Get Your Ducks in a Row

As a follow on to Tom’s post about security, let’s look again at the weakest link in your security – You… and the little scraps of paper that contain your user names and passwords.

As noted earlier in this forum, accumulating wealth can be quite simple: buy a lottery ticket, get lucky, voila! you’re wealthy. But even with that simple, albeit  unlikely scheme, you still have to remember where you stored the lottery ticket.

Using Tom’s ( and Smith-Barney’s)  “old fashioned way” of accumulating wealth takes more time, patience and a lot more remembering.  You have to remember more than just user names and passwords.  There are  account numbers, safe combinations, pin numbers, life insurance policies, spouse’s SSN, etc., ad nauseum, ad infinitum.  Now, if you’re twenty-something, have only a few accounts spread around and most of your brain cells are still in tact, you’re thinking “How bad can it be?”  However, if,  like me, you’re a (way) bit older and haven’t  organized this information, you’re most likely rocking in the fetal position, hoping your  memory will return.

Of course, you can organize data on a sheet of paper, put it in a drawer and like the lottery ticket simply remember where it is so you can constantly keep it up to date.  You just have to hope your 7 year old daughter doesn’t take it to school for financial “show and tell” or the new puppy doesn’t rearrange a few figures when you forget to put it back in the drawer (the paper, not the puppy!).

A better solution is a simple and, preferably secure, database.  There are several solutions out there ranging from cheap to free.  Unless you’re reading this article at the library (you’ll need your own computer), the cheapest digital solution is a text file or spreadsheet with a few columns for description, user name, password, URL and account number(s). Although I would contend, it’s better than nothing, this solution has some serious security issues and is not as easy to use as a dedicated program.

The database I have used for the past 5 years is Passwords Plus.  It’s under $30, is extremely easy to use and syncs with any device running the Palm OS.  This last feature saved my butt a couple of years ago when my wife and I, while vacationing in Maine, discovered the rustic little cabin (read “hellhole”) we were staying in didn’t take credit cards.  Because my PDA  contained my checking account number, we were able to quickly secure cash at the local bank without resorting to masks.

KeePass, mentioned in Tom’s post,  is another program that I tried recently just for comparison.  It’s friendliest feature is that it’s free!  It also appears to have another layer of protection that Passwords Plus doesn’t have, that being a “disk key” that you generate yourself.  So, if super security is one of your requirements, it may be the better choice.  Also, for you Mozilla Firefox users (like myself), KeePass allows you to import any usernames and passwords you’ve captured in your browser.  However, I think I will still stick with Passwords Plus just because it’s so darned easy to use.

In conclusion, there are several other similar solutions out there, but it’s not so important which one you use as that you organize your important data…now!   If you’re currently using Passwords Plus, KeePass or another similar program, let us know; we’d love to hear from you.

This article is the introduction to the series.  When we talk about retirement, there are a couple of factors that are important to understand:

1. Retirement does not just mean “quit working.”  On this site it really means finding financial freedom to do what you want to do. That could be reduced or no work hours. Or it could mean starting a business, volunteering, or opening a daycare for grandchildren.  Retirement is just a convenient word for that, but financial independence is the real goal.
2. Reality matters here. If you do not have enough money already saved and invested to be financially independent with a portfolio growth of 6 – 10% annually over ten years, then you won’t be done in ten years.

Before we get started on investing, let’s do some pre-work. Specifically we need to determine the following:

• Are you debt free or nearly debt free?
• What is your risk tolerance?
• How much money do you need to be financially independent?

Are you debt free or nearly debt free?

With 10 years left to go before retirement, you should be on your way to being debt free with the exception of a mortgage. This isn’t easy, and it isn’t reality for everyone. However, it is where you need to start.  Debt quickly cancels income, which hurts your ability to accumulate wealth. Debt represents risk to you. Paying off debt gives you a guaranteed return matching your interest rate (unless the interest is deductible for you). Aside from overextending yourself and not having cash on hand (an emergency fund), there is little risk to paying off debt.

Some people want to compare the interest rate with the return on investments they could have.  Usually they forget risk in that equation.  For example, if you have a home equity loan at 8% from rates before the housing market crash, payments to that loan “earn” 8% while the stock market jumps up and down.

But really the bottom line is that you cannot feel financially independent with significant debt, and debt makes getting there that much more difficult. A mortgage is the only debt that you should not pay off before investing, since the home tied to the mortgage will gain value over time.

What is your risk tolerance?

This is a huge factor in deciding what to invest in. Many people moved happily along with their 401(k)’s until the 2001 tech crash and the latest recession turned them into “201(k)’s”.  If you have a low tolerance for risk, your investments need to reflect that. However, the sobering truth is that if you tolerate no risk in your portfolio, you will get little to no growth relative to inflation. Your entire contributions will need to support your financial freedom. A lot of people have moved their retirement investments into cash and conservative investments because of low risk tolerance. No one gets wealthy by investing without risk. Whether that risk is by investing time and energy into a new business, focusing intensely on your career, or putting money in the stock market.

