401k

‘Never invest in a business you cannot understand.’
-Warren Buffett

If your company offers a 401k, use it. This is a great tax deferred investment tool made even better if your company matches your investment. Still there are things to watch out for says money.msn.com.

1. How much is the employer really matching?
Some companies require a vesting period of 3-5 years and won't match a penny until you've worked for them that long. They may show matching dollars in the quarterly statements but they reserve the right to take it back if you leave the company too soon. Also find out if there is a maximum your company will match or if the matching ratio is not 1-1.

2. You may borrow against your 401k BUT...
If you quit, are laid off or fired, you may be required to pay back the 401k immediately. Not what you want to hear when unemployed.
And if you can not pay it back? Then the IRS counts the loan as an early withdrawal with taxes and 10% penalty.

3. If you 401k is less then $5000 when you leave the company...
the company has the option to cash out the plan instead of holding on to it or rolling it over to a new 401k for you. If cashed out you have 60 days to find a new 401k or IRA or the IRS will impose tax penalties for early withdrawal.

4. Your 401k funds might charge a load
If your company is small, the investment house managing the 401 might charge a front-end load, often 4%, for every investment.  This is not acceptable - especially since the same company will also be charging administrative fees to your account. I try never to buy a load fund. Lobby your employer to move to Fidelity or Vanguard or similar 401k provider which do not charge loads.

5. Avoid tax-advantaged investments in a 401k
A 401k is already tax deferred. There's no reason to use it to buy a fund whose goal is to minimize taxes. The goal should be to make the most money you can in the 401k and pay the taxes on it at a lower tax bracket when you've retired.

Bottom Line

Watch out for the hidden fees and gotchas when investing. Read and understand what you're buying.

Ten Worst Money Mistakes Anyone Can Make

"Money get back,
I'm alright Jack keep your hands off my stack."
-lyrics to Money by Pink Floyd

FreeMoneyFinance.com says there is just one rule to managing your money:
Spend less than you earn over a long period of time

While this is great advice, you can still lose your shirt by making one these Ten Worst Money Mistakes.

1. No Emergency Fund
Things happen; the washing machine breaks, car needs repairs, kids need braces, and so on. Borrowing money to pay for life’s emergencies will just put you deeper in debt. Protect yourself by keeping six months of living expenses in a SAFE place. Safe means not in stocks or any investment that can lose value suddenly. CDs are nice but the money is locked up for months or years. I keep six months in a savings account. It earns peanuts but it’s always there if I need it.
Corollary: if you use your emergency fund, pay it back ASAP.

2. No Will
57% of Americans have no will, including 69% of parents with kids under 18. If the parents die the State will decide how the money is allocated.

3. Not Enough Insurance
Insurance is the ultimate emergency fund for really big events like the total loss of your house or car. Consider also an umbrella policy on your house that covers lawsuits and liability like someone slipping on your icy sidewalk. Our umbrella policy paid off when a small leak was found in our underground oil tank.

4. Marrying the Wrong Person
Marry someone who agrees with your money style. A miser and a spendthrift are incompatible and divorce is expensive.

5. Not Saving
Put away at least 10% of each paycheck for future expenses like a new car, college tuition, vacation, etc. Don’t borrow for these big ticket items. The only item that is just TOO big to save for is a new house.

6. Too much house
Speaking of houses, don’t buy more house than you can afford. Don’t count on overtime or a future raise to pay the mortgage. Put as much money down as you can, say 20%, and aim to pay off the loan within ten years. The interest on a 20-30 year loan is a monster. My parents bought a $70,000 home but the total mortgage payments over 20 years would total $240,000.

7. Waiting to Invest
Don’t wait for a “good time” to invest. I’ve had stocks plunge to half their value and thought they would never recover. But they did. The NY Lottery (which I don’t recommend) says you have to Play to Win. Likewise you have to invest to make any gains.

8. Being in Debt
Debt eats your money. The goal is to earn interest and make money, not pour it down a hole to make someone else wealthy.

9. Not maximizing your Career
Your job is where you’ll earn most of your money. Even a small raise in pay will accumulate over the years to a nice amount. Work hard and get paid what you’re worth.

10. Over Spending
This violates the prime directive (spend less than you earn) and is a sure way to go into debt. Everyone says, “I don’t earn enough”, but in reality it’s how you spend, not what you earn that makes a difference. Boxer Mike Tyson earned $300 million in his career, but it wasn’t enough for his lavish lifestyle. He filed for bankruptcy in 2003, owing $27 million.

Bottom Line

Check out the full article at Ten Worst Money Mistakes Anyone Can Make. It contains dozens of useful links for Estate Planning, emergency fund planning, Insurance planning, etc, contained within the story.

Roth IRA's in 2010

"If stock market experts were so expert, they would be buying stock, not selling advice."-Norman R. Augustine

In 2010 the law for Roth IRA's changed (for the better). But you ask, what the heck is a Roth IRA?

