Checking out retirement account options

If you earn employment income (or receive alimony), you have options for
putting money away in a retirement account that compounds without taxation until you withdraw the money. In most cases, your contributions to
these retirement accounts are tax-deductible.

Starting your savings sooner

The common mistake that many investors make is neglecting to take advantage of retirement accounts because of their enthusiasm to spend or invest in
non-retirement accounts. Not investing in tax-sheltered retirement accounts
can cost you hundreds, perhaps thousands, of dollars per year in lost tax savings. Add that loss up over the many years that you work and save, and not
taking advantage of these tax reduction accounts can easily cost you tens of
thousands to hundreds of thousands of dollars in the long term. Ouch!
To take advantage of retirement savings plans and the tax savings that
accompany them, you must first spend less than you earn. Only then can you
afford to contribute to these retirement savings plans (unless you already
happen to have a stash of cash from previous savings or inheritance).
The sooner you start to save, the less painful it is each year to save enough
to reach your goals. Why? Because your contributions have more years to
compound.
Each decade you delay saving approximately doubles the percentage of your
earnings that you need to save to meet your goals. For example, if saving 5
percent per year in your early 20s gets you to your retirement goal, waiting
until your 30s to start may mean socking away 10 percent to reach that same
goal; waiting until your 40s, 20 percent. Beyond that, the numbers get truly
daunting.

If you enjoy spending money and living for today, you should be more motivated to start saving sooner. The longer that you wait to save, the more you

ultimately need to save and, therefore, the less you can spend today!

Gaining tax benefits

Retirement accounts should be called “tax-reduction accounts” — if they
were, people may be more motivated to contribute to them. Contributions
to these plans are generally deductible on both your federal and state taxes.
Suppose that you pay about 35 percent between federal and state income
taxes on your last dollars of income. (See the section “Determining your tax
bracket” later in this chapter.) With most of the retirement accounts that I
describe in this chapter, you can save yourself about $350 in taxes for every
$1,000 that you contribute in the year that you make your contribution.

After your money is in a retirement account, any interest, dividends, and
appreciation grow inside the account without taxation. With most retirement
accounts, you defer taxes on all the accumulating gains and profits until you
withdraw your money down the road, which you can do without penalty after
age 591⁄2. In the meantime, more of your money works for you over a long
period of time. In some cases, such as with the Roth IRAs described later in
this chapter, withdrawals are tax free, too.
The good, old U.S. government now provides a tax credit for lower-income
earners who contribute up to $2,000 into retirement accounts. The maximum
credit of 50 percent applies to the first $2,000 contributed for single taxpayers with an adjusted gross income (AGI) of no more than $17,000 and married couples filing jointly with an AGI of $34,000 or less. Singles with an AGI
of between $17,000 and $18,250 and married couples with an AGI between
$34,000 and $36,500 are eligible for a 20 percent tax credit. Single taxpayers
with an AGI of more than $18,250 but no more than $28,250 and married couples with an AGI between $36,500 and $56,500 can get a 10 percent tax credit.

Funding Your Retirement Accounts

Saving money is difficult for most people. Don’t make a tough job impossible
by forsaking the tax benefits that come from investing through most retirement accounts.

Determining your investment tastes

Many good investing choices exist: You can invest in real estate, the stock
market, mutual funds, exchange-traded funds, or your own or some else’s
small business. Or you can pay down mortgage debt more quickly. What
makes sense for you depends on your goals as well as your personal preferences. If you detest risk-taking and volatile investments, paying down your
mortgage, as recommended earlier in this chapter, may make better sense
than investing in the stock market.
To determine your general investment tastes, think about how you would
deal with an investment that plunges 20 percent, 40 percent, or more in a
few years or less. Some aggressive investments can fall fast. You shouldn’t go into the stock market, real estate, or smallbusiness investment arena if such a drop is likely to cause you to sell low or
make you a miserable, anxious wreck. If you haven’t tried riskier investments
yet, you may want to experiment a bit to see how you feel with your money
invested in them.
A simple way to “mask” the risk of volatile investments is to diversify your
portfolio — that is, to put your money into different investments. Not watching prices too closely helps, too — that’s one of the reasons real estate investors are less likely to bail out when the market declines. Stock market
investors, unfortunately from my perspective, can get daily and even minuteby-minute price updates. Add that fact to the quick phone call or click of your
computer mouse that it takes to dump a stock in a flash, and you have all the
ingredients for short-sighted investing — and potential financial disaster.

