Category Archives: Investing

HSAs – The Best Thing Congress Has Created in My Lifetime.

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I want to welcome Casey Murdock to the YNAB family of authors. Casey is a financial adviser serving clients in multiple states. He brings a strong technical expertise to the YNAB blog and we’re happy to have him on board. If you have any questions specifically for Casey, you can email him at Casey@MurdockFP.com. We bought some life insurance through him and he found us a steal of a deal.

Jesse

In 2003 the United States Congress passed into law something truly great. With the passing of the Budget Reform Act, a little known, little understood, but very powerful tool was created for taxpayers called a Health Savings Account. And with this tool Congress gave us something that I believe is the best deal we have gotten from Washington in a long, long time.

What is a Health Savings Account (HSA)?

An HSA is an opportunity given to individuals and families who have high deductible health insurance plans to save for their medical expenses, with tax benefits attached. It allows individuals save up to $2,900 ($5,800 for families) per year ($3,800/$7,600 if over 55), and when they do so they get a tax deduction (above the line) on that year’s tax return. Then, for as long as the money remains in the HSA it grows tax free. Finally, when the funds are taken out of the investment for medical reasons they come out tax free as well. Did you catch that? If you put money into an HSA and use it for medical reasons it is never taxed! There is nothing else like it.

Don’t I Get a Deduction for Medical Expenses Anyway?

Yes, subject to three big “ifs.” You can deduct out of pocket medical expenses on you tax return if you have enough other deductions to itemize (not just take the standard deduction), if your income is not so high that your itemized deductions begin to be reduced by formula at the end of Schedule A, and Big If your medical expenses exceed 7.5% of your Adjusted Gross Income (AGI). Only expenses over 7.5% of AGI can be deducted. That means that if you make $80,000 this year the first $6,000 (80,000 x .075) of medical expenses cannot be deducted.

Double Up the Tax Benefits!

So, if you open up an HSA and fund it during the year you automatically get the benefits of a tax deduction. This is the case even if you spend the same money on medical costs a week later. You could literally know that you have a $1,000 medical bill coming, put the $1,000 into your HSA and then go pay the bill the next day. Just for doing so you get the deduction. However, in doing it this way you only take advantage of one of the tax benefits.

If you have the money, an even better way would be to fully fund an HSA each year and then pay for medical expenses out of pocket. Then you would get the deduction for the HSA. On top of that you could also get the itemized deduction for medical expenses (subject to the things mentioned above). The money in the HSA would grow tax free. Then when you need it for medical expenses that you can’t afford in the future it would come out of the account free of tax as well. Double the deductions while you are in need of them and then get the money tax free in the future when your income is lower (such as in retirement).

Is it Worth Having a High Deductible in Order to Have an HSA?

In almost all cases I would give an emphatic yes! I have spent many, many hours analyzing health insurance options for myself and my clients. I look through 100+ options for a person or family, taking into account the premium, deductible, co-insurance payments, etc. When all costs are considered together, higher deductible plans work out to be the better deal almost every time. This is actually a good topic for a future blog entry. Anyway, HSA plans on there own are often the best deal in health insurance, and then when you add in the tax benefits they are even harder to beat.

Some Other Great Tax Perks

For those in the higher tax brackets, as well as those who are eligible for employer retirement plans, there is an additional bonus to an HSA. As you probably already know, your ability to contribute to an IRA or Roth IRA is phased out and then eliminated at certain income levels. There is no income limitation on eligibility to contribute to an HSA. This is a way that you could contribute to something much better than an IRA even when you can’t contribute to a Traditional or Roth IRA because of your income. Also, with many retirement accounts you are required to begin withdrawing funds (and being taxed on them) once you reach 70 1/2. With an HSA you can leave the money growing in the account until you need it.

What if I Need the Money for Something Else?

The answer to this depends on your age. If you are not 59 ½ or older during the year there is a 10% penalty plus taxes for pulling the money out for non-medical reasons. Once you arrive at 59 ½ the penalty goes away. At that point you will pay taxes on the money you use for non-medical purposes, just as you would if you used money from an IRA or other retirement account.

Some Nuts & Bolts

In order to take advantage of this incredible opportunity you must first have a “High Deductible Health Plan” (as defined by congress). Also, you (and your spouse) must not be eligible for employer sponsored health insurance (unless the employer offers an HSA plan). The easiest way to know if a health plan meets the definition of “high deductible” is to ask the insurance company or agent. Every company that I am aware of offers at least one (and usually several) HSA eligible plans, and usually it is indicated in the name of the plan. (By the way, “high deductible” is only $1,100 for an individual or $2,200 for a family). Also, you cannot contribute to an HSA after you turn 65.

Once you have an HSA eligible plan the next step is to actually set up an HSA account. Most health insurance companies do not offer the actual savings account, but require you to do it through a third party instead. This is most commonly done at a bank. As HSAs are a relatively recent creation there are not a ton of options out there yet. And unfortunately many of the options do not pay a lot of interest. However, with a little research you can find some good deals. One national bank that I know of actually offers six types of investments for the funds – anything from a money market account to 100% stock mutual funds. So if you are pretty confident that the money you are putting into your HSA will be there for a long time before you need it you would be able to invest it a little more aggressively and make it grow.

