Uncommon Cents

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.

It’s likely that your 401(k) will be your largest investment account. Knowing that, it’s prudent to determine what asset allocation you want in that account, as well as what mutual funds you’d like to be included.

We’ve discussed asset allocation before; basically it’s how much money you would like in certain kinds of investments. I’ve pretty much standardized on a mix of 50% domestic stocks, 25% high quality bonds, and 25% international stocks. This makes the math easy and builds you a fantastic portfolio with just three funds. If I was very close to retirement (or in it) I’d likely be closer to 35% domestic stocks, 15% international stocks, and 50% high quality bonds, but your mileage may vary. This is, in fact, the way my portfolio is currently constructed.

In an ideal world, I’d construct this portfolio with these three funds:

Vanguard Total Stock Market Index (VTSMX)
Vanguard GNMA Fund
Vanguard Bond Index

That said, there are many, many fine mutual funds out there, and your 401(k) plan may not offer the ones you want most. In my case, they only offer one of the three funds, so I have substituted a couple of other funds [given that my plan, which is actually a 403(b) because I work for a non-profit, has a brokerage option which I am still investigating, I may in fact someday get exactly the funds I want]. In any case, my first choice for the portfolio in principal would be low cost, passively managed, no load index funds–while Vanguard is the king of these, there are many alternatives such as T. Rowe Price, Fidelity, and TIAA-CREF.

While I am not a fan of actively managed funds, if you for some reason do want to include them in your investments, the best place to keep them is in a tax sheltered account of some kind like a 401(k). The reason for this is that these funds tend to generate taxable capital gains every year which are much larger than the negligible capital gains generated by passively managed funds, so if you for some reason want to have a few actively managed funds in some segment of your total holdings, this may be the place to do it (this concept is known as asset location, which is similar to but definitely not the same as asset allocation). I would, however, totally recommend staying away from load funds–there’s no reason to pay a load, ever.

One other issue to consider is your employer match. If your employer matches you using the stock of the company you work for, it is quite likely you will quickly become overweighted in your company stock. This becomes one of the basic issues of diversification; all is well while the company is doing well, yet if the company falls on hard times (Bear Sterns, anyone?) so will your portfolio. Strive to keep your own company stock under 5% of your total if at all possible.

Thinking about what you will have in your 401(k) is almost as important as starting it in the first place. Consider asset allocation, asset location, and diversification while working on this aspect of your portfolio and you will do just fine–with only three funds, too!

A 401(k) is an employer sponsored retirement savings plan that is common in for profit companies. Non profits have a largely equivalent plan known as a 403(b) and public sector employees often have the also largely equivalent 457.

Dollars contributed to the 401(k) plan are pre-tax [although there has recently emerged a "Roth 401(k) which allows the contribution of post-tax dollars allowing withdrawals past age 59.5 tax free], meaning the employee receives an immediate tax break which could be substantial. For myself, this tax break amounts to approximately 30%; if I was to invest the same amount of dollars post tax, I would require about 30% more earned income, meaning that the $15,500 I put away last year would take more than $20,000 in earned income. Contributions also grow tax deferred–no need to pay taxes on interest, dividends, or capital gains every year!

Contributions by an employee to a 401(k) plan are often matched by the employer up to a certain amount; for instance, for every dollar an employee contributes to the plan, the employer may also contribute a dollar up to a certain limit, typically 5%. That’s free money! Don’t leave that one unaccepted; it’s like your boss telling you they’ll give you a raise and your turning it down.

If you leave your employer, 401(k) plans can be rolled over into a traditional IRA without any tax penalty, which may give you a lot of flexibility in terms of what you can invest in. You can also roll an older 401(k) into a new one at your new employer, but this is more complicated.

401(k) plans tend to offer a choice of several different mutual funds; hopefully your plan allows you choices of passively managed, low cost index funds including the total stock market index, the total bond market index, international funds, and many, many others. I am fortunate in that our plan is managed by Vanguard, the king of low cost index funds, and we have a large selection of funds through them as well as other vendors.

Finally, when you are eligible to withdraw funds from your 401(k) without penalty at age 59.5, the money is taxed as ordinary income; if you are in a lower tax bracket than when you were working, you’ve made out like a bandit on your taxes. There are some circumstances under which you may be eligible to withdraw money from your 401(k) without penalty (but still with tax implications), such as a first time home purchase or for high medical expenses–check with your plan and your tax professional for details.