Investing as couples

You’ve probably learned over the years how
challenging it is just for you to navigate the
investment maze and make sound investing
decisions. When you have to consider someone else, dealing with these issues becomes
doubly hard given the typically different money
personalities and emotions that come into play.
In most couples with whom I’ve worked as a
financial counselor, usually one person takes primary responsibility for managing the household
finances, including investments. As with most
marital issues, the couples that do the best job
with their investments are those who communicate well, plan ahead, and compromise.
Here are a couple of examples to illustrate my
point. Martha and Alex scheduled meetings
with each other every three to six months to discuss financial issues. With investments, Martha
came prepared with a list of ideas, and Alex
would listen and explain what he liked or disliked about each option. Alex would lean toward
more aggressive, growth-oriented investments,
whereas Martha preferred conservative, less
volatile investments. Inevitably, they would
compromise and develop a diversified portfolio that was moderately aggressive. Martha
and Alex worked as a team, discussed options,
compromised, and made decisions they were
both comfortable with. Ideas that made one of
them very uncomfortable were nixed.
Henry and Melissa didn’t do so well. The only
times they managed to discuss investments

were in heated arguments. Melissa often criticized what Henry was doing with their money.
Henry got defensive and counter-criticized
Melissa for other issues. Much of their money
lay dormant in a low-interest bank account, and
they did little long-term planning and decision
making. Melissa and Henry saw each other
as adversaries, argued and criticized rather
than discussed, and were plagued with inaction because they couldn’t agree and compromise. They needed a motivation to change their
behavior toward each other and some counseling (or a few advice guides for couples) to make
progress with investing their money.
Aren’t your long-term financial health and marital harmony important? Don’t allow your problems to fester! Remember what the famous
psychologist Dr. Phil McGraw says about problems and making changes: “You can’t change
what you don’t acknowledge.” I couldn’t agree
more with this assessment when it comes to
money problems, including investing issues.
In my work as a financial counselor, one of the
most valuable and difficult things I did for couples stuck in unproductive patterns of behavior
was to help them get the issue out on the table.
For these couples, the biggest step was making
an appointment to discuss their financial management. Once they did, I could get them to
explain their different points of view and then
offer compromises.

If you don’t know how to evaluate and reduce your spending or haven’t
thought about your retirement goals, looked into what you can expect from
Social Security, or calculated how much you should save for retirement,
now’s the time to do so. Pick up the latest edition of my book Personal
Finance For Dummies (John Wiley & Sons, Inc.) to find out all the necessary
details for retirement planning and much more.

Establishing Your Financial Goals

You may have just one purpose for investing money, or you may desire to
invest money for several different purposes simultaneously. Either way, you
should establish your financial goals before you begin investing. Otherwise,
you won’t know how much to save.
For example, when I was in my 20s, I put away some money for retirement,
but I also saved a stash so I could hit the eject button from my job in management consulting. I knew that I wanted to pursue an entrepreneurial path and
that in the early years of starting my own business, I couldn’t count on an
income as stable or as large as the one I made from consulting.
I invested my two “pots” of money — one for retirement and the other for
my small-business cushion — quite differently. As I discuss in the section
“Choosing the Right Investment Mix” later in this chapter, you can afford
to take more risk with the money that you plan on using longer term. So I
invested the bulk of my retirement nest egg in stock mutual funds.
With the money I saved for the start-up of my small business, I took an
entirely different track. I had no desire to put this money in risky stocks —
what if the market plummeted just as I was ready to leave the security of my
full-time job? Thus, I kept this money safely invested in a money market fund
that had a decent yield but didn’t fluctuate in value.