Let’s say you are open to risk. Is there such a thing as too risky?  There absolutely is. Bernie Madoff and Enron have shown us this. No one person, no one stock should have all of your money, ever! They key is to spread the risk across areas that you are comfortable in.

So pick where you are at with one of the following (this will be important in future editions of this series):

• Conservative – You don’t ride roller coasters, and you tremor in fear at the thought of your retirement investments looking like a roller coaster.
• Moderate – You enjoy the thrill rides and roller coasters, but only on a few vacation weekends out of the year. You aren’t willing to put half of your money “at risk.”
• Aggressive – You realize what goes up can and will come down, you don’t read the news or you disregard the news, and you believe in the economic machine of our global economy

How much money do you need to retire / be financially independent?

This is not as difficult a question as it seems. Though you can save more to be comfortable and to reduce risk, the simple answer is that you need enough money so that the earnings meet or exceed the income of your “day job”. You can get buy with a bit less if you have no debt at all and most of your income is going to increasing your savings. A common suggestion is that you be able to replace 80% of your pre-retirement income. My suggestion is aim for 100% and re-evaluate every 5 years. If at that point you can replace 80% or more and are comfortable with that amount (for the rest of your life) then you are set.

Types of Investments

We are almost at a point where we can start looking at investments. When we talk about investing, while keeping in mind your risk tolerance, we must identify the key requirements of any investment that you make:

• You must understand the investment. You don’t have to understand it enough to run a mutual fund, for example. But you must understand what it invests in, how it grows, how the management company makes its money, and how the financial adviser that suggested it makes his/her money.
• You must accept volatility. Only a bank account, money market account, or a CD is going to have a guaranteed or nearly guaranteed rate of return.  Assuming you decided that your risk tolerance is at least enough to allow some growth over inflation, you will have to accept volatility in the market of whatever the investment is.

There are many people who are quite savvy about investing and meet both of these requirements hands down. This article series  is not really intended for that audience — those folks already know how to make money in the market, likely in both down and up markets. If you like your ETFs, your hedge funds, your variable annuities, and your gold, you won’t like my plan.  But if you are like the majority of people out there, you have a cursory knowledge of most investments and you do not want to become an expert in many different investments. So it really comes down to just a few investment types that I would recommend:

• A U.S. Market Index Fund
• An emerging market index fund (foreign markets like Brazil, China, India)
• Real Estate (either a Real Estate Investment Trust, REIT, or renting out property)
• Guaranteed fund, CDs, Money Markets, and Savings Accounts

Whoa!  I left a lot off of the list, right?  I don’t believe so. The reality is that investments beyond this group get more difficult to understand and manage. As we get into the remaining articles in this series, we will cover these investment types in more detail.If you wish to get more fancy than these options you certainly can. But my plan, and my recommendation to anyone, for the most part sticks within these categories.  I will describe later in the series some ideas on how to get a bit more aggressive, or how to “try out” other investments within your retirement portfolio. But as we cover this series the biggest question will become: what kind of mix of investments do you need?  This all comes down to your risk tolerance and the years you have left until financial independence / retirement. And that is why I am covering these topics in stages. So keep an eye out for the next article in the series!

To start this discussion, let’s take a look at some statistics on the distribution of income in the United States. Maybe from this there is something to learn, or perhaps its just interesting data.  First let’s look at some of the 2005-2007 census data. Statistics show that we have 111.6 million households. So what is the relative wealth breakdown of those households?

Income Levels (2005-2007 Census Data)

The median income during this time period is right around $50,000. If you are significantly lower than that, you might be struggling to make ends meet. If you are higher than that, you might have a good income, especially relative to the rest of the country… but even then you might not feel like it is sufficient. And if you are way off the charts, you might be Obama-rich (congratulations if that is the case)!

So how do these numbers differ from the past?  Below is the same data from 1993.  You can see the trend as fewer households are in the under $15k range, and significantly more households are in the greater than $75k range.

Income Levels (1993 Census Data)

In 1993, the median income was $31,553 compared to the $50,000 number for 2005-2007.  During this time period (1993 to 2005) the consumer price index grew from 213.7 to 284.3, an increase of 33%. The median family income grew over 58%. So why are incomes outpacing consumer price index during that time period?  One of my thoughts is that a certain portion of that increase is represented in the increase of dual income families.

