Annuities – The Basics (Part 1 of 4)

Posted on July 23, 2008 by casey

There are few people who haven’t at least heard the word annuity. But I think that there are few people who actually understand what an annuity is. I think it is important to understand what an annuity is because there is a very large effort in our country to get people to invest their money in annuities and a lot of misinformation, both for and against, such an action. From the beginning I will let you know that I believe there are annuities available that would be good for some people in certain situations – in fact that would be the best choice that they could make. However, I also believe that way too many people are sold annuities that would be much better served in other ways, as well as many annuity products that are not beneficial to anyone.

In the Beginning

To begin, the word annuity means a series of payments at set intervals for a defined amount of time. You most commonly find this term (when it comes to income) in lottery payments, pension payments and insurance products. When it comes to the insurance products the word annuity has come to mean a lot of other things in addition to the definition that I gave. However, that definition is the underlying basis of the product.

Insurance Annuities

The fact that annuities come from insurance companies is significant. When you purchase an annuity you are really purchasing insurance on your money. Just like you insure a car or a house in case of loss, you are insuring your money in case the value goes down. If it does, the insurance company makes up the difference, to one extent or another. And, just as with any other form of insurance, for that protection you are paying premiums or fees as you go along in order to get that promise of protection. The fees are taken as a percentage of the amount of money that is being protected, or the total value of the investment.

To continue the analogy, with car and home insurance there are things that you automatically protect and then other things that you can add to protect as well. Each time you increase the level of protection you also increase the fees that you pay for that protection. So, I may choose not to protect my car against theft or chipped windshields, but you may think it is worthwhile. All else being equal, you will pay more for that protection than I will.

What Kind of Protection Can I Get?

There are three basic things (with tons of variations) that annuities can protect against. I will discuss these options further in subsequent installments. For now I will give you the basics.

Income Protection
Annuities got their name from this protection feature. The idea is to protect you against a shortfall in future income. In essence, the insurance company takes your money and, in turn, promises to pay you a certain amount for a defined amount of time. That time period might be 5 years, 10 years or even a promise that they will pay that amount for as long as you live. The alternative is to have your money elsewhere and take the risk due to market fluctuations, inflation or theft (if you put the money in your mattress). Like I said before, there are a bunch of variations of this protection feature, but this is the basic idea underlying all of them.Principal Protection -

In this case the protection that you are purchasing is a promise that no matter what happens in the investment world (including where your money is invested) you will not lose money. It may not go up in value, but it won’t go down either. With this promise there are also rules that you have to abide by in order to receive the promise. Usually one of the rules is that you can’t withdraw the money for a certain amount of time. Break the rules and all bets are off.Inheritance Protection -

This type of protection is usually called a death benefit. It is very similar to the principal protection, except that there is usually no time frame and no extra rules. It is basically a promise that if you die your heirs will receive at least an amount equal to what you put in, or more if the account has a greater value. This feature is an automatic part of almost every annuity that I have seen, but there are a few exceptions.

Taxes and Penalties
One more feature of an annuity that is often touted by those who sell them is the tax benefits. The IRS gives to annuities many of the same rules as they do to IRAs or 401(k)s. You will not receive a tax deduction for investing in an annuity (unless it is also an IRA or the like). However, the money grows in the account tax deferred – meaning you won’t pay any taxes on the growth while it remains in the annuity.

Along with the tax benefit also come the consequences and possible penalties. First, when you to pull money out of an annuity you will be taxed on the growth. Second, if you remove money before the year in which you turn 59 ½ you will also have to pay an additional 10% penalty. This is the case even if you don’t use the money but only move it to a different type of investment, like a mutual fund (for non-qualified money only).

To top it off, nearly every annuity product has its own penalty schedule and rules for how and when you can take your money out. There is usually a period of years after the initial investment where you have a penalty assessed on the entire principal for taking the money out early. That number of years varies greatly, but I usually see four years at the low and I have seen as many as fifteen years at the high end. The penalties tend to range from 8 to 10% for the first year, and then slowly move down over the remaining years.

A Few More Quick Things

All of the promises and guarantees are based on the insurance company’s ability to pay. Be careful which company you are choosing. Second, should you choose to annuitize (start that guaranteed income stream) that is almost always a permanent decision. Usually there is no turning back once it starts.

In the following three parts I will discuss in more detail the annuity options that are available in the market today. Whether one or another is right for you depends completely on your personal situation and on the particular product that is being offered. I will only discuss the general details of each type of annuity.

* This article is commentary on basic principles. In no way should the things said in the article be construed or interpreted to be advice for your specific situation. Before making any financial decision you should consider all factors and consult with a professional.

A Scam of the Highest Degree

Posted on July 21, 2008 by casey

A year or two ago I received a phone call from a couple that I know, but that were not clients. The wife was on the phone and told me that they were about to sign refinance papers on their house the next day but were having reservations. They wanted to get my opinion on what they were about to do. I listened to their story and told them that they had to come right down and talk to me before they moved forward. Their foresight to call may have saved them from financial ruin.

