I’ve talked quite a bit about making “backdoor” Roth contributions if you’re over the income limits for contributing to a Roth IRA. In short, you can make a non-deductible contribution to a traditional and then immediately convert it into their Roth.

This strategy has become so popular that mainstream publications such as Forbes have started talking about it. But is it legal? That was the topic of a recent discussion over on the Bogleheads forum.

This discussion was prompted by an article by Michael Kitces, who is a financial planner extraordinaire and the Director of Research for the Pinnacle Advisory Group.

According to Kitces, while the individual steps of the backdoor Roth maneuver don’t run afoul of IRS regulations, these contributions could be disallowed under the step transaction doctrine.

The step transaction doctrine is a legal principle that essentially allows the IRS to look at the overall effect of a multi-step transaction and treat it as a single, integrated event.

In other words, rather than looking at the legality or tax treatment of individual steps, the IRS is free to look at the overall result of the transaction — i.e., that an individual over the contribution limits was able to make a Roth IRA contribution — and tax (or penalize) it accordingly.

So… The question is whether or not the IRS would balk at backdoor Roth contributions. I’m not particularly concerned about it, in part because the removal of income limits for converting funds to a Roth IRA appears to have been specifically intended to allow high income individuals to do just that, but…

It seems at least theoretically possible that the IRS could view this as an over-contribution, which comes with a recurring penalty of 6%/year (albeit with a 3 year statute of limitations), and these transactions could be messy to unwind.

At the same time, it’s worth noting that IRA expert Ed Slott weighed in on this issue last spring, arguing that the step transaction doctrine is a non-issue for backdoor Roth contributions.

My pal TFB has also tackled the subject. The short version is that he’s recharacterizing his recent conversions, and will re-convert at a later date to reduce the odds of his conversions being viewed through the lens of the step transaction doctrine.

What about you? If you’ve been making backdoor Roth contributions, are you concerned about running afoul of the IRS?

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Related Articles at fivecentnickel.com:

» Contribute and Convert: Funding Our Roth IRAs Through the Backdoor
» Withdrawing Your Roth IRA Contributions (Followup)
» Contribute to Your Roth IRA, Even if it Stretches Your Budget
» Roth IRA Income Limits for 2007
» Traditional IRA vs. Roth IRA: What’s Your Preference?
» Roth IRA Income Limits for 2012
» Tax Credit for Retirement Savings Contributions
» Ratcheting up our Roth IRA Contributions

Do you have a workplace retirement plan such as a 401(k), 403(b), or 457(b)? If so, then you might be interested in knowing that the contribution limits for these account types has increased for 2012.

This means that individuals under age 50 can contribute up to $17,000 to their 401(k) account this year, up from last year’s limit of $16,500. And if you’re over age 50, you can contribute an extra $5,500 toward your retirement this year.

Beyond the above, the aggregate limit (employer + employee contributions), which is specified by Section 415(c)(1)(a) of the Internal Revenue Code, has increased to $50k/year. This is the so-called 415(c) limit and, while it doesn’t affect many of you, it does have an impact on some people (especially if you’re self-employed and have a high incomes).

Note that 403(b) and 457(b) plans, as well as the Thrift Savings plan, are subject to the same contribution limits, so those of you in the non-profit, educational, and public sectors will likewise be able to save a bit more this year.

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Related Articles at fivecentnickel.com:

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» 401(k) Limits to Decrease in 2010?
» 401(k), 403(b) and 457(b) Contribution Limits for 2008
» 401(k), 403(b), and 457(b) Contribution Limits for 2009
» 401(k), 403(b), and 457(b) Contribution Limits for 2010
» Open Enrollment Time
» Roth IRA Income Limits for 2007
» Roth IRA Income Limits for 2012

Your 2011 taxes are due in just under three months. That also means that you have just under three months left to make any 2011 IRA contributions that you might have been putting off.

But what if you’re neglected to contribute to an IRA because you’re not sure you can afford it? Maybe the only cash you have on hand is earmarked for emergencies, and you’re not willing to risk the 10% early withdrawal penalty that comes with a traditional IRA.

Well, I’d like to encourage you to think twice about that stance and consider making a Roth IRA contribution. As I noted the other day, Roth IRA contributions can be withdrawn at any time and for any reason without penalty. And if you don’t believe little old me about this, you can check it out for yourself in IRS Publication 590.

While I’m not crazy about this flexibility to the extent that it encourages (or at least allows) people to raid their retirement to buy shiny things, one huge benefit is that it gives you the flexibility to make a contribution even if you’re not sure you can afford it.

This flexibility is very valuable because you’re only allowed to contribute a limited amount to IRAs each year. In other words, if you fall behind on contributions now, you won’t be able to make up for it later when you can (hopefully) better afford it.

If you make the contribution now and fate smiles upon you, you’ll be able to re-build your emergency savings “on the outside” while having more money stashed away inside your Roth IRA. And if things go awry, you’re free to yank that money out (up to the amount that you’ve contributed) and use it to take care of whatever emergency you’re dealing with.

Some issues to be aware of:

1. This rule applies to Roth IRAs only, so don’t try this trick with a traditional IRA.
2. The usual contribution limits still apply, so don’t try to sock more money away than is allowed.
3. Roth IRA conversions are subject to a five year waiting period before they can be withdrawn without facing a penalty.
4. Make sure a Roth is right for you. If you expect to pay the same or higher taxes in the future, then a Roth might make sense for your situation. But if you expect your tax burden to fall in the future, a traditional IRA might be better — but remember, only Roth IRAs qualify for the penalty-free withdrawal of contributions.
5. Given that this is money that you may need to withdraw at any time, be sure not to put it at risk once inside the Roth. Instead, plug it into a money market fund or something similar until you’ve re-built your emergency savings.

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» Roth IRA Contribution Limits: How the ‘Phaseout’ Works
» Max that Roth!
» Funding an IRA When You’re Not Sure You Can Afford It
» Contribute and Convert: Funding Our Roth IRAs Through the Backdoor
» Three Ways to Make Your IRA Work Harder
» Max That Roth! (Yet Again)
» Max That Roth! (Again)
» Traditional to Roth IRA Conversion at Vanguard

As a followup to Friday’s post on contributing to a traditional IRA and converting to a Roth IRA (i.e., funding a “back door” Roth) I wanted to spend a little time talking about Roth IRA withdrawal rules.

This post was actually inspired by a comment from a reader named John who is interested in using IRA funds to buy his family’s farm in about five years:

If I convert traditional, previously-deducted IRA funds to Roth IRA funds and then pay taxes on it, can I then withdraw the taxed contributions at a later time in order to purchase the investment property? I would not be withdrawing earnings, only the initial contribution.

The short answer is yes – with some restrictions.

Unlike the situation I talked about in my previous post, where you’re making a non-deductible contribution and then converting it, John is correct that he’ll have to pay taxes when he converts his deductible contributions (and any subsequent earnings). The reason for this is simple: you’ve never paid taxes on this money, so you have to do so before you can stick it in Roth IRA (since you pay taxes up front with a Roth).

The real question is whether or not John can pull this money out without consequences at some point in the future — but presumably before he reaches retirement age. Of course, if he waits until age 59.5, then all bets are off. He’s free to withdraw whatever he wants, whenever he wants.

But before that time… Can he make a penalty-free withdrawal to buy the family farm?

For starters, we need to talk about the order of distribution. As with others types of IRAs, the IRS views all of your Roth IRAs (assuming that you have more than one) as a single pot of money. And when you withdraw, you are assumed to first be accessing your original contributions. After that money is depleted, you are assumed to be accessing dollars that you converted. And after that, you are assumed to be accessing earnings.

For original contributions: This would be money that he contributed straight into his Roth IRA, subject to annual contribution limits. As it turns out, you can withdraw your Roth IRA contributions at any time without paying any taxes (you’ve already paid taxes on this money) or penalties.

For conversions: Conversions (money converted from a traditional IRA into a Roth IRA are treated similar to contributions, with an important difference. If you withdraw money that you converted into your Roth less than five years after the conversion, you have to pay a 10% penalty. This stops people from simply converting their traditional IRAs into a Roth to gain immediate access to the money. But once the five year rule has been met, you can withdraw your conversions at any time without paying any taxes (you’ve already paid taxes on this money) or penalties.

For any subsequent earnings: Finally, what about any investment earnings/gains that have occurred inside of you Roth? Let’s say you contributed a total of $10k over the years, and it’s now worth $12k. The last $2k that you withdraw would be the earnings. For starters, any earnings that are withdrawn less than five years after you opened your Roth IRA are subject to income taxes. Moreover, if you are under 59.5, the withdrawal will be taxable unless you meet certain exceptions, and you it will also be subject to a 10% penalty. Once you reach age 59.5 and your account has satisfied the five-year rule, you can withdraw your earnings free and clear.

So what about these exceptions that I mentioned above? There are several things that will make a distribution “qualified,” and thus not subject to taxes or penalties. One is reaching age 59.5 (and having satisfied the five year rule in the case of earnings). The others include: distributions made to a beneficiary after your death, disability, or using the funds to pay certain costs associated with being a first-time homebuyer.

So…. The short answer is that yes, John can convert from a traditional IRA to a Roth IRA, pay any taxes that are due (just be careful about getting bumped into a higher tax bracket!) and then withdraw the conversions in five (or more) years without paying any additional taxes or penalties.

Note that I’m not saying that this is necessarily a good idea — that depends on the details of John’s circumstances, and that’s a decision that he’ll have to make for himself after considering a number of factors. Rather, I’ve just focused on what’s possible, and when the penalties will (or won’t) kick in.

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As a followup to my post earlier this week on Roth IRA income limits, I wanted to highlight how we typically make our Roth IRA contributions. For background, we’re in a relatively high (and variable) income tax bracket. Because of this, we flirt with the Roth income limits on an annual basis, and it’s hard to know for certain whether we’ll be above or below the line until late in the year.

While we could wait until the end of the year, or even early the following year, to determine whether or not we can contribute, I’d rather get it knocked out right away. Thus, we make what others have termed “backdoor” Roth IRA contributions.

For background, the income limits for converting from a traditional IRA to a Roth IRA went away back in 2010. Beyond this, there are no income limits for contributing to a traditional IRA. Yes, there are income limits for determining whether or not you can deduct your traditional IRA contributions, but you’re free to contribute no matter how much you make.

The workaround, then, is to contribute to a traditional IRA (this will be non-deductible if you make enough to be ineligible for a Roth) and then convert it to to a Roth IRA. And that’s exactly what we do every January. For those of you that invest with Vanguard, I’ve outlined the steps below to show you exactly how it’s done…

For starters, you’ll need to make your traditional IRA contribution. There are a variety of ways to do this, with the easiest be funding your IRA from a linked bank account. For now, I’ll assume that you’ve already done this.

Once your traditional IRA fund are in place, simply log in and select “Exchange (Sell funds to buy funds)” option from the “Transact on this account” pulldown menu.

When asked what you want to sell, choose the traditional IRA holding(s) that you wish to convert out of. When asked what you want to buy, choose the Roth IRA holding(s) that you wish to convert into.

Once you click to review, you’ll be warned that “A conversion is a taxable event. Generally, you’ll owe taxes on the amount you convert from your traditional, SEP, or rollover IRA into a Roth IRA.”

Assuming that you made a non-deductible contribution, that you don’t have any untaxed gains in the account you’re converting, and that you don’t have any other non-Roth IRA IRA accounts in your name, however, there will be no tax liability*. It will be as if you had contributed directly to the Roth IRA in the first place, except you’ll have circumvented the income limits.

Given the above, I selected the “Do Not Withhold” option when asked about tax withholding and then submitted the order.

That’s it. We’ve now fully funded our Roth IRAs for 2012 and don’t have to think about whether or not we’ll finish above/below the income limits.

*Note: If you have previously made tax-deductible contributions to a non-Roth IRA, even if they’re in a different account, making a conversion like this will generate a tax liability. The reason for this is that the IRS views all of your IRAs as one big pot of money, and they don’t let you pick and choose which dollars you convert.

The good news is that money in “qualified” plans, such as 401(k) or 403(b) plans, is not included in the tax calculation, so you could conceivably move all of your pre-tax money into a Solo 401(k) to effectively hide it before doing the “contribute and convert” thing.

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Related Articles at fivecentnickel.com:

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» Roth IRA Withdrawal Rules: How to Get Your Money Out Early
» Traditional to Roth IRA Conversion at Vanguard
» 2007 IRA Contribution Limits
» Ratcheting Up Our 403(b) Contributions
» Funding an IRA When You’re Not Sure You Can Afford It
» Look Before You Leap: Roth IRA Conversions in 2010

I recently wrote about Roth IRA contribution limits for 2012, which are unchanged from 2011. Today I want to talk about the current income limits for contributing to a Roth IRA. Here goes:

Married Filing Jointly: Contributions phase out from $173k-$183k
Single or Head of Household: Contributions phase out from $110k-$125k
Married Filing Separately, Living Apart: Contributions phase from $110k-$125k
Married Filing Separately, Other: Contributions phase out from $0-$10k

(Note that these numbers all refer to modified adjusted gross income, or MAGI)

The good news is that even if you exceed the income limits, there is a workaround for funding your Roth IRA. Indeed, as of 2010, the income limits for converting from a traditional IRA to a Roth went away, so if you earn too much, you can make a non-deductible traditional IRA contribution and then convert it to your Roth.

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Related Articles at fivecentnickel.com:

» Contribute and Convert: Funding Our Roth IRAs Through the Backdoor
» Will the IRS Disallow Backdoor Roth Contributions?
» Roth IRA Conversion in a Down Market
» IRA Changes for 2008
» Roth IRA Income Limits for 2007
» What are the 2012 Traditional and Roth IRA Contribution Limits?
» Postponing Taxes on a Roth IRA Conversion
» 2007 IRA Contribution Limits

A few notes…

First, note that this limit is a combined limit for traditional and Roth contributions. Thus, while you can contribute to both in the same year, the total contribution cannot exceed the $5,000 (or $6,000) limit.

Second, your traditional IRA contributions may be tax deductible, depending on whether or not you’re covered by a retirement plan at work, and how much money you make. Details can be found here and here.

Finally, remember that you can make contributions for 2011 all the way up to April 17th, 2012 (the due date for filing 2011 tax returns). Thus, if you still haven’t gotten around to it making your 2011 contributions, you still have time.

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Related Articles at fivecentnickel.com:

» Roth IRA Income Limits for 2012
» Contribute to Your Roth IRA, Even if it Stretches Your Budget
» 2007 IRA Contribution Limits
» 401(k), 403(b), and 457(b) Contribution Limits for 2009
» Contribute and Convert: Funding Our Roth IRAs Through the Backdoor
» IRA Changes for 2008
» Max that Roth!
» Ratcheting Up Our 403(b) Contributions

Earlier this week, I ran across an article about a new piece of legislation being promoted by two Georgia Congressmen who want to allow people to pull money out of their retirement accounts to pay down their mortgages.

