After taking advantage of those matching funds by investing through the company match, it most advisers recommend investors turn to the Roth IRA to take advantage of tax free growth opportunities.  After that, you are on your own, and left with a lot of questions.  Do I return to the 401(k) plan and max out my annual contribution there?  Do I invest in company stock?  Do I park anything left over in cash, or single stocks?  Let’s take it one step at a time.

Invest In 401(k) Through Matching Funds

Let’s assume your company offers to match the first 3% of your annual salary if you contribute to the plan.  If you earn $50,000 a year, and agree to participate at a 3% contribution, your annual contribution amount will be $1,500.  Your employer will kick in another $1,500, bringing your total contribution each year to $3,000.  That $1,500 contribution from your employer is almost like free money (nothing is completely free – you will owe taxes on it when you withdraw it down the line).

Max Out Roth IRA Contribution For You and Spouse

If you are living frugal, and haven’t buried yourself in house and car payments, you can probably afford to kick in another few thousand dollars each year to saving for retirement. Assuming you are eligible to contribute to a Roth IRA, it probably makes sense to turn your investment dollars above your employer’s 401(k) match here.

Contributions to a Roth IRA won’t help with your taxes in the year they are made, but earnings grow tax free over the life of the investment.  If your $5,000 contribution this year turns into $40,000 by retirement, you get to keep all $35,000 growth tax free, assuming you withdraw after reaching retirement age, or for a narrow list of specified qualified withdrawals.

Another beauty of Roth IRAs investments is that Roth IRA contributions may be withdrawn at any time, without penalty.  So theoretically, you could park money in a Roth IRA to grow for three or four years, and then only withdraw contributions, leaving the earnings untouched and continuing to grow.

Max Out 401(k) Contributions or Taxable Investing

At this point you’ve invested in a 401(k) through the company match, and maxed out contributions to a Roth IRA for you and your spouse (if married).  If you still have money to invest for retirement you have a choice:  return to your 401(k) plan and invest up to your annual maximum contribution, or invest in non-retirement, taxable accounts.

The path you ultimately take here depends on your goals for the future, and your overall financial picture. Personally, I would begin to invest in low-cost, low-turnover, taxable investment vehicles such as a broad index fund.  I have plans to “retire” early from full-time employment, and to do so will need access to savings prior to the IRS-defined retirement age (currently 59 1/2). If I planned to work well past the currently defined retirement age, I would probably plow more money back into the 401(k) plan to lower my taxable income and defer those taxes to retirement.

If you do decide to invest in taxable accounts go with a low-cost brokerage such as Vanguard or Fidelity.  These brokerages are widely recognized as two of brokerages with the lowest expense ratios in the industry.  Inside those brokerages, look for mutual funds with low turnover.

Remember, each time an investment inside a mutual fund is sold or exchanged, or “turns over,” it is a taxable event.  Those taxes will be distributed to mutual fund owners at the end of the year, and can create quite a tax hit, even if your overall mutual fund performance is down.

If I had to pick one fund to invest in it would the Vanguard Total Stock Market Index fund, which owns a little piece of every stock listed.  As you can imagine, there is not a lot of buying and selling happening here, which minimizes your tax hit.  It is also about as diversified as one could get within the domestic equities market (the Total International Stock Index fund is the international investment equivalent).

Additional Resources:

• 2009 401k And IRA Contribution Limits
• Roth IRA Investment Account Basics
• Retirement Saving After 401(k) and IRA
• Find the best stocks to buy in today’s few hot industries
  

Post by Frugal Dad

Photo courtesy of danperry.com

When I got a little older my dreams graduated to a grand retirement played out in an expensive condo on the beach, or a million-dollar cabin in the mountains.  After I got a job, got married, and had two kids I quickly realized this idea of a luxurious retirement was not very realistic. My early ideas were shaped more by the movies than the real world.

Now that I’m a “thirty-something” (and old enough to remember the television show by the same name), my dreams for retirement are more centered around spending time with family. I’d like to do a little traveling (nothing glamorous, and mostly domestic), and spend some time working with young people by either coaching or teaching, or some combination. While my retirement plans are still a little vague, I am certain that I do not want to still be working in the corporate world in my old age.

