Is Your Plan in need of a Stress Test?

Baby Boomers may be acquainted with stress test and treadmills. But the importance of testing your retirement plan under certain types of stress is just as important as trying to figure out how well your heart is pumping.

The term stress test brings the fear of the unknown to otherwise stable events in our lives. The term became part of the vernacular of the financial system when the Secretary Treasurer  Andrew Geithner began asking how well the banking system would hold up under certain conditions. He knew that there were problems in how well a bank would withstand a crisis but until they tested for it, few people knew it as much more than a gimmick. Turns out, the nineteen banks that were tested, eleven failed.

Now stress testing adds its own stress. In part because we are all optimists at heart, seeing the future as brighter than it is and always believing that somehow we will survive whatever life throws our way. Even the off-handed question: "what's the worse that could happen?" never really attempts to answer the query, simply make you consider that something wrong might occur. And when it does occur, we simply suggest that we didn't see it coming.

In the world of personal finance, asking what's the worst that could happen is not the same as asking: "will I be able to afford this?" or "have I saved enough for retirement?" The worse-that-can-happen actually imagines the worst. It doesn't make plans for the worst based on optimistic scenarios. It plans for the downside and readjusts the outlook from just-in-case to what-now?

We're not conditioned to think like that. So I thought I'd give you some scenarios you think so brightly about and throw a little water on them. First: your budget. You lie about this too often. You project into the future (I'll be receiving a bonus or a raise next month) and spend money as if you had it. Otherwise you would even pull your credit card from your wallet. it is borrowed money that projects your optimistic ability to pay the money back at the end of the month. There are few of us out there who prudently deduct this cash from your available cash balances; but their number is small.

To stress test your budget you will need to know exactly how much meeting the so-called ends actually is. Not adding in the incidental items that can be canceled in the event of an extreme financial emergency (cable, internet, cell phones all of which are still luxuries even though we identify them as necessities), how much is your survival costs: housing, food, fuel, utilities?

A stress test would ask if you have accumulated enough in reserve to pay those basic necessities in the event of an emergency. How long could you pay for these necessary items based on what you have in your emergency accounts? My guess is not long. But once you identify this problem, you have to solve it - which is why many of us fail to do this sort of test. It adds stress. To realign this budget problem you can do three basic things: put $25 a way each week for emergencies (a cookie jar is just fine and you'd probably be surprised at how much loose change you can accumulate over time), stop spending someone else's money (try to get through a month, perhaps two without using a credit card - yes you will have to think more about each purchase) and debate the worth of every purchase (remember, just because something is on sale or looks inexpensive doesn't make it something you need.)

Another optimistic project that needs to be stress tested is your retirement. I suggest based on what I know and what I research, that most of us are not in a good position to retire anytime soon. But even these folks who acknowledge their financial shortfall are still looking at the big picture through rose colored glasses. We project investment earnings (without any real basis for these conclusions). We often think our portfolios will return 5-7% even as we switch from aggressive investments in our youth to conservative investments as we near retirement, which even a math challenged person will see as a falsehood. You can't protect money and still earn better than historic returns.

We base inflation numbers on what we know. We think of taxes based on what we currently pay. And we calculate our withdrawal based on what we think we'd like to live on. These aren't stress tests; they're optimistic projections. Stress tests give us a worse case scenario. You can also do three things here as well: contribute more, use both a before tax and after tax retirement plan (such as a 401(k) and a Roth IRA) and lastly, imagine life on half the income you currently earn.

Paul Petillo is the managing editor of Target2025.com and BlueCollarDollar.com

Using Mutual Funds in 2011 for Investment Success

Everyone wants investment success. And everyone has the tools at their disposal to do so. If that is the case, why aren't our retirement plans doing far better than they are?

You have mutual funds if you have a 401(k). Individual Retirement Accounts (IRAs)hold mutual funds as the primary investment and despite their use throughout the world of investment and retirement planning, too few people have a positive attitude about what this tool can do for them. Most of the negative propaganda comes in spite of the ease of use, often lower expenses than any other investment tool, accessibility, better transparency (or well on the way to providing better insight) and often, tax efficiency. Some do this with great effort; others revamp their portfolio only when an index is restructured.

So what are mutual funds and how can they improve your life in 2011? There are only two types: actively managed or those indexed to a specific grouping of investments. From there, it gets complicated but getting from there is where the whole traffic jam of ideas begins. It makes no matter, which school of thought you ascribe to if you do at all: everyone needs and actively managed group of mutual funds and a passive group if you expect to do anything worthwhile in 2011.

In the coming year, one which is predicted to be quite good despite my doubts, which I will put forth in couple of days with my year-end look at 2011, diversity will deliver more than simply chasing one ideology of the other. The "indexers believe that these sorts of funds are all you need to succeed in any year. Offset by relatively low costs, these funds make up for hoping that that through diversity they can achieve better than average returns for those who invest in them.

As a group, index investors are a fervent bunch. They espouse this investment as the be-all-to-end-all tool and in doing so, give those who chose the other camp - the actively invested mutual fund - to wonder if they may be right. There are reams of research that indexers point to as the reason why they believe this approach. But passively sitting back and letting the market determine your investment outcome is not for everyone.

Actively managed mutual funds are structured in the same way as index funds: a portfolio of investments (stocks, bonds or both), a manager (be it one, more than one or a computer), disclosure and regulatory rules that they must abide by, and performing as billed, if not better. The difference in who picks what is in the fund. Index funds are determined by an index published by such notables as Standard and Poors or Russell or Wilshire. Actively managed funds contain investments picked by management.

