How To Open An IRA On A Shoestring Budget

A friend of mine recently asked me about how to get started with opening an IRA since his employer doesn’t offer a 401k. The tricky part of his situation, though, is that he is making minimum wage and said he can only set aside $500 a year. First, I’d like to applaud his efforts to start contributing for his future retirement needs, especially with such limited financial resources.

Minimum Investments
As I mentioned in a previous post, most investment companies (Vanguard, Fidelity, etc.) require minimum investments of between $1,000 and $3,000 to open an account. He mentioned the idea of opening a ShareBuilder account online at ING Direct, since they have no minimum investment amount. However, the downside is they charge a $4 fee every time you make your monthly contribution. So, if my friend contributes $41.66 a month (to add up to $500 a year), then it will cost $48 in fees (just under 10% of his entire yearly contribution).

The Workaround
We came up with a workable alternative. Most banks and credit unions offer what are called IRA CD’s. These are normal IRA’s that are simply invested in certificates of deposit instead of stocks and bonds. The advantage is that you can typically open one of these accounts with as little as $250. Granted, the interest rates on the certificates of deposit are not very high, but there are no fees involved either.

So, the plan we came up with is for him to transfer the $41.66 every month into a savings account. In December (once the account has grown to $500), he will open a Roth IRA CD at his local credit union. The goal is to do this every year until he has enough funds in the IRA to meet the minimum investment at a traditional investment company (say $3,000). At $500 a year, this will take roughly 6 years at his current contribution level. So, this December he will invest $500 in a 5-year CD. The next year he will invest an additional $500 in a 4-year CD. The next year he will invest another $500 in a 3-year CD, and so on. By the end of that sixth year, he will have more than $3,000 and can then move his IRA to a traditional investment company and invest in stocks and bonds for the higher investment returns. An additional point is to structure the CD maturities to coincide with the timeframe you will want to move your money. For example, each of his IRA CD’s will mature at the same time (the end of year 6), so he doesn’t have to worry about paying any early withdrawal penalties on the CD’s.

Additional Benefits
One additional benefit I mentioned to my friend is that there is a tax credit for retirement contributions, commonly referred to as the “Savers Credit”. Depending on your income level, filing status, and retirement contributions, you can receive a tax credit of up to 50% of retirement contributions up to $2,000. In my friend’s situation he can receive a $250 tax credit from his $500 IRA contribution, which is a great benefit. Now I’m not a tax professional, and your individual tax situation may be different than his, so consult with your tax preparer to make sure you’re eligible.


What To Do With A Tax Refund

I’m going to assume that most of you have already filed your taxes. But if you haven’t, this is a reminder that tomorrow is the deadline. Did you know that according to the IRS, the average tax refund is right around $3,000? That is a pretty nice chunk of change, which leads me to today’s post. What are some of the most useful things you can do with a tax refund? Here are six ideas…

1. Start (or add to) an emergency fund
If you don’t have an emergency fund, your tax refund is the perfect opportunity to get started. Put $1,000 in a savings account and then work to gradually build it higher. Look into an online bank such as ING Direct or Ally for the best interest rates.

2. Pay off (or pay down) consumer debt
If your refund is more than $1,000, then complete item #1 first. Then if you have credit card debt or other consumer debt (a car loan, etc.) put your refund towards paying off those debts. If your credit card charges 18% interest (about average) then paying $2,000 towards the balance will save you $360 a year in interest.

3. Get current on household and/or vehicle maintenance
It’s easy to put off routine vehicle and household maintenance when your budget is tight. Getting your oil changed, tires rotated, or other important things may end up falling off your priority list during the year. The same applies with household maintenance. It can be easy to put off putting on a new coat of paint, replacing worn carpet, or having your heater serviced. Use your tax refund to get caught up this year, and then plan for how to stay up-to-date on all your maintenance in the future.
(See ‘How to handle irregular but expected expenses’ for tips on how to better plan for these items’).

4. Improve the energy efficiency of your home
Along the same lines as maintenance, there are a number of little things you can do to improve the energy efficiency of your home to save money year-round. You could replace your regular light bulbs with CFL bulbs, switch to low-flow shower and faucet heads, add insulation to your attic, air seal your home, and replace old windows. Start out with getting an energy audit (most utility companies offer this service at a very reasonable cost) to see what areas of your home can be improved.

5. Open an IRA
Sometimes it can be difficult to save enough money to open an IRA. Most investment companies (Vanguard, Fidelity, etc.) have minimum investment amounts to open an account. If you receive an average-sized tax refund, you probably meet those minimums. As an added bonus, contributions to a traditional IRA reduce your taxable income. Or if you open a Roth IRA, future investment earnings are tax-free.