Dubbed the Hardship Outlays to Protect Mortgage Equity (HOME) Act of 2011, the legislation would allow homeowners to withdraw up to $50k or half of the account value, whichever is smaller, without paying the usual 10% penalty. In short, you’d have to use the funds to make mortgage payments within 120 days of receiving the distribution.

You can read the text of the bill here: HOME Act of 2011

The sponsors, Sen. Johnny Isakson and Rep. Tom Graves, argue that people who are faced with losing their homes should not be forced to pay a penalty to access their own money. At the same time, many financial experts are skeptical. One big concern is that people would be pulling money out of 401(k) accounts that are protected from creditors and putting it into a home that could ultimately be taken from them.

Another justification that Isakson gave is that people could use the withdrawals to get their underwater mortgages back above water, thereby allowing them to refinance their mortgage to a more favorable rate. Of course, with the recently announced changes to the HARP program, those with underwater mortgages will now have an easier time refinancing, so it might not be necessary to raid their 401(k) to make this happen.

One concern I have is that, if passed into law, the new rules would effectively allow anyone with a mortgage to raid their retirement account, whether or not they really need the money to cover their payments. While I understand the desire to help people stay in their homes, the last thing we need to do is make it too easy for anyone and everyone to pull money out of retirement accounts.

What do you think? Is this a good policy move? Or are we just kicking the can down the road, essentially transforming the problem from unaffordable mortgages into unaffordable retirements?

As an aside, I know of at least one reader out there will likely be strongly in favor of this idea… Our good friend Carlos, who cashed out his 401(k), paid the 10% penalty (plus taxes), and used the proceeds to pay off his mortgage just three years after buying his house.

Source: AJC.com

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Related Articles at fivecentnickel.com:

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Everyone has seen how housing prices have taken a nosedive in most markets across America since the start of the 2008 recession. Almost $3 trillion worth of equity has disappeared, and homes are now worth significantly less than what their owners paid for them. This evaporation of equity has dealt a devastating blow to many elderly Americans who were originally planning on tapping into that equity to supplement their retirement through reverse mortgages.

The truth is that reverse mortgages shouldn’t be used as a last minute tool to fund your retirement. Unfortunately, the lack of homeowners’ equity and a host of other factors have made reverse mortgages a thing of the past as a retirement option.

What is a reverse mortgage?

A reverse mortgage is much like a standard mortgage for your home. It is called a reverse mortgage because the homeowner will receive a cash payment based on the amount of equity he or she has in their home. So, after you finally get your home mortgage paid off and you own your home free and clear, you can go back into debt again for the exact same house with a reverse mortgage.

In contrast to a conventional mortgage, however, there is no repayment requirement as long as the homeowner meets certain requirements, such as continuing to use the home as his or her primary residence. Once the borrower dies, the loan must be repaid.

Reverse mortgages require equity

One of the biggest realizations to come out of the current housing crisis is that reverse mortgages require homeowners to have equity in their homes. If you’ve been banking on a reverse mortgage to fund your retirement instead of investing for your financial goals that you should be been doing all long, you could be in for a rude awakening if the equity in your home has vanished.

This is exactly what happened during the recent (and ongoing) housing crisis, and many Baby Boomers and retirees have been left in a tough situation with little in the way of retirement savings and a hope of using home equity and a reverse mortgage to fund their retirement dreams. But, when the equity disappeared, so did their ability to borrow against their home for retirement. Traditionally, homeowners thought that home prices would rise forever, but that has proven not to be the case in recent years.

Reverse mortgages can hurt your heirs

When you borrow against your home equity to cover living expenses in retirement, you’re putting your heirs at risk of some serious estate planning consequences. When you die, your reverse mortgage must be repaid. Many estates do this either with insurance proceeds or by selling the primary home that was mortgaged. This can be devastating news to family members who may have been counting on those funds for one reason or another — e.g., daily living expenses, paying for a future college education, or paying off other debts of the deceased. Reverse mortgages also have the potential to forcing the sale of homes that have been in families for generations.

Reverse mortgages aren’t a substitute investing

When home prices in America were skyrocketing, many people skipped funding their retirement accounts in favor of buying a bigger home and paying down their mortgage. The trouble with this is that you really need to have a well-rounded financial plan that includes investing for retirement and other goals, saving, paying down debts, and protecting yourself and your family with insurance. Banking on the ability to borrow against the equity in your home during your retirement years is a very risky strategy that can blow up in your face.

Reverse mortgages are expensive

Historically, reverse mortgage are very expensive because of very high fees. These fees erode the value of what little equity you have built up in your home. Like all home loans, there is an origination fee, appraisal fees, closing costs, insurance, and a host of other fees that are tacked onto your reverse mortgage. Because of this plethora of fees, the cash payout that you receive in this depressed housing market will be even further reduced.

In the final analysis, there’s no better alternative to investing for retirement than a well-balanced portfolio of stocks, bonds, and/or mutual funds. Using your home as a way to fund your retirement dreams is fraught with potential drawbacks, and the expectation that you’ll have a ton of equity at retirement is based on the faulty assumption that your home will necessarily increase in value, or at least retain its current value.

Do you have any experience with reverse mortgages? Has your declining home value now made a reverse mortgage impossible? I’d love to hear your thoughts in the comments section.

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» Retirement Savings Options, Part I

The American paradigm for decades was that you worked for an employer your entire life. Then at 65, you were feted at a retirement party, handed a gold watch by your boss, and sent off on a serene path into your Golden Years.

After 40 or 50 years savoring all the good things about work life — the satisfaction of challenges surmounted, the colleagues who turned into friends, the reassurances of a steady paycheck and a comforting routine — you were suddenly expected to love a new life of sleeping in, idling away long afternoons, playing a little golf, and trying to keep out of your spouse’s way.

Where once you’d enjoyed a built-in social network provided by your co-workers, the folks with whom you rode the bus or train to work, the waitresses at your workday lunch spot, your world now grew exponentially smaller — a first but significant shrinkage on the path to dwindling to the size of your deathbed.

No wonder there was another American cliche associated with the above. It involved the guy who, after retiring in fairly good health, suddenly dropped to the pavement, dead of a heart attack a few short years or months after retiring.

More recently, I’ve heard of a new standard replacing the old one. It’s being forged by retirees who, after learning that a life of golf games, grandkids, and gazing at TV didn’t match their retirement dreams, decided they needed to go back to work. Not necessarily for money, but for their mental health.

I’ve heard these stories over and over: The former watch repairman who returned to tinkering with timepieces three days a week, the barber who took over a chair in the very shop he’d sold years before, the retired construction tradesman who assumed the reins of the home delivery service at his sons’ eatery.

About seven years ago, I interviewed Dr. John Gorham, who started work at the Washington State University College of Veterinary Medicine in Pullman, WA right after World War II. When Gorham logged his very first workday, Harry S. Truman was in the White House, TV was in its infancy, and the Chicago Cubs’ last World Series appearance had come a few months earlier.

An awful lot had changed by the time of that interview nearly 60 years later. But one thing hadn’t changed. In 2004, Gorham, then 81, still came to work each day as a professor of veterinary pathology, just as he had since 1946.

“It’s because I like to go to work every day,” he told me. “The people here are all 30 or 40 years younger than I am, and I get a kick out of being around the group. They’re after new research, and it’s just fun going to work.”

Paradigm shift

Turns out, Gorham was out ahead of the pack on this issue. Many folks today are realizing that spending the last years or decades of their life without ambition, challenges, or paychecks isn’t a particularly bright idea.

A few weeks ago, I spoke with Sara Rix, senior strategic policy advisor with the AARP Public Policy Institute in Washington, D.C. The topic: the merits of working longer. Today’s labor force is adding a lot of older people, especially those between 65 and 69, as folks delay retirement, or retire the retirement idea entirely, Rix told me. The rate of employment beyond the traditional retirement age has ballooned from 18.4% in 1985 to 31.5% last year. Among women, it’s actually doubled, from 13.5% in 1985 to 27% in 2010, Rix says, adding, “They like the social environment work provides.”

AARP’s Jean C. Setzfand puts it a different way. “Few people anymore see retirement as a time when they’ll put their feet up and do nothing,” she wrote recently. “Increasingly, people expect to work past 65 or 67, even if their job is something completely different from the one they’ve done their whole lives.”

And the fact is, it’s a brilliant money move to work a little longer, AARP points out. “Remaining at work longer is an option for many of us,” Rix says, noting the benefits of delaying retirement by even a few years means that many more years of savings, and that fewer number of years of financial outflow.

There’s also the issue of Social Security payments, which can be taken starting at 62, 65, or 70. If you hold out taking Social Security payments until age 70 because you can, your benefits are about 80 percent higher than at 62.

And that’s yet one more reason to consider working a little longer.

To give you an idea of the most advantageous age for you to take social security, and to learn the penalties for starting the flow of social security checks earlier rather than later, visit AARP’s new Social Security Benefit Calculator.

“Even a year of extra work makes a difference,” Rix says. “People ought to look into the advantages of working longer. And it doesn’t have to be 10 years longer. It can be one, two, or three years longer.”

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Earlier this week, a long-time commenter named Carlos (aka CharlieBoy) mentioned that he paid off his mortgage early. Having done the same thing myself, I was intrigued, so I sent him a note asking for details.

Within a few hours, Carlos sent a lengthy reply with tons of details. Today, I’ll be summarizing his story.

“My wife and I purchased our house in the fall of 2008 for $300,000. I believe the interest rate was 6%. We used the equity from our old house to pay off three small auto loans and to make a 35% down payment on our new house. The big down payment made it easy for us to refinance it two times since 2008 because we were never under water.

We didn’t want to buy a huge house with a huge mortgage. We decided not to let the bank or agent tell us how much house we could afford. WE did the math, WE knew our budget; therefore, WE decided how much we were comfortable paying each month. We found a house that works well for us within our budget.

Sure, it doesn’t have the desirable three-car garage that we wish we had, but a bigger garage comes with even a bigger mortgage, so we decided we could live with a smaller garage but with the smaller mortgage. [...] Back in 2008 the bank would have let us borrow two times the amount that we borrowed. Ouch!”

That’s quite impressive… They paid paid off a $195k (= $300k – 35% down payment) mortgage in about three years. But how? Well, a big part of it was the decision to downsize so they could pay off those three auto loans and put up a big, fat 35% down payment. But there’s more…

“Just a few weeks after we bought the house in 2008, we refinanced our mortgage into a 5%, 15-year loan. To make up for the larger monthly payment of a 15-year mortgage, we had to make some budget cuts. It wasn’t too hard because we no longer had car payments. We don’t go to regular restaurants, and we rarely go to movie theaters.

Last December, we refinanced it again at 3.75%. That was our Christmas gift to ourselves. That lowered our monthly payment once again, but the thought of spending the next 15 years slaving away for a mortgage company continued to bother me every day, we started saving even more to pay it down faster.

By living below our means, we started sending every extra penny we saved to pay down our mortgage principal after we saved a little for emergencies.”

Okay, they refinanced to more agreeable terms, scraped up additional money for extra mortgage payments, etc. But still, how so fast?

“The extra payments towards the principal were making a huge difference, but then something else happened. In April, I changed jobs, which meant I had to decide what I wanted to do with my 401(k). I kept going back and fourth between cashing it out to pay off my mortgage or just rolling it over to an IRA.

I know very well that cashing out your 401(k) to invest in a 3.75% mortgage is not considered wise when you look at the stock market’s historic returns of 7% to 8%. I don’t even recommend it to anybody.”

Yikes. Cashing out a retirement account early results in a hefty tax bill plus 10% early distribution penalty. Ouch. So why did he do it?

Well, he went on to argue that, due to our country’s massive deficits and the political mess that has developed over the past few years, the investment outlook in this country just isn’t that good, and he’s not expecting anywhere near historic returns for the foreseeable future. Given an expectation of low returns, he could justify taking the hit to get out from under his mortgage.

This is a pretty extreme view, and Carlos is well aware of that. After all, he explicitly states that he doesn’t necessarily recommend this course of action to others. But it was the right decision for him.

Looking forward:

“By not having a mortgage, I can now focus more aggressively on my retirement. Who knows, I might save enough money to invest in a small business. Not having a mortgage will create more opportunities for me. Getting rid of my biggest financial responsibility makes sense in every way to me.”

Having paid off a mortgage myself, I can say with certainty that it does free up a lot of cash and provide a lot of flexibility. That being said, trading your 401(k) for a mortgage-free life isn’t a decision to be made lightly. Given that contributions to retirement accounts are capped on an annual basis, Carlos will have to work extra hard to rebuild his retirement nest egg.

Sure, he’ll be able to pour money into a tax-efficient (but taxable) portfolio to complement the money he’s able to stash in retirement accounts, but he’s lost a bunch of tax-advantaged space (not to mention the 10% penalty) that he can’t easily re-gain.

So… What do you think? Is Carlos crazy for cashing out his 401(k)? Or crazy like a fox? As much as I disagree with the decision to liquidate his 401(k), I have a feeling that Carlos is going to be just fine in the long run.

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I recently ran across some interesting data on the differences between men and women when it comes to investing for retirement. What follows is based on “How America Saves 2011,” which is Vanguard’s annual report on retirement plans.

And yes, I realize that it’s dangerous to generalize, but there are some interesting nuggets of wisdom in here…

Participation rates

According to the report women who earn between $30k-$100k/year are more likely to participate in their workplace retirement plan than men in the same income range. The differences aren’t always huge, but they’re definitely noticeable. For example, in the $50k-$75k range, 78% of women joined their retirement plan vs. just 68% of men. Moving outside of that range (below $30k or over $100k) the situation reverses, and men are slightly more likely than women to participate.

Savings rates

Women who have joined their employer’s retirement plan also tend to save more than men. For example, returning to that $50k-$75k range, women put an average of 7.4% of their income into their retirement plan vs. 6.8% for men. Looking more broadly across the data, women out-contributed men by a 6.9% to 6.7% difference, and they have done so in seven of the past ten years.

While the difference here isn’t huge, it adds up over time. For example, consider someone at the top end of that $50k-$75k pay range. The extra 0.6% they’re saving amounts to “just” $450/year. But if we hold that contribution rate constant over time and assume an annual salary increase of 3.5% on that base $75k salary along with an 8% investment return, we’re talking about nearly $80k more in savings over 30 years.

Diversification

On average, women tend to have a more diversified investment portfolio than men. In 2010, women held and average of 10% of their portfolio in bonds funds vs. 9% for men, and women had an average of 25% of their account balance in balance (stock + bond) funds vs. 22% for men. This isn’t necessarily a good or bad thing, as it really just means that men are slightly more aggressive in their investing, and it ignores factors such as age.

Nonetheless, this difference appears to have served women well during the recent market downturn, as the average woman’s retirement account grew more than the average man’s retirement account from 2005-2010. Of course, this also includes contributions, so the higher savings rates mentioned above contribute to this difference.

Changing course

Based on an analysis of IRA accounts, men were 10% more likely to abandon stock between January 2007 and October 2009. Of course, we all know what happened at the tail end of that time period – the S&P 500 skyrocketed 56% from March to September 2009. While a lot people jumped back in during this run up, many of them sold near the bottom and then missed at least part of the recovery.

