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A Roth IRA is a great retirement savings vehicle. Money is invested with after tax dollars and grows tax-free. When you withdraw your money in retirement you do not pay taxes. Let’s review income limits, contribution limits, and the easiest way to get started.

Individuals are allowed to invest $5000 in 2008 (if you are over 50, you can add an additional $1000) as long as their adjusted gross income is less than $101,000. The adjusted gross income is shown on line 4 on a 1040EZ tax form, it’s on the bottom of page 1 for a regular 1040 form. If you make between $101,000 and $116,000 the allowed contribution is gradually phased out. Above an adjusted gross income of $116,000 a Roth IRA contribution is not allowed. A married couple can invest $5000 each as long as the combined adjusted gross income is less than $159,000. Above an adjusted gross income of $169,000 the allowed contribution is phased out. If you exceed these income limits then you can invest in a traditional IRA.Starting a Roth IRA is easy.

The easiest investment option for starting your Roth IRA is to use a lifecycle retirement fund.  All that you need to do is identify the year that you want to retire.   For example if you want to retire in 2035, you would invest in a 2035 lifecycle retirement fund.  Lifecycle retirement funds automatically transitions from a high percentage of stock market investments  (typically 80% stocks for young investors) and transition to a balance of 50% stocks and 50% bonds.  Your main job is to add money, the fund automatically takes care of the asset allocation (the mix of stocks and bonds).  Recently most lifecycle funds have added a small percentage of international investments.   

To get started simply contact a low expense no-load mutual fund company (such as Vanguard or Fidelity) by visiting their web site or by telephone.  I like Vanguard and Fidelity because they use low cost index funds in their lifecycle retirement funds.  Vangaurd calls their lifecycle retirement funds Target Retirement Funds and Fidelity call their the Freedom Funds.  

I really like and recommend lifecycle funds for retirement because I think it’s most important for people to get started with retirement savings.  The next most important tasks are increasing the savings rate and then evaluating if you want to take a more proactive role in choosing index and no-load mutual funds.

Follow your dreams, Achieve your goals!

When investing, the majority of people don’t evaluate the significant impact of investment expenses over time. There are three classes of mutual funds relative to expenses; index funds, no-load managed mutual funds, and loaded mutual funds.

Index funds are designed to mirror major market indices such as the Wilshire 5000 (the largest 5000 US Corporations) or the S&P 500 (the largest 500 US corporations). The most common index that you hear quoted daily is the Dow Jones Industrial (which tracks 30 large Corporations).

One key feature of an index funds is that the ownership of different shares is proportion to the market value of each corporation. This is to say that the Wilshire 5000 index invests a lot more in large corporations such as Exxon and Microsoft, and a lot less in a small growing company such as Starbucks. Index funds are self-correcting in that they will increase investments in winning companies like Microsoft and Starbucks and divest from tanking companies such as and Enron and WorldCom. Given that these adjustments occur daily, an index fund investor can sleep soundly knowing that they don’t have to worry about the performance of individual stocks.

The most significant advantage of index fund investing is the low expense ratio fee. The average managed mutual fund has an annual expense ratio of 1.35%, while index fund expense ratios from low cost mutual fund companies such as Vanguard and Fidelity are 0.2%. This represents a 6X reduction in cost from the typical mutual fund- this is like buying a $30,000 car for just $5,000.

Managed mutual funds differ from index funds in that the fund manager attempts to beat the index by picking a portfolio of stocks. In the long-term, less than 20% of managed funds outperform index funds; therefore the risk with managed funds is that 80% of the time you will end up with lower performance plus higher expenses. Average expense on a no-load managed fund is 1.35%, but can range from 0.4 to 2% depending on the specific fund. I recommend that you only purchase managed funds that have outperformed their comparative index for last 3, 5, and 10 years.

Loaded mutual funds charge an upfront sales fee of 3% to 6% and have annual expenses that range from 1 to 2%. The upfront sales fee is charged to provide a commission to the salesperson. For example, a 5% load fee means that only $95 out of every $100 is invested. I recommend that you NEVER invest in loaded mutual funds since a portion of your money is confiscated.

The following graph shows the impact of expenses when investing $100 per month over 30 years. In this calculation different levels of fees are applied to average annual historic stock market returns. In reality the returns for different mutual funds vary and 80% of managed funds do not achieve average market performance. The black dashed line represents a portfolio without fees.

The impact of expected returns based on the expense ratios and upfront fees is quite dramatic. Examine the difference in the expected return at 30 years of each portfolio versus the benchmark index. The expenses of an index fund only absorb 4% of the portfolio potential, while the expenses of a loaded fund confiscates 35% of your portfolio potential. A mutual fund with a 1% expense ratio eats into 17% of your portfolio. Many investors do not notice the impact of fees until their portfolios are large. I recommend that you think with the end portfolio in mind. Employ low fee mutual funds all of the time to maximize your nest egg.

Follow your dreams, Achieve your goals!

