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In just my last post I commended the “expert” on CNNMoney on his recommendation of pairing a Roth IRA with a 401(k). Unfortunately, he’s back to missing the mark with today’s installment.

The question had to do a with a $3,500 windfall from selling a car. The reader asked if he should put it into a Roth IRA or pay down his $8,000 credit card balance first. He starts out all good and logical by suggesting to pay down the debt because the reader will never approach the return necessary to make the investment have a higher return than the interest rate on his credit card.

Then he goes off the reservation and discusses why the reader should actually open the Roth with the majority of the money if not with all of it. It is true that people are irrational and may just spend the credit card debt back up. However, since the person is asking the question it seems like they have realized that they need to save rather then racking up credit card bills. The reader is paying more than the minimum already, so it doesn’t sound they’re completely financially strapped.

It’s hard to tell intent from a reader question, but I’d have a hard time telling someone to do anything other than pay off credit card debt first. Free Money Finance is having a similar discussion over a similar USA Today article that punted and said to do both (gee, you think?). Overall, I would always suggest plowing the money into credit card debt and then using the free cash to go into savings (emergency or retirement).  

Technorati Tags: Roth IRA, credit card, credit card debt

CNN Money’s Ask the Expert column often fails to hit the mark. Today, the expert is spot on. The question came from someone that is maxing out their 401(k) wondering if it’s a “waste” to contribute more to a 401(k) than the employee match (his buddy says so). The columnist says that it’s not a waste, but it might not be the best idea.

He suggests that the writer hedge his bets (he calls it “tax diversification”) and contribute the max $4,000 to a Roth IRA and the rest to his 401(k). That way, when he retires he will have money that will be taxed and money that will not be taxed, essentially hedging his bet on tax rates being higher in the future than they are now.

He also smartly suggests that the Roth IRA contributions be made via direct deposit so that the writer doesn’t have to write the check. Contributions are much less painful that way because you never “had” the money. It also makes it impossible to forget or “forget” to make the contribution.

I love the idea of pairing a 401(k) with a Roth. I haven’t done it yet because I don’t have a Roth set up (I invest through my 401(k)). We’re focusing on our emergency fund before funding the Roth.  

The CS Monitor’s Work/Money section is a virtual cornucopia of social investing articles. They have weekly podcasts that are as much ad as advice, but they often feature different social investing strategies and articles. This week’s article focuses on seniors and socially responsible investing.

The article points out (implicitly) that socially responsible investing means different things to different people. The first gentleman focuses on investing in developing nations such as Brazil and Russia as a way to send needed capital to those countries. The second lady invested in a Federal low-income housing partnership that generated tax credits and appreciated assets. Another gentleman invests in the most typical socially responsible screen: no gambling, alcohol, tobacco, weapons, or nuclear power plants.

The article is part cheerleader for socially responsible investing, especially a well placed ad for Calvert in the middle. I think it’s important that people realize these options are out there if you so choose. But as I said, socially responsible investing means different things to different people so if you do invest in a SRI fund make sure their ethics match up with your ethics.

That question is one that haunts personal financial professionals. Really, it haunts investors as well. In the investing sense, too much debt is obviously a bad thing. A company may go under if it cannot handle its debt load. But in a lot of ways no debt could be just as big of a red flag. Is the company passing up opportunities? Is the company resting on its laurels content to stay where they are presently at while others grow around them?

In the personal financial realm, too much debt is also bad for obvious reasons. But is no debt necessarily the best result? Mighty Bargain Hunter argues that it is. His argument is that all debt is bad, whether it mortgage debt, student loan debt, or credit card debt because if something should happen, you will still have those expenses even if you have no income.

The overly pessimistic conservative money manager in me believes that as well. However, depending on your situation some debt could be advantageous. Student loan debt in particular because not only does it increase your earning potential, but it is deductible for tax purposes. That cuts your interest rate by 25%. My wife and I locked in our student loans at somewhere around 3%. That means our after-tax interest rate is around 2.25%. If I pay off my student loans early, I receive a return of 2.25% on that money (the interest I no longer have to pay). If I invest that (even in a money market account) I will surely earn better than 2.25% on my money. So, in this case I will actually have less net worth in the long run if I pay off my student loan debt rather than investing the money.

The same is true with a monthly mortgage. If you locked in at 5.5%, your “true” interest cost is 4.125%. By not paying off your mortgage and investing in the stock market, your annual return would be closer to 10% over the 30 years of your mortgage (the long term return of the stock market). Again, you may have less net worth in the long run by going for zero debt. Also, studies have shown that homeowners generally increase wealth faster than renters due in the same income brackets. That’s because, generally, the rent the homeowner is paying is going towards an appreciating asset whereas the rent a renter is paying is going towards their landlord’s appreciating asset.

This process of using debt to increase net worth is called leveraging. As long as you can earn more on your money than what you pay in interest, your personal returns will be greater when you leverage than when you do not. This is the basic concept behind the Zero-Interest game that I have previously blogged about. However, there is the ever-present tipping point where too much debt will laden you down and you will be unable to repay your debts.