Putting it all together

When you read through the above, it sounds like women are (on average) doing very well when it comes to retirement investing… And yet the median account balance for women in employer-sponsored plans was just over $21k vs. more than $33k for men. In terms of averages, the difference was even greater – $96k vs. $59k.

What gives? According to the report, though women have better investing habits, they tend to have (again, on average) shorter job tenures and lower incomes. In other words, they have much more to overcome when it comes to preparing for retirement.

As for why women are better investors, Vanguard suggests that women might be more likely than men to seek advice – and to follow the instructions that they are given. At the same time, economists have suggested that men then to overestimate their investing abilities which can result in bad decisions and poor results.

Source: The Vanguard Group

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In thinking about how much money you need for retirement, you need to consider both your age at retirement and how long you can reasonably expect to live. The earlier you retire or the longer you expect to live, the more you’ll need to ensure a comfortable retirement, so… Just how long do you expect to live?

A brief history of life expectancy

Back in 1900, a newborn in the United States could be expected to live 47.3 years. In 1950, that number had risen to 69.7 years, and by the year 2000, it was 76.8 years. According to the most recent CDC estimates, which are based on data from 2007, life expectancy in the United States currently stands at 77.9 years.

As a side note, this increase in life expectancy is one of the reasons that many pension plans and Social Security have been struggling to make ends meet. In fact, Americans are living nearly twice as long in retirement as they did back in the late 1960s.

The above estimates, of course, are based on broad averages so they’re not all that accurate for any particular individual or situation. Moreover, they’re for newborns, so they don’t account for the fact that you’ve already survived for (say) 40 years, and thus are likely to live somewhat longer than average. What we need, then, is a tool for personalizing the prediction.

Personalizing the prediction

Guess what? I’ve found a great calculator for doing just that. It was put together by researchers at the Wharton School of Business at UPenn. It was actually created with life insurance in mind, but it works equally for getting a better handle on how long you might expect to live in retirement.

It’s pretty detailed, so it takes a few minutes to run through it, but it’s well worth the time. Here’s the link (or click the graphic, below). And here are my results:

Obviously, you can’t put too much stock in a point estimate like this, but it’s definitely informative.

Assuming that I retire at the traditional age of 65, I can expect to live roughly 23 years in retirement though, based on the lower and upper quartile estimates, it could be as short as 15 years or as long as 33 years. If I retire earlier, I’ll have an even longer post-retirement existence.

The takeaway

An important takeaway here is that retirement isn’t the finish line. Not only does your expected time in retirement govern how much money you’ll need to make it through to the end, but it also influences how aggressively you should be investing.

The general consensus is that you should invest more conservatively as you get closer to retirement. This makes good sense, as your time horizon will be getting shorter and shorter as time wears on. That being said, shorter does not necessarily equal short. Even once you’ve reached retirement age, you may have another 20-30 years (or more) to go before the bitter end.

In short, while you may not have time to recover from a stock market drubbing as you approach (or enter) retirement, you also have to be careful not to ratchet things back too far. After all, you can’t afford to get too conservative unless you’re sitting on an enormous pile of cash.

Anyway… I’m mostly just musing here. But I am curious to hear about your results. What’s your life expectancy? And, given when you expect to retire, how long will you be living off your portfolio?

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You’ve likely heard that, due to meager retirement savings, many working Americans will have to delay retirement. Unfortunately, according to a study by the Employee Benefits and Research Institute (EBRI), deferring retirement by a few years won’t be enough to ensure even a bare-bones retirement for millions of older Americans.

In fact, the study found that:

…the lowest-earning 25 percent of Americans would have to work until age 84 so that 90 percent of them would have even a 50-50 chance of having enough money to afford basic living expenses and out-of-pocket medical care.

That’s a lot of percentages, but the upshot is that even if they work until age 84, the majority of those in the lowest income quartile will only have a coin flip chance of having enough money to make it to the end. Obviously, if you require a higher likelihood of having enough money, then you significantly decrease the fraction of households that will achieve “income adequacy.”

For example, if we require a 70% likelihood, then just 40% of households in the lowest quartile will attain “income adequacy” by deferring retirement to age 84. And by changing to an 80% likelihood, that number drops to 1 in 7. Of course, when we’re talking about the lowest quartile, we’re talking about those earning $11,700 or less, so it’s perhaps not surprising that they’ll have trouble making ends meet.

At the other end of the spectrum, however, only 76% of those in the highest income quartile are expected to achieve the 70% likelihood of income adequacy if they retire at the traditional age of 65. This number falls to 61% if we increase the likelihood to 80%. Not pretty.

Of course, these numbers are based on averages, so the key here is to strive to be well above average. Don’t wait until the last minute. Instead, pay off your debts, start investing as early as possible, cut out unnecessary spending, and so forth. You should be taking advantage of any and all retirement accounts that are available to you. If you’re not able to max them out, consider finding ways to earn extra money.

Source: EBRI.org via Yahoo! Finance

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One of the brilliant innovations of the last couple decades, I think, is the drive-thru pharmacy. Ponder the concept a minute and you’ll likely agree.

With the advent of TV prescription drug advertising, most Americans dutifully began turning their homes into mini apothecaries. But about the same time, studies started showing many ills requiring medications could be avoided altogether if we just got out and exercised a bit. These findings couldn’t have inspired bacchanalia at firms whose profits rested on prescription drug sales.

The genius solution, of course, was the drive-thru pharmacy. No longer would folks have to leave their cars and walk through a crowded store to the drug counter. No, now they could sidestep even that minimal exercise, thereby hiking the odds they’d go on needing medications, would eventually need even more, and sometime later still more Rxs to combat the side effects from the first pills.

Is that genius, or what?

Another marketing marvel

As a marketing masterstroke, the drive-thru drug window ranks right up there with big-screen TV. Of course, the big-screen is just the latest in a long series of stratagems by television makers, networks, and production companies.

Soon after the first TV sets arrived in U.S. homes, most folks realized not much worth viewing ever aired. What was true in 1951 with four channels wasn’t much different 60 years later with four hundred.

The sole entertaining exception in that span was the spot depicting the fun of popping a pill and then soaking in side-by-side, his-and-hers tubs.

If they couldn’t count on enjoying the TV experience, what would spur people to go on buying TVs? Answer: the opportunity to one-up their neighbors, naturally! So screens got larger. Color TVs arrived. Picture-in-picture dawned. Remotes requiring handbooks to comprehend were born. And finally came the TV big enough to fill a wall. Through it all, only one thing remained constant: that you’d be far better off doing almost anything other than watching TV.

And here’s the part that’s sheer marketing magic. What appears regularly amid commercial programming dreck on any big-screen? Why, ads trumpeting the next generation of super-colossal television sets, don’t ya know?!

No retiring this idea

If there’s any invention more ingenious than drive-thru pharmacies and big-screens, it’s the retirement planning field and the hubbub it spawns. Think about it. Insisting we all expend time, effort, and worry planning for retirement keeps vast industries humming and millions of people employed. The only ones suffering are the poor souls driven to early graves fretting they have no plan.

Retirement planning funds the existence of brokerages, mutual funds firms, financial advisors, estate planning lawyers, authors of books on retirement, and publications explaining how to save for retirement, to name just a few.

The idea that we all must retire, presumably so we can spend more time idling at drive-thru pharmacies and watching big-screen TV, is a given for most Americans. They take as gospel that around their mid-60s, they’ll shed that old job and the rest of their life will be spent hand-in-hand with their significant other, gazing at a sunset over a glorious beach. After sundown, they’ll be able to catch some tube while downing the meds they got earlier at the drive-thru.

All this certainty, despite the fact that the concept of retirement is really a fairly recent development, having sprung up after the dawn of the 20th Century. Until then, people didn’t have any choice but to keep working until they kicked the bucket.

That sounds like a dismal fate until you consider they had some things 21st Century retirees don’t. Because retirement planning is an inexact science, many now trade stressful jobs for the anxiety of worrying that their savings will expire before they do. They also have to find something to give them purpose, a reason to get up in the morning, and a challenge of the kind we all need. Earlier Americans who worked to their dying day didn’t face any of these issues.

Just think, if we didn’t have to retire, we’d suffer the fate of saving tons of cash on retirement planning advice and tools! We’d be forced to find something we loved doing, maybe the job we’d done all along or another we’d always had a passion for, and keep right on working and earning. We’d have to confront an absence of anxiety over whether our money would run out before our lives did.

With all the money saved not employing retirement gurus, plus the cash we’d earned working longer, plus savings we HADN’T withdrawn, we would have to endure genuine choice in what we did, where we traveled, how we lived.

Thank goodness the American Marketing Machine is always revved and ready to remove any stomach-churning choice we might opt to take on. Work out rather than pop pills? Read or pursue a hobby rather than stare at pap on a giant screen? Keep working longer at something you love promising a purposeful life, rather than doing nothing? “Balderdash!” the Machine informs us.

But psssssst! If you want to see what it feels like to have choice, you might do a search for high-yield savings accounts. Or possibly look for some zero-percent apr credit cards. Questioning the autocratic lectures of the Marketing Machine is a bit unusual these days. But doing so may be the single best innovation of all.

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Over the weekend, I ran across a fascinating study that suggests that retiring early can significantly increase your lifespan. This work was based on an analysis of longevity data from former Boeing Aerospace, and it concluded that “for every year one works beyond age 55, one loses 2 years of life span on average.”

Here are the relevant data:

(Source: “Actuarial study of life span vs. retirement age” by Ephrem Cheng)

As you can see, these data appear to indicate a continuous decrease in lifespan the longer one works. Perhaps the scariest bit of data here is that those that work through the traditional retirement age of 65 only cash their retirement checks for an average of 17 months. 17 months! Is that what you have in mind when you think about your future? That your “retirement years” will be reduced to little more than a “retirement year”?

Unfortunately, the study didn’t include an analysis of why someone that works longer might die sooner. Of course, you also can’t easily extrapolate from one workplace to another, and we’re running the risk of confusing correlation with causation. Nonetheless, it’s fun to speculate…

Given that many jobs are filled with stress and frustration, it’s not hard to imagine that their might be some health problems associated with working – e.g., heart disease, hypertension, etc. On top of that, a busy work life leaves less time for exercise, eating right, and so forth, which only compounds the problem. I guess the silver lining is that you won’t need as much money for retirement.

What do you think? Is working longer a grave health risk? Or do you think there’s another explanation for these data? Please weigh in with your thoughts.

Update: The veracity of this study has been called into question, with Boeing stating that there is no such trend in the data, and that “Boeing retirees live longer than the national average, regardless of age at retirement.”

Source: Retiring Early via extremejacob

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I recently ran across a post by sometimes-FCN-guest-poster Richard Barrington over at Money Rates. In it, he talked about ways to overcome the general lack of savings that is threatening the retirement dreams of many Baby Boomers.

You can read the full article on Baby Boomer Retirement for more details, but here are his six tips:

1. Work longer
2. Diversify your investments
3. Use laddering to manage interest rate risk
4. Save on bank fees
5. Actively shop for the best rates
6. Monitor your progress

To these, I would add that you should consider making deep spending cuts to allow for an increase in your savings rate. When combined with working longer, this will give you the best chance of digging yourself out of your retirement savings hole.

Obviously, diversifying your investments, seeking out the best rates, etc. also have their place, but those things will only get you so far. You really need to ramp up your savings rate and/or save for longer (thereby shortening your retirement) if you want to make a meaningful dent in the problem.

Source: Six Ways to Avoid the Baby Boomer Retirement Bust

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When it comes to planning for your financial future, inflation is a huge issue. In fact, given the historic annual inflation rate of 3.75% a million dollars today will be worth just over $190k in 50 years. Moreover, using that historic rate along with the rule of 72, we can further conclude that prices will double every 19.2 years.

CPI vs. the true cost of living

Of course, it’s also been argued that the true cost of living is increasing faster than the official inflation rate. One problem is that gas and groceries are omitted from the so-called “core inflation rate,” meaning that when food and fuel prices spike, this particular inflation indicator might not budge. For this and other reasons, it has been argued that official inflation estimates understate the true situation.

The motivations for underestimating inflation are obvious. Because numerous governmental programs, as well as estimates of “real” economic growth are indexed to inflation, the federal government can (at least in theory) save money and paint a rosier economic picture by understating inflation. I’m not going to wander of into the weeds and debate whether or not this is happening. Rather, I’m just pointing out the potential benefits of inflation manipulation.

Note: Just to clear up any confusion, inflation-indexed government programs typically use the CPI-U, which does include food and fuel prices. The point here was just that, for a variety of reasons, the various inflation estimated have been criticized as inaccurate, with a tendency to understate the real situation.

If inflation were to be understated, however, this would be a huge deal from an investor’s perspective. After all, if you think that inflation is running at X% and it’s really running at Y% (where Y > X), then you’re likely to fall well short of your goals – at least in real terms. The reason for this is that, even though your portfolio may be growing, the value of each dollar is shrinking faster than you expected.

Estimating inflation in the real world

With that as a backdrop, I wanted to point out an interesting website that I ran across this past weekend. It’s called The Billion Prices Project (BPP). The BPP is an academic project based at MIT which seeks to use prices collected at hundreds of online retailers to estimate a daily price index.

As of now, they are still well short of covering all of the goods and services that go into the CPI. If you click through and look at the graph, you’ll see that there is a rough correlation between the BPP index and the CPI. Since late 2009, however, it appears that the BPP index has been running ahead of the CPI.

Given the differences in what the two indices cover, it’s difficult to say if this difference is real, but this is (to me at least) a fascinating project with a lot of potential. It would be great if they can tweak the BPP to the point that it converges on the CPI. It would be especially nice to see a real-world calculation that includes the cost of fuel.

While fuel prices aren’t easy to come by online, and thus aren’t part of the BPP index, it seems like they could partner with a crowd-sourced database such as Fuelly (which I’ve written about before) to get real-time estimates of fuel prices from throughout the country.

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Earlier this week I proposed the idea of building a personal endowment. In short, this involves building an investment portfolio that is 25x-33x your annual living expenses. If you can achieve this goal, then you can fund your ongoing expenses from your investment income, without ever having to touch the principal.

Given the large numbers involved (e.g., $50k annual expenses = $1.25M-$1.7M, depending on the multiplier), I also talked about breaking this down into sub-goals. That way you can buy your financial freedom one piece at a time. Your $1k rent expense? That’s yours for a $300k-$400k. You groceries – at $250/month? You can eat for “free” (for the rest of your life) for $75k-$100k.

Today, I want to talk about two related items…

First, a reader (and fellow finance blogger) named Evan pointed out that it’s also useful to look at this concept in reverse. That is, if your ongoing grocery expenses is $250/month, then a “passive” income stream* such as a blog that earns $250/month is roughly equivalent to an investment portfolio worth $75k-$100k.

*Note: As any serious blogger will tell you, this is hardly as a passive endeavor. Nonetheless, it’s an enjoyable hobby, so it doesn’t necessarily count as “work.”

Obviously, this logic scales up with the amount of additional income, and highlights the value of earning extra money. That being said, you have to be careful about the stability of this income stream if you are counting on it being there in the long run.

