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.

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.

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.

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.

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.

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!

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:

Alright, 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:

Alright, 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:

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

So am I trying to tell you that it doesn’t matter? It’s all a wash in the end? Not 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.

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:

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 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.

It’s tough to find a savings account that does a good job doubling as your emergency fund account. I think the ING Orange Savings Account fits the ticket.

My wife and I recently signed up. Previously we were using Vanguard to house a money market account. The service was great. I use Vanguard for other services still. However, as most of you know, money markets are not FDIC insured. An ING Orange Savings Account is.

In our money market account (which is a mutual fund with very stable holdings), we were getting an annual interest rate of about .67 percent. Now, with our Orange Savings Account we’re getting 2.2 percent (UPDATE: we’re now getting 4.75%). You might be thinking, “2.2 percent is still so low!” And you’re right. It isn’t a lot. But when you consider that it’s more than three times what we were getting with our money market, all of a sudden the savings account looks pretty attractive - especially in orange.

We’ve recently had quite a few “emergency” expenses, including three plane tickets, an anesthesiologist’s bill, some prescriptions, a speeding ticket (that was me), four new wheels & tires for the car, along with a new battery. This all happened during October and the first ten days of November.

I’m thankful we had a reserve. If you don’t have three to six months of expenses sitting in a safe, liquid account, it’s time you get working on it. Start with step one of the Four Steps to Cash Flow and get moving! The lasting rewards are worth the temporary sacrifice.

ING has been a very simple, efficient, alternative to what we were using before for our emergency fund. I was pleasantly surprised to find that we didn’t need to sign any papers to open an account. They have many security questions they ask you, and one of those questions is asked each time you log in (along with your customer number and PIN). These extra security measures allow the entire process to be paperless.

Your interest is accrued daily. When you log in you can see how much interest you have accrued so far for the year and for the month. I enjoy seeing money being created from virtually nothing. It’s empowering to have your money be working for you (even in a small way), rather than having it working against you.

Transferring money is pretty easy also. The Orange Savings Account you open is linked to a checking or savings account of your choice. Each time you deposit money you simply log in, click deposit, enter the amount, and the money is automatically pulled from the linked account. If you want to make a withdrawal, the process is virtually the same. It usually takes between three and four days for the withdrawn money to be deposited into your linked account.

The ING Orange Savings Account may not be right for you. However, having an emergency fund is right for everyone - even stuck in a shoebox behind the fish tank. You need to make sure you have the money set aside for a rainy day. I’ve become a recent fan of the ING Orange Savings Account and will continue to promote it unless and/or until I find something better.

Start Your Emergency Fund

It seems as though people in the money industry thrive on confusion. They enjoy knowing cool numbers that mean neat things to boring people. If the discussion of topic doesn’t involve a 1040, 401k, or 403b it involves a SEP, Roth IRA, or HSA.

I won’t go into each of these today. But we should really take some time to talk about the basics of a 401k.

Planning for retirement is crucial. The time-value of money principle has proven itself time and time again. You have to begin saving for retirement as soon as possible. However, you must make sure your financial situation allows it. If you have done the following four things then you are ready to begin investing for retirement:

1. Stop living paycheck to paycheck.
2. Begin budgeting your money and sticking to it.
3. Get out of debt except for your home.
4. Save three to six months’ expenses in a liquid account (I recommend ING DIRECT).

Once you have these four steps down, you can begin thinking about retirement.

I admire the fact that some people want to begin investing for retirement early, but if you have debt, that is probably not the wisest financial decision. For example, suppose you have a $3,000 balance on your credit cards with an interest rate of 9%. You’re anxious to begin putting some money away so you start a retirement fund that could potentially earn 10% per year. If you would simply pay off your credit card balance you would, in effect, be making a guaranteed return of 9%! Make sure you have completed the first four steps mentioned above before you begin worrying about retirement (an exception might apply if you have massive student loans, i.e. they’re the size of a mortgage).

On to the 401k basics. Once you begin investing for retirement, you should first look to your company’s basic 401k plan if there is an employer match involved. The reasoning behind this is pretty straightforward. If you work for a company that matches 2 for 1 then that would mean that for every $1 you invest into your 401k, your employer invests $.50. This is subject to IRS limits that we’ll talk about a bit later. This is essentially free money. To not be contributing to an employer-matched 401k is like flushing money down the toilet. Holding all other things constant, if your employer matches your donation 2 for 1 then you are making a return of 50% on your investment. That’s not too shabby partner.

In general, payments are auto-deducted from your paycheck. This is advantageous to many people who lack the discipline to not spend that money as soon as it touches their hands. It’s also pretty darn convenient - one less thing you have to worry about doing each time you’re paid.