So, is debt right for you? Only you can truly decide your tolerance, but every debt carries risks. Do the benefits outweigh the risks? One way to mitigate the risk of losing your income due to disability is to purchase long-term disability insurance. Life insurance is a more extreme version of this philosophy guaranteeing income in time of death of an income earner. An emergency fund is a must for everyone, but especially for those with debts relating to basic transportation and housing. Most analysts suggest 3-6 months of income, I would say 6 months at a minimum. Put it in a high-earning money market account from Emigrant Direct or HSBC and you’ll be earning at least a little income while still having the flexibility to draw from it if necessary.
 

Roth and Co. has an excellent roundup of the key provisions in the new tax extenders bill (HR 4297). For most people, the most important item is that the AMT “fix” has been extended for one year and indexed for inflation. Also, the capital gains and dividend cuts have been extended for two years (until 2010).

The games that the government plays with numbers are astounding to me. Quoting Roth and Co.

Corporate estimated tax games. They couldn’t possibly have done this one with a straight face. C corporations with $1 billion or more in assets will deal with bizarre estimated tax requirements in 2006, 2012 and 2013:

- The 2006 estimated tax payment installments due in July, August or September (third quarter, for calendar year taxpayers) will be 105% of the amount otherwise due for the quarter. The same installment in 2012 will be 106.25% of the amount otherwise due; in 2013, the magic number will be 100.75% of the amount otherwise due.

-In 2010, 20.5% of the third quarter installment due September 15 will be payable October 1; in 2011, 27.5% of the third quarter installment is payable in October.

The government has a September 30 fiscal year, and these rules obviously shuffle income among the fiscal years to meet some arcane budget rule, at least on paper and in a laughably phony manner.

Yeah, that’s not a nightmare at all for people trying to calculate how much to pay in estimates (and the resulting penalty calculation for underpayment). I can hear Mark Everson screaming from here. Congress did raise revenues in at least one good way. They scrapped the grandfathering of an illegal subsidy so that the EU won’t impose trade sanctions again. One might argue the obviously illegal trade subsidies should never have been in place. But it is Congress.

Other provisions that may affect you is an extension of the $100,000 small business write-off for equipment and an elimination of the income cap for conversions of IRAs to Roth IRAs.

All in all, another bill that makes January 1, 2011 D-Day for the tax code. The Tax Policy Blog lists all of the tax changes that will happen on that day.

• Individual income tax rates go from 10%, 15%, 25%, 28%, 33%, and 35% to 15%, 28%, 31%, 36%, and 39.6%.

• Child credit falls from $1,000 per child to $500 per child.

• Capital gains tax rates would revert back to 10% and 20% (depending on AGI), while they are currently at 5% and 15%.

• Dividends would once again be taxed at the ordinary income rates (see above), while today they are currently at 5% and 15%.

• After being fully phased out for tax year 2010, the estate tax would be fully reinstated with a top rate of 60 percent and a $1 million exemption.

Wow. Whomever takes over for President Bush is going to have a mess on his (or her) hands. Coming from proponents of Starve the Beast (where taxes are cut to the point Congress has to restrain spending in a reckless game of fiscal chicken) I’m sure it’s intentional that the IRC is so messed up and that there is a ticking time bomb left for a future Congress to deal with.

Technorati Tags: AMT, capital gains, dividend, small business, IRA, Roth IRA

Beginning in 2006, employers can offer their employees a choice in their 401(k) plan. Contributions by employees can either be made to a traditional 401(k) or to a new version, the Roth 401(k). The two types of plans are identical save one catch. With a traditional 401(k), the IRS doesn’t tax your contributions but any income you later take out is fully taxable. With a Roth 401(k), you don’t get the current tax break but all earnings are taken out tax-free. 

Why would you want to switch? If you pay a relatively low Federal tax rate currently and expect to pay more in the future, you would want tax-free earnings later when your taxes are higher. For instance, my effective tax rate last year was 8% after taking out child credits and itemized deductions. It’s unlikely that I would pay less than 8% tax in retirement, so a Roth 401(k) would be a good idea for me. 

Many employers did not offer Roth 401(k)s in the first year of eligibility (2006). There were several reasons, with a lack of IRS regulations on the workings of the new accounts being at the top of the list. With IRS regulations promulgated, more employers may offer the accounts in the next few years. It will still be more record keeping and more expense for the employer so I don’t expect Roths to catch on like traditional 401(k)s did, but there will be more than a few employers offering the accounts. 

One of the caveats with a Roth account is how investments will be taxed in the future. Unless Congress plans ahead [pauses for laughter] [no, really it could happen] [okay, better now?] you could be paying taxes to put money in a Roth and getting a tax break when earnings from investments are no longer taxed. That would effectively nullify the tax advantages of a Roth and would actually put Roths at a disadvantage to traditional 401(k)s. Now, I don’t really believe that earnings from investments will actually ever get to be tax free, but if it is something you think may happen in the future, you may want to hedge your bets and just use a traditional 401(k).