6. Have a little fun
Take a small portion of your refund (say 5%) and do something fun. If you get an average-sized refund of $3,000, this would be around $150. Take your spouse out for a nice dinner. Take your family (including kids) out to the movies. Spend it on something you enjoy, and do it without feeling guilty about it. Just be careful not to spend too much of your refund on “fun” stuff.

How much was your refund and what did you do with it? Share your story in the comments below…

What Does It Mean To Diversify?

I hope everyone had a good Easter weekend. We certainly did. Our little Tyler had two Easter egg hunts that he thoroughly enjoyed. He’s a year old, so it was neat to watch him learn to look for and pick up the eggs. That aside, let’s talk about a nice topic for a Monday: Diversification.

When investing in stocks and bonds, one of the common terms you will hear is “diversification.” While this terminology is widely used, it is not always widely understood. I’ve had several people ask me questions about it. What does it mean to diversify? Why is it important to diversify? How do I know if my investments are diversified? Today’s post should help answer those questions.

The Idea Behind Diversification
We’ve all heard the phrase, “Don’t put all your eggs in one basket,” and we all understand why. If you have all your eggs in one basket and something happens to that basket, then you lose all of your eggs. If you instead split your eggs up into, say, four baskets and something happens to one basket, then you still have the eggs you put in the other three baskets.

The same general idea is true for investing. You should not put all your investment dollars into any one particular investment or even one particular type of investment. “Diversification” is just a fancy term for a simple idea: spread your investment money among different investments. This way if one investment or category of investments falls in value, your other investments will help insulate you. Now, even a well-diversified portfolio will not eliminate potential risk. There will be times (such as 2008 & 2009) when the stock market as a whole falls in value. But over time, a diversified portfolio of stocks and bonds is the best place for your retirement fund.

Let’s look at an example: John is 55 years old and has a 401k through his employer that he has been steadily contributing to for 20 years. Over those years, he has accumulated $300,000. In April, he receives his quarterly account statement, which shows the following investment holdings:

– Large-cap, Stock Index Fund: $150,000
– Large-cap, Technology Industry Stock Fund: $100,000
– US Government Bond Fund: $50,000

Is this a diversified retirement portfolio?

Red Flag #1
John has $250,000 (83%) of his money invested in stocks. A general rule of thumb is to subtract your age from 120, and the resulting number should be the percentage invested in stocks. For John, this would point to investing $195,000 (65%) in stocks. By actually investing 83%, he faces a larger risk of a stock market downturn that he wouldn’t have time to recover from by the time he wants to retire.

Red Flag #2
Of the $250,000 that John has invested in stocks, more than half of that is concentrated on stocks of companies in the technology industry. So, whatever happens to the technology industry will have a very large impact on John’s retirement account. This could be really good if technology stocks do well, but it could also be disastrous if technology stocks go down. A better suggestion for John would be to put his stock investments all in stock index funds. These funds have stocks in multiple industries and represent the overall stock market as a whole, rather than any one specific industry.

Red Flag #3
John has $50,000 invested in U.S. government bonds (Treasury bills, notes, and bonds) of various maturities. We already indicated above that using the general rule of thumb, he should have 35% ($105,000) invested in bonds. With the additional money to invest in bonds, one suggestion would be to spread that out into a couple different bond funds. It’s fine to have some money in U.S. government bonds, but you can also put some into corporate bonds and municipal (state & local government) bonds to spread things out.

Now, let’s see one option for John’s portfolio that is better diversified:
– Large-cap Stock Index Fund: $195,000
– U.S. Government Bond Fund: $50,000
– Corporate Bond Fund: $30,000
– Municipal Bond Fund: $25,000

This retirement portfolio has less exposure to stocks, which is appropriate for John’s age and proximity to retirement. It also reduces exposure to the technology industry and instead focuses on the overall stock market as a whole. This portfolio increases his investment in bonds, and spreads out his bond holdings among different categories rather than only holding U.S. government bonds.

Diversification is really a simple concept. Spread your investment dollars among different investments to help lower the risk of your entire portfolio going down. You’ll never be able to eliminate risk completely, but a well-diversified portfolio of stocks (of companies in various industries and sizes) and bonds (of various types) will help.

Have You Bought Your Mega-Millions Ticket?

It’s been all over the news lately that the “Mega-Millions” lottery jackpot is over $500 million dollars. That’s right, half a billion dollars. With this being a record high jackpot, people everywhere are buying tickets for their shot at hitting it big. With the odds of winning at 1 in 176 million, you’re a lot more likely to get struck by lightning.

I’ve had a lot of people ask me if I’ve bought my ticket yet. I can’t say that I have. I’m not opposed to buying a lottery ticket on moral grounds or anything, and I would consider buying a ticket as any other entertainment expense. The drawing is today at 11:00 pm, so I would have several hours to dream about why I would do with that much money.