Both bring like-minded investors together to pool their money and in doing so, offset the risk and cost of having to build a similar portfolio on your own. Actively managed funds try and outperform their index counterparts in large part because it is these indexes, right or wrong, in which their performance is gauged and graded. If they do better than an index, investors notice, add their money and create increased opportunities for the fund manager to increase those returns with additional acquisitions.

It doesn't always work and some comparisons are unjust (how can you compare a fund with fewer than 100 holdings to one where 500 are held?) and do not paint a true picture of performance. But in tandem, they might work for different reasons for everyone interested in a more profitable 2011.

In times of turmoil, everyone feels pain. When the whole of the marketplace dropped precipitously in 2008, no investor escaped. Some were damaged more than others but as a group, we all felt pain in some form almost at the same time. Investors who simply plowed money into a 401(k) or loaded up on their own company's stock and thought that investing was a world of do-no-wrong, were given a rude awakening. Those that traded actively on their own and were beginning to feel some invincibility creep into their results were caught unaware as well.

And in the past year, investors in US stock funds did what they had done in the previous three, withdrew more than they invested, Called outflows, they impact mutual funds harder than the selling of shares from your own portfolio. These outflowing funds are produced with the sales of a portion of the portfolio. And every such move impacts the remaining shareholders in the mutual fund.

Inflows, or your money pouring into a mutual fund comes automatically in a 401(k), through deductions into an IRA and self-deposited by individual investors. Yet only a handful of people I speak with everyday likes the idea of a mutual fund as an investment and if last year was any indication, think fund focused on the US stock market alone is not the path to financial success.

Why? We want simple things to work extraordinarily well. Nothing does but we expect it of mutual funds. We want low fees, we want moderate risk and we want to know that our money is safe from market interruptions and taxes. And at the same time, we want growth, to retire early and to have our investments perform without hiccup for decades. Only mutual funds can do this - even if we dislike the idea.

Low fees, moderate risk, safety and tax efficiency is a tall order with three of the four fitting the index fund bill. Safety is subjective and safer, even more so. But no equity index fund alone can do this. No bond index fund alone can do it either. Target date funds, hybrids of other equity and bond funds (and often a basket of such funds from the fund family) promise all of the above but have yet to prove they can deliver.

Yet three out of four isn't bad. Put this type of fund in a Roth IRA and put as much as you can in it, consistently over 2011 and you will do as well as this year has done (which looks to be two back-to-back years of double digit gains for the S&P500 index). Even if you do half as well as the 20% plus gain in 2009, you'll be way ahead of where you'd be otherwise.

In the other group, looking for growth, outsized returns and freedom from hiccups, look to your 401(k) where your employer may be retuning to offering a match in 2011. If they do, this is not so much free money as hedged money. A 6% match added to your 6% contribution gives you a lot more room to assume risk that you probably are. Retiring early is a dream even as we acquiesce to work longer. But it can be closer to a reality if two things happen: you invest more and use actively managed funds in your 401(k) to get there and the market corrects a little in the first half of the year. This means buying more for less and positioning yourself for a good 2011. Not 2010, but close.

Whatever your outlook for 2011, a tandem approach to investing - using index funds and actively managed mutual funds might be the best approach in the next year. Be cautious of only two things: this isn't advise and be careful you don't over-expose yourself in any one sector.

Next up, my predictions for 2011.

Paul Petillo is the managing editor of BlueCollarDollar.com/Target2025.co

Is it Management or Retirement Planning?

It seems you can't pick up a paper, read about it online or see on television these days without the conversation turning to the dire straights the economy is in. This gives us cause to worry because we know all too well what it's like to be close to retirement. But I have always been concerned with the phrase. Just saying it make the whole process seem like a carrot on a stick, always within sight; never quite reachable. Why does it have to be like that? is I there perhaps a better way to planning for retirement? Possibly the key is in the management.

From the minute you put your first dollar to work for you in 410(k) or an IRA, you were close to retirement. Age suggested you were closer but we soon learned that it wasn't so much a date on a calendar that determined the retirement scenario. It was the date plus the money you had invested.

Unfortunately, this is sort of backwards. The approach can be forgiven in part because we are constantly exposed to planning as the key to getting from that first dollar to that toes-in-the-sand-drink-in-your-hand place called retirement. Planning offers us some solace that we are doing something. What we find out too late is that "something" in more prone to failure than we had previously anticipated. So we back-off, give-up, resign ourselves, or worse, make the same mistakes again.

Why would we, knowing what failure tastes like continue to make the same mistakes? We are groomed to do what we have always thought was the right thing to do: plan. Fredrich Hayek, the Nobel prize winning economists suggested that you can't possibly know everything at once - there is simply too much data and it is happening too fast. Trying to collect in one place to make a decision is only asking for trouble. There is an African proverb that suggests only a fool test the water's depth with both feet. So why do we think we can jump into retirement using only one tool?

We are conditioned in our business dealings to think that we can control various aspects of the world around us, bending it to our will. But these are simply reactions to what has already passed. And that further conditions us to accept failing as long as, according to Francois Gadenne, CFA, who is the current co-founder, chairman and executive director of the Retirement Income Industry Association in Boston: "To succeed we must fail, early and often -- and cheaply."

Writing in a recent edition of AdvisorOne, Mr. Gadenne sought to reverse the planning of retirement by suggesting that it should be a management of funds. By building what he calls a funded floor, you are essentially unable to make big bets about an uncertain future. He blames the current state of retirement on the idea of central planning. Central planning becomes rationale on top of failed rationale and that is not based on what could happen but rather who is in charge when it did.