At the same time that households appear to have more money relative to the cost of goods, people have felt increasingly more strapped. Take a look at some data from Pew Research (The Median Debt-to-Income Ratio for Households With Debt Holdings) that really highlights what I believe to be a major contributor, if not the largest contributor, to any disparity in wealth and the “fading middle class.”  This graph shows the median debt to income ratio of high, middle and lower income earners in 1992 and 2004:

Median Debt to Income (1992 and 2004)

Notice the tremendous growth in debt compared to income! We can consider what goes into that. For instance, I have no doubts that rising health care costs are a contributor. But I also believe that our excess is a factor as well — our Starbucks, BMWs, and our willingness to take on house we cannot afford.. If you compare the income data, it seems we should feel better about our position not worse. And certainly it is difficult to see the middle class disappearing from the income data. Compared to inflation it seems middle class should be getting richer. But this debt is a tremendous burden. And doesn’t Congress provide a wonderful example of keeping debt within reason?

What are your thoughts on what contributes to this drastic increase in debt?

Because of the removal of MS Money from the market, the discussion of alternatives such as Mint.com and Quicken On-line came up. These tools are considered on-line account aggregators because they typically connect to your accounts at various institutions and download statements. Below is a list of common account aggregators:

• Mint.com
• Wesabe
• Yodlee
• Geezeo
• Quicken On-Line

The most common concern of using these on-line account aggregators is security. How safe are these on-line account aggregators?

Mint

Current Security Measures

First let’s take a look at the security the sites do provide, before we get into the possible weaknesses. We are going to focus on Mint.com, though all of the sites provide similar security. Mint.com’s security features can be viewed here. But here is a basic rundown of those features:

• Anonymimity
• 128-bit SSL encryption
• Secure facility protected by biometrics palm scanners and 24/7 security guards
• Bank-level data security standard (encryption, auditing, logging, backups, and safe-guarding data)
• The site has the VeriSign seal.
• Mint has anti-phishing protection provided by RSA

So what does all of this mean? Well, first, anonymimity means that Mint does not ask for personally identifying information, for the most part. This includes data like name, social security number, etc. However, they do ask for e-mail. The point here, though, is that the data that they have on you (financial account balances and transactions) cannot easily be traced specifically to you.

The 128 bit SSL means that the data you submit from your browser to Mint’s network is encrypted in a fairly difficult to decrypt manner. This is the web standard SSL that you see when you use a bank or a web site that has the security lock on your browser. This is good, it protects your data as it travels to Mint. The VeriSign seal primarily validates that this SSL encryption is in place between your computer and Mint’s servers. Once it gets to Mint, they can encrypt your data using SSL as they pass it around internally so that no one at Mint can see it. And when they send it to your bank or other service providers it can be and likely is encrypted with SSL.

The bank level data security helps give some assurances about what happens with your data, including your bank log on credentials, while it is inside Mint’s network. If encryption of your credentials and data is maintained always while in Mint’s network, then only a security breach of the encryption key could compromise the data. Usually it takes more than just having the key, you also have access to the devices that have the data stored on it. The bottom line is that once it reaches Mint’s servers, we have to take their word for it that it remains encrypted, and I will give them the benefit of the doubt on this based on what they have stated here.

Of course physical security like biometric palm scanners and security guards means they don’t just let anyone into their facility. That is a good thing.

Where Are the Issues?

Mint handles two types of sensitive data. One type of information it holds consists of records of your account balances and transactions that it has aggregated from various sources. This information is valuable to you, but has limited valuable to anyone else. As long as the login information for your bank is not stored along with the account data, you cannot do damage just knowing the location and amount of the account. That brings us to the second type of information, your login information, or credentials.

According to Mint.com, the credentials information is not stored within their network. From their site:

“We need your online banking user name and passwords so that we can help you organize and manage your accounts, that information is encrypted and transferred in a secure manner. We store only the information needed to save you the trouble of updating, syncing or uploading financial information manually. Your banking login credentials are securely stored by our online financial service providers. Your Mint login credentials are not shared with these providers.”

This is reassuring, the bank user names and passwords are not stored by Mint. Instead those credentials are stored by their online financial service providers. Basically after the first time that you enter your credentials for a financial institution, Mint connects to their online service provider to retrieve the account data, and also received an ID or token at the same time. That token allows them to retrieve, read only, account balance and transaction information in the future to keep Mint in sync with your accounts. Although it isn’t stated directly, on-line financial service providers seems to imply banks. In fact, banks could provide this service. However most of them do not. Most banks and financial institutions require your login information, including possibly additional information like answers to your “secret” questions.

The reality is that Mint’s online financial services provider(s), if there are more than one, are not the banks and financial institutions. Instead it is a third party company, Yodlee. As mentioned earlier, Yodlee also provides its own on-line aggregation service for customers.  While it is difficult to find direct mention of Mint using Yodlee behind the scenes, looking through the forums and some other websites you can find that Yodlee is indeed their provider. Below is Mint’s statement on its liability for any loss with their third party system(s):

“However, it is important to understand that these precautions apply only to our Site and systems. We exercise no control over how your information is stored, maintained or displayed by third parties or on third-party sites.”