To make my dream of financial independence a reality, I need to put a number on it, and devise a plan to hit that number in a reasonable amount of time.  Lots of theories out there on how to calculate your “number,” and depending on the formula used there is some fluctuation in the amount required. However, this is a case where being in the same ballpark is close enough for me, so I don’t overly concern myself with the math.

The 4% Rule

To demonstrate the 4% rule I’ll use a fictitious 30 year-old worker named Dan.  Dan works as a software engineer by day, and builds decks and fences on the weekends.  He earns $80,000 a year for his combined efforts. Ideally, Dan would like to reach financial independence at 50 years-old and spend his time modifying homes for those with disabilities – things like building wheelchair ramps, widening doorways, and similar accessibility features.  The service would represent a combination of his love for carpentry and a call to service Dan has wanted to fulfill his entire life.  What kind of nest egg would Dan need to pull this off?

The rule of 4% uses a couple assumptions, some of which are hard to justify in our current market conditions. In a typical market, it is not unreasonable to expect a 10%-12% annual return on a portfolio of stock market investments. That means you can safely withdraw 4% of your portfolio each year and not reduce your principal balance, even after accounting for inflation.

Anything earned above the 4% withdrawal and the rate of inflation grows your balance even higher (with the idea that you may have to increase withdrawals later to cover increased medical costs, insurance premiums, etc. as you get older).

To figure out the number required to maintain your current style of living, divide your current income by a factor of 0.04. In Dan’s case, maintaining an $80,000 yearly income would require a $2 million nest egg. But Dan is a frugal guy, and he and his wife plan to pay off the mortgage early – in their early 40’s. They buy older, used cars and trucks with cash, and have managed to pay off credit cards they ran up in their twenties.  They could easily live on $50,000 a year.

Running the formula again reveals Dan would only need $1.25 million to become financially independent.  He could withdraw a guaranteed $50,000 a year, or in years where his new business earned money he may not have to touch the nest egg at all.

Is 4% Too Much To Expect?

As I mentioned, the 4% formula uses some long-held assumptions about investments that may or may not be true in the coming decade.  I personally look for things to turn around in the next two years, but that doesn’t mean we’ll see a repeat of the “irrational exuberance” of the last 90s in the market. I think going forward investors will slowly have their confidence restored, but because it will take some time we can probably expect lower rates of return than in previous periods.

I also expect inflation to rise at a faster pace in the next few years.  Actually, I expect currency deflation to occur, but the net result is the same – future dollars will be worth much less than they are today.  The rise in inflation, coupled with lower expected yields from the market, mean it might be asking too much to expect to withdraw 4% from your nest egg without lowering your principal.

So What’s My Number?

My lifestyle lines up pretty well with Dan in that I hope to be living completely debt free by 50 – no credit cards, no car loans, and no mortgage.  If I can get to that point, my lifestyle needs will be fairly basic, and we could live very comfortably on $40,000-$50,000 per year (in fact, we could probably live on much less, but I’m being conservative here).

Reducing my expected withdrawal rate to 2-3% means I would need between $1.5 million and $2 million to live comfortably on $40,000-$50,000 a year.  I’ll split the difference and make my goal for financial independence $1.75 million.  Looks like I’ll need a few more side hustles.

Post by Frugal Dad

It’s an interesting question for a couple reasons.  “Retirement” means different things to different people, and that idea can change over time.  When I was a kid, retirement meant sitting on a lake fishing several hours a day, and basically being able to do whatever you wanted, whenever you wanted.  I suppose that is still true, to a certain extent.

Today my definition of “retirement” is centered more around continuing to find ways to contribute to causes you believe in, regardless of compensation.  In other words, I look forward to “retiring” from working for money so that I can begin working for something I believe in.  Not that I don’t believe in the mission associated with my current job, but let’s face it, most of us are not lucky enough to be able to wake up every single morning totally inspired by our 8-5 jobs.

At this point I’d like to turn things over to readers, and offer up the following question for discussion in the comments below.  What does retirement mean to you?

Post by Frugal Dad

Target Retirement Funds

Following that theme of keeping things simple, I have been able to assemble a very modest portfolio of well-diversified mutual funds in my 401(k) account and a Roth IRA. For the Roth IRA, I decided to give target retirement funds a try. Target retirement funds are basically a collection of mutual funds offered by brokerages to provide the right allocation mix based on your anticipated retirement date.  If I was working with short time horizon of say five years, I would select something like a 2015 targeted retirement fund which would be comprised of mostly conservative investments.