He Wants You To Do What?
A few weeks earlier a man had come to their house. He presented to them a new way to give more security to their family, pay off their home quickly and save for their retirement. All of this would be possible without any money out of their pocket. How was this miracle possible?

He told them that all they needed to do was to refinance their home, taking out every penny of equity that they could get, using a reverse amortization loan. They would then place all of the proceeds of the loan in a Variable Universal Life Insurance policy (VUL). They were also to begin putting hundreds of dollars per month into the policy as a premium. Then, like magic, the loan on their house would grow, but at a much smaller rate than the value of their home. In the mean time, the investments in the VUL would grow at 10-12% or more per year.

After the investment had grown at a great rate for a number of years they could take it back out and pay off the balance of the loan. In fact, this was such a perfect plan that he told them they should take all of their money out of their retirement account at work (even with the penalties) and invest it in this VUL as well. And to top it all off, the VUL would provide life insurance that would pay off the loan in the event of their death. Why hadn’t someone thought of that before? (By the way, the commission that this guy would have earned on this deal would have been very nice!)

My Advice
RUN! This was a scam if I had ever seen one. Perhaps in the best possible scenario this scheme would work – I don’t know. I haven’t bothered to spend the time with the numbers. All I know is that I never plan on the best possible scenario because I have never seen it happen. To me this was a recipe for disaster. This couple was not in a position for a house payment that would go up in the future. They didn’t need the amount of insurance that he was suggesting. They certainly shouldn’t take the money out of the employer retirement plan. What would happen if it didn’t work out?

Hindsight
Looking back now I can’t believe how bad it would have been for them:

First, interest rates began to go up. They didn’t have the money to pay any more than they were on their home. They would have been in real financial trouble.

Second, they have since tried to sell their home (for other reasons) and have not been able to at all. If they had not been able to make the increasing payments they could not have gotten out of the home.

Third, the value of their home has dropped significantly. As it is they don’t have much equity left in it right now. Had they gone forward with this scam they would be seriously upside-down in their mortgage to home value.

Fourth, I don’t know the specifics of that VUL, but I doubt it has done much better than the market – likely worse because of the high internal fees of a VUL. It is very likely that the money that they had put into it would be worth quite a bit less today.

I am glad to say that they followed my advice and they are much better off for it today. They bought a very inexpensive term policy on their lives (that they could actually afford) and kept the rest the same.

Warn Your Neighbor
That was the first time that I had heard of this scam. I have run into it three other times since then, so it’s a growing trend. Now there are seminars that you can go to and learn how to make such a “wise” investment. There are even two multi-level marketing organizations that I am aware of that are touting this scheme to their customers (victims). Better yet, they have figured out how to make even more money from the whole deal. I am aware of one group that will do the refinance (and make a commission) and then do the investment (and make a commission).

Surprisingly a lot of people are falling for it. “Too good to be true” still seems to sell very well.

A Good Advisor, or a Bad One – Both Can Have Significant, Lasting Effects

Posted on July 17, 2008 by casey

It was Tuesday, April 15, 2008. Yes, the infamous “tax day.” It was about 11:00 a.m. as I sat outside on the deck of our office speaking with a client. She was there to sign the last tax return that I had to do for the 2008 season. The feeling of relief was very nice. However, the topic of our conversation muted my joy and saddened my spirits. This client had a story that hurt to hear.

They Had Done Everything Like They Should
Her husband had joined a Fortune 500 company right out of school. He worked very hard in their manufacturing operations until he had become a very essential part of the entire operation. He often worked 12-16 hour days. It got to the point where only he and two others had the knowledge and experience necessary to perform certain critical functions in the operation.

Then, out of the blue the company announced that they would be dissolving that area of their business. My client was not quite sure what to do. He was in his mid-forties and was not mentally prepared to start over, even though the company offered to transition him into a new role. He and his wife discussed their options and decided to take an early retirement.

You see, in addition to working very hard in his career my client had done something else right. During the twenty years that he worked for this company he also put a ton of money away into his retirement plan. Now, facing the choice of a new career or retirement, he had $1,200,000 available to help him make that decision. He had done exactly what any good advisor would have told him to do. He saved really well throughout his working life and, because of that, he had options when life changed. And so he retired.

Well . . . Almost Everything
Now, with a very large sum of money in their bank account, they knew that they needed to invest it. Along came a friend that had recently entered the financial industry. He assured them that he could invest their money in a way that they would have a very comfortable retirement. They trusted him and did exactly what he told them to.

Ten Years at a Glance
He told them that they could invest their money in a way that they could earn 12% a year and withdraw 9% to live on. That way their money would continue to grow at the rate of inflation and they would always have enough. They did the calculation and figured out that they could withdraw $108,000 per year, and so they did exactly that.

