Illustration by Tim Bower
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Web Exclusive…
Q&A With Finance Guru David Bach
November 2005, April 2006
Answers to reader-submitted questions
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When we posted the article "Start Late, Finish Rich" (September & October 2005), we invited readers to pose their own financial challenges to the author. David Bach's answers to selected questions are presented here. Thanks to everyone who submitted questions.
I recently changed employers. I like the investments in my old employer's 401(k) and would like to leave the money there. Do I have to withdraw this money and roll it into my new 401(k) plan or can I leave it in the old plan indefinitely?
You never want to leave money behind in an old 401(k) plan and here is why: When you leave your employer and you leave money in an old 401(k) plan, at the end of the day, you have given up control of your money.
Enron is a great example of this. What happened to Enron happens at a lot of companies, and I am not talking about the stock problems. During the time that their stock was starting to drop, Enron went through the process of moving their 401(k) plan from one provider to another provider. Companies do this all the time. For example, let's say your money is in a Vanguard 401(k) plan, and your former employer moves it to a Fidelity 401(k) plan. When the money is moved, the plan has to be frozen. In many cases, when employers move the money, you could be invested all in stocks and they may move you to a money market account. When the plan is frozen, you cannot get out of or change the plan. So, at Enron, when people left the company and their money behind in their Enron 401(k) plan, they could not sell their stock because the plan was frozen. Now, had departing employees done what is called a 401(k) rollover and rolled their money over into an IRA account in their own name, they would be in control of their money.
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So my first recommendation is always this: if you are in a 401(k) plan, when you leave an employer, you should choose one of two types of rollovers. With an IRA account you will be rolling your money over tax-deferred so as not to get hit with a tax withdrawal fee. In essence, the money goes from your 401(k) plan to an IRA account. The second option is to roll it into your new employer's 401(k) plan. Your question indicated that you like the investments that you already have in your 401(k) plan. In that case, let's go back and use Vanguard as an example. If you are in a Vanguard 401(k) plan, you can call Vanguard and ask them to switch you from your employer's 401(k) plan to an IRA account at Vanguard and use the same mutual funds. So, the fact that you like your investments in your old employer's plan does not mean that you have to leave money in it in order to keep those investments.
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What really are the best vehicles for saving for a child's college education? One of our children recently selected a private college, which is fine with us. During the financial aid assessment process, however, it seems as if we were penalized for being prudent with our spending habits in the past. What gives?
This is a great question with a really simple answer: 529 college savings plans. I love the 529 plans for several reasons: 1) You can put money in a 529 plan and it stays in the parents' or grandparents' name. It does not go into the child's name. The child can be the beneficiary of the 529 plan and use the money for education costs, but he or she does not control the money. This is a huge advantage over the old college savings plans typically referred to as UGMA accounts or Uniformed Gift to Minors Act accounts. In UGMA accounts, the child gets control of the money at the age of majority that you select, from 18 to 21. My recommendation, if you already have a UGMA account, is to make sure you choose the later age. Again, I like the 529 plans because the parent controls the money. 2) The money that you put in is after-tax money, so it grows tax-free. 3) If you take the money out for educational costs, it comes out tax-free.
A great website for 529 plans is www.savingforcollege.com. The fees inside some of these 529 plans are very high, so if you go with a 529 plan, remember to look for a low-cost plan. Also, check your individual state for tax deductions. For instance, I live in New York, and if you have a New York 529 plan, you actually get a New York State tax deduction. It is definitely worth looking into your own state's situation.
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My employer offers a 401(k) but doesn't match contributions. I have thought about discontinuing my contributions and putting the money into a Roth IRA instead. Would this be wise? I'm about seven years away from retirement.
No matter what, you should always use your employer's 401(k) plan and here's why. First of all, when you use a 401(k) plan at work, you have done a couple of critical things: 1) You are now paying yourself first. The only legal way to defer taxes is to use a tax-deductible retirement account. I recommend saving one hour a day of your income. Assuming you work a 40 hour workweek, keep one hour a day of your income. That should be your ultimate goal, which comes out to about 12½ percent of your gross income. Now, what about the fact that your employer does not match? Well, it is still a great plan for you to use because, again, you get a tax deduction. 2) You get to put money in the plan every two weeks and you get to do it automatically. It is very easy to use a 401(k) plan. All you have to do is go to your benefits department, sign up for it, and that money is going in your plan every two weeks, growing tax-free. 3) You can also borrow against your 401(k) plan. I do not necessarily recommend that, but it is an option that you have. Most 401(k) plans will allow you to borrow money up to $50,000, assuming you had $50,000 in the plan.
