Tuesday, September 28, 2010

Tier 4: Retirement Accounts

There are several advantages and disadvantages of a tax-advantaged accounts. The biggest advantage is that they can grow tax deferred, meaning that taxes don't have to be paid on growth until the money is withdrawn. The biggest disadvantage is that they are illiquid, meaning that once you put the money into them it better stay. Early withdrawals can mean extra tax and penalties. The biggest problem with them is that most people contribute to them before they are ready. Then, without savings and protection, unexpected events happen, and suddenly they are in debt and have to make early withdrawals from their tax-advantaged accounts and they incur those taxes and fees.

After, and only after you have the proper protection and savings, and you are out of debt, should you start contributing to retirement accounts. If you are not sure whether or not you have the proper savings or protection see Tier 1 and Tier 2. So many people contribute to their 401k, IRA or 403b plans as soon as they become available. When I got my first full-time job with benefits, I made the mistake of contributing to the 401k plan they offered. I thought it was a great deal because they matched part of what I contributed. The problem was vesting. Vesting is when you gradually earn the right to keep what your employer has contributed on your behalf. If you don't work for them long enough, and I did not, then you don't keep their contributions.

So when I left I didn't get to keep anything that they contributed. I thought, "That's ok, because I was saving for retirement. I converted my small 401k to a Roth IRA and two years later I had lost enough money and my account was so small that the investment company closed my account and sent me a check. So A couple hundred  dollars and a few years got me nothing. That is why it is so important for  you to know when and how to contribute.

Roth VS Normal

In a Roth account contributions are made with money that has already been taxed. The contributions are then allowed to grow tax free and if properly withdrawn the proceeds are tax free as well.

In a normal tax advantaged account you are allowed to make contributions with money before taxes are paid. These contributions are commonly used to defer a tax burden.

As an example a person contributing to a normal account contributes a full $1. The person contributing to a Roth account has to pay their taxes and only contributes $0.70.  If they both grow at 5% for ten years then the Normal account will have $1.63 and the Roth account will have $1.14. Upon withdrawal the Normal account has to pay a 30% ($0.49) tax burden leaving $1.14. Mathematically it doesn't matter if you pay the taxes before or after. The trick is knowing when you will pay a lower percentage of taxes. Will taxes go up or down? Will your tax bracket go up or down?

IRA VS 401k

An IRA (Individual Retirement Account) is essentially for people who do not have 401k's available to them. However, just because someone has access to a 401k does not mean they cannot contribute to an IRA. An IRA is self managed. You decide what you invest in and, you are responsible for the success of your account. However, there are income and contribution limits.

A 401k is a retirement account sponsored by an employer. There are similar types of limits on these accounts, but different amounts. Each account has different rules depending on the plan provider. Generally there are 1/2 a dozen investment options you can choose from based on your time frame. Though I cannot speak on any specific option, usually these aren't too bad (i.e. you could do worse).

Friday, September 17, 2010

Get Out of Debt

I know we hear this all the time. "Get out of debt." Sometimes I feel like we are children who's parents keep telling us the stove is hot. We still have to touch the stove and learn our lesson the hard way. Well let me sum it up for you. THERE IS NOTHING MORE FINANCIALLY DESTRUCTIVE THAN DEBT! Debt is literally captivity. Those who have debt are enslaved to their debtors. If that debt is directly or indirectly callable (the debtor and ask for payment in full) then it isn't only enslavement but it is complete control.

Types of Debt

Mortgage: There is nothing wrong with one modest home mortgage. The problem with that statement is that everyone has their own definition of modest. I grew up with two brothers and two sisters. For most of my childhood the girls had one room and the boys had another. That small one story, three bedroom house was modest and justifies. My parents never got into financial trouble while we were living in a house like that. Now is a great time to buy. The market is down, but don't be in a hurray because the market isn't going anywhere anytime fast. Buy when you are financially ready to buy. I recommend doing this after you have at least a 6 month emergency fund and no other debt.

School Loans: Education is very important, but I have seen school loans abused. Don't kid yourself, this type of debt is just as bad as any other. I remember my senior year in high school I had an Engish teacher in her mid 50's come in and tell us how excited she was because she had finally paid off her school loans. Are you kidding me!? Most people start going to college before they have any clue what they want to do for a career. A large portion of the people that graduate don't even do anything in their field of study. If school loans are the only way you can go to school then I wouldn't not tell you to stay at home, but I have respect for the man that works full time and pays for his schooling. Even greater respect for the man who works full time and goes to school full time. If you do decide to get school loans you better be living off rice and beans.

Auto Loans: Today it is almost impossible to function as a member of society without a car. Yet millions of people do it successfully. It is easier when you live in a metro area or in a warm climate. A bike is a great alternative, also walking and public transportation. If a car is necessary then try not to drive it when you don't have to.

I read a story about a man that came to the united states. He worked in a bakery owned by his brother. He also lived there with his wife and two children. He said that he didn't get an apartment because then they would have to get a car, and if they had a car they would want to go places. After working in his brothers baker for two years he had saved enough money to buy the baker and pay cash. With in a few more years he had open several other bakeries and was a millionaire.

I would never use financing to buy a car PERIOD! Despite what people think it is not a necesity and if you are still convinced it is a necessity, then you can buy a car that you can affoard. By that I mean a car that you can pay cash for. I had a friend that was getting started from scratch in a new city. He needed a car but barely had money to pay rent. He traded his T.V. for a car that wasn't worth the gas you put in it, but the car ran and it ran until he could affoard a better car. I'm proud of him for making that decision.

