Uncommon Cents

I received a note from the State Tax Collector in the mail.

“Uh oh.”

The letter stated in a rather straightforward matter that I had miscaclulated and underpaid on my taxes. I immediately got out my photocopy of my 2007 taxes and discovered that yes, indeed, I had made an error. I had taken the amount I owed from a column one too far to the left while looking it up in the tax table, meaning I underpaid my taxes by $83.

Moreover, I owed a bit of interest and a penalty due to the underpayment. A statement would be forthcoming (it came about a week later), so my total owed was approximately $100.

A $17 lesson.

Next time I work on my own taxes–and I have a hard time seeing myself not working on my own taxes, even when they are a bit more complicated–I need to triple check them. That’s the lesson–we learn through mistakes, and the difference between a beginner and a master is 10,000 mistakes. There’s one of them.

The silver lining is that I can charge the amount owed online, which will get me a little back (1.25%) and let me get a little more time to come up with the cash. And hopefully, I’ve learned my lesson.

May seems to have been another positive month in the stock market; my initial belief just looking at (but not actually running) the numbers is that it was not quite as positive of April but it was quite decent in and of itself. Let’s take a closer look:

The Vanguard Total Stock Market Index Fund (VTSMX), which makes up the largest portion of my portfolio, ended May at $34.16 a share after closing April at $33.46, a gain of a bit over 2%. The Vanguard Total Bond Market Index Fund closed May at $10.07 vs. $10.18 at the end of April, down just over a percent but putting out that nice 4.86% yield for the fixed income portion of your portfolio. Finally, the T. Rowe Price International Discovery Fund (PRIDX) finished May at $46.23 versus the $45.28 it finished April at, a nearly identical gain of a bit over 2% to VTSMX.

Hopefully, the market continues to stay on course for a positive end to 2008!

An expense ratio is a way to understand the costs of operating a mutual fund. The operating expenses associated with a fund [usually the fee for the fund manager, bookkeeping fees, accounting fees, auditing fees, taxes, and marketing costs (the infamous 12b-1 fee) are some of these expenses] are combined, then divided by the average dollar value of its assets. These expenses are taken from the fund’s assets and, as you would expect, reduce the return investors experience.

Expense ratios are expressed as a percentage. Typically, passively managed index funds have very low expense ratios; for example, the Vanguard Total Stock Market Index Fund (VTSMX) has an expense ratio of .15%–that’s right, well under a single percentage point.

Expense ratios do not include loads, taxes, or surrender charges, which can add heavily to your costs. Sticking to no load, passively managed index funds with low expense ratios is one of the best ways to maximize your returns by minimizing your costs. Pay attention to the expense ratios of your funds and you will help your bottom line!

The last time we looked at “Basics”, I discussed the cash flow equation, which is:

income - expenses = cash flow

Now, once cash flow is positive (and the more positive, the better) the wealth equation is also simple:

(cash flow + sensible safeguards + wise investments) x time = wealth

Simple, but not necessarily easy. Once your cash flow is positive, it’s time to do some smart things with your money and let time do its thing.

What are these smart things?

Sensible safeguards: these are your emergency fund, term life insurance, long term care insurance, and disability insurance. You don’t want to toss money away, but you also don’t want to under insure. Keep a reasonable amount (many say a minimum of $1,000, others say six months of salary–personally, I split the difference and say three months of take home pay) in a money market account with check writing and an ATM card (Capital One Direct is the one I use). If you have dependents, get term life insurance; you may also want to consider disability and long term care insurance.

Wise investments: what we’ve been discussing on this blog forever. Passively managed, no load, low cost, tax efficient index funds and exchange traded funds. High quality bonds and bond funds. Traditional and Roth IRAs, 401(k)s, and their equivalents. Reasonable asset allocations. Investments made at regular intervals. Diversification, diversification, diversification.

Time: you know what this is, and the more you have the better.

Wealth: the dollars you end up with at the very end.