In 2002 alone their portfolio value dropped by $500,000. However, they continued to pull the same amount of money out of their investments each year. Well, with $500,000 left that meant they were pulling out 20%, then 25%, then 33%, then 50%, then . . .

In 2007 they were out of money. Now, in a panic, she scrambled to start a business and he scrambled to get trained in a new industry and find a job. They held on for dear life to their house and possessions and did everything they could to keep it all together. They were starting over from scratch!

Who’s to Blame?
Probably both are to blame – the advisor and my clients. My clients made two big mistakes. The first was putting their trust in an advisor who, at best, was doing a lousy job for them. In fact, it seems to me that once his commission was earned he wasn’t doing anything at all for them. But I only know one side of the story, so I will withhold that judgment. My clients, when deciding what to do with their entire financial future, should have at least interviewed a few financial planners and gotten second opinions about the advice that they were about to follow. It could very well have saved them from impending ruin. The second big mistake that they made was not paying attention to what was going on in their portfolio. When they saw the value dropping at a very fast rate they should have clued in much sooner and made adjustments before it was too late.

What did the advisor do wrong? First, he never should have planned for them to be able to take out 9% and have their money last – especially with a 40-50 year time horizon for their retirement. There are multiple studies that show that planning to take out more than 5% is a dangerous prospect. Once you cross the 5% line your likelihood of running out af money increases substantially.

Second, in order to try to achieve a 12% return, he had to invest their money way too aggressively for someone in retirement. When invested aggressively there is too great a chance for a substantial downturn and loss of money, which can devastate the portfolio and which, in fact, is what happened.

Last, he should have been monitoring their situation. To have lost half of the value of their portfolio and then to not advise them to take out less money is like seeing someone hanging off a cliff, clinging to a rope, and then cutting the rope. There is no way that the money could last or recover if they continued to pull it out at that rate. He should have been meeting with them at least annually, monitoring the situation and advising them to reduce the amount they pull out if they want it to last.

Significant, Lasting Effects
A good advisor could have kept this from happening, at least if his advice had been followed. Yes, there could have still been ups and downs in the value of their investments, but they would never have run out of money so fast had they received sound advice in the beginning and continued to receive it on a regular basis. I hurt for them, and after talking with them I am certain that they will not make the same mistake again.

One Thing The Government Does is a Good Pattern For Our Own Lives (I Can’t Believe I Just Said That!)

Posted on July 1, 2008 by casey

If you knew me, the title of this article would be reason to take pause. However, there are a few things that our government does that are worth taking note of, understanding, and then implementing into our lives. One thing in particular is the way that they tax us.

Withholdings – A fairly recent, extremely brilliant development

Did you know that we used to pay our taxes once a year at “tax time?” Depending on your age, your parents or your grandparents lived in a time when there was no such thing as taxes being withheld from your paycheck. Then, as a way to finance the war, the government began asking us to send in estimated tax payments (as part of our patriotic duty). People weren’t too keen on the idea. So the government began to offer incentives for doing so. Eventually the incentives became enticing enough that many were lured into the trap. And from there we slid down the slope to where we are now – being charged penalties and interest for not paying as we go!

So, why is this so brilliant?

How often do you take note of the amount of taxes that were taken out of your paycheck? Could you tell me, without looking, what that dollar amount is? Could you tell me, without doing the math, what that amount adds up to per year? Unless you are in the small minority you probably don’t have any idea. That, right there, is part of the genius of the plan. (That “small” amount of money is taken out of your paycheck before you ever see it, think about it, touch it or wonder what you might be able to do with it if you didn’t have to pay taxes.) The vast majority of people never even notice that it is gone. All that matters to them is the net amount in their wallet.

Unbelievable!

I can’t tell you how many people I have spoken to that tell me they don’t pay any taxes. It is hard for me not to laugh. Many love the fact that they get most or even “all” of their money back from the government. For them it is like a highly anticipated bonus that comes once a year and they can’t wait to find out how much they are going to “get.” This is like thinking you are getting a great deal from your credit card company who gives you 3% cash back (while charging you 12% and the store you bought from 2%). Who is getting the great deal?

Few are the people that actually get all of their money back. The largest tax that most people pay is FICA (Social Security and Medicare). Do you realize that you pay 15.3% of your earnings for this tax, which is separate from any income tax that you are liable for? Now, if you are self-employed you are probably painfully aware of this fact. If you are an employee you might think it is only 7.65%, if you have done the math. This is the subject for another entry, but let me leave it at the fact that 7.65% shows up as a withholding on your pay stub and the remaining 7.65% (to make a total of 15.3%) is not shown on the stub because the employer takes it out when deciding how much you will get paid and then pays it to the government. You don’t get this money back because it doesn’t even figure into you income tax liabilities (in most cases).

So Am I Just Venting Or Is There A Point To All Of This?

