interest is being paid, someone is making taxable income.

The IRS’s enthusiasm does not stop there. Not only does the agency place a tax on imaginary income, but it assumes that the borrower could not afford to make the interest payments (he had to borrow money, didn’t he?) and then acts as though the lender gave him the money to pay the interest. Enter the gift tax. So the money the lender never received but pays taxes on anyway could also count against the $11,000 annual tax-free gift limit, and if it exceeds that, then the gift and estate tax exemptions. This is not all as bad as it sounds, and in most cases these penalties can be avoided with good planning.

Avoid Imputed Interest

First, imputed interest and all the crazy imputed income and gift tax problems generally do not apply when a loan totals no more than $10,000. However, watch out for this: The $10,000 limit applies to all outstanding loans between you and the lender, including those charging interest. But if the $10,000 rule does not help, you can turn to the $100,000 rule.

The $100,000 rule applies when the aggregate balance of all outstanding loans (interest-free or otherwise) between you and the lender is $100,000 or less. For income tax purposes, the amount of imputed interest is zero if the borrower’s net investment income for the year is no more than $1,000. (Net investment income, which includes interest, dividends and certain royalties, but not necessarily capital gains, is the figure used to determine how much margin-account interest can be deducted on Schedule A.) Since most people who borrow money from family members are probably not sitting on large investment portfolios, imputed interest can generally be avoided.

Under the $100,000 rule, when the borrower’s net investment income exceeds $1,000, imputed interest is limited to the actual amount of investment income. Here is an example: If a mother lends her daughter $100,000 interest-free but the IRS sets an interest rate of 5 percent, then the mother would have to declare imputed interest payments of $5,000. But if the daughter’s investment income is less than $1,000, the imputed interest would be zero. If the daughter earned $1,500 in interest income, the mother would have to pay taxes on only $1,500 rather than $5,000.

To qualify for the $100,000 rule, the lender must collect an annual statement that discloses the borrower’s net investment income.

Demand a Demand Loan

So far, so good. Unfortunately, the $100,000 rule gets really tricky when it comes to the gift tax. The net investment income rule does not apply here. To minimize gift tax problems, designate the interest-free advance as a “demand loan.” This means the lender can demand full repayment at anytime. While this may seem unduly threatening, it could save your lender money because of the way the IRS calculates the imputed gift. You can still informally agree on a repayment schedule. With a demand loan, the amount of the imputed gift is calculated on a yearly basis and will total less than $11,000 a year, so the imputed gift for each year the loan is outstanding will fall harmlessly below the $11,000 annual limit for tax-free gifts.

But if you do not designate the loan a demand loan, the IRS will add up all the interest you would pay for the life of the loan and count it as a gift in the year the loan is made. The result could be a relatively large imputed gift that exceeds the $11,000 annual tax-free limit, and also cuts into the lender’s gift and estate tax exemptions.

These rules can get tricky, though, so it is probably a good idea to consult a tax pro before drawing up this kind of loan. The IRS will let you avoid all these hassles if you simply charge interest on the loan. The IRS uses what it calls applicable federal rates, which change monthly, to determine if the interest rate is proper. If the lender charges at least the applicable federal rates, he simply reports the interest payments as taxable income. You can find those rates on the IRS web site.

What if You Default

There are few things that hurt family relations more than bad debts. But the IRS is not ashamed to get involved. If your lender tries to write off your bad debt on his tax return, the IRS will then seek to collect the lost tax from you. Think it won’t happen? Well, a 1995 U.S. Tax Court case tells the story of a father who made thousands of dollars in undocumented loans to his 23-year-old daughter, who wanted to open a roller-skating rink.

The skating rink eventually failed, and the father claimed a $35,000 nonbusiness bad-debt deduction, even though no formal collection efforts were undertaken against his daughter. (She had filed for bankruptcy four months earlier.) The Tax Court concluded that the advances were loans because of “loan” notations the father had made on some of the checks, and because he had previously made undocumented loans to family members and friends and had been repaid.

So the IRS’s collection efforts against the daughter were approved

Best And Worst Health Insurer

Health insurance is one of the trickiest subjects in personal finance. For many, just finding coverage is a challenge. Once you have health insurance, getting the benefits you’ve paid for isn’t always as easy as it should be. Making sure you keep your coverage if you change jobs or move to a different state can be essential to managing your health care costs successfully.