He writes: "Retirement income advisory processes should work like market prices rather than like central planning because, once we move beyond didactic examples, central planning cannot be smart enough or large enough or coercive enough to overcome the knowledge problem in the real world." In some ways, he seems to be deflecting the blame, something we are very comfortable doing when it comes to our money. Planners should merely advise and review that advice annually.

This seems to give advisors some distance between what you are doing and what you should be doing it. That chasm can become incredibly wide and because you are mostly conditioned to react to after-the-fact events, it is now you, not those who advise you, who are responsible for your failure to manage while trying to make a plan succeed.

Because retirement planning - or management - is often so far away and the people involved in the earliest stages of this process have probably drifted away, it is a wholly "you" process. You bring the mistakes that you have been conditioned to bring. When things get risky and when the risk costs too much, you take fewer of them because you know that they are less expensive. And because the retirement pundits also suggest that the earlier you start, the better opportunity you have to weather the downturns that await us, we accept them, regret them and learn to move on. And often repeat them.

Paul Petillo is the managing editor of BlueCollarDollar.com/Target2025.com

Another Retirement Survey

Many of you may not be aware of the Unretirement Index published by SunLife Financial. Based on a phone survey of over 1200 households, this wonder of a poll offered most of us a peek into the world of retirement that, unless you were living under a rock for the last couple of years, comes as no surprise.

What retirement boils down to, based on this survey and my own taking of the online version: one, what retirement was previously though of as, will change, two, we never gave retirement a serious thought until we found out we didn't really focus on it, and three, if you have a pension or as it is known in the financial business as a defined benefit plan (rather than 401(k) or IRA), you are much more likely to think of retirement in terms of what it used to be rather than what it has morphed into of late.

The SunLife Unretirement Index does not paint a very pretty picture of the concept of retirement. It goes so far as to report that for the vast majority of us, the concept of retirement means working longer to recoup investment losses, never stopping working in some way, or simply working as long as we can to achieve a state of living well. If you read the report, you will think that there is no difference between living well and living within your means.

We still have a preconceived notion of what retirement should be. We think of it as the old, production era idea of retirement as simply having toiled as a laborer until you were physically unable to continue. Without some retirement in place for this group of workers, the country would have spiraled quickly into poverty. Now, pensions do still exists and in many cases, for just this sort of worker. At not surprisingly, it is this group of workers that tend to respond favorably to their retirement outlook.

But the workplace dynamic has changed from industrial to service and with it, the belief that pensions are a way of rewarding the worker. Once the IRA or 401(k) became the commonplace, which has taken about two decades, the worker was given the tools to invest and it was widely believed, that was all that was needed. And many did.

But just having hammer doesn't make you a builder and more than half of us simply did not heed the call, buy the sell of these plans or were otherwise restricted by long vesting period, unattractive investment choices or low incentives. Did I mention that we didn't get it either?

If we had we would have been among the elite ranks of the investor class, the group that has few members and even fewer winners. Expecting the average person to grasp the nuances of the stock market, the convoluted thinking of fixed income, or the ability to balance the two in the right proportions as we aged turned out exactly as most would have predicted it would - had they been able to foresee a downturn: badly. We either assumed too much risk or we didn't assume any.

We either invested or we didn't invest enough, if at all. So where does that leave us?

There are basically three consideration in retirement: the ability to meet the basic needs to survive, the cost of health care, and defining quality of life. Most of us can't understand the cost of the basic needs to survive. We think of this in terms of what we have now instead of against what we absolutely need in terms of income flow to keep what we have now. That is simply skewed financial thinking. If you were to retire today, and were expected to live only another twenty years or so, on an income that was 40% smaller than your current one, could you do it without making some changes? Of course you couldn't.

But most respondents to these surveys believe that nothing should change. You should be able to keep your home (even if it will eventually be too big, too costly for upkeep and perhaps taxed right out of the reach of even a working family with growing income potential). This group also believes that restricting how much you consume will negatively affect that quality of life and among those restrictions are less debt, fewer toys and what some may see as an otherwise boring post-work life.

While a great many of the respondents suggested mental activity as reason to remain working, this is only part of the reason. The real reasons are the financial implications of retiring after having not given it much if any of a consideration. Some jobs are rewarding. But no job comes without performance stress and if this is the sort of mental activity they believe will keep them young, they should think again.

Marcelle Pick, OBGYN NP in Portland Maine recently wrote that "The World Health Organization estimates that by the year 2020, psychological and stress-related disorders will be the second leading cause of disabilities in the world." This sort of flies in the face of "we will all live longer, happier and healthier lives" and points to "shorter, stressful and ultimately less robust lives".

Back in the day, the benchmark for financial health, the one the bank often used during the mortgage process was 60/40, obligations to unencumbered income. This is the template we should all be using for retirement. It is a bit more complicated than that but like all templates, it focuses on what you need to get by.

Those who are older than 50 can count on most of the current support programs such as Social Security and Medicare being in place. This time frame also provides you with some time frame in which to hunker down so to speak, and save more, spend less and begin to experience the 60/40 lifestyle.

Those in their 40's can expect some of the social support programs to still be in existence but not as they were for the retirees a decade before you. But on the flip side, you will have a full decade longer to begin financing your 60/40 lifestyle. What retirement will look like in 20 to 25 years is anyone's guess. But if you assume the worst and plan for it, you should be at least cautiously optimistic about where you will be.

Those in their 30's or younger should never forget the look on your parent's faces post-2008. No one can say with any certainty what your retirement will look like or whether such a concept will even exist. One thing does remain constant, even in these seemingly inconsistent times: the longer you have to prepare, the better your financial outlook will be.