If you are an employee that does have a choice, The Tax Guide for Investors website has a great guide to Roth 401(k) accounts. It explains how the accounts work and how they differ from traditional 401(k)s and other types of retirement accounts. It’s definitely worth checking out for someone that is confused as to how they should allocate their contributions.

A lot of people ask themselves that question every day. For retirement plans, it’s an extremely confusing question for anyone, much less someone at the beginning of their careers (like me). I decided to test two web calculators to see if they were any more confident than I was in my own predictions (which say my retirement kitty will crap out in 20 years using current projections).

I used the “Where am I heading?” calculator from Alliance Bernstein to estimate how much I will have to live on in my retirement given constant savings rate. Right now, I am putting away 7% of my salary to a 401(k), which gets me to 10% of my salary including company match.

Alliance Bernstein estimates a 2% cost of living adjustment in retirement and estimates future inflation using a series of 10,000 simulations to pick the most likely rate over the rest of your working career (40 years in my case).

The calculator estimates that I will be able to replace my current salary (the results are calculated in today’s dollars) and have an 85% chance that my money will outlive me. This assumes I retire at age 65 and live for another 30 years. If I can up my contributions by one percent per year, it will mean an extra $4,000 in income per year.

Next, I used the online Social Security calculator from the Social Security Administration. While I assume in my own calculations that Social Security will not be available when I retire, it is a useful tool for those that are closer to retirement. If I take Social Security at age 67 (when I will be eligible), I will receive $19,116 annually in today’s dollars as my SSA benefit. If I hold off until age 70 to take benefits, I will receive $23,712 annually in today’s dollars. Like I said, this will be found money for me if SSA benefits are available in retirement.

I am okay with these calculations. Like I said, my own shows I am in a little more trouble, but I expect (possibly foolishly) to increase not only my income but also my contribution percentage faster than my current calculations show. Plus, my wife is a teacher and will have generous benefits of her own in retirement (I ignored her salary in all this). Overall, I think we’re okay (it doesn’t keep me up at night), but I think we could do better. Later, I will discuss the model that I currently use to calculate my retirement.

This week’s article on the CS Monitor Work/Money section says that “even those of modest means can afford a financial planner”. However, the article spends the vast majority of its real estate describing why people of modest means can’t get an advisor.

Financial planners help people build wealth and guide them toward financial milestones such as retirement, vacation homes, or funding children’s educations. But they don’t work free of charge. Some, like the one who worked with Rohall, charge an hourly rate for their advice. Many more charge a commission on the products they sell, so they want clients with assets to invest in order to generate fees.

As I’ve discussed before, I am a big believer in avoiding the people represented by the bolded part at the bottom. There are clear conflicts of interest between the advisor and the client. Don’t think it happens? Free Money Finance has a post today on an advisor advising a client to cash out all the equity in his home and putting it into some sort of variable life insurance policy three years from retirement so he could generate commissions. Amazing.

Back on topic, it is difficult, but not impossible, to find a decent financial planner even if you are of modest means. Fee-only advisors generally take on those with fewer assets because they are not paid based upon commissions. The CS Monitor article basically says you either have to find a planner with a charitable streak or have family connections. Maybe if you were, say, a newly minted doctor you could find one, but otherwise you are SOL. I disagree. If you want someone to review a budget or get your 401(k) on track, you should be able to find someone easily. If you are looking to have someone manage your money for you, you probably will be out of luck without a large kitty. But that doesn’t mean you can’t afford a financial advisor of any sort.

The CS Monitor had an article in it’s Work/Money section on how cash-strapped investors can break into the stock market. The basics of the article is that unless you have $2,500 to slap into a mutual fund, you’re basically locked out of the market.

The savior listed in the article is Sharebuilder. I’ve used Sharebuilder in the past and it’s far from the savior it pretends itself to be. First, the fees are high. $4 per investment, or $14.95 per trade. If you manage to invest $100 per month, you are still paying a 4% commission and need to make that return just to break even. If you save $50 per month, it’s an 8% commission, which is the average return for an entire year.

My suggestion would be exactly what the Motley Fool editor suggested in the article, save the money in a taxable high-yield savings account until you accumulate the required minimums to get into an IRA from Fidelity, Vanguard, or any of the other major brokerage houses. You’ll get a tax deduction once you accumulate the minimum required, which will more than offset any taxes you’ll pay on the interest earned in the savings account.

Additionally, some companies have automatic investment programs to allow you to build up balances gradually. Fidelity requires $200/month, but T. Rowe Price only requires $50/month to be invested in their plan. It requires an automatic deduction from your paycheck or bank account and there are stiff penalities if you stop the automatic contributions.

I found this resource through work. It’s a boatload of free templates for Excel. It includes tax forms, personal finance templates, calendars, etc.

Even though I’ve developed my own version of many of these, it looks like the ones I looked through would work really well for someone to determine if their retirement plans are on track, for example. Or to get started on a budget. So, go check them out.