Your 401k contribution, along with your employer’s matching contribution, will usually be invested in some type of a mutual fund. Some companies allow you to invest in company stock - even at a discount. My heart aches for those Enron employees who lost all of their retirement savings when Enron collapsed. Please, please don’t put all of your eggs in one basket. Diversify.

Diversification is accomplished quite easily with a mutual fund. Generally with a 401k plan you’ll be given several fund choices. I am partial to index funds for their ease of administration and low expenses. In the long run, with an index fund you will out-perform 2/3 of investors. You will of course, under-perform against the other 1/3. For a more in depth explanation of this concept, take a look at this article. Make sure to choose a fund with a risk profile you feel comfortable with. If your allocation doesn’t allow you to sleep at night then it’s probably not worth it to you. Understand what you’re investing in and keep it simple.

The tax implications of a 401k are powerful and in your favor as long as you play your cards right. Generally, contributions to your 401k are made pre-tax, which saves you the amount contributed times your tax rate. For example, suppose you have an income of $100,000 without contributing to your 401k. If you contribute $10,000, then your taxable income will now be just $90,000. If you were taxed in the 30% bracket without having made the contribution, you would owe $30,000 in taxes. If you make the contribution however, you would only pay $27,000. You save $3,000 in taxes for contributing to your own retirement!

Another tax advantage to the 401k is that all of your earnings from your investment are tax deferred. Let’s do another hypothetical. Suppose you invest $10,000 just one time into your 401k and then sit on it for 40 years. After 40 years you withdraw the money and pay taxes on the entire amount. You would end up with $316,815. What if you just invested into a mutual fund that had no tax advantages? You would have $149,755. Less than half! The 401k is a powerful vehicle to minimize your tax bill while maximizing your return on investment.

Be warned: the 401k is there for retirement. The IRS imposes a 10% early withdrawal penalty if you’re under age 59 1/2 which can be absolutely devastating to your growing nest egg. Avoid withdrawing your 401k at all costs. If you have followed the steps outlined at the beginning of this article, the chance of you needing to borrow against your 401k balance is very, very slim.

There are limits to how much you can invest in your 401k. In 2004 the IRS has capped the contribution limit to $13,000. Current law provides for growth of the annual contribution limit to match cost-of-living increases. Currently the contribution limits are set to increase by $1,000 each year until 2006, where it will be $15,000.

If you change jobs, start your own business, or are laid off, there are a few options available to you regarding your 401k:

1. Take a cash disbursement. This is the absolute worst choice. Your employer is required by law to withhold 20% of the disbursement amount to pay your taxes, and if you are under 59 1/2 years of age then you will also be assessed a 10% early withdrawal penalty. Something else to keep in mind is that your tax liability for the disbursement may be greater than 20%, which would leave you with taxes to pay that you may not have anticipated.
2. Leave the investment with your employer. This choice is much better than the first. If you choose to leave it with an employer it continues to grow tax-deferred. You would most likely end up opening another 401k at your new employer and begin contributing to that. Switching between jobs can cause quite a bit of confusion with your retirement funds however. Many people find it hard to manage funds when they are spread in many different places, which may lead to sub-optimal investment performance.
3. Transfer your 401k to your new employer. This is a solid choice. You end up having your investment under one adminstrator, which makes it easier to manage and monitor. Not every employer allows you to do this, which might make the last option your best choice.
4. Rollover the 401k to an IRA. This option is a great choice for a couple different reasons. First, you can always rollover and don’t have to worry about whether your employer accepts transferred 401k plans. Second, a traditional IRA offers all of the tax advantages of a 401k plus increased flexibility. You can invest in almost anything you want with an IRA, while a 401k’s choices are limited by the employer plan options (usually 10-15 different funds).

One other important term you might want to be familiar with is vesting. Most companies have certain requirements regarding when the contribution they make on your behalf actually becomes your money. Usually you have to work a certain number of years before the employer contributions are vested. Being vested simply means that those funds now belong to you and you can do with them as you please. If your company’s vesting requirement is 3 years, and they’ve matched your contributions at all, it would be a good idea to stick it out if you’re thinking of quitting with 2 years and 8 months left. You could be leaving a lot of money on the table! Not only would you be letting go of the amount contributed, you’d also be letting go of any capital gains attributed to that amount and any future capital gains that amount would have earned for you.

If you’re over the age of 50 and need to move quickly in planning for retirement then the 401k is still a great vehicle. Current legislation allows anyone 50 years of age or older to contribute an additional $3,000 in 2004, $4,000 in 2005, and $5,000 in 2006. Many plans offer these catch-up contributions, but check with your employer first to make sure.

The 401k is there for your use. It’s a powerful, tax-advantaged tool when used correctly and should belong in your arsenal of retirement savings weapons. Hopefully this basic 401k discussion has helped you. Use it wisely.