Second, I also wanted to point out the importance of keeping your expenses in check if you want to achieve financial independence. Look at it this way: for every $10k you reduce your living expenses, you reduce your necessary target portfolio by $250k-$330k. That’s huge.

If you sit down and calculate your number (which I encourage you to do – right now!) and you find that it’s dauntingly high, you have several options:

1. Give up
2. Increase your earnings to reach your goal faster
3. Cut your expenses to reduce the size of you goal

For obvious reasons, I don’t recommend option #1. In reality, the best strategy is a combination of #2 and #3. Minimize your expenses to reduce your target by as much as possible, and then maximize your earnings to get there as soon as possible.

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If you feel like your retirement plan is DOA, you are in good company. The financial crisis of 2008 whacked most people’s faith in the future. In fact, this is one big reason why more and more people aren’t ready for retirement.

Government debt is astronomical, and many people aren’t sure Social Security is going to be there as promised. Long-term interest rates are low, which reduces your potential income from fixed income investments. We’re living longer and high-paying jobs are more difficult to land. People are worried about potential inflation and what it might do to their savings. Taken together, it might be reasonable to conclude that you’ll be working for a living as long as you can breathe.

According to Allianz Life Insurance Company, the statistics for retirement are sobering. The average person:

1. Retires at 62
2. Will be retired for 18 years
3. Spends $50,000 a year
4. Gets a little over 40% of their income from Social Security
5. Spends about $5,000 a year on health insurance and medical care
6. Owes $50,000

If this describes you, there should be a number of questions that are raised in your mind:

1. How much am I going to spend in retirement?
2. How am I going to generate the income that I need in retirement?
3. How can I get out of debt before I retire?

And the Grandmother of all retirement questions:

Will I ever be able to retire? And what happens if I physically can’t work?

Each of these questions deserve real consideration. Let’s go through each and see if we can answer them:

1. How much am I going to spend in retirement?

There is no sure-fire way to answer this question. You have to approximate. But there is no way you’ll be able to approximate the answer to this unless and until you know how much you spend now. As you probably know, I’m a huge fan of tracking your spending against your budgets. You should implement a budget tracking system today no matter if you are retired now or plan on retiring in the distant future. This information is central to your retirement plan.

2. How are you going to generate income during retirement?

The first question approximates how much you’ll need. The next question tries to answer how you’re going to get it. The only way I know how to address this is to make a list of all the possible ways you can generate income during retirement.

How much in social security benefits are you going to receive? Are there any pensions that will be coming in? When will you stop working? Will you work part-time after you retire? If so, how much will you earn? How much money will you have saved for retirement> How will it be invested? How much money can your retirement investments produce?

All these questions can be answered by creating a mini-financial plan. Don’t ignore this step.

3. How can I get out of debt before I retire?

If you’re in debt, you have to first identify what caused the debt problem. Some people find themselves in debt because of some calamitous situation. Others accumulate debt slowly over the years and find they can’t get out. Believe it or not, it’s the latter situation that troubles me. People in this situation face chronic debt issues. If you are in this camp, then you owe it to yourself to do whatever it takes to get out of debt now.

The last question – when will I be able to retire? – can only be answered by your own retirement plan. I strongly recommend that you create a plan and then update it every year. I recently updated my own plan and, when I did, I realized that I needed more term life insurance. Even though I’m a professional, I would never have realized that I needed to do this had I not created a plan.

Doctors need checkups sometimes. So do you. Financial planners need financial plans. You do too.

If you run your financial plan, track your budget, get out of debt, and set up your retirement income, you’ll have done everything possible to make your retirement dream become reality. You may realize that you missed the mark and have to make adjustments. No problem. It’s far better to realize this sooner rather than later.

Have you run retirement projections? How often do you update them? Were you surprised by what you learned?

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Many academic institutions, charities, and foundations fund their operations with a financial endowment. In other words, they use a pool of assets to generate an ongoing income stream without touching the principal. If this approach works for them, why can’t it work for you?

How much do you need?

Assuming a safe withdrawal rate (SWR) somewhere in the 3-4% range, you’ll need to amass an endowment of 25-33x the amount of income you’re hoping to generate. Note that the old 4% SWR is based on an academic study that has come to be known as “the Trinity study.”

According to the Trinity study, which relied on backtesting using historical investment performance data, a portfolio with a 75/25 stock/bond allocation has a 98% chance of surviving 30 years at an inflation adjusted 4% SWR. In this case, however, portfolio survival was defined as not running out of money.

If you want to avoid touching the principal, you may need to dial back that withdrawal rate to 3%. If, on the other hand, you have a relatively short time horizon and/or are okay with running down your investments, then you might opt to go higher. This part is entirely up to you.

As for that 25-33x range listed above, that calculated by simply diving your withdrawal rate (expressed as a fraction) into one. So for a SWR of 4%, you’ll need 1/0.04 = 25x your expenses, and for a 3% SWR, you’ll need 1/0.03 = 33.3x your expenses. Got it? Good.

Breaking your goal into pieces

Wherever you settle with respect to withdrawal rates, you now have a target. And, in all likelihood, it’s a massive, imposing, and seemingly insurmountable target. Let’s assume, for example, that you have annual living expenses of $50k, and that you’re young so you want to be conservative when it comes to withdrawal rates.

If you target a 3% SWR to produce that $50k in living expenses, you’ll need to accumulate just shy of $1.7M. Perhaps you could bump that SWR up a bit – after all, you can’t take it with you – but even then, you’re looking at a huge chunk of change.

So why not break the problem into pieces? Instead of trying to amass a fortune capable of covering your entire cost of living, why not shoot for incremental amounts that will cover specific aspects of your lifestyle?

Are you a self-avowed, lifelong renter? Assuming that’s the case, and that your rent is currently $1k/month, you’ll need a portfolio of somewhere between $300k-$400k if you want to live “rent free” for the rest of your life. Still overwhelmed? Let’s break things down further.

Is your grocery bill in the neighborhood of $250/month? You can “eat for free” with a food endowment of $75k-$100k. Do you love taking an annual vacation at the cost of $1500/year? Then you’ll need a “vacation endowment” of somewhere between $38k-$50k to support that habit for the rest of your life.

Note that I’m not really suggesting that you create a separate investment portfolio for each and every expense. Rather, this is more of a thought exercise designed to help you achieve financial freedom one step at a time.

Enforcing frugality

This is also a very powerful concept when it comes to valuing the things that you’re paying for on an ongoing basis. Do you pay $200/month for lawn service? By choosing not to do it yourself, your required endowment goes up $60k-$80k. Your $100/month cable bill? That “little” luxury raises the target another $30-$40k. The same goes for your daily $3 cup of coffee.

Are these things worth it? That’s for you to decide. But your spending really looks different when you view it in these terms. Try it. You’ll like it. Or maybe you won’t. But hopefully this worldview will help you make better financial decisions.

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A client came in today and he asked me an important question. We were doing some retirement planning and he asked me about the rule of thumb for saving.

Andy and his wife Rachael are both 46 years old. They have two children, ages 7 and 4. They don’t have to worry about getting out of debt. They don’t believe in credit card balances. They own 2 rental homes overseas, and the condo in which they live. They actually use the cash flow from their rentals to help out relatives who still live overseas. They are givers!Other than that, they have some money in a money market account, a long-term CD worth about $20,000 and an IRA with $27,000. He contributes to his IRA each month.

Rachael is a stay at home mom, and Andy brings home about $3700 a month. They have absolutely no debt other than the mortgage on their the condo and, like I said above, they pay off their credit cards every month.

If Andy asked you how much he should be saving every month for retirement, what would you say?

I told him I was amazed that he was able to save anything on the salary he brings in. (Of course I put it more gently than that.) Remember, LA is a very expensive place to live. I gave him the Gold Star Award for frugality, but wasn’t about to let him out of my office so easily. He wanted to know how much money he should be saving, and I wanted to help him find the answer.

I suggested that he forget about rules of thumb. Those general concepts are useless, and you’ll see why in a moment. Instead, I asked Andy about his ultimate financial goals. He told me that he wanted to save $1,000,000 in financial assets and then retire to his native country where he could make that money really last. He told me that he wanted to achieve that goal in 20 years – when he will be 66 years old. Now I had something to work with.

I did a little math using my fancy calculator and determined that Andy needed to save $20,000 a year over the next 20 years and invest it at 7% in order to achieve his goal. If you are interested, you can easily do these projections yourself with an online calculator. As soon as I told Andy this, his eyes lit up. Now he had something concrete to work towards rather than an abstract “rule of thumb.”

He told me that his wife Rachael would start working in September, and that he was in the middle of starting a side business. He committed to saving every incremental dollar that he and his wife earned until he reached that $20,000 annual goal, which he thought was very doable.

I told Andy that the real power of knowing his “magic number” was that he can now treat that savings goal as an obligation – like a bill that he has to pay (to himself!) every month. I know that I wasn’t able to really save until I started looking at it this same way.

I’ll admit that for many years, as my income increased, so did my standard of living. I was frustrated to see that even though I was earning, I wasn’t saving. The only way I found to solve that problem was to treat my savings goal as a debt that I owed myself – which it is really is. I pay myself first so I don’t spend it. That’s the only way I found to consistently achieve my financial savings goals, and that’s what I recommended to Andy, too.

We both realized that it would be difficult to hit those savings goals immediately. He needs to ramp up his small business ideas. And his wife won’t start working until after their youngest starts school in September. I told him not to worry. While it’s unlikely that he’ll reach his savings goals this year, he can build up to it. I’m convinced that he will grow that annual savings far beyond the $20,000 target as soon as his business starts humming and his wife starts bringing home those sweet pay checks.

Have you asked yourself how much you should be saving?

In my opinion, the bottom line is that you need to focus on your own goals rather than saving an arbitrary percentage to save every month. By doing so, I’ve found it much easier to achieve my financial objectives.

What about you? Are you saving a fixed percentage of your income? Shooting for a certain dollar amount? Or doing something else entirely?

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Today, I want to propose that what money people are searching for is something that the excellent book Your Money or Your Life calls the “crossover point.” Simply stated, the crossover point is that point at which your investment income exceeds your expenses.

Graphically, it looks something like this:

(this is Figure 8-7 from the book)

Once you reach the mythical point where your investment income finally exceeds your expenses, you will have effectively achieved financial independence. By saving more and spending less, you’ll accelerate your approach to this magical benchmark.

If you’re interested in playing with the numbers, you can do so at a website called What’s My Crossover? Here are some examples…

First up, let’s consider a hypothetical 25 year old with an annual income of $60k, a 15% savings rate (i.e., spending = 85% of income), an annual raise of 3%, annual inflation of 3%, an annual investment return of 6%, and a current portfolio of $10k.

As you can see, our hypothetical investor won’t actually reach the crossover point before the traditional retirement age of 65 rolls around.

But what if they ratchet up those savings to 25%?

As you can see, this strategy accelerates things significantly – our hypothetical investor now reaches their crossover point (where the blue and red lines intersect) by their mid-50s.

Obviously, the math underlying these scenarios is a major oversimplification (most notably that returns are included as a constant), and there are some questionable assumptions – e.g., that your spending will increase as a constant percentage of your income. Nonetheless, it’s still instructive to play with the numbers.

It’s also worth nothing that you can have a comfortable retirement even if you never hit the crossover point. By getting to a point where your portfolio can more than provide for your needs without touching the principal, you’ll have income in perpetuity – but you won’t live forever.

So, dear readers, how do things look for you? Are you on the path to financial independence? If so, when do you expect to get there? If not, what (if anything) are you doing to get yourself on track?

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The survey was based on 1,000 millionaire households, where “millionaires” were defined as having a minimum of $1M in net investable assets, excluding retirement accounts and real estate. Despite the $1M cutoff, the average net worth (again, in terms of investable assets) of those who were surveyed was actually $3.5M.

Overall, 42% of respondents reported that they didn’t feel wealthy despite having $1M+ in their savings account, investment portfolio, etc. When asked how much it would take for them to feel wealthy, the average response was $7.5M.

Yes, you read that right – 7.5 million dollars.

Assuming a safe withdrawal rate of 4% per year, that $7.5M portfolio would generate $300,000 in annual income. And that’s ignoring retirements savings as well as real estate values!

While I realize that a million dollars ain’t what it used to be, that number seems rather high to me. When I asked my wife how much she’d need to feel “wealthy,” she said somewhere between $1M-$2M, and that would include the value of our house as well as our retirement accounts. Interestingly, when I asked our 9 year old son how much money he thinks it takes to be rich, he thought for a moment and then replied $1.5M – I guess the acorn doesn’t fall far from the tree.

What about you?

How much in the way of “net investable assets” (i.e., money in the bank, stock market, etc.) would it take for you feel wealthy? Would a million dollars do it? More? Less? Please share your thoughts in the comments.

Source: WSJ.com

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I will be 55 yrs old in another month (ugh!) and have made very poor financial choices in my life. Because of that, I have very little retirement savings (about $8,000), nothing in my savings account, have a job where I live paycheck-to-paycheck.

I do have great computer skills, but no college degree. I have tried to figure out how to make some more money with my computer skills.

Right now, I am trying to figure out how to change my financial life.

I have a history of health and longevity on both sides of my family, so I am expecting I will live well into my 90s.

Any suggestions???

First off, I really appreciate the e-mail. There is a great deal going on here this and I want to break it down. As I see it, “R” has a number options – all is not lost! As always, I like to look at things in a linear fashion:

1. Stop beating yourself up

I’m not sure if I am reading too much into the e-mail, but I just want to make sure that “R” remains focused on the good things rather than on her mistakes. She has great computer skills, and it sounds like she isn’t in debt. That’s not a bad starting point if you ask me.

She has also realized that it’s time to make a change, and that’s really important. Lots of people come to see me when they are heavy in debt – and much older. “R” is being proactive here, and that’s great. I love it.

I know this sounds corny but the first thing I’d ask “R” to do would be to create a gratitude list, and write down all the wonderful things she loves about herself. This is going to instill a very positive attitude, which will translate into greater financial opportunities.

(Don’t worry… I’m not going “OPRAH” on you… I also have some very practical ideas to start putting some cash in her pockets.)

2. Break it down

If “R” focuses on the need to accumulate a massive retirement fund, she might get discouraged. A bad attitude is the kiss of death for financial success, so it’s dangerous to think about that right now.

For starters, “R” should consider launching a side business or getting a weekend job with her computer skills. Even though she doesn’t have a degree, she should be able to leverage her skills.

For the time being, I just want “R” to take action and get some side income flowing. With computer skills, it shouldn’t be hard to do. Once that money starts streaming into her hands, it’ll be time to consider if the job she has is appropriate, or if she can upgrade. I don’t know enough about her situation to say anything in detail here, but she needs to be sure that the job she has is the best value proposition.

3. Plan

Once “R” starts working that side business, she should set up a retirement plan. She’s going to have to be willing to compromise. Given her currently small retirement savings, she’ll have to work more years, and possibly live more modestly – but for now she needs to formulate a plan and work towards it.