Although many people don’t have a lot of options in choosing coverage — they’re stuck with what their employer offers — you still want to make sure your health insurance company meets your particular needs. Yet according to a recent survey released by J.D. Power, a number of insurers, especially those that trade publicly on stock exchanges, don’t do as well as others in providing good customer service.

The best insurers
The survey looked at available health-insurance coverage in four regions of the country. For the most part, private insurers topped the lists in each region. Blue Cross and Blue Shield groups in a number of states performed very well, as did other closely held entities such as Harvard Pilgrim in the Northeast, Wellmark in the Midwest, and Kaiser in the West.
What made these insurers the best was a combination of things that are important to health-care consumers. Offering plans with sufficient coverage and choices of doctors was of utmost importance, as were the procedures in place to facilitate communication and obtain quick approvals for claims. Readable statements, prompt customer service, and efficient claims processing also were important facets of a good experience.

Public insurers trailing
On the other hand, insurers like Aetna, Cigna, and UnitedHealth Group got below-average ratings from most consumers. J.D. Power representatives suggested that one reason might be poor communication and informational resources.

It’s important to remember that these companies are at a competitive disadvantage to some of their counterparts. Some private health plan providers are organized as non-profit entities, which benefit from favorable tax provisions. Even among other for-profit insurers, publicly traded companies must pay more attention to shareholder value and short-term performance. Given the advantages that private insurers have, it will be interesting to see whether the recent rise of private equity activity begins to focus more attention on these companies or at least their health insurance divisions.

What Do You Must Know About Tax Terms

Taxes

One of the hardest things about taxes is learning the language. You’ve got all the forms and instructions, but it seems they’re harder to decipher than your VCR user manual! Here are 10 common tax terms to help you start talking taxes.

AGI — Adjusted gross income, AGI, is all the income you receive over the course of the year such as wages, interest, dividends and capital gains minus things such as contributions to a qualified IRA, some business expenses, moving costs and alimony payments. The adjusted gross income is the first step in calculating your final federal income tax bill.

Credits — Tax credits are much like credits you get from a store. After you figure your tax bill, you can use the credit to reduce the amount of the check you must write to Uncle Sam. Tax credits are more valuable than deductions because they directly cut the amount of tax you owe, rather than reducing the amount of taxed income. A $200 credit, for example, will turn a $1,000 tax bill into only $800. And a few even could give you a refund you weren’t expecting.

Deductions — Deductions are expenses that the Internal Revenue Service allows you to subtract from your AGI to arrive at your taxable income. In most cases, the lower your income, the lower your tax bill. If, for example, a single filer has income of $35,000 and $5,000 in deductions, then he would pay taxes only on $30,000. The IRS offers all filers a standard deduction amount (more on this later). Some other deductions, such as student loan interest, moving expenses, deductible IRA contributions and alimony payments, also are listed directly on the 1040A or long Form 1040. But the term is most commonly associated with the itemized deductions (more on this later, too) that are claimed by taxpayers who file Schedule A.

Standard deduction — This is a fixed dollar amount that a taxpayer can subtract from his or her income. The standard deduction is available to all filers and is determined by the taxpayer’s filing status. The amounts change each year because of inflation adjustments; you can find the current standard deduction levels listed on each of the three individual tax forms. This deduction method is used by most taxpayers and eliminates the need for them to itemize actual deductions such as medical expenses, charitable contributions or state and local taxes.

Taxes

Itemized deductions — These are expenses that can be deducted from your AGI to help you reach a smaller income amount upon which you must calculate your tax bill. Itemized deductions include medical expenses, other taxes (state, local, property and sales tax), mortgage interest, charitable contributions, casualty and theft losses, unreimbursed employee expenses and miscellaneous deductions such as gambling losses. Some itemized deductions must meet IRS limits before they can be claimed. When you itemize, you must file Form 1040 and detail your deductions on Schedule A.

Exemption — This is an amount that the IRS lets you subtract from your income to reflect all the people who count on your income. Exemptions can be claimed for yourself, your spouse and your dependents. The IRS allows a set amount for each exemption and, as with deductions, this total is subtracted from your adjusted gross incometo come up with your final, lower earnings amount upon which you must figure your tax bill. Your personal exemption amount is in addition to any deductions, either standard or itemized, that you claim.