If you would like to take the SunLife Unretirement survey, something I did and they suggested that I was a cautiously optimistic, which seemed to be an odd conclusion considering you either are or you aren't. Click here unless you already know who you are and what you have to do.

Paul Petillo is the Managing Editor of Target2025.com/BlueCollarDollar.com

Retirement Planning for the Next Generation

Most of us are barely able to accumulate enough wealth for own retirement let alone thinking about providing for generations far removed from the event.  But if you could, would you?

The assumptions you make about how much money you will need in retirement are probably the most difficult exercise in the whole of retirement planning. The unknowns are so numerous that simply thinking too much about it gives many people the incentive to simply ignore the question. Taxes and inflation play a role in how much money we will need along with the condition of our health, our portfolios and our living arrangements. Who could possibly guess with any accuracy what those costs will be?

Yet, some of us can with certain investments. If you can wait until you are 70 1/2 years-old to begin taking your distributions from an IRA, and you take only the minimum amount needed, you may be in a position to make that IRA last much longer, across generations. Called a Stretch IRA, the sort of planning can create untold wealth for a child or grandchild.

More on the Stretch IRA from Paul Petillo, managing editor of Target 2025.com

Roth IRA and Taxes

Putnam recently surveyed clients about this and found that investors who could pay the taxes on their tax-deferred accounts now, at their current tax rate, are not flocking to this retirement product the way they assumed they would.  The Putnam Investments LLC survey was focused on the higher tax bracket IRA owners who could take advantage of the window of opportunity that would allow them to spread their tax liability over 2011 and 2012 making their future tax obligation disappear.

According to Christine Fahlund, senior financial planner for Baltimore-based T. Rowe Price Group Inc. the fear of the government lifting the tax-free status of these plans would leave the higher income earners – the IRS lifted the income restrictions which had previously been at $100,000 – in jeopardy.  She said in a recent Bloomberg article: “If that happened, you would have accelerated your tax payments unnecessarily.”

More here on Roth IRAs and Taxes

Doing it Yourself: A Retirement Plan You Control

Today we are going to tackle the self-directed IRA. We all know what an Individual Retirement Account or IRA is. Briefly, it is the retirement tool for those of us who may not have access to a 401(k) that defers taxes for retirement. The deferring part is not really as complicated as it seems. In a 401(k), you have your contribution taken out before you pay taxes; in an IRA, you pay with after-tax money and then take the deduction when you file, basically subtracting the taxes from your contribution to be paid later.


How is a regular IRA different than a self-directed IRA?
The differences are not as obvious as the title of these products sounds. An IRA is an investment chosen by you and you direct the funds to it for your retirement. It seems like this should be called self-directed but in reality, it is very different from what the IRS views as a self-directed IRA.

In a self-directed IRA, you become the manager of the whole process. Rather than simply sending money to a mutual, fund company, the most common sponsors of IRAs, you direct the underlying investments. In the previous example, the institution is the middleman. In a self-directed IRA, the institution, whomever or whatever one you chose, does what you tell them to do.

While it might seem complicated and finding good help at a reasonable cost is not that easy, the rules are relatively straightforward. Following to the letter is something you have assumed was done for you in the past; not it is up to you.


Find a Trustee for your Self-Directed IRA
A person looking to open a self-directed IRA is in the same position as someone who is opening a Solo 401(k), which we discussed a couple months ago in our retirement planning for small business owners. You need to find a company that will open the self-directed IRA and act as a Trustee, essentially doing whatever you tell them to do. Then you sign broker-to-broker papers and you are done.

Keep in mind, that if you have a Solo 401(k) for self-employed investors, this process was already completed. If you have what is known as Customized Business Pension, you are also ready to take the next step. Sometimes, a self-directed IRA is referred to as checkbook IRA and the rules may require you to open an LLC or limited liability company. Either of these plans removes the custodian and that makes the investment possibilities immediate and up-to-you.

This is relatively easy and worth the effort. But you do have to be careful. Be sure that whatever the self-directed IRA profits from is paid to the trust and not to you directly. This will be the same as a distribution before they are done without penalty. This means that any gains in the IRA will be tax-deferred. So what you are doing is making your money work harder for you now than it might have been in the past.

You can invest it virtually anywhere: a franchise, rental property, annuities, you name it. You are in charge. The only two things you cannot invest in are life insurance and collectibles.


The Rules
There are few rules to follow when choosing your investments. One, you can’t invest in yourself or the spouse of the IRA owner. For that matter, the Internal Revenue Code or IRC prohibits you from investing with any of your lineal descendants and ascendants. This also includes an entity with combined ownership greater than 50% by a disqualified person(s), a 10% owner, officer, director or highly compensated employee of such entity or a fiduciary of the IRA or person providing services to the IRA.

You can’t sell your assets to the IRA either. You can’t use it to loan money to your kids or pay yourself fees for the work you have done. And you can’t use it to buy the home you live in now.


Opportunities for the Post-Recession World
This types of retirement plans opens a whole slew of possibilities for someone who as an IRA or possibly has been rolled over into one because of a job loss. There are some hard fast rules, which you can check last week’s show link to hear about, but done right, this can create outsized gains your plan may not have created otherwise.
First off, I want to caution you. Not so much about following the rules, but understanding right away, that every investment involves risk and investing in real estate can involve quite a lot of it.

The money in this IRA can be used to buy anything from Single family and multi-unit homes, apartment buildings, co-ops, condominiums, commercial property or land, improved or unimproved, leveraged or not.

The goal here is to find income producing property and have it pay your IRA. Whether you buy the property outright or finance it, the IRA owns the asset, not you.


