Better Tomorrow Financial

Disturbing (but not altogether surprising) news about the financial bailout

No one seems to know where the $700 billion financial bailout went, what’s being done with it, and how much is still in the bank’s coffers to be used for who know’s what. Read about this below:

http://news.yahoo.com/s/ap/20081222/ap_on_go_ca_st_pe/meltdown_secrets

Now I can understand how normally, banks wouldn’t track dollars that came from one source versus dollars from another. However, in THIS case, the government fronted billions in taxpayer money (not private investment.) Therefore, I can’t imagine congress requiring anything less than full disclosure of how the money was going to be allocated and spent.

It appears that the rush to get money to the banks has succeeded in giving banks no incentives whatsoever to transparently disclose what’s being done with the money, or ‘where’ it’s at within each bank. If one made the assumption that these banks were all going to use this money for the best possible long-term usages for their firms, this lack of disclose might be okay. BUT, the fact that banks are in this mess due to poor financial decisions (and NOT “bad luck” due to the economic downturn, despite the fact that it exacerbated the situation), destroys that assumption.

While I do strongly believe that private firms generally perform better than government-owned ones (been to your local post office lately?), one thing that political trumpeters of the “free market” like to neglect are the conflicts of interest between firms and their management teams. Unfortunately, CEOs are often rewarded with compensation that focuses on the short term stock price (stock options and bonuses dependant on share price) rather than being aligned with the company’s long term future.

Warren Buffet, CEO of Berkshire Hathaway and arguably the greatest investor of all time, is a notable exception. His substantial net worth of many billions is almost completely investing in the company he leads. This long term ownership, combined with the fact that Buffett’s salary is a meager (for CEOs) $100,000 per year, with no fancy options deals, means that Buffett’s incentives are aligned with those of his long term shareholders.

Also, CEOs are generally paid more relative to the size of the company they control***. This creates the incentives to make fiscally irresponsible mergers just to “grow the empire.” And now, with the precedent being set of companies designated “too big to fail,” managements have even more incentives to grow the size of their firms. These incentives by themselves do not encourage firms to pursue social gains (either for consumers or shareholders) and therefore are undesireable.

Coming back to the financial bailout, it is very troubling that in an effort to quickly sustain failing companies within the financial services industry (without discussing whether that was the right thing to do or not), congress and the administration may have not addressed the threat of those firms failing in the future, throught poor use of the bailout money in the present. This lack of oversight may result in these same companies returning years later in similar predicaments. (Of course, that may have resulted anyway, even with oversight, calling into question the wisdom of the bailout, of which I’m not knowledeable enough to discuss.)

Hopefully failure of many of these companies down the road does not turn out to be the case. But, when one has no idea of what’s happening with the bailout money those firms received, how can we know one way or the other?

*** From nobel prize-winning economist Gary Becker (on the Becker-Posner-Blog.com): “For every 10 per cent increase in firm size, measured by the market value of assets, by sales, or by related variables, compensation increases by about 3 per cent. This “30 per cent” law held during the 1930’s, and has held for every succeeding decade, including right up to the present.”

What to do (and what NOT do to) in today’s turbulent financial markets

Unless you’ve been living in a cave that’s under the ocean AND on another planet, you have likely heard about a bit of trouble going on throughout the US’s financial system. First, house prices dropped, then stocks prices, now entire banks like WaMu and Lehman Brothers have gone under (taking the markets further down with them.)

While Congress and the United States Treasury Department try to figure out what to do about the mess that Wall Street (and, let’s be fair, Main Street) got us into, most investors are left trying to figure out what actions to take in their personal lives. Although I certainly don’t pretend to be an expert on the macro economy (and you don’t need to be to make good decisions when that same economy is acting crazy), I will offer some advice. The first step is absolutely essential; fortunately, it’s pretty straightforward:

DON’T PANIC!

This is a pretty standard rule in any scenario of perceived crisis. If you’re panicked, you can’t think straight. If you can’t think straight, you can’t make good decisions, SO RELAX! Take a deep breath, remind yourself of all the things that are going fine in your life (or at least pretend if things aren’t), and try not to think about that tanking retirement fund.

Really though, after you’ve calmed down, stop and reflect on your personal financial situation. (Stop worrying about the rest of the country for a minute, and do Ayn Rand proud by thinking only of yourself, and your immediate financially dependent family, if applicable.) If you’ve followed the rules I’ve recommended, you are hopefully already in solid financial shape. If you’re not, you need to apply the next step. (Even if you don’t think you need it, read over it anyway, just in case there are some things you’ve missed.)