So, while it is by no means a secret, it is important to keep in mind that if you use Mint, your credentials are stored somewhere. And they are all likely stored in one location at Yodlee. To me it seems clear that Mint.com obscures this fact. You can see in their forums that they use Yodlee, but you see no reference to it on their site directly. Although they don’t directly say it, their wording implies that credentials are not stored by them and are instead stored only by financial institutions. One of the reasons they do not make this obvious may be for security itself, however I do believe they are intentionally vague on this for marketing purposes.

I do not want to give the impression that if you use Mint your credentials are being passed around in numerous e-mails at Yodlee or outside of Yodlee. Yodlee itself is no slouch on security. They provide many of the security precautions that Mint provides, probably quite a bit more. Broke Grad Student provides a good synopsis on Mint Myths Debunked where it is mentioned that Fidelity and Bank of America use Yodlee, for example. So even without using Mint, your credentials may be stored at Yodlee for other financial institutions.

With that said, many people have an issue with having ALL of their account information in a single place. An intelligent, disgruntled employee at Yodlee could find a way to get to that data. It would be difficult, but not impossible. Using the desktop version of Quicken reduces that risk. Desktop Quicken stores your credentials locally on your computer. So unless your computer is compromised, that information is safe. Even if your computer is compromised, someone would have to break Quicken’s security measures. However there are two slight risks, even to the desktop version of Quicken:

• There is nothing stopping Quicken desktop from passing credential information through Quicken’s servers on the way to the financial institution. I don’t believe they do this, and I don’t believe they intend to do it. But it would be difficult to detect if they started. If they did, eventually I would expect this to come out and there would be negative repercussions with Quicken for such a move. But if they chose to do this, it would put Quicken desktop in the same position of every other on-line account aggregator.
• Quicken provides automatic bill pay. So unlike Mint there is the possibility of moving money from within Quicken desktop if someone were to break in. (But if someone breached Yodlee, they would have access to full credentials, not just read only tokens)

The Banks Role

For services like these on-line aggregators and Quicken desktop to work, Banks and financial institutions must provide the mechanism to retrieve account information. For years they have provided the ability to download transactions from their site into desktop software using Quicken and MS Money formats. In the past 5 years or so it has been possible to download some financial institution’s transactions directly from within these tools. Some banks have been supportive of that capability while others have been wary of the security.

Regarding on-line aggregators though, many banks have a firm position. Below is an excerpt from an e-mail from ING Direct to a customer regarding Mint.com:

“I understand that you recently had an issue trying to connect to our website using Mint.com. This service is commonly referred to as an account aggregator. While this service may have worked in the past, most users are finding that their aggregator does not work with our New Sign In Process.

The security of your information is very important to us. Once your personal information leaves ING DIRECT, we have no control over your information or how it is used by third parties. Because we have no way of monitoring how account aggregators address security, privacy or the use of cookies we are unable to support the use of these services.

To best protect your personal information and your funds, we recommend that you do not share your personal information (including your Customer Number and PIN) with any third party.”

Many other banks have the identical position that using account aggregators is at your own risk.

Conclusion

In the end you have to do what you feel comfortable with. Yodlee’s servers are many times more secure than most people’s home computers. Take that into consideration when considering the on-line aggregators versus something like Quicken’s desktop version. Consider your bank’s and other financial institutions position on using such services.

For my own part, I have been using Quicken for many years after giving up on MS Money. Recently I gave Mint a try and I do like its ease of use and slick interface. But I had significant trouble interfacing it with my ING Direct account, which is what led me to research this information. In the end I am going to stick with Quicken.

Ultimately the best thing you can do to protect yourself is to periodicially change your password and use strong passwords. If you choose the desktop Quicken solution, be sure you have a quality firewall and virus protection in place. There are some other best practices here that we can tackle in a future post.

http://www.hulu.com/watch/74840/the-dave-ramsey-show-frid-may-2-2009

Now that I have been able to watch it, I have some thoughts that I want to share on the event.  First and foremost I do recommend that everyone watch the Town Hall for Hope. The message is excellent despite any shortcomings I mention in the rest of this post.  It is important that we continue to work our way out of difficult economic times with as much optimism and hope as possible. Key components of Dave’s message in this event include:

• The fear and hysteria can get to anyone, the media has done an excellent job publicizing it.
• Although 45+% of people believe there job may be at jeopardy, the reality is that unemployment has increased only around 3% (this has gone up slightly since the broadcast; also, 3% is based on the official unemployment number — some believe it is optimistic because it does not include underemployed).
• For those who have lost their jobs, attitude is a critical component to moving on and landing the next job.
• Although it is always difficult starting a new business during an economic downturn, there are advantages and opportunities that exist when compared to times of strong economy.