Consider your investment opportunities

When evaluating whether to pay down your mortgage faster, you need to
compare your mortgage interest rate with your investments’ rates of return. Suppose you have a fixed-rate mortgage with an
interest rate of 6 percent. If you decide to make investments instead of paying
down your mortgage more quickly, your investments need to produce an average annual rate of return, before taxes, of about 6 percent to come out ahead
financially. (This comparison, technically, should be done on an after-tax
basis, but the outcome is unlikely to change.)
Besides the most common reason of lacking the money to do so, other good
reasons not to pay off your mortgage any quicker than necessary include
the following:

✓ You instead contribute to your retirement accounts, such as a 401(k),
an IRA, or a Keogh plan (especially if your employer offers matching
money). Paying off your mortgage faster has no tax benefit. By contrast,
putting additional money into a retirement plan can immediately reduce
your federal and state income tax burdens. The more years you have
until retirement, the greater the benefit you receive if you invest in your
retirement accounts. Thanks to the compounding of your retirement
account investments without the drain of taxes, you can actually earn a
lower rate of return on your investments than you pay on your mortgage
and still come out ahead. (I discuss the various retirement accounts in
detail in the “Funding Your Retirement Accounts” section later in this
chapter.)
✓ You’re willing to invest in growth-oriented, volatile investments,
such as stocks and real estate. In order to have a reasonable chance of
earning more on your investments than it costs you to borrow on your
mortgage, you must be aggressive with your investments. As I discuss
in Chapter 2, stocks and real estate have produced annual average rates
of return of about 8 to 10 percent. You can earn even more by creating
your own small business or by investing in others’ businesses. Paying
down a mortgage ties up more of your capital, and thus reduces your
ability to make other attractive investments. To more aggressive investors, paying off the house seems downright boring — the financial equivalent of watching paint dry.
You have no guarantee of earning high returns from growth-type investments, which can easily drop 20 percent or more in value over a year
or two.
✓ Paying down the mortgage depletes your emergency reserves.
Psychologically, some people feel uncomfortable paying off debt more
quickly if it diminishes their savings and investments. You probably
don’t want to pay down your debt if doing so depletes your financial
safety cushion. Make sure that you have access — through a money
market fund or other sources (a family member, for example) — to at
least three months’ worth of living expenses (as I explain in the earlier
section “Establishing an Emergency Reserve”).
Don’t be tripped up by the misconception that somehow a real estate market
downturn, such as the one that most areas experienced in the mid- to late
2000s, will harm you more if you pay down your mortgage. Your home is
worth what it’s worth — its value has nothing to do with your debt load.
Unless you’re willing to walk away from your home and send the keys to
the bank (also known as default), you suffer the full effect of a price decline,
regardless of your mortgage size, if real estate prices drop.

Don’t get hung up on mortgage tax deductions
Although it’s true that mortgage interest is usually tax-deductible, don’t
forget that you must also pay taxes on investment profits generated outside
of retirement accounts (if you do forget, you’re sure to end up in trouble with
the IRS). You can purchase tax-free investments like municipal bonds , but over the long haul, such bonds and other types of lending
investments (bank savings accounts, CDs, and other bonds) are unlikely to
earn a rate of return that’s higher than the cost of your mortgage.
And don’t assume that those mortgage interest deductions are that great.
Just for being a living, breathing human being, you automatically qualify for
the so-called “standard deduction” on your federal tax return. In 2011, this
standard deduction was worth $5,800 for single filers and $11,600 for married
people filing jointly. If you have no mortgage interest deductions — or have
fewer than you used to — you may not be missing out on as much of a writeoff as you think. (Plus, it’s a joy having one less schedule to complete on your
tax return!)

Mitigating your mortgage

Paying off your mortgage more quickly is an “investment” for your spare
cash that may make sense for your financial situation. However, the wisdom
of making this financial move isn’t as clear as paying off high-interest consumer debt; mortgage interest rates are generally lower, and the interest is
typically tax-deductible. When used properly, debt can help you accomplish
your goals — such as buying a home or starting a business — and make you
money in the long run. Borrowing to buy a home generally makes sense. Over
the long term, homes generally appreciate in value.
If your financial situation has changed or improved since you first needed to
borrow mortgage money, you need to reconsider how much mortgage debt
you need or want. Even if your income hasn’t escalated or you haven’t inherited vast wealth, your frugality may allow you to pay down some of your debt
sooner than the lender requires. Whether paying down your debt sooner
makes sense for you depends on a number of factors, including your other
investment options and goals.