Of course, any financial plan has at it’s core a spending plan. My experience tells me that your spending is the foundation of your financial future. I know plenty of people who earn more than a $1M/year but can’t afford to retire because they spend all of it – and then some!

On the other hand, there are plenty of people who have built a wonderful financial future on a relatively limited income. The difference? These people track their spending and understand just how important that is.

“R” should create a financial plan for herself, but she shouldn’t dwell on how far she has to go. Her plan is going to change and look better as she bumps up her income and starts tracking her spending. Her plan needs to be dynamic so she can refer back to it and update it often.

In summary, “R” needs to approach her situation one issue at a time. If she tries to process it all at once, she’ll be immobilized by fear and panic.

In summary, here’s what “R” should do:

1. Build a rock-solid positive attitude by writing all the lovely, wonderful, and talented things she loves about herself.
2. Get a side business/job.
3. Implement a tracking system for her budget and spending.
4. Create a mini-financial plan and update it as things improve.

Obviously, there are no magic bullets here. But without a firm plan, she’ll go nowhere fast. What other tips would you give to “R”?

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Lifecycle funds (also known as target date mutual funds and ETFs) are marketed mostly as a solution for folks who want to achieve a financial goal by a specific time. The most popular are those are structured for people planning on retiring, but they have also become popular in 529 college savings plans, too.

Lifecycle retirement funds manage your asset allocation such that the mix of assets becomes increasingly conservative as you get closer to retirement. Most 401(k) plans offer these funds because they don’t want the responsibility of helping you make good decisions on your own.

In truth, the plan administrators don’t really care if these investments work. If they did care, they wouldn’t be offering them to you. Investors often choose these funds because they don’t know any better, and because it seems like an easy way to reach their goals without too much work. It is easy, but it won’t help anyone reach their goals. Lets take a look and see why.

Let’s say you are 50 years old now. While you’d like to retire now, a more realistic plan is to retire in 15 years, and you’re hoping to become a millionaire by the time you collect your gold watch.

Since it’s 2011 now, you might buy a 2025 target date or lifecycle fund (such funds are typically targeted at years ending in 0 or 5). The fund might have 50% or 75% in equities now. Each year, little by little, the manager will shift assets into bonds over the following 15 years. What a stinky idea. Why is this such a terrible move?

1. Costs

Target date funds have a lot of hands-on management. As a result, the expenses are higher than for standalone mutual funds. Guess who pays those high costs? You, that’s who. Since expense ratios are recognized as the best predictor of mutual fund performance, you shouldn’t take this point lightly.

2. Limited choices

Lifecycle funds usually only tap into the funds of one fund family. Very few fund families excel in all areas. You may be better served by selecting the best funds from multiple fund families. Why restrict yourself?

3. Performance

During the 2008 market debacle, lifecycle funds – which were supposed to protect people who were about ready to retire – didn’t do the job. In many cases, these funds suffered just as much as full equity funds.

4. Wrong timeframe

This is perhaps the most important reason why you should stay away from these funds. Here’s what I mean… Recall the example above. You buy a lifecycle fund when you are 50 and the fund “matures” when you are 65, coinciding with your retirement date. At the time, many of these funds will be invested almost entirely in bonds.

Unfortunately, that just doesn’t suit your needs. Just because you hit 65 doesn’t mean you don’t need the money to grow. Quite the opposite, at 65, you might live another 25 or 30 years. That’s your timeframe. Whether or not you still have a job, your money has to keep working.

Note from Nickel: I just checked the Vanguard Target Retirement 2010 fund, and it’s currently holding a roughly 50/50 mix between stocks and bonds, which might actually wind up being too aggressive for your tastes (if you ascribe to the “age in bonds” rule). For comparison, the Target Retirement 2005 fund has 35% in equities.

In my opinion, lifecycle funds are yet another Wall Street invention that sounds great on paper but just doesn’t deliver. They’re not good for your 401(k), and they’re not your best IRA investment choice either.

But don’t despair. You have great options. Remember, you need to invest over your lifespan. Your timeframe may be much longer than you realize.

Develop a balanced portfolio

Developing a well diversified, balance portfolio is perhaps the best approach to investing, and it’s what lifecycle funds try to replicate. Your portfolio should be made up of a mix of equities and fixed income instruments. Importantly, this allows you to control the mix of investments, so you can be sure it matches your needs and risk tolerance.

Sure, your portfolio will move up and down in value, but short term fluctuations really don’t matter. What you care about is having an investment mix that will make your money last a lifetime. To do that, you’ll need healthy dose of equities even after you retire.

Add some real estate

Real estate is another fine idea. Prices and interest rates are very currently very low. While I don’t recommend buying real estate in your IRA (even though you can do it), you can make great investments for retirement income outside of your retirement accounts.

Real estate might just fit your needs. Over time, the value of your property will increase, and so will the rent you receive. And you don’t necessarily have to manage the property yourself, as you can hire a property manager to do the dirty work. Just do your homework so you’ll know what you’re getting into.

These are just two alternatives to building an investment portfolio. What other options would you recommend? Have you had better experiences with target date funds?

More notes from Nickel: As I’ve noted in the past, I’m not a fan of target date funds, either, but my reasons are a bit different. For one thing, they’re prone to performance chasing – e.g., Vanguard re-worked their funds in 2006 to reduce bond exposure in every fund with a 25+ year time horizon from as high as 24% to just 10%. Great timing, huh?

I’m also not crazy about the “glide path” that these funds use. To get an appropriate allocation right now, I’d have to choose a less distant target date, but then it gets too conservative too fast.

Finally, you have no control over asset location with target date funds. Unless your investments are entirely in tax advantaged accounts, you lose tax efficiency with these funds because you’ll end up with a portion of your bonds being exposed to taxes. You’re better off splitting things up and holding your tax inefficient investments entirely within tax sheltered accounts.

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If you are interested in getting rich, or just doing significantly better in the long-term, then I have a piece of advice.

A serious chunk of the wealth you’re going to accumulate over your lifetime is going to be in your retirement accounts. That’s because the Government encourages you to use them, and it’s very hard to tap into them early. You get tax benefits for leaving them alone and allowing them to grow.

Having said that, you’ll do really well if you take advantage of 5 tips that will help you maximize the growth of these accounts:

1. Know your limits

The amounts that you can deposit into retirement accounts change all the time. This year you can put $5000 into an IRA ($6000 if you are over 50) and $16,500 into a 401k. If you’re age 50 or older, you can make additional “catch-up” contributions.

It’s really easy to keep up on these amounts, and you should do so every year. You can either do a quick internet search or just ask your benefits department at work. Of course, once you have this knowledge you should…

2. Maximize Your Contributions

Take the maximum amount that you can deposit into your retirement account and divide it by 12. Now, multiply that amount by 65%. That’s the amount you have to cut in spending in order to maximize your contributions. Let me provide an example.

Let’s say you save nothing now, but you want to start maximizing your IRA contributions. If you’re under 50, the maximum you can contribute is $5000. If you divide that by 12, you arrive at a monthly contribution of $425. The good news is that you don’t have to cut your spending by that much to afford the contributions. If you’re in the 35% tax bracket (federal + state), you only have to cut your spending by 65% of $425, or $275 per month.

This is because the nice folks at the IRS are going to give you a tax break to make up for the other 35%. You see, when you make your IRA contributions, you’ll have lower taxable income to report and therefore, lower taxes to pay. That’s why you won’t have to cut your savings by the full amount you deposit into your retirement accounts.

Note: If you are participating in an employer-sponsored plan, the ability to deduct your IRA contributions is phased out above certain income levels. See IR-2010-108 for details.

Every dollar you deposit into your retirement account could provide $5 or $10 when you retire. The specifics depend on how old you are now and how you invest your retirement money. And remember this, it’s not all that tough to save a few hundred dollars a months. In other words, you can cut back on your visits to a restaurants each month in order to secure your retirement. Isn’t that a good trade off?

A special word to people with retirement accounts at work. You might hear horror stories about people who lost their 401k due to employer funny business. These situations are few and far between, and you shouldn’t use those stories as an excuse to not save. There are plenty of things you can do to keep your 401(k) safe from employer fraud.

3. Use time wisely

When it comes to retirement plans at work, you have until December 31st to make your contributions. Of course, if your situation changes during the year, you can always vary the amounts and contribute more or less in any given month. Don’t assume that once you set up a monthly amount for your 401(k) contribution, you are stuck with that amount for the entire year. You can simply call the HR department and presto – your amount can be changed.

Here’s a tip: Front-load your contributions if possible. The sooner you deposit your money into your 401k, the sooner that money works for you. If you can get all that money into your 401k by September rather than December, so much the better.

When it comes to IRA contributions, you have even more flexibility, as you can contribute all the way up until April 15th of the following year. That’s a full 4.5 months of extra IRA depositing fun for you. And don’t forget… You can use this extra time this year to make contributions for last year. What are you waiting for?

As with employer plans, it’s better to make your IRA contributions early (and often!). Don’t wait for the last minute. Even though you can wait until April 15th of 2012 to make your IRA contributions for 2011, you’d be better off making those contributions as soon as possible so that money can work an extra 16.5 for you.

4. Respect yourself

If you want that money to be there when you retire, you have to leave it alone. Maybe you can tap into the plan early or use your IRA or 401(k) for things other than retirement, but you shouldn’t.

Unless it’s a medical emergency, nothing is worth tapping into your retirement money… Even if the idea seems really good. You might tell yourself that you’ll pay it back, but you probably won’t. When was the last time you had extra money laying around that you didn’t know what to do with? Probably never. Well, it’s not likely that you’ll get the money to repay your loan so don’t kid yourself. Leave the retirement money alone, okay?

5. Stop procrastinating

If you’re reading this and thinking about starting an IRA, the best time to do is today. Putting your retirement plans off until tomorrow can cost you more than all the other mistakes combined. There is always an excuse, and never enough cash flow. But by waiting you are dooming yourself to repeat the mistakes of yesterday.

Even if you don’t have all, most or any of the money, open the account. Get a plan together to cut your spending, get a weekend job if you need to earn extra money. Whatever you do, start making it happen.

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This is just a quick note to let you know that you can download a free electronic copy (direct link to pdf) of Jim Otar’s book “Unveiling the Retirement Myth.” This book sells for $49.99 on Amazon, and is currently rated 5 stars by the six individuals who have reviewed it.

The general topic is how to make your retirement portfolio last when you are living off your savings and investments. I have not yet had a chance to read it myself, but wanted to share it with you now so you could download it before the offer disappears. The free download should be available through January 10th.

After quickly skimming over it, I will say that the book appears to be fairly technical in places, but he’s structured many of the chapters such that you can read the background and conclusions and still get the gist of things without reading the meaty parts in the middle.

Note that the pdf is protected, such that you can’t print it out, but… Hey, it’s free! And it’s also 500+ pages long, so you probably wouldn’t want to print it out in the first place. Happy reading!

Hat tip to The Finance Buff for point it out.

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About three weeks ago, I wrote about rolling my SEP-IRA holdings (all of which are tax-deferred) into a Solo 401(k). My primary motivation for doing this is to get my pre-tax retirement holding into a so-called “qualified” plan so I can convert non-deductible Traditional IRA holdings into a Roth IRA with minimal tax consequences.

Once again, if you’re not sure what I’m talking about, here are a handful of older posts that describe the issue in more detail:

• Roth IRA Contribtion Limits: How the ‘Phaseout’ Works
• Roth IRA Conversion Limits Going Away
• Look Before You Leap: Roth IRA Conversions in 2010
• Using a Solo 401(k) to Facilitate Roth IRA Conversions

Back when I first talked about this, I noted that I was opening my Solo 401(k) with Fidelity because they’re willing to accept a rollover from an IRA into a Solo 401(k). The first step in the process was to fill out (and submit) a plan adoption form along with an account application.

The next step was to get the money out of Vanguard, where I’ve been holding my SEP-IRA, and into a Rollover IRA at Fidelity. The reason I went this route is that Fidelity can’t accept a direct, trustee-to-trustee rollover into a 401(k) from an outside vendor.

In other words, I either had to do a “double rollover” or request a check from Vanguard and then do a 60-day rollover on my own. Since the trustee-to-trustee rollover is a cleaner solution when it comes to IRA reporting requirements, I decided to Fidelity two-step is actually the simpler option.

The good news is that I was able to do these initial steps simultaneously. That is, I submitted the plan adoption and account application paperwork at the same time that I initiated the rollover. The only wrinkle here was that I needed to stop by the bank for a “Medallion signature guarantee” on the rollover paperwork.

My new Solo 401(k) was created quickly, and I received word last week that the Vanguard-to-Fidelity rollover was complete. In other words, it was time for the last step… The IRA-to-401(k) rollover.

To complete this final step, I needed to fill out and submit the IRA Single Withdrawal Request form along with a letter from me (as the plan administrator) stating that I was willing to accept the IRA rollover into the 401(k) plan.

I filled out that form and drafted the letter over the weekend, and will head to the bank shortly for another signature guarantee. From there, it should only be a matter of days before the entire process is complete. A bit complex, but actually pretty easy, and well worth the trouble since I’ll now be able to beef up my Roth IRA.

Throughout this process, I’ve been very impressed with Fidelity. Their reps answer the phone quickly and are always well informed. Beyond that, I’ve been notified via e-mail every step of the way so I’ve never been left waiting or wondering.

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It’s that time of year again… Time to start thinking about retirement plan contributions for next year. With that in mind, I wanted to point out that 401(k) contribution limits will not be changing from their 2010 levels.

This means that individuals under the age of 50 will be able to contribute up to $16,500 to their 401(k) during 2011. If you are age 50 or over, you can make $5,500 in additional “catchup” contributions, which brings your total to $22k in 2011.

Beyond the above, the aggregate limit (employer + employee contributions), which is specified by Section 415(c)(1)(a) of the Internal Revenue Code, will also be unchanged at $49k/year – this is the so-called 415(c) limit.

Note that the $16.5k limit to 403(b) and 457(b) plans as well as the Thrift Savings Plan, so those of you in the non-profit, educational, and public sectors share will likewise be limited to $16.5k in contributions.

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At long last, I’ve finally gotten around to opening a Solo 401(k) with Fidelity. My primary motivation for doing this is to move pre-tax contributions out of my SEP-IRA and into a “qualified” plan so I can convert non-deductible Traditional IRA contributions into a Roth IRA with minimal tax consequences.

If you’re not sure what I’m talking about, take a look at these older posts, as I don’t want to re-hash everything here:

• Roth IRA Contribtion Limits: How the ‘Phaseout’ Works
• Roth IRA Conversion Limits Going Away
• Look Before You Leap: Roth IRA Conversions in 2010
• Using a Solo 401(k) to Facilitate Roth IRA Conversions

So now that you know why, let’s talk a bit about how.

Why Fidelity?

My SEP-IRA is currently at Vanguard, and my preference would be to leave the funds in place. Unfortunately, Vanguard won’t accept a rollover from an IRA into a Solo 401(k) whereas Fidelity will. Thus, I’m making the switch.

