Chapter 3
In This Chapter
Saving money for emergencies
Managing your debt
Setting financial goals
Funding retirement and college accounts
Understanding tax issues
Exploring diversification strategies and insurance
Before you make any great, wealth-building investments, I recommend that you get your financial house in order. Understanding and implementing some simple personal financial management concepts can pay off big for you in the decades ahead.
You want to know how to earn healthy returns on your investments without getting clobbered, right? Who doesn’t? Although you generally must accept greater risk to have the potential for earning higher returns (see Chapter 2), in this chapter, I tell you about some high-return, low-risk investments. You have a right to be skeptical about such investments, but don’t stop reading this chapter yet. Here, I point out some of the easy-to-tap opportunities for managing your money that you may have overlooked.
You never know what life will bring, so having a readily accessible reserve of cash to meet unexpected expenses makes good financial sense. If you have a sister who works on Wall Street as an investment banker or a wealthy and understanding parent, you can use one of them as your emergency reserve. (Although you should ask them how they feel about that before you count on receiving funding from them!) If you don’t have a wealthy family member, the ball’s in your court to establish a reserve.
Consider the case of Warren, who owned his home and rented an investment property in the Pacific Northwest. He felt, and appeared to be, financially successful. But then Warren lost his job, accumulated sizable medical expenses, and had to sell his investment property to come up with cash for living expenses. Warren didn’t have enough equity in his home to borrow. He didn’t have other sources — a wealthy relative, for example — to borrow from, either, so he was stuck selling his investment property. Warren wasn’t able to purchase another investment property and missed out on the large appreciation the property earned over the subsequent two decades. Between the costs of selling and taxes, getting rid of the investment property cost Warren about 15 percent of its sales price. Ouch!
Yes, paying down debts is boring, but it makes your investment decisions less difficult. Rather than spending so much of your time investigating specific investments, paying off your debts (if you have them and your cash coming in exceeds the cash going out) may be your best high-return, low-risk investment. Consider the interest rate you pay and your investing alternatives to determine which debts you should pay off.
Borrowing via credit cards, auto loans, and the like is an expensive way to borrow. Banks and other lenders charge higher interest rates for consumer debt than for debt for investments, such as real estate and business. The reason: Consumer loans are the riskiest type of loan for a lender.
For example, if you have outstanding credit card debt at 15 percent interest, paying off that debt is the same as putting your money to work in an investment with a guaranteed 15 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you need to earn more than 15 percent by investing your money elsewhere in order to net 15 percent after paying taxes. Earning such high investing returns is highly unlikely, and in order to earn those returns, you’d be forced to take great risk.
Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your future earnings. I often hear people say things like “I can’t afford to buy most new cars for cash — look at how expensive they are!” That’s true, new cars are expensive, so you need to set your sights lower and buy a good used car that you can afford. You can then invest the money that you’d otherwise spend on your auto loan.
Paying off your mortgage more quickly is an “investment” for your spare cash that may make sense for your financial situation. However, the wisdom of making this financial move isn’t as clear as paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is typically tax-deductible.
When used properly, debt can help you accomplish your goals — such as buying a home or starting a business — and make you money in the long run. Borrowing to buy a home generally makes sense. Over the long term, homes generally appreciate in value.
If your financial situation has changed or improved since you first needed to borrow mortgage money, reconsider how much mortgage debt you need or want. Even if your income hasn’t escalated or you haven’t inherited vast wealth, your frugality may allow you to pay down some of your debt sooner than the lender requires. Whether paying down your debt sooner makes sense for you depends on a number of factors, including your other investment options and goals.
Besides lacking the money to do so (the most common reason), other good reasons not to pay off your mortgage any quicker than necessary include the following:
You have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year or two.
Although it’s true that mortgage interest is usually tax-deductible, don’t forget that you must also pay taxes on investment profits generated outside of retirement accounts (if you do forget, you’re sure to end up in trouble with the IRS). You can purchase tax-free investments like municipal bonds (see Chapter 7), but over the long haul, such bonds and other types of lending investments (bank savings accounts, CDs, and other bonds) are unlikely to earn a rate of return that’s higher than the cost of your mortgage.