Since I have a few years (decades) to go to reach retirement, I selected a 2040 target retirement mutual fund. Who knows, I might not be ready to retire in 32 years, but when I am five to ten years out I want to slowly move towards a more conservative allocation to avoid losing all I’ve worked to save the 25 years prior.  Ideally, I would like for this to happen automatically, without requiring me to log in and make transactions to move funds to conservative investments, rebalance my portfolio, and manually change allocation percentages for new investments.  Target funds are designed to handle all of those chores for you. However, they are not a totally “hands free” investment strategy.

Do your homework before investing in target retirement funds.  Some have fee ratios higher than that of individual funds. Targeted retirement funds have one other potential drawback: they may become more conservative than your risk tolerance is at the predetermined life stage you are in.  For instance, if I am nearing 60 years-old, but love my job, am in good overall health, and would like to work another ten years, I might like to extend a more aggressive mix of equities to maximize growth potential.  That is not possible with money locked away in a targeted retirement fund.

It is possible to invest in a well-diversified mix of low-cost mutual funds on your own, and manage them accordingly as you near retirement. However, it might make sense to make a targeted retirement fund part of that portfolio to further your diversification even more, and give you one less thing to micro-manage related to finances.

Post by Frugal Dad

So the markets are in a tailspin. If you have any money invested in the stock market, you’re probably not very happy right now. With all the panic and commotion going on, what can a regular investor do? If you’ve heard the advice to go out and buy more stocks right now because they’re so much “cheaper” than they were earlier in the year (and even last year), then you already know what to do.

The Roth IRA Debate

At the beginning of the year, there some debate online about how and when to fund a Roth IRA. I wrote about it at the end of June, claiming that dollar-cost averaging was the way to go. That means putting in a portion of the Roth IRA limit ($5,000 this year) throughout the whole year. 

But a lot of people thought that the best option was to fund the whole $5,000 right away. The reason? There were a few, but mainly it was to give their money as much time to compound as possible and to just get it all done right away and not have to think about it the rest of the year.

Well, the markets are WAY off their January numbers and it’s one of those rare times I get to look back at something I wrote earlier in the year and go, “I was right.” I just hope karma doesn’t come back to bite me in the butt.

If you put the whole $5,000 in your Roth back in January and invested in index funds (like the S&P 500), you’d have around $4,100 right now, that’s a loss of around 18%. But the worst part about it is that you can’t buy any stocks right now even though they’re “cheaper”! You’ve reached your limit and lost all flexibility. There is nothing you can do.

On the other hand

If you put $1,000 into the market in January, then in April, and then in July, you’d have around $2,641 left, a drop of only 12%. And you’d have the flexibility to put more money ($2,000) in at these lower prices, which would reduce your losses if the market keeps going down.

I know that we’re talking a few hundred dollars and, in the grand scheme of your retirement it’s not “that much.” But for me, my retirement is a big deal and if I can do a little maneuvering here and there to save me a few hundred bucks, that’s great. That’s another couple hundred dollars I can compound for 30-some years, and now we’re talking some serious money (around $25,000 compounded at 8%). And don’t forget that you’d be buying more stock at a lower price.

For those of you that find it more convenient (and you have $5,000 laying around in January) to contribute the whole amount right away, I won’t argue with you. But for those of you out there that like to squeeze every last penny out of important things like retirement accounts and that have the time to send money to your brokerage four or five times a year, dollar-cost averaging is a no-brainer.

A Marathon

Since it’s a retirement account, I know it doesn’t really matter how much money you have in your Roth today – you care about how much money you’ll have when you retire. It’s a marathon, not a race – so what happens over the course of one year shouldn’t be too important. But if you can do a little bit every year to make your overall returns that much better, isn’t that a good thing?

P.S. What if the market is going up, smarty pants? Well, then this whole argument needs to be re-evaluated. Maybe when the market is actually going up I’ll revisit that side of the coin.

Post by Frugal Dad

“I’m 22 years old, just graduated from college. In a few weeks I’ll be starting a new job. It’s very entry-level, so I don’t have benefits or a 401(k) plan. I’m wondering if I should find some other kind of retirement account or what I should do. I don’t understand 401(k)s at all or even know what a Roth IRA is. What would you suggest someone in my position do?”