Dave’s message is extremely consistent with his show, and as he puts it, this is common sense — this is advice your grandmother might give.  That is true to an extent, though not everyone believes that avoiding debt completely is necessary. In fact many believe debt can be a key to financial well being (for example, buy real estate at no money down). If you have listened to Dave’s radio show, watched his television program, or read his book The Total Money Makeover, you will see that much of the content of the Town Hall for Hope has been delivered before. That is acceptable here, because in this event it is delivered to a potentially wider audience.

Dave believes that you cannot separate the spiritual from finances. Maybe more accurately he believes you cannot separate the spiritual from anything in one’s life, financies being a component of life. Although occasionally he will encourage his listeners to seek advice from their pastor or their church, usually he keeps religion out of the discussion unless he knows one’s faith. A big part of his delivery of Financial Peace is through the church community, so clearly his message has tie-ins with religion. Like his traditional shows, this event was mostly finance and economy with a little bit of spiritual mixed in.  This may turn off viewers who do not hold views of any religion, or believe in religions other than Christianity.

Near the end of the event the question / answer session between David Asman and Dave Ramsey added less value to the overall conversation than the initial discussion and the question / answer session with viewers. With the crowd gone and the seats empty, it made me feel as if it were time for me to leave as well.

Dave adds many of his usual quips and expressions to much of the conversation, and if you listen to or watch his show you may be quite familiar with them – to the point where they are overused. But there is something rewarding in Dave’s delivery in general, whether part of this event or his show. To me that reward is a very motivating financial adviser that constantly reminding me of my own financial goals. There are certainly other ways to attain the same motivation, however for those that are looking for the motivation, Dave Ramsey provides it.

In the end, for anyone with uncertainty and concern about our economic climate, the Town Hall for Hope is a must watch. For those who want motivation and want to help spread the message of hope, there is value in the event as well. The only group I might recommend not watch the program are doomsayers, there may be too much hope for even the pessimistic to withstand.

What to invest in is obviously an important topic as well, but I am not going to cover that in this post. Instead here we are going to talk about the different types of plans. It is important to keep in mind that with most retirement account plans, there are a range of options from conservative to aggressive investments. If you have 10 or more years until your retirement, the most important factor here is that you are contributing to some retirement plan. If you are closing in on your retirement and have less than 10 years left, it starts to become more important where the money is invested. Asset allocation, risk, and all that good stuff is still very important. You do not want to be too conservative early, or too aggressive late. But before we talk about how to invest the money, let’s first cover whether to contribute to a retirement plan and which one to choose.

Should I Contribute to a Plan?

The answer to this should almost always be yes. If you have company matching, at the very least you should contribute enough to get that match.  You may not have the benefit available in the future, and with every paycheck that passes by when you do not contribute enough to get the match, you lose some income opportunity.

Beyond the match, you should contribute as much of your income as possible, targeting 15% or higher, into retirement accounts. But I do believe there is an exception to this, and that is when you have consumer debt, vehicle debt, or high interest student debt. Debt creates a stranglehold on your finances and ultimately your freedom. Some people are able to handle debt and wealth accumulation at the same time. But the reality is that most people cannot handle both simultaneously.

Once the debt is paid off, if you do not have an emergency fund of at least 3 months, you need to get that in place first. Your chances of staying out of debt and continuing to contribute to your retirement is at risk without this savings cushion. After the debt is paid off and the emergency fund is established, you should begin contributing to your retirement above and beyond any match.

If you have to hold off from your retirement savings to pay debt, you must make certain that debt payoff and creating the emergency fund are a one time, relatively short (1-3 year) process. That means that process must be done with intensity. If you can’t pay off debt and get the emergency fund established in that time frame, then consider looking for additional sources of income to attack the debt or cutting back lifestyle to make it work.  Dealing with debt and retirement at the same time is usually extremely difficult unless your income is high enough to handle both. But in that case, attacking the debt first should take very little time.

Preparing for Retirement

How Much Should I Contribute?

We already mentioned contributing at least enough to get the company match.  If you have none of the consumer debt mentioned and are able to contribute beyond that, how much should you save? You should consider contributing as much you are able up to 15% of your total household income. You can go beyond that if desired, especially if you are looking to retire early. But 15% is a good guideline for what should be “good enough.”  This of course does depend on a few factors such as when you start saving for retirement. If you start saving early, 15% may seem like too much. But if you can manage it, I would stick with 15% or higher. If you started saving later and are closer to retirement age, you are going to have to save beyond 15%.

In future topics we will discuss determining how much money you might need. This is a more concrete and realistic way to determine how much you need to save. For now, 15% is just our guideline to get started.

Which Plan Should I Choose?

Once you have decided how much to contribute, choosing the plan itself has some challenges.  Income limitations, investment options, fees, and taxes are all considerations for where you should put your money. So let’s go through the most common available options

IRA (Individual Retirement Account, a.k.a. Traditional IRA)

An IRA is a pre-tax (or deductible) investment option. The investments in the account grow tax free, however taxes are taken on all distributions from the account. In 2009, the contribution limit for Traditional IRA’s is $5000 for those under age 50. For ages 50 and older, the contribution limit is $6000.  This limit is shared with the Roth IRA. That is, you cannot contribute more than this limit in a Traditional IRA and a Roth IRA combined.

