Advanced Personal Finance

We’re in the midst of adjusting our family budget to account for some major changes that will be happening over the next couple of months. In the process, everything is getting looked at, including savings. Just like anybody, we have lots of things competing for our dollars. We save a pretty sizable portion of our income right now:

• Retirement
• College
• Short-term savings for known expenses
• Taxable index mutual fund

Since everything is being evaluated, the topic of saving for retirement versus college came up. This should be an easy one. Everything you read says save for your own retirement first and college funds come somewhere lower down on the list. It’s in any personal finance book or blog. Easy.

Only it’s not so easy if your a parent.

Any way you look at it, saving for yourself first seems like putting yourself in front of your kids. And something happens to your mind when a child arrives. You become incapable of putting yourself before your offspring. What’s a positive genetically speaking can be a serious negative financially speaking.

So we’re at a decision point. Which gets reduced and by how much? First, the changes to the budget will be temporary. Second, they may not be necessary at all if things fall right.  As things stand right now, though, it looks like they’ll each take a hit.  We’ll be saving a little less in each of our children’s college funds and a little less for retirement.  It goes against all the personal finance advice I’ve read, but it’s the right decision for us.

Now let’s cross our fingers and hope it won’t be necessary…

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Tired of the same old 401(k)?  How about a Super 401(k)?

Some companies have started offering a new defined contribution retirement plan to employees.  Here’s how it works.  In return to ceding control over how your contributions get invested, you gain a turbocharged contribution from your employer.  As this article from Business Week points out, these plans are hybrid of a traditional 401(k) and a pension.

And the increased employer contributions can be substantial - think 15% to 20% of your yearly salary.  That’s in addition to the more standard 6% match on your contributions.

So what’s not to love?  Well, like the man says, there’s no such thing as a free lunch.  In return for the increased match, you turn over control of how the plan (and your money) is invested.  Typically, the employer will select a so-called lifestyle or target date fund.  Such a fund matches your projected retirement date to an appropriate asset allocation.  I personally like target date funds and recommend them to people without much interest in investing.  In this case, you’d be turning over control of the investment, but it would like be invested how you would have done it anyway.

That isn’t so bad until you consider the down side of the equation.  If how the employer invests the money isn’t so smart and you don’t have enough to retire at your projected retirement age, tough luck.  You keep working.

I’m not so sure you’ll see a lot of this in the future.  I don’t think turning over control of their money would appeal to a great many people.  Besides that, there’s the legal risk.  You can sign all the papers you want, but if your company takes your retirement money and invests it inappropriately, I tend to think you’d have legal recourse.

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At CNN/Money, their personal finance columnist, Walter Updegrave, fields a question from someone wondering if he has enough saved for retirement. The specifics of the question and the answer aren’t of particular interest, but Updegrave did write several things I agree with and want to emphasize.

In the letter, the writer says he wants a specific amount of income ($125,000 per year) in retirement, which happens to be his current income. He writes that he has an investment property and has saved a considerable amount already. He also states that he saves $30,000 per year after tax in addition to his 401(k).

Updegrave points out a couple of important points:

1. He correctly points out that $125,000 today will not have the same buying power 10 years hence. Inflation is something people often forget when and if they bother to calculate how much they need for retirement.
2. When considering how much income you need in retirement, it’s important to note how much you save for that goal now. That is, if you save $15,500 (the 2007 maximum) in your 401(k) and $4,000 in a Roth IRA (also the maximum for 2007), you’re really currently living on your salary minus almost $20,000. For example, if you are making $90,000 and saving like this, you’re really living on more like $70,000.

I’d add one more:

• What you need in retirement is largely dependent on your health. I’d wager that, for most people, their expected standard of living in retirement probably isn’t much different than what it is today. The big unknown, though, is just how healthy (or unhealthy) they’ll be at retirement. With health care costs climbing much faster than inflation every year, I believe this is the key factor in retirement income planning.

When I look at our retirement ‘number’ I try to look at each of these three things - inflation, actual current income, and expected health. Then, I just do the best I can to plan accurately. The plan will be wrong, but I believe the planning process is worthwhile.

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The Thrift Savings Plan (TSP) has to be one of the best reasons going for working for the federal government. Well, that and some of the jobs have nice perks like:

• Instilling fear in your fellow citizen just by your presence (IRS auditor)

• Getting to blow stuff up (Military)

• Deciding how long people will spend locked up in jail (Federal judge)

The TSP is the gub’ment’s version of the 401(k) or 403(b). Only it’s way better. To wit,

• You can contribute any percentage of your pay, regardless of your income, up to the federal max ($15,500 in 2007).

• Depending on the situation, there is sometimes a match.

• The contributions are pre-tax, just as in a 401(k), so contributing reduces your tax bill.

• The investment selections are superior to just about any private plan I’ve seen.

Investment options

Where the TSP really shines is in its investment options. There are really two categories - Lifestyle and regular funds.

A lifestyle fund is one that changes the underlying investments gradually as you approach retirement. So as you age, your exposure to stocks decreases. The lifestyle funds are just like the better versions of the same in the private sector. For example, the 2040 fund investments are just about perfect, as far as I’m concerned. It has 60% in a total market stock index fund, 25% in an international index fund, 10% in a bond fund, and 5% in a cash equivalent.