Once you have established the account the bank usually issues a debit card for you to use to pay for your medical bills. This makes getting money out of the account very easy. Just don’t accidentally use it to buy gas or groceries!

eFinplan, In-Depth Review – Financial Planning for All

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eFinplan logoIn times past, access to financial planners was something for those already well-to-do, with money that needed some direction. Thankfully, with the advent of the internet and the scaling that’s possible, professional financial planning is right at your fingertips for a fraction of the cost.

A financial planner’s job is to gather information from you about your current financial situation and your desired future situation. You take your goals and aspirations and you build a roadmap for how you’ll get there. eFinplan does just that with a straightforward web interface.

Knowing the best way to learn is by doing, I spoke with a co-founder of eFinplan, Kent Irwin, and he let me give the software a test run. Because the software is so straightforward, I’m not going to talk about how to navigate it or anything like that. If you’ve filled out a form online before, then you can use the software. What I’d like to talk about, and the part that got me so excited, was the end product.

When I finished entering my financial information into eFinplan, I was given a 63-page comprehensive financial report. Emphasis on comprehensive. It’s broken down into easily-digestible sections so no need to feel overwhelmed. You can just work through it one bit at a time.

To be clear: the document is in no way an advertisement for anything. My first though was, “Oh, they’ll get this information and then be able to refer people to planners or insurance brokers.” I was dead wrong. The report is a plain vanilla report chock full of information.

Section 1: Present Financial Condition
The first section deals with how things are right now: a statement of net worth and a breakdown of capital assets (between taxable and tax-advantaged funds). An example of a tax-advantaged fund would be a traditional or Roth IRA, or a 401k, among others.

You then work through some basic assumptions (which are adjustable, but I recommend you leave them at the default) such as your life expectancy, expected rate of inflation, expected expenses at retirement and a slew of others. Just stick with the defaults and you’ll be fine :)

Section 2: Future Goals
Section Two is where things start getting fun. You work through your future goals (Maui+Golf, just for instance) to see if you’ll be able to fund those goals.

The great thing about eFinplan is that it’s not just a data output (from what you just input). It actually walks you through and explains the what, why and how of the whole plan. That’s where the value really is — in the education.

Continuing on with the goals section, it breaks down each of your retirement years and shows how your cash flow situation might be. If you worked things into your plan like funding college for kids (can you say expensive, hello?!), you’ll see a breakdown of how much you’ll need to contribute to meet goals for each of your kids, how much tuition is expected to be, etc.

As part of the college funding section, they give you a nice, consolidated report on the different funding opportunities available (529, UGMA/UTMA, etc.). It was nice to have all of that presented in one place instead of spending an hour on Google. It even educates you on various tax credits and deductions that make college funding easier.

As part of your future goals, you may have some milestone such as the purchase of a home (that was ours). That will be factored into your situation to make sure you don’t overestimate your retirement nest egg by not considering that hit.

At the end it gave a brief synopsis of my goals to:

  • Retire at 40 (13 years away)
  • College education for the (now three) kids
  • Buy a Home

Section 3: Investments
Section Three is all about your investments. the eFinplan does a great job of teaching you about risk tolerance, diversification, risk vs. return, etc. It’s like having a financial planner teach it to you, but you can refer to this forever without having to pay again :)

You’re taught about the various asset classes (large cap, small cap, foreign, bond), selecting the right security (bond, stock, etc.) and timing the market (don’t!). You’re then instructed with great summary information about how different risk tolerance plays to different asset classes and their historical performances.

You’re then presented with what your asset allocation is verses what it should be. The eFinplan goes through rebalancing (there are funds that do this for you automatically).

Section 4: Risk Management
The eFinplan looks at your emergency reserves, property and casualty insurance, life insurance, etc.

The eFinplan gives great advice on cost saving tips for property and casualty insurance and when it comes to life insurance the information simply blew me away. It’s not that the information is secret or anything like that, it’s just that they present the different insurance options (term, universal life, variable universal life, and whole life — as an aside, I recommend term for 99% of people) with a brief descriptions and advantages/disadvantages of each one. Again, the information provided is stellar – it’s a great future reference.

The risk management section continues with disability, and long-term care insurance (again, with great comprehensive information).

Section 5: Your Spending
This is the section where YNAB comes into play as your method of aligning your spending with your values. The eFinplan analyzes your debt-to-income ratio and lets you know where you stand (I’m a fan of no debt), gives you solid advice regarding credit scores, taxes, trusts, health care, etc. The list goes on.

Section 6: Legacy Planning
This is the section where you’re reminded to get a will, a power of attorney, a living will, etc. Vital for anyone that would leave people behind over which you have financial responsibility.

Section 7: Implementation
The eFinplan report then walks you through which advisors you may need, and gives you great advice on how to select them. At the end of section 7 you have a consolidated report of action steps necessary for you to meet your goals.

The nice thing about how the report is organized is that each section has definable action steps that you should take, with a checklist to make sure you don’t miss anything. The eFinplan, for me at least, served as a great reminder of where I am, what I want to accomplish, and how I can get there. In comparison to the cost of a financial planner, it’s an absolute bargain.