I haven’t decided yet, but I might end up rolling it back from Fidelity, Vanguard does accept 401(k) to 401(k) rollovers, so I can always move the funds back at some point in the future.

Filling out the paperwork

In order to set up a Solo 401(k) with Fidelity, there are two key pieces of paperwork that need to be filled out. The first is the plan adoption form, and the second is the account application.

If you’re interested, you can access the forms here: link

Executing the rollover

Once I have the plan in place and the account opened up, I need doing the actual rollover. For this, I have two choices. I can either request a check from Vanguard and do a 60-day rollover, or I can do a trustee-to-trustee rollover.

While the latter is definitely a cleaner solution – it’s not reportable to the IRS – there’s another wrinkle… Fidelity can’t accept a trustee-to-trustee rollover to a 401(k) from an outside vendor.

The solution here is to either do the 60-day rollover, or open a Traditional IRA with Fidelity, do a trustee-to-trustee rollover, then move the funds from the Fidelity IRA straight into the Solo 401(k).

While this sounds rather complex, it only requires about 30 minutes of work on my part. After that I’ll be free to funnel money non-deductible IRA contributions into a Roth with a quick conversion.

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After all (they tell themselves) they won’t have to support the kids anymore and the house will be paid for. And the media encourages people to think this way too. They make the argument that once folks retire, they usually spend 80% of what they spend while they are working.

This kind of thinking is wrong and dangerous… Unless you are very mindful and really understand how much money you will need to retire.

My experience tells me that retired people can easily spend as much (or more) than they do when they were working.

Why is that?

For starters, people spend money when they have free time. If you think about it, I’m sure you’ll agree that you spend more money during the weekends than during the week. Why? Because you have the time to do it.

When you’re retired, every day is a Saturday. You can go to movies, have lunch, buy clothes, bowl. Whatever you want. For many, the alternative to spending is sitting at home doing nothing. That’s why they go out and spend.

Their are a few more reasons to explain why we often spend more money during retirement than when we were working.

First, if you got lassoed into paying for your childrens’ expensive college education, you might have refinanced your home. So even though your plan was to pay off your mortgage by the time you retired, the actual situation might be very different. That means you’ll be paying that mortgage for much longer than you had originally anticipated.

Also, times are tough right now. You might be supporting your adult children now. There is a lot of that going around these days.

Finally, there is always inflation. When you are retired, you might spend a disproportionate amount on items that inflate faster than average. Think about what inflation will do to your retirement.

Medical care is one example of this. Another is travel and entertainment. What I’m saying is that the overall inflation number isn’t all that important. What matters to you is the price increases for those things you’ll spend money on once you retire.

So how do you combat this issue before it becomes a huge problem?

1. Track your spending

Tracking your spending and having a budget is more important once you retire than before you retire. I say this because once you retire you can’t just go out and earn more money. In most cases, your income will be fixed and the only thing you’ll have any control over will be your spending. Track your spending and make sure you make adjustments sooner rather than later if problems start coming up.

2. Be a pessimist

When it comes to retirement planning, you should definitely be a pessimist. Plan for the worst and hope for the best. This way, you won’t be eating Purina Cat Chow and looking for a second job when you’re 87 years old. Don’t assume you’ll spend less once you retire. Build your financial plan on current spending and add in inflation.

3. Get Busy

Ever wonder why some smart retirees are busier after they retire than when they worked? It’s because they are smart. They know that they have to fill up their day with activities they enjoy or make money doing (or preferably both). They realize that if they don’t, they’ll have nothing but time on their hands. And they’ll use that time to spend money.

Volunteering is actually very profitable for retirees if for no other reason than it keeps them out of the shopping mall. Start thinking about getting involved in groups you care about now… Before you retire. This way, when you do ring the bell, you’ll have a welcoming support group and fun activities you can enjoy from day one.

4. Make new friends and get rid of some of your old ones

This might be a hard pill to swallow, but you really have to think about who you’re going to spend time with. If you’re on a on a middle-income budget but have friends who are used to going first class, that’s going to be a problem. It will be difficult for you to disengage and you’ll find yourself spending more money than you really want to spend. Start looking at your friends and their spending patterns now. Spend more time with people who have patterns similar to those you can afford.

If you’re in the home stretch for retirement, have you considered these issues? Do you think you’re going to spend less once you stop working? Why?

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While the focus of the study was rather narrow (micro-entrepreneurs in the Dominican Republic), the results were quite interesting. In short, they found that “standard” financial training had no impact on business practices and outcomes, but that simplified, rule-of-thumb based training produced “significant and economically meaningful improvements.”

While it’s probably a stretch to take lessons from micro-entrepreneurs in the Dominican Republic and apply them to your family’s budget, I’d be willing to be that there’s some truth to the idea that it pays to keep things simple.

For example, instead of teaching people how to calculate their needs income needs in retirement and how to project their exactly what it will take to get there, simply telling them to save and invest 10% (or 15% or 20%, whatever) for the future.

Likewise, instead of teaching people about modern portfolio theory and the importance of asset allocation, maybe we should just tell them that their percentage stock allocation should be 100 minus their age.

Of course, rules such as these aren’t failsafe, nor should we expect them to be. After all, a rule of thumb is defined as:

…a principle with broad application that is not intended to be strictly accurate or reliable for every situation. It is an easily learned and easily applied procedure for approximately calculating or recalling some value, or for making some determination.

Source: Wikipedia

Beyond the inherent limitations of a one-size-fits-all rule, it’s also important to recognize that these rules can change over time. While sometimes these changes are warranted, other times they may not be. For example…

The old “100 minus your age” advice, mentioned above, eventually morphed into “120 minus your age” when modern pundits got their hands on it during the high-flying markets of a decade ago. To be fair, this change was also likely influenced by longer life expectancies, but still… How does that change look in the context of the past three years?

Similarly, the age old advice of spending no more than 28% of your monthly income on your mortgage payment gradually swelled to 30%, then 33%, and finally 36% as housing prices spiraled out of control. Once again, how does that change look in the context of the recent history of the housing market?

But in the end… If preaching rules of thumb spurs people to action – as opposed to overwhelming them into inaction – then maybe that’s where our focus should be.

What are your favorite financial rules?

Hat tip: Barbara Kiviat for linking the original study

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What is a Social Security statement?

A Social Security statement is a snapshot of your contributions into the Social Security and fund.

You receive it annually, approximately 3 months before your birth month. If you’re under 25 or currently receiving benefits, you won’t have a statement mailed out to you. If you haven’t received on, you can request it by simply contacting the agency.

As a reminder, while Social Security is mainly thought of as a retirement program, it also covers those that are disabled and families who have lost a parent.

What information is included?

There is a lot of information covered in your Social Security statement, so let me share some highlights of the form.

• Your estimated benefits. The second page will let you know if you qualify for benefits based on your current credits. What you may notice is the big jumps in Social Security benefits if you take it at age 62, 67, and 70. This information can affect your decision on when you want to use your Social Security.
• Your earning record. This is an important section, as you get to see what the Social Security Administration has recorded for your Social Security and Medicare earnings. Make sure that your information is correct as it affects what you can collect when you retire.
• Facts about Social Security. While they don’t share the exact formula for calculating benefits, the Social Security Administration shared the process. In short, your benefits are based on your lifetime earnings. Your actual earnings are “indexed” to account for changes in average wages since the year the earnings were received, and they estimate an average based on the 35 years during which you earned the most.

Social Security benefits and retirement planning

Now that you have this information, how can you use it? If you’re approaching retirement, then it probably makes sense to include your benefits in your retirement planning, as it’s unlikely that things will dramatically change.

If you have decades before you’re going to retire, on the other hand, then I suggest using your statement in a slightly different way. I find that seeing how much (or how little) Social Security will cover for me is motivation to build up my own retirement fund.

The currently estimated payments from Social Security will not cover my living expenses, so I need to build my own nestegg. Since Social Security is intended to be a safety net, as opposed to a primary source of income, that’s how we’re treating it when coming up with our retirement planning.

If the Social Security is still intact when we retire, then we’ll consider it a bonus. But we’re not counting on it as a core piece of our retirement strategy. What’s sad is even your own statement acknowledges that fact on the front page. Too many people have it as their largest source of income while retire.

Create a tripod to support your retirement

If you’re planning for retirement, you should try to have at least three forms of income for your future.

• Employer plan. Depending on where you work, this might be a 401(k), 403(b), 457(b), Thrift Savings Plan, or some combination of the above.
• Personal savings. These are most often held in a Traditional or Roth IRA, as well as a taxable brokerage account.
• Social Security. Like I said above, it’s probably best to treat this as a safety net.

Check with your employer to see if they will match your 401(k) contributions, and then automate your contributions. Currently, you can contribute $16,500 annually to your 401(k) if you’re under 50 and $22,000 if you’re age 50 and above.

The annual elected deferral limit for the Thrift Savings Plan is also currently $16,500. The same goes for your 403(b) account, so there are no excuses to skimp on saving.

If Social Security doesn’t come through, you still have your 401(k) or IRA to count on. If you haven’t already, start contributing. The annual contribution limit for IRAs is $5,000 if you’re under 50 and $6,000 if you’re over.

Thoughts on Social Security

Have you ever caught a mistake with your statement? Do you think Social Security will be around when you retire? If so, how do you account for it when planning your retirement?

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My goals were:

• Consolidate my student loan
• Start a car replacement fund
• Contribute more to my Roth IRA for retirement

I don’t think these goals are unique; many people are looking to get their finances in order. I’ve been doing pretty well, but there’s definitely room for improvement.

Like others, I’ve been distracted and I’m behind on one of my goals. That being said, I’m determined to get back into the swing of things and complete my list. What about you?

Whatever it is that you hope to achieve, I hope I can help you get back on track (or stay on track) and meet your goals. What follows are three common financial goals, and steps you can take to meet them.

Building up your emergency fund

Your circumstances (single, married, with kids or not) and risk tolerance will dictate how much money you need to have in your emergency fund.

We’ve found that treating our savings goals as bills is the best way to keep us on course. When you develop your monthly budget or spending plan, include your ‘emergency fund’ and other savings goals in it.

Next, set up an auto-payment (transfer) to cover that bill each and every month. If you wait until all the bills get paid before save, you’ll rarely have anything left to set aside.

Getting out of debt

Right now, our only debts are my student loans and our mortgage. We had a car loan when we got married and decided to accelerate the payments and get rid of it. We were planning to buy a house and figured it would look better if reduced our debt-to-income ratio.

Getting out of debt is a great goal to have, but it’s not easy to implement and maintain. I think the biggest issue for most people is making debt reduction a priority.

If you’re sick and tired of being in debt, then debt reduction is likely a priority. Your intensity level may vary, but when once you make it a part of your routine, you have a much better chance of eliminating your debt.

One big thing to do is to ask yourself tough questions when you’re about to spend money.

• Is my money better spent paying off my credit card or buying new clothes?
• Do I want to pay off my credit card sooner, or do I want to eat out more often?
• Is having a new car that important, or can I keep my used (but good) car for an extra year or so?

What helped me was to: (1) keep reminding myself that these sacrifices were temporary, and (2) avoid cutting out the extras entirely. I know, I know, we weren’t “gazelle intense,” but it was sustainable. I’ve done the extreme frugal routine in the past, and wound up burning myself out within a couple of months.

Contributing more for retirement

This is an area where I could definitely use some improvement. I’ve made contributions, but I know I could do better.

The good news I have until I file my 2010 taxes to make my IRA contributions. I plan on using that extra time to deposit more than I otherwise would have. My problem has been that I’ll tell myself that I’ll transfer the funds at the end of the month, but then I often don’t.

How did I overcome my procrastination? I took the plunge and automated my Roth IRA contributions. I think this is the best option for me personally. I set aside a monthly amount I know I can make. If I earn more or spend less than expected, I’ll take a portion of that extra money and deposit it into my Roth IRA.

If you’re behind on your IRA contributions for the year, try to make an automatic contribution each month or pay period. While you might not make the $5,000 limit, you’ll wind up saving more than if you didn’t take action.

Your goals and progress

How are you been doing this year when it comes to meeting your financial goals? What’s gone well? And what obstacles have you come across?

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People can easily be intimidated by the amount of money it takes to fund retirement. However, it all becomes more manageable if you approach building your savings rates the way you would build muscle in a gym — starting with moderate exercises, and then increasing the intensity as your ability increases.

Fortunately, life makes this process of ramping up seem natural, by placing savings tasks along the path of life in order of difficulty, starting with some easy ones:

1. Saving your allowance. When do positive savings rates begin? For many people, the first transition from spending immediately to setting aside some money happens during childhood when they receive an allowance. This will generally be for a modest, short-term goal, but the fundamentals of positive savings rates are there — chiefly, budgeting and deferred gratification.
2. Saving for a car. Moving from childhood to young adulthood, often the first meaningful savings goal on the horizon is to save enough money to buy a car. This will typically represent an investment in the thousands of dollars, so it will not only take more effort, but also an ability to see saving as a multi-year commitment.
3. Saving for a house. Speaking of multi-year commitments, this notion really comes into focus when you start saving for a house. This will probably be the first time you’ve bought something that costs much more than you make in a year, so planning has to stretch out over several years. First you have to build savings rates up enough to accumulate a down payment, and then you have to maintain that budget discipline to make sure you meet your mortgage obligations, keep up with your insurance, and maybe even buy some furniture. Saving that down payment might be the first time you accumulate a significant lump sum of money, so for the first time you’ll have to face decisions such as spending time to find the best CD rates, money market rates and savings account rates to get the most out of your savings until you need them.
4. Saving for college. The next major savings challenge may come when you have to put your kids through school. Is this really a bigger saving challenge than buying a house? It can be. The College Board estimates that for the 2009-2010 academic year, total annual expenses at a private four-year college for a student living on campus were $39,028. Multiply that by four (all the while keeping your fingers crossed that your child gets through college in four years) and it’s a commitment of $156,112. Then, if you have more than one child, start multiplying that total. College can definitely be a big ticket item, and given that student loan terms are generally shorter than mortgage terms, it’s at least as tough a challenge as buying a house.
5. Saving for retirement. The right retirement goal for your lifestyle might be one million dollars, it might be two million, or even more. Still, you have the advantage of time. If you start early, retirement saving has a longer lead time than any of the above savings challenges.

In short, life’s savings challenges grow in size as time goes on, but that’s a good thing. It allows people to start small, and then tackle bigger challenges as they develop better savings habits.

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Salaried employees generally have an employer-sponsored 401(k) retirement account administered by the company’s HR department. Failing that, many use Individual Retirement Accounts (IRAs) from local banks, credit unions, or brokerages. Some especially conscientious employees use both.

Small business owners tend to likewise be big fans of the IRA, either in Traditional or Roth form. And while these are certainly better than having no retirement plan at all, an IRA is rarely the ideal plan. The self-employed have several retirement options which are both exclusive to them and, often times, more lucrative than the more traditional plans above.

Simple IRA

Simple IRAs are ideal for small business owners who wish to set up retirement accounts for their employees. As Bankrate explains, these accounts were established with businesses of “no more than 100 employees who earned $5,000 or more on the payroll for the previous calendar year” in mind.