Can You Finance this sort of loan with your IRA?
Because the IRA owns the property and the property’s value is the collateral for the loan, the only thing you have to figure out is how to pay off the loan. If the property is producing income, it pays the IRA which in turn pays the mortgage holder. Sometimes you can use other assets in the IRA or permissible contributions can be made. This is what is known as a non-recourse loan because you cannot extend credit to your own IRA.

The whole transaction needs to flow through the IRA as if it were separate from you, which it sort of is.
The cost is broken down into two categories. Management fees that the custodian charges. Not all firms who manage retirement accounts can so your choices are limited. I’ve included a few links to begin your research but by no means are these companies recommended. This is relatively small, niche market with only about 2% of the almost $4 trillion invested in IRAs under management.

And the cost of property management, taxes, and repairs is another fee the IRA must pay. With any luck, the property will be able to cover these costs with the rental or lease payments.


Some might say “buyer beware”.
Whenever you have such a small marketplace, oversight is not always done the same way it is done among bigger segments of the investment world. I expect that this particular segment of the world will begin to grow rapidly as folks realize that their old job isn’t coming back, their unemployment insurance is about to run out and they haven’t borrowed from their IRA – so far.

Another reason you should be careful is more about what you know. Buying real estate with your retirement money is actually done best by folks who have some prior knowledge about what they are getting into. Perhaps they were involved in the business before. That doesn’t mean it can’t be done, but the more you bring to the game, the better your chances of winning.

You might also look into a franchise with this money. You can also buy debt. Your IRA can become a lender of sorts buying notes on cars, Treasury bills, even lending money to companies looking to raise capital. Always wanted to invest in a hedge fund, with a self-directed IRA, it can invest. Want to invest in precious metals, foreign stock or partnerships and/or joint ventures; your IRA can do this as well.


A couple of simple pieces of adviceObviously there is the risk factor, which makes this not the be-all-to-end-all for all investors. But if you know what you are investing in and the pitfalls of that investment, you can calculate the costs in advance, this can be like heaven-sent. If you are looking at real estate, the potential is there for people who have the money to pursue some amazing bargains. 

Paul Petillo is the Managing Editor of Target2025.com

How Much Control over Your Retirement Plan Do You Have?

Today we are going to tackle the self-directed IRA. We all know what an Individual Retirement Account or IRA is. Briefly, it is the retirement tool for those of us who may not have access to a 401(k) that defers taxes for retirement. The deferring part is not really as complicated as it seems. In a 401(k), you have your contribution taken out before you pay taxes; in an IRA, you pay with after-tax money and then take the deduction when you file, basically subtracting the taxes from your contribution to be paid later.

How is a regular IRA different than a self-directed IRA?
The differences are not as obvious as the title of these products sounds. An IRA is an investment chosen by you and you direct the funds to it for your retirement. It seems like this should be called self-directed but in reality, it is very different from what the IRS views as a self-directed IRA.

In a self-directed IRA, you become the manager of the whole process. Rather than simply sending money to a mutual, fund company, the most common sponsors of IRAs, you direct the underlying investments. In the previous example, the institution is the middleman. In a self-directed IRA, the institution, whomever or whatever one you chose, does what you tell them to do.

Learn more about self-directed IRAs.

Catch our daily column: Repercussions, a Retirement Review

The Roth Debate

You don't know what your taxes will be when your retire.  You don't really know whether your retirement expenses will exceed your projections or not.  In fact, your retirement picture might just be a little on the hazy side of things.  So how do you make the decision of whether to use a Roth 401(k) or the traditional 401(k)?

This can be easier than you think.  More...

When the 401k is Not an Option

Some of us may be entering a new job that does not have a 401k or has one that you do not feel is as good as the one you just left. And your employer won't let you keep your money where it was. What to do?

Rolling your 401k into an IRA is another matter. This is for the investor who has some concept of what lies before them. If I were to guess, this type of investor has had an active roll in how their former employer's 401k was allocated. They paid close attention to diversity, perhaps even following conventional wisdom of limiting risk as they aged.

For this retirement investor, the IRA rollover is viable option. It allows closer control of how this money is invested with a variety of considerations weighed with each decision. Not only will this investor spread their allocation over a number of funds, they will do so with an eye on fees and expenses, a consideration of performance of the fund under both good and adverse conditions, and clearheaded understanding of the risks involved.

IRAs cannot be borrowed against and restrict a penalty-free withdrawal of money before 59 1/2 years old. But the choices are the primary attraction. This investor knows, and you should as well, the risks of building a successful IRA portfolio also increase. The biggest concern is investments that crossover.

What 401k plans are supposed to do is provide the investor with a fiduciary responsibility to provide the right tools for their employees. You, as an IRA investor are on your own.

You must monitor the funds you invested in for a change in investment strategy, style drift (when a fund manager invests on the edges of what s/he was hired to do; such as when they invest in large-caps when mid-caps are the focus), and an increase in turnover (a cost for trading repeatedly that the shareholder pays for directly, often done in an attempt to boost returns in the short-term, like at the quarter's end). You bear the burden of this responsibility to your future.

The terms of disbursement are spelled out when you leave the job in the 402(f) notice. This explains your options for handling a 401k disbursement. Even if you want to stay, your old employer really doesn't want the continued burden.

Bottom Line: Once you receive that 402(f), begin to research your options. And even if you think that money will come in handy, never take the cash.

Paul Petillo is the Managing Editor of Target2025.com

What to do with a 401k from an Old Job?

Some of us may be entering a new job that does not have a 401k or has one that you do not feel is as good as the one you just left. And your employer won't let you keep your money where it was. What to do?

