I currently receive a healthy employer contribution into my retirement plan, and have considered fully funding a Roth IRA before adding any of my own contributions to the retirement plan at work. While investigating brokerages, investment minimums, etc. I ran across the term “Spousal IRA.” I had heard this term tossed around before, but never really taken the time to read up on the rules. Apparently, non-working spouses are eligible to use a portion of their working spouse’s income to fund their own Roth IRA. Before starting my own Roth IRA I think we’ll start one for my wife, and we’ll use her account to further diversify our overall portfolio.

Eligibility

Spousal IRA contributions can be made to either a Traditional or Roth IRA. Even though they don’t offer the same upfront tax deductions as the Traditional model, we’ve elected to invest in Roth IRAs because the earnings grow tax free. The limits for contributing to a spousal Roth IRA are the same as those listed for individual investors - $5,000 per tax year if under age 50, and $6,000 for those 50 and older. The following income limits also apply:

• For married filing jointly — $169,000 modified adjusted gross income for tax year 2008
• For married filing separately — $10,000 modified adjusted gross income for tax year 2008.

We shouldn’t have to worry about the $169,000 combined income any time soon, although that would be a great problem to have!

Diversify Your Strategy

My wife and I agreed we would take a more conservative approach with her investment selections, sticking to well-diversified mutual funds aimed at both capital preservation and appreciation. I’m the risk taker in the family when it comes to investing, but at the age of 30 I can afford to take some risks. I don’t mean to imply my wife is older (in fact, we are the same age), but if I were to kick the bucket she would need to preserve the proceeds from insurance and investments for as long as possible. It makes sense to us to lay the foundation for such a plan now while I’m still around. While the proceeds would be invested outside of retirement accounts, her strategy would be much the same.

Inside my employer’s retirement plan I’ve selected an aggressive portfolio from the mutual funds available. To offset some of this risk, my wife’s spousal Roth IRA will be comprised of less-risky mutual funds, a few of which offer a balanced mix of equities, bonds and other fixed-value investments. In times of market expansion my employer plan will likely grow much faster than her Roth IRA will. But in rough times, while my balances are falling, her Roth IRA should hold much of its value in tact. This seems to be a good way to hedge against market fluctuations over the next couple decades.

What’s Mine is Hers; What’s Hers is Hers

Sorry, I couldn’t resist the joke. Actually, my wife and I pool all of our earnings together and consider any savings, investments, and debt to be both of ours, as it should be. I’ve never liked the idea of separate finances, unless you have a situation where older couples remarry and both have their own set of income and expenses. Even then, why not just share everything. After all, isn’t marriage the ultimate partnership?

I’d be interested to hear from any couples out there who have funded an IRA for a non-working spouse.

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Do you dream of one day leaving the rat race? Who doesn’t? For me the idea of “retirement” does not evoke visions of fishing and golfing, rather the ability to do whatever it is that I truly want to do. Personally, that looks a lot like writing, coaching youth sports, and perhaps working with a non-profit for a cause I strongly believe in. Unfortunately, much talent is wasted doing the 30-year corporate shuffle to pay for “stuff.” What if you could begin to eliminate some of this “stuff” and find new ways to diversify your income to cover basic expenses?

Step 1: Tracking Expenses

One of the best ways to begin any new plan is to figure out a baseline. Dieters often begin a new fitness plan with the dreaded measurements of weight, BMI and bodyfat percentages. Think of this portion of your plan for an early “retirement” as your financial fitness evaluation. The very first thing you should do is figure out what you’ve been doing. Stop reading this and estimate in your head how much your monthly expenses are (debt payments, utilities, food, gas, etc.). Keep that initial estimate in mind as you move forward with this exercise.

At the beginning of the next calendar month start recording all expenditures, from the $2.00 cup of coffee to the $1,000 mortgage payment. If it is early in the month you may begin this step retroactively, assuming you can account for expenditures up to this point. For now, don’t be overly concerned with the method of recording these figures, just record them. Some people like to set up elaborate Excel spreadsheets; others prefer a ledger pad and pencil. During this first month resist the urge to reduce your spending. Try to spend and save as you have been doing to get an accurate representation of your starting point.

Step 2: Tracking and Diversifying Income

This step will take much less time, unless you are already in the enviable position of receiving daily income from multiple income streams. Most of you are probably like me. My first month of tracking income had exactly three records. Two paychecks and about $0.16 in interest from a savings account. Some of you may have even less. That’s fine - as they say in the book that inspired this entire exercise, Your Money or Your Life, “No shame, no blame.”