How Much Would I Really Get?
But let’s look at some numbers first. If you choose the lump sum payout, you would really receive only $359.4 million. Keep in mind also that is pre-tax. After taxes of around 40%, you’d be left with around $219 million. This is also assuming no one else picks the same numbers as you, in which case the jackpot would be evenly divided among the winners. Even so, that is a lot of money… more than any person or family would ever need.

Get Rich Quick
People love the idea of getting rich quickly. They could quit working and live on easy street. Now, as I said before, I have nothing against buying a lottery ticket as entertainment. But if you’re in a situation where it’s a struggle to make ends meet, then playing the lottery every week hoping to “win big” definitely is not the thing to do. Too often you’ll see people at the gas station on Friday after getting paid spending a big chunk of their pay on lottery tickets. Or you’ll hear them talk about going to the casino every week or so. Instead of working on improving their financial situation, they’re actually making it worse.

For example, if you spend $20 a week on lottery tickets, that adds up to $1,040 a year. That’s the start of an emergency fund, a good extra payment toward credit card or loan debt, or a nice contribution to an IRA.

Final Word
If you haven’t already spent all of your entertainment budget for the month, go ahead and buy your mega-millions ticket and dream for the next several hours of what you’d do with that kind of money. Just know that it’s just for fun.

Don’t cut back on groceries, debt repayment, or retirement savings thinking that it won’t matter because you’ll win the lottery.

What is a Mutual Fund?

We’ve discussed some of the most common types of investments (stocks, bonds, CD’s and savings accounts). Each investment type has its advantages and disadvantages, and ideally you should have funds in each type. Retirement savings should be in stocks and bonds, and your everyday savings and emergency fund should be in savings accounts and maybe some CD’s.

But just knowing what these various investment instruments are isn’t enough. For the average Joe/Jane investor, what is the best way of actually building an investment portfolio? There are basically two ways of doing this: you can pick out and buy individual stocks and bonds or you can invest in what are called “mutual funds.”

Mutual Fund Basics

A mutual fund is an investment that allows you to invest in a multitude of stocks or bonds all at once. These funds are typically operated by large investment firms, such as Vanguard, Fidelity, T. Rowe Price, and others. Individual investors such as you and me can then buy into the fund, hence the name “mutual fund.”

Mutual funds come in a number if varieties. There are bond funds for government bonds, municipal bonds, corporate bonds, and combinations of each type. There are stock funds for large companies, midsize companies, small companies, specific industries, international companies, etc.

Mutual Fund Advantages

An important feature of mutual funds is that these funds are managed by investment professionals at the sponsoring investment firm. You see, the problem with individuals like you and me buying individual stocks is that, in order to have a diverse portfolio (lots of different companies, of different sizes, and in different industries) you have to have a lot of money to invest. Not only that, but you have to spend a lot of time researching the companies financial data before investing in them. Personally, I have no doubt that I could do the research and build a nice, well-diversified portfolio of stocks and bonds. But it would take me a lot of time to do that research. This is despite the fact that I have a strong financial background with a bachelor’s degree in accounting, an MBA with a concentration in finance, and having worked in corporate accounting and banking for my entire working career. The point is that the averge investor simply doesn’t have the time and resources necessary to successfully pick individual stocks on a consistent basis. I know there are exceptions to every rule, and most of us know someone that has done very well buying individual stocks. But again, that us the exception rather than the rule.

How Do I Get Started?

If your primary source of investing is through your employer-based 401k plan, your investment choices most likely already consist of mutual funds.

However, if your employer doesn’t offer a 401k or you are self-employed, you can open an IRA at any of the investment firms I mentioned earlier and invest in mutual funds. You can also invest in mutual funds through any brokerage firm (online or through an actual broker).

As far as choosing individual funds, I highly recommend stock index funds for the bulk of your investing. An index fund is representative of the overall stock market as a whole, so it is pretty well-diversified. Additionally index funds typically have very low fees, so you get to keep more of your investment returns.

A good idea is to invest in several different types of mutual funds to stay diversified and minimize risk. For example, you could invest in a stock index fund, a bond fund, and an international stock fund. This would give you exposure to U.S. stocks, foreign stocks, and more conservative bonds.

An even easier option is to invest in what is called a “target date retirement fund” that automatically adjusts its investment holdings to become more conservative as you approach retirement. So basically you would only need to invest in one fund. Not all 401k plans offer target date funds, though.

Bank CDs and Savings Accounts

I’ve shared with you the basics of stocks and bonds. Another source of investment options is your bank, which offers various savings accounts and certificates of deposit.