I’d encourage you to check it out.  Consider it an experiment. You won’t be disappointed with the end product (though you may get a kick in the pants telling you to start taking more action — but that’s a good thing!).

Click here to check it out

If you’re budgeting’s going well, your logical next step is planning. It’s basically what you get to do with that cash flow you’re finding!

The Automatic Millionaire Strategy and YNAB

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As many readers probably already know, we’re now a “working” family and no longer part of the student life that we grew to love over the past several years. I’ve recently written about the change to expenses that can happen with income rising even a little bit. In light of this phenomenon of expenses following income, it becomes extremely important to implement the “Automatic Millionaire” strategy made popular by David Bach.

I would like to get out in the open that Bach says budgeting isn’t necessary. While you can get by without a budget, you’re many, many times better off using one in conjunction with disciplined saving strategies. I think he does a disservice to people for not letting them know that they need a budget.

He is right on the money regarding the automatic millionaire principle. Just not budgeting. Ahh, that feels better already.

While I was in school, my main focus was to avoid debt at all costs. I didn’t want to graduate with a ball and chain. And I certainly didn’t want someone to have dibs on my money before me (Isn’t that what debt comes down to? Who gets first dibs?) I knew I would finish up my degree at 25 and 1/2 years old, and that I would have a job. (The nice thing about accounting is that you get a job when you graduate. That’s where the ‘nice’ part ends.) With that job would finally come the coveted salary.

Starting accountants don’t make a lot of money. That’s no secret. But fresh college graduates who have been miserly up to this point certainly can feel a bit of entitlement fever coming on. I’ve certainly felt it. The rationale is pretty easy: “I’ve scrimped and saved all of these years. I put myself through school. I worked the entire time. I never did anything fun. I’ve been depriving myself. I deserve [fill in want here].” Like I said before. I’m certainly guilty of it at times.

All throughout school I had read books on the side about personal finance. It’s certainly (obviously) a hobby of mine. Once this site started to pick up a little bit I naturally felt the desire and need to read more. One of the things I consistently read is that it’s better to start early with retirement investing. That’s a no-brainer. I won’t bother showing you the exponential trend line that can be yours if you begin investing at the age of seven…

But at any rate, the knowledge is there for me. I know it’s the early bird that gets the nest egg. Or however that goes.

However, with my anti-debt intensity throughout school, that was my real focus. I avoided debt 100% and snagged that degree. I really didn’t put anything away toward retirement during those college years. I just focused on avoiding that debt. I knew that 25 and 1/2 would still be early enough.

And then, we moved. To a nicer place. We now have another car. Our new social circle is used to doing things a bit more expensive than brownies and a game of cards. Other expenses have risen along with income. It’s a strange and very powerful phenomenon.

And frankly, it kind of scared me.

It scared me enough to realize that the first thing I needed to do was go to my trusty Vanguard and set up automatic deductions twice a month to fully fund the Roth IRAs. It also scared me enough to realize that I needed to make sure I was maxing out my 401(k) contribution up to the employer match (read: free money).

And now, I’m not so scared.

David Bach has this automatic millionaire bandwagon going at a pretty good clip and I’m going to jump on for the automatic ride to automatic millions.

It’s interesting to see how this panned out. For years I had been saying no to retirement savings (in a regular, big way) because I was so focused on staying out of debt during school (also a worthy goal). And then, when it came right down to the wire, where I actually had to start acting on my knowledge, it wasn’t quite as easy as I thought it would be. And I love this stuff!

YNAB fits into this equation quite easily. Each month as you sit down for your Budget Meeting, you’re going to want to make sure, first and foremost, you pay yourself. You budget that money away and never think about it again. It’s working toward your future!

I don’t believe a budget stops when you’re running your savings on autopilot though. Just because you’re obviously living within your means does not mean you aren’t missing out on opportunities to maximize your dollars by minimzing your expenses. A sound budget will help you prioritize your money to be in line with your values. So even when money is tight, you will be content because your money will be doing the things that are important to you — instead of doing things that society and advertisers tell you are important.

Bach had a great idea in writing the Automatic Millionaire. The idea to just set aside some money, out of sight out of mind, is a sound one. It will protect you from your knowledgeable self.

Living Within Your Means is More than Having Enough

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A few years ago I wrote about some of the practical aspects of living within your means. The gist of the article: if you want to successfully live within your means over the long term, you need to have some sort of system in place to record, track, monitor, and evaluate your spending. With whichever system you choose, consistency in the execution is paramount to your success.

Being a budgeting aficionado, it’s no wonder I think a system is necessary to live within your means. But today my focus is not going to be on the how, but on the why. I hope to open your eyes to a benefit of living within your means that is sometimes overshadowed by the ‘How’ of the principle. It’s a huge benefit. Perhaps infinitely huge.

Forgive the shallow talk of getting rich for the next few minutes, but that is basically going to be the benefit I’ll be talking about. We’re just going to get at it from a different angle.

No — I’m not going to talk about how living within your means enables you to invest the difference in well-selected mutual funds and how, over time, the compounding of those investments will make you a millionaire (perhaps a few times over). We’re going to talk about risk. Risk is a rich man’s best friend, and the enemy of anyone living paycheck to paycheck

Why the Rich Stay Rich (and Get Richer)
I’m sure you’ve heard it often enough. The rich are privy to secret investments, inside networks of private businesses needing equity infusions, IPOs for only the accredited, sweet real estate deals, lucrative side partnerships, yada yada, etc. and blah blah.