Progressive taxation — This is the system in which higher tax rates are applied as income levels increase. The U.S. tax system uses progressive taxation with tax brackets starting at 10 percent and rising to 35 percent for the wealthiest taxpayers.

Taxable income — Your overall, or gross, income reduced by all allowable adjustments, deductions and exemptions. It is the final amount of income you use to figure just how much tax you owe.

Voluntary compliance — This describes the philosophy upon which our tax system is based: that U.S. taxpayers voluntarily comply with the tax laws and report their income and other tax items honestly.

Withholding — Also known as pay-as-you-earn taxation, this method enables taxes to be taken out of your wages or other income as you earn it and before you receive your paycheck. These withheld taxes are deposited in an IRS account and you are credited for the amount when you file your return. In some cases, taxes also may be withheld from other income such as dividends and interest

Guide to College Savings

college savings

Is your child hurtling toward college but you haven’t given more than a few anxious thoughts to how you’re going to pay for it?

Join the club.

For every parent who has been dutifully socking it away since the baby was in onesies, I seem to run into 10 more who feel like they’re playing an unwinnable game of catch-up. School is drawing closer, tuition projections seem to grow more outlandish by the year, and the stock market is moving sideways–and that’s on a good day.

With mortgages to pay and sneakers to buy, many families have difficulty finding the extra money to save for college. But judging from feedback from my friends and acquaintances, a time crunch has been an equally important deterrent against creating a college-savings program. The alphabet and number soup of college-savings vehicles (529s, Coverdell Education Savings Accounts, UTMA/UGMAs) seems hopelessly complex–surely more than anyone could tackle on a Saturday morning or a Wednesday night before going to bed.

True, there are many different avenues to college savings, and your own savings rate and tax bracket play a significant role in determining which route is best for your family. (For a thorough overview of the different options, check out my colleague Sue Stevens’ column.) But there are a handful of college-savings solutions that make sense for a broad swath of parents, even those who think they’re getting a late start.

Read on for a look at our best tips for getting going today.

1. Resist the urge to stand still.
I’m a lifelong procrastinator; heck, as a high-school student I was once so behind on a term paper that I had to dictate it to my sister while she typed. (As you might expect, that was the first and last time she let me get away with that.) So trust me when I say I know the sick logic that we procrastinators employ. If I haven’t done anything yet, you think, why start this minute?

But look at it this way. Thanks to compounding, a dollar saved today is much more valuable than a dollar saved 10 years from now. And even if you manage to save only a small amount between now and the time your child is ready for college, he or she is going to have to borrow that much less for tuition. The key is taking that first step.

2. Don’t play catch-up by chasing overly risky investments.
Instead of sitting still, some parents who fear they won’t be able to afford skyrocketing college costs might be tempted to do the opposite: swing for the fences in the hope of hitting it big.

But as anyone who bought an Internet stock in the late 1990s will tell you, investments that have posted big past returns often carry extreme risks. Thus, the best way to save for college isn’t to concentrate in a single risky stock or sector, but instead to build a well-diversified portfolio with a stock/bond mix that suits your child’s time horizon. Bear in mind that if your child’s college years are drawing near, you’ll want to be taking fewer risks with any money you have earmarked for college, not more. While savings for children under 10 may safely be invested in stock funds, the majority of your child’s college savings should be in cash and bonds by the time he or she hits high school.

True, bonds and cash don’t have the same return potential as stocks do. But if you’re afraid that your college savings will come up short when it comes time to matriculate, your best option is to plan to save more rather than venturing into inappropriately risky investments.

guide to cllege savings

3. Consider a 529 savings plan.
529 plans have been getting a lot of negative press lately, with critics citing high expenses, hidden fees, and substandard investment choices. But given that 529s permit extremely generous contributions and offer tax benefits to boot, these programs can be ideal for late-start college savers who need to sock away as much as possible in a short period of time. The key is to choose carefully.

Although Section 529 prepaid tuition programs essentially allow you to lock in today’s tuition rates, such plans can be somewhat inflexible. If your child wants to go to school in another state, for example, some of the tuition costs many not be covered.