The one other thing that you need will be discipline. We’ll cover that later, but in the meantime, remember that formula. It’s a simple, get-rich-slowly, tried and true over time formula that will help you reach your goals–it’s helped me build a six figure portfolio in less than half a decade!

Many investors worry about stock market risk when dealing with their money, and admittedly, very few investments are without risk. The risk in the stock market tends to be around the market declining and the volatility the market often displays. These factors many times scare investors out of the market and into “safer” investments, like money market accounts, government issued bonds, and FDIC insured certificates of deposit.

While there certainly is a place in any investment account for bonds and cash, these investments only isolate you from certain types of risk. They have their own risks, as well, the biggest one being that your investments will not keep up with inflation.

With the current low interest rate environment, many investors (or just people with an emergency fund) are seeing evidence of just this. If headline inflation is 4% right now and your “high yield” account pays 3.5% (which is a pretty decent rate these days), your money not keeping pace.

This does not mean to pump every dollar you have into stocks; quite frankly, there are good reasons to have other types of investments (see our articles on asset allocation). What it does mean, however, is to be aware that what are considered “safer” investments are not totally safe; there are still risks involved, and in some ways, the risks are more dangerous than those in the stock market. Consider other ways (like diversification, asset allocation, and tax advantaged means of investing) to reduce your risk and help your dollars do better than the rate of inflation–hopefully far better!

Well, I was expecting direct deposit of my economic stimulus payment this week based on the final two digits of my Social Security number and… it hasn’t shown up yet! In addition, the IRS Web tracker states that my stimulus payment hasn’t been sent yet. Of course, I know why: it wasn’t processed by April 15th. Since I always owe money on April 15 (and if I didn’t, I’d fix it so I did the next year), the tax returns never go out until the last possible two days. However, the IRS has cashed my check, so I was hoping that the payment would be on its way…

But it didn’t help my anxiety level to discover that a bunch of directly deposited stimulus payments were sent to incorrect accounts.

While I’m certainly not dying financially, getting the stimulus would really, really help! Particularly my bid to get to KansasFest for yet another year!

April was a fantastic stock market month. It was such a great month that it almost made up for the awful start to the year in the markets.

Recalling my previous articles in this series, my three portfolio fund consists of the Vanguard Total Stock Market Index Fund (VTSMX), the Vanguard Total Bond Market Index Fund (VBMFX), and the T. Rowe Price International Discovery Fund (PRIDX), with VTSMX making up the majority (approximately 50%) of the portfolio and the remaining being split about equally between VBMFX and PRIDX.

VTSMX started the month at $31.86 a share (as of the close of business March 31, 2008); it ended April at $33.46. That’s a gain of over 5% for the month. VBMFX started the month at $10.22 a share and ended at $10.18, a loss in net asset value of just .3% (yes, three tenths of a percent) but continues to put out monthly dividends, including one of almost four cents that month. Finally, PRIDX began the month at $43.96 and ended it at $45.28, a gain of a hair over 3%.

Hopefully, we’re over the funk that the markets have been in the last few months and we’ll continue to see gains in the months to come–and as much as I’d like to say, “big gains,” I try not to, because booms tend to be followed by busts–which is really what I don’t want. So instead of a boom, in keeping with our April theme, let’s hope for a bloom–like a rose.

When we last left our heroine, we had given Chris some information on the Roth IRA, which appears to be her best choice for the $5,000 she has set aside. We also discussed asset allocation and diversification, and gave her some idea of what percentage of her money she might want in domestic stocks, international stocks, and high quality domestic bonds. We also gave her some ideas about where she might want to open this Roth IRA and discussed issues of risk, which not only include market exposure but also the risk of not keeping up with inflation by being too conservative.

It would be easy to put together this portfolio with three no load index funds, and in many cases that would be the thing to do. However, it’s often difficult for the beginning investor to do that because funds often have minimum investments in the thousands of dollars. Instead, since this Roth IRA will be opened with a discount broker, we’ll use a great alternative: exchange traded funds, also known as ETFs.