The last question you asked me is, do I think it is a good idea if you are seven years away from retirement to use a 401(k) plan, or should you use a Roth IRA. Again, this is my personal preference; I like the 401(k) plan because you are getting a tax deduction upfront. Now granted, when you go take the money out of a 401(k) plan, you will have to pay tax on the gains and tax on the money that you put in, so it is all going to be taxed at withdrawal. On the other hand, if you use a Roth IRA the money grows tax-free and then comes out tax-free, but that is because you did not get a tax deduction upfront. So, if your goal is to put as much money away as possible, I would go with the 401(k) plan; it is easier to save in those plans because you get a tax deduction. If it is more important for you to have tax-free money when you retire, a Roth IRA could be the way to go.
Ultimately, I like the 401(k) plans better because you can put more money away, it is easier, and in most cases, it is cheaper because you are not paying a fee for the 401(k) plan.
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Is it better to pay off debt before purchasing a home or to still have debt but be in good standing?
You should not worry about paying off your debt before purchasing a home. Many people wait to purchase a home, wait to pay off all their credit cards and never get around to purchasing a home. My recommendation is, if you have debt, you should still be trying to save money to buy a home. Here is an example I use: if you have $50,000 in student loans, you should not wait to pay off all your student loans before you buy a home. If you do that, you could be 45 before you buy a home. Now credit card debt, that's a different ballgame. If you are carrying $20,000 in credit card debt at 19 percent interest, it is very hard to get ahead. What I would focus on first is getting the credit cards paid down as fast as possible, and getting the interest rate lower on those credit cards. I still think buying a home is the single most important investment decision you will ever make. A good friend of mine, Tom, had $15,000 in credit card debt. I recommended to him that he go and buy a home anyway. Ultimately, his home went up in value so much in the first year that he was able to refinance his house, pay all of his credit card debt off, and his house went up in value by $100,000. Three years later, that same house had gone up in value by $250,000. Tom is completely out of credit card debt and now he has $250,000 in the bank because of his first house. So, I think buying a home is a really good idea. I highly recommend it.
I am a 21-year-old college student. I just started using credit cards and they are ruining my life. I cannot believe how much debt I have accumulated in just a few months. Most of my money was spent at Starbucks and on clothes. I have a few necessary expenditures, such as my car insurance, car payment, maintenance on my car, and my cell phone bill. I don't pay rent or buy my own food. During the summer I bring home about $400 a week; during the school year I make $225 per week. I have about $1,900 in credit card debt. What budget would you recommend for this 21-year-old fashion and Starbucks fanatic?
Here is my answer to you, my friend: you have what I call a Latte Factor and I think you know it. You are $1,900 in credit card debt at the age of 21. While that is not horrible, you could easily get yourself into trouble because you are spending more money than you earn. My recommendation is for you to do the following: for one week, I want you to track where all your money goes. I mean everything, including cash, checks, and credit cards. At the end of the week, go to our website, www.finishrich.com. You will find a Latte Factor calculator for you to calculate how much all of your expenses could be worth to you later. Focus on finding the money that is going toward all the little extra things that add up (cell phone, candy, lattes, etc.). The key thing for you to realize is that small amounts of money add up. If you spend an extra $10 a day, at the end of the month, you spend an extra $300. If you put that on your credit card, at the end of the year you are up to $4,000 when you factor in interest. Now do that for just two years and before you know it, you could have close to $10,000 in credit card debt. If you pay just the minimum on your credit card debt, it could take you 37 years to fully pay it off. So basically, for the rest of your life you will be in credit card debt that only took you two years to get into by only spending an extra $10 a day.
So watch your Latte Factor. As for the credit card debt that you have already, try to find the money to pay it off now. First, call the credit card companies today and ask if they will lower your interest rate. If they will not, try to transfer your credit card debt to a zero-percent-interest credit card. You can find some good deals on credit cards right now at www.lowermybills.com and www.bankrate.com.
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I have $50,000 in an IRA, but due to a job loss in 2004, also have about $50,000 in credit card debt. Should I use the IRA to pay off the debt?
