Money To Live

September 17, 2008

Roth vs Trad 401(k)

Filed under: investments,retirement,savings,taxes — by moneytolive @ 5:00 am
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There are two kinds of employer sponsored defined contribution retirement accounts: the Roth and traditional 401(k). These two options are analogous to the Roth and Traditional IRA accounts:

  • With a Roth 401(k), taxes are paid on the contribution, and withdrawals in retirement are tax free.
  • With a traditional 401(k), contributions are not taxed, but withdrawals in retirement are.

In Money Magazine, Walter Updegrave compares the two types of accounts:

Investing $11,625 in after-tax dollars in the Roth 401(k) is the equivalent of making the maximum $15,500 contribution of pre-tax dollars into a regular IRA. But you’re not limited to contributing $11,625 in after-tax dollars to the Roth.

Which means that as long as the dollar amount you can contribute to a regular 401(k) and a Roth 401(k) are the same, the Roth 401(k) effectively gives you the chance to sock away more money on a tax-advantaged basis for retirement, assuming you’re willing to part with the extra bucks. [emphasis added]

At my new job, I have the option of opening a retirement account of either type. Last summer I worked out my budget assuming that I would open a traditional IRA (because I did not know the Roth was an option). The immediate benefit of the traditional 401(k) is the tax savings, leaving more money in my pocket each month.

But since a Roth 401(k) is available and it allows me to ultimately save more money for retirement, I am going with a Roth. That makes my take home pay a bit smaller, but in the long run I will appreciate having more money in retirement.

September 9, 2008

Guaranteed Returns

Filed under: investments,retirement — by moneytolive @ 5:00 am
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This week I am writing about conversations I had with my extended family about finances. Today, I turn to a conversation with my father.

Since my father retired and rolled over his 401(k), my parents were considering hiring a financial advisor. Fidelity offered an advisor for 1% of assets under management. This 1% would be in addition to fees charged in mutual funds.

Instead of hiring someone else, I suggested that I could help my parents to manage their retirement funds. My dad wanted me to guarantee him a rate of return. I said that I could only guarantee a weighted average of major market indices. He chuckled and said ok.

Weighted Averages

The Dow Jones Industrial Average (DJIA) and the S&P 500 are two of the best known indices in the US. Each of these is a “basket” of stocks that represent part of the stock market. The DJIA consists of 30 large companies, such as American Express, Coca-Cola, HP, and Wal-Mart and Walt Disney; the list is maintained by the editors of the Wall Street Journal and “for the sake of continuity, composition changes are rare.” The S&P 500 consists of 500 large companies that are financially viable and represent a range of industries (see the criteria for inclusion here).

There are many other indices that track specific sectors (i.e., technology, energy, pharmaceutical, real estate) or parts of the world (China, Europe, …). Investment firms Fidelity and Vanguard offer mutual funds that track indices.

By investing in funds that track major indices, you can expect returns that are a weighted average of internaional market returns.

p. s.

We worked out a nice deal — Since I am helping my parents manage their money and my brother is not doing anything, he has to give them money if they run out. (It is a joke, and my brother laughed when he heard it.)

This is my mom’s perspective on my financial advice.

September 8, 2008

Retirement benefits for teachers

Filed under: education,retirement — by moneytolive @ 5:00 am
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After I gave copies of On My Own Two Feet to some of my cousins, my extended family had a conversation about money and finances.

On one side of my extended family, all of the women out of college (except me) are either contributing to or receiving income from a teacher retirement fund. All of the women (except me) either are currently working in education or worked in education in the past. I was very surprised to realize this, but maybe it should not be too surprising in a family that is overall highly educated and that has houses full of books.

Good teachers and educators are never paid what they are worth and frequently spend money out of their own pockets to provide for their students. While I think teacher salaries should be much hire (1.5x or 2x what they are currently), I am glad to know that teachers are supported in retirement.

Teacher retirement plans vary by state and by education level. Calculating expected benefits can be complicated, and the easiest way to get information is to visit your HR department. I spent some time reviewing benefits from the Teacher Retirement System of Texas, and it took a significant amount of time to wade through the information and determine what was applicable to my mom. Some information about health insurance in retirement was not available online, but a friendly customer service agent was able to answer all of our questions.

If you are a teacher or are considering teaching, I recommend that you look through the retirement papers as soon as you start working (even if retirement is 30+ years away). In Arkansas, for example, retirement benefits can vary drastically based on a contribution choice made at the initial hiring.

September 1, 2008

Follow the news?

Filed under: retirement,savings,taxes — by moneytolive @ 5:00 am
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I recently had a conversation with a friend about reading financial news. She said it was not worth reading the news; she has an investment plan and sticks to her target asset allocation.