Some people are bitter about the opportunities that apparently present themselves to the rich, other people only envious. I don’t want to take any position here except the position that opportunities to earn more money do indeed present themselves.

Consider the well-to-do person that is presented with an opportunity to invest $10,000 in a very small, private startup company. The person could very well lose their $10,000. They could also turn that $10,000 into $200,000 in a matter of five years. The person takes the plunge, writes the check, and invests the $10,000. Do they lose sleep at night because they have $10,000 of equity in some shaky startup? Not hardly. Why? Because they can afford the risk.

Consider the person that is not living within their means. $10,000 to invest is a dream to them and nothing more. If they did have the $10,000 they certainly could not afford to risk it on something as shaky as a startup company.

However, if this second person cinched up the belt, got a budget, and gave him or herself a bit of breathing room, would a $1,000 investment in something seem so unbearable? Probably not. Could they afford a $1,000 loss if worse came to worse? Probably so.

I Can’t Afford That
A few years ago in my corporate finance class we talked about risk. Actually, we talked about it pretty much every day. The rule is that the return you require on your money invested should be equal to the risk you’re taking when you invest. While there are a few people that are risk-seekers, others risk-avoiders, the core principle is the same. Where there is low risk, there is low reward. Where there is high risk, there is high reward.

The rich can afford to take on higher-risk projects, which gives them the opportunity for higher reward. Those living above their means, with no (or even negative) disposable income, cannot afford high-risk investments. As a result, they’re immediately disqualified from high returns (we’re talking about the norm here, not the exceptions to this rule). And if you can never “afford” to invest, you’ll never be rich.

The trick is to get to that disposable income I’ve mentioned a few times. And begin investing.

While I’m not a Rich Dad, Poor Dad diehard, I did appreciate Kiyosaki’s push to begin thinking a little bit differently about money. This is one of those ways.

I’m not saying you’re going to suddenly become privy to new investment opportunities just because you now have some disposable income. What I am saying is that without disposable income, you cannot take advantage of any opportunities that may roll your way. And that would be a shame.

It’s the Famous Debt Snowball…in Reverse
Perhaps it will take a few years before something comes up in which you feel you could invest your disposable income. Perhaps you’ll keep things simple and invest purely in index funds until another erm, more flavorful, opportunity comes along. But you can rest assured that the opportunity will come.

And maybe I’ve been indoctrinated by optimistics (the class was called “Entrepreneurial Perspective” and every week a different “normal” speaker would come and tell the class how they made it big. The opportunities ranged from hair salons, to time organizers, to multi-family apartment buildings), but is there really any healthier way to be?

What will happen once you seize the opportunity to invest in a local hair salon? You’ll probably need tax advice. You’ll hire an accountant. A few years later your accountant gives you a call because he has a client that’s looking to market an invention and needs some equity partners. You’ve grown to trust your accountant, so you take a look at the opportunity. One of the other investors in this invention does a lot of residential real estate development and is wondering if you want to invest in a new duplex he’s looking to build…

Of course I’m making this up, but the principle I’m trying to illustrate is this reverse snowball effect. Opportunities beget even more opportunities and after several years of waiting, saving, evaluating, and networking, you’ll have more than you can even possibly look at.

The rich stay rich because they consistently find opportunities to invest their (large amounts of) disposable income. And I am saying that you can become rich by creating disposable income and searching for opportunities in which to invest it.

That is the benefit of living within your means. If you don’t do it, your opportunities are severely limited.

A Nugget of Investing Wisdom, Not So Much About Investing

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I like this guy, Brett Platt for two reasons: 1) his first and last name both end with a double ‘t’ and 2) he offered some rock-solid investing wisdom to readers of Kiplinger’s Personal Finance.

The article, “Ordinary investors, Extraordinary Results” highlighted six people that have done really, really well investing. They’re not billionaires, but they’ve done really well. I thought it was a pretty cool idea to feature some average Joes.

The first person featured is Brett. Kiplinger’s focused at first on his strategy, his returns, how big his nest egg is, what he focuses on, etc. It was all great reading. But the part that stuck out to me was Brett’s advice at the end:

First, cut back on luxuries so you’ll have more to invest. Next, bounce stock ideas off tough critics…Finally, make time at home to research stocks by throwing out your TV.

I liked the first part about living within your means because he didn’t just end there. He didn’t say, “live within your means because it’s the right thing to do” or “live within your means because you really don’t need all that extra stuff.” He said live within your means so you’ll have more to invest. There’s purpose behind that principle, and I like that.

I attract (and continue to try and do this even more) people to this website who are interested in learning how to budget effectively. I’ve written before about how budgeting is really your foundation to financial health. But what Brett’s short comment so aptly points out is that the budget is only the foundation.

You still need to build something.