And don’t assume that those mortgage interest deductions are that great. Just for being a living, breathing human being, you automatically qualify for the so-called “standard deduction” on your federal tax return. In 2014, this standard deduction was worth $6,200 for single filers and $12,400 for married couples filing jointly. If you have no mortgage interest deductions — or have fewer than you used to — you may not be missing out on as much of a write-off as you think. (Plus, it’s a joy having one less schedule to complete on your tax return!)
You may have just one purpose for investing money, or you may desire to invest money for several different purposes simultaneously. Either way, you should establish your financial goals before you begin investing. Otherwise, you won’t know how much to save.
For example, when I was in my 20s, I put away some money for retirement, but I also saved a stash so I could hit the eject button from my job in management consulting. I knew that I wanted to pursue an entrepreneurial path and that in the early years of starting my own business, I couldn’t count on an income as stable or as large as the one I made from consulting.
I invested my two pots of money — one for retirement and the other for my small-business cushion — quite differently. As I discuss in the section “Choosing the Right Investment Mix” later in this chapter, you can take more risk with the “longer-term” money, so I invested the bulk of my retirement nest egg in stock mutual funds. With the money I saved for the startup of my small business, I took an entirely different track. I had no desire to put this money in risky stocks — what if the market plummeted just as I was ready to leave the security of my full-time job? Thus, I kept this money safely invested in a money market fund that had a decent yield but didn’t fluctuate in value.
In order to accomplish your financial goals (and some personal goals), you need to save money, and you also need to know your savings rate. Your savings rate is the percentage of your past year’s income that you saved and didn’t spend. Without even doing the calculations, you may already know that your rate of savings is low, nonexistent, or negative and that you need to save more.
An important benefit of knowing your savings rate is that you can better assess how much risk you need to take to accomplish your goals. Seeing the amount that you need to save to achieve your dreams may encourage you to take more risk with your investments.
During your working years, if you consistently save about 10 percent of your annual income, you’re probably saving enough to meet your goals (unless you want to retire at a relatively young age). On average, most people need about 75 percent of their pre-retirement income throughout retirement to maintain their standard of living.
If you’re one of the many people who don’t save enough, you need to do some homework. To save more, you need to reduce your spending, increase your income, or both. For most people, reducing spending is the more feasible way to save.
If you don’t know how to evaluate and reduce your spending or haven’t thought about your retirement goals, looked into what you can expect from Social Security, or calculated how much you should save for retirement, now’s the time to do so. Pick up the latest edition of my book Personal Finance For Dummies (Wiley) to find out all the necessary details for retirement planning and much more. (If you’re age 50 or over, check out Personal Finance For Seniors For Dummies, which I coauthored with retirement expert Bob Carlson.)
Many good investing choices exist: You can invest in real estate, the stock market, mutual funds, exchange-traded funds, or your own or someone else’s small business. Or you can pay down mortgage debt more quickly. What makes sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down your mortgage, as recommended earlier in this chapter, may make better sense than investing in the stock market.
To determine your general investment tastes, think about how you would deal with an investment that plunges 20 percent, 40 percent, or more in a few years or less. Some aggressive investments can fall fast. (See Chapter 2 for examples.) You shouldn’t go into the stock market, real estate, or small-business investment arena if such a drop is likely to cause you to sell low or make you a miserable, anxious wreck. If you haven’t tried riskier investments yet, you may want to experiment a bit to see how you feel with your money invested in them.
Saving money is difficult for most people. Don’t make a tough job impossible by forsaking the tax benefits that come from investing through most retirement accounts.
Retirement accounts should be called “tax-reduction accounts” — if they were, more people would be more motivated to contribute to them. Contributions to these plans are generally deductible for both your federal and state income taxes. Suppose that you pay about 35 percent between federal and state income taxes on your last dollars of income. (See the section “Figuring your tax bracket” later in this chapter.) With most of the retirement accounts that I describe in this chapter, you can save yourself about $350 in taxes for every $1,000 that you contribute in the year that you make your contribution.