The point of this is that nearly all of us go along in life, planning our budgets based on the net amount of money that we earn after taxes. We usually don’t even think about the money that we paid in taxes because we can’t get it back. So we think of it as a cost of living, or of working, really. If taxes go up we might feel a little frustrated, but then we forget about it and move forward. We make life work regardless of the amount coming out of our checks. This is the brilliance of tax withholdings. We just don’t notice how much we are really paying and we move forward without thinking about it. I truly believe that if everyone had to write a check once per year for the full amount of taxes that they owe (Income, FICA, FUTA, SUTA, Sales, Property, etc.) that there would very quickly be a revolt and the tax laws would change very fast.

And herein lies the lesson: The government has figured out the best was to get us to put away 10-50% of our money without giving it a lot of thought. Why don’t we use the same psychology on ourselves when it comes to saving? If we truly have our own best interests in mind we should set up an automatic “withholding” plan from every paycheck that we earn to save for the future. Automatic savings plans are the best way that I have ever seen for people to put away a good amount of money.

The similarities between taxes and automatic savings are striking. When I talk to people about starting to put away a set amount every month they often wince. Even those who are already doing it and seeing the success of the plan wince when I talk to them about increasing the amount. This is the same reaction that people have when taxes go up and their withholdings increase. In both cases they wince, wonder how they can do it, and then they move on and forget all about it! I can’t tell you how many times I have heard people say “I don’t even notice that it is missing.” And, like taxes, when someone has to write a check for their investments once a year it is a much harder, and often impossible thing for them to do. The government is really good at getting our money from us. We should follow suit in gettingey from ourselves as well.

How We Manage Our Finances

Posted on June 21, 2008 by jesse

Your mileage may vary.

I was trained in accounting and, though I don’t do much accounting these days (I can still hold my own with some pretty sweet tax strategy), all of the ideas are still very much a part of me: double-entry bookkeeping, accruals, deferred revenue…blah blah blah.

One takeaway I got from some 150 credit hours of accounting? Keep things simple. Should there really be any other way?

Simpliciple

One Checking Account
We have one checking account. Julie has a debit card and I have a debit card. The debit card is used at Costco and for a few places that don’t take a credit card (health insurance and electricity). We also write a few checks a month (rent, tithing, babysitting -> worth every penny, etc.). There’s very little volume in our checking account. Looking at it right now, 2/3 through the month, there are 12 transactions.

Whenever we earn money, it always hits the checking account. The checking account is the gatekeeper. To get in, you go through there.

One Credit Card Account
The credit card gets quite a bit more volume. We run everything we can through there and enjoy the measly cashback of 1%. Right now, on the 21st of June, there are 29 transactions in there. I just saw four in a row from Target, all on the same day.

JULIE?!!?

Just kidding. I’m sure she has a very reasonable explanation. And I’m sure we budgeted for it (right?).

These two accounts are the only ones I actually track in YNAB. The checking account and credit card are both at the same bank (alright, it’s Wells Fargo okay? I love the stagecoach so much.) I’m sure there are credit cards with better cashback and all of that, but I thoroughly enjoy having the same bank handle both — payments (in full) on the credit card from the checking account are instant. We have several more savings accounts that I’ll get to in a second.

Savings Accounts – A Lot – But Not a Lot of Work

Car Replacement Fund
Each month we budget $75 into our Car Replacement category. Our savings account is set up to automatically transfer the $75 from checking. Yes, we realize that $75 is terribly low when you’re saving for a BMW Hard-Top Convertible, but it’ll have to do and no, I’m not giving up the dream.

How does it work in YNAB? I just plug $75 into the Budgeted cell of the Transportation : Car Replacement category and let the balance accrue. At the time of this writing, we have $1,315.14 in there. Last year we made $23.28 in interest. This year so far it’s at $14 (interest rates have dropped).

Yes, because of that interest, what my balance shows in the Car Replacement category is not the actual bank balance. I don’t really care at the moment. I’ll do a true-up when we actually buy the Beamer (in about 30 years at our rate). When we do buy the Beamer, I’ll transfer the money from our savings back to checking, record an uncategorized inflow into the checking account for the interest, record the transfer of money, and budget a negative $40,000 in the Car Replacement fund to make it Available. I’ll then spend all of that money on a piece of well-engineered metal.

House Downpayment Fund
We also socked money away into this account for some five-odd years. Pleased to report that we are now first-time homeowners (as of yesterday), not just first-time homebuyers or, before that, first-time homebrowsers.

I transferred all the money in that account to checking and wired that money to the title company. None of this has been entered into the budget yet, because it’s not Sunday (I’ll get to that).

Julie’s Fun Money
Julie has so much fun money saved, it actually seemed worthwhile to have her open her own savings account to earn interest and shortly retire. That money just sits there, taunting me. She never spends it.

