Sunday, July 15, 2012

Paying Off Student Loans Early Strategies

In the current depressed economic climate, many young professionals are having a difficult time staying current with the monthly payments on their student loans. However, for 20 somethings that have been lucky enough to get a good paying job and are interested in paying off their student loans early they have a couple of options.

One strategy is that any extra money, money above the monthly loan payment, should be put towards the loan with the highest interest rate. This strategy minimizes the total amount of interest that will be paid over the life of a 20 something's student loans.  From a purely monetary standpoint this is the cheapest strategy to employ.

The other strategy that is promoted by many people, including popular financial adviser Dave Ramsey, is to put the extra money towards the loan with the smallest balance. The benefit of this strategy is that a young professional can minimize the amount of payments they have to make each month. By paying off the smaller loans quickly, a 20 something can see very clearly the tangible benefit of putting there extra money towards their student loan debt. Also, once a small loan is paid off the money that had been allocated for that loan can be put towards the next smallest loan and so on. This is called payment "snowballing".

My Opinion: With my background as an engineer and being a confessed "numbers guy" I choose to utilize the strategy of putting my extra money towards the loans with the highest interest rates. I am very dedicated and interested in managing my finances, so I use the strategy that is the cheapest. I do this because I have little fear of losing interest even though I haven't paid off any of my loans yet. I do believe that for somebody who is not as interested in money and has a more difficult time managing their finances, that the strategy of paying off smaller loans first is the better choice. Typically these people need to see the gratification of paying off loans along the way to stay focused on paying extra towards their loans versus going to the mall to get that feeling.

Which school of thought do you follow?

Thursday, July 12, 2012

Roth IRA Perks for Generation Y

Roth IRAs are wonderful investment vehicles for all people who meet their requirements as listed below:
  • Single filers: Up to $110,000 (to qualify for a full contribution); $110,000–$125,000 (to be eligible for a partial contribution)
  • Joint filers: Up to $173,000 (to qualify for a full contribution); $173,000–$183,000 (to be eligible for a partial contribution)
Perks for All: The fact that any withdrawals in retirement are tax exempt is a wonderful perk. Also, the fact that there are no required withdrawals during retirement, as there are with a Traditional IRA and 401K, is beneficial as well. In addition to these perks Roth IRAs hold additional benefits for 20 somethings. 

Tax Bracket Advantage: For young professionals just starting out their salary is as low as it ever will be. In most cases 20 somethings are in the lowest tax bracket they will be in during their entire career. With this being said it makes sense for them to take the tax hit up front as opposed to using a tax deferred account (401K/Traditional IRA). With the current economic outlook, I believe that income tax rates will only go up from today and could be dramatically higher 40 years from now. For this reason young professionals should pay the tax man now to ensure future savings when they hit retirement.   

Combined Retirement/Emergency Savings: Most young professionals don't have the ability to save for retirement, emergencies and big ticket items simultaneously. That is why the fact that all contributions (not interest or returns) to a Roth IRA can be taken out at any time without penalty is so crucial for a 20 something. This means that in the event your car breaks down or you have an unexpected medical emergency the money you have saved can be tapped without penalty. I believe that all young professionals should use Roth IRAs for rainy day funds.

Retirement Saving For Beginners

How to Start: The sooner a young professional can start saving for retirement the longer they can let the miracle of compound interest work for them. I know that most 20 somethings that are fresh out of college feel like there is no extra money for retirement savings once all the bills are paid (student loans anyone?). I have two pieces of advice for these retirement virgins:
  1. Start Small
  2. Make it automatic
By starting small and making the process painless by automation, you can exponentially increases the likely hood that you will be able to make retirement saving a positive habit. If a young professional is lucky enough to get a match on their 401K at work they should start saving $50 - $100 dollars per month in their plan. By setting this up through their plan the money will be automatically contributed out of each paycheck. The goal in this case is to increase the monthly contributions to the maximum amount that the employer will match ASAP (within a year if possible). By slowly escalating the amount saved each month you won't see a dramatic step change in their disposable income which as I previously mentioned will increase the chances that the habit will be manageable and sustainable. 

No 401K?: In the event that a 401K is not offered by your employer I would recommend saving through a Roth IRA and a low cost provider like Vanguard. I would still start with $50 - $100 per month with increases as possible.  

Investment Choices: In either the 401K or Roth IRA method I would recommend that a 20 something that is an investing novice put their savings into a low fee Stock Index Fund. An index fund will mirror the stock market as a whole. This eliminates the need for a young professional to know anything about the stock market. The index fund will have moderate risk for a stock fund and the low fees will help boost the compounded return. I would recommend a 90% - 100% stock allocation for a young professional because they should have at least 30 years until retirement which allows them to take the additional risk that stocks have over bonds or money market funds. Over a 30 year time frame stocks have historically had the best return of any investment class. For a super risk adverse individual I would recommend putting 10% of their savings in a total Bond Fund to offset some risk.