The funds that underlie the lifestyle funds are the same ones you can invest in directly. That way, if you don’t like the lifestyle fund target mix, you can do it yourself.

There are two great things about the regular funds. First, they have the most awesome management fee around - 0.03%. That’s right, on a $10,000 investment you’d pay $3 in fees per year. That’s lower than even Vanguard’s ETFs. Unreal.

The second great thing about the funds is they’re simple. There are only five of them, so even novice investors aren’t going to be overwhelmed with options. They’re all also index funds. Since it’s been proven over and over that index funds beat actively managed funds over the long haul, that’s a good thing.

Other notes

Another thing to know about the TSP is that it’s portable. That is, you can roll it over when you leave government service. You can also roll over previous qualified plans into it. That keeps all your investments together, and since the funds are so great, I recommend that.

Normally, National Guard and Reserve members can’t contribute to the TSP. However, if you’re called to active duty, you can. That’s what I did when it happened to me right after 9/11. I knew about the program and enrolled. I was able to save, like, $3,000 in addition to my 401(k) that year (which is probably against the rules, but since I’m one of probably three people who’s ever done it, I’m not too concerned). Once I left active duty, I rolled it over into an IRA.

So what does all this boil down to? If you’re employed by the federal government, you owe it to yourself to invest in the TSP as much as you possibly can. If you’re unsure how to invest, pick the lifestyle fund closest to your target retirement date. Then, when you retire, you can sleep on piles of money, free from worry.

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For many people (me included), maxing out both a 401(k) (or 403b) and Roth IRA isn’t feasible. (Ok - for us, it’s feasible, we’ve just chosen to go a different way with our money.) Everyone must make the same decision with their money - how to allocate it. You could max out a Roth IRA, but maybe you’d rather eat out often. That’s a perfectly valid decision assuming you’ve actually made the decision consciously.

So if, like many people, you’ve decided maxing a 401(k) and Roth IRA is an either/or proposition, you have a big decision to make.

Is it better to save in a 401(k) or a Roth IRA?

Here is a head-to-head comparison of the 401(k) and Roth IRA. Assuming you’re eligible for both, this guide should help guide you to the right retirement savings account for you.

• Investment Options

Many 401(k) plans offer an inappropriate number and type of investment choices. Plans can have either too many or too few choices. Too many can cause investor paralysis or a ‘little bit of everything’ allocation. Too few choices can cause a dangerous overweighting in one asset class and other problems. Another problem with 401(k) plans can be the investment options themselves. Funds that are expensive in terms of load and/or management fees directly and dramatically affect your account balance at retirement.

On the other hand, a Roth IRA can be invested in almost anything. You can invest in Exchange Traded Funds (ETFs) with their low-fee advantage. You can choose mutual funds, fixed income assets (e.g. bonds), Real Estate Investment Trusts (a kind of real estate ‘mutual fund’), or most anything else. Being able to invest in whatever you want obviously is a great advantage because you’re not limited to your company’s investment choices.

Advantage: Roth IRA

• Access to Funds

You might need access to your savings prior to retirement for any number of reasons. While it’s almost never advisable to withdraw money you’ve saved for retirement before actually reaching retirement, circumstances sometimes dictate that course of action. For example, an extended job loss may require you to dip into retirement savings.

Most 401(k) plans offer an option to borrow some of what you’ve contributed. If you take this route, you pay the money back just like any other loan. Effectively, the loan payment comes right out of your paycheck and goes back into the 401(k) account.

The main thing to note about 401(k) loans is that, with most plans, you must pay any remaining balance in full immediately upon leaving your place of employment. If you can’t, the loan becomes a distribution with all the major disadvantages that come with those.

You can get money out of a Roth IRA in an emergency, too. There are two major differences with a Roth, though. First, the money you take out is not a loan. You can’t put the money back into your IRA once you take it out. That’s a major downer because you’re forgoing all the compounding that money would have had until retirement.

Second, you can always withdraw your initial contribution penalty-free. In other words, you can get at the money you put into the Roth IRA any time, but cannot get at the gain on that investment without penalty. So if you invested $1,000 and the account balance is now $1,500, at most you can withdraw the $1,000 without penalty.

Advantage: Depends. If you are confident you’ll be able to repay the money and will remain employed until you do, a loan from a 401(k) is the way to go. If the money won’t likely be repaid (e.g. a house down payment), use the Roth IRA.

• Creditor Shielding

The 401(k) is protected from creditors under federal law. You can be forced to surrender part in a divorce, but not in the event of a judgment or bankruptcy.

The Roth IRA, on the other hand, is at the whim of state law. As such, it’s possible a creditor could attach your Roth IRA depending on the state you live in.

Advantage: 401(k)

• Matching Contribution

Some 401(k) plans include a employer match. Typically, for some percentage, your employer will match your contributions. If your plan offers a match, not contributing up to this maximum is leaving free money on the table. There are times, however, when it may make sense to forgo an employer match and save outside the 401(k).

Naturally, the Roth IRA offers no matching contribution. You’re on your own with a Roth.

Advantage: 401(k)

When weighing whether to invest in a 401(k) or a Roth IRA, give these four points some thought. The answer won’t be the same for everyone, but thinking it through will help get you to a nice comfy retirement.

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