If you really want to step off the corporate treadmill one day, you simply have to increase your passive income either by investing current earnings in high-yield accounts, or by developing multiple income streams from part-time or freelance work, or some combination of the two. As long as you rely on your current full-time paycheck to pay for your expenses you are trapped in the rat race.

Step 3: Creating a Freedom Chart

At the end of the first month you should now have a detailed cash flow statement listing all of your expenditures and your household income. You may need to sit down for this step. For most people this is the point where they realize they are spending more than they earn. This overage accounts for what I refer to as “lifestyle debt.” It is the two hundred dollars you charged at the grocery store to float until you got paid, or the insurance bill you paid with your credit card because there wasn’t enough in checking. Lifestyle debt is a killer when it comes to early retirement plans. It ties up your income from future investment, and the interest accrued cheapens your future earnings.

Step 4: Project the Intersection

At some point in the future, as your passive income increases and daily living expenses decrease, your monthly expenses will equal your passive income. It is at this point that you are technically free from the rat race. If you received a pink slip from your job tomorrow you could survive indefinitely assuming your expenses did not increase significantly due to health coverage, etc. From this point of intersection forward you are continuing to work, save and invest to improve the quality of life in your early retirement. The more you have invested in high-yield accounts the higher your passive income will be, allowing you a few more expenses each month. You may decide to continue working at your full time job to generate some capital to put into your own business, adding even more to your passive income stream. Whatever you decide, the choice is now yours. At this point of intersection you are officially free from the rat race.

photo by davidandnasha

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A reader recently asked whether or not they should stop contributing to their 401(k) plan to get out of debt faster. This is a question anyone eager to become debt free has asked themselves, and there is really no right or wrong answer. I do have a couple guiding principles that may help you decide, but in the end it is a personal finance decision between you and your family. Similar to other unconventional financial advice, the best plan is not always the smartest one, mathematically. Mathematically, it makes sense to continue retirement contributions to take full advantage of compounding interest. However, laser intensity can sometimes make up for math and by focusing all your resources on becoming debt free can immeasurably improve your life.

photo by: Thiru Murugan

Dave Ramsey is Right: Intensity Changes Everything

I don’t agree with everything Dave Ramsey says, but he is right on this one. Ramsey advocates suspending retirement contributions while working to become debt free. However, he also offers a couple stipulations that I also agree with. First, do not suspend retirement contributions if it will take longer than eighteen months to become debt free. Giving up eighteen months to two years worth of compounding growth may prove too costly for those hoping for an early retirement. So if you have thousands of dollars in debt, and don’t have enough cash flow, even after suspending retirement contributions, to clear this debt in less than a year and a half then do not suspend your retirement contributions. Consider continuing contributions to your 401(k) and as quickly as possible continue paying off your debts.

If you do suspend retirement contributions make getting out of debt your number one priority. The longer you do not contribute to your 401(k), the more you are sacrificing in potential growth. In a down market like the one we are currently in, it is tempting to want to buy mutual funds at a deep discount. However, contributing a couple hundred dollars towards retirement each month can significantly slow your debt elimination progress, possibly costing you much more than you could earn in growth.

Reminder, it is a Personal Decision

Many people will provide a host of reasons why this idea is flawed, and I suspect a few will do so in the comments here. That’s fine. Like I mentioned in the opening paragraph, the decision to suspend retirement contributions to attack debt is a personal one. You could run some elaborate formulas to determine the money paid in interest on debt versus the money earned by contributing to a retirement plan and come up with many different conclusions based on different factors. Two points for paying off debt:

• Eliminating a 14% credit card is a sure 14% net gain, but investing in a stock or mutual fund averaging 14% is not a sure thing. As the prospectus states, “past performance is not a predictor of future gains.”
• Removing debt from your life reduces risk, something most mathematical formulas fail to include in their calculations. Living debt free gives you options, and frees up earnings for future investments.

Ask the Readers: Have any of your temporarily suspended retirement contributions to become debt free?

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The other day my annual dose of reality arrived in the mail - my social security statement, sent compliments of the Social Security Administration. In it I found the usual listing of annual wages dating back to my first pizza job at 16 years old. It is comforting to know that if I die my wife and kids will receive a “special one-time death benefit of $255.” Great, that ought to be just enough to pay off the singer at the funeral. Instead of doing the usual file-it-and-forget-it routine I decided to run through a little exercise I read about in Your Money or Your Life.

