AskDong

RK asks,

I need to roll over a state educator’s retirement fund of $18,000 into an IRA when I move from MS to CO. Should I roll over this money in a traditional or Roth IRA? Which one makes the most money?! How much should I contribute each year? What investment company do you recommend?

I believe you are only eligible rollover your state plan into a traditional rollover IRA.   You can later choose to rollover that money into Roth IRA, but would have to pay income taxes at that point.  Currently if you make more than 100k, adjusted gross, you would be ineligble to rollover to a Roth IRA, however that requirement will be dissapearing in a few years.  The contributions to your state retirement fund were untaxed. A traditional rollover IRA allows keep your money in its untaxed state.

As for which one makes more money, it’s a matter of what investment you purchase within the IRA account. The IRA account is just holding account in which you can choose to invest in anything you want. Stocks, CDs, Mutual Funds, Bonds, and even Real Estate (though it gets complicated investing non traditional investments). What an IRA allows you to do is avoid some taxes. In a traditional deductible IRA, you’ve avoided paying taxes on the outset but do need to pay taxes at withdrawal.  With a Roth IRA, you pay taxes on the outset since it’s funded with post income tax money, but avoid paying taxes at withdrawal.  During the time investments are held in either type of IRA, there’s no need to pay taxes on earnings within the account.  Typically in a taxable account, you would have to pay taxes every year on interest payments, dividends, and other periodic incomes which then reduces what you have available to reinvest.  IRAs allows you to avoid that yearly skim and therefore increase your overall return. That tax deferral can make a large difference over extended time period.  Assuming a 6% rate of rate return, a marginal income tax rate of 30%, and 30 year time frame that $18,000 would grow into $77,768 after paying taxes in a tax deferred account like a rollover IRA vs. $61,845 in a regular taxable account.  In reality the tax benefits are more complicated depending on the types of investments you held in the account.  I have posts here and here that discusses what types of investments are best held in different holding accounts for tax reasons.

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Dear Dong,I’ve read a lot of financial advice columns that recommend cutting out small daily expenses to save money. Some examples include cutting out the daily Starbucks coffee and other similar expenses. Do you think that saving an extra $4 a day is worth giving up the decaf latte for? Will this really have much of an impact on my retirement? Aren’t there more effective ways to put together an effective budget to save money?”-Spooner

Yes, the Latte factor, I’m familiar with it. There’s reason to it, but at other times I think Sally Struthers is pitching it. I don’t think people necessarily have the same item in their budget to cut (with the possible of exception of an over-status car). I think passing up a latte a day for the 300k+ earner is hardly going to make (un)dent in the wallet. Not buying that Aston Martin might on the other hand make an appreciable difference. People should cut items that are significant as compared to their income. It’s pointless to give up lattes and yet spend tens of thousands on a car.  If you’re making minimum wage and buying 4 lattes a day then beyond just having a serious caffeine problem, you have a serious financial problem.

If I were making a budget today, I would order all my expenses relative to my income, and start cutting expenses at the top. Are lattes a big part of my budget? Below is what my budget looked like soon after I graduated college.

There was no point in cutting the latte’s when the bulk of my after tax income was being spent on three items, Dining + Going Out, and Rent.  I highlighed fixed items in blue, everything else is discretionary.  That’s one key in budgeting is realizing there really aren’t need to pay items (at least in terms of actual dollar amount) other than taxes, loans and other contractual obligations.  I was young, single, new to the city and enjoyed my food and drink. I still enjoy my food and drink, but alas my days of consistently going out ‘til the wee hours of the night are past me. Sure I could’ve cut the lattes from my budget, but clearly that wasn’t what was driving my expenses.  So I did the next best thing, I convinced my roommates to move with me to a cheaper apartment.

The next year I only paid $425 a month in rent, saving $150 a month or equivalent to about 2 lattes a day during that day and age.  If I were having two lattes a day then I would’ve have looked at cutting that, but I wasn’t.  I know some people are thinking – whoa whoa why didn’t this guy cut back on his discretionary entertaining budget?  In my opinion, you’re only young once, and you should enjoy it.  While I could’ve saved more money, I was still living under my means. Budgeting is not just about saving money, but spending money on the things you enjoy.   I enjoy food and drink, and housing not so much.  In my mind rent was where I could cut, and still enjoy nearly the same quality of life.

Hi Dong,

Thanks you so much for encouraging me to set up both an online savings account with HSBC, and a Roth IRA with E*Trade. My question has to do with my Roth. I have been socking money in there for a few months, but have not allocated the money yet.

What is your advice on how to allocate for someone who is just starting out on retirement savings plan? (I have had a 401k for a few years, too).

-Rachel

Rachel I’m glad to hear you’ve been socking money away in your Roth and HSBC account. Now that you have a kitty built up in your Roth – there’s still a question of what to do it. There are embedded in that one question, two separate questions:

1. What do Invest In?
2. How do I time my Investments?

The first one is actually easier to answer as it’s a more straightforward. At this point given that you are just starting to accumulate substantial capital in your ROTH IRA, I would stick with mutual funds. You always want to make sure you’re diversified and that’s what a good Mutual Fund will give you. What Mutual Funds specifically? My mutual funds of choice for broad diversification are:

WFIVX - Wilshire 5000 Total Market Index Fund

DODFX – Dodge and Cox International

The Wilshire 5000 is index of the entire U.S. Stock market – you can’t get much more diversified (at least as far as U.S. stocks are concerned). You wouldn’t go wrong if you opted into any of other the broad market funds as the Vanguard 500 VFINX, or Vanguard Total Market VTSMX Full Disclosure, I own both DODFX and WFIVX at part of my portfolio. I do think it’s important to get international exposure and in some ways would recommend a fund like DODFX over a purely domestic fund if I had to pick just one. DODFX and funds like it are international not foreign which means that they actually have a fair amount of exposure to U.S. companies via large multinationals. News Corp, Murdoch’s baby, for example is one of DODFX largest holdings.