With a normal IRA you put in "tax-free" money now and pay taxes when you cash it in during retirement. You get a credit on current taxes for the money deposited and will pay taxes on the money invested and all the interest earned at time of withdrawl. Hopefully you'll pay from a lower tax bracket in retirement.

With a Roth IRA you invest money and get no up-front tax credit. You're investing after-tax dollars. But once invested, there are no further taxes (provided you follow the rules and wait until age 59 1/2, have a disability, or are a 1st time home buyer). You can withdraw the money and interest tax free!

This may sound like 6 one day, half-a-dozen the other, but Roth has some clear advantages.

1. You can withdraw the principal (but not the interest) early if you're strapped for cash.

2. You can invest in Roth and have a company 401k at the same time

3. With a normal IRA you must withdrawl by age 70 1/2 or face a 50% penalty. With Roth there is no age limit for required withdrawls.

Bottom Line

So what is the good news for 2010? In prior years there were restrictions on Roth IRA's for anyone earning more than $100,000. Now those restrictions are lifted and anyone can convert a normal IRA to a Roth (by paying the taxes now).

Why convert now? If you're unemployed part of the year, you'll be in a lower tax bracket and will pay less tax during conversion. If the stock market collaspe took a big bite out of your IRA, there will be less money to convert and tax.

Financial Pyramids

“I've got all the money I'll ever need; if I die by four O'clock” - Henry Youngman

During yesterday’s blog I was tempted to talk more about our emergency fund but didn’t want to get too far off track from CD ladders. So this blog will be dedicated to my family’s theory for investing. With the recent Madoff ponzi-scheme fraud you hear of people who put their entire savings into one Hedge fund and lost everything. This violates the second law of investing:

2. NEVER put all your money in one basket

No matter if it were your mattress, a bank, a CD, a great stock or a hedge fund, DO NOT put all your money in one place. Smart thieves will check for money in your mattress; your bank might fail; your hedge might be a fraud. But unless you are the world’s most unlucky person, it is unlikely that all these will happen together to wipe out everything. Diversify so a loss in one place is buffered by money kept elsewhere.

Side note: while mutual funds are a great way to diversify amongst stocks, you are still invested in the stock market itself and when it tanks (like now) nearly all stocks go down. It is safer to spread money across multiple markets like bonds and foreign stocks as well as domestic stocks. It is also important to keep in mind that your mutual funds may be less diversified than you think. You can buy 20 different funds but discover that they all invest in the same “top” 20 stocks. Or you may discover that your mutual funds are heavily tilted toward some favored sector. My funds were “bank heavy”, i.e. overly invested in the stocks of banks when the bank crisis hit and wiped out value; e.g. Citibank has fallen from $50 per share to $1. To find out how diversified you are, check out Vanguard.com. You fill out an online form with your mutual fund accounts and their Portfolio X-Ray will look inside the funds to tell you what stocks and market sectors you are weighted in.

So if Diversify is Rule #2, what is the First Law of Investing? It is:

1. NEVER invest what you can NOT afford to lose

The mathematical “laws” of the marketplace reward higher rates for higher risk. When you chase high rates you are “accepting” a greater risk of a total wipe out. We are in the current financial crisis because banks and investors thought they had found an exception to the rule, Collateralized Mortgage Obligations (CMOs). The high paying CMO “tranches” bundled together the mortgage payments of high default-risk homes. The risk of mortgage default was waved away in two ways:

• With many homes bundled together it was unlikely that the majority of them would all default at the same time. (This proved false when the housing bubble burst).
  
• The mortgage payments were insured by AIG. If homes defaulted, AIG would bail out the CMO funds. (The default crisis proved so big that AIG ran out of money. They lost $64 BILLION (with a B) last quarter and the US government has given them over $150 Billion to keep AIG out of bankruptcy.)

There is no magical investment. High rate = high risk.

BOTTOM LINE

So are high rates always bad? No.
No one will ever get wealthy with rates paid by banks and CDs. In times of high inflation your money actually loses value in the bank if the interest rate is below the inflation rate.

So what do I do? I diversify and build a financial security net before investing. Keep in mind that I am not a financial planner and that this is just my family policy. We establish investment tiers, a financial pyramid with a firm (but low rate) foundation to a high and risky (but great rates) peak.

• First we keep enough money in our checking account to pay the month’s bills. Any money in excess of this goes to our emergency fund savings account, which pays some interest (but not much).
• The emergency fund is capped at a value that would keep us afloat for about 3-6 months. When this grows too big we move the money to CDs or investment funds.
• The CDs are our buffer to last us for a few years of bill paying. The rates are OK and the money is safe. The size of the buffer should vary based upon circumstances. Since I’m employed in a good job and retirement is far way, our buffer is about 5 years. When retirement gets near, I will start moving money out of risky investments and into safe CDs or equivalents.
• Lastly, after we’ve filled out the immediate, short-term, and long-term tiers, anything left over is invested in the markets for a long-term return. This is the tier that has taken a huge hit this past year. Our near-term security is safe but I’ll have to rethink dreams of early retirement.