When should you contribute to a Traditional IRA?

• If you have reached your contribution limit in other retirement investment options, and you still have money to to contribute to a tax deductible retirement account.
• If you have no company match in a 401(k), contribute to the Traditional IRA first, then contribute to the 401(k).
• If you believe that taxes will go down in the future, invest in a Traditional IRA over a Roth IRA.

In general, since I don’t recommend guessing where taxes are headed (though it seems clear they can only increase with the significant debt we now have), if you have the option to invest in a Roth IRA and a Traditional IRA, you may want to split the investment in half. This gives you a hedge against taxes without guessing incorrectly on which direction they go.

Traditional and Roth IRA’s can be opened at many financial institutions. However, usually banks are not the best place for these retirement vehicles.  I specifically like Fidelity and Vanguard for opening IRA’s because of their low fees on some of the best mutual fund investment options, and because of their range of investment options.

Roth IRA

Unlike the Traditional IRA, the Roth IRA is an after tax investment. But the investments in the Roth IRA grow tax free and you do not pay any taxes on distributions (unless they are early distributions).  The contribution limits are the same as the Traditional IRA with one notable exception.  With a Roth IRA there are contribution limits based on Adjusted Gross Income (AGI).  For married couples with an AGI of $166,000 or less, they can contribute up to the full $5000 each. There is a phaseout (reduced contribution limit) between $166,000 to $176,000.  Above an AGI of $176,000. a married couple cannot contribute to a Roth IRA.  For single filers, the phaseout range is $105,000 to $120,000.

When should you contribute to a Traditional IRA?

• If you have contributed up to the company match of your 401(k) and you are eligible for a Roth IRA.
• If you cannot contribute to a 401(k) or SEP-IRA.
• If you believe that taxes will go up in the future, invest in a Roth IRA over a Traditional IRA.

Like with the Traditional IRA I don’t recommend guessing where taxes are headed. But, given the advantage of being able to take tax free distributions out at retirement, the Roth IRA and Roth 401(k)’s are my favorite plan. And except for the company match, I prefer the Roth IRA over the Roth 401(k) because it gives you more control over your money.

Traditional and Roth IRA’s can be opened at many financial institutions. However, usually banks are not the best place for these retirement vehicles.  I specifically like Fidelity and Vanguard for opening IRA’s because of their low fees on some of the best mutual fund investment options, and because of their range of investment options.

401(k) / 403(b)

401(k)’s and 403(b)’s are pre-tax or tax deductible employer sponsored retirement plans. While most of the contributions are made by the employee, companies may match a certain amount of employee contributions. Employer matching has of late been a benefit that many companies have cut back on.  A 403(b) is a very similar retirement investment, however it pertains primarily to employees in public education and some non-profit entities. In this section we refer to 401(k) but a 403(b) should have the same considerations.  The one likely negative difference of the 403(b) is that they reportedly have significantly higher fees. The best 403(b) provider in terms of fees is TIAA-CREF, so if that is your option then you are ok here.

The contribution limits for 401(k)’s, if your employer offers one of them, is $16,500 for 2009. For those individuals 50 and older, the limit is $22,000 when “catch-up” contributions are included.  This limit is shared with the Roth 401(k) if it is offered by the employer. That is, the total contributions to the Traditional 401(k) and the Roth 401(k) cannot exceed this limit.

Other limitations apply that may affect your eligibility for 401(k)s. For instance, some employees deemed “highly compensated employees” are not eligible to contribute to 401(k)’s. The income threshold for this depends on the contributions of lower income workers in a company versus the deferrals of higher income workers.

When should you contribute to a 401(k)?

• If you have a company match, contribute at least enough in the 401(k) or Roth 401(k)  to get the match. Whether you have debt or not, it is important to contribute enough to get the match. This provides “free money” in a sense.
• If you have maxed out your eligible IRA contributions and want to put more into retirement.
• If you believe that taxes will go down in the future, invest in a 401(k) over a Roth 401(k).

401(k)’s exist within a plan that is sponsored by employers and managed by an investment company.  Once your money is in a 401(k), you can move it between investments managed by the investment company. You cannot move out of the 401(k) into a more flexible IRA until you leave the company. Some plans do allow a wider range of investments by participating in Self Directed accounts. These allow investing in more stocks and mutual funds than the predefined plans usually allow. For the average investor, the predefined plans are usually sufficient and often better because of lower expenses and fees. We will discuss more about this in a future topic.