ETFs are mutual funds that trade like stocks. ETFs have very low expense ratios and low barriers to entry versus mutual funds that require minimum investments often in the thousands of dollars. We discussed one ETF not long ago when we talked about how to get the performance of the entire S&P 500 in a single share of an ETF; we’ll look at three others to make this portfolio happen. To meet this asset allocation, I would suggest using the Vanguard Total Stock Market ETF (VTI) for domestic stocks, Vanguard Total Bond Market ETF (BND) for domestic bonds, and Vanguard FTSE All-World ETF (VEU) for international stocks.

After figuring out how many shares would make up each allocation, one will realize that it’s about impossible to get the allocation perfect in real terms, leaving a little bit of cash in the account to pay for those $6.95 trading fees. Also remember that these pay dividends and you likely want to reinvest (buy more shares of the fund that paid the dividend). You may also want to consider rebalancing the asset allocation once a year or so.

So, there we have it. In three low cost ETFs with low barriers to entry, we have diversification, asset allocation, and market matching performance with low costs and tremendous tax advantages for Chris to start her retirement account. A simple portfolio that’s poised to pay big dividends over the next thirty or so years while Chris works toward retirement. Good luck!

I had hoped to look at doing a makeover on one of my physician friend’s portfolio, but she still has homework to do. So, in the meantime, another person I know has asked for help doing a portfolio makeover–on to makeover II!

Chris is a 36 year old single administrative assistant with no unsecured debt other than her vehicle. She has set aside $5,000 and wants to start investing. When asked what her goal is, she says, “I guess retirement.” She states she has minimal risk tolerance and was counseled about the risks of not just market trends and net asset valuation but inflation.

For her purposes with this lump sum of money, Chris would seem to be best served by a Roth IRA. She meets the income qualifications and already has a 403(b) plan which she contributes to; she has way more than the five year minimum before she’d withdraw from the Roth, and the amount of money she has saved up is perfect for the Roth IRA. It’s too late to contribute for 2007, but well early in the year for a 2008 contribution.

Where to start a Roth IRA? There are many, many choices; I would recommend a discount broker with online access. Firstrade is what I use and generally recommend, but there are lots of other choices like Scottrade, E*Trade, and TD Ameritrade. Unfortunately, while I highly recommend Vanguard funds, it’s hard for me to recommend them as an IRA choice because they have some fees that seem to be worse for the small individual investor starting out than the discount brokers.

What to buy with the Roth IRA? That’ll be in our next segment! Remember, though, that we’ve discussed asset allocation, costs, taxes, and diversification to the hilt over the last few months; with a Roth IRA, we’ve already addressed taxes and with Firstrade’s low fees we’ve already addressed costs. Next time we’ll look at asset allocation and diversification. We’ll get Chris on the road to retirement in a very simple way!

401(k) loans drive me crazy; you immediately lose the big advantage of the 401(k), the immediate tax break, because when you borrow from your 401(k)–which is filled with pre-tax dollars–you must pay them back with post-tax dollars. Still, many people consider their 401(k) to be a kind of piggy bank for withdrawals for whatever reason.

But the danger of the 401(k) loan is not just in the loss of the tax break–it’s in the possibility of a job loss. For whatever reason, a relative of mine decided to take a loan out on her 401(k) of $7,000. She was about 1/3 through repayment of the loan when the job ended because the company folded. This leaves her in a bind–pay the loan back immediately [which she can't do--and pretty much no one with a 401(k) loan would be able to do--or she already would have done it] or consider it a payout rather than a loan–with the accompanying taxes and 10% penalty! For someone who is in dire straits enough financially with a loan like this and a job loss, this is devastating.

So consider more than just whether or not you can pay back a 401(k) loan if you’re on the fence about taking one; also consider whether or not your job (or your entire company) is in jeopardy. If your job goes away, the loan might too–not in the sense that you don’t owe on it anymore, but in the sense that it becomes income, and usually not in the way you want.