So when you’re effectively living within your means, budgeting, telling your dollars what to do, maximizing the power of your hard-earned dollars, you need to be doing it for a reason. One reason should be investing. While the article highlights mainly stock market investing, there was one person featured who made a lot of their money in real estate. There are diverse ways to invest your money. Thomas Stanley in The Millionaire Mind makes the point that a lot of millionaires invest in what they know a lot about already. Are you a retailer? Then you’re probably a darn good investment analyst for retail stocks. Are you a realtor? Then why the heck are you not buying properties that are bargains? Your network and information is so valuable! Are you a stay-at-home Mom? What stores do you frequent and why? What products do you and your friends purchase and why? Do you patronize some businesses that have a lot of potential?

Live within your means and invest in what you know.

On to the second point. Brett tells beginning investors to throw away their TV. Been there. Done that. Never looking back.

When my wife and I first married we didn’t own a TV. We also lived in a basement apartment where the kitchen and living room were combined, and our bedroom was–small. Our rent was dirt cheap though and we were able to save money as a result. I’m sure we looked pretty destitute to some. We didn’t have a couch for the first little while either.

Some people from our church anonymously dropped off a TV, VCR, and some VHS movies one night. We were surprised by the generosity of these anonymous givers.

We kept the TV for a while and enjoyed watching BYU football during football season (though their season wasn’t much to brag about). We got used to the TV. I’d flip it on to see what was on. We’d watch programs now and again. I noticed I began watching more of it actually. I probably got up to about an hour a day. One Saturday was the straw that broke the camel’s back. I decided I’d watch The Abyss, which is a great movie, but when the network takes an already long movie and inserts tons of commercials into it, it lasts four hours. I sat in front of the TV for four hours on a beautiful Saturday!

Later that night we decided the TV had to go. We sold it to a guy and grabbed some Chinese food with the proceeds.

That was several years ago and we haven’t looked back since. I know it may appear that I’m getting off-topic a bit, but bear with me.

When we knew our first baby was on the way, I began stressing about money quite a bit. Keep in mind, we’d been using YNAB since Day One of our marriage and as a result, had saved a good amount of money. I was still stressed though. I was working a part-time job while going to school and Julie had been the breadwinner, working full-time. We both really wanted her to be able to stay home and be a mom when the baby came, so I knew her income was completely out of the question.

For several weeks I would crunch numbers different ways, trying to figure out if we could live off of savings, avoid borrowing money, and still have me working just part-time. I started throwing in variables like me working 30 hours per week instead of 20 and it wasn’t looking so bad.

Well, when you don’t have a TV around, I think you have more time to be productive. Shortly before the baby came, I decided to look into selling YNAB to make some extra money. Friends had expressed an interest in it, and I thought it might fly (for the record Julie didn’t think anyone would every buy it, boy was she wrong!).

I had more spare time than the next guy because I didn’t watch TV. Really. People watch way more TV than they think they do. That time adds up.

As a result of having that extra time I was able to learn 1) how to code macros in Excel, 2) write web pages, 3) code rudimentary PHP, 4) a bit about how search enginges work, 5) more about writing, 6) online marketing, 7) customer service, etc. The list goes on. The most satisfying thing about the whole ordeal is that I’ve been able to meet a whole bunch of new people, strike up new friendships and business relationships, and help a lot of people budget.

I’ll also be the first to tell you that I possess no extraordinary skills whatsoever. I’m your very average Joe, working toward being a Jack-of-all-trades apparently.

No, not having a TV was not the sole reason the website came into being, but I can’t just write it off either. I talk to my peers every day who are still in school, starting their first real job, etc. and they all express the same lamenting wish for more time. A quick way to give yourself more time is to sell your TV and grab some Chinese takeout.

While Brett meant to use the saved time for stock research, I see it as much more far-reaching than that. Look for places where you truly waste time and try and eliminate those from your life. Fill the wasted hours with something meaningful and productive. You just never know what will come of it.

Put your savings on automatic, advises financial journalist

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Check out the full article here

Jane Bryant Quinn spoke to the graduates of the Niagara County Community College and gave a few nuggets of great advice (and one I totally disagree with).

The gist of her speech was to keep things simple.

“You can set [things] up and get on with your life, because who wants to think about money all the time? I don’t.”

She’s talking about automatic investments here. I couldn’t agree more. I find it funny that she says she doesn’t want to think about money all the time – being the financial columnist for the Washington Post.

I have to admit though that I do feel the same way. I’m not really big on spending a lot of time with my money. I guess that’s where the whole YNAB idea came from in the first place. The trick with money is to make your life easier, not more difficult!

Keeping it simple will also most likely save you money:

“I run my money very simply,” she said. “From experience, I’ve found complicated investments only benefit brokers, insurance agents and bankers.”

This is a great point. Many (good) financial advisors will offer the same advice. If you don’t understand the investment then it’s not a good investment for you. If you can’t explain the investment to your teenager and have them understand it pretty quickly, it might not be a good investment. Keep things simple!

A now I need to take issue with Ms. Quinn’s mockery of the budgeting process :)

“I don’t do a budget,” she said. “You’re budgeting in order to get something, and if that’s savings, then the automatic savings plan [does the same thing].”

Hardly! You’re not just budgeting to “get something” you’re also budgeting to not lose things through the normal process of money leakage that happens to even the best of us.