Jesse’s Fun Money
This account is much smaller, but that’s only because last year I bought a practice putting green for the office, a set of clubs, and innumerable driving range buckets. There’s just enough in there to pick up some hybrids, which will take my game to the next (low) level. Oh, and last year I took up golf. Thanks to Mom and Dad for the graduation present, which fully-funded this quickly-dwindling account.

Emergency Fund
You got it. There for emergencies only. We’re working on getting it to six months’ expenses. It’s taking F-O-R-E-V-E-R. (As an aside, we’re also starting to stock up on food, bullets, and gold bouillon — a necessary component of any TEOTWAWKI plan).

Float
A little over two years ago I started playing the float by taking our average expenses and having that amount automatically sucked into this online savings account right after we paid our credit card off. It would then automatically be spit back out of this account into our checking just before we paid the credit card again. All in all, it meant that money was sitting there for about 23 days per month. We now have in this account $130.63 (approximately).

I stopped playing the float early this year because recording the transactions in the checking account of YNAB was starting to annoy me.

I also believe that since I came up with the scheme that the $130.63 should be transferred to Jesse’s Fun Money. We’re yet to reach consensus. Until we do, I guess that money will just sit there earning piles and piles of interest (at 2.75%).

(We could play the float because we charge virtually everything on a credit card – not to mention having the Buffer)

How this all Fits into YNAB

Like I mentioned above, the only accounts that are in YNAB are the checking and credit card accounts. All of these other accounts have such a low volume that it wouldn’t add much value to track and reconcile them to the same level that we do the Big Two.

Each of these savings accounts I listed is simply a budget category in YNAB. When we physically move money into any of those accounts then we record a category-less outflow from Checking and make sure we input the budgeted number. The balances accumulate sans interest and everyone’s happy.

How do we handle Cash?

If I have cash in my wallet it’s officially off-radar (Oh What a Beautiful Feeling!). We record outflows in the budget when the withdrawal happens and that’s the end of that.

Why is my budget-centric mind comfortable with this? Because we withdraw very little cash — somewhere in the neighborhood of less than 1/2 of one percent of our spending is with cash. Increase that number to somewhere around five percent and the story would change.

I think sometimes Julie extorts money by buying something with the credit card, then returning it and getting cash back. How else does she ever manage to not spend her Fun Money? I see a charge on our card, inquire…and she just says, “Oh I took that back.”

“And they gave you cash for it? Dearest?” I lovingly ask.

“Yep” replies the normally very-talkative Julie.

Wise men simply leave it at that. And so do I.

Budget Frequency – Weekly

Back before we could import bank transactions, this was a nightly affair. Also, back then we were learning a lot more about spending and awareness and it was important that the frequency be pretty high.

Now, things are so much better. We feel “in the groove” with spending so to speak. We update the budget every Sunday evening. On the first (or last) Sunday of the month we’ll sit down and have our Budget Meeting (Emily wrote a great piece on that a bit ago). We’re usually done in about 15 minutes.

Our Budget Categories

Our budget categories are basically what you see as the default when you start a new Budget. I think that’s far too many (we’ll be changing it). Lately I’ve been working on consolidating categories as much as possible. In my ideal world, I think I would have a Walmart category so I didn’t have to do receipt splitting (it’s the only store that requires splitting for us!). I’d also consolidate all of the insurance premiums into one category (health, life, auto, home). Those are just a few ideas though.

Fewer categories, as a rule I think, is better because it means less thinking, typing, and checking.

However, if you’re really trying to apply some downward pressure on your spending, more categories means more granularity, which means more awareness, which means less spending. You’re the only one really qualified to decide.

Retirement and Investments

I didn’t mention retirement accounts or things like that. It’s getting kind of nuts on us again and I don’t like it. We have 529 plans for the three kids, one from each parent, so that’s six plans in all (bleh). It’s some goofy Utah thing I guess where the parents can’t combine their allowable deposits into one account. We have a Roth for me and a Roth for Julie. We started a SEP-IRA last year, funded that, and now aren’t using it anymore because I moved to a Solo 401(k) (should’ve done my homework earlier and never done the SEP in the first place).

We also have a few single stocks (AAPL, GE, COP and SVN if you’re at all interested). SVN was delisted, demoted to the pink slips. That’s how good of a stock picker I am. I bought AAPL back in 2005 because I kept seeing more of their laptops (one of which is sitting atop my lap) on the university campus. Wish I would have bought more. I bought GE because Fortune told me to and man were they wrong. I bought COP because I wanted to feel slightly happy when gas prices go up (the happiness doesn’t offset the sadness however). Wish I would have bought more. Oh and yeah, Fortune told me to buy SVN as well.

I’ve been clean with single-stock buying for a year now. Don’t know when I’ll sell.

How do we handle these investments with YNAB? They’re all just outflows in their respective categories. Why? I’ve purchased a mutual fund, a stock, or a bond with our cash — just like I purchase milk. The only difference is that when I sell, I’ll record an inflow again. Budget-wise, retirement is pretty darn straightforward.