As for timing your investments, it depends a little on what mutual funds you’ve decided to make the core of your holdings and how frequently you fund your IRA. If you’re constantly funding your IRA and can purchase a mutual fund free of any sales charge then you might want to set up a purchase schedule of a fixed dollar amount to coincide with your funding schedule. I know for instance that WFIVX is free to acquire on E*Trade while DODFX is not. The advantage of spreading your purchases over many different intervals is that you reduce your exposure to the volatility inherent in the market. You’re not buying everything at a peak nor are you buying everything at a valley, this is commonly referred to as “dollar cost” averaging. If there are transaction charges associated with the purchase of a fund then its better not to incur them. For example if you were to buy $100 of DODFX every month, it’d cost you $240 while you’d be only purchasing $1200 of the fund. Right off the bat, you are 20% in the hole. You would be better off just purchasing the full $1200 in one slug at cost of $20, only putting you 1.6% down due to transaction costs.

Now specifically for you, if you have less than $2000 but more than $1000, I’d go ahead just purchase one fund like DODFX. If you have more than $2000, I’d still go ahead and purchase a fund such as DODFX, but limit that purchase to about $1500. Then start purchasing a transaction free fund such WFIVX via a set schedule (once a month should work) until you are robustly invested. If you have substantially more than $5000 seek more advice as that might imply a much more complicated course of action. If you have less than $1000, and are consistently funding the account, I’d go ahead setup a schedule to purchase shares of a fund like WFIVX. Purchase a fixed amount that is less than the deposit amount so the leftovers can accumulate for a bigger purchase on fund like DODFX at a later date. It’s likely that you might have to first purchase some initial quantity of WFIVX before you can setup a recurring plan. In either case use what you have in the account already for a seed purchase.

There’s also an argument to be made to invest in a life-cycle fund that is tailored to your age group. A life cycle fund involves the least work on a ongoing basis as it is designed to shift it’s holdings to best match the risk profile related to one’s age. I haven’t looked at the details of the specific funds and can’t really make a recommendation there. All I know is they vary greatly and widely and because of that will have to save any advice with regards to those for another day.

Disclaimer Below:

Any investment decision lies in the scope of a greater context, and should reflect your complete financial situation. That said it’s better to do something in your Roth rather than nothing just because a decision can’t be made. Again, I’m not a financial advisor – just a friendly guy with friendly advice. This answer should not be construed as anything but that.

Dear Dong,

Is there any financial reason (I know there are psychological ones) to have
money in a savings account when you are paying a significantly higher rate on
your HELOC? For example, if the savings account is paying 5% and the HELOC is
costing you Prime (now 8.25%), wouldn’t it make sense to pay down as much of
the HELOC as possible and then borrow from it (with no transaction costs) when
you needed to dip into your “savings?”

Sincerely,

CFO

Simple Answer: No.

There’s absolutely no reason not to pay down a HELOC from savings if you have it. As you said, you can always dip into the HELOC if the need arises. However that is not to say that you shouldn’t have extra savings once you’ve paid off the HELOC. While I think it’s okay to “fund” some of you emergency fund via a HELOC, it’s better to fund it with actual savings.

A reader asks the following:

 My wife and I are in the process of looking at mortgages for a house that we
hope to close in the next 6 weeks.  Rates have come down a bit, which we’re
happy about, but we still have 2 questions:1. What do you think of an interest only loan with a slightly lower rate if we
commit(to ourselves)to making payments as if it were fully amortizing?  Is
there any drawback to this strategy aside from the possibility of not being
dilligent about payments?2. Have you heard of having your parents (or another relative/friend) granting
you a mortgage and you paying them instead of the bank?  This seems like a good
idea to me because it keeps the money in the family.  While it may not be the
best financial investment for them in the short-term it seems that they would
be interested because ultimately that money would come back to their kids
anyway.  Thoughts?

1.  Interest only mortgages in themselves like any other type of mortgage is not problematic.  As with any mortgage, they become problematic when they are used by borrowers to buy more house they can actually afford  or exposes the borrower to more risk than he or she might understand.   From what I can pick up from your letter this is not your case.   I’d say if you can get interest only mortgage with the exact same terms as conventional mortgage, go for it.  Why ever bypass a free option if you have discipline not use it?  Of course that’s the rub (or rather rubs).  Do you have the discipline and all the other terms equal?  I’ll take your word for the former.   The latter however is unlikely to be the case.    I like to think of all mortgages as a variation of 30 year amortized 1 year ARM.     Want the option of amortizing it over 40 years?  You have to pay for it.  Want to lock in rate for 3-Years or a longer long in period such as the full 30 years, you have to pay for it.   Want to only have to pay the interest on the loan?  You have to pay for it.  And how do you pay for it?  Either directly via the rate or by paying points.   So any lender offering an interest only option on loan should have the same  loan without the interest only option at better rate or lower points.  If this is not the case, by all means take the free option.

2.  Yes I have.  And each time I’ve heard of complications.  Some are administrative and financial.  Taking the mortgage deduction will not be an easy matter.    There are a bunch of legal hoops to jump through.  The loan must be securitized by the home.   Remember when you get a mortgage through a traditional lender, the title is strictly speaking in their name.  If you were to borrow from relatives, those same conventions must be followed, and your relatives would then be of course subject to the income taxes associated with the interest they earn.   Financially speaking assuming you do everything on the up and up, it’s not a bad move that may be beneficial to all parties.   However this is more of personal issue rather than a financial one.   It really depends on the type of relationship you have with the potential lender.  Power and control issues could easily arise.