After your money is in a retirement account, any interest, dividends, and appreciation grow inside the account without taxation. With most retirement accounts, you defer taxes on all the accumulating gains and profits until you withdraw your money down the road, which you can do without penalty after age 59½. In the meantime, more of your money works for you over a long period of time. In some cases, such as with the Roth IRAs described later in this chapter, withdrawals are tax-free, too.
The good old U.S. government now provides a tax credit for lower-income earners who contribute up to $2,000 into retirement accounts. The maximum credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $18,000 and married couples filing jointly with an AGI of $36,000 or less (these income ranges are for tax year 2014). Singles with an AGI of between $18,000 and $19,500 and married couples with an AGI between $36,000 and $39,000 are eligible for a 20 percent tax credit. Single taxpayers with an AGI of more than $19,500 but no more than $30,000 and married couples with an AGI between $39,000 and $60,000 can get a 10 percent tax credit. This credit is claimed on IRS Form 8880, “Credit for Qualified Retirement Savings Contributions.”
To take advantage of retirement savings plans and the tax savings that accompany them, you must first spend less than you earn. Only then can you afford to contribute to these retirement savings plans (unless you already happen to have a stash of cash from previous savings or inheritance).
Each decade you delay saving approximately doubles the percentage of your earnings that you need to save to meet your goals. For example, if saving 5 percent per year in your early 20s gets you to your retirement goal, waiting until your 30s to start may mean socking away 10 percent to reach that same goal; waiting until your 40s, 20 percent. Beyond that, the numbers get truly daunting.
If you enjoy spending money and living for today, you should be more motivated to start saving sooner. The longer that you wait to save, the more you ultimately need to save and, therefore, the less you can spend today!
If you earn employment income (or receive alimony), you have options for putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to these retirement accounts are tax-deductible.
If you work for a for-profit company, you may have access to a 401(k) plan, which typically allows you to save up to $17,500 per year (for tax year 2014). Many nonprofit organizations offer 403(b) plans to their employees. As with a 401(k), your contributions to a 403(b) plan are deductible on both your federal and state taxes in the year that you make them. Nonprofit employees can generally contribute up to 20 percent or $17,500 of their salaries, whichever is less. In addition to the upfront and ongoing tax benefits of these retirement savings plans, some employers match your contributions.
Older employees (defined as being at least age 50) can contribute even more into these company-based plans — up to $23,000 in 2014. Of course, the challenge for many people is to reduce their spending enough to be able to sock away these kinds of contributions.
If you’re self-employed, you can establish your own retirement savings plans for yourself and any employees that you have. In fact, with all types of self-employment retirement plans, business owners need to cover their employees as well. Simplified employee pension individual retirement accounts (SEP-IRA) and Keogh plans allow you to sock away about 20 percent of your self-employment income (business revenue minus expenses), up to an annual maximum of $52,000 (for tax year 2014). Each year, you decide the amount you want to contribute — no minimums exist (unless you do a Money Purchase Pension Plan type of Keogh).
If an employee leaves prior to being fully vested, his unvested balance reverts to the remaining Keogh plan participants. Keogh plans also allow for Social Security integration, which effectively allows those in the company who earn high incomes (usually the owners) to receive larger-percentage contributions for their accounts than the less highly compensated employees. The logic behind this idea is that Social Security taxes and benefits top out after you earn $117,000 (for tax year 2014). Social Security integration allows higher-income earners to make up for this ceiling.
Owners of small businesses shouldn’t deter themselves from doing a retirement plan because employees may receive contributions, too. If business owners take the time to educate employees about the value and importance of these plans in saving for the future and reducing taxes, they’ll see it as a rightful part of their total compensation package.
If you work for a company that doesn’t offer a retirement savings plan, or if you’ve exhausted contributing to your company’s plan, consider an individual retirement account (IRA). Anyone with employment income (or who receives alimony) may contribute up to $5,500 each year to an IRA (or the amount of your employment or alimony income if it’s less than $5,500 in a year). If you’re a nonworking spouse, you’re eligible to put up to $5,500 per year into a spousal IRA. Those age 50 and older can put away up to $6,500 per year (effective in 2014).