A budget is a plan for your money, a value compass – and that plan needs to be revised on a regular (I suggest monthly) basis. Ms. Quinn admits to having a plan – she just says to have it set up automatically. I think she’s leaving the graduates lacking something important. When you’re actively budgeting, you make your money work harder. Having a laissez-faire approach to what you’re doing with your money leaves room for money leakage.

Automatic savings addresses a large portion of this because you know those dollars are doing their job, but how do you know if your grocery bill isn’t becoming pretty exorbitant, or if you couldn’t possibly get a better deal on your car insurance? It’s good to be aware of these things so you can make sure you’re maximizing your dollars.

Budgeting: Invest it and Watch it Grow (Part IV)

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This is the fourth and final part of my series on the power of budgeting. In the first article we talked about the cash flow that is freed up when you begin budgeting. The next two parts of the series addressed the first two things you can do with excess cash. You can either have fun with it, or give it. Today I’m going to finish off by talking about one of my favorite things you can do with extra money: invest it.

Investing is an absolutely enormous subject. People devote their entire lives to the study of investing. Some people are quite successful with it. Others lose their shirts. I don’t claim to be a very savvy investor and, to be honest, if I did have some way of investing that would ensure profits every time I would not share it here (unless I wanted to wave goodbye to my profits).

I want to talk about one aspect of investing that is not based on theories – but rather on hard facts and real-life experience. One of the most sure-fire ways you can retire sitting on top of a sufficiently-large golden nest egg is to invest regularly. I know – it’s boring isn’t it?

When you regularly invest, you ensure that you are investing without emotion. For instance, let’s say I set up an account with a mutual fund house (such as Vanguard, or T. Rowe Price). The emotionless way to invest is to just decide how much of the excess cash (created from budgeting) that is available should go toward your investments. You can then set up with the brokerage house exactly how you want it handled. They’ll gladly draw on your account each month and throw your money into the fun(d).

I personally prefer the idea of investments that don’t require much maintenance, or thought :). I just don’t want to be a full-time investor. And even if you were a full-time investor, your chances of doing better than the market would be pretty slim.

This ‘walk-away’ approach to investing is why I personally prefer index funds to make up the bulk of my retirement portfolio. There are index funds for just about everything now, so don’t think your options will be limited in any way. Ocassionally, I do dabble in single stocks, but only with money I can afford to lose.

A relatively new approach with index funds is to even remove the investor’s need to make annual adjustments to their holdings. (Each year you should look at your portfolio and make sure it syncs up with your risk tolerance and retirement goals). For instance, the Vanguard Target Retirement Fund Family is built on the fact that things change, time passes. For instance, I am 25 and would like to retire when I’m 65 (well, 55 really). I would choose the Vanguard Target Retirement 2045 fund. The fund automatically adjusts its portfolio each year to reflect the fact that I’m am coming closer and closer to retirement. The adjustments are to move to a more conservative approach (less equity, more bonds to state it simply).

I personally love this idea. I can invest with confidence that I’m extremely well diversified, my portfolio is adjusting automatically to reflect the ever-changing environment I live in, and the fund is extremely cheap (meaning more of my money goes toward growth than toward one-time management fees).

In no way am I endorsing this fund in particular. I’m only highlighting the characteristics that appeal to me when it comes to investing:

  1. Automatic
  2. Consistent, emotionless
  3. Cheap
  4. Diversified
  5. Low maintenance

What you’ll find is that your excess cash will just grow and grow and grow once you begin a consistent investment plan. I’m reminded of a caller I heard a while back on the Dave Ramsey show. He had a particularly vexing problem. He and his wife had been very good about budgeting and watching their money. As a result, they had a lot of excess cash that had been built up over the years – about $3 million. They were still relatively young (67 and 68). So what was the problem? Their money was growing so fast they didn’t know where to spend it or what to buy.

Gosh. What a problem.

Budget. Give. Have fun. Invest. Rinse and repeat.

Stock Market Investing for the Dummy

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I figured I’d borrow the oft-used title of books for beginners. My focus in this article is to discuss the very basics of stock market investing. We’ll pretty much go a mile wide but an inch deep.

What is a stock
A stock is a share of ownership in a company. In this article we’ll be focusing on public companies, but the same principle basically applies to private companies as well.

As a part owner (you might own one millionth of the company, or one hundredth of the company, depending on how wealthy you are), you have certain rights. One of the rights you have is to vote each year for the Board of Directors. The Board of Directors represents the shareholders’ best interest (hopefully) and holds management accountable to do those things with the company that will maximize shareholder value.

As a shareholder, or part owner, you are also entitled to dividends – profits of the company. If you own one share, and the company has 10 shares outstanding, you own ten percent of the company. If management decides to issue a dividend (distribute corporate profits to shareholders) of $1000, you will receive ten percent of that, or $100.

If the corporation carries debt, and it files for bankruptcy, the creditors are first entitled to be paid. In this way, when you own a share of a company, your investment could (hypothetically) go up infinitely, but can only go as low as zero.

While you used to actually own a stock certificate that you might keep in a bank safe deposit box, today only the information is stored. You don’t actually receive a piece of paper representing the shares of a company that you own.

How are stocks traded?
Stocks are traded on exchanges. One exchange that is very familiar is the New York Stock Exchange, or NYSE. The NASDAQ is an exchange for technology stocks. These exchanges are part of the secondary market – where buyer A purchases shares from seller A. A primary market would be where buyer A purchases shares directly from the company in an initial public offering (IPO).