Conquering consumer debt

Borrowing via credit cards, auto loans, and the like is an expensive way to
borrow. Banks and other lenders charge higher interest rates for consumer
debt than for debt for investments, such as real estate and business. The
reason: Consumer loans are the riskiest type of loan for a lender.
Many folks have credit card or other consumer debt, such as an auto loan,
that costs 8, 10, 12, or perhaps as much as 18-plus percent per year in interest
(some credit cards whack you with interest rates exceeding 20 percent if you
make a late payment). Reducing and eventually eliminating this debt with your
savings is like putting your money in an investment with a guaranteed tax-free
return equal to the rate that you pay on your debt.
For example, if you have outstanding credit card debt at 15 percent interest,
paying off that debt is the same as putting your money to work in an investment with a guaranteed 15 percent tax-free annual return. Because the interest on consumer debt isn’t tax-deductible, you need to earn more than 15
percent by investing your money elsewhere in order to net 15 percent after
paying taxes. Earning such high investing returns is highly unlikely, and in
order to earn those returns, you’d be forced to take great risk.
Consumer debt is hazardous to your long-term financial health (not to mention damaging to your credit score and future ability to borrow for a home or other wise investments) because it encourages you to borrow against your
future earnings. I often hear people say such things as “I can’t afford to buy
most new cars for cash — look at how expensive they are!” That’s true, new
cars are expensive, so you need to set your sights lower and buy a good used
car that you can afford. You can then invest the money that you’d otherwise
spend on your auto loan.
However, using consumer debt may make sense if you’re financing a business.
If you don’t have home equity, personal loans (through a credit card or auto
loan) may actually be your lowest-cost source of small-business financing.

Evaluating Your Debts

Yes, paying down debts is boring, but it makes your investment decisions
less difficult. Rather than spending so much of your time investigating specific investments, paying off your debts (if you have them and your cash
coming in exceeds the cash going out) may be your best high-return, low-risk
investment. Consider the interest rate you pay and your investing alternatives to determine which debts you should pay off.

Establishing an Emergency Reserve

You never know what life will bring, so having a readily accessible reserve of
cash to meet unexpected expenses makes good financial sense. If you have
a sister who works on Wall Street as an investment banker or a wealthy and
understanding parent, you can use one of them as your emergency reserve.
(Although you should ask them how they feel about that before you count on
receiving funding from them!) If you don’t have a wealthy family member, the
ball’s in your court to establish a reserve.

Should you invest emergency money in stocks?

As interest rates drifted lower during the 1990s,

keeping emergency money in money market

accounts became less and less rewarding.

When interest rates were 8 or 10 percent,

fewer people questioned the wisdom of an

emergency reserve. However, in the late 1990s,

which had low money market interest rates and

stock market returns of 20 percent per year,

more investors balked at the idea of keeping a

low-interest stash of cash.

I began seeing articles that suggested you

simply keep your emergency reserve in stocks.

After all, you can easily sell stocks (especially

those of larger companies) any day the financial markets are open. Why not treat yourself to

the 20 percent annual returns that stock market

investors enjoyed during the 1990s rather than

earning a paltry few percent?

Stocks can drop and have dropped 20, 30, or

50 percent or more over relatively short periods of time. Consider what happened to stock

prices in the early 2000s and then again in the

late 2000s. Suppose that such a drop coincides

with an emergency — such as the loss of your

job, major medical bills, and so on. Your situation may force you to sell at a loss, perhaps a

substantial one.

Here’s another reason not to keep emergency

money in stocks: If your stocks appreciate and

you need to sell some of them for emergency

cash, you get stuck paying taxes on your gains.

I suggest that you invest your emergency

money in stocks (ideally through well-diversified mutual funds) only if you have a relative

or some other resource to tap for money in

an emergency. Having a backup resource for

money minimizes your need to sell your stock

holdings on short notice. As I discuss in Chapter

5, stocks are intended to be a longer-term

investment, not an investment that you expect

(or need) to sell in the near future.

Make sure you have quick access to at least three months’ to as much as six

months’ worth of living expenses. Keep this emergency money in a money

market fund. You may also be able to borrow against your

employer-based retirement account or against your home equity should you

find yourself in a bind, but these options are much less desirable.