Rolling your 401k into an IRA is different that moving it to a new employer's 401k. In fact, it is wholly another matter. Given the option, keep the money in a 401k. But some of you will want to venture forth on your own even if your employer has a plan in place you could have used.

This is for the investor who has some concept of what lies before them. If I were to guess, this type of investor has had an active roll in how their former employer's 401k was allocated. They paid close attention to diversity, perhaps even following conventional wisdom of limiting risk as they aged.

For this retirement investor, the IRA rollover is viable option. It allows closer control of how this money is invested with a variety of considerations weighed with each decision. Not only will this investor spread their allocation over a number of funds, they will do so with an eye on fees and expenses, a consideration of performance of the fund under both good and adverse conditions, and clearheaded understanding of the risks involved.

IRAs cannot be borrowed against and restrict a penalty-free withdrawal of money before 59 1/2 years old. But the choices are the primary attraction. This investor knows, and you should as well, the risks of building a successful IRA portfolio also increase. The biggest concern is investments that crossover.

What 401k plans are supposed to do is provide the investor with a fiduciary responsibility to provide the right tools for their employees. You, as an IRA investor are on your own.

You must monitor the funds you invested in for a change in investment strategy, style drift (when a fund manager invests on the edges of what s/he was hired to do; such as when they invest in large-caps when mid-caps are the focus), and an increase in turnover (a cost for trading repeatedly that the shareholder pays for directly, often done in an attempt to boost returns in the short-term, like at the quarter's end). You bear the burden of this responsibility to your future.

The terms of disbursement are spelled out when you leave the job in the 402(f) notice. This explains your options for handling a 401k disbursement. Even if you want to stay, your old employer really doesn't want the continued burden.

Bottom Line: Once you receive that 402(f), begin to research your options. And even if you think that money will come in handy, never take the cash.

Paul Petillo is the Managing Editor of Target2025.com

Is Roth IRA Investing Different?

Where to put your retirement money is always a problem. There is allocation, diversification and risk to consider. Expenses and fees, performance and tenure also come into play. If that is the case, is investing with a Roth IRA that much different than with a Traditional IRA?

Yes and No.

In a traditional IRA, the money you invest is done so on a tax deferred basis. Money you invest in a Roth IRA has been taxed, leaving only your earnings on those investments taxable at the date of your retirement. Because you paid taxes on the money you have put in, it is essentially yours to remove at any time. But once you do, although you will not face the tax or penalties associated with withdrawing invested dollars from a Traditional IRA, it still hampers the overall investment.

In both plans, the money is set aside (invested) for the future. It is not meant to be taken out before you retire - for any reason. Doing so will take potential growth off the table and this will change any projections you may have made based on assumed growth and potential retirement distributions, no matter how small.

The inside workings of these two types of IRAs is essentially the same. Although Roth 401(k) plans have surfaced recently, Roth IRAs have gained acceptance as a way for folks to continue to invest for their future in lieu of pensions and 401(k) plans. This makes the Roth IRA perfect for the investor who has maxed out every other form of tax-deferred investment.

Which makes the Roth IRA not so ideal for those looking to pay less taxes now by deferring those taxes until a time when their income will be less (most retirement planners will point to an annual income post-work of 75% of your current/future earnings as a benchmark for your retirement plan's success). Using a Roth may seem attractive at first glance, but unless you are swimming in invest-able dollars, it might be wise to keep the tax deferred plans fully funded first.

If you have, your current fund family, broker or bank will be a good first place to look. If you do, you should have a working knowledge of how to solve those nagging allocation and diversification problems (be careful to avoid buying funds that have similar investment goals in both your Traditional IRA and your Roth IRA - although they seem different, they still belong to you), fund expenses and fees (I'm assuming that if you have already committed to a group of funds in your tax-deferred accounts, they are already inexpensive compared to their peer group and in some instances, to the benchmark) and the overall performance of the offerings (look long-term, preferably longer than five years).

Once that is accomplished, you can invest in a Roth IRA with exactly the same discipline you would any other investment. You should understand your objectives, have a relatively decent grasp on your own investing behaviors and tolerance for risk, and do so with an eye on investing as inexpensively as possible.

Paul Petillo is the Managing Editor of BlueCollarDollar.com

Retirement Planning: Rollovers and Other 401(k) Considerations

While the 401(k) plan you have access to at your place of employment is a a "better-than-nothing" retirement plan doesn't mean that you should ignore the benefits of investing for your future.

There are three basic problems with the retirement plan (and how you use it) known as the 401(k). You can read the full article here.

What to keep in mind about your 401(k) plan and rollovers:

If you have a 401(k) plan use it and if possible, use it to its fullest.

Get your financial house in order while you are working, especially if you have only been in your 401(k) plan for less than fifteen years.

Rollover your old 401(k) into a Traditional IRA within 60 days and be careful with the paperwork.

If you have more money to invest, open a Roth as well.

Why Investors Do What They Do: Mental Accounting

Many of us can rattle off the balance in our set-aside accounts, the small stashes of money we allot for some special purpose. These accounts, whether they be for a down payment on a house or a vacation have been designated for something and when you mentally account for this money, you put a barrier around your access to it.

These are essentially illiquid accounts - at least in your mind. This type of thinking and the ability to strictly categorize is a special talent that many of us have and some of us need to work on. If you are able to keep even so much as a general budget of your household, you are probably using this kind of separation technique to make sure ends meet and the other accounts you have set-aside do not become victims of a small loan.