Roth 401(k) / Roth 403(b)

The Roth 401(k) and Roth 403(b) are offered at fewer companies than the Traditional 401(k) / 403(b). Like the Roth IRA, contributions are after tax and earnings and distributions are tax free.

If your company offers a match and you contribute to a Roth 401(k), the matching funds will be placed in the regular 401(k) because company matches are always pre-tax (therefore you need to pay taxes on the funds contributed by the company match when you receive the distributions).

When should you contribute to a Roth 401(k)?

• If you have a company match, contribute at least enough in the 401(k) or Roth 401(k)  to get the match. Whether you have debt or not, it is important to contribute enough to get the match. This provides “free money” in a sense.
• If you have maxed out your eligible IRA contributions and want to put more into retirement.
• If you believe that taxes will go up in the future, invest in a Roth 401(k) over a 401(k).

Most of the same rules apply for Roth 401(k)’s as they do for 401(k)’s, with the exception of Roth 401(k) contributions being after tax. My recommendation is always to prefer the Roth 401(k) to the regular 401(k). This allows you to effectively put more money in even at the contribution limit, since it is after tax.

SEP-IRA

The Simplified Employee Pension or SEP-IRA is an employer funded IRA. This becomes a fantastic option if you are self employed, are the sole employee of the company, and have significant profits. A self employed individual can contribute up to 25% of compensation, up to a maximum of $49,000 in 2009. Since the contribution amount has to be the same for all employees, it may be rare to find an employer willing to put aside the maximum 25% for all employees of a company. But for small companies with one or two employees, you can set aside significantly more money with this retirement option than the others.

Since this is a rare scenario compared to other options, this is really only recommended in those situations of a small company with few employees. And for employees other than the owner, this is more of a pension than a self funded retirement option.

Whole Life Insurance

Whole Life insurance is not really a retirement vehicle, but it does offer a savings component. Often it is offered by insurance companies as a way to save money for later in life. The problem is that the investment portion of the policy is not a good investment. You can, with a little bit of work, do much better with the other retirement options.  And the other side of the product, life insurance, is not usually a great deal either. Term life insurance is a much better product if you are looking for life insurance.  Combining savings and life insurance together seems like a great idea, but in this case the sum of the whole is not greater than the individual parts.

Annuities

Annuities are a product that you typically buy with retirement savings that provides a constant distribution over a period of time (a defined period or the life of the annuity owner). Annuities are sold by insurance companies in the form of variable annuities and fixed annuities. The problem with annuities are that they while they are a fairly simple concept, the investment vehicle within them are very complex and fees are generally high.  Variable annuities offer different investment options inside the annuity, giving the potential for a higher overall return from the annuity.

When you should you choose an annuity?

• Ideally I would say never, however:
• If you need a guaranteed monthly check or deposit into your account to support your finances

Really you can do better on your own. But if you don’t have the desire or discipline to manage the money yourself, an annuity is a viable option.

None of the Above

Once your have contributed the maximum to IRA’s and 401(k)’s, what next?  What if you don’t have 401(k) as an option, but you have more money to save than the $5000 IRA limit?  First, if you have children, consider saving in a College 529 plan. If you don’t have children or want to allocate the additional money to retirement, there are many options.  There is nothing wrong at this point at paying down your mortgage or investing in options outside of a retirement account.

Conclusion

The most critical step in preparing for retirement is simply setting money aside.  The investment vehicle helps determine how efficient that money keeps its value or grows, but that is still secondary to the process of saving over long periods of time. And remember that referring to retirement here means more than just socking away money to stop working and live happily ever after. Beyond the traditional retirement, what we are really after here is providing freedom of career choice and  security when you may want to do something else in your life or when you may have no choice but to do something else.

There are certainly more options, limitations, and considerations than covered here. Of course the limits and the options in general are also changed regularly by Congress. Once you have an idea of which option(s) might fit best for you, do some further research on the specific option. Also consider the details of your employer’s plan if you are considering the 401(k) options. And if you have concerns over your options, consult a fee only financial advisor to help create a viable plan.

Putting the Plan Together

Our Goals

We would not have a plan without first setting out some goals. While we have long term goals around our childrens college savings and our retirement, the short term goals are the focus for this topic. The short term goals are part of the longer term plan, but the 1-2 year goals really indicate what we need to be doing today.

Two primary factors have led to creation of these goals:

• Birth of our premature son – demonstrating the need for an emergency fund and more stability in our finances
• Upcoming reduction in income – my wife will be reducing her work within the next two years

So here we have a past event that encouraged us to take action. But we also have a future event that we control. Because it is our choice to reduce income in this case, we have set some predefined targets that we must hit before my wife can reduce work. This gives us real incentive to work together and hit the goals. Our two financial goals for the short term are 1) reduce our debt to the point where our home value is greater than our remaining debt, and 2) establish an emergency fund of at least 4 months expenses. When we started the plan last May, we had two 401(k) loans, a home equity loan, a student loan, and a mortgage.  And we had no sizable emergency fund.

