For many, the family home may end up being one of their largest assets. It’s a great way to be invested in real estate as well. But beyond home ownership is the opportunity to invest in rental property.
Minimizing Real Estate Risk
Good friends of my parents began investing in real estate in the 1950s. They started slow and purchased a duplex as their first home. The rent they received covered the cost of their total payment, so they were able to save money to eventually purchase a single family home. Over the years, they were successful at obtaining and managing many additional properties that have performed very well for them.
Many real estate investors rely heavily on debt to finance the purchase of their properties. As a result, especially during the early years of ownership, they are at high risk of default if the local market experiences major price and rent declines. If you have an interest in investing in real estate, start small and minimize the level of debt you’re taking on. Make sure the debt is secured only by the related property and not your personal residence or other investments.
In addition, it’s wise to have an adequate cash cushion so you know that you can weather any economic downturn. Also remember that real estate is historically a cyclical investment — some people have lost everything because they were overly aggressive with the use of debt to acquire properties they really couldn’t afford.
One final note on the subject: It’s important that you factor in the total cost of ownership, including the amount of time that this type of investment can take from your family life. Real estate can be a great way to make money, but go into it with your eyes wide open.
Regularly Monitor Your Investment Portfolio
Before you select funds to invest in, you’ll want to understand their past performance. While it’s no guarantee of how the fund will perform in the future, it’s an important step in the selection process. Then, once you’ve begun investing, it becomes crucial to track how your portfolio is performing. The Website www.Morningstar.com offers an array of free tools that allow you to accomplish both of these objectives by monitoring the most important factors related to your investments. I recommend keeping track of at least the following:
• the rate of return over four periods of time: year to date, three-year, five-year, and ten-year;
• the name of the fund manager and his tenure with the fund — you’re looking for stability at the management position;
• expense ratio: While it’s certainly good to have a low expense ratio, greater emphasis should be on net return;
• stock index results for indexes comparable to your fund. Examples include the S&P index for large cap (large company) funds, the Russell 2000 index for small cap (small company) funds, and the MSCI EAFE index for international funds. By comparing your fund’s results to these benchmarks, you can see if it’s performing at a reasonable level.
Fortunately, Morningstar automates this process, so all you need to do is know the “ticker symbol” of your investments. If you’re the average investor who is steadily saving and investing in mutual funds, but isn’t truly active, quarterly reviews of your funds’ performance should be adequate. You’re in it for the long haul, and are primarily interested in knowing that your funds are performing at least on par with the primary indexes they’re compared to. Again, the Morningstar site can help make this very easy as it allows you to track data on up to 50 stocks/funds in one portfolio.
If you find that you own certain funds that are consistently underperforming, sell them and reinvest in better performing ones. (Before you do so, check with your tax advisor regarding the tax consequences of selling your investments.)
Look for Tax-Favored Investments
The federal government provides special tax incentives to help fund higher education costs. These incentives come in the form of tax deductions for certain education expenses and tax-favored savings plans, which allow your investments to grow tax free. As you would expect with tax-related issues, each of these benefits comes with its own complex set of rules, so you’ll want to consult a professional advisor about how you can take advantage of them. I won’t go into a detailed explanation of these tools, but here is a brief summary. (Find a more complete explanation at http://www.irs.gov/pub/irs-pdf/p970.pdf.)
There are two types of tax credits related to higher education. The first is the HOPE scholarship credit, which allows taxpayers to take a credit of up to $1,500 per student per year for qualified tuition and fees paid for the first two years of qualified higher education expenses. The second deduction is the Lifetime Learning Credit, which allows a credit of up to 20 percent of qualified tuition and fees paid on behalf of the taxpayer, his spouse, or dependents. You have the option of using one or the other of these credits, but not both for the same expenses.
There are also two types of tax-favored savings plans available for higher education (post-secondary). The first is the Coverdell Education Savings Account, which allows you to save up to $2,000 per year per beneficiary. While there is no deduction for the initial contribution, the earnings grow tax free if used for qualified expenses.
Finally, qualified state tuition programs, more commonly known as 529 plans, offer a way to set aside a higher level of savings than the $2,000 per year allowed by the Education Savings Accounts. You’ll probably want to start by funding the Education Savings Accounts since you’ll have more flexibility with how the investments are managed.
The government also offers incentives for individuals to save for retirement, whether employed by a company that offers a retirement plan or not. If you work for a company that offers a 401K or 403B savings plan, by all means, take advantage of it, especially if they offer to match a portion of your savings. That’s like getting a 100% return! Even if your employer offers no plan, the government allows individuals to save for retirement via standard Individual Retirement Accounts (IRAs) and Roth IRAs, which allow you to save several thousand dollars per year and receive tax-favored treatment. The primary difference between the two IRAs is that the standard IRA allows a deduction from current income and earnings to grow tax deferred. Taxes are paid on the contributions and earnings when the money is withdrawn at retirement. The Roth, on the other hand, doesn’t allow for a current deduction, but the earnings grow completely tax free.
Many financial planners lean toward the Roth IRA as the better option for most people, although it truly depends on a number of factors, including the following:
• your marginal tax rates at the time of contribution and the expected rate at the time of distribution;
• how long the account can grow before the money will be distributed. (The longer the time period, the better the Roth account is.)
In addition to the typical 401(k) plans sponsored by many employers, the government also offers an array of options for small business owners when it comes to retirement plans. If you are a small business owner, check with your accountant to better understand your options.
Phil Lenahan is President of Veritas Financial Ministries. If you have questions you would like Phil to address, please email them to [email protected].