Over time, Simple IRAs have become most commonly used by employers with seven or fewer employees. Fortunately, the Simple IRA is extremely easy to set up, requiring just four pages of paperwork and about ten minutes of one’s time. Employers are limited to contributing 3% of an employees pay, up to an $11,500 yearly contribution limit.

The Solo 401(k)

One rarely discussed advantage of self-employment is the existence of retirement accounts with much higher yearly contribution limits. The Solo 401(k) account is a prime example. SmartMoney explores how Solo 401(k) plans work, explaining that they’re essentially regular 401(k) accounts with much higher contribution limits: up to $49,000 per year in 2010, depending on age, income and other circumstances.

Putting things in perspective, regular 401(k) and IRA contribution limits top out at $16,500 and $5,000 per year (not counting catchup contributions), respectively. It should be noted that Solo 401(k) plans are generally restricted to business owners, rather than employees of the business in question.

The Solo Roth 401(k)

Solo Roth 401(k) plans are similar to regular Solo 401(k) plans, but offer the tax advantages of a Roth IRA. As you may know, Roth IRAs are accounts for which contributions get taxed, but withdrawals (which contain the accumulated savings, interest and investment returns of decades) do not. Moreover, InvestorGuide reveals several key advantages the Solo Roth 401(k) holds over a regular Roth IRA:

• High income earners can contribute to Solo Roth 401(k) accounts even if they’re not eligible for a Roth IRA
• You can contribute much more per year to a Solo Roth 401(k) as compared to a Roth IRA
• You can borrow from your Solo Roth 401(k)
• You can avoid (if you wish) the required minimum distributions of a Roth 401(k) by rolling its funds over to a Roth IRA prior to age 70-1/2, so long as you set up the Roth IRA account five years prior
• You can also maintain a Roth IRA in conjunction with a Solo Roth 401(k), which expands your potential annual contributions even further

The Simplified Employee Pension (SEP) IRA

The Simplified Employee Pension IRA (SEP-IRA) is in many ways similar to a Solo 401(k). While both have the same maximum annual contribution limit, it takes a higher level of income to max out the SEP-IRA. In 2009 and 2010, self-employed individuals and business owners can contribute 20% of net self-employment income or 25% of W-2 wages up to $49,000 per year. Contributions are tax deductible.

Withdrawals prior to turning 59-1/2 are subject to a 10% penalty (plus income taxes), while withdrawals after 59-1/2 are just taxed as ordinary income. Unlike defined contribution plans, there are no restrictions on whether or how much money you can contribute to a SEP-IRA in a given year. SEP-IRAs are also designed for one person businesses or business owners with employees, rather than for the company’s employees themselves.

Keogh Plans

Keogh plans are a type of defined contribution retirement plan. Established by Congressional legislation in 1962, Keoghs allow tax deductible contributions of up to 25% of annual income up to $49,000. Keogh funds can be withdrawn by 59-1/2 and must begin by 70-1/2.

A Keogh (also known as an HR10 plan) can be invested into the same broad range of securities – stocks, bonds, CDs and annuities – as can traditional accounts like 401(k)s and IRAs. Investopedia cautions, however, that their high contribution limits are accompanied by greater paperwork burdens and upkeep costs.

Defined Benefit Plans

Described by Bankrate as “the most expensive and complicated retirement plan for the self-employed,” defined benefit plans are nevertheless an option for self-employed individuals with “mountains of money” to put toward retirement. Employers can save an eye-popping maximum of $195,000 per year, but there’s a catch: an actuary is needed to determine the exact amount that can be contributed (a rather costly expense).

In contrast to the flexibility offered by Solo 401(k) accounts and Simple IRAs, a defined benefit plan is an extremely structured arrangement that must be operated in accordance with strict rules. Largely because of these expenses and complications, Bankrate finds that there are roughly 38,000 defined benefit plans today, down from 114,000 in 1985. Nevertheless, they remain a worthwhile tax-deferral possibility for wealthy business owners.

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Aside from increasing your investment options, rolling your 401(k) protects you from early withdrawal penalties associated with cashing in your account. The key is finding a way to manage your retirement fund effectively and stick with your overall retirement plan.

Why cashing out is a bad move

When moving from one job to another, you might be tempted to cash in your retirement account to pay off some bill, or even have a little bit of fun. Don’t do it. If you do, you’ll get hit hard. Twice.

For starters, you’ll expose that money to income taxes, and it might even be enough to bump you into a higher tax bracket. On top of the taxes, you’ll also get hit with a 10% early withdrawal penalty.

I learned this the hard way when I changed jobs years ago. Since I didn’t meet the minimum balance requirement to keep my old 401(k) open, I was sent a check with the balance of my account.

I should have immediately opened an IRA and completed a rollover, but instead I used it to pay off bills. I thought I was being smart, but the penalties ate a good chunk up of my savings, and I was left with no retirement savings.

I won’t ever do that again. Next time, I’ll inform HR to send it to my IRA directly, avoiding the temptation for me to spend the cash.

Where to roll over your 401(k)

You have two options for rolling over your retirement fund, either to an IRA or into your current company’s 401(k). You’ll have to the weigh the pros and cons for yourself.

Into an IRA

You’ll have complete control over your money with an IRA. You can choose your preferred brokerage or mutual fund company, and you’ll likely wind up with more and better investment options than with a 401(k).

If you’re working with a financial planner (fee only, please!), feel free to ask for their advice on the matter. I would also suggest you check out some of the following companies to see if they would fit your needs:

• Charles Schwab
• Vanguard
• T. Rowe Price
• Fidelity

In most cases, you can initiate the rollover online. Just be sure to have all of your old 401(k) information on hand. When we opened an account with Vanguard, we were able to fill out all of the information online, but we still had to sign and mail the documents.

As with any financial transaction, just be sure to read all of the paperwork carefully, and don’t be afraid to call and ask questions if anything is unclear.

New company’s 401(k)

The primary advantage of this option is simplification. By rolling your investments into your new 401(k), you’ll have one fewer account to deal with. Another advantage, if you want to call it that, is that you can borrow from your 401(k), but not an IRA.

In my view, the ability to borrow isn’t typically an advantage, though there are some circumstances in which it might be the best option available. By having all of your funds in a 401(k), you’ll have a larger balance to borrow against.

Another consideration, of course, is whether or not your new plan accepts incoming rollovers. Even if they do, you might have to satisfy a minimum waiting period before you’re eligible.

Choosing your investments

If you’re looking for the easiest option that you can set and forget, you might want to look into target date mutual funds. These funds are designed to adjust asset allocation as you get closer to the retirement date, though there are some disadvantages to them.

Index mutual funds are another great option for people who are willing to construct their own portfolio while minimizing their expenses. Index funds are designed to track specific market indices, and thus don’t incur expenses associated with an active fund manager.

Exchange traded funds (ETFs) are similar to index funds in that they typically track a market index. ETFs can be traded through out the day like stocks. One major downside of ETFs is that, depending on where you buy and sell them, you may have to pay brokerage fees.

If you’re looking for some more information to help you decide, there are plenty of posts on the topic here at FiveCentNickel:

• Index Mutual Funds vs. Exchange Traded Funds (ETFs)
• ETFs vs. Index Mutual Funds, Revisited
• Avoiding and Reducing Mutual Fund Fees and Expenses
• Stocks and Bonds vs. Mutual Funds

And here are some articles on asset allocation:

• Our Investment Portfolio: Asset Allocation and Location
• Reconsidering Our Asset Allocation
• The High Cost of Low Risk Investing
• How Much International Exposure Should Your Portfolio Have?
• Market Turmoil, Portfolio Drift, and Asset Allocation: Time to Rebalance?

I would also recommend reading a few good books on investing if you’re going to start taking a more active role in managing your portfolio.

Your Thoughts on Rolling Over Your 401(k)

Have you changed jobs in the past? If so, how have you handled your associated retirement savings? Did you leave it in place? Roll it into an IRA? Or maybe you rolled it into your new 401(k)? Do you have any tips for making the process easier?

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To make a long story short, you’ll have to pay taxes on any tax-deferred funds that you convert. This includes any pre-tax (i.e., tax-deductible) contributions that you’ve made as well as any earnings that your IRA investments have generated.

The catch is that the IRS will look at all of your IRAs (Traditional, SEP, and SIMPLE) as one big pot of money when determining taxable amounts. Thus, if you have a mix of deductible and non-deductible contributions, you can’t just cherry pick the dollars that would minimize your tax burden.

Example: You have a SEP-IRA with $5000 in tax deferred funds (deductible contributions + earnings) along with a Traditional IRA with $4000 in non-deductible contributions plus $1000 in earnings.

In this case, 40% of the holdings ($4k out of the $10k total) have already been taxed, so 40% of your conversion would be tax-free. This is true regardless of which account(s) the money actually comes from.

That’s the bad news. The good news is that, as long as you do the conversion in 2010, you have the option of deferring the tax burden until 2011 and 2012. If you do this, you will pay taxes on 50% of the conversion in 2011 and the remaining 50% in 2012.

Given that income tax rates are generally expected to increase in 2011 with the expiration of the Bush tax cuts at the end of this year, you’ll have to decide for yourself whether or not this is a good idea.

A couple of other considerations…

Do you have enough cash on hand to pay the taxes on the conversion? If you’re under 59.5 years of age and you use any of the cash that you take out of your to cover the tax burden, you’ll have to pay a 10% early distribution penalty. Not good.

Will booking the entire conversion during 2010 push you into a higher tax bracket? If so, then it might be better to wait even if income tax rates increase next year. Again, you’ll have to run the numbers and see what’s best in your specific case.

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Not surprisingly, pessimism is inversely correlated with age. Ask those in the 55+ age bracket and only 26% doubt Social Security will make good on its obligation. But ask those int the 18-34 age bracket, and the number skyrockets to 76%. This pattern isn’t terribly surprising, but it’s interesting nonetheless.

At the same time, 56% of current retirees think that they will eventually see their benefits cut. Just five years ago, only 32% of retirees anticipated a reduction in benefits. That’s quite a change.

Running on fumes

We’ve heard for years that the Social Security system will eventually start paying out more than it takes in. However, this wasn’t supposed to happen until at least 2016. Well… Guess what? Thanks to the recent economic downturn, the timeline has been shortened to this year.

That’s right. According to an article in the NY Times earlier this year, the bleak job market has resulted in more people applying for benefits sooner than expected while revenue because there are fewer paychecks available to tax.

This isn’t to say that the Social Security Administration (SSA) will be unable to meet their near-term obligations, but it’s only a matter of time before they go broke unless something changes.

No news is… troubling?

That NY Times article alluded to the SSA’s forthcoming annual report, which was expected to provide insight into the true financial condition of the system. This report is supposed to be published by April 1st each year, but this year’s report has been postponed indefinitely.

According to Forbes, the stated reason for the delay is to provide more time to account for the effects of the recent Healthcare Reform legislation.

One possibility is that the new legislation will cause employers to substitute higher taxable wages in place of employee health insurance coverage. Likewise, employers that offer so-called “Cadillac” health plans might trim benefits in favor of higher wages. Both scenarios would boost tax revenues and help balance the books.

While this sounds like a plausible excuse, rumors are swirling that the truth is that the Feds are just buying time while they try to figure out how to put a positive spin on what may be a very bleak report.

Fixing the system

So… What about the future?

My personal view is that Congress will do whatever it takes to keep Social Security unchanged for as long as possible. It’s just too popular, and politicians are too self-interested to rock the boat.

Of course, eventually something will have to give. As always, proposals for “fixing” the Social Security system include tax increases, benefit reductions, and delayed eligibility. The longer we wait, the bigger the changes will have to be.

My best guess is that any future reform will involve some combination of all three as opposed to somehow re-inventing the system. But will these things be enough to stave off a collapse?

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After all, markets are driven by supply and demand. If a bunch of Boomers start selling to meet their needs and prices dip, others might sell to avoid a loss, thereby causing a greater drop, and so on.

I was thus very interested when I ran across an article in USA Today by John Waggoner on this very topic. The first of the Boomers will be turning 65 next year, with tens of millions to follow in coming years. This begs the question:

“If Boomers follow the usual pattern of shifting their portfolio mix toward income-generating investments — bank CDs, bonds and dividend-paying stocks — will the stock market’s long dry spell drag on?”

But will boomers really shift to a dramatically more conservative asset allocation? In theory, they should, and Jeremy Siegel (author of Stocks for the Long Run) has argued that stocks could plunge by as much as 50%.

At the same time, it’s been argued that this demographic shift won’t be enough to overwhelm other market forces. Rather, political and economic events could wind up being far more important. Beyond this, it’s not clear that Boomers will sell, or at least not all at once.

Why Boomers won’t sell

In many cases, boomers already hold a well-diversified portfolio, so there won’t be a precipitous change. In addition, those with the largest portfolios are more likely to be concerned with passing their wealth to the next generation (estate tax be damned!) than they are with preserving principal in the short-term.

But what if they do?

Waggoner argues that, even if they do ultimately sell their stocks, “any movement the Boomers make will be gradual at best,” and might be slowed further by the currently low interest rates. I agree with this to a point, but rates won’t stay low forever, and the average Boomer will liquidate stocks over time.

Perhaps the most compelling argument in favor of a healthy stock market in the face of mass Boomer retirements is that Gen Y (those born 1983-2001) is coming of age, and it’s actually slightly larger than the Baby Boomer generation. These individuals will need to save and invest, and will thus help to offset Boomer liquidations.

What do the Feds think?

While researching this topic, I ran across an interesting report from the Government Accountability Office (GAO). In it, they tackled the issue of whether or not Boomer retirements would precipitate a stock market drop.

“Our analysis of national survey and other data suggests that retiring boomers are not likely to sell financial assets in such a way as to cause a sharp and sudden decline in financial asset prices. A large majority of boomers have few financial assets to sell. The small minority who own most assets held by this generation will likely need to sell few assets in retirement. Also, most current retirees spend down their assets slowly, with many continuing to accumulate assets. If boomers behave the same way, a rapid and large sell off of financial assets appears unlikely.”

The report also pointed to an increase in life expectancy as a mitigating factor, as a longer lifespan will translate into Boomers working past traditional retirement age as well as a greater spread in the timing of asset sales.

What do you think?

So, dear readers… What’s your view? Do you anticipate stock market troubles due to Baby Boomer retirements and the accompanying asset liquidations? Or do you think other factors will overwhelm the “Boomer Effect”?

I’m currently on the fence. It’s hard to ignore such a huge demographic shift, but there’s a lot of data out there suggesting that there won’t be much of an impact. For now, we’re sticking to our plan, but will be keeping a close eye on any further research on the topic.

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However, as many of you know, the income limits for converting from a traditional to Roth IRA went away this year. In other words, anyone making too much to contribute to a Roth IRA can simply make a non-deductible traditional IRA contribution and immediately convert it into a Roth account.

Shortly before our taxes were due, we opened a traditional IRA in my wife’s name and made contributions for both 2009 and 2010. Since she doesn’t have any deductible IRA funds laying around, we can simply convert these funds into her Roth without paying any additional taxes.

