A Roth IRA is a retirement account that is funded with after taxed dollars (as opposed to pre-tax dollars such as a 401k) and grows completely tax free. The best part is while in retirement there are no taxes due on any money pulled out from a Roth IRA. In the past many people did not consider Roth IRAs because either they were limited on the amount they could contribute, or because of their higher income, they were unable to contribute anything at all to a Roth. That is about to change in 2010.
In 2010 the government is allowing those with IRA’s or other pre-tax qualified plans to go ahead and pay the income taxes today and “convert” their retirement account to a Roth IRA. The regular income taxes will have to be paid on the amount converted to a Roth IRA. However, in 2010 the federal government is allowing individuals to pay the taxes equally over a two year period, following the year of conversion, where normally they would have had to pay in the year their account was reclassified to a Roth IRA. That means someone converting to a Roth IRA in 2010 would owe ½ the income taxes in 2011 and the other half in 2012.
Roth Conversions are good for those who believe taxes may go up in the future. Having a tax-free source of income in retirement could mean you have more income to enjoy while you’re alive because you are not worried about pulling out more money in a higher tax bracket. Also, there are other less obvious benefits to having a Roth IRA in retirement under current tax law. Some benefits include the possibility of the reduction of the taxes paid on social security benefits and also lower Medicare Part B supplemental health insurance premiums.
The Roth IRA is something everyone should at least consider. As always it makes sense to professional advice to see if something like a Roth IRA conversion makes sense for your particular situation.
Friday, January 22, 2010
Friday, January 1, 2010
New Year…New Equation…. Opportunity Costs= Unintended Consequences
As we have come into a new year most of us have made a list of resolutions. I am no different than many others. One of my professional resolutions is to teach as many people as possible about a term called “Opportunity Costs”, or as I like to say unintended consequences.
So what is an opportunity cost you ask? In simple terms it is an idea about money where if you put your money in one place you may be giving up something in return, many times without knowing it (i.e. unintended consequences). Many other people who give financial advice behave as if the only way to eliminate opportunity costs is to give up some part of your lifestyle (i.e. that cup of coffee in the morning at your favorite coffee shop). While this is true, I want others to know you can reduce or eliminate opportunity costs simply by where you put your hard earned assets. Knowing about opportunity costs and its unintended consequences can have long reaching effects in the future.
For most people it is still a difficult concept to get so I thought I would list some examples of where opportunity costs (or unintended consequences) of money might come into our everyday lives.
Money in a Savings Account/C.D./Money Market at a Bank…There are two opportunity costs most commonly found in these types of accounts:
1) Often we are earning little to no interest on these accounts.
2) Any interest that is earned is fully taxable as regular income.
As an example, using a 5% opportunity cost rate, a $100,000 saving account earning 4% will be worth $324,340 after 30 years. You would have paid $67,302 in income taxes, assuming a 30% tax rate (federal= 25% + State= 5%), along the way. However, the opportunity cost (or unintended consequence) is the money you could have earned on the taxes paid along the way. That total (Taxes + Opp. Cost) is equal to $129,425. Factoring all costs your left with a net balance of $324,340 - $129,425 = $194,914. So your account over those 30 Years compounds at a net rate of return of 2.25%, not 4%, when factoring in taxes plus opportunity costs
Putting Money In a 401(k)/IRA…The opportunity costs here is you lose the use of this money as a source of financing. So you are forced to pay someone else interest for the use of their money (most often a bank or finance company).
As an example say you are in the market for a new $20,000 car. Since you can not access your 401(k), due to your age and many other restrictions, you are forced to finance the car at a 6% interest rate. After 30 years the opportunity costs of financing just this one car is $86,823 in “After-Tax” dollars. In other word your 401(K) would have to be equal to $124,032 “Pre-Tax”, assuming a 30% tax rate (federal= 25% + State= 5%), just to equal the cost of financing one car after 30 years.
Buying Term Life Insurance…The opportunity cost here is the premiums you pay and the fact that less than 1% of all term life policies ever pay a claim. So in other words 99% of the people who have term life insurance are simply just giving away their money to an insurance company for nothing in return.
As an example say a young couple (husband and wife good health age 30) purchases (2) 30 year term policies worth $1,000,000. We will also assume they get the 2nd highest health rating, which lowers their cost. The annual premium is about $1,660/year. At the end of 30 years, they would have no life insurance and the term insurance would have costs them $129,577 net “After-Tax” using a 5% opportunity cost.