Not including the $1,300 per year I earned rolling out pizza dough, collecting golf balls, and assembling fast food sandwiches in college, I’ve earned $368,569 over the course of my professional working lifetime. That figure is alarmingly high when I consider how little I have to show for it. I now understand why this is such a sobering exercise. If I had managed to save just half of that figure (after taxes) I should have well over $150,000 socked away in mutual funds, stocks and cash reserves. Suffice it to say, I’m not even close.

What can I learn from this painful exercise? The reality that this much money has slipped through my fingers has me reaching for a bottle of Tums. My entire adult life I have been working and earning and working and earning, and I have basically managed to save none of it. I have this vision of someone trying to collect rain water while stranded on a deserted island. They set up an elaborate bucket system to catch runoff, only to discover after the rain has stopped their bucket has an enormous hole in the bottom. Time to get a new bucket - fortunately there are few more rain clouds left on the horizon.

Ten years from now I plan to be holding a bucket full of mutual funds, stocks, and cash. The patch for my bucket will come from a variety of sources. First, I am using this year to build my knowledge of personal finance by becoming a voracious reader on the subject. By eliminating time-wasting activities such as watching television, or playing video games, I have managed to free up more time for reading books. Second, I plan to continue writing here to express my opinions on the subject of frugal finances. The research, planning and writing I do here, as well as the interaction with my readers and other bloggers, keeps me motivated to stay on track, financially. Finally, I now have a firm grasp on my spending and no longer buy things on a whim. By walking away I have learned to say “no” to myself, something most people with financial problems have yet to learn.

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This is the seventh article in Frugal Dad’s week-long series, The 7-Day Turnaround: One Week to Change Your Family’s Financial Destiny. Each day brings a new step to implement and help you get control of your finances.

The word “retirement” has always evoked day dreams of playing out the remainder our lives fishing, golfing and joining a bridge club. However, with improvements in preventive medicines people are living longer, and with a bull market at the end of the last decade, many of those people are “retiring” earlier. Instead of retiring from the work world entirely early retirees are simply hanging up their careers and looking for more fulfilling work, a search for that self-actualization Maslo referred to. That is a noble goal. We spend the majority of our early careers working to pay for things (houses, cars, college for the kids). Why not start saving for an early retirement from your day job so you can then go do something you have always wanted to do, regardless of the pay.

Invest outside of retirement accounts. We’ve already learned the virtues of investing inside retirement accounts, but in this final step let’s start to invest outside of retirement accounts so that money is available to tap before 59 1/2, the current minimum age to withdraw from an IRA. This step requires closer scrutiny of investment options than investing inside retirement accounts. For one thing, your time horizon is shorter so you have less time to recover from making a bad investment selection. You also have less time to recover from a market downturn, so riskier investments are usually off the table for this type of investment. Capital preservation is nearly as important as capital appreciation in this step.

Don’t forget about taxes. Since these investments are outside a tax-deferred, or tax-free retirement account you have to be more conscious of the tax implications. Consider investing in a more conservative mix of index mutual funds with a low turnover to minimize taxes. Vanguard’sTotal Stock Market Index Fund and 500 Index Fund are good examples of low-cost mutual funds with low turnover. With interest rates hovering near record lows, high-interest savings accounts are not as attractive an option as in times of higher rates. Still, keeping a portion of your “early retirement” fund in cash may make sense if you can find rates that significantly out-pace inflation. Treasury bonds, high-interest bearing CDs and money market mutual funds offer decent returns with minimal risk, but should only represent a portion of your total early retirement fund in the beginning stages. You need growth on your side up front, and once you’ve earned that growth you can begin to take those profits and preserve them in these safer savings vehicles.

At some crossover point in the future your monthly investment income will match your monthly expenses. At this point the money in your “early retirement” account is generating enough working capital to pay your monthly expenses. You are no longer dependent on earning a wage to provide necessities. This point was best illustrated in the book Your Money or Your Life. Author Joe Dominguez used a graph to plot monthly expenses and monthly investment income. Over the years his investment income grew, and as he practiced frugal living principles his expenses decreased. One day the two figures met. It is at this point that you can finally break away from the daily grind. What is it you’ve always wanted to do, but could never afford to start? Maybe you want to start your own business, or perhaps you would like to volunteer more of your time towards a particular cause. Regardless of your chosen endeavor, you are now free to make the jump without worrying about how much money is involved. With that kind of freedom creativity is released in waves, and you just might find yourself making more money than you made in your working lifetime.