Whenever a stock is sold, there is a buyer on the other end. Many times people think of selling stock as simply “cashing out” – while that may be accurate, you must rememeber that there must always be a willing buyer to take your shares at their market value.

How are stocks priced?
Stock prices change through basic supply and demand. If stock A is $10, but there is a sudden surge of demand for it, people will be willing to pay a higher price. Perhaps the increased demand brings the stock’s price to $12. On the flip side, if there is a lot of shares being sold (supply, or availability of those shares), the price will decline. Think Tickle Me Elmo. The price went up because the “market” demanded it. There was no other rational reason for it.

What a stock price really comes down to though, is what investors feel the company is worth. That is the key. The number that drives a stock price (in the long run) is its earnings, or profit. So investors can look back historically and see the earnings a company has managed to attain in the past. Using this historical knowledge, they will forecast what they think earnings will be in the future.

Forecasting earnings is more than just numbers. You must look at the type of industry the company is in, macro economics affecting that sector, the industry, and the global economy. You need to look at firm-specific items, such as a change in upper management, a new growth strategy, new products in the pipeline, etc.

Many professional analysts do just what we’ve discussed above, and issue estimates of what they believe a company will make. These estimates are given by quoting the Earnings Per Share (EPS) of the company. The EPS is simply the company’s forecasted earnings divided by the number of shares outstanding.

Basically though, nobody can really tell you the exact reason why stock prices change. People devote their entire careers toward this field – it is large and deep.

How do I Purchase a Stock?
You can purchase single stocks through any number of brokerages. These brokerage houses will charge a commission for each transaction. Some online brokerages, such as Scottrade charge only $7 per transaction. The growth of the internet as a trading medium has exhibited significant downward pressure on the costs of stock trading (and this is a good thing). Some other online brokerages you could look at would be Sharebuilder or E-Trade.

How do I know when to buy a stock and when to sell it?
There are many sophisticated mathematical models, technical analyses, strategies, omens, rituals, software packages etc. that supposedly help you buy low and sell high in the market. And there is no doubt that some people possess a special nack for it. Others lose their shirts.

Some people are big proponents of passive investing as a solid investment strategy. Others totally disagree.

It comes down to what you personally feel good about doing. I wouldn’t even think about investing in stocks unless I was:

1. Budgeting faithfully
2. Out of debt
3. Living with a fully-funded emergency fund

Hopefully this little introductory article gave you a small insight into the world of stocks. There’s a ton to know out there. Good luck on your investing!

The Difference Between a Roth IRA & Traditional IRA

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I could probably explain the difference between a Roth IRA and a traditional IRA in one sentence (don’t expect me to do that though):

With a Roth, you tax the seed. With a traditional IRA, you tax the tree:

difference between roth ira and traditional ira
All right, there you have it.

We’ll do a little number crunching to fully illustrate the difference between these two retirement vehicles. Check out the article on Roth IRA Basics if you want to get into specific rules and regulations regarding the Roth specifically. If you just want to know the difference between the Roth and traditional, stick around.

With a Roth, you contribute after-tax money. So, if I have taxable income of $50,000 and put $4,000 into my Roth, I still pay taxes on $50,000. With a traditional IRA, your contribution is pre-tax. Given the same situation of $50,000 taxable income, if you put $4,000 into your traditional IRA, you would pay taxes on $46,000 (50,000-4,000). Traditional IRA contributions are deductible. Roth contributions are not.

Let’s get an investment going:

difference betewen roth ira and traditional ira table
All right, so what can actually be invested? Well, if you can only afford to invest $4,000, then, after taxes, your Roth would be funded with $3,000. $1,000 less than your traditional IRA. That’s because the traditional IRA contribution is deductible.

“Echo to base. The seed has been planted“. Let’s say we contribute $4,000 before tax each year to our investment. We do this faithfully for 30 years. Let’s also assume we get an 8% return on our investment (after inflation) for both the Roth and traditional IRA. Here’s what our nest egg would’ve grown to given these assumptions:

difference between roth and ira
So the difference between the traditional IRA and Roth IRA nest eggs? You have another $113,283 in your traditional IRA.

Except we haven’t paid Uncle Sam

difference between roth and ira
So am I trying to tell you that it doesn’t matter? It’s all a wash in the end? Hardly. The one key assumption I haven’t talked much about is the tax rate. If you contributed starting at age 35 (start earlier!), until you were age 65, we’re talking about a 30-year spread of future history (?) there. I assumed your tax rate at 35 would be 25 percent. However, who’s to say that Uncle Sam won’t raise the tax rate to 35 percent? Or, what if you’re earning significantly more money during retirement (now wouldn’t that be sweet?), so you’re naturally in a higher tax bracket, maybe 37 percent?

What if Uncle Sam lowered the tax rate to 10%…

You get my point. The tax rate is an unknown variable. I personally choose the Roth IRA for the following reasons: I’m a college student. My tax rate is virtually zero percent. I am fully expecting my tax rate to go up in the future. Also, I sure hope I’m in the highest tax bracket when I retire; that means I’ll be making a ton of money.