I hope these examples are helpful, and you are able to see places where opportunity cost may be affecting your life!
So what is an opportunity cost you ask? In simple terms it is an idea about money where if you put your money in one place you may be giving up something in return, many times without knowing it (i.e. unintended consequences). Many other people who give financial advice behave as if the only way to eliminate opportunity costs is to give up some part of your lifestyle (i.e. that cup of coffee in the morning at your favorite coffee shop). While this is true, I want others to know you can reduce or eliminate opportunity costs simply by where you put your hard earned assets. Knowing about opportunity costs and its unintended consequences can have long reaching effects in the future.
For most people it is still a difficult concept to get so I thought I would list some examples of where opportunity costs (or unintended consequences) of money might come into our everyday lives.
Money in a Savings Account/C.D./Money Market at a Bank…There are two opportunity costs most commonly found in these types of accounts:
1) Often we are earning little to no interest on these accounts.
2) Any interest that is earned is fully taxable as regular income.
As an example, using a 5% opportunity cost rate, a $100,000 saving account earning 4% will be worth $324,340 after 30 years. You would have paid $67,302 in income taxes, assuming a 30% tax rate (federal= 25% + State= 5%), along the way. However, the opportunity cost (or unintended consequence) is the money you could have earned on the taxes paid along the way. That total (Taxes + Opp. Cost) is equal to $129,425. Factoring all costs your left with a net balance of $324,340 - $129,425 = $194,914. So your account over those 30 Years compounds at a net rate of return of 2.25%, not 4%, when factoring in taxes plus opportunity costs
Putting Money In a 401(k)/IRA…The opportunity costs here is you lose the use of this money as a source of financing. So you are forced to pay someone else interest for the use of their money (most often a bank or finance company).
As an example say you are in the market for a new $20,000 car. Since you can not access your 401(k), due to your age and many other restrictions, you are forced to finance the car at a 6% interest rate. After 30 years the opportunity costs of financing just this one car is $86,823 in “After-Tax” dollars. In other word your 401(K) would have to be equal to $124,032 “Pre-Tax”, assuming a 30% tax rate (federal= 25% + State= 5%), just to equal the cost of financing one car after 30 years.
Buying Term Life Insurance…The opportunity cost here is the premiums you pay and the fact that less than 1% of all term life policies ever pay a claim. So in other words 99% of the people who have term life insurance are simply just giving away their money to an insurance company for nothing in return.
As an example say a young couple (husband and wife good health age 30) purchases (2) 30 year term policies worth $1,000,000. We will also assume they get the 2nd highest health rating, which lowers their cost. The annual premium is about $1,660/year. At the end of 30 years, they would have no life insurance and the term insurance would have costs them $129,577 net “After-Tax” using a 5% opportunity cost.
I hope these examples are helpful, and you are able to see places where opportunity cost may be affecting your life!
Wednesday, December 16, 2009
An Early Christmas Gift to my Engineering Friends! The Difference Between Arithmetic and Geometric Averages in Finance?
What is the Average rate of return? For most people this is the very question that will determine whether or not they put their money in a particular investment. How someone determines that average rate of return number however can tell a completely different story about the investment. The link below talks about the difference between arithmetic and geometric averages. Arithmetic averages are what most of us used to use to determine our grade in school. However, in finance arithmetic averages can hide the true performance of an investment.
If someone is trying to sell you on an average rate of return be sure to ask them if they calculated that using an arithmetic or geometric average (and probably watch their eyes glaze over).
The formula below shows how to calculate an annual geometric compound average rate of return on an asset invested as a single lump sum (this is only for lump sums, and would not work for something you are making ongoing deposits, like a 401k).
(((Current Asset Value/Original Asset Value)^(1/Number of Years Compounding))-1)*100= Average Percentage Compounded Return
As an example say you originally had $100,000 in an IRA 8 years ago and today it is worth $150,000. Your average annual compounded rate of return is 5.1990%
See the Article Below for the Difference Between Arithmetic and Geometric Averages:
http://www.investopedia.com/ask/answers/06/geometricmean.asp
If someone is trying to sell you on an average rate of return be sure to ask them if they calculated that using an arithmetic or geometric average (and probably watch their eyes glaze over).