Get fit financially

No course changes here folks, continue to pay off your high-interest debt, establish a short-term “emergency fund” (you could put it into a Money Market Fund like Vanguard’s VMMXX. Don’t worry, the government has said it will guarantee Money Market Funds for a while.) Get yourself the necessary insurance for your health, life (I believe term is best for most people), disability, car and house, and whatever else you need insured. (Keeping in mind that many of those types of insurance may be provided by your employer at a good price. Check into the details with your Benefits department at work.)

Note that we haven’t decided to take any different course of action yet due to the fiscal crisis that we’re facing. “But, surely” you might be saying, “our plan of action has to change when it comes to our investments, right? The stock market just isn’t safe any more! Our retirement and kid’s college funds are in there!” Well, sorry to disappoint, but the next vitally important step in our plan to deal with these troubling times is…

DO NOTHING!

Well, almost nothing at least. DON’T rush to cash out your stocks and bonds. DON’T take all the money out of your savings and checking accounts to stuff it under your mattress (the FDIC insures those deposits at up to $100,000 per account.) DON’T lose faith in the stocks, the number one wealth-creating opportunity available to all Americans. In fact, the only “change” I might recommend is to strongly consider starting to invest in stocks (and to continue your regular investing if you’ve already started.) Over long time periods, stocks are by far the best investment you can make with your money.

Unless you plan on needing the money in less than 3-5 years, the majority, if not ALL, of your long-term savings should be in stocks. That especially includes your retirement, young children’s college funds, etc (assuming, of course, those events are still several years away.)

With the market in turmoil, it can be very difficult to maintain your disciplined investing strategy. Stick to it! Keep investing regularly, DON’T try to time the market, and avoid trading in and out of stocks. The market has been hit hard recently, but as history shows, the biggest upturns in the economy generally follow the biggest downturns. Don’t miss out on a huge rally by setting your long-term money on the sidelines.

Remember that volatility (referred to as “risk” by some folks) is your friend. Steady investments like bonds and CDs generally pay low to middling returns. When you buy (and more importantly HOLD) those broad index funds (like the total stock market index fund VGTSX from Vanguard), those short-term ups and downs historically translate into huge gains after many years.

Conclusion

So, to summarize, DON’T PANIC, get yourself financially fit enough to weather any financial storm and keep investing regularly in a diversified collection of stocks, like low-fee index funds (that way, if one of them blows up, you’ll have plenty of other quality business to fall back on.) Your own financial security is in your hands! This is just a broad overview of how to handle this adversity, if you have specific questions, please leave a comment or email me.

Hang in there!

The two most important books you’ll ever read on becoming (and staying) wealthy

If I had to choose any two books to recommend to people who want to become financially independent, what do you think they would be? Maybe Warren Buffet’s excellent biography ‘Buffett: The Making of an American Capitalist’by Roger Lowenstein? Perhaps Buffet’s compilation of Berkshire Hathaway letters to shareholders.

Surely at least ONE of the books would be written by or about a famous investor, or contain at least for key insights into stock-picking, real estate, how to be successful in business or another get rich plan? Judging from the tone of this article, you can probably guess that the answer is “no” — and you would be right.

The first book that I believe gives the best advice on how to be successful in your financial life (and how to make your children successful as well) was written by two professors who set out to study millionaires. What they found surprised them. In ‘The Millionaire Next Door’, the authors discovered that those with over a million in assets were NOT the people driving expensive vehicles, renting high-priced downtown apartments or drinking Dom Peringnon.

Instead, many of the millionaires they studied had the following seven traits, which the authors flesh out further in the book:

1. They live well below their means.

2. They spend their time, energy, and money in ways leading to wealth.

3. They do not worry about social status, preferring financial independence.

4. They did not receive a lot of financial help from their parents.

5. Their own adult children are not financially dependent upon them.

6. They target opportunities that benefit from large amounts of spending.

7. They work in the right jobs, often for themselves.

I believe, as do many others, that the most important of these commonalities is number 1 – living well below your means. I think the authors might agree with that priority when they write: “Being frugal is the cornerstone of wealth building. … [F]ew could have ever supported a high-consumption lifestyle and become millionaires in the same lifetime.”