Most people don’t really consider these options as “investments” in the same way they think of stocks and bonds, but they really do the same thing. You invest a certain amount and receive interest on your investment.

Savings Accounts
We all know what a savings account is. You put some money into your account, and the bank pays you a tiny bit of interest.

There are several nice features to a savings account. For one, you have immediate access to the funds in the account, either by visiting the branch, using an ATM, or making an online transfer. You don’t have to call a broker and wait a few days for the money to arrive. Second, you don’t have to worry about your investment losing money. Unlike stocks and bonds, the value of what you have in savings doesn’t fluctuate with the financial markets. Finally, funds in a bank account are federally insured up to $250,000 per person per bank/credit union. So, if you have a joint savings account (two people’s names are on the account) it is actually insured up to $500,000.

Of course the disadvantage to a savings account is that interest rates are very low. At a typical bank branch you might be able to earn 0.1%. At an online bank such as ING Direct or Ally, you’ll get closer to 1%. So, you definitely wouldn’t want to use a savings account for your retirement fund, but they are certainly the best option for storing your emergency fund, house savings fund, etc.

Certificates of Deposit
These are similar to a savings account with the exception that CDs have a specific maturity date, and you must wait until that date to receive your funds. Maturities can range anywhere from 7 days to 10 years. Again, you don’t have to worry about losing your money since these are federally insured accounts. Since your money locked limits until maturity, CDs typically pay higher interest rates than a savings account. Again, the rates are still lower than what you can earn on stocks or bonds (the average 3-year CD special at a bank will run close to 1%, even at an online bank). Make sure to check out smaller local banks and credit unions, as they typically offer higher rates than the large national banks.

CDs are good for the conservative investor whose primary investment goal is capital preservation. They don’t want to risk losing their money and are willing to accept a lower return as a result. CDs are a good investment option for those in retirement.

Some banks require you to maintain a checking account with their bank to get the highest CD rates, and there can also be minimum investment requirements as well. Always be sure to read the fine print.

What is a Bond?

Stocks and bonds are two of the most common investment terms you’ll hear. Last week I answered the question “What is a stock?” Today I’ll answer a similar question: What is a bond?

A bond is a financial instrument that works essentially the same way as a loan. They are mostly issued by corporations, municipalities, and the federal government. The bond issuer agrees to pay a certain amount of interest (called a coupon) every six months until the bond maturity date, where they also repay the bond principal. For example, you purchase a $1,000 bond (bonds are always sold in increments of $1,000) that has a 5% interest rate and a five-year maturity. Every six months you will receive a payment of $25 ($1,000 x 5% / 2 payments per year). After 10 payments (2 per year for five years) the bond matures, so with the 10th payment you receive both your $25 payment and your initial $1,000.

Bond Benefits
The most appealing thing about a bond is that when you purchase it, you know exactly what you are going to get out if it. It is a contractual debt agreement with fixed payments and a set maturity. Unlike a stock that can go up or go down in value, pay dividends or not pay dividends, a bond provides certainty.

Another advantage of a bond is that, should the corporation/municipality go bankrupt, you are treated as a creditor rather than an owner. What this means is that when the bankruptcy court doles out the remaining assets to the creditors, you will be in line far ahead of the stockholders.

These two advantages are what makes a bond less risky than a stock, and is why your investment portfolio should gradually shift to more bonds and fewer stocks as you get closer to retirement. We all know what happened in 2008 and 2009 when so many retirees and soon-to-be retirees lost huge portions of their retirement funds because they were too heavily invested in stocks.

Risk vs. Reward
Because there is less risk associated with investing in bonds, the returns you get are going to be less than the return on stocks.

However, it is important to note that less risk is not the same as no risk. You can still lose money on bonds if the corporation goes under without enough assets to pay its creditors. Some bonds come with insurance to cover such losses, but not all bonds have this.

There is also what’s called interest rate risk. If you buy a 5% bond and rates in general then move up to 8%, the bond you bought is worth less money. So, if you wanted to sell your bond, you would lose money on the sale. This is because other bond buyers aren’t going to pay full price for a bond paying less than current interest rates. Now, this has no impact on your contractual payments; it only has an impact on the price you would receive if you want to sell your bond.

Bottom Line on Bonds
To put it simply, both stocks and bonds should be a part of your retirement fund. However, the percentage split between stocks and bonds should change the closer you get to retirement. One commonly used guideline is to subtract your age from 120, and the resulting number is the percentage of your retirement fund that should be invested in stocks. Using myself as an example, I would have 92% of my retirement fund in stocks (120-28 = 92) and 8% in bonds.

Of course this is just a guideline. Depending on your individual risk tolerance you may decide on a more conservative mix (more bonds) or a more aggressive mix (more stocks).