One controversial feature of a 401(k) is the ability to take a loan from them, for any reason. Avoiding this if at all possible tends to be the best idea–you lose your tax advantage when you do this! First, you will have to pay the loan back with post tax dollars (so much for the tax break contribution!), and second, you still have to pay taxes at the time of withdrawal, so you end up getting taxed twice on that money. It’s also less money to earn returns over time in your account.

All in all, however, I think the 401(k) is a great financial tool to save for retirement and if you’re not taking advantage of it, you’re leaving money on the table–and that’s not something many people can afford to do.

I was surprised to learn this past week that one of my blogging buddies who I consider a brilliant guy was not participating in his company’s 401(k) plan. I coincidentally got a request by a reader to cover some 401(k) basics, which has lead to this article.

In traditional Uncommon Cents fashion, I’ll discuss what a 401(k) actually is in a coming Working Backwards segment. In the meantime, just know that a 401(k) [or its equivalents, including the non-profit version 403(b)] is if not the best, at least one of the best ways to save for retirement. The 401(k) allows an employee to contribute a percentage of their gross income, typically up to a yearly maximum of (currently) $15,500 pre-tax (with “catch up” provisions for those who are a bit older allowing even more to be contributed) and let it grow tax deferred until you reach 59.5, at which time you can make withdrawals at your marginal tax rate (which is likely to be lower at retirement than when you’re working)–this means that if you’re someone like me, in the 25% Federal tax bracket with about a 5% state tax, I’m getting a 30% tax break on that money right off the top. In addition, employers often offer a “matching” contribution, meaning that, for example, for the first 5% of your money that you contribute to your 401(k), the company will contribute a matching 5%–which is, essentially, free money. Your employer is trying to give you free money!

For whatever reason, people don’t always use their 401(k) plans to their maximum, or, sadly, at all. That’s wild; can you imagine your boss telling you that they want to give you a raise and your turning them away? This is essentially the same thing!

If you are 401(k) eligible but haven’t started and want to–and it’s hard to imagine not wanting to–here are the steps you need to follow to get going:

1) Contact your human resources department and request to get started. They’ll likely send you some documentation and papers you need to sign.

2) Determine what kind of match your company offers. It may be in stock or in cash (hopefully the latter). Warning: if your company’s match is in stock, be very careful about having a high level of concentration in that particular stock! Diversification is key.

3) Contribute at least the amount needed to make the most of the match. If you can contribute more, that’s fantastic, but at the very least max out the match. If not, you’re leaving money on the table!

4) Determine your asset allocation and which funds to purchase to reach your allocation targets. Remember that costs are critical (as they always are); if you decide to have actively managed funds in your portfolio (and I typically don’t recommend them), this would be the place to have them, as the tax deferral of the 401(k) allows you to sleep easy with capital gains.

5) Pull the trigger. Go ahead with your plan and don’t worry about it!

Seriously, the 401(k) is one of the best investment vehicles available, and for most of the people who are offered it, not using it is essentially turning down free money. That’s really not something I want to do! We’ll look more at the 401(k) in the coming weeks, but if you haven’t gotten started, get started now.

Yes, March is long over, but the analysis is not. As we take yet another look at my retirement portfolio, which continued to struggle as the market as a whole has this year, we see that the ship might be righting itself.

The Vanguard Total Stock Market Index Fund which, as a reminder, is about 50% of my total portfolio, was down a small bit in March, just a hair over 1%. The Vanguard Total Bond Market Index Fund was up a hair, under .3% (yes, three tenths of a percent). Finally, the T. Rowe Price International Discovery Fund was down, close to 2%, for the month of March.

All of these are very small numbers, matching the rather small period of time we’re looking at. If anything, it looks like it’s possible that the bleeding may have stopped and that the downward tumble the market’s been in for a few months may be reversing itself; given the (so far!) strong results we’ve seen in April, I’m hoping that the bad times are behind us–for awhile–and there’s good times in the here and now. And that’s no April Fool’s joke!

One of my physician friends (when you work in a hospital, you tend to have a lot of physician friends) asked me about dividends last year and whether or not she had to pay taxes on them.

“Is this an IRA or 401(k) or other tax sheltered account?” The answer was no.