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Technorati Tags: early retirement, minimize taxes, inflation

This is the fifth article in Frugal Dad’s week-long series, The 7-Day Turnaround: One Week to Change Your Family’s Financial Destiny. Each day brings a new step to implement and help you get control of your finances.

Now that you have moved beyond the half-way point in your 7-day turnaround, it’s probably a good time to look back and see what all you have accomplished. After taking an inventory of your finances you established a three-month emergency fund to break the cycle of relying on credit cards. In step three we cut up those credit cards, saving one no-fee, low-interest card for emergencies only. Slashing your monthly, non-utility expenses was a major emphasis in step four, requiring you to think long and hard about trading your hard-earned income for things like gym memberships and cable service. By now you are debt free with a solid emergency fund - it’s time to start saving for your retirement.

The first step in planning for your retirement is coming up with your Number. Everbody has a Number, but few of use know what it is. Your Number is the amount of money that will grant you the level of financial independence that allows you to quit working for money. The Number, by Lee Eisenberg, offers many strategies for calculating your Number. It isn’t good enough to say, “I’ll retire when I have a million dollars in the bank.” Determining your Number takes actual planning, determining how much working capital you will need to live off of your investments, and estimating your expenses in your golden years.

Take advantage of matching funds from employer retirement plans. Most employers offer full time, professional employees the opportunity to invest in an employer-sponsored 401k plan (or 403b, if you work for a non-profit or educational institution). Many companies even offer to match employee contributions up to a certain percentage of the employee’s income. This is like free money. Get your retirement savings started by enrolling in the plan and contributing up to the percentage of income the company matches. Don’t worry if it is only 3% of your income, we’ll use your remaining earnings to save in a different savings vehicle.

A Roth IRA is the best retirement savings vehicle around. Some experts argue over whether or not to fully fund a 401k or a Roth IRA. For me, the argument for Roth IRAs is explained beautiful in the following analogy.

Would you rather pay taxes on the seed or the crop?

In other words, would you rather pay taxes on your income now, when it is smaller, or later when you are a millionaire (and you will be if you stick to this plan!). Easy choice. I would rather pay taxes on money now, and invest in a Roth IRA with after-tax dollars. When you withdraw that money in retirement Uncle Sam will let you keep 100% of the contributions and earnings, tax free! Conversely, 401k balances grow tax-deferred, which means you will save a little now diverting pre-tax income to your 401k plan, but you will have to pay more when making large withdrawals in retirement. Remember, the key to any good financial plan is to keep a long-term view. Sacrifice the reduced tax liability now offered by the 401k for a tax free payoff from the Roth IRA years down the road.

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Technorati Tags: retirement, investments, 401k plan, Roth IRA, taxes

The February edition of Kiplinger’s Personal Finance magazine ran an intriguing cover story, “Six Simple Ways to Retire Rich.” As part of the article Kiplinger’s ran a feature titled “How to Make a Million: Strategies at Every Age.” Most of us are aware of the power of compounding interest, but this feature really drove home the importance of starting early to retire rich.

A 25 year-old with no savings needs to save $286 a month to reach $1 million by age 65. If your new employer offers a matching contribution, participate up to the match and then consider investing above that in a Roth IRA. The forty years of growth will make you a millionaire, maybe many times over depending on investment performance.

A 35 year-old with no savings needs to save $671 a month to have a $1 million nest egg in thirty years. Notice the jump in required monthly contributions? That’s what waiting ten years gets you. At 35 there are several family priorities competing for your money such as college savings, housing, etc. However, this is one of those times when you need to exercise the “pay yourself first” plan. No, you aren’t being selfish. You are laying the groundwork for a solid financial future to provide for your family for years to come.

At 45 years-old it takes nearly a mortgage payment, $1698, to generate a $1 million portfolio. With only a twenty year window it’s time to get busy, but it’s not too late to get started. Many people this age develop a loser’s attitude, “It’s too late so why even start. I’ll just live on social security.” Social security insolvency aside, this is not a plan for success at any age. Take responsibility for your inability to save up to this point by making it a top priority over the next two decades.

Technorati Tags: Kiplinger’s, compounding interest, retire rich, Roth IRA, college savings, Social security