After reading “The Millionaire Next Door,” you will have seen the blue print for attaining wealth. However, implementing that plan is the hard part. Living below your means, regularly investing (and rarely taking capital back out), and foregoing some of the perks that TV commercials and rap songs have convinced us we “deserve” takes discipline, faith, and hard work. This difficulty is why I believe the second most important book to read with respect to wealth building is Elaine St. James’ ‘Simplify your Life’.

St. James’ lays out 100 ways to simplify your life. The idea is that as Americans in our modern world we’ve become to obsessed with “keeping up with the Jones’s”, buying bigger houses, flashier cars, and working longer hours to pay for it (while starving our retirement funds, I might add.) Her goal is to show people the way to reduce their consumption while simultaneously increasing their happiness. She recommends “selling the damn boat” and consolidating your investments to help reduce the time, money and worry in one’s life.

While St. James’ book is not dedicated solely to reducing your expenses and making you wealthy, it gives the proper framework to get the most out of life without rampant consumerism.

Taken together, I believe “The Millionaire Next Door” and “Simplify your Life” will show you the plan to wealth, and then help you execute it. Start living cheaply right now and check ’em out from your local library for free!

All about the Roth IRA – your key to tax-free retirement!

If you’ve read my primer on retirement, you should have a good idea of the benefits of investing in a Roth IRA. If you haven’t read it, let me give you a quick rundown before we get into the gritty details:

Meet the Roth IRA

Unlike a Traditional IRA (“Individual Retirement Account”), with a Roth IRA you have to pay taxes on the income that you invest. (The money you put into a Roth IRA is called a “contribution.”) However, instead of that money (plus all the growth) being taxed when you take it out at retirement (after age 59 1/2), with a Roth IRA you get to make the withdrawal tax-free (The money that you take out of a Roth is called a “distribution.”)

Also, like a Traditional IRA or 401k, all the growth and reinvested dividends in a Roth IRA grow tax-free while they remain in the Roth account.

That’s the Roth IRA in a nutshell. Now let’s look at some of the details below that might also sway your decision on where to put your retirement money. (And for a complete look at those details, you can check out IRS publication 590. I’ll warn you though, it’s as dry as the name suggests.)

The Roth IRA has “rules and $#%&” too…

Contributions

In order to contribute money to a Roth IRA, you must have “earned income” that amounts to at least as much you’re going to invest. Thus, if you want to put in $2500 into your Roth IRA in 2010, you must’ve received at least that amount of earned income in the same year. This then begs the question, “what the heck counts as earned income?”

Earned income (or “compensation”) is defined as wages, salaries, tips or professional fees. Essentially, it’s what shows up on your W-2 as “wages, salary, tips” etc. This does NOT include money from investments like interest, dividends, or capital gains. Also NOT included as compensation are payments from social security, disability, pensions, annuities or income from property.

The most you can contribute in one year to a Roth IRA is $5,000 for 2010 (that is, if you ONLY contribute to a Roth IRA for retirement.) This amount will be adjusted in $500 increments, when required, to keep pace with inflation. There is one exception to this maximum IRS limit: if you’re 50 years old or older prior to 2011, you can contribute an additional “catch up” amount of $1,000 to your Roth IRA, for a grand total of $6,000 in 2010.

In 2010, in order to contribute to a Roth IRA, you also must have an Adjusted Gross Income (AGI) of less than $121,000 if you’re filing single ($177,000 for those married filing jointly.) Also, the amount you can contribute to a Roth IRA is “phased out” for those filing single whose AGI is between $106,000 ($167,000 if filing jointly) and $121,000 ($177,000 filing jointly.)

One nice thing about the contributions to a Roth IRA is that for a given year (say, 2010), you have until the tax deadline in the following year to make contributions. Therefore, for most people, April 15th 2011 would be the last day you could make Roth IRA contributions for 2010.

(Special note on employer-matching contributions for Roth 401ks: Employer-sponsored Roth 401ks are similar in their tax treatment to Roth IRAs (and similar in their contribution limits to ‘regular’ 401ks, which are pre-tax. One important difference is that employer matching contributions are ALWAYS pre-tax, and will go into regular 401k accounts, even if your own contributions are sent to a Roth 401k.)

Distributions

If the idea of receiving tax-free income in your golden years isn’t enough, the Roth IRA also has some other benefits when it comes to receiving distributions. These benefits give you some flexibility and liquidity that is usually reserved for taxable accounts.