Disclaimer for Those with Credit Card Debt: The only instance when I recommend that an young professional not save for retirement is when they have outstanding credit card debt. Credit card debt is typically over 10% interest which is higher than a reasonable return from the stock market. In this case it doesn't make sense to make 10% return on your retirement savings when you are paying 20% interest on your credit card debt. The best financial decision in this scenario is to focus on paying off the credit card debt ASAP, and then utilize the methodology I outlined above.

Summary: For any young professional just starting to save for retirement you should start small ($50-$100 per month), automate contributions, increase contributions incrementally, and focus on low cost stock index funds. This simple recipe will start you down the path of comfortable retirement.

Retirement Savings Options for a Young Professional

Is this type of retirement still possible?

Retirement is the last thing on the minds of many young professionals. However, with all of the turmoil caused by the recent market crash and ongoing global economic recession this should receive much more attention. To reach reach retirement comfortably young professional should start laying the ground work for retirement during their 20's when time is on there side. I've heard many young adults say that they don't know anything about investing so they never get started. The following is my attempt at a high level overview of the 3 most widely used options the 401K, the Traditional IRA, and the Roth IRA.

Traditional 401K

A 401K is a tax deferred account that is provided by an employer to its employees. In these employee sponsored plans the employee elects a percentage of their before-tax income to contribute to the account. This is known as the employee contribution. Many companies elect to also contribute to the account based on how much the employee is willing to contribute. Most companies utilize a program where they match X percent on the first X percent the employee contributes (example: 100% match on the first 3% of the employee's before tax income).


There are two big advantages of a 401K:
  1. The money contributed is not taxed up front and is only taxed one time (upon withdrawal). This allows for a larger starting amount that can appreciate with compounding interest.
  2. Any employee contribution is essentially free money. In the event that an individual is lucky enough to get a 100% match on some percentage they contribute, they are essentially guaranteed a 100% return on their money before they even invest it. 
  3. A larger amount of money can be invested in a 401K than any type of IRA ($17,000 for 2012, $22,000 if over 50 years old)


There is one main disadvantage to a 401K:
  1. A 401K plan only allows the individual to invest in a small number of funds provided by the employer or the administrator of the plan.  Typically 401K's do not have the quality or quantity of options that an IRA has. Also the funds provided in a 401K package typically have higher fees than funds found in IRA's. These higher fees can decrease the overall return by over 1%.
  2. The money invested in a 401K cannot be withdrawn before the age of 59 1/2 without paying income taxes and an additional 10% penalty.
  3. An individual must start taking distributions from the account at 70 1/2. This forces the individual to take money out every year even if they do not want to.

Traditional IRA

A traditional individual retirement account (IRA) is another type of tax deferred account. A bank or brokerage house serves as custodian of the account and determines the funds that the individual can invest in.  Typically these custodian companies allow the individual to invest in every type of fund imaginable.  Any individual is able to open a traditional IRA as long as they have the money to make the minimum contribution. However, an IRA does have a maximum annual contribution which for 2010 was $5,000 for ages 49 and under, and $6,000 for ages 50 and above.


A traditional IRA has two advantages:
  1. Like the 401K a traditional IRA is a tax deferred account where the money is only taxed upon withdrawal. This gives a head start to compounding interest.
  2. The traditional IRA has more quality and quantity of investing options.  In an IRA an individual can invest in nearly anyway they choose.


The traditional IRA has two main disadvantages:
  1. Depending on your age you may only contribute $5,000 or $6,000 per year. This means if you are lucky enough to have more that that amount to save towards retirement each year you will have to look at another account type for the rest of your savings.
  2. As with the 401K, an individual must start taking distributions from the account at 70 1/2
  3. As with the 401K, any withdrawals made before 59 1/2 will be hit with a 10% penalty.

Roth IRA

A Roth IRA is similar to a traditional IRA in structure. It is managed by a bank or brokerage institution. However, there are many differences between the two. A Roth IRA is not a tax deferred account.  The money contributed to a Roth IRA is "after tax" money, but the money is not taxed when withdrawn from the account.


The Roth IRA has a couple of advantages:
  1. The money contributed to the account is "after tax" money.  This means that at any time the money contributed can be withdrawn from the account (not including interest) without penalty.
  2. There is no age at which distributions are required.  The individual can leave their money in the account for as long as they want. This makes a Roth IRA a good way to leave money as an inheritance.


The Roth IRA has one disadvantage:
  1. Depending on your age you may only contribute $5,000 or $6,000 per year. This means if you are lucky enough to have more that that amount to save towards retirement each year you will have to look at another account type for the rest of your savings.

I hope this overview will start to get young adults thinking about which investment type could work for them. In subsequent posts I plan to build on this overview and discuss retirement strategy as well as other savings such as emergency savings, large purchase (house/car) savings etc.