Your contributions to an IRA may or may not be tax-deductible. For tax year 2014, if you’re single and your adjusted gross income is $60,000 or less for the year, you can deduct your full IRA contribution. If you’re married and you file your taxes jointly, you’re entitled to a full IRA deduction if your AGI is $96,000 per year or less.
If you’ve contributed all you’re legally allowed to contribute to your IRA accounts and still want to put away more money for retirement, consider annuities. Annuities are contracts that insurance companies back. If you, the annuity holder (investor), should die during the so-called accumulation phase (that is, prior to receiving payments from the annuity), your designated beneficiary is guaranteed reimbursement of the amount of your original investment.
Annuities, like IRAs, allow your capital to grow and compound tax deferred. You defer taxes until you withdraw the money. However, unlike an IRA that has an annual contribution limit of a few thousand dollars, you can deposit as much as you want in any year to an annuity — even millions of dollars, if you’ve got it! However, as with a Roth IRA, you get no upfront tax deduction for your contributions.
When you establish a retirement account, you may not realize that the retirement account is simply a shell or shield that keeps the federal, state, and local governments from taxing your investment earnings each year. You still must choose which investments you want to hold inside your retirement account shell.
You may invest your IRA or self-employed plan retirement account (SEP-IRAs, Keoghs) money into stocks, bonds, mutual funds, exchange-traded funds, and even bank accounts. Mutual funds (offered in most employer-based plans), which I cover in detail in Chapter 8, are an ideal choice because they offer diversification and professional management. After you decide which financial institution you want to invest through, simply obtain and complete the appropriate paperwork for establishing the specific type of account you want. (Go to the later section “Choosing the Right Investment Mix” for more information.)
When you invest outside of tax-sheltered retirement accounts, the profits and distributions on your money are subject to taxation. So the non-retirement account investments that make sense for you depend (at least partly) on your tax situation.
You may not know it, but the government charges you different tax rates for different parts of your annual income. You pay less tax on the first dollars of your earnings and more tax on the last dollars of your earnings. For example, if you’re single and your taxable income totaled $50,000 during 2014, you paid federal tax at the rate of 10 percent on the first $9,075, 15 percent on the taxable income above $9,075 up to $36,900, and 25 percent on income above $36,900 up to $50,000.
Your marginal tax rate is the rate of tax that you pay on your last, or so-called highest, dollars of income. In the example of a single person with taxable income of $50,000, that person’s federal marginal tax rate is 25 percent. In other words, he effectively pays a 25 percent federal tax on his last dollars of income — those dollars earned between $36,900 and $50,000. (Don’t forget to factor in the state income taxes that most states assess.)
Table 3-1 shows the federal income tax rates for singles and for married households that file jointly.
Table 3-1 2014 Federal Income Tax Rates
Singles Taxable Income |
Married Filing Jointly Taxable Income |
Federal Tax Rate |
Less than $9,075 |
Less than $18,150 |
10% |
$9,075 to $36,900 |
$18,150 to $73,800 |
15% |
$36,900 to $89,350 |
$73,800 to $148,850 |
25% |
$89,350 to $186,350 |
$148,850 to $226,850 |
28% |
$186,350 to $405,100 |
$226,850 to $405,100 |
33% |
$405,100 to $406,750 |
$405,100 to $457,600 |
35% |
More than $406,750 |
More than $457,600 |
39.6% |
Interest you receive from bank accounts and corporate bonds is generally taxable. U.S. Treasury bonds pay interest that’s state-tax-free. Municipal bonds, which state and local governments issue, pay interest that’s federal-tax-free and also state-tax-free to residents in the state where the bond is issued. (I discuss bonds in Chapter 7.)
Taxation on your capital gains, which is the profit (sales minus purchase price) on an investment, works under a unique system. Investments held less than one year generate short-term capital gains, which are taxed at your normal marginal rate. Profits from investments that you hold longer than 12 months are long-term capital gains. These long-term gains cap at 20 percent, which is the rate that applies only for those in the highest federal income tax bracket of 39.6 percent. The long-term capital gains tax rate is just 15 percent for everyone else, except for those in the two lowest income tax brackets of 10 and 15 percent. For these folks, the long-term capital gains tax rate is 0 percent.