In contrast to the prepaid programs, money invested in Section 529 savings plans can be used at any college in the U.S. There are no earnings restrictions on who can contribute to a 529 plan, and you can contribute up to $55,000 per year per child without triggering the gift tax. Aggressive 529 savers could, in theory, sock away enough to cover a child’s complete education. Your contributions to a 529 plan can grow tax-free, you can take tax-free withdrawals to pay for college expenses, and you may also enjoy a state-tax break. (Beware, however: Some states, including Illinois, essentially cancel out the 529’s state-tax benefits if you opt for an out-of-state plan. And while many experts expect that 529’s tax benefits will remain intact for years to come, the tax-code provision that allows federal tax-free withdrawals from 529s is set to expire in 2010 unless Congress renews it.) Finally, the 529 assets are held in the parents’ name, meaning these assets receive more favorable treatment than the child’s assets in financial-aid calculations.

Not all 529s are created equally, however. Although you may enjoy a state-tax break by sticking with your own state’s plan, high costs and poor investment returns could outweigh that benefit. Thus, it pays to shop carefully, and to look beyond your home state’s plan if it’s not up to snuff. Check out Morningstar’s 529 Plan Information Table for a snapshot of the various states’ plans. To date, our analysts have identified Utah’s plan as the gold standard of 529 plans: Not only is it the least costly 529 around, but it also carries a stellar lineup of Vanguard funds. Maryland, Virginia, and Nebraska all have standout 529 programs as well.

4. Simplify with all-in-one funds.
For college savings, I’m a fan of funds that “mature,” or grow more conservative, as the child nears college age. (The closer your child is to needing to tap into those assets, the thinking goes, the less fluctuation you want to see in your principal value.) Many 529 plans, including the topnotch Utah program, feature such one-stop, “age-based” options, and they make perfect sense for parents who would prefer to select a plan and tune out.

If the costs and complexities of 529 plans lead you to opt to save for college in your taxable account or via a Coverdell Education Savings Account (the old Education IRA), you can still find plain-vanilla mutual funds that grow more conservative as college draws closer. Most such funds are designed for people nearing retirement age, but I think they’re equally useful for college savings. Vanguard’s Target Retirement funds, Fidelity’s Freedom funds, and T. Rowe Price’s Retirement series funds are all solid, low-cost, low-maintenance options. All of these funds carry specific years in their names (e.g., Fidelity Freedom 2020 FFFDX); simply choose the fund with the year that corresponds with your child’s college start date.

5. Cheap out.
If your investment horizon is relatively short, it’s all the more important to pay attention to how much you’re shelling out in fund fees. That’s because cash and bonds–which should form the bulk of your child’s portfolio as college draws near–have low returns to begin with. If you layer on excessive expenses, your take-home return will be that much lower. For your college-savings plan, focus on stock funds that charge less (preferably much less) than 1% per year in annual operating expenses; look for bond funds with expense ratios of 0.75% or lower.

For similar reasons, late-start college savers will want to be careful about how much they’re shelling out in brokerage charges and other administrative fees. Morningstar’s 529 Plan Information Table includes details on 529 fees and other administrative expenses associated with each state’s plan.

6. Accentuate the positive.
Even if you haven’t established a dedicated college-savings fund, you may be able to tap valuable assets right under your nose. After a decades-long runup in real estate prices, for example, many homeowners are sitting on fat home-equity balances that you can draw upon to pay for education expenses; you’re also likely to enjoy a tax break on the interest from the home-equity loan.

Similarly, parents might also consider tapping their own IRAs to pay for college. Depending on the type of IRA, you’ll pay taxes on part or all of the withdrawal, but you won’t pay the usual 10% early withdrawal penalty if you use the money to pay for qualified education expenses. If you engage in such a maneuver, however, bear in mind the costs to your own retirement savings plan. Loans and financial aid may be available to your college-bound child, but you’ll have fewer options available if your own retirement-savings plan falls short.

How To Start Your Financial Life With Just a Few Bucks

Personal Finance

Maybe you’re nervous about the financial markets and looking to start small. Maybe you’re aiming to help your children or grandchildren make their first investment. Maybe you’re just out of college, with precious little cash to spare.

True, many brokerage firms and mutual funds now demand $2,000 or $3,000 to open an account. But you can get started with far less.

Getting your share

Even if you don’t have much to invest, you still want to be diversified, spreading your money across three key sectors: U.S. stocks, foreign shares and high-quality bonds.