The formula below shows how to calculate an annual geometric compound average rate of return on an asset invested as a single lump sum (this is only for lump sums, and would not work for something you are making ongoing deposits, like a 401k).
(((Current Asset Value/Original Asset Value)^(1/Number of Years Compounding))-1)*100= Average Percentage Compounded Return
As an example say you originally had $100,000 in an IRA 8 years ago and today it is worth $150,000. Your average annual compounded rate of return is 5.1990%
See the Article Below for the Difference Between Arithmetic and Geometric Averages:
http://www.investopedia.com/ask/answers/06/geometricmean.asp
Friday, November 6, 2009
401k- Easy to Put Money In..Hard to Get It Out
How much to put in my 401k/retirement plan? That is a question almost everyone who has a job thinks about from time to time. There are better ways to get to a decision than taking advice from a TV personality, your company match, or a co-worker. I think one factor in your decision making process should be the following:
Take the number 60 - (Your Age). Then decide am I okay giving up the freedom, control, and use of this money for this many years or more (could be more according to your plan document or if the government changes the rules).
If you have a 401k or similar retirement program at your work just remember these plans make it easy to put in your hard earned money. Remember once your money is there it is very difficult or maybe even impossible to get it out. You have to follow not only the current government rules, but also the company's 401k rules as well.
So before you put your hard earned money in your company 401k know the rules. Also, be open to other alternatives outside of government sponsored plans that might be of more benefit to you and your family.
Take the number 60 - (Your Age). Then decide am I okay giving up the freedom, control, and use of this money for this many years or more (could be more according to your plan document or if the government changes the rules).
If you have a 401k or similar retirement program at your work just remember these plans make it easy to put in your hard earned money. Remember once your money is there it is very difficult or maybe even impossible to get it out. You have to follow not only the current government rules, but also the company's 401k rules as well.
So before you put your hard earned money in your company 401k know the rules. Also, be open to other alternatives outside of government sponsored plans that might be of more benefit to you and your family.
Friday, October 30, 2009
Let's Talk About Money: A Scary Call to Action
A scary call to action
One of the number one causes of divorce in our country has its roots in our relationship with Money and Finances. These times are especially difficult for those that are out of work. Money is just a commodity resource that we use to get through life. No man or woman is better or worse for having more or less of this commodity.
It surprises me the number of hard-working, well meaning people who will work 40-60 hours a week yet not even spend an hour going over their finances. Even worse, fewer take the time to discuss their family finances with their significant other. I relate to this first hand. Growing up my parents thought talking about money was taboo, and rude. In the past talking about it became a point of stress in my own life.
I'd to challenge anyone reading this to make it a point to review your own situation on a periodic basis. If you are married share this with your spouse as well. If you have teenagers or young adult children maybe get them involved.
One of the number one causes of divorce in our country has its roots in our relationship with Money and Finances. These times are especially difficult for those that are out of work. Money is just a commodity resource that we use to get through life. No man or woman is better or worse for having more or less of this commodity.
It surprises me the number of hard-working, well meaning people who will work 40-60 hours a week yet not even spend an hour going over their finances. Even worse, fewer take the time to discuss their family finances with their significant other. I relate to this first hand. Growing up my parents thought talking about money was taboo, and rude. In the past talking about it became a point of stress in my own life.
I'd to challenge anyone reading this to make it a point to review your own situation on a periodic basis. If you are married share this with your spouse as well. If you have teenagers or young adult children maybe get them involved.
Thursday, October 22, 2009
3 Reasons Everyone Should Demand an “In-Service Withdrawal” Provision in Their 401k Plan?
Almost all 401k participants are unaware that they can legally remove a portion of their 401k into their own self-directed IRA, without penalty or taxes, and without quitting their job. This is provision is most commonly known as an “In-Service Non-Hardship Withdrawal”. However, most 401k plan administrators do not put this provision in many company’s 401k plan documents. It’s my belief they do not have this provision for fear of losing assets by which they can continually collect fees from plan participants (employees). Below are 3 reasons why all employees should demand an “In-Service Withdrawal” provision in their company sponsored 401k plan:
#1) More Options:
Money removed can be put in any savings vehicle that allows for IRA (Individual Retirement Account) contributions. This means that participants are not limited only by the choices in their current 401k plan. With your own IRA you are in control of your money!