“Then, of course. It’s income, but if they’re qualified dividends, typically the federal tax is pretty low.”

She said that she didn’t understand how this was income as she never saw any money.

“Well, if you’re not actually seeing checks, either cash is being deposited in your investment account or better yet, it’s being reinvested and buying more shares of whatever stocks or funds are generating the dividends.”

I mostly forgot about this discussion until this year, when the same friend asked about capital gains as well as dividends and why she had to pay taxes on money that she didn’t earn, and in fact that her portfolio was really no bigger than it was last year.

“What’s in your portfolio?” I asked.

“I don’t really know.”

She and her husband (who is also a physician) have turned over control of this portfolio to a financial planner. They have absolutely no idea what is in the portfolio aside from generically (”mutual funds and stocks”), but she does know that she is being taxed for dividend income and capital gains and not seeing much of an increase in the value of her portfolio.

It looks like it’s time for a change, I think.

“Tell you what, I don’t want to know the details of your actual numbers, but at least get the names of the funds and stocks in your portfolio and I’ll take a look at them.”

If she follows through, I’ll share what I find and look at what we can do to give this portfolio a total makeover. Let’s see how we can combine her goals with our investing principles of low cost, indexing, passive management, high quality, and diversification to make her portfolio a winner!

A tax is a fee imposed by the government on products, forms of income, or activities. In the United States we are very familiar with various taxes on products (such as a gasoline tax or tobacco tax), income (such as the federal income tax or state income tax–which is not in all states, Medicare tax, and Social Security tax), or activities (such as retail sales tax). Taxes fund public goods and services (think sewer services, trash pickup, and street lighting). In some cases taxes may also be used to try to discourage certain types of activity (such as cigarette smoking) and/or attempt to recoup public dollars spent dealing with that activity (such as Medicaid funds spent to deal with lung cancer).

One of the best ways to help your investments is to take advantage of tax advantages. IRAs and 401(k)s offer ways to build your portfolio tax free and/or reduce or eliminate taxes in the end. There are certain government bonds and money market accounts that are tax free as well. Taxes are also one of the reasons why passively managed portfolios and mutual funds tend to outperform actively managed ones–when stocks or bonds within the portfolio or fund are sold, they typically trigger a capital gain, which is subject to tax. I suspect we will see some of this when I assist my friend with her portfolio makeover in coming posts!

I am personally not opposed to the idea of paying taxes because I like having paved roads and trash pickup; I do, however, want my tax dollars to be used wisely–which is an entirely different issue that we won’t get into on this blog. What do you think about your taxes?

With tax time in a few days for the feds (and for those of us in the Aloha State, a few more days for Hawai’i), I’m wondering how many of you actually have your taxes wrapped up.

As for me, I went over both the state and federal returns with a fine toothed comb last week, and have photocopied the finals. The checks are written, the envelopes are sealed, and they’re both just waiting until it’s the day to send them (I often say that there are two things it’s against my religion to do: pay a bill early and turn down free food).

In contrast, I had a boss who, for every year I worked for her, took the 14th and 15th of April off to finish her taxes. I was always astonished; how can you plan your budget without knowing how much you’re going to owe, and the earlier you know, the better! Still, if there is anything I’ve learned from being a social worker, it’s that not everyone thinks or acts like you do, no matter how rational and reasonable it is.

How about you? Have you finished your taxes yet?

I sent a $4,000 check to Firstrade last week, my 2007 Roth IRA contribution. It takes awhile for the transaction to be credited and the 15th is the deadline for a contribution to count for last year, so I thought I had plenty of time.

I was wrong.

On Wednesday when I returned home from teaching my parenting class, I discovered a FedEx overnight letter delivered to me. From Firstrade.

I had neglected to sign the check.

Given the distance between the Firstrade office (New York) and my mailbox (Hawai’i) and the deadline for the 2007 contribution, I considered going to the post office to have the check sent overnight–a totally unnecessary fee caused by my incompetence.

Until I realized that I could have done the transfer online all along. I logged onto Firstrade.com and got the transfer going with a few days to spare.

So, one of the few times I relied on old technology to deal with a financial matter, new technology had to come to the rescue. Thank you, Firstrade, for having the option of doing a money transfer online; it saved my bacon–and my 2007 Roth contribution!