Conclusion

Hopefully this helps someone out a bit. Just try and keep your finances simple. Don’t get all crazy and have quarters falling out of your pockets while you’re chasing dimes, so to speak. If you’re just starting to really “manage” your money, then you’ll need to be more involved with it and update your budget more frequently. That will naturally bring your spending down and increase your awareness. And you’ll start winning.

Untapped Funding for Real Estate Investing and a Few Tax Benefits to Boot

Posted on June 20, 2008 by casey

Real Estate can be an important and often successful part of a wealth-building strategy. For this reason, many people buy investment property. However, a major barrier to entering the Real Estate market for many people is a lack of money available for a down payment. Even those who have done a great job saving for their retirement often have most of their savings tied up in accounts that are penalized if the money is withdrawn before age 59 1/2. What most people don’t realize is that the money in a retirement account such as an IRA or an old 401(k) can be used to buy Real Estate or other non-traditional investments. With a self-directed IRA, these funds can be used to make such an investment.

What is a self-directed IRA?

All retirement accounts are maintained in the name of a custodian. A custodian exists, in part, to assure the IRS that you have not tapped into your accounts during the year (thus triggering taxes and potential penalties). In addition, these custodians often assume a level of fiduciary responsibility. As a fiduciary they limit the investments that you can choose from so that they are not held liable for allowing you to invest in something “crazy.” Such custodians will not allow use of a retirement account to invest in Real Estate.

However, a few custodians offer what is called a self-directed IRA. In this case the custodian withdraws its fiduciary responsibility and allows you to choose the investments that you think are appropriate. With this option, you can take the money that is in your IRA, or that is in a 401(k) from a previous employer, and use those funds to purchase investment property, precious metals, or even a new business. The ability to use these funds in such a way allows for significant risks to your investment, but also offers two great benefits that would not otherwise be available.

Two Great Benefits of a Self-directed IRA

The first benefit is probably obvious from what has been said so far. You are able to invest the money in your retirement savings account in almost any way that you feel is best. You can choose the investment that you think will bring the greatest success in preparing for your future needs and you have a source of money for such investments that you may not have realized was available to you.

The second benefit may be quite as obvious. This benefit comes at tax time. Since the property is held within an IRA, all income and gains are tax deferred. No longer do you have to pay taxes each year on the rental income, but can defer that income to a future time. You can keep the income within the IRA account and reinvest it elsewhere, or have it in reserve for future expenses. Even more exciting is that if you decide to sell the property and buy another, or even if you just keep the gains and invest in something else, it isn’t necessary to deal with the headaches of a 1031 exchange. Timing of sales and purchases can thus be made when they are optimal instead of being forced to buy something within the strict 1031 guidelines in order to avoid the taxes.

Some Words of Caution

Of course, you must use great prudence and caution when investing your retirement savings. You should not, for example, “put all of you eggs in one basket” by using all of your money to buy one property. You must also be aware of the many risks that are inherent in Real Estate, including a measure of illiquidity.

Additionally, you must remember that the IRA owns the property. Should you need to make repairs or replace the roof that money needs to come from the IRA. Otherwise, if you pay for anything out of pocket, it is considered a contribution to your IRA (subject to all of the limitations of an IRA). Therefore it would be wise to have a significant portion of your IRA money in reserve (not invested in the property) so that you are free to make adjustments as needed.

You also need to be aware of some special rules. For example, you must use an independent property manager to receive the income and pay the expenses. Remember, the IRS doesn’t want you to touch the money in your IRA, and in this situation any money involved in the investment would count. The property manager would collect income and send it to the IRA custodian would bill the custodian for expenses. The custodian will also charge a fee for this service. You still have control over the property manager; you just can’t touch the money. The rules for owning a business within an IRA become even more complicated. With any such investment you must be sure that you first completely understand how it works.

In Conclusion

The tax benefits of this type of investment can be enormous. The ability to tap into retirement funds to make a great investment can be wonderful. But the decision to make such investments through a self-directed IRA should be made with the help of competent professionals, in order to avoid serious pitfalls. With that said, a self-directed IRA is a lesser-known option that can be a great asset in your strategy for financial independence and tax-benefited investments.

How a video game programmer started writing software that is _really_ fun (Howdy ya'll)

Posted on June 20, 2008 by taylor

I’m new to the blog, but not new to YNAB. I’m proud to be the lead programmer behind YNAB Pro.

But let me start at the beginning. A couple of years ago, I was looking for a better budget program, and when I found YNAB I knew I’d found a good thing. Jesse and I started talking, and in short order we discovered that we were both excited about the idea of YNAB evolving into more than a spreadsheet. A few months later we released YNAB Pro (to great acclaim).