If you don’t have a financial safety net, you may be forced into selling an

investment that you’ve worked hard for. And selling some investments,

such as real estate, costs big money (because of transaction costs, taxes,

and so on).

Consider the case of Warren, who owned his home and rented an investment

property in the Pacific Northwest. He felt, and appeared to be, financially successful. But then Warren lost his job, accumulated sizable medical expenses, in Order before You Invest

and had to sell his investment property to come up with cash for living

expenses. Warren didn’t have enough equity in his home to borrow. He didn’t

have other sources — a wealthy relative, for example — to borrow from

either, so he was stuck selling his investment property. Warren wasn’t able

to purchase another investment property and missed out on the large appreciation the property earned over the subsequent two decades. Between the

costs of selling and taxes, getting rid of the investment property cost Warren

about 15 percent of its sales price. Ouch!

Considering Your Goals

How much do you need or want to earn? That may seem like an extraordinarily stupid question for me to ask you! Who doesn’t want to earn a high
return? However, although investing in stocks, real estate, or a small business can produce high long-term returns, investing in these vehicles comes
with greater risk, especially over the short term.

Some people can’t stomach the risk. Others are at a time in their lives when

they can’t afford to take great risk. If you’re near or in retirement, your

portfolio and nerves may not be able to wait a decade for your riskier investments to recover after a major stumble. Perhaps you have sufficient assets to

accomplish your financial goals and are concerned with preserving what you

do have rather than risking it to grow more wealth.

If you work for a living, odds are that you need and want to make your investments grow at a healthy clip. If your investments grow slowly, you may fall

short of your goals of owning a home or retiring or changing careers.

Are smaller-company stock returns higher?

Stocks are generally classified by the size of the

company. Small-company stocks aren’t stocks

that physically small companies issue — they’re

simply stocks issued by companies that haven’t

reached the size of corporate behemoths such

as IBM, AT&T, or Coca-Cola. The Standard &

Poor’s 500 index tracks the performance of 500

large-company stocks in the United States. The

Russell 2000 index tracks the performance of

2,000 smaller-company U.S. stocks.

Small-company stocks have outperformed

larger-company stocks during the past seven

decades. Historically, small-company stocks

have produced slightly higher compounded

annual returns than large-company stocks.

However, nearly all this extra performance is

due to just one high-performance time period,

from the mid-1970s to the early 1980s. If you

eliminate this time period from the data, small

stocks have had virtually identical returns to

those of larger-company stocks.

Also, be aware that small-company stocks can

get hammered in down markets. For example,

during the Great Depression, small-company

stocks plunged more than 85 percent between

1929 and 1932, while the S&P 500 fell 64 percent. In 1937, small-company stocks plummeted

58 percent, while the S&P 500 fell 35 percent.

And in 1969 to 1970, small-company stocks fell

38 percent, while the S&P 500 fell just 5 percent.

Small-business returns

If you have the drive and
determination, you can start your own small business. Or perhaps you have
what it takes to buy an existing small business. If you obtain the necessary
capital and skills to assess opportunities and risk, you can invest in someone
else’s small business.
What potential returns can you get from small business? Small-business
owners like me who do something they really enjoy will tell you that the
nonfinancial returns can be major! But the financial rewards can be attractive
as well.

Every year, Forbes magazine publishes a list of the world’s wealthiest individuals. Perusing this list shows that most of these people built their wealth

by taking a significant ownership stake and starting a small business that

became large. These individuals achieved extraordinarily high returns (often

in excess of hundreds of percent per year) on the amounts they invested to

get their companies off the ground.

You may also achieve potentially high returns from buying and improving an

existing small business. As I discuss in Part IV, such small-business investment returns may be a good deal lower than the returns you may gain from

starting a business from scratch.

Unlike the stock market, where plenty of historic rate-of-return data exists,

data on the success, or lack thereof, that investors have had with investing

in small private companies is harder to come by. Smart venture capitalist

firms operate a fun and lucrative business: They identify and invest money in

smaller start-up companies that they hope will grow rapidly and eventually

go public. Venture capitalists allow outsiders to invest with them via limited

partnerships. To gain entry, you generally need $1 million to invest. (I never

said this was an equal-opportunity investment club!)