Photo Credit:US National Oceanic and Atmospheric Administration 

I’m sure that you have heard the airline pilot say many times to buckle your seatbelt since there is the chance of turbulence ahead. On a flight to Texas the pilot gave this standard advice.  The overhead seatbelt light came on and I heard a couple of clicks nearby.  I have always been an obedient passenger so I didn’t need to buckle my seatbelt.  We entered some mild turbulence within several minutes and then all of a sudden (gasp) the entire plane fell faster than any roller coaster ride that I have ever been on. I observed the beverage cart jump 6 inches off the ground, the flight attendant hit the ceiling, and about one out of four passengers rose a foot out of their seats.  The intensity was so significant in the the plane that you could hear people taking breaths over the roaring of the engines.  After the 3 second free fall the plane quickly leveled. Within seconds of stability all you heard was .. CLICK CLICK CLICK CLICK CLICK CLICK … The pilot came on the overhead speaker and indicated that we had hit an air pocket that caused the plane to drop.  He indicated that we were fortunate in that we only hit a moderate pressure drop.

What impressed me most about the remainder of the flight was that the flight attendant locked herself in her seat and refused to get out. She was so shaken up that I wouldn’t have been surprised if she quit her job after that flight.

Why am I taking the time to tell you my air travel woes? Right now the market is quite turbulent.  Many people are not very comfortable and they want off the plane.  When I fly today I know there are risks of turbulence, but I believe overall that the time benefits and safety of air travel outway the cost of driving across the country.

I believe investors need to take at least a 5 year time horizon.  We are invested in the market for long term results, short term turbulence is a natural part of investing.  Given the reasonable PE ratios of the market I’m going to keep my seatbelt fastened and continue dollar cost averaging in new money.

What are your thoughts about the turbulent market?

There are two types or IRAs, Roth and traditional.  Roth IRAs are great for new investments since the money grows tax free.   Of course if you exceed the income limitations then a traditional IRA is the next best option. The traditional IRA is used when rolling a 401K or 403b plan from your employer. I recommend setting up automatic monthly withdrawals from your checking account for discipline. The table below details the difference between the Roth and traditional IRA and the contribution limits.

 The contribution limit for IRAs increased to $5000 in 2008 ($6000 if you are 50 years old).  In future years the contribution limit will be indexed to inflation.

Follow your dreams, Achieve your goals!

If you don’t know where you are going, you’ll end up somewhere else.
-Yogi Berra

Once when hiking in a wilderness area, a tired and weary hiker approached me and asked directions to the trailhead. I pulled out my hike book and showed him the trail map. Quickly he identified the route back to his car. He thanked me, and with new energy he hiked off. I felt a great sense of satisfaction helping the hiker get back on course. I then thought, “How could he have gotten lost, there are only two turns that he had to make?” Later that day as I headed back toward the trailhead it became evident how the hiker missed a key turn. The path to the trailhead was so faint and the main trail was so dominant, you would have guessed it was a game trail. My thought at that point was, “Who would walk in the wilderness without a map?”

Do you have a financial plan? A clear map to help navigate you to retirement security and financial independance? I have created the following financial steps to to guide you through the finanical wilderness.

A complimentary PDF version of this test is posted at book resources 

1. Define your goals
Write down your dreams. Identify, clarify, and prioritize your goals. For each goal track the next actoin step that you can complete. Keep your goals visible and review your goals weekly.

2. Live within your means
Pay as you go! Spend less than you make every month. Maintain a balanced checkbook, put your credit cards on sabbatical, eliminate impulse purchases, save up for large purchases, detail your monthly cash flow, and reduce fixed and variable expenses. Achieving your goals is the motivation to reduce your spending.

3. Create and emergency fund
Create an emergency fund that is one-quarter of your montly living expenses, then gradually increase to a full month of living expenses. Only use the money for true emergencies such as medical expenses and car repairs.

4. Eliminate high interest debt
Eliminate all credit card and consumer (i.e. auto loans, student loans, etc) with greater than or equal to 6% interest. Attack outstanding loans with the highest interest rates and lowest remaining balances first.

5. Contribute 10% to retirement savings
Save 10% of your salary for retirement. Use automatic deductions and payments to contribute to your 401k/403b or a Roth IRA. If you can’t immediately save 10% of your income then take advantage of any matching available from your employer in your retirement plan. Increase your contributions both when you achieve pay increases and when you eliminate debt. Commit to save for the long haul. When changing jobs, roll your retirement plan to an IRA - avoid the temptation to cash out the money.

6. Pay off credit card and consumer debt
Attack and prepay all debt greater than 4% interest. Debts lower than 4% interest rates can be paid on the regular schedule. Do not incur any new consumber debt (i.e. auto loans, home equity lines of credit, etc). If you use credit cards then pay off the balance every month.

7. Fully fund your rainy day fund
Be prepared for the loss of a job or a serious medical event. Rainy day reserves help make lifes difficult transitions manageable. If you’re under 30 years old, save 3 months worth of living expenses. If you are between 30 to 40 then save 6 months of living expense. Above 40, accumulate 12 months of living expense.

8. Maximize retirement savings contributions
Fully contribute to your 401k/403B plans and Roth/traditional IRAs. Continue increasing your contributions until you reach 15% of your income. Either invest in index funds to keep expenses low and achieve market performance or invest in no-load mutual funds that outperform index funds.

9. Continuously build equity and then pay off your mortgage
Purchase a home with 30% down and fixed 15 or 30 year morgage. Do not take out home equity line loans. Pay off your mortgage to reduce your living expenses and achieve peace of mind.

10. Achieve retirement security / financial independence
Financial independence is the point at which your assets provide the necessary income to cover your expenses. You are now in the position to pursue your passions full time. You also can increase your giving.

Follow your dreams, Achieve your goals

How is your journey going?  What step number are you on?