#2) Reduce Fees:
According to the Department of Labor there are up to 17 fees a 401k plan administrator can charge. Even worse they found that 78% of workers did not know what fees they were being charged in their 401k.
#3) Safer Options:
Many articles are coming out stating that the 401k system is simply broken (see links below). A common complaint is there are no safe options available. There are many safe places you can put an IRA today, including some that will guarantee you an income for life in retirement (just like granddad’s pension).
In conclusion, like most people I prefer options as opposed to a one size fits all approach. An “In-Service Withdrawal” provision gives these options. Without this provision you are stuck with whatever choices your employer provides.
Links to article regarding our broken 401k system:
http://www.forbes.com/forbes/2009/0907/investing-retirement-ira-saving-401k-rethink.html
http://www.usatoday.com/money/perfi/retirement/2009-10-19-401k-savings-retirement_N.htm
#1) More Options:
Money removed can be put in any savings vehicle that allows for IRA (Individual Retirement Account) contributions. This means that participants are not limited only by the choices in their current 401k plan. With your own IRA you are in control of your money!
#2) Reduce Fees:
According to the Department of Labor there are up to 17 fees a 401k plan administrator can charge. Even worse they found that 78% of workers did not know what fees they were being charged in their 401k.
#3) Safer Options:
Many articles are coming out stating that the 401k system is simply broken (see links below). A common complaint is there are no safe options available. There are many safe places you can put an IRA today, including some that will guarantee you an income for life in retirement (just like granddad’s pension).
In conclusion, like most people I prefer options as opposed to a one size fits all approach. An “In-Service Withdrawal” provision gives these options. Without this provision you are stuck with whatever choices your employer provides.
Links to article regarding our broken 401k system:
http://www.forbes.com/forbes/2009/0907/investing-retirement-ira-saving-401k-rethink.html
http://www.usatoday.com/money/perfi/retirement/2009-10-19-401k-savings-retirement_N.htm
Friday, October 16, 2009
What is a Fixed Index Annuity?
What is a Fixed Index Annuity?
Rarely do you hear much about fixed index annuities in the financial press. This could be due to the fact that only around 6% of all financial professionals even sale these products. I think however these financial products would be much more popular if the general public knew how they actually worked. Basically, fixed index annuities allow someone to participate in a portion of the gain in an index each year without the risk of loss of principal or previous year gains (See link #1 below to learn more about Fixed Annuities).
Recently I came across a study completed by the Wharton School of Business (see link #2 below). In this study they found that not only did the fixed index annuities outperform their risk-adverse counterparts, but also, in some cases, they even outperformed their more risky counterparts. Their study concludes that fixed index annuities were designed for safety of principal with the gains linked to a given index.
I am very grateful to have owned a fixed index annuity inside my IRA since 2006 and can tell you first hand that I have never lost $0.01 or any previous year gains. In these volatile times I think these are the type of solutions most consumers are seeking to protect their hard earned nest egg.
Link #1 to learn more about Fixed Annuities:
http://www.indexannuity.org/ic2002b.htm#reporter
Link #2 to see the Wharton Study:
http://fic.wharton.upenn.edu/fic/Policy%20page/RealWorldReturns.pdf
Rarely do you hear much about fixed index annuities in the financial press. This could be due to the fact that only around 6% of all financial professionals even sale these products. I think however these financial products would be much more popular if the general public knew how they actually worked. Basically, fixed index annuities allow someone to participate in a portion of the gain in an index each year without the risk of loss of principal or previous year gains (See link #1 below to learn more about Fixed Annuities).
Recently I came across a study completed by the Wharton School of Business (see link #2 below). In this study they found that not only did the fixed index annuities outperform their risk-adverse counterparts, but also, in some cases, they even outperformed their more risky counterparts. Their study concludes that fixed index annuities were designed for safety of principal with the gains linked to a given index.
I am very grateful to have owned a fixed index annuity inside my IRA since 2006 and can tell you first hand that I have never lost $0.01 or any previous year gains. In these volatile times I think these are the type of solutions most consumers are seeking to protect their hard earned nest egg.
Link #1 to learn more about Fixed Annuities:
http://www.indexannuity.org/ic2002b.htm#reporter
Link #2 to see the Wharton Study:
http://fic.wharton.upenn.edu/fic/Policy%20page/RealWorldReturns.pdf
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