But how can you get that sort of mix for a few hundred dollars? Consider buying exchange-traded index funds, or ETFs, through one of the low-cost Internet stock-purchasing services, such as www.buyandhold.com,www.foliofn.com, www.mystockfund.com and www.sharebuilder.com.

ETFs are mutual funds that trade on the stock market, just like any other share. You might tap into the three core sectors by buying, say, Vanguard Total Stock Market ETF, which tracks the U.S. stock market; iShares MSCIEAFE, which mimics foreign markets; and iShares Lehman Aggregate Bond.

One warning: The four stock-purchasing services don’t all offer these ETFs, so you may have to substitute other funds. The services charge around $3 or $4 to purchase a stock, with lower prices available for more frequent buyers.

“We push ETFs because we think they’re good for people,” says ShareBuilder Chairman Jeffrey Seely. “It gives them diversification in a single security. It’s an accurate way to capture asset classes. And they have very low expenses.”

First Steps

Here’s how to start investing even if you’re strapped for cash:

• Sidestep a mutual fund’s investment minimum by committing to a $50 or $100 monthly automatic investment plan.

• Buy stocks through low-cost services such as www.buyandhold.com, www.foliofn.com, www.mystockfund.com and www.sharebuilder.com.

• Get a list of no-load stocks at www.dripinvestor.com.

• Buy bonds from Uncle Sam through www.treasurydirect.gov.

While services like ShareBuilder are undoubtedly cheap, a $4 trade can take a big bite out of a $100 investment. My advice: By all means start small — but, as soon as you can afford it, crank up your monthly investment.

• Taking a load off. Looking for other low-minimum ways to buy individual stocks? A popular strategy is to use a company’s dividend-reinvestment plan, or DRIP.

You first buy a few shares through a broker and then use those shares to enroll in a company’s plan. Thereafter, not only are your dividends automatically reinvested in additional shares, but also you can send in monthly cash investments of as little as $25 or $50.

Problem is, acquiring the initial shares can be a costly and bothersome business. In response, some 400 U.S. companies will now sell you those first shares directly, with the required initial investment typically running around $250.

Many of these “no-load stocks” charge a slew of small but irritating fees. But there are some plans that remain relatively fee-friendly.

On that score, consider Becton Dickinson, Cash America, Emerson Electric, Entertainment Properties, Exxon Mobil, Kellogg, Lockheed Martin, Paychex, PepsiCo and Piedmont Natural Gas, suggests Charles Carlson, editor of DRIP Investor, a newsletter based in Hammond, Ind.

Mr. Carlson says that, taken together, these companies would give you a broad investment mix. “You’ve got everything from specialty finance to business services to oil to health care,” he notes. “It’s a neat little portfolio.” You can find a list of no-load stocks at Mr. Carlson’s Web site, www.dripinvestor.com.

To balance out your portfolio, you will need bonds. For those, try TreasuryDirect, the government program for selling Treasury and savings bonds directly to the public without commissions. To buy a Treasury bond, the minimum is $1,000, while a savings bond can be bought for as little as $25.

Treasury bonds should generate higher long-term returns than savings bonds. On the other hand, Treasurys kick off taxable interest each year, while savings bonds grow tax-deferred.

• Riding the cycle. Today, many no-load mutual funds insist on a $2,500 or $3,000 initial investment. But if you hunt around, you can find low-cost, well-diversified funds that require far less.

Which funds fit the bill?

Check out the “lifecycle” funds managed by AARP Financial of Tewksbury, Mass., and Baltimore’s T. Rowe Price Group. Lifecycle funds combine a fistful of market sectors in a single portfolio, thus giving you one-stop investment shopping.

T. Rowe Price’s 10 Retirement funds are each geared toward a particular retirement date and charge annual expenses of 0.56% to 0.76%. The funds will waive their usual $2,500 minimum if you commit to socking away at least $50 a month through an automatic investment plan.

Meanwhile, AARP’s three funds levy 0.5% a year and offer investment mixes aimed at conservative, moderate-risk and aggressive investors. It takes just $100 to buy one of the AARP funds — and, no, you don’t have to be an AARP member.

“We want to give people a chance to get started earlier,” explains Nancy Smith, a vice president at AARP Financial. “But we also want to make sure that they continue to save. It doesn’t help anybody to have $100 in an account