Since then, we’ve always been trying to improve YNAB Pro, and I’m proud of how far it’s come. Our forums are probably the most helpful place on the internet! If you haven’t before, I encourage you to read through them. There’s nary a question unanswered, and that even includes the ones that leave Jesse and I scratching our heads! I honestly don’t think you can find a friendlier group of folks anywhere. In addition to helping each other, our customers really help us too. When they share their ideas (and yes, even their frustrations), it helps Jesse and I to know what to focus on for our next release. Up until now, there’s only been one problem: time.

What some people might not know is that YNAB Pro has been a side-project for me for the past couple of years – not a full time gig. (For my day job I was a programmer for a big video game publisher.) I’m proud of what we’ve accomplished in this time, but I have always wanted to accomplish things faster. When you know it will just take a few minutes to add a feature that will save thousands of people hours of time managing their money, you want it done yesterday!

I’m excited to announce that as of a few days ago, I began working on YNAB Pro full time. I get to work with Jesse on budget software all day long, which means more frequent releases of YNAB Pro, which makes for a happy lead programmer and even happier budgeters.

I’ve already begun working on the next release. I’m fixing lots of little annoyances, like allowing you to easily change the order of the account tabs so that people don’t have to do silly things anymore, and making it easier to import bank transactions. I’m also going to be adding official transfer functionality. I’m excited about it. Have something you’d like to see get added to YNAB Pro soon? Please let us know!

P.S. For those of you scratching your head at the title of this post, that’s how we say “Hi” down here in Austin, Texas.

On Home Buying

Posted on June 19, 2008 by jesse

We are about a year and a half removed from our first home buying experience. Reflecting on the purchasing process through the clarity of hindsight, I’ve compiled a bit of amassed wisdom I’d share with other first-time buyers:

Slow Down. There will always be great houses, with great yards, in great neighborhoods on the market. And there will always be good deals. Abandon the scarcity mentality, especially in the present market that is, and will continue to be, plump with anxious sellers. Wait not just for a good opportunity, but for the right opportunity.

Don’t fall for the “rent = throwing away your money” myth. Renting is not throwing away your money — it is exchanging your money for a roof over your head. And, depending on your circumstance, the flexibility that comes with renting can be extremely valuable. Also remember that much of the money that is lumped into the term “mortgage payment” is essentially rent. Consider how much goes to taxes, interest and insurance, and you’ll realize that there is, in fact, just a small portion of what you send away each month that translates into actual equity.

Keep an intensely accurate budget for several months preceding the purchase of your home (especially your first home.) Be familiar with utility rates, maintenance/repair fees, and fixed expenses so that you know exactly how much you can comfortably afford to allocate for a mortgage payment each month. In addition, carefully consider the increased expenses that often come with ownership (new appliances, yard maintenance and equipment, higher utility bills if you’re moving to a larger residence, increased fuel costs if you’re moving farther from work, etc.) Familiarize yourself with all the financial implications of ownership and make sure you still have a cushion to absorb the shock of unanticipated home maintenance or just the rising cost of daily living that so often takes us by surprise. The flood of foreclosures on the market at present is evidence of the fact that many recent buyers were overly optimistic about what they could afford.

Don’t get emotionally attached. I know. Easier said than done, right? But if there is one thing that will help you make a more astute financial decision with regards to the purchase of your home, it is this principle. Be willing to walk away from a seller who won’t negotiate into your price range. Understand your “Best Alternative to no Agreement,” (that you will be able to find another suitable residence,) and be willing to walk away from a deal that is not right. Don’t make emotional concessions (i.e. I love this house SO much that I’d be willing to spend a little less on food every month and buy less clothing to be able to live here,) that will stretch you beyond your predetermined price range. A house will not sate your desires and fill your happiness quotient like you might imagine. The granite and stainless will lose their luster remarkably quickly if you’re stretched to (or beyond) your financial limits month after month to afford them.

Buy with your values in mind. Be thorough and thoughtful in establishing your criteria for a home before you start looking. Consider things like commute distance, yard size, proximity to shopping, schools, parks, etc., and let your predetermined values guide your search and ultimately your purchase.

Finally, when trying to nail down the right mortgage, remember these things:

Money is a commodity. You are trying to find the lending establishment that will get you the most affordable money (i.e. money with the lowest interest rate and closing costs.) Approach the process with that kind of objectivity in mind.

Get five ballpark estimates from mortgage brokers based on a set of realistic assumptions about your financial situation.

Go back to the most competitive three ballpark estimates and ask for a “good faith estimate” based on your credit score and down payment capacity. It’s generally poor policy to come in much over a good-faith estimate, so these figures should give you fairly accurate ideas about rates and closing costs on a mortgage.

Take the best of the three good faith estimates to the other two bidders and see if they’ll come down from their original quotes. Let the mortgage establishments bid each other down; find out how badly they want your business.

Avoid interest only and adjustable rate mortgages. Beware of prepayment penalties and other fine print that often accompanies sub-prime loans. It is generally best to wait until you can afford a fixed rate, traditional mortgage.