Credit Cards: Do I seriously need to say anything. I guess the only thing I would say is that if you have ANY credit card debt then you should be living off of rice and beans until you get them paid off. This debt is the most destructive debt and second only to the next type of debt.

Retail Credit: This is actually a similar type of debt to credit cards. The only reason why I put this below credit cards is because the credit reporting agencies do. I feel this is just as bad or worse than credit card debt, and again if you have ANY of this debt you should be living off of rice and beans.

Friday, September 3, 2010

Ten Stock-Market Myths That Just Won't Die

The Dow Jones Industrial Average last week ended up pretty much where it had been a little more than a week earlier. A rousing 200-point rally on Wednesday mostly made up for the distressing 200-point selloff of the previous Friday.
The Dow plummeted nearly 800 points a few weeks ago -- and then just as dramatically rocketed back up again. The widely watched market indicator is down 7% from where it stood in April and up 59% from where it was at its 2009 nadir.
These kinds of stomach-churning swings are testing investors' nerves once again. You may already feel shattered from the events of 2008-2009. Since the Greek debt crisis in the spring, turmoil has been back in the markets.
At times like this, your broker or financial adviser may offer words of wisdom or advice. There are standard calming phrases you will hear over and over again. But how true are they? Here are 10 that need extra scrutiny.
1 "This is a good time to invest in the stock market."
Really? Ask your broker when he warned clients that it was a bad time to invest. October 2007? February 2000? A broken watch tells the right time twice a day, but that's no reason to wear one. Or as someone once said, asking a broker if this is a good time to invest in the stock market is like asking a barber if you need a haircut. "Certainly, sir -- step this way!"
2 "Stocks on average make you about 10% a year."
Stop right there. This is based on some past history -- stretching back to the 1800s -- and it's full of holes.
About three of those percentage points were only from inflation. The other 7% may not be reliable either. The data from the 19th century are suspect; the global picture from the 20th century is complex. Experts suggest 5% may be more typical. And stocks only produce average returns if you buy them at average valuations. If you buy them when they're expensive, you do a lot worse.
3 "Our economists are forecasting..."
Hold it. Ask your broker if the firm's economist predicted the most recent recession -- and if so, when.
The record for economic forecasts is not impressive. Even into 2008 many economists were still denying that a recession was on the way. The usual shtick is to predict "a slowdown, but not a recession." That way they have an escape clause, no matter what happens. Warren Buffett once said forecasters made fortune tellers look good.
4 "Investing in the stock market lets you participate in the growth of the economy."
Tell that to the Japanese. Since 1989 their economy has grown by more than a quarter, but the stock market is down more than three quarters. Or tell that to anyone who invested in Wall Street a decade ago. And such instances aren't as rare as you've been told. In 1969, the U.S. gross domestic product was about $1 trillion, and the Dow Jones Industrial Average was at about 1000. Thirteen years later, the U.S. economy had grown to $3.3 trillion. The Dow? About 1000.
5 "If you want to earn higher returns, you have to take more risk."
This must come as a surprise to Mr. Buffett, who prefers investing in boring companies and boring industries. Over the last quarter century, the FactSet Research utilities index has even outperformed the exciting, "risky" Nasdaq Composite index. The only way to earn higher returns is to buy stocks cheap in relation to their future cash flows. As for "risk," your broker probably thinks that's "volatility," which typically just means price ups and downs. But you and your Aunt Sally know that risk is really the possibility of losing principal.
6 "The market's really cheap right now. The P/E is only about 13."
The widely quoted price/earnings (PE) ratio, which compares share prices to annual after-tax earnings, can be misleading. That's because earnings are so volatile -- they're elevated in a boom, and depressed in a bust.
Ask your broker about other valuation metrics, like the dividend yield, which looks at the dividends you get for each dollar of investment; or the cyclically adjusted PE ratio, which compares share prices to earnings over the past 10 years; or "Tobin's q," which compares share prices to the actual replacement cost of company assets. No metric is perfect, but these three have good track records. Right now all three say the stock market's pretty expensive, not cheap.
7 "You can't time the market."
This hoary old chestnut keeps the clients fully invested. Certainly it's a fool's errand to try to catch the market's twists and turns. But that doesn't mean you have to suspend judgment about overall valuations.
If you invest in shares when they're cheap compared to cash flows and assets -- typically this happens when everyone else is gloomy -- you will usually do very well.
If you invest when shares are very expensive -- such as when everyone else is absurdly bullish -- you will probably do badly.
8 "We recommend a diversified portfolio of mutual funds."
If your broker means you should diversify across things like cash, bonds, stocks, alternative strategies, commodities and precious metals, then that's good advice.
But too many brokers mean mutual funds with different names and "styles" like large-cap value, small-cap growth, midcap blend, international small-cap value, and so on. These are marketing gimmicks. There is, for example, no such thing as "midcap blend." These funds are typically 100% invested all the time, and all in stocks. In this global economy even "international" offers less diversification than it did, because everything's getting tied together.
9 "This is a stock picker's market."
What? Every market seems to be defined as a "stock picker's market," yet for most people the lion's share of investment returns -- for good or ill -- has typically come from the asset classes (see No. 8, above) they've chosen rather than the individual investments. And even if this does turn out to be a stock picker's market, what makes you think your broker is the stock picker in question?
10 "Stocks outperform over the long term."
Define the long term? If you can be down for 10 or more years, exactly how much help is that? As John Maynard Keynes, the economist, once said: "In the long run we are all dead.