Diversifying your investments helps buffer your portfolio from being sunk by one or two poor performers. In the following sections, I explain how to mix up a great recipe of investments.
When you’re younger and have more years until you plan to use your money, you should keep larger amounts of your long-term investment money in growth (ownership) vehicles, such as stocks, real estate, and small business. As I discuss in Chapter 2, the attraction of these types of investments is the potential to really grow your money. The risk: The value of your portfolio can fall from time to time.
The younger you are, the more time your investments have to recover from a bad fall. In this respect, investments are a bit like people. If a 30-year-old and an 80-year-old both fall on a concrete sidewalk, odds are higher that the younger person will fully recover and the older person may not. Such falls sometimes disable older people.
If you want to be more aggressive, subtract your age from 120:
Note that even retired people should still have a healthy chunk of their investment dollars in growth vehicles like stocks. A 70-year-old person may want to totally avoid risk, but doing so is generally a mistake. Such a person can live another two or three decades. If you live longer than anticipated, you can run out of money if it doesn’t continue to grow.
No hard-and-fast rules dictate how to allocate the percentage that you’ve earmarked for growth among specific investments like stocks and real estate. Part of how you decide to allocate your investments depends on the types of investments that you want to focus on. As I discuss in Chapter 5, diversifying in stocks worldwide can be prudent as well as profitable.
Here are some general guidelines to keep in mind:
Dollar cost averaging (DCA) is the practice of investing a regular amount of money at set time intervals, such as monthly or quarterly, into volatile investments, such as stocks and stock mutual funds. If you’ve ever had money deducted from your paycheck and invested it into a retirement savings plan investment account that holds stocks and bonds, you’ve done DCA.
DCA is made to order for skittish investors with large lump sums of money sitting in safe investments like CDs or savings accounts. For example, using DCA, an investor with $100,000 to invest in stock funds can feed her money into investments gradually — say, at the rate of $12,500 or so quarterly over two years — instead of investing her entire $100,000 in stocks at once and possibly buying all of her shares at or near a market peak. Most large investment companies, especially mutual funds, allow investors to establish automatic investment plans so the DCA occurs without an investor’s ongoing involvement.
Of course, like any risk-reducing investment strategy, DCA has drawbacks. If growth investments appreciate (as they’re supposed to), a DCA investor misses out on earning higher returns on his money awaiting investment. Finance professors Richard E. Williams and Peter W. Bacon found that approximately two-thirds of the time, a lump-sum U.S. stock market investor earned higher first-year returns than an investor who fed the money in monthly over the first year.
However, knowing that you’ll probably be ahead most of the time if you dump a lump sum into the stock market is little solace if you happen to invest just before a major plunge in prices. In the fall of 1987, the U.S. stock market, as measured by the Dow Jones Industrial Average, plummeted 36 percent, and from late 2007 to early 2009, the market shed 55 percent of its value.
So investors who fear that stocks are due for such a major correction should practice DCA, right? Well, not so fast. Apprehensive investors who shun lump-sum investments and use DCA are more likely to stop the DCA investment process if prices plunge, thereby defeating the benefit of doing DCA during a declining market.
So what’s an investor with a lump sum of money to do?
DCA makes sense for investors with a large chunk of their net worth in cash who want to minimize the risk of transferring that cash to riskier investments, such as stocks. If you fancy yourself a market prognosticator, you can also assess the current valuation of stocks. Thinking that stocks are pricey (and thus riper for a fall) increases the appeal of DCA.
As for the times of the year that you should use DCA, mutual fund and exchange-traded fund investors should use DCA early in each calendar quarter because funds that make taxable distributions tend to do so late in the quarter.
Your money that awaits investment in DCA should have a suitable parking place. Select a high-yielding money market fund that’s appropriate for your tax situation.
Suppose, for example, that you want to value-average $500 per quarter into an aggressive stock mutual fund. After your first quarterly $500 investment, the fund drops 10 percent, reducing your account balance to $450. Value averaging suggests that you invest $500 the next quarter plus another $50 to make up the shortfall. (Conversely, if the fund value had increased to $550 after your first investment, you would invest only $450 in the second round.) Increasing the amount that you invest requires confidence when prices fall, but doing so magnifies your returns when prices ultimately turn around.