Converting your Vanguard IRA

I’ve actually been meaning to take care of this for quite awhile now, but just haven’t found the time. Fortunately, it’s very easy to execute the conversion through Vanguard’s online interface.

Simply login, click your way into your traditional IRA account, click the “Buy & Sell” link, and then do an “Exchange” between your traditional and Roth IRAs.

When you do this, you’ll get the following warning:

“A conversion is a taxable event. Generally, you’ll owe taxes on the amount you convert from your traditional, SEP-, or rollover IRA into a Roth IRA.”

The good news is that, assuming you’re converting non-deductible contributions, and further assuming that you don’t have any other IRA accounts with deductible contributions in them, this should be a tax-free maneuver.

In our case, we have a tiny amount of investment gains that have accumulated on top of the original non-deductible contributions, so we’ll wind up owing a few cents in taxes. We’re not worried, though, as we’ll be juicing up our Roth accounts.

Looking ahead

I’m actually working on doing the same thing myself, though I have a SEP-IRA with significant pre-tax (i.e., deductible) contributions. Thus, I still need to roll my SEP-IRA into a Solo 401(k) to avoid a nasty tax hit when I do convert.

To be honest, I’m not sure that it really matters if I get the SEP rollover done before I do the conversion, so long as I do it during 2010. In fact, based on my read of the current version of IRS Form 8606, either way should be fine. I’m not, however, interested in taking any chances, so I’ll be doing the rollover first.

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Assuming that this legislation made it through the Senate unscathed and was signed into law, it would have become effective for plan years beginning after December 31, 2011. While this sort of disclosure isn’t currently required under federal law, the Department of Labor has been working to standardize disclosure requirements for defined contribution retirement plans.

While some have argued that new legislation would delay the implementation of the DOL’s regulations, others have argued that this legislation “give the force of law” to the DOL regulations and help to clarify their authority to require retirement plan providers to conform to the rules.

Either way, I’ve just learned that the Senate has proposed removing this provision from H.R. 4213. Thoughts?

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More specifically, this legislation requires that:

• Before enrollment, workers be provided with basic investment disclosures for each investment option, including information on risk, return, and investment objectives.
• 401(k) service providers must disclose to employers all fees being assessed against a participant’s account, broken down into: plan administration and recordkeeping fees, investment management fees, and all other fees.
• Fees be disclosed for each investment option, both in terms of dollars amounts and percentages.
• A workers quarterly statement list total contributions, earnings, closing account balance, net return, and all fees subtracted from the account.

What do you think? As far as I’m concerned, more information is better. Currently, federal law does not require this sort of disclosure. Hopefully, this sort of improved transparency will bring lower fees.

Update: Assuming this makes it through the Senate unscathed, it would “apply to plan years beginning after December 31, 2011.” In other words, it will be about 1.5 years before it goes into effect.

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Each approach has its advantages, and the optimal strategy may vary based on your circumstances. For example, if you’re currently in a low tax bracket, Roth contributions may be in your best interest. On the other hand, if you’re currently in a higher tax bracket, you might be more interested in an upfront tax deduction.

Given the importance of this topic for retirement planning, I thought that it would be worth running a poll to facilitate further discussion. When answering the question below, assume that you have both options at your disposal.

As always, I encourage you to not only participate in the poll, but to also weigh in with a comment providing some context for your answer.

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We’re hoping to develop a big picture plan that will allow us to save for retirement without leaving us financially deprived now. Figuring out how much you need is easier said than done. There are plenty of tips, suggestions, and ideas on the web to get you started.

Since we’ve been running our numbers, I wanted to share some of the thoughts that have gone into it.

Define Your Retirement Goals

One of the things that makes retirement planning difficult is determining exactly what you want out of retirement. There are some important questions that you need to answer before you can determine how much you’ll need to stash for retirement.

• When do you plan on retiring?
• What kind of lifestyle do you want to maintain while retired?
• How long will your retirement money need to last?
• How much (if anything) can you count on from Social Security?

When you do you want to retire?

Retirement means different things to different people. Some people don’t want to stop work; they may just want to cut back on hours and work (for example) as a part-time consultant. Others may be looking at a more traditional retirement, and need to make sure they have a big enough nest egg to live off of for several decades (or more).

Or maybe you want to take a series of “mini-retirements” during the next few decades before take the big one. My husband and I are thinking about moving more toward freelance and location-independent work. While we want to significantly cut back on hours, we probably wouldn’t want to completely stop working as long as we’re able to do something we love.

How much annual income will you need during retirement?

To determine future income needs, you should start by analyzing your current annual expenses. Look at what expenses you may not have during retirement as well as what new expenses you may take on. For example, some people will have paid off their mortgage, or may be planning on downsizing to a smaller home. For many, health insurance will become a much bigger expense later in life.

You can use a spreadsheet to figure out your required nest egg. Just be sure to factor in the effects of inflation when running your numbers. We’ve been using an average rate of 3.75%.

When we thought about it, we’re looking at needing around $45,000/year (in current dollars) for our retirement years. By paying down our mortgage, we’re hoping to help lower retirement expenses and give us some peace of mind.

How long do you need your retirement income to last?

I found determining our life expectancy a bit weird. We can’t predict how long we will live, but we can plan based on average life expectancy. According to the US Census Bureau, if you’re a 30 year old female, you have a life expectancy of 76 years (72 years if you’re male). Based on that, we’re estimating around 80 years for both of us, which is a bit longer than the current averages.

After using the spreadsheets to give us a ballpark figure, we’d need around $1.3M if we were retiring right now. That looks like a pretty steep number, so we’re hoping that the power of compound interest will help us out.

Do you include Social Security with your retirement planning?

Many members of Generation X or Y are wondering if Social Security will be around when they retire. While it seems likely that something will be around, the program as it stands doesn’t have enough money to sustain itself. Thus, there will almost certainly be changes. Given the uncertainty, we’ve decided not to count on it.

If there are some benefits when we retire, then we’ll have some extra income to work with and I’m sure we’ll put it to good use. I just don’t want to our plan to require Social Security to be successful — it’s better to be safe than sorry!

Executing the plan

Once you know how much you need to retire, you have to figure out how to fund it. Start by checking your monthly cash flow, and figuring out how much you can afford to set aside for the future.

Depending on how much you have to invest, here are some ideas beyond high yield savings accounts and certificates of deposits on where to put your retirement savings.

• 401(k): Be sure to get your employer’s match – my husband gets a 100% match on the first 5% of his salary that he contributes
• Roth IRA: Fund it up to the annual contribution limit – currently $5,000
• More 401(k): Once you’ve done the above, focusing on maxing out your 401(k) – currently limited to $16,500/year

I’ve found that automating our investments and savings is the most painless way to keep you on track. If we can pay off the student loans, then we’ll have more money to direct towards the retirement fund.

What about you?

I’d love to hear from you about how you’re preparing for retirement. How soon are you hoping to retire? And how much money will you need?

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I have a small traditional IRA that I’m tired of dealing with. I’m no longer contributing to it, and would like to roll it into my 401(k) so I won’t have to keep track of two accounts. Can I do this?

The short answer is that yes, you can roll the funds from a traditional IRA into a 401(k) as long as the 401(k) plan allows it. The same goes for doing a rollover into a 403(b). The slightly longer answer is that you can only roll over tax deductible contributions and earnings.

Thus, if you’ve also made non-deductible contributions to your IRA you won’t be able to move the full amount. Rather, you’ll have to subtract out your “basis” when determining how much money you can move. It’s also worth noting that inherited IRAs cannot be rolled over in this fashion.

Another important question is whether or not you should execute a rollover of this sort. While it might be convenient to consolidate your accounts, you should look carefully at the investment options and fees in the 401(k) plan before executing the rollover. If your 401(k) options aren’t great, you might be better off keeping the IRA.

Another minor consideration is that you can withdraw funds from your IRA whenever you want. While withdrawing funds from an IRA isn’t typically a good idea, there are circumstances in which doing so is the lesser of two evils. You’ll have to pay taxes and penalties, but you can access IRA funds early. In contrast, you’ll have to meet specific hardship guidelines before you can touch the money in your 401(k).

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For the sake of simplicity, I’m going to restrict today’s discussion to IRAs, but it’s applicable to any retirement vehicle with a tax-deferred vs. Roth option. For example, an increasing number of 401(k) and 403(b) plans offer a Roth option.

As a quick refresher, traditional IRA contributions are tax deductible (assuming you don’t make too much money). Your money will then grow tax-deferred until you take it out, at which time taxes will be due at regular income tax rates.

With a Roth IRA, you lose the upfront tax deduction. However… Your distributions will be completely tax free, meaning that you don’t pay a dime of taxes on your investment gains.

Traditional vs. Roth

The common arguments when it comes to debating traditional vs. Roth IRA contributions revolve around your current and future tax brackets. If you’re in a lower tax bracket now than you expect to be in at retirement, you should use a Roth.

In contrast, if you’re in a higher tax bracket now than you expect to be at retirement, you should make deductible contribution to a traditional IRA. That way you can get the tax break now (in the higher bracket) and pay less in taxes later.

The future of taxation

Of course, this all assumes that you can accurately predict future tax rates. While you might be able to accurately predict whether your inflation-adjusted income will be higher or lower in retirement, you’ll need a crystal ball to predict what tax rates will look like in 30 years.

In other words, while you may drop to a lower bracket, future tax increases could mean that the percentage associated with this bracket is higher higher than what you’re paying today.

And what if we convert to a consumption-based tax system (such as the “Fair Tax”) in place of our current tax system? That seems unlikely, but if it happened, people with Roth IRAs could get if they paid income taxes on the front end and then got hit with a consumption tax on the back end.

How to avoid current and future taxes

Another consideration that many people overlook is that, while the current income tax brackets bottom out at 10%, a married couple filing jointly will pay no taxes on their first $18,700.

Why? Because they’d be entitled to the standard deduction ($11,400 in 2009) and two personal exemptions ($3650 each). Beyond this, the 10% tax bracket for married couples extends up to $16,750 and the 15% tax bracket extends up to $68,000.

Ultimately, this means that at least a small amount of traditional IRA money could be very valuable. Consider the following scenarios for a married couple filing jointly:

• With $18,700 in income…
  …no taxes are due.
• With $35,450 in income…
  …the Federal tax bill will be $1675.00 (10% of $16,750).
• With $86,700 in income…
  …the Federal tax bill will be $9362.50 (10% of $16,750 and 15% of $51,250).

This works out to a effective income tax rate of 0.0%, 4.7%, or 10.8%. By taking advantage of the very low end of the income tax brackets, you can take a tax deduction now and pay very little in income taxes later.

In other words… You can have your cake and eat it to. By balancing traditional and Roth contributions during your pre-retirement years, you’ll have the flexibility to minimize your tax hit on both ends.

If you only make Roth contributions, then you’re paying taxes now to pay nothing later. But with at least a small amount of traditional IRA income, you can avoid taxes now and later.

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So… When you switch jobs, what should your old 401(k)?

Don’t cash it out

First and foremost, do not cash out your 401(k). Tax-deferred savings accounts are hugely valuable in the long run, and unqualified distributions will result in both taxes and penalties. This is a bad, bad thing and should be avoided at all costs.

Consider leaving it alone

Perhaps the easiest thing to with your old 401(k) is to simply leave it alone. If you’re happy with your investment alternatives, and your former employer will allow it, you might just want to leave it in place.

This can also be a useful strategy if your new employer has a waiting period before you’ll be eligible for their 401(k) plan. Once the waiting period is up, you’ll be free to roll the money into the new plan — assuming that the new plan accepts rollover contributions.

Roll it into your new employer’s plan

Another potentially attractive option is to simply roll your 401(k) balance into your new employer’s plan. Not all 401(k) plans accept incoming rollovers, but if yours does, then consolidating the money would simplify your financial life. Of course, there are other considerations here…

Are you happy with the investment choices? What about the fees and other expenses? While you will likely want to participate in the new plan, at least to get any matching funds that might be available, you might not want to move additional money into it.

Roll it into an IRA

The big problem with 401(k) accounts is a lack of control when it come to investment options and expenses. While there are some really good 401(k) plans out there, many others are really, really bad. The investment choices stink, they’re laden with fees, and so on.

When you change jobs, you have an opportunity to roll the money into an IRA, choose your own broker or mutual fund family, and really take control of your investments. In most cases, this is a very attractive proposition, and you should seriously consider doing it.

Other considerations

There are a few other considerations to keep in mind when deciding what to do with your old 401(k). For example, you’re allowed to borrow against your 401(k) balance, but you cannot borrow against your IRA. I’m not a fan of borrowing from your retirement plans, but it’s a difference worth mentioning.

Conversely, with an IRA you can withdraw money at any time for any reason. Yes, you’ll pay taxes and penalties, but you can do it. With a 401(k) you’ll have to meet specific hardship guidelines before you can touch the money early.

Another point is that, once you get the money out into an IRA, you have the option of converting some or all of it into a Roth IRA. Conveniently, the income limits for Roth IRA conversions have just gone away. Yes, you’ll face taxes when you convert deferred money into a Roth, but it may be worth it depending on your circumstances.

While we’re on the subject of Roth IRA conversions, however, there’s a downside to moving your 401(k) money into a traditional IRA. If you’re over the income limits for contributing to a Roth IRA, you might be tempted to make non-deductible contributions to a traditional IRA and then convert the money into your Roth.

The problem is that, if you have tax-deferred money in an IRA (traditional, SEP, or SIMPLE), you’ll have to factor that in when determining the tax status of your conversion. Here’s a snippet from Fairmark.com that I’ve previously used to illustrate the problem:

“For example, if you happen to have a traditional IRA with $96,000 of money from a 401k rollover (zero basis) and you make a $4,000 nondeductible contribution to a new IRA, thinking you can convert it to a Roth at little or no cost, you’ll be wrong. You have to add the two IRAs together to determine the taxable amount, and in this case your conversion will be 96% taxable.”

The workaround here is to simply keep your 401(k) money in a 401(k), Alternatively, if you have money in (say) a SEP-IRA, you may be able to roll it into your employer’s plan, or perhaps a solo 401(k) to avoid the pooling of funds mentioned above.

In some ways, the solo 401(k) gives you the best of both worlds, as you get freedom to choose your own brokerage and slate of available investments while still shielding the money from the unfortunate tax calculations associated with a Roth IRA conversion.

Of course, as noted above, you also lose the ability to withdraw funds on a whim, and there is an extra form that you’ll have to file at tax time once your solo 401(k) balance reaches $250k.

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If you were 65 and retiring today, how much do you think you would need?

Interestingly, 42% of respondents said they’d need over $1M, and 27% said they’d need more than $2M. At the other end of the spectrum, 8% thought they could get by on less than $500k.

If you assume a safe withdrawal rate of 4% (as many do), then a $500k nest egg would throw off an inflation-adjusted $20k/year. At $1M, we’re talking $40k/year. At $2M, it’s $80k/year.

What do you think? If you were 65 and retiring, how much would you need?

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» Life Expectancy, Retirement, and Your Investment Time Horizon
» Is Your Retirement Plan DOA?
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