- Chelsey

First of all, congratulations on finishing your degree.  I’m impressed that you are even thinking about this stuff at 22 years-old!  I sure wish I had been thinking like you at that age.  Your dilemma is not uncommon for people just starting out in a career, but just because your employer doesn’t offer a retirement plan certainly doesn’t mean you can’t begin planning for your own retirement now. When I was in my early twenties I took some time off from school to work a variety of jobs, and none of them offered benefits.  I figured since I didn’t have access to a 401(k) I just wouldn’t pursue investing for my retirement.  Besides, that was decades away and I needed money now.  I lost a few years of potential compounding growth to that lazy way of thinking.

Without the benefit of a 401(k) at your new employer you would be wise to investigate other options for retirement savings such as the Roth IRA.  A Roth IRA is basically an individual retirement account that allows you to contribute after-tax dollars.  The earnings may be withdrawn tax free after you reach the standard retirement age (currently 59 1/2).  Your contributions to a Roth may be withdrawn at any time without penalty.  Roth IRAs are offered through most banks and brokerages, and places like Vanguard, Fidelity, T. Rowe Price, and TIAA-CREF have solid investment options, and are among some of the lowest cost providers.  Each brokerage website also offers updated information on contribution limits, income eligibility, etc.  A few brokerages have steep minimums for initial investments.  If you find this to be the case with a fund you are interested in simply save in an account at ING Direct, or similar high-yield account, until you have enough to saved to start investing.

In addition to online research, I’d recommend checking out the book The Bogleheads’ Guide to Investing, which is one of the better primers on investing.   As for the selection of individual funds, well, that is a personal choice based on your level of risk tolerance.  Whatever you do, don’t select funds based solely on something you read here, or anywhere else for that matter.  Only invest in things you understand, and move slowly to make sure you fully understand a fund’s objective, its top holdings, its fee structure, etc.  You are well on your way to building wealth for the future.

I know many readers have been in similar situations when starting their careers.  What’s the single best piece of advice you would give Chelsey?

Post by Frugal Dad

A Shift in Thinking About Earnings

To fully appreciate the idea of passive income, one must shift their previously held assumptions on earning income.  Most people, myself included, think of earning money as something we get in exchange for some amount of work.  In its most basic form that is a pretty good definition of “earnings.”  Some people refer to this as “dollars for hours” thinking.  However, the part about exchanging some amount of work, or life energy, is not necessarily a requirement in the income-earning equation.

Passive income refers to income that is generated without any (or very little) additional effort on our part.  Some effort may be put in up front, but the payoff from passive income can last for years.  A few examples of opportunities to earn a passive income are:

Royalties on books. Royalties represent passive income in that the author of the work puts in all the work up front, but does not have to do much work to continue to receive payment for his or her work (with the exception of self-promotion, etc.).

Real Estate.  Passive income from real estate can be derived in two ways, primarily.  Homeowners may choose to rent out their property in which case the rental income is mostly passive, although basic landlord duties do require time to manage.  The appreciation of real estate also has a networth increasing effect without requiring any additional work from the homeowner.

Interest.  Interest income is passive income in that it does not require any additional work on the part of the recipient.  The money invested may have been earned through work, but the residual interest and dividends received is passive income.

Why is Passive Income Important?

Every dollar you earn in passive income is a dollar you didn’t have to earn by working.  In this way, passive income puts you closer to financial independence, a stage of life where you no longer have to sell hours for dollars in order to earn an income.  A simple example assumes you have $1,000 saved in an interest-bearing account earning 3% (the current interest rate on ING Direct’s Orange Savings Account).  Over the course of a month that $1,000 capital is working to earn you roughly $2.50 in passive income. If you had $100,000 in that same account it would bring $250 in passive income each month.  Of course, money parked in investments earning an even higher yield, such as CDs, would bring in even more monthly interest income.

At this rate, it wouldn’t take long to earn enough in interest alone to cover your basic life expenses, especially if these earnings are reinvested (or compounded) until income from the fund is required.

How are you creating a passive income?

Post by Frugal Dad

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?

Consider opening your IRA at E*Trade, where you will receive 100 commission-free trades.

Post by Frugal Dad

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

Post by Frugal Dad

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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Post by Frugal Dad