The difference between the Roth IRA and traditional IRA lies in your current tax rate, and your expected tax rate upon retirement. Remember, it’s not set in stone which one you’ll use forever. You can contribute and not contribute at will, even doing both simultaneously (subject to certain limits).

1,006 more words to finalize my point.

roth and ira comparison

Roth IRA Basics: What to Know Before Opening a Roth

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The Roth IRA is arguably one of the best retirement vehicles out there. It is important that you understand the basics of a Roth IRA. This basic knowledge will go a long way in helping you figure out whether opening and funding a Roth IRA would be in your best financial interest.

It’s my goal to discuss Roth IRA basics in very clear terms, forgoing any confusing terminology (which is tough to do if you’re talking about legislation in any form, and if this legislation affects taxes in any way? Your chances are even slimmer).

Roth IRA Basic Outline:

1. What is a Roth IRA?
2. Why should I open one?
3. Who’s eligible for a Roth?
4. How do I make contributions?
5. When and how do I get distributions from my Roth IRA?

What is a Roth IRA?
A Roth IRA is a type or classification of an investment. So when someone says, “I have a Roth.” It really doesn’t tell you too much. That’s like me saying, “I have a car.” Neat-o. The more relevant question is probably, “What kind of car do you have?” Or, in retirement talk, “What assets are you holding in your Roth IRA?”

So remember, that a basic Roth IRA is simply a classification of an investment. You can hold almost anything in a Roth: mutual funds, single stocks, bonds, CDs, etc.

Now, because these investments you have are classified as a Roth (only certain institutions, such as banks, brokerage companies, or federally insured savings and loans or credit unions have approval from the IRS to offer Roth IRAs), it earns special treatment come tax time. One of the basic components of a Roth IRA is that your investment earnings grow tax-free, and are distributed to you tax-free, if the distributions are qualified.

Why should I open one?
An example will probably work wonders here:

Let’s say you contribute $1,000 after-tax income a year to your Roth IRA (below contribution limits, but just to keep it simple for now). And let’s say this $1,000 each year is invested in an S&P 500 Index fund. If you do this from age 25 to 65, at an average annual return of 10%, you will end up with $527,000. Now, remember, you contributed a total of $40,000 to your fund (40 years at $1,000 per year), so your investment grew $487,000. That whole $487,000 is tax free baby!

If you had simply invested that $1,000 in a normal mutual fund, where your earnings did not grow tax-free, and the capital gains rate remained at 20%, you would have a mere $291,000. So you can see that the Roth IRA, by being allowed to grow, and distribute its funds to you tax-free, saves you almost $200,000! That is sweet.

Who’s eligible for a Roth IRA?
You are eligible to open and/or contribute to a Roth IRA if you have taxable compensation during the year, or self-employment income (as with sole proprietors or partners). Your modified adjusted gross income (MAGI) cannot exceed certain limits however. These limits depend on your tax filing status, and are outlined below:

Filing Status MAGI Limit
Married filing jointly $160,000
Married filing separately, lived w/ spouse $100,000
Single, Head of Household, or Married filing separately, did not live w/ spouse $110,000

 

How do I make contributions?
If you’re working for an employer, basically your compensation that is eligible for contributions is anything in Box 1 of your W-2. This includes wages, salaries, commissions, and bonuses. If you’re self-employed, your eligible compensation consists of your net earnings less any contributions to retirement plans and less 50% of your self-employment tax.

There is, unfortunately, a limit to how much you can contribute to your Roth IRA each year. For the 2005 tax year, the limit is $4,000 per person. So, if you are married you could potentially contribute $8,000 in 2005 ($4,000 for you, $4,000 for your spouse). However, spousal contributions must meet the following requirements:

* The couple must be married.
* The couple must file a joint tax return.
* The person making the contribution must have eligible compensation.
* The total contribution made for both spouses cannot exceed the taxable compensation of the couple.

Rental income, and interest and dividends are not eligible for contributions.

When and how do I get distributions from my Roth IRA?
Alright, this gets a bit hairy, but it’s not really too bad. In order for a distribution to be tax and penalty free, it must be a qualified distribution. A qualified distribution must take place at least five years from the establishment of the Roth IRA and meet at least one of the following requirements:

* The IRA holder is at least 59 1/2 years old when the distribution occurs.
* A distrubtion of no more than $10,000 ($20,000 for married filing jointly) is used toward the purchase or rebuilding of a first home for the Roth holder, OR spouse, child, grandchild, parent, or ancestor of the Roth holder. This can only happen once per lifetime.
* The distribution takes place after the IRA holder is disabled.
* The assets are distributed to the spouse upon death of the IRA holder.

If an unqualified distribution is made then you will be required to pay income tax on any amount that was not an original contribution and an early-withdrawal penalty of 10%. This can be a huge hit. I strongly discourage taking any unqualified distributions. Certain exceptions apply, but for the sake of brevity (have I already lost my chance with that?) we won’t get into it.

Conclusion
As illustrated above, the Roth IRA is a powerful investment vehicle when used properly. You can potentially save yourself hundreds of thousands of dollars you might otherwise would have to hand over to Uncle Sam. I strongly encourage you to look into opening a Roth IRA so you can begin benefitting from the tax-free growth it offers.