Venture capitalists, also known as general partners, typically skim off 20 percent of the profits and also charge limited partnership investors a hefty 2 to

3 percent annual fee on the amount that they’ve invested. The return that’s

left over for the limited partnership investors isn’t stupendous. According to

Venture Economics, venture funds have averaged comparable annual returns

to what stock market investors have earned on average over this same

period. The general partners that run venture capital funds make more than

the limited partners do.

You can attempt to do what the general partners do in venture capital

firms and invest directly in small, private companies. But you’re likely to be

investing in much smaller and simpler companies. Earning venture capitalist

returns isn’t easy to do. If you think that you’re up to the challenge.

Real estate returns

Over the years, real estate has proved to be about as lucrative as investing in
the stock market. Whenever the U.S. has a real estate downturn, folks question this historic fact. However, just as stock
prices have down periods, so too do real estate markets.
The fact that real estate offers solid long-term returns makes sense because
growth in the economy, in jobs, and in population ultimately fuels the
demand for real estate.
Consider what has happened to the U.S. population over the past two centuries. In 1800, a mere 5 million people lived within U.S. borders. In 1900, that
figure grew to 76.1 million, and today, it’s more than 310 million. All these
people need places to live, and as long as jobs exist, the income from jobs
largely fuels the demand for housing.
Businesses and people have an understandable tendency to cluster in major
cities and suburban towns. Although some people commute, most people
and businesses locate near major highways, airports, and so on. Thus, real
estate prices in and near major metropolises and suburbs generally appreciate the most. Consider the areas of the world that have the most expensive
real estate prices: Hong Kong, San Francisco, Los Angeles, New York, and
Boston. What these areas have in common are lots of businesses and people
and limited land.
Contrast these areas with the many rural parts of the United States where the
price of real estate is relatively low because of the abundant supply of buildable land and the relatively lower demand for housing.

Stock returns

Investors expect a fair return on investment. If one investment doesn’t offer
a high enough rate of return, investors can choose to move their money into
other investments that they believe will perform better. Instead of buying a
diversified basket of stocks and holding, some investors frequently buy and
sell, hoping to cash in on the latest hot investment. This tactic seldom works
in the long run.
Unfortunately, some of these investors use a rearview mirror when they purchase their stocks, chasing after investments that have recently performed
strongly on the assumption (and the hope) that those investments will
continue to earn strong returns. But chasing after the strongest performing
investments can be dangerous if you catch the stock at its peak, ready to
begin a downward spiral. You may have heard that the goal of investing is to
buy low and sell high. Chasing high-flying investments can lead you to buy
high, with the prospect of having to sell low if the stock runs out of steam.
Even though stocks as a whole have proved to be a good long-term investment, picking individual stocks is a risky endeavor.arket returns. In fact, in
the U.S. markets, data going back more than two centuries documents the fact
that stocks have been a terrific long-term investment. The long-term returns
from stocks that investors have enjoyed, and continue to enjoy, have been
remarkably constant from one generation to the next.
Going all the way back to 1802, the U.S. stock market has produced an annual
return of 8.3 percent, while inflation has grown at 1.4 percent per year. Thus,
after subtracting for inflation, stocks have appreciated about 6.9 percent
faster annually than the rate of inflation. The U.S. stock market returns have
consistently and substantially beaten the rate of inflation over the years
Stocks don’t exist only in the United States, of course . More
than a few U.S. investors seem to forget this fact, especially during the sizzling performance of the U.S. stock market during the late 1990s. As I discuss
in the earlier section “Diversify for a gentler ride,” one advantage of buying
and holding overseas stocks is that they don’t always move in tandem with
U.S. stocks. As a result, overseas stocks help diversify your portfolio.
In addition to enabling U.S. investors to diversify, investing overseas has
proved to be profitable. The investment banking firm Morgan Stanley tracks
the performance of stocks in both economically established countries and socalled emerging economies. As the name suggests, countries with emerging
economies (for example, Brazil, China, India, Malaysia, Mexico, Russia, South
Korea, and Taiwan) are “behind” economically but show high rates of growth
and progress.