Retirement accounts, even those with restrictions on how you may access the principal amount you have contributed (penalties for early withdrawal, tax consequences) are good examples of this kind of behavior. Setting aside money to grow and adding to it on a regular basis is mental accounting. These kinds of accounts are often of the traditional 401(k) and IRA variety. It should be noted that one of the major selling points of the Roth IRA and Roth 401(k) is the access you have to your principal.

Mental accounting really becomes a problem, almost without noticing it has, is when you separate different elements of an investment. Some are willing to pay higher fund expenses in return for a riskier fund that has done well in the past. This is a cost trade-off that you make using this type of accounting error. Another example might be a bond fund that entices investors with a high yield but the underlying investment is losing capital.

(This last example is why there may be a flaw in the thinking that we overload a portfolio with dividend paying investments at the end of our careers. Once we begin drawing down the underlying investments, the dividends will also fall and this will lead to a quicker drain on the account.)

Much of this has to do with our love affair with our investment picks. Only the most hardened among us can engage in the cold-calculations that stock pickers really employ. Listen for the insincerity when a talking head on television begins a conversation about an investment with "we really like this stock...". That is, until something changes.

Mental accountants ignore these warning calls and often miss selling winners when they are winners and even worse, selling losers when they are losers. This throws the whole diversification within a portfolio out of whack. While we are still working, it pays to focus how we bracket our investments. Keep in mind that studies have proven beyond a doubt, bets on long shots increase as the last race approaches.

If you find evidence that an investment has changed, and some suggest that loss aversion plays a role in this type of mental reasoning, you need to reposition your portfolio. This is not as hard as it seems nor does it require as much time as you might think.

It does however require you open your statements when they come each quarter or look at them online once a month. Set-up a Google alert for each underlying investment (a good retirement account should have no more than eight mutual funds and as little stock as possible) or build a sample portfolio at anyone of the sites that provide the free service. At the first hint of doubt, investigate and make a decision on what you should do with the whole of the portfolio as the benchmark, not the performance of the individual holding.

Next up: Diversification

Retiring with a Plan: Is the Roth 401(k) Conversion Worth Trying?

In 2010, you will be allowed to convert not only your current 401(k) plan but your IRAs and any 401(k) plan you might have rolled over into an IRA. The question: is rolling your retirement money into a Roth 410(k)the right move to make?

As with all financial decisions, this takes a little bit of planning and consideration. The conversion will cost you money, mostly in tax dollars paid because your 401(k) plan, IRA or rollover action, saved you from paying on taxes that a Roth 401(k) will require you to pay.

Traditional plans defer those taxes. But once you opt for the Roth 401(k) or even a Roth IRA, the taxes on the transferred amount will need to be paid. This is because the money invested in a Roth is done after taxes. The first consideration is whether you will be able to pay those taxes.

A Window Of Opportunity
You do have a window of opportunity though. Taxes due on these types of conversions in 2010 are payable in 2011 and you have two years to pay them. Estimate the taxes on what you have in these accounts based on your ordinary income tax rate. There are no penalties other than this in the conversion. But depending on the size of your account balance, you will need to set aside this amount starting before you make the conversion.

The simplest way to do this is to set aside the money in a separate account - preferably away from your emergency account. (An emergency account is savings set aside for emergencies and if you can have a minimum of three months set aside, you are well ahead of what you neighbor probably has.) On the other hand, this money should not be invested either. This is cash for taxes and has no risk potential. Some of you might be tempted to put it in a taxable indexed mutual fund to get some work out of the cash, but this would not necessarily be the wisest choice.

This is also an opportunity best used for those who are above the current $100,000 a year income threshold. These folks have been unable to save more for their retirement because of this ceiling. Expect this group to do this in droves - if they are smart. For the rest of us, the transition may not be worth it.

Many of us are underinvested as it is. We cannot accurately see what the future tax rate will be on these invested dollars yet we can be assured that we will not have the same tax rate as we do know. If studies are correct, most of us will be in a far lower tax bracket, lower than most of assumed we would be in come retirement.

Keep in mind that if you do exceed the AGI (adjusted gross income) of $100,000 the conversion doesn't necessarily mean that you will be able to contribute more. There is way around this. If you were to make nondeductible contributions to a Traditional IRA and roll them into a Roth IRA in 2010, but only the contributions, not the investment gains, that part of the rollover is not taxable. The gains on those "nondeductible" contributions would however be taxed.

Ultimately a Tax Issue
Phase-outs are linear, meaning what you make determines the level of contribution. Because this is a tax issue and you should always consider speaking with a tax professional first, the following is just a guide to see where you fall in terms of income, phase-outs and contribution levels.

If you are a Single filer, your Roth contribution limit is reduced when your modified AGI or adjusted gross income exceeds $101,000.00, It is eliminated completely when it reaches $116.000.00

A person wishing to determine their contribution status if they are Married Filing Jointly will find their limit is reduced when their modified AGI exceeds $159,000.00 and is eliminated completely when it reaches $169,000.00. When it falls in between those amounts, the linear contribution phases in. For instance, if you were half way between, your contribution would be reduced by 50%.

Another tax filing status might affect your contribution levels differently. A person Married but Filing Separately, (and) Living Apart would find their Roth contribution limit is reduced when the AGI income exceeds $101,000.00. It would be eliminated completely when your modified adjusted gross income reaches $116,000.00

Those choosing the Married Filing Separately, or Other has a limit as well. These folks will find their contribution is reduced when their modified AGI exceeds $0 and is eliminated completely when your modified adjusted gross income reaches $10,000.00.

Once it exceeds those limits, you will not be allowed to contribute.

But as with all financial investments, they are not static. They may in fact be worth less. Because of that, you may want to look into a IRA Recharacterization.