Bringing our debt down below the current value of our home is advantageous because we could then sell the house and be completely debt free. With the housing market down, we do have to work harder than we expected when we started the plan!  Nevertheless it is still our target. Establishing the emergency fund is key to providing the stability we craved after the birth of our son.

Crafting the Plan

Our first decision to make was which loans to pay off and in what order. After some thought about each loan the decision was not all that difficult. The type of loan, the size of the loan, and the interest rate were all factors. Here is how we broke it down:

• 401(k) Loans – Generally speaking 401(k) loans are recommended against, which I will cover in a future topic. The only factor for making these loans the top priority was to have more freedom to change jobs (or withstand a layoff) without having to repay the loan immediately or owe interest and a penalty.
• Home Equity Loan – This became our second priority because of the relatively high 8.85% interest rate.
• Student Loan – Our interest rate on this loan is a very fortunate 1.75%. If it were 2 or more percentage points higher, I would be inclined to include it in this debt repayment plan. This became our lowest priority and would only be paid off in a medium to long term plan.
• Mortgage – The interest rate for the mortgage is 5.75%, and it is our largest debt balance. This is our third debt priority, but would have to be addressed after retirement savings and various other needs and wants in our medium to long term plans.

Our intention was to attack this debt with extreme focus. So while we have not followed Dave Ramsey’s Baby Steps exactly, the steps we have taken are not far removed from his approach.

Started a Budget and Reduced Spending

Where we had no formal budget before, we began to track our spending. We tracked our spending for the first month before establishing any budget. We identified areas to cut and began implementing those changes. The key point here is that we communicated what each of our priorities were within the budget, including some available money for non-essentials such as entertainment, eating out, and so on. Instead of eliminating all of the non-essentials, we put together a budget that reduced the number of smaller non-essential items like eating out. Where we really created room in the budget though was by eliminating and putting off the big non-essentials like out of state vacations, recurring monthly expenses, and cosmetic home improvements. Our income situation allowed for this, though if we had more debt or less income we would have had to focus on all discretionary expenses.

Created an Emergency Fund

Getting the budget completed allowed us then to put together a small emergency fund.   As quickly as possible we put in place $2000 for this emergency fund. We chose $2000 because while our expenses we under more control, they were still high enough that an expensive emergency could derail our plan. We keep this money in our ING Savings account in order to be able to access it quickly if an emergency required it.

We Threw Money at the Debt Constantly

All “extra” money we had went directly to the debt.  Well almost   With the 401(k) loans we had to pay them off in full, so we had to save the money first. This gave us extra perceived cushion on our emergency fund as well, but it requires much discipline to avoid dipping into the money that is saved to pay off debt.  All of our excess money went to paying off debt. By the end of 2008 we had our two 401(k) loans paid off. This had a fortunate side effect as well, at least for one of the loans. With the crash in the stock market, if we had all of the money from the loan still in our 401(k), we would have lost much of it in the crash. But instead it was like having a cash investment. We paid one loan off before the crash, so we lost around 40% of it in the downturn. But the other loan was repaid after the crash, coincidentally a great time to be buying into the stock market. This of course was luck, and I would not suggest trying to plan it this way.

Aside from the budget and reduced spending, we also made some other temporary changes:

• Reduced 401(k) contributions – we reduced our 401(k) contributions to just enough to get the company match.  If this plan were going to take more than two years, or if we were going to just incur more debt after we paid these debts off, then this would be a bad move.  All the money that previously went to 401(k) contributions now goes to the debt.
• Any extra income or money such as bonuses, income tax refunds, and reimbursements from Child Care Dependent Care account and our Health Savings Account goes directly to the debt.

Our Current Progress

These changes enabled us to pay off our two 401(k) loans by the end of last year, and cut our home equity loan debt in half. At this rate, we should be able to meet our goal of having less total debt than the value of our home by February of next year. Then within about 6 months of completing that goal, we should have our emergency fund established. So a plan that originally took us through mid 2011 is on track to be accomplished by mid 2010.  We are thrilled about the progress, especially given the current economic conditions. What we have found is that this focused intensity has enabled us to meet these goals much earlier than we imagined. It does not always work out that way for everyone, but my hope is that this provides some motivation for others.

Next Steps

Once we meet our target around mid 2010, our focus will shift slightly to medium range plans.  A major item for that time frame will include saving to buy our next cars.  Our current cars will reach 10 years old around 2013 and we want to be prepared to buy our next cars without incurring new debt. Once we have saved the money, if the cars are still running fine we will wait to buy them though. We own our current cars and are in no rush to replace them — we want them to last as long as possible.

Also during this timeframe we will re-establish fully funding our retirement accounts.  We will plan a vacation.  And my wife will be able to scale back her work.  So with that, I will provide more information on our progress and our medium to long term plans in future posts!