Okay, this is a great question. The simple quick answer is no. Let me explain why. If you take $50,000 out of your IRA account, two things are going to happen. Assuming you are under the age of 59, and I am going to make that assumption, you are going to get hit with tax penalty from the government. All right? So that tax penalty is going to start at 10 percent. You are also going to be hit with ordinary income tax, and because you are taking so much out at once, it is probably going to kick you into a higher tax bracket. So, let us just assume that on $50,000 out of your IRA account, easily $20,000 of it is going straight to the government, probably more. That leaves you with $30,000, and you still will not be able to pay yourself out of credit card debt. Number two, you lose tax advantaged money. In other words, the money you have in your IRA account that can grow tax-free until you retire, you lose that. The real question becomes, how are you going to get out of credit card debt? And for that, I recommend to you that you read a book I wrote called The Finish Rich Workbook which focuses on how to get yourself out of credit card debt. You can also go to my website and read about DOLP, which stands for Dead On Last Payment. It is a way to refinance your credit cards and the order in which you pay your credit cards off. The biggest things that will keep you from paying your credit cards off right now are really simple: high interest rates and making minimum payments. You are going to have to accelerate your payments and the easiest way to do that is get your interest rate on these credit cards lower. The good news right now is that many credit card companies are offering zero-percent-interest-rate credit cards now for up to a year. In some cases, they are even offering it for up to 15 months, so you really need to shop around for a better deal on your credit card and that should help you. Do not take your money out of your IRA account. I think it is a huge mistake. Use it as your last option.
What's going on with inflation bond funds? Year to date they've returned 0.3 percent or so. Some junk bond funds, meanwhile, are at 5 percent or more. You would think I-bond funds would at least stay even with inflation—after all, isn't that what I-bonds are supposed to be all about? What's going on?
What is going on with inflation bonds? Nothing. Inflation bonds are doing just fine. What happens is this: When interest rates go up, the price of a bond drops. So right now you are looking at the face value of your bonds but with an I-bond, realistically, you will be holding this I-bond for a period of time. Probably up to five years. In which case the I-bonds that you have purchased, probably off the government's website, are just fine. They do keep track with inflation and, in fact, in this low-interest rate environment, I-bonds are outperforming most things that you can get at the bank, including savings accounts and one-year CDs. So do not fear. Your I-bonds are just fine. I happen to be a big believer in I-bonds and I think they are a very good investment for conservative investors who are not looking for a high rate of return but just want other money saved that can keep place with inflation. I think it will be just fine.
I'm a "late starter" at saving. Six years ago I signed up for deferred comp savings through my employer. Problem is, I have made zip. Fifty dollars a month is automatically deducted from my paycheck. I've thought about increasing the amount but considering my money is not growing, I'm reluctant. The amount I'm saving is small, but I feel my balance should be more than the amount invested. What do you suggest?
Yes, if you are a late starter, you absolutely should save $50 a month automatically. In fact, the truth is you should save more, so the fact that you want to increase the amount is the right decision to make. Now the question becomes, why is the money that you are saving not growing? I really do not know because you do not say in your email what you are putting your money into. My guess is you are putting most of your money into a stock fund, and the stock market, quite honestly at this point, is lower than where it was five years ago. So if your account has not gone up a lot in the last five years, my guess is it is because you are in an aggressive growth mutual fund. I would go back and look at the mutual funds that you are investing in. I would do a balanced portfolio where you have got some in guaranteed investments, some in bonds, some in stocks, and some in global accounts. Contact your financial advisor or you could even call your 401(k) provider and see if they can give you some advice on the funds that you are selecting. Remember, your investments should be boring and your life should be interesting. And absolutely increase how much money you are putting away automatically.
I have an equity note on my home. I would like to pay additional money on the principal. Is it wiser to pay the additional amount monthly or save the money and pay the extra at the end of the year, or does it matter?
There are a couple ways you can accomplish this. 1) You can add money to your monthly check that you send in and tell them to add the extra money towards your principal. This is not necessarily how I would choose do it. I would actually write a separate check or do a separate wire transfer into your account that goes towards the principal because it is easier to track whether or not they have credited the principal on your mortgage. 2) Or, you could simply switch your mortgage to what is called a biweekly payment plan. What that means is you can call your bank or go to a company, like Paymap, and you can switch your account from paying once a month to having them take money out of your bank account and paying half of your monthly mortgage every two weeks. What this does is make you automatically do one extra payment a year, and what that will do on a 30 year mortgage is pay your mortgage off about five to seven years early, depending on your interest rate. You will get that mortgage paid off in 23 years. But if you do not want to pay the small fee required to do a biweekly mortgage, you can simply add some extra money or you can make one extra mortgage payment at the end of the year. For most people, however, making one extra payment at the end of the year usually does not work because they run into the holidays and do not have any extra money. A good time of the year to do it is often April or May, when you get your tax refund check. And then take your refund and apply it to the principal. That will get your home paid down early.
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David Bach is the author of Start Late, Finish Rich (Broadway Books, 2005). The Latte Factor is a registered trademark of Finish Rich Inc.
Listen to an interview with David Bach on AARP Radio.
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