Distribution of your regular contributions – You can take out the amount you’ve contributed to a Roth IRA tax- & penalty-free at anytime (I recommend only doing this if you really have to; chant the mantra: “Retirement savings are for retirement!”) For example, let’s say you’ve contributed $5000 per year for 4 years to your Roth IRA. Then, at age 42, you lose your job and need to tap your IRA in this emergency situation. You could take up to $20,000 worth of distributions from your Roth IRA without penalty tax-free, since you made an equal amount of contributions over the years.

Qualified Distributions – With a Traditional IRA, you can generally only take the money out without penalty if you’re over 59 1/2, and then you still have to pay normal income tax on that money. With a Roth IRA, some of the ways in which you can take out money tax and penalty-free are known as “qualified distributions.”

“A qualified distribution is any payment or distribution from your Roth IRA that meets the following requirements.

It is made after the 5-year period beginning with the first taxable year for which a contribution was made to a Roth IRA set up for your benefit, and
The payment or distribution is:
1. Made on or after the date you reach age 59½,
2. Made because you are disabled,
3. Made to a beneficiary or to your estate after your death, or
4. One that meets the requirements listed under First home under Exceptions in chapter 1 [of IRS publication 590] (up to a $10,000 lifetime limit).”

If you receive a distribution that is not a qualified distribution, you may have to pay the 10% additional tax on early distributions.

Item D means that if you’re a first-time home-buyer, you can take a distribution of up to $10,000 in earnings (after using all the contributions) for the purchase of this home (as part of a down-payment, for example.) If your spouse has a Roth IRA and is also a first-time home-buyer, she could use $10,000 of her Roth IRA in the home purchase as well (for a total of $20,000 between the two of you.) Note that you can also use your Roth IRA distributions in the same way for a child, grandchild, parent or other ancestor that is a first-time home-buyer.

Additionally, should you kick the bucket early, your beneficiaries can use your Roth IRA distributions tax-free. This makes a nice life insurance bonus out of the Roth IRA (for your sake, a benefit that hopefully won’t be used!)

You can also use Roth IRA distributions penalty-free (but not tax-free) for up to the amount required to pay for your qualified higher-education expenses (as long as you paid for those expenses with savings, loans, wages, a gift or an inheritance, and NOT through a tax-free scholarship or grant.) Even though your Roth earnings withdrawals are not tax-free for qualified higher education expenses, you may be able to used tuition deductions or education credits to offset the taxes from that income. (However, there are much better ways to save for eduction.)

“Qualified higher education expenses are tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible educational institution. They also include expenses for special needs services incurred by or for special needs students in connection with their enrollment or attendance. In addition, if the individual is at least a half-time student, room and board are qualified higher education expenses.”

This means that if you want to start a retirement fund but think that in several years you might decide to buy a house (for the first time) or go back to school, a Roth IRA may be a good place for your money in any event. However, I would caution that if your plan is to use a Roth IRA to fund something other than your retirement, you can’t really count that Roth IRA money as part of your future retirement.

As stated in my article on retirement, I believe that funds set aside for retirement should ONLY be used for that purpose. So, make sure you keep your “true” retirement money separated (at least in your mind) from your “maybe-for-school-or-a-house, maybe-for-retirement” money.

Conversion – You can also convert a Traditional IRA or 401k/403b into a Roth IRA. Keep in mind that you’ll have to pay the taxes in the current year at ordinary income rates on the basis amount of Traditional IRA that you’re converting. So, if you’re in the 25% tax bracket and convert a $100K Traditional IRA to a Roth, you’ll pay $25K in taxes that year. (For 2010 conversions ONLY, you have the option of spreading the $100K of income equally over 2011 and 2012.)

Avoid the 10% penalty on withdrawals of Roth funds from converted IRAs

One important exception to the general rule of being allowed to take contributions out of Roth IRAs at any time tax & penalty-free is converted IRAs. If you convert a Traditional IRA/401k to a Roth IRA, you cannot take out any money within the 5 tax-year period starting with the year that the conversion was made unless you want to pay the 10% penalty (bad idea.) So, if you convert in tax year 2010, you can’t withdraw those rollover contributions until January 1st, 2015.

Ready, set, Roth!

Now you should have a deeper understanding of the Roth IRA, a powerful retirement vehicle that could save you a bundle in taxes after you retire. If you combine the over-59 1/2 tax-free distributions with the additional distribution flexibility of funding your first home purchase or higher-education costs with your Roth, this IRA might be the right investment vehicle for you.

(To find out why the Roth IRA may NOT be the best retirement vehicle for you, read this.)