We received almost all of this advice in some form or another prior to our home purchase; we gave strict heed to some suggestions and not so much to others. We’re happy in our home and comfortable in our mortgage and still, in hindsight, I wish we’d let all of these principles guide all of the decisions that affected such a substantial budget and life-altering commitment.

Spotlight: Are We Crazy? (I love this story)

Posted on June 12, 2008 by casey

My father is also a financial advisor. About 12 years ago he had a couple in their early thirties come into his office. They owned a business and were now at the point where they wanted to start saving and planning for their future. They were in the process of finding a financial advisor that they felt good about and had interviewed several before they came to my dad.

They spent a fair amount of time interviewing my father and he, in turn, found out as much as he could about them. At the end of the meeting, as they were about to leave, the wife asked my dad one last question: “Are we crazy?”

By Who’s Definition?

My father asked what she meant and she replied with something like the following: We are in our early thirties. We own a successful business and make a great income. We have every indication that that income will only improve. And yet, we don’t have a lot to show for it. Our friends are about the same age and make the same amount of money, or even less. And yet so many of them look like they are doing so much better. They have bigger houses, drive nicer cars, and go on nice vacations. They look at us and wonder why we don’t do the same. But we know that they are going into debt for all of this stuff and we don’t want to. We are debt free and saving, but sometimes it is hard to see all of the stuff that we are missing. My dad smiled and only said, “Ask me that question again in ten years.”

Jump Forward Ten Years

About two years ago this same couple came into our office to review their financial plan and investments. At the end of the meeting my dad reminded her of their conversation the first time that they met and of her question. Then he said, “So, are you crazy?” They smiled big and laughed. They were probably still smiling as they drove off in their Corvette.

You see, they had just reviewed their portfolio of well over $1 million in assets (in their early 40’s), not including the business. They still had no debt and had all of the disposable income that they needed. At the same time, their friends were in about the same circumstances that they had been in 10 years earlier. I guess it all depends on how you define crazy. If “crazy” means seeing the world differently and acting differently than the average person then I would say that they definitely are crazy, by that definition. Oh that the rest of the world were crazy too!

It Gets Better

Soon after this meeting the housing crunch was becoming a real issue. This couple’s business is building spec. homes and selling them. When the Real Estate market came to a screeching halt, so did their income from home sales. However, even in their business they had not used debt. So, while their homes sat on the market and didn’t sell, they also had no payments to make on those homes as they would have if they had used debt. In their personal lives they had no debt as well. This meant that their necessary monthly expenses were minimal, and their supply of cash to get them through this hard time was plentiful. All of this while many of their competitors are going out of business or getting night jobs to stay afloat.

So, who is crazy? In this case the definition, in my mind, changes: Almost everyone in the world is crazy except a select few. Getting out of debt is the only sane thing to do!

Spotlight: They Are On Their Way (I’m Proud of These Guys)

Posted on June 5, 2008 by casey

I have a young married couple as clients with whom I love to meet. They are in their late 20’s / early 30’s. Both went to college to become teachers and both taught in local elementary schools. You might guess that they don’t have large sums of money to invest. You might also guess that their disposable income isn’t in plentiful supply. In both cases you would be correct.

Is It What You Earn or What You Spend?

Despite a relatively low combined income as two new teachers, this couple went about putting first things first. They made a budget and began learning to stick to it. They started saving for an emergency fund, college for their kids, and retirement. They purchased life and disability insurance. They took care of those things that mattered most to them and they still made it work. Many people on much higher incomes cannot seem to figure out how to do what they were doing.

From Little to None

Over the time that we have met they have made some choices that, at first glance, do not seem helpful to their financial situation. They have had two children. After their first was born they decided that the wife should work two days a week instead of full time. After their second was born they decided to have her stay with the children full time. That was more important to them than their financial goals, as long as they could survive.

As they were making the decision to have the wife stay home full time they came to me for help. They could not see how to make their budget work, but they felt like it was really important that they did. We spent some time together working through it all and even though it was tough, we found a way to make it work. Soon after I even got an email from them saying that their email address would be changing because they had started using a free internet service.

Some Things Just Don’t Add Up (Because Parts of the Equation Aren’t Visible)

Soon the husband found a job as an assistant principal. Not only would the salary increase but the commute was better. Other things have worked in their favor. They have not needed to take any money out of their emergency fund. It is still an ongoing and recent change in their lives, but I know that it will work out.

I want to go on record with this prediction: If this couple stays on course with the decisions that they are making I will be writing about them again in future years. In 10-15 years they will be in a better position than nearly all of their peers, even if they remain on one income. When we want badly enough for a decision like this to work out, it does. There is magic that enters our lives as we make good decisions and parts of the equation that we never saw begin to appear and have a multiplying effect on financial and family wellbeing.

YNAB

You haven't budgeted like this.

Category Archives: Investing