Trash Talking Mutual Funds

As I drift around the web, I inevitably end up on some other blogger's site as they talk about investing, mutual funds or retirement. While everyone is guaranteed an opinion online, these missives may be as balanced as a morning spent watching Fox News.

And sometimes, I leave a comment of my own. Today, was one of those days.

Dr. Scott Brown, Ph.D., a.k.a. The Wallet Doctor, is a successful futures trader, real estate investor, and stock investor. Dr. Brown who hold a Ph.D. in finance from the University of South Carolina wrote: "These funds are also sold and managed on pure hype, short term trading, and with key information withheld from the public."

He continues after explaining briefly the history of how mutual funds grew, leaving out key tax code changes that created the 401(k) and the IRA during the time frame in question. He adds: "Many mutual funds are able to cheat the public with excessive fees because investors don't understand how these big costs destroy their profit. Mutual funds have no interest in educating investors because it is easier to hoodwink the ignorant!

"Don't put your trust in mutual funds unless they are fully indexed." And even though Mr. Brown suggest that he knows what the SEC really thinks about funds, he never does tell us what they are doing to regulate the industry.


So I asked Dr. Brown: "Tell me I am wrong":

Indexed mutual funds are too tax efficient to be locked inside a retirement account such as a 401(k).

While the low costs (fees) are always attractive and can lead to more profits, all index funds are not created equal nor do they charge the same fees. Some make up for their low fee structure by charging the individual investor $3,000 or more to make an initial contribution - far more than anyone would suggest the average investor plunk down at any one time.

Mr. Levitt did have a great deal of trouble back in 1993 (he referred to the former SEC chairman's divesting of common stock into mutual funds and some of the difficulty he had with transparency). But the industry has come a long way since and while it has further to go, the journey is at least headed in the right direction.

Actively managed mutual funds are far better for the average investor than buying individual stocks for three reasons: they can offer diversity and research; they can offer the ability to purchase new shares without charging each time you do, and they take they mental maniac out of the investor experience - the one that wants to sell on the way down, buy on the way up and mostly fails at determining their own risk tolerance.

Yes, far too many funds chase the same stocks. But it is the ETF that causes the wildest, end-of-the-day trading and market gyrations - not mutual funds.

Most folks equate the failure of 401(k) retirement accounts on mutual funds when in fact, more folks were invested in their own company stock, often upwards of 50% of the portfolio and often because this was the only way to get the company to match.

The creation of so many mutual funds is a result of the mimic effect. Those 500 funds that were in existence in 1980, that grew to over 8,000 by 2003 were the result of marketplace diversification. They sliced and diced the markets down into ever increasingly specific areas. Yet you fail to mention the same sort of slice and dice market done by the ETF markets.

Now that the SEC is back in the hands of an administration that cares, I expect their job will be much more focused and far less scattered than it was over the last eight years.

Mutual funds, while not perfect are much better than they were and are improving all of the time.

Retirement Planning - B is for Balance

As we continue our alphabetical look at the wide variety of investment terms that are thrown about - in such a way as to generally assume you know what is being spoken or written - we will look at balance.

B is for Balance

There has been entirely too much emphasis placed on the need for balance. I firmly believe that in order for each part of your plan to work, it needs to have time to develop. Few people are willing to ride market unrest out, constantly tweaking their portfolio of mutual funds to get the same return, quarter over quarter, year over year.

Not only is this difficult for professional money managers, it is nearly impossible for the average investor to do.

There are far more important things to “waste” our time doing. If you follow some basic rules, you will be fine.

Ask The Right Questions

Among the first things you should ask yourself is “why did I buy this fund?” If it was because you found the long-term returns to be in line with your goals, then let the fund manager work out any kinks the market might throw his/her way. Check the fund each quarter but focus on the yearly prospectus. You should also keep those dollars invested. A down market is a buying opportunity for investors who use dollar cost averaging.

What is DCA?

Dollar cost averaging or DCA is one of the single most important ways to build a retirement portfolio. The method invests money each month directed to your defined contribution plan in equal amounts. This allows you to buy more shares of your mutual fund when the price is low and less when the price is high. It employs one of the basic market principles better than most investors would and does it with no effort.

There are several reasons that this works. Suppose the mutual fund you purchased was selling shares for $5. For each $5 you invested, you received a share in the fund. The market, doing what it does best changes based on an innumerable amount of factors. In some instances, this makes the share appreciate, increasing the price and in others, the price goes down.

When the price increases to $7, your designated investment dollars does not see that as a buying opportunity. Your five dollars instead buys only a portion of a share, in this case, only about three quarter of a share. In this instance, it keeps you from buying shares that might be overpriced.

But if the market goes down and the share price decreases to $2.50, your five-dollar investment has bought a share and a half. Investors have a difficult time controlling the desire to buy more when the markets are on the way up and selling when they are declining in value. DCA solves this.

In your Retirement Plan

The idea behind it is simple and is employed with great success in your company-sponsored plan. In those plans, money is automatically taken from your paycheck. If you are using a traditional 401(k), it is done before taxes are taken from your paycheck. If you are participating in a Roth 401(k) it is taken from after-tax dollars.

In both plans, a steady stream of cash is invested for your future. IRA users have some different challenges facing their use of DCA to its best advantage. Often, IRA investors opt for sending their mutual funds a check each month. This allows them to act based on current headlines.

If this sounds like something you are doing, set-up your contribution to be done automatically and write that amount in your budget. This will give you the opportunity to take advantage of all of the magic the DCA offers.

Previously: A is for Asset Allocation