The more money you accumulate outside tax-sheltered retirement accounts, the less assistance you’re likely to qualify for from federal and state financial aid sources. Don’t make the additional error of assuming that financial aid is only for the poor. Many middle-income and even some modestly affluent families qualify for some aid, which can include grants and loans available, even if you’re not deemed financially needy.
Under the current financial needs analysis that most colleges use in awarding financial aid, the value of your retirement plan is not considered an asset. Money that you save outside of retirement accounts, including money in the child’s name, is counted as an asset and reduces eligibility for financial aid.
Also, be aware that your family’s assets, for purposes of financial aid determination, also generally include equity in real estate and businesses that you own. Although the federal financial aid analysis no longer counts equity in your primary residence as an asset, many private (independent) schools continue to ask parents for this information when they make their own financial aid determinations. Thus, paying down your home mortgage more quickly instead of funding retirement accounts can harm you financially. You may end up with less financial aid and pay more in taxes.
If you plan to apply for financial aid, it’s a good idea to save non-retirement account money in your name rather than in your child’s name (as a custodial account). Colleges expect a greater percentage of money in your child’s name (35 percent) to be used for college costs than money in your name (6 percent). Remember, though, that from the standpoint of getting financial aid, you’re better off saving inside retirement accounts.
However, if you’re affluent enough that you expect to pay for your cherub’s full educational costs without applying for financial aid, you can save a bit on taxes if you invest through custodial accounts. Prior to your child’s reaching age 19, the first $2,000 of interest and dividend income is taxed at your child’s income tax rate rather than yours. After age 19 (for full-time students, it’s those under the age of 24), all income that the investments in your child’s name generate is taxed at your child’s rate.
Also known as qualified state tuition plans, Section 529 plans offer a tax-advantaged way to save and invest more than $100,000 per child toward college costs (some states allow upward of $300,000 per student). After you contribute to one of these state-based accounts, the invested funds grow without taxation. Withdrawals are also tax-free so long as the funds are used to pay for qualifying higher educational costs (which include college, graduate school, and certain additional expenses of special-needs students). The schools need not be in the same state as the state administering the Section 529 plan.
If you keep up to 80 percent of your investment money in stocks (diversified worldwide) with the remainder in bonds when your child is young, you can maximize the money’s growth potential without taking extraordinary risk. As your child makes his way through the later years of elementary school, you need to begin to make the mix more conservative — scale back the stock percentage to 50 or 60 percent. Finally, in the years just before your child enters college, whittle the stock portion down to no more than 20 percent or so.
You may be at risk of making a catastrophic investing mistake: not protecting your assets properly due to a lack of various insurance coverages. Manny, a successful entrepreneur, made this exact error. Starting from scratch, he built up a successful million-dollar business. He invested a lot of his own personal money and sweat into building the business over 15 years.
One day, catastrophe struck: An explosion ripped through his building, and the ensuing fire destroyed virtually all the firm’s equipment and inventory, none of which was insured. The explosion also seriously injured several workers, including Manny, who didn’t carry disability insurance. Ultimately, Manny had to file for bankruptcy.
Here’s what you need in order to protect yourself and your assets:
Consider taking a health plan with a high deductible, which can minimize your premiums. Also consider channeling extra money into a Health Savings Account (HSA), which provides tremendous tax breaks. As with a retirement account, contributions provide an upfront tax break, and money can grow over the years in an HSA without taxation. You can also tap HSA funds without penalty or taxation for a wide range of current health expenses.
In my experience as a financial counselor, I’ve seen that although many people lack particular types of insurance, others possess unnecessary policies. Many people also keep very low deductibles. Remember to insure against potential losses that would be financially catastrophic for you — don’t waste your money to protect against smaller losses. (See the latest edition of my book Personal Finance For Dummies, published by Wiley, to discover the right and wrong ways to buy insurance, what to look for in policies, and where to get good policies.)