Generally, I agree that it is a waste of most people’s time to follow financial news on a daily basis. There are several things going on right now, though, that I follow in the news.

This is what I am paying attention to now.

  • Home heating costs
    Last year I spent twice as much money on oil for my home (around $1,000) as gasoline for my car (around $500). At my old apartment in New Jersey, a giant oil tank in the basement was used to generate hot water and heat in the winter. Each time the tank was re-filled, I got a bill for at least $600. With higher oil prices, these re-fills will cost even more. For example, in New Hampshire, “retail heating oil costs about $4.50 a gallon, up from $3.30 last winter.”
  • Nearing retirement in a downturn
    I care about this topic because my parents are in/near retirement (my father is retired, my mother is still working). There is compelling advice to near-retirees that it makes sense to work longer, giving retirement accounts time to bounce back before withdrawals begin. (NYT)
  • Changes in the tax law
    Specifically, changes in capital gains tax, the Alternative Minimum Tax, and limits on retirement account contributions.
  • The housing market
    I may (or may not) buy a condo in the next few years. If prices decrease significantly in the DC area, I probably will buy. (Washington Post)
  • Which Wall Street firms are closing
    Since I have friends on Wall Street, I am curious about how the major companies are faring and who is planning lay-offs. (TheStreet.com)

There are some things I am intentionally not paying attention to.

  • 529s/ ESA
    I will most likely not have children within the next few years, and when/if I do have kids, I may live in a different state. Also, these accounts have only existed for a short amount of time. If the laws change, it may not make sense to use these anymore (or it may make more sense)
  • News about “hot” funds/sectors/stocks …
    Here I completely agree with my friend — follow your asset allocation and ignore the market fluctuations.

August 18, 2008

Reader Question: Individual Retirement Accounts

Filed under: retirement,savings — by moneytolive @ 5:00 am
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A reader wrote in requesting information about Roth IRAs. If you would like to read about something, let me know in the comments or on the contact form.

An Individual Retirement Account is an account that you set up on your own (as opposed to through your employer), and you are the only owner of it (as opposed to a joint account with a spouse).

Some decisions to make:

  • Should I open an IRA or invest the money in a taxable account?
  • Where to invest?
  • Roth or Traditional?
  • How much to invest?
  • How will I invest the money?

Advantages of an IRA over a taxable account:

  • The money is “off limits.” There is an extra 10% penalty to withdraw the money for a non-qualified reason (i.e., a vacation). It is like your mom holding your allowance to help you save up for a new bicycle, but in this case the bicycle is retirement.
  • The money grows tax free. You do not have to pay taxes on stock dividends or bond interest.

Where to invest? Most of the large investment firms are fine choices, especially Fidelity and Vanguard. My favorite firm is Vanguard; the fees are very low. If you are a member of USAA, it might make sense to invest there, keeping all of your accounts in one place. For buying and selling individual stocks, I use E*Ttrade.

How much to invest? The government sets limits for the maximum amount that can be invested in an IRA. In 2008, the maximum amount is $5,000 for individuals age 49 and under and $6,000 for individuals age 50 and over. Individuals with high incomes may not be able to contribute.

Invest as much as you can while still covering your expenses. It can be pretty disappointing to contribute $1,000 to an IRA only to discover that the minimum contribution for all of the funds is $3,000. Just keep contributing until you reach the minimum amount needed.

Roth IRA vs. Traditional IRA. With a Roth IRA your contribution is taxed the year it is contributed, but earnings are not taxed upon withdrawal. With a Traditional IRA, you can deduct the contribution on your income taxes, but when you take a withdrawal, it is taxed as income.

Which is better – Roth or Traditional? The short answer is that if you are young and satisfy the Roth income limits, you are better off putting the money in a Roth IRA than a Traditional IRA. The long answer depends on what you believe will be the income and capital gains tax rates when you retire.

What to buy? The easiest thing to do is buy low-cost index funds and mutual funds. One great option is a Target Date fund (or Life Cycle fund, each investment company calls it something slightly different). Figure out when you want to retire (for me, it’s 2045), and buy shares in a fund with that date. The fund automatically rebalances (changes the ratio of stocks/bonds/cash, to be in line with that retirement date).

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If you still want to know more, here is a brief history of the IRA.

Individual Retirement Accounts were introduced in 1974 by the Employee Retirement Income Security Act (ERISA), and individuals could not contribute if they had an employer-sponsored retirement plan.

Roth IRAs were introduced recently in the Taxpayer Relief Act of 1997.

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More info on IRAs

All About IRAs (Fool